Any calculator which has the primary function of a calculator is allowed.

For example, calculators on mobile

phones or similar electronic devices are not allowed.

SPR 17 Page 1 of 12
SPR 17 Page 2 of 12
 Disclaimer
This sample exam is provided simply to give an indication of the format and difficulty of the
CFM final examination. Students should not assume that any questions similar to the
questions in this sample exam paper will necessarily appear in the final examination.

This Examination consists of five (5) parts. Students should attempt only four (4) parts. Each
part is of equal value (12.5 marks)

PART 1
This part consists of 2 separate sub-parts, (a) and (b).

(a) Consider the following profit diagram for a share option. Questions (i), (ii) and (iii) below refer to this
diagram.

Profit ($)
8

-1 8 Share price ($)

(i) State whether the above diagram is for a put option or a call option, and whether it depicts the
profit to the seller or the buyer of the option. (1 mark)
(ii) Assuming one option contract is for 1,000 shares, what is the intrinsic value (fundamental value)
of an option contract if the share price in the market is $10? (1 mark)
(iii) Again assuming one option contract is for 1,000 shares, what would be the overall net profit to
the holder of one option contract if the option is exercised when the share price in the market is
$6? (2 marks)

(b) The SWU Company produces a single type of environmentally friendly shopping bag that can be sold
at a constant price of $1.50 per bag. Variable cost per bag is $0.90 (regardless of the production
volume), and fixed costs amount to $180,000 per year. The firm pays a tax rate of 30%. The
company’s assets, valued at $625,000, are financed by 40% debt and 60% equity, with the latter in the
form of 20,000 ordinary shares (no preference shares are issued). The firm pays annual interest of 8%
on its debt financing.
(i) Calculate the annual operating break-even level (volume) of bag sales. (1 mark)
(ii) Calculate the firm’s earnings before interest and taxes (EBIT) and earnings per share (EPS) at
annual sales volumes of 350,000, 400,000 and 450,000 bags. (3 marks)
(iii) Calculate the firm’s degree of operating leverage (DOL), degree of financial leverage (DFL) and
degree of total leverage (DTL) at an annual volume of sales of 400,000 bags.
(3 marks)
(iv) State in words the meaning of total leverage. (1.5 marks)

SPR 17 Page 3 of 12
PART 2

This part consists of 3 separate sub-parts, (a), (b) and (c).

(a) Distinguish between business risk and financial risk. (4 marks)

(b) State the circumstances under which a firm’s overall weighted average cost of capital can validly be
used to calculate the net present value of a particular project the firm is considering undertaking.
(3 marks)

(c) The Photo Art photographic studio is considering acquiring the Perfect Day Company, a provider of
wedding photography services. The acquisition is expected to result in Photo Art’s cost of capital rising
from 7% to 8% per annum. The purchase price of the acquisition would be $1,500,000 cash and it is
expected that the acquisition