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CIMA F3 practice questions

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Question 1Financial strategy formulation

A company's board is deciding whether to enter a new overseas market. In CIMA's strategic planning framework, which activity best describes formulating the financial strategy that supports this decision?

  1. Calculating the monthly payroll for transferred staff
  2. Recording the daily sales transactions once the new market opens
  3. Selecting the financing mix and investment criteria that will fund and appraise the market entry Correct answer.
  4. Preparing the annual statutory accounts for the overseas subsidiary

Explanation

Financial strategy formulation sets long-term financing and investment policy that align with corporate objectives, so choosing the funding mix and appraisal criteria for a market entry is a strategic finance task. The other activities are operational accounting processes that follow once strategy is set.

Question 2Financial strategy formulation

Which statement best captures the relationship between an organisation's mission and its financial strategy?

  1. Financial strategy replaces the mission once budgets are prepared
  2. The two are independent because finance deals only with numbers
  3. The mission is derived from the financial strategy after capital is raised
  4. Financial strategy should translate the mission into measurable financial objectives and resource allocation Correct answer.

Explanation

The mission states the organisation's purpose, and financial strategy operationalises it through objectives, targets and allocation of capital. Strategy formulation therefore flows from mission to financial goals rather than the reverse.

Question 3Financial strategy formulation

A listed company states that its primary financial objective is shareholder wealth maximisation. Which measure is most directly consistent with this objective?

  1. Increase in the book value of non-current assets
  2. Reduction in the number of employees
  3. Growth in total sales revenue
  4. Increase in the market value of equity plus dividends paid Correct answer.

Explanation

Shareholder wealth is increased by capital gains in share price plus dividends received, so total shareholder return captures both components. Revenue growth or asset growth only matter if they ultimately raise the value delivered to shareholders.

Question 4Financial strategy formulation

An analyst is assessing whether a company's strategy creates value. Which concept requires that the return generated exceeds the cost of the capital employed?

  1. Current ratio
  2. Dividend cover
  3. Economic value added Correct answer.
  4. Gross profit margin

Explanation

Economic value added deducts a charge for the cost of capital from operating profit, so positive EVA signals that returns exceed the required return on capital. The other ratios are accounting measures that ignore the cost of capital.

Question 5Financial strategy formulation

In stakeholder analysis, which group would typically be classified as having high power but low interest in a company's day-to-day financial strategy?

  1. A government regulator that sets industry rules but does not monitor routine operations Correct answer.
  2. A major lender with covenants and board representation
  3. The finance director who prepares the strategy
  4. Employees whose pay and conditions depend on company performance

Explanation

Under the power-interest grid, a regulator with rule-setting authority but limited routine involvement sits in the high-power, low-interest quadrant and should be kept satisfied. Employees, lenders and the finance director all have direct, ongoing interest.

Question 6Financial strategy formulation

Which of the following is the clearest example of an agency problem in a listed company?

  1. A bank charging interest on a term loan
  2. A firm issuing shares to fund a value-adding project
  3. A company paying dividends out of distributable reserves
  4. Managers pursuing acquisitions that enlarge their empire but dilute shareholder returns Correct answer.

Explanation

Agency problems arise when managers act in their own interests rather than those of shareholders, such as empire-building acquisitions that serve managerial prestige. The other options are normal financing or distribution transactions.

Question 7Financial strategy formulation

A company wishes to reduce the risk of relying on a single customer for most of its revenue. Which strategic response does this represent?

  1. Diversification of the customer base Correct answer.
  2. Working capital tightening
  3. Financial gearing reduction
  4. Vertical integration backwards

Explanation

Diversifying the customer base spreads revenue risk so that the loss of one buyer does not threaten the business. Backward integration, gearing and working capital changes address different risks.

Question 8Financial strategy formulation

A not-for-profit organisation states that its objective is to maximise the social value delivered per unit of funding received. Which term best describes this type of objective?

  1. Profit maximisation
  2. Shareholder return
  3. Capital gearing
  4. Value for money Correct answer.

Explanation

Value for money expresses the relationship between the economy, efficiency and effectiveness of resource use and the outcomes achieved. Profit and shareholder return are commercial objectives, and gearing is a financing measure.

