Questions 1 to 15 cover enterprise risk management, the subject of Part A of the BPP Study Text for Risk Management.

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1 ENTERPRISE RISK MNGEMENT Questions 1 to 15 cover enterprise risk management, the subject of Part of the PP Study Text for Risk Management. 1 Risks may be analysed according to their frequency and to their severity of loss. Which type of risk is usually considered to be best dealt with through insurance? Frequency Severity of loss High High High Low Low High Low Low 6/ 04 2 Three derivatives that may be used to manage financial risk are as follows: 1 Futures contracts 2 Forward contracts 3 Swaps Which of the above may be traded on an organised exchange? 1 only 1 and 2 2 only 2 and 3 12/04 3 Which of the following is not an example of operational risk? Event risk Gearing risk People risk Process risk 12/04 4 onsider the following statements concerning enterprise risk management 1 n entity's risk management philosophy reflects the entity s values and influences its culture and operating style 2 Event identification techniques need only look to the future since nothing can be done about past events 3 Management should use quantitative risk assessment techniques in preference to qualitative techniques 4 Events with a relatively low possibility of occurrence need not be considered Which of the above statements would form part of a valid framework for enterprise risk management? 1 only 1 and 2 1 and 3 1, 2, 3 and 4 12/04 79

2 5 onsider the following statements concerning techniques to manage financial risk. 1 Sensitivity analysis is used to assess the impact of normal, or routine, changes in potential events. 2 Stress testing assesses the impact of a single event that has an extreme impact. Which one of the following combinations (true/false) concerning the above statements is correct? Statement 1 Statement 2 True True True False False True False False 12/04 6 onsider the following hedging methods. 1 International diversification of operations 2 Matching receipts and payments 3 Leading and lagging 4 Forward exchange contracts Which of the hedging methods above are suitable for hedging transaction exposure? 1 and 2 1, 2 and 3 2 and 3 2, 3 and 4 6/05 7 onsider the following two statements concerning futures contracts. 1 futures contract is negotiated between a buyer and seller and can be tailored to the buyer s particular requirements. 2 futures contract can be traded on a futures exchange. Which of the following combinations (true/false) is correct? Statement 1 2 True True True False False True False False 6/05 8 The following European-style options are held at their expiry date by an investor: 1 call option of 20,000 shares in Peterhouse with an exercise price of 860c. The market price of the shares at the expiry date is 880c. 2 put option of 600,000 in exchange for euros at a strike rate of 1 = 1 5. The exchange rate at the expiry date is 1 = Which one of the above combinations (exercise/lapse) concerning the options should be undertaken by the investor? Option 1 2 Exercise Exercise Exercise Lapse Lapse Exercise Lapse Lapse 6/05 80

3 9 Risk mapping is a technique for assessing the severity of a risk and the probability or frequency of its likely occurrence. For what type of risk would it probably be most appropriate to take out an insurance policy from an insurance company? Severity high, frequency high Severity high, frequency low Severity low, frequency low Severity low, frequency high 10 bank has assessed that there is only a 5% probability that the losses on its portfolio of assets will exceed $250 million. Which technique of risk management has the bank applied in reaching this analysis? Value at Risk Sensitivity analysis The lack-scholes model Risk audit 11 What is the name given to a review by an organisation of all its risks? Risk mapping Risk management Risk assessment Risk audit 12 Which of the following definitions best describes risk aversion? voiding risks by refusing to invest in high-risk projects or investments Trying to reduce or minimise risks through risk management voiding investments where the risk is high if an investment offering the same return for less risk is available Investing in projects offering the highest expected value of net present value 13 The most common measure of risk used to evaluate the risk/return trade-off is: Liquidity Probability of default Standard deviation of expected returns Probability of making a loss 14 company is considering four projects which are mutually exclusive owing to a shortage of investment funds. For each project, it has estimated the internal rate of return, and calculated a measure of risk, based on probability analysis. The risk/return profile of each investment is as follows. Project Return Risk % % W 18 6 X 17 7 Y 16 6 Z 18 7 If the company's board of directors is risk-averse in its project selection, which of these projects would it select? Project W Project X Project Y Project Z 81

4 15 company is considering four mutually-exclusive investments, for which the expected internal rate of return and the expected risk (measured as a standard deviation of the expected return, based on estimated probabilities of different outcomes) are as follows: Project Return Risk % % W 16 6 X 17 5 Y 18 7 Z 19 8 If the company's board of directors is risk-averse in its project selection, which of these projects would it not select? Project W Project X Project Y Project Z If you struggled with these multiple choice questions, go back to your PP Study Text for this paper and revise hapters 1 to 5 before you tackle the written questions on enterprise risk management. 82