Question 9Financial strategy formulation

A manufacturer's board is weighing whether to build a new plant or to license its process to an overseas partner. Which stage of the strategy formulation process does this decision represent?

  1. Strategic choice between alternative courses of action Correct answer.
  2. Environmental scanning of external trends
  3. Setting the mission statement
  4. Post-completion audit of a finished project

Explanation

Choosing between building a plant and licensing is a strategic choice among feasible options generated after analysis. Environmental scanning and mission setting precede the choice, and post-completion audit follows implementation.

Question 10Financial strategy formulation

A company has a return on capital employed of 12 per cent and a weighted average cost of capital of 9 per cent. What does this imply about value creation?

  1. The company is destroying value because ROCE is above WACC
  2. The company is generating positive economic spread and creating value Correct answer.
  3. The company is exactly at break-even in economic terms
  4. The company cannot assess value creation without dividend data

Explanation

When ROCE exceeds WACC, the return on invested capital is above the required return, producing a positive economic spread and value creation. Dividend policy affects distribution, not the existence of the spread.

Question 11Financial strategy formulation

Which factor would most likely increase the power of a supplier in Porter's five forces analysis?

  1. Switching costs for buyers are negligible
  2. The supplier's product is highly differentiated and has few substitutes Correct answer.
  3. There are many alternative suppliers offering identical components
  4. The buying industry is highly concentrated relative to suppliers

Explanation

Supplier power rises when its offering is differentiated and hard to substitute, giving it bargaining leverage. Many alternative suppliers, concentrated buyers and low switching costs all reduce supplier power.

Question 12Financial strategy formulation

A company operates in a mature industry with stable cash flows and few growth opportunities. Which financial strategy is most appropriate?

  1. Invest heavily in research and development for new products
  2. Maintain moderate gearing and return surplus cash to shareholders Correct answer.
  3. Increase gearing to the maximum level permitted by lenders
  4. Retain all earnings to fund aggressive expansion

Explanation

Firms in mature, cash-generative industries typically carry moderate debt and distribute surplus cash when reinvestment opportunities are limited. Retaining all earnings or maximising gearing would misallocate capital given the lack of growth projects.

Question 13Financial strategy formulation

A company's directors are considering a takeover that would significantly increase the size of the group and their own remuneration. Which governance mechanism is most directly designed to constrain such behaviour?

  1. Reducing the dividend payout ratio
  2. Independent non-executive directors and performance-related pay linked to shareholder return Correct answer.
  3. Extending supplier payment terms
  4. Increasing the marketing budget

Explanation

Independent non-executive oversight and remuneration aligned with shareholder return are core governance mechanisms that curb managerial self-interest. Marketing, payment terms and dividend changes do not address the agency conflict.

Question 14Financial strategy formulation

Which statement best explains why a company might adopt a strategy of related diversification rather than unrelated diversification?

  1. Unrelated diversification guarantees higher returns than related diversification
  2. Related diversification avoids the need for any financial appraisal
  3. Related diversification always eliminates business risk entirely
  4. Related diversification can exploit shared capabilities and reduce risk while retaining strategic fit Correct answer.

Explanation

Related diversification builds on existing skills, brands or technologies, creating synergies and strategic fit that unrelated diversification lacks. No diversification strategy removes all risk or removes the need for appraisal.

Question 15Financial strategy formulation

A company's board is setting objectives for the coming five years. Which objective is best expressed in a way that is consistent with good strategic practice?

  1. Increase return on capital employed from 10 per cent to 13 per cent by year five Correct answer.
  2. Become a better company
  3. Grow as much as possible
  4. Improve performance significantly

Explanation

Good objectives are specific, measurable, achievable, relevant and time-bound, and the ROCE target meets these criteria. Vague aspirations such as becoming better or growing as much as possible cannot be monitored or appraised.

Question 16Financial strategy formulation

A company operates in a highly cyclical industry. Which financial policy would best support strategic resilience through a downturn?

  1. Committing all available cash to a single large project
  2. Borrowing heavily on short-term overdraft to fund expansion
  3. Maintaining lower gearing and a buffer of undrawn committed facilities Correct answer.
  4. Relying on a single customer for revenue

Explanation

Cyclical businesses benefit from conservative gearing and committed liquidity buffers so they can survive troughs and fund opportunities. Heavy short-term borrowing, cash concentration and customer concentration all increase vulnerability.