5 MNGEMENT OF FINNIL RISK Questions 16 to 67 cover management of financial risk, the subject of Part of the PP Study Text for Risk Management. 16 business uses each of the hedging methods described below to protect against a particular type of foreign exchange risk: Hedging method used Type of foreign exchange risk 1 Matching receipts and payments Transaction risk 2 Matching assets and liabilities Economic risk 3 Leading and lagging Translation risk Which of the hedging methods described above are suitable for their intended purpose? 1 and 2 1 and 3 1, 2 and 3 06/ onsider the following statements concerning currency risk: 1 Leading and lagging is a method of hedging transaction exposure. 2 Matching receipts and payments is a method of hedging translation exposure. Which of the above statements is/are true? Statement 1 2 True True True False False True False False 12/03 18 alculate the forward per annum premium or discount given the following information: Spot 1 = $1.4000; 3 month forward 1 = $ The $ is at a premium of 1.43 percent The $ is at a discount of 1.43 percent The $ is at a premium of 5.71 percent The $ is at a discount of 5.71 percent Pilot paper 19 What is the correct definition of value at risk? single number estimate of how much a company can lose due to the price volatility of the instrument held The standard deviation of the changes in value of the total portfolio of instruments held by a company The variability of movements in a security's price The total amount of interest payable as a percentage of the amount lent or borrowed. Pilot paper 83

6 20 To what does interest rate risk relate? The sensitivity of profit, cash flow or valuation of the firm to fluctuations in the interest rate The difference between short term interest rates prevailing in two money centres at any given time Futures contracts which relate wholly to levels of interest rates The condition that the interest differential should equal the forward differential between two currencies Pilot paper 21 Using the following information, which of the variables is the least sensitive with regard to the overall profitability of the project? Initial costs = $15,000 ; Ongoing costs = $2,000 p.a. ; Revenue = $5,000 p.a. ; Project life 8 years. Initial osts Ongoing osts Revenue Project Life Pilot paper 22 hocshop distributes exotic chocolates from around the world. It buys chocolates from Ruritania which cost Ruritanian $130,000 and the goods are resold in the UK for 42,500. t the time of importation, the /R$ rate is What is the expected profit or loss on the resale of the chocolates in the UK? 6,389 profit 4,321 profit 5,384 loss 6,898 loss 6/02 23 What is the purpose of hedging? To protect a profit already made from having undertaken a risky position To make a profit by accepting risk To reduce or eliminate exposure to risk To reduce costs 12/02 24 Which of the following is the lowest investment grade in the Moody's system of credit ratings for bonds? aa a 25 Volans is seeking to borrow $50 million for five years at a variable rate of interest and pus is seeking to borrow $50 million for five years at a fixed rate of interest. The amount required by each company can be borrowed at the following interest rates: Variable rate Fixed rate Volans LIOR + 1.2% 5.2% pus LIOR + 1.4% 6.0% The two companies enter into a swap arrangement and any benefits are shared equally. 84

7 What is the net annual interest rate for Volans when LIOR is 5%? 5.7% 5.8% 5.9% 6.1% 6/04 26 Sirius is a UK business that has recently purchased machinery from a ulgarian exporter. The company has been invoiced in sterling and the terms of sale include payment within sixty days. uring this payment period, the sterling weakened against the ulgaria lev. If neither Sirius nor the ulgarian exporter hedge against foreign exchange risk, what would be the foreign exchange gain or loss arising from this transaction for Sirius and for the ulgarian exporter? Sirius ulgarian exporter No gain or loss Gain Gain No gain or loss No gain or loss Loss Loss No gain or loss 6/04 27 Polaris, a UK-based business, has recently exported antique furniture to a US customer and is due to be paid $500,000 in three months' time. To hedge against foreign exchange risk, Polaris has entered into a forward contract to sell $500,000 in three months' time. The relevant exchange rates are as follows: Spot 1 = $ Three months' forward cents premium How much will Polaris receive in sterling at the end of three months? 321, , , ,477 6/04 28 Tucana, a UK-based business, has placed an order for goods from a French supplier and a payment of 1,000,000 for the goods is due in two months' time. The company has decided to take out an option at a strike price of 1 = to hedge the currency risk. call option would cost 0.50 per 100 and a put option would cost 0.40 per 100. These options relate to the purchase or sale of euros. What is the maximum amount that the company will have to pay if the spot rate in two months' time is 1 = ? 623, , , ,552 6/04 85