Question 17Financial strategy formulation

A company is evaluating whether to outsource its logistics function. Which consideration is most relevant to the financial strategy dimension of this decision?

  1. The names of the logistics provider's directors
  2. The colour scheme of delivery vehicles
  3. The location of the provider's head office
  4. The net present value of incremental cash flows and the effect on the firm's cost structure Correct answer.

Explanation

Financial strategy evaluates outsourcing through the incremental cash flows, cost structure and value impact, typically using NPV. Cosmetic, personnel or geographic details are not financial strategy considerations.

Question 18Financial strategy formulation

A company's mission emphasises environmental sustainability. Which financial strategy action would most clearly align with this mission?

  1. Cutting the training budget to reduce costs
  2. Delaying supplier payments to improve cash flow
  3. Applying an internal carbon price when appraising capital projects Correct answer.
  4. Reducing the dividend to increase director bonuses

Explanation

An internal carbon price embeds the sustainability mission into investment appraisal, aligning financial decisions with the stated purpose. The other options pursue short-term financial or personal gain without regard to the mission.

Question 19Financial strategy formulation

A company is considering entering a foreign market and faces political risk in the target country. Which financial strategy response is most appropriate?

  1. Financing the entire investment with short-term local debt
  2. Transferring all cash out of the country immediately
  3. Denominating all revenues in the home currency regardless of local practice
  4. Structuring the investment through a joint venture with a local partner and arranging political risk insurance Correct answer.

Explanation

Sharing ownership with a local partner and using political risk insurance are established ways to mitigate expropriation and political risk. Short-term debt, rapid cash repatriation and currency mismatches can worsen exposure.

Question 20Financial strategy formulation

A conglomerate's board is debating whether to divest a low-return division. Which argument most strongly supports divestment from a financial strategy perspective?

  1. The division's products are the most familiar to the board
  2. The division has the longest history in the group
  3. The division employs the most staff
  4. The division's return on capital is below the group's cost of capital and capital could be redeployed to higher-return uses Correct answer.

Explanation

Divestment is justified when a division earns less than the cost of capital and the released capital can generate better returns elsewhere. Longevity, headcount and familiarity are not financial value criteria.

Question 21Financial strategy formulation

A company's shareholders are widely dispersed and the board proposes a rights issue to fund an acquisition. Which factor is most likely to determine whether the acquisition creates value for shareholders?

  1. Whether the acquisition increases the number of employees
  2. Whether the acquired business earns returns above the cost of capital after the acquisition premium Correct answer.
  3. Whether the acquisition increases the group's total revenue
  4. Whether the acquisition is financed by equity rather than debt

Explanation

Value creation depends on post-acquisition returns exceeding the cost of capital, including the premium paid. Revenue growth, headcount and the choice of financing do not by themselves establish value creation.

Question 22Financial strategy formulation

A company's board is considering a share buyback funded by new debt. Which consequence should the board weigh most carefully in its financial strategy?

  1. The increase in financial gearing and reduced financial flexibility Correct answer.
  2. The effect on the company's brand image
  3. The change in the accounting depreciation policy
  4. The reduction in the number of shares in issue

Explanation

Debt-funded buybacks raise gearing and reduce headroom, increasing financial risk and reducing flexibility to respond to future events. The share count falls but that is the mechanism, not the key risk, and brand and depreciation are unrelated.

Question 23Financial strategy formulation

A company's strategy involves significant investment in new technology with highly uncertain outcomes. Which approach to financial strategy formulation best suits this environment?

  1. Relying solely on payback period to screen projects
  2. Committing the full budget upfront to a single design
  3. Avoiding any quantitative appraisal
  4. Using staged investment with decision gates and real options analysis Correct answer.

Explanation

Staged funding with decision gates and real options analysis allows the company to commit capital progressively as uncertainty resolves. Upfront commitment, payback-only screening and avoiding appraisal all fail to handle uncertainty well.

Question 24Financial strategy formulation

Which statement best distinguishes strategic financial management from routine financial management?