8 29 Typha, a UK business, has recently sold goods to a US customer and expects to be paid $300,000 in three months time. Typha enters into a forward exchange contract to sell $300,000 in three months time to protect against foreign exchange risk. Exchange rates are: /$ spot months forward $ pm What is the sterling amount that will be received by the company in three months time (to the nearest )? 205, , , ,182 12/ Taxus takes out a borrower s option on a loan for 10 million that has a notional interest period of 92 days. The business can borrow over this period at LIOR plus 0 2%. The option has a strike rate of 5 5% and a premium of 10,000. What is the total borrowing cost for the business if LIOR is 5 0% at the expiry date of the option? 5 3% 5 6% 5 8% 6 1% 12/03 31 Nicandra, a company that is committed to increasing shareholder wealth, holds the following European-style options at their expiry date: 1 call option on a notional loan that gives the right to borrow 5 million for one year at a strike rate of 5 0%. LIOR is 4 5% at the expiry date of the option. 2 put option on 500,000 in exchange for euros at an exchange rate of 1 = The exchange rate is 1 = at the expiry date of the option. 3 call option on 10,000 shares in Potentilla at an exercise price of 840p. The current share price is 820p at the expiry date of the option. Which of the above options should be exercised and which should be allowed to lapse at their expiry date? Option Lapse Exercise Exercise Lapse Lapse Exercise Exercise Exercise Lapse Lapse Exercise Lapse 12/03 32 onsider the following statements concerning forward rate agreements (FRs): 1 FRs cannot be tailored to the specific requirements of a customer. 2 FRs are binding agreements that must be settled at the settlement date. 3 FRs do not require any payments or receipts until the settlement date. 4 FRs can be resold in the secondary market. Which of the above statements are correct? 1 and 2 1, 2 and 4 2 and 3 2, 3 and 4 12/03 86

9 33 What does the term matching refer to? mechanism whereby a company balances its foreign currency inflows and outflows The coupling of two simple financial instruments to create a more complex one The adjustment of credit terms between companies ontracts not yet offset by futures contracts or fulfilled by delivery Pilot paper 34 firm deals a $5 Million 3 v 6 FR on 8 pril 20X1 for settlement on 8 July 20X1, based on a maturity date of 8 October 20X1. The contract period is 90 days and the contract rate is 9.05%. The three-month LIOR fixing is 9.5%. Given the above information, what would be the amount payable to the buyer on 8 July 20X1? $ 5, $ 10, $ 5, $ 10, Pilot paper 35 Which of the following statements is true? high interest rate positively affects the value of a put option high interest rate adversely affects the value of a put option Volatility of the underlying share decreases the value of a put option The market price of a put option increases as the share price increases Pilot paper 36 UK company is bidding for a contract with the Thai government, but will not know for three months if the bid has been accepted. The company will need Thai currency (the Thai aht) to cover expenses but will be paid in sterling by the Thai Government if it is awarded the contract. In order to minimise its exposure to currency risk, what should the UK company do? Sell Thai aht futures uy Thai aht futures uy Thai aht put options uy Thai aht call options Pilot paper 37 Which of the following is true? s the majority of futures contracts are never taken to delivery a futures contract is not legally binding The quantity in a futures contract is agreed between the buyer and seller elivery dates on futures contracts are specified by the futures exchange and not by the buyer and seller The margin requirement is a purchase cost of a future 12/02 38 Williamson, a UK based firm, is about to tender for an overseas contract. Williamson's internal budgets for the tender indicate the following: % % Sales value US ollar ($) 100 osts Sterling ( ) 65 US ollar ($) Profit 10 The dollar costs include the costs of short-term US finance and it is intended to pay for these dollar costs out of the dollar receipts. The total amount of the tender is $25 million and, if the tender is successful, the work will be carried out in the next seven months with payment due to be received in full in ten months. 87

10 The budgeted figures are all based on the current /$ exchange rate and there is concern that the project is vulnerable to exchange rate fluctuations. ction is proposed to protect the firm against exchange rate fluctuations. To protect itself Williamson should: Sell forward $18.75 million for settlement in ten months Sell forward $25 million for settlement in ten months Purchase an option to sell $18.75 million in ten months Purchase an option to sell $25 million in ten months 12/02 39 Netherfield, a UK company, purchases a borrower's option for six-month LIOR on a notional principal sum of 10 million. The strike rate is 5.4% and the LIOR rate is 6.5% at the expiry date of the option. The notional six-month interest period is 183 days. ssuming the option is exercised, what is the cash flow relating to the option (to the nearest )? 53,410 53, , ,300 6/03 40 Lucas Lodge Hotels wishes to borrow 20 million for four years at a fixed rate of interest and Hunsford, another company, wishes to borrow 20 million for four years at a floating rate of interest. Each company can borrow the required amount as follows: Floating rate Fixed rate % Lucas Lodge Hotels LIOR plus 60 basis points 6.8 Hunsford LIOR plus 120 basis points 7.0 ssuming the companies agree to an interest rate swap and any benefits are shared equally, what will be the annual net interest cost for Lucas Lodge Hotels? 6.4% 6.5% 6.6% 6.7% 6/03 41 Gracechurch is a UK business that imports cheese from France. The business is due to pay one of its suppliers 2,125,000 in 30 days and the treasurer is concerned that, in the intervening period, the euro will strengthen against the sterling. The current spot rate of / is and euros futures contracts are trading at / To hedge against a possible strengthening of the euro, the treasurer decides to purchase 17 futures contracts at 125,000 each and to sell them in 30 days' time. ssuming that at the end of the 30-day period, the spot rate of / is and the futures price is / , what is the hedge efficiency of the above transactions (to the nearest percent)? 60% 84% 119% 166% 6/03 88