  1. Strategic financial management focuses on daily cash bookkeeping
  2. Strategic financial management focuses on long-term value creation and resource allocation aligned with corporate objectives Correct answer.
  3. Strategic financial management focuses on preparing monthly management accounts
  4. Strategic financial management focuses on payroll and tax compliance

Explanation

Strategic financial management is concerned with long-term direction, value creation and the allocation of scarce capital consistent with corporate objectives. Management accounts, payroll and bookkeeping are routine operational finance tasks.

Question 25Financial strategy formulation

A company's board is reviewing its dividend policy. Which consideration is most consistent with the residual theory of dividends?

  1. Dividends should be paid regardless of available cash
  2. Dividends should be maximised to signal confidence
  3. Dividends should always equal a fixed percentage of revenue
  4. Dividends should be paid only from earnings left after funding all positive-NPV projects Correct answer.

Explanation

Under the residual theory, retained earnings are first applied to positive-NPV investments and any surplus is distributed as dividends. Fixed percentages of revenue, payments without cash and maximisation ignore investment needs.

Question 26Financial strategy formulation

A board is drafting a financial strategy to support a stated corporate goal of doubling shareholder value over five years. Which characteristic must the financial strategy have to be judged fit for purpose?

  1. It must prioritise short-term earnings per share growth over long-run cash generation.
  2. It must be aligned with and derived from the corporate strategy rather than set independently of it. Correct answer.
  3. It must be delegated in full to the finance director without board-level review.
  4. It must avoid setting measurable financial targets so that it remains flexible.

Explanation

Financial strategy is a subordinate, enabling strategy: it exists to resource and fund the corporate strategy, so its targets, funding choices and investment criteria must flow from the corporate plan. A strategy set independently, or one that sacrifices long-run value for short-term metrics, cannot be fit for purpose.

Question 27Financial strategy formulation

A retail group states that its financial objective is to achieve a return on capital employed of at least 15 per cent within three years. Which feature makes this objective suitable for guiding financial strategy?

  1. It refers only to accounting profit and ignores the capital invested.
  2. It is unquantified and therefore leaves management free to choose any project.
  3. It is set for an indefinite horizon, allowing managers to defer action.
  4. It is expressed as a ratio that can be compared with the group's cost of capital. Correct answer.

Explanation

A ROCE target is useful because it can be benchmarked against the weighted average cost of capital, so the board can judge whether returns exceed the cost of the funds employed. It is quantified and time-bound, which makes it monitorable.

Question 28Financial strategy formulation

A company's directors want to raise new equity but fear that a large issue would dilute control of existing family shareholders. Which financing route best addresses this concern while still raising new equity capital?

  1. A rights issue made to existing shareholders in proportion to their holdings. Correct answer.
  2. A public offer for sale of new shares to the general investing public.
  3. An issue of convertible loan notes to a venture capital fund.
  4. A placing of new shares with a small group of institutional investors.

Explanation

A rights issue offers new shares to existing holders pro rata, so shareholders who subscribe keep their proportional stake and control is preserved. A placing or public offer brings in new holders who dilute existing voting percentages.

Question 29Financial strategy formulation

A company's board is choosing between paying a special dividend and retaining the cash for future investment. Under the residual theory of dividends, what determines the dividend decision?

  1. Dividends are maintained at the prior year's level to signal stability to the market.
  2. Dividends are paid only from cash left after all positive-net-present-value investment opportunities have been funded. Correct answer.
  3. Dividends are set at a fixed percentage of accounting profit regardless of investment needs.
  4. Dividends are paid only when the company has surplus cash and no debt outstanding.

Explanation

The residual approach treats retained earnings as the cheapest source of equity finance and pays a dividend only from what remains after funding all value-adding projects. Investment needs therefore drive the dividend, not a fixed payout ratio.

Question 30Financial strategy formulation

A company's share price is currently 400 cents and it announces a 1-for-4 rights issue at 300 cents per share. What is the theoretical ex-rights price per share?

  1. 375 cents
  2. 350 cents
  3. 325 cents
  4. 380 cents Correct answer.

Explanation

Four existing shares at 400 cents plus one new share at 300 cents gives a total value of 1,900 cents for five shares. Dividing by five gives a theoretical ex-rights price of 380 cents.

Question 31Financial strategy formulation

A company has a dividend cover of 3 times and earnings per share of 45 cents. If the board wishes to reduce dividend cover to 2 times while holding earnings constant, what dividend per share must be declared?

  1. 45 cents
  2. 22.5 cents Correct answer.
  3. 15 cents
  4. 30 cents

Explanation

Dividend cover equals EPS divided by dividend per share, so a cover of 2 times with EPS of 45 cents implies a dividend of 22.5 cents. Reducing cover means paying out a larger share of earnings.

Question 32Financial strategy formulation

A company is financed 60 per cent by equity and 40 per cent by debt on a market value basis. The cost of equity is 12 per cent, the pre-tax cost of debt is 6 per cent and the corporate tax rate is 25 per cent. What is the weighted average cost of capital?

  1. 10.2 per cent
  2. 9.0 per cent Correct answer.
  3. 7.8 per cent
  4. 8.4 per cent

Explanation

The after-tax cost of debt is 6 per cent times 0.75, which is 4.5 per cent. Weighting gives 0.6 times 12 per cent plus 0.4 times 4.5 per cent, equal to 7.2 plus 1.8, or 9.0 per cent.

Question 33Financial strategy formulation

A divisional manager is evaluated on divisional return on investment and rejects a project that would earn 14 per cent when the division currently earns 18 per cent and the company's cost of capital is 10 per cent. Which critique of this behaviour is most valid?

  1. The manager is correct to reject the project because it would lower the division's average return.
  2. The manager should accept the project only if it is funded entirely from retained cash.
  3. The manager is acting rationally under the ROI measure but destroying group value, since the project exceeds the cost of capital. Correct answer.
  4. The manager's decision is irrelevant because ROI and cost of capital measure different things.

Explanation

ROI-based appraisal can cause goal congruence problems: a manager whose bonus depends on the divisional percentage may reject any project below the current average even when it earns more than the cost of capital. The project adds value to the group, so the rejection destroys value.

Question 34Financial strategy formulation

A company has 200 million shares in issue and announces a 2-for-5 bonus issue. What is the number of shares in issue immediately after the bonus issue?

  1. 280 million Correct answer.
  2. 240 million
  3. 200 million
  4. 320 million

Explanation

A 2-for-5 bonus issue adds two new shares for every five held, a 40 per cent increase. Applying 40 per cent to 200 million gives 280 million shares, with no change in total shareholders' funds.

Question 35Financial strategy formulation

A company's gearing measured as debt to equity at book values is 25 per cent, but at market values it is 60 per cent because its shares trade well below book value. Which measure is more relevant to a lender assessing financial risk?

  1. The market value measure, because it reflects the current value of the assets and claims available to the lender. Correct answer.
  2. Neither measure, because gearing is irrelevant to lenders once a loan has been granted.
  3. The higher of the two measures, because prudence requires using the most conservative figure.
  4. The book value measure, because accounting carrying amounts are objective and audited.

Explanation

Lenders care about recoverable value, so market-based gearing better reflects the cushion protecting their claims. Book values are historical and can materially overstate the security available if assets have fallen in value.

Question 36Financial strategy formulation

A company is considering whether to hedge a forecast foreign currency receipt in nine months' time. Which risk does the hedge primarily address?

  1. Economic risk arising from long-run changes in the competitive position of the business.
  2. Transaction risk arising from the exposure of a known future foreign currency cash flow. Correct answer.
  3. Translation risk arising from converting overseas subsidiaries' net assets at the year end.
  4. Political risk arising from possible expropriation of overseas assets.

Explanation

A known future receivable in a foreign currency is a transaction exposure, because the domestic currency amount will vary with the exchange rate before settlement. Hedging locks in a rate for that specific cash flow.

Question 37Financial strategy formulation

A company's board is weighing a leveraged recapitalisation that will substantially increase debt. Which consequence should the board weigh most carefully in a financial strategy context?

  1. The tax deductibility of interest makes the change value-neutral at any level of debt.
  2. Higher gearing always lowers the cost of equity because shareholders face less uncertainty.
  3. Lenders are indifferent to gearing once a facility has been agreed.
  4. The increased fixed interest obligation raises financial risk and reduces the capacity to absorb a downturn. Correct answer.