11 42 KidsTogs buys clothing from Lithuania which cost 600,000 Lithuania Litai (LTL) and the goods are resold in the UK for 135,000. t the time of importation, the /LTL rate is What is the expected profit or loss on the resale of the clothing in the UK? 14,397 profit 19,615 profit 13,774 loss 14,397 loss 12/04 43 errington purchases a borrower's option for six-month LIOR on a notional principal sum of 5 million. The strike rate is 3.7% and the LIOR rate is 5.2% at the expiry date of the option. The notional six-month interest period is 183 days. ssuming the option is exercised, what is the cash flow relating to the option (to the nearest )? 36,647 36,918 90, ,982 12/04 44 owning has $50 million loan stock with a fixed rate of interest of 6 0%. The company wishes to swap the fixed rate of interest for a floating rate of interest by entering into a swap agreement. swap bank offers a fixed rate of 5 5%, and will receive LIOR in return, for a swap agreement. What will be the overall cost of borrowing for the company during the first year of the swap agreement if LIOR for that period is 5 1%? 5 1% 5 5% 5 6% 6 4% 6/05 45 Girton is a UK business that has recently purchased machinery from a US supplier. Girton expects to pay $600,000 in three months time for this purchase. To hedge against foreign exchange risk, the company uses currency futures. US$ futures contracts are currently trading at /$1 80, which is also the current spot rate. The contract size is 62,500 and the tick value is $6 25 per tick. What is the total gain or loss from trading futures contracts if, in three months time, the future price is /$1 65? (Work to the nearest contract) $4,687 gain $4,687 loss $46,875 gain $46,875 loss 6/05 46 Which of the following risks is not associated with high financial gearing? Greater volatility in earnings Greater risk of inability to redeem debts Greater risk of inability to meet interest payment obligations Greater volatility in operating profit 89

12 47 company is financed by a mixture of debt and equity. It has 50 million shares in issue, with a market value of $150 million. It also has $100 million of 8% debt capital, valued at par. The company expects to achieve earnings per share for the year of 14c. The rate of income tax is 30%. What would be the percentage increase in EPS arising from an increase of 10% in operating profit? 8.1% 12.6% 15% 18% 48 What is meant by structural hedging? Trying to ensure as far as possible that a company has matching amounts of assets and liabilities in any currency, so as to reduce currency exposures Using the financial derivatives markets to hedge exposures to financial risks Managing the financial gearing of the company, to ensure that the company is always in a position to meet its debt payment obligations and have scope for further borrowing if needed arrying out an annual review of the organisation's risks, and planning a risk management strategy to deal with them 49 What term is used to describe an organisation's exposures to the effect of changes in currency exchange rates on its international competitiveness? Translation exposures Transaction exposures Economic exposures Structural exposures 50 The following cash flows have been estimated for a capital expenditure project. ost of equipment (year 0) $100,000 Revenues (years 1 5) $50,000 each year Running costs (years 1 5) $20,000 each year Project duration 5 years ost of capital 10% The NPV of the project is + $13,700. iscount factors at 10% Year Factor Which of the following variables is most sensitive with regard to the overall financial viability of the project? apital expenditure Revenues Running costs Project duration 90

13 51 The following cash flows have been estimated for a capital expenditure project. ost of equipment (year 0) $200,000 Revenues (years 1 5) $200,000 each year Running costs (years 1 5) $120,000 each year Project duration 5 years ost of capital 12% iscount factors at 12% Year Factor Which of the following variables is least sensitive with regard to the overall financial viability of the project? apital expenditure Revenues Running costs Project duration 52 n investor buys a put option on XYZ shares, with an exercise price of 250c. The option was bought for a premium of 10c. If the price on expiry of the option is 220c, what is the gain or loss made by the investor? 10c gain 20c gain 30c gain 10c loss 53 The anadian dollar/swiss franc ($/SFr) exchange rate is quoted three months forward at What would it cost a company to sell SFr 1,000,000 three months forward at the quoted rate? $1,019,500 $1,018,500 $981,836 $980, eurodollar bank account yields 5% per annum. company places 100,000 on deposit for three months at an exchange rate of 1 = $1.43, and sells the proceeds forward for that period at $1.40. What is the return on investment for the three-month period? 1.25% 1.28% 3.42% 7.25% 55 The sterling/us dollar spot rate is and the forward rate is quoted as cents premium. t what forward rate will the bank sell US dollars?