Explanation

Adding debt increases fixed commitments, so earnings volatility translates into greater risk of covenant breach or distress, and the cost of equity also rises as financial risk increases. The tax shield is valuable only up to the point where distress costs and risk outweigh it.

Question 38Financial strategy formulation

A company's board is choosing between a market-based and an asset-based valuation of a target for an acquisition. Which statement best explains when an asset-based valuation is most appropriate?

  1. When the target's future cash flows can be forecast with high confidence.
  2. When the target is an asset-holding company whose value lies mainly in its property or investments rather than in earnings. Correct answer.
  3. When the acquirer intends to realise synergies from combining operations.
  4. When the target is a fast-growing service business with substantial intangible value.

Explanation

Asset-based valuations focus on the realisable or replacement value of net assets and are most useful for property or investment holding companies. For going concerns whose value derives from earnings or cash flows, income-based methods are more appropriate.

Question 39Financial strategy formulation

A company has a price-to-earnings ratio of 12 and earnings per share of 25 cents. What is its market price per share?

  1. 300 cents Correct answer.
  2. 37 cents
  3. 208 cents
  4. 480 cents

Explanation

The P/E ratio equals market price divided by EPS, so price equals 12 times 25 cents, which is 300 cents. The ratio expresses how many years of current earnings investors are paying for.

Question 40Financial strategy formulation

A company's board is reviewing its treasury policy and wants to specify the counterparties with which surplus cash may be deposited. Which control objective does this requirement primarily serve?

  1. Managing the translation of overseas earnings.
  2. Managing the liquidity of the company's trade payables.
  3. Managing the company's exposure to interest rate movements.
  4. Managing counterparty credit risk on short-term investments. Correct answer.

Explanation

Restricting deposits to approved counterparties with minimum credit ratings is a credit risk control: it limits the loss the company would suffer if a bank failed. It is a standard element of a treasury management policy.

Question 41Financial strategy formulation

A company expects to receive 1 million euros in three months and wants to eliminate the uncertainty of the domestic currency amount now. Which instrument achieves this without an upfront premium?

  1. A forward contract to sell euros in three months at a rate agreed today. Correct answer.
  2. A purchased call option on euros with a three-month maturity.
  3. A purchased put option on euros with a three-month maturity.
  4. A currency swap to exchange fixed euro interest for fixed domestic interest.

Explanation

A forward sale locks in the rate today and carries no initial premium, so the domestic currency proceeds are certain. Options provide protection but require a premium and leave the outcome open if the option is not exercised.

Question 42Financial strategy formulation

A company has annual demand of 36,000 units, an ordering cost of 50 per order and a holding cost of 4 per unit per year. Using the economic order quantity formula, what is the EOQ?

  1. 600 units
  2. 949 units Correct answer.
  3. 1,200 units
  4. 1,897 units

Explanation

The EOQ equals the square root of twice the annual demand times ordering cost divided by holding cost, that is the square root of 2 times 36,000 times 50 divided by 4. This gives the square root of 900,000, approximately 949 units.

Question 43Financial strategy formulation

A company's board is deciding whether to adopt a policy of matching the maturity of its debt to the life of the assets it finances. Which benefit does this policy primarily deliver?

  1. It reduces refinancing risk because long-lived assets generate cash over the period when the debt falls due. Correct answer.
  2. It removes all interest rate risk from the company's borrowings.
  3. It minimises the interest cost because short-term debt always carries the lowest rate.
  4. It guarantees that the company will never breach a debt covenant.

Explanation

Maturity matching aligns the cash generation of assets with the repayment obligations of the debt, so the company is less exposed to the risk of being unable to refinance at maturity. It is a liquidity and refinancing risk control rather than a cost-minimisation rule.

Question 44Financial strategy formulation

A company operates in a country where the government has announced that it may impose temporary restrictions on dividend repatriation by foreign-owned subsidiaries. Which financial strategy response best mitigates the exposure?