14 56 What is the maximum liability of the writer of a put option? Unlimited Zero Exercise price Premium Exercise price + Premium 57 The current spot rate for US dollar/south frican rand (US$/R) is The three-month forward rate is quoted as discount. You wish to convert R5 million into US dollars in three months' time, and you intend to hedge the currency exposure with a forward exchange contract. How many US dollars will you receive in three months' time? $570,125 $570,321 $571,429 $571, company holds shares, which it believes will soon fall in price, in another listed company. It wishes to hold on to the shares as a strategic investment, and to hedge the exposure to a price fall. Which of the following would be appropriate trades to hedge the market risk exposure? I II III IV uy call options on the shares Sell call options on the shares uy put options on the shares Sell put options on the shares Trades I and III Trades I and IV Trades II and III Trades II and IV 59 company sold three three-month sterling futures at and closed the position by buying three contracts at The contract size is 500,000 and a tick is one basis point (one hundredth of one per cent, or ). What is the profit on the transactions? 1,100 3,300 4,400 13, You are expecting to borrow $50 million in five months' time, for a period of six months. Which of the following instruments would enable you to hedge against the risk of an increase in interest rates in the next five months? Forward exchange rate Interest rate cap FR uying an interest rate put option over the counter 61 company wants to create a hedge against the risk of a rise in six-month interest rates during the next five months, when the interest rate on its 8 million floating rate bank loan will be re-set. Which of the following would provide a suitable hedge? uy a 5 v 11 FR uy a 6 v 11 FR Sell a 5 v 11 FR Sell a 6 v 11 FR 92

15 62 company buys a $10 million 6 v 9 FR on 12 February for settlement on 12 ugust, based on a maturity date of 12 November. The contract period is 92 days and US money market interest is calculated on the basis of actual interest days and a 360-day year. The FR rate is 6.8% and the three-month LIOR settlement rate at fixing is 7.25%. What is the amount payable at settlement on 12 ugust? The company will receive 11, from the bank The company will receive 11, from the bank The company will receive 11,500 from the bank The company will pay 11, to the bank 63 company can borrow at 125 basis points above LIOR. It wants to fix the interest rate for a three-month loan, starting in four months' time. bank has quoted the following FR rates: id Offer 3 v v What will be the effective borrowing rate secured by the company through its purchase of an FR? 6.89% 6.91% 6.93% 6.98% 64 company has a floating rate loan of 5 million with four years remaining to maturity, on which it pays interest of LIOR plus 75 basis points, but it would prefer to pay a fixed rate of interest on this loan amount. It therefore arranges a 'plain vanilla' four-year interest rate swap. The bank's rates for a four-year swap are 5.20% %. What is the effective net interest rate that the company will pay, as a result of arranging the swap? 4.45% 4.50% 5.95% 6.00% 65 company can borrow at a fixed rate by issuing five-year bonds at 7.4% or can borrow at a variable rate of LIOR basis points. It has been quoted rates of 6.70% % for a five-year plain vanilla swap. The company wants to borrow at a floating rate of interest. How much would it save by borrowing fixed and arranging a swap, compared with issuing bonds? 0.30% 0.35% 0.70% It would be cheaper to issue bonds 93

16 66 company has a three-year variable rate loan of 6 million on which it pays three-month LIOR plus 100 basis points. It would prefer to borrow at a fixed rate, and mostly in euros. bank quotes a fixed rate of 3.25% for the euro in a cross-currency swap. The rate of exchange for the swap would be ( / ) , i.e per 1. What will be the payments in the swap? The company will pay 3.25% on 10 million and receive interest on 6 million at LIOR, and at maturity the company will pay 10 million in exchange for receiving 6 million. The company will pay 3.25% on 10 million and receive interest on 6 million at LIOR, and at maturity the company will pay 6 million in exchange for receiving 10 million. The company will receive 3.25% on 10 million and pay interest on 6 million at LIOR, and at maturity the company will pay 10 million in exchange for receiving 6 million. The company will receive 3.25% on 10 million and pay interest on 6 million at LIOR, and at maturity the company will pay 6 million in exchange for receiving 10 million. 67 Swaps could be used for a number of different purposes. Which of the following would not be a reason for entering a swap transaction? To switch net interest obligations out of one currency and into another currency. To benefit from favourable interest changes during the term of the swap. To reduce net borrowing costs through credit arbitrage. To alter the mix of fixed and floating rate debt obligations in the organisation's debt structure. If you struggled with these multiple choice questions, go back to your PP Study Text for Risk Management and revise hapters 6 to 11 before you tackle the written questions on management of financial risk. 94

17 PITL STRUTURE N IVIEN POLIIES Questions 68 to 94 cover capital structure and dividend policies, included in Part of the PP Study Text for Risk Management. 68 Ecliptic has ordinary shares in issue that have a beta of 0.8. The current market rate of return is 9% and the risk-free rate of return is 3%. The company pays a constant dividend of 40 cents per share. What is the predicted market value of each of the company's shares? 392 cents cents cents cents 6/04 69 Galanthus is a recently listed company that is financed entirely by equity shares. The directors of the company wish to establish the likely beta value of the equity shares and wish to use data from Hesperis, a similar listed company within the same industry, to do this. Hesperis has an equity beta of 1 2 and is financed by 60% equity shares and 40% loan capital. The loan capital of the company can be regarded as risk-free and the rate of income tax is 20%. What is the estimated equity beta for Galanthus, based on the information above? /03 70 Mentha is financed entirely by equity and has a cost of capital of 10%. Picea has the same operating and risk characteristics as Mentha but is financed by 30% loan capital and 70% equity. The cost of the loan capital, which is risk free, is 4%. The rate of income tax is 20%. Using MM theory (including taxation), what is the cost of equity capital of Picea? 10 57% 11 44% 12 06% 21 20% 12/03 71 What is the expected rate of return on a share with a β of 1.5, where the risk free rate is 6% and the market risk premium is 8.6%? 9.9% 12.5% 21.5% 18.9% Pilot paper 72 Poole issues irredeemable debt with a coupon of 5% and a market price of $ If the tax rate is 30%, what is the after tax cost of debt capital? 3.55% 5.33% 1.53% 3.15% 5/02 95

18 The following information relates to questions 73 and 74. oris and oris are identical listed companies although their capital structure differs. oris has a debt equity split of 1:3 and oris has a debt equity split of 2:3. oris has an equity β of 0.8. oth companies pay income tax at 25%. 73 What is oris's ungeared β? /02 74 What is oris's geared β? /02 75 Shares in Eric are currently trading for $2.00 per share. Next year's dividend is expected to be $0.15 and subsequent dividends are expected to grow by 3% year on year. What is Eric's cost of equity? 10.50% 3.0% 15.15% 6.5% 6/02 76 uxholm has a policy of reinvesting 35% of its earnings year on year. It aims to achieve a return of 6.5% on the investment. ssuming the same dividend payout ratio, what is the estimated long-term growth in dividends? 5.39% 6.50% 1.88% 2.28% 6/02 77 The Modigliani and Miller (no taxes) proposition concerning capital gearing states that, as the level of capital gearing increases from zero: The cost of equity capital will remain unchanged The weighted average cost of capital will decrease The value of the business will remain unchanged The cost of loan capital will increase 6/03 96

19 78 Meryton issued 10% loan stock some years ago, which is redeemable at par in exactly one year's time. The interest rate offered by the company is 3 percentage points higher than the interest rate offered on one-year government bonds. credit-rating agency now estimates that there is a 5% probability that the company would default on its payments and that lenders would receive nothing in one year's time. The market price of the loan stock reflects this default risk. n investor purchases some loan stock. Ignoring tax, what is the actual achieved yield on the loan stock over the year to redemption if there is no default on payments? 8.88% 11.22% 12.64% 15.79% 6/03 79 Pemberley pays a constant dividend of 25 cents per ordinary share and the ordinary shares of the company have a beta of 1.2. The risk-free rate of return is 4% and the current market rate of return is 11%. What is the predicted market value of each of the company's shares? 49.6 cents cents cents cents 6/03 80 Kajan has recently issued a dividend of $0.20 per share. The company has a constant dividend payout ratio of 30 per cent and achieves a 10 per cent return on new investments. What is the predicted market value of a share in the company? $1.13 $2.94 $6.67 $ /04 81 art is financed entirely by equity shares and has a cost of capital of 10%. Onega is identical to art except that it is financed by 600,000 $1 ordinary shares, currently trading at $2 50, and $500,000 of 6% loan stock, currently trading at $80 per $100. Using Modigliani and Miller (ignoring taxation), what is the cost of equity capital in Onega? 10.7% 11.8% 14.2% 19.4% 12/04 82 onsider the following statements concerning capital structure. ccording to both the traditional view and the Modigliani and Miller (including taxes) view of capital structure: 1 the point at which the weighted average cost of capital is minimised provides the optimal capital structure for a company 2 the weighted average cost of capital is minimised at the maximum level of gearing 97