  1. Increase the proportion of profits retained indefinitely in the overseas subsidiary.
  2. Arrange intra-group charges or royalties that are settled before dividend remittance is restricted. Correct answer.
  3. Denominate all intra-group transactions in the overseas currency.
  4. Reduce the level of local borrowing in the overseas subsidiary.

Explanation

Where dividend remittance may be blocked, legitimate transfer pricing arrangements such as management fees, royalties and interest allow value to be extracted through deductible payments. Retaining profits indefinitely simply increases the trapped cash at risk.

Question 45Financial strategy formulation

A company's board is considering a share repurchase financed by surplus cash. Which effect on the company's financial profile should the board expect?

  1. The company's market capitalisation will rise by the amount of the repurchase.
  2. The company's gearing ratio will fall because cash is used.
  3. Earnings per share may rise because the same earnings are spread over fewer shares. Correct answer.
  4. The company's dividend cover will necessarily fall to one times.

Explanation

Buying back shares reduces the number of shares in issue, so if earnings are unchanged the earnings per share increases. Using cash also reduces the asset base, which can raise rather than lower gearing.

Question 46Financial strategy formulation

A company has an operating profit margin of 8 per cent and an asset turnover of 1.5 times. What is its return on capital employed?

  1. 12 per cent Correct answer.
  2. 9.5 per cent
  3. 5.3 per cent
  4. 16 per cent

Explanation

ROCE equals operating margin multiplied by asset turnover, so 8 per cent times 1.5 gives 12 per cent. This decomposition shows how profitability and efficiency combine to determine the return.

Question 47Financial strategy formulation

A company's board is debating whether to adopt a formal financial strategy at all, arguing that the business is small and the owner-manager makes all decisions. Which argument most strongly supports formalising the financial strategy?

  1. A written strategy sets decision criteria and funding limits that remain valid as the business grows and as control passes to others. Correct answer.
  2. A written strategy transfers responsibility for financial decisions to external advisers.
  3. A written strategy removes the need for the owner-manager to monitor cash flow.
  4. A written strategy guarantees that the business will obtain external finance on favourable terms.

Explanation

Formalising financial strategy creates explicit criteria for investment, funding and dividend decisions that survive changes in management and scale. It is a governance and consistency device, not a guarantee of financing outcomes.

Question 48Financial strategy formulation

A company is evaluating two mutually exclusive projects with different lives. Project A has a net present value of 2 million over four years and Project B has a net present value of 2.6 million over six years. Which method best allows a valid comparison?

  1. Compare the two payback periods and select the shorter one.
  2. Compare the equivalent annual annuity of each project's net present value. Correct answer.
  3. Compare the two internal rates of return and select the higher one.
  4. Compare the two net present values directly and select Project B.

Explanation

When projects have unequal lives, converting each net present value into an equivalent annual annuity puts them on a common per-year basis and allows a like-for-like comparison. Direct NPV comparison is biased towards the longer project.

Question 49Financial strategy formulation

A company's board wants to ensure that its financial strategy supports a stated objective of maintaining an investment-grade credit rating. Which policy is most consistent with that objective?

  1. Funding acquisitions predominantly with short-term bank overdrafts.
  2. Maximising dividend payout each year regardless of cash generation.
  3. Maintaining no formal limit on gearing so that managers can pursue opportunities quickly.
  4. Setting a target range for net debt to EBITDA and suspending buybacks when the upper limit is approached. Correct answer.

Explanation

A credit rating depends heavily on leverage and interest cover metrics, so a target range for net debt to EBITDA with a pre-agreed response protects the rating. Discretionary distributions are curtailed when headroom narrows.

Question 50Financial strategy formulation

A company's board is considering whether to fund a new venture with equity or debt. The venture's cash flows are highly uncertain and may not begin for three years. Which argument best supports equity finance?

  1. Equity finance carries a tax deduction that reduces the effective cost.
  2. Equity finance preserves existing shareholders' control in all circumstances.
  3. Equity finance is always cheaper than debt because dividends are discretionary.
  4. Equity has no fixed servicing obligation, so the company is not exposed to default if cash flows are delayed. Correct answer.

Explanation

Where cash flows are uncertain and delayed, the absence of mandatory interest and repayment obligations reduces the risk of financial distress. Debt would impose fixed claims before the venture generates cash.