20 Which one of the following combinations (true/false) concerning the above statements is correct? Statement 1 Statement 2 True True True False False True False False 12/04 83 lare pays a constant annual dividend of $0 60 per share and the shares of the company have a beta value of 1 2. The average market rate of return is 8% and the risk-free rate is 5%. What is the predicted market value of a share in the company? $0 70 $3 33 $4 11 $6 98 6/05 84 company's shares have a beta of The risk-free rate of return is 3.5% and the expected market return is 6%. What is the expected return on the company's shares? 5.1% 5.625% 8.125% 8.6% 85 Shares in Hat have a beta of 0.8. The risk-free return is 3%. ue to adverse stock market conditions, the average market return is 5%. What would be the expected return on Hat shares? - 3.4% - 4.0% - 6.4% + 1.4% 86 Risk which is specific to a particular share is called: Systematic risk Market risk Unsystematic risk Undiversifiable risk 87 share has a beta of zero, the risk-free rate of return is 3% and the market premium for risk is 6%. What is the required return on the share? 0% 3% 6% 9% 88 Four companies are identical in all respects, except for their capital structures, which are as follows. W X Y Z Equity as a proportion of total market capitalisation 95% 80% 50% 40% ebt as a proportion of total market capitalisation 5% 20% 50% 60% The beta value of the equity shares of X is 0.90 and the beta of the equity of Z is

21 Within which range will the beta values of the equity of W and Y lie? The beta of W is above 1.57 and the beta of Y is below 0.90 The beta of W and the beta of Y are both below 0.90 The beta of W is above 1.57 and the beta of Y is within the range 0.90 to 1.57 The beta of W is below 0.90 and the beta of Y is within the range 0.90 to company has issued share capital with a current market capitalisation of $80 million. It has also issued $50 million of 7% bonds with a current market value of The after-tax cost of the bonds is 5.25%. The expected market return is 9%, the risk-free interest rate is 5% and the beta factor for the company's equity is What is the company's weighted average cost of capital? 7.8% 7.9% 8.7% 8.8% 90 What is indicated by a dividend cover of less than 1? The company is insolvent The dividend payment has been partly satisfied by retained earnings The company has exhausted its distributable reserves The company has made substantial exceptional profits during the year that have been paid out as dividends 91 What is the residual theory of dividend policy? That companies should pursue a policy of smoothing dividends from one year to the next, and reinvest only those profits that are not needed to maintain the dividend payments That dividends should act as a signal to the market, and should be used by a company to indicate to investors its likely future prospects That companies should invest profits in all available projects with a positive net present value, and pay out as dividend only what profits are left over That companies should have a long-run aim of paying out a fixed proportion of earnings as dividends, and only use what is left to re-invest long-term in the company 92 Strike has just made profits after tax of $4 million. Its cost of capital is 10%, and it can re-invest retained profits to earn returns of 10% per annum. Which of the following dividend policies would maximise the total value of the company's equity, assuming that the dividend growth model of share valuation is valid? Policy Proportion of profits re-invested 1 25% 2 50% 3 75% Policy 1 will maximise shareholder value Policy 2 will maximise shareholder value Policy 3 will maximise shareholder value Shareholder value is unaffected by dividend policy 99

22 93 The cost of equity in an ungeared company is 12%. The cost of risk-free debt is 5%. ccording to Modigliani and Miller, what would be the cost of equity in a similar geared company which is 50% equity-financed and 50% debt-financed, assuming an income tax rate of 20%? 14.8% 15.5% 16.0% 17.6% 94 and are companies in the same industry, with the same business risk and operating characteristics. is an all-equity company, with shares valued at $100 million. The annual profits of are double those of. Income tax is 30%. is financed partly by 10% debt capital, which has a market value of $20 million. The value of shares is thought to be at its equilibrium level. ccording to Modigliani and Miller, what will be the equilibrium value of the equity shares of? $36 million $56 million $86 million $106 million If you struggled with these multiple choice questions, go back to your PP Study Text for Risk Management and revise hapters 12 to 15 before you tackle the written questions on cost of capital, capital structure and dividend policy. 100

23 ORPORTE GOVERNNE Questions 95 to 112 cover corporate governance, the subject of Part of the PP Study Text for Risk Management. 95 The ombined ode states that an audit committee should contain: 1 a minimum of three non-executive directors 2 non-executive directors only Which one of the following combinations (true/false) relating to the above statements is correct? Statement 1 2 True True True False False True False False 6/04 96 The ombined ode has a number of things to say about directors' remuneration including the following. 1 Non-executives should not receive share options. 2 Executive contracts should have a minimum notice of 12 months. Which of the following combinations is correct with regard to the above statements? Statement 1 2 True True True False False True False False 97 Which of the following is NOT a recommended structure for good governance? udit ommittee Employee Representative The oard Remuneration ommittee Pilot paper 98 Under the provisions of the ombined ode, which of the following are NOT specifically recommended? Separation of the role of EO and hairman Establishment of an Environmental ommittee Establishment of an ppointments ommittee Establishment of an internal audit function 6/02 99 Which of the following is recommended under OE guidelines for good governance in relation to external auditors? They should present an understandable and balanced assessment of the company's position They should be re-appointed every three years They should be given statutory protection to report suspicion of fraud They should bring independent judgment on matters of strategy, performance and resources 6/02 101

24 100 The ombined ode states that all directors should be required to submit themselves for re-election: nnually t least every two years t least every three years t least every four years 12/ onsider the following statements concerning the principles of corporate governance contained within the ombined ode. 1 Non-executive directors should comprise at least one quarter of the total board membership. 2 ll directors should submit themselves for re-election at least every two years. Which one of the following combinations relating to the above statements is correct? Statement 1 Statement 2 True True True False False True False False 6/ The ombined ode states that: 1 The directors should conduct a review of the system of internal controls at least once every two years. 2 The directors should submit themselves for re-election at least once every three years. Which one of the following combinations (true/false) concerning the above statements is correct? Statement 1 Statement 2 True True True False False True False False 12/ The directors of a listed company wish to comply with the requirements of the ombined ode and believe that, to do this, the following reports should be included in its annual report and accounts: 1 corporate governance report 2 report on board remuneration Which one of the following combinations (required/not required) is correct? Report 1 2 Required Required Required Not required Not required Required Not required Not required 6/ What is the minimum number of non-executive directors recommended for the board of directors of a listed company by the ombined ode? Two Three t least one quarter of the board t least one third of the board 102

25 105 The ombined ode recommends that non-executive directors should make up the membership of certain sub-committees of the board of directors of a listed company. Which of the following committees is not specified by the ode as a committee that should be made up of non-executive directors? Risk committee udit committee Remuneration committee Nominations committee 106 Which of the following guidelines has been issued to its members by the I? The most appropriate long-term share incentive scheme for senior executives should be based on Total Shareholder Return as a measure of performance Share options should be issued to senior executives infrequently, but in sufficiently large amounts to provide an incentive for better performance Shareholders should restrict their approval for the quantity of shares that a board of directors can issue without a rights issue to 2.5% within any rolling two-year period Shareholders should give positive support to the board of directors, unless there is a good reason for not doing so 107 Which of the following is not a recommendation of the Turnbull report for listed companies? ll companies should have in place a robust system of internal control Risks facing the business should be reviewed regularly by senior management ll companies should have an internal audit department, which should review the system of controls at least every two years Risk management is the collective responsibility of the board of directors, although some aspects of the work can be delegated 108 The OE principles of corporate governance are divided into five categories. One of these is the equitable treatment of shareholders. Which of the following principles comes within this category? The directors should disclose to shareholders any material interest they have in transactions affecting the company The equity shareholders should have the right to elect the members of the board of directors Where a stakeholder's rights are protected by law, the stakeholder should have an opportunity to obtain effective redress for any violation of those rights nti-takeover devices should not be used to shield management from accountability 109 Which of the following would not be a breach of the OE principles? n article in the company's constitution whereby the voting rights of any shareholder with more than 30% of the equity shares should be restricted to just 20% refusal by the board of directors to appoint non-executive directors alling a general meeting of the company at short notice, giving foreign shareholders no time to arrange attendance or proxy voting Using as the external auditor an individual or firm of accountants that is not independent of the company 103

26 110 What is the purpose of a nominations committee of the board of directors? To nominate the directors who should stand for re-election at each annual general meeting of the company To put forward nominations for new appointments to the board To decide whether to accept nominations for new appointments to the board, put forward by the chairman or the chief executive officer To review nominations for appointments to senior executive posts and the position of company secretary 111 Which of the following is a requirement of the ombined ode? There should be at least four formal board meetings each year The board should use the annual general meeting to communicate with private investors in the company Non-executive directors should attend at least one half of the formal board meetings each year When the roles of chairman and chief executive officer are separated, there is no requirement for a senior non-executive director 112 Which report in the UK introduced the recommendation that a remuneration report should be published in or with the annual report and accounts of listed companies? adbury report Greenbury report Hampel report Turnbull report If you struggled with these multiple choice questions, go back to your PP Study Text for Risk Management and revise hapters 16 to 18 before you tackle the written questions on corporate governance. 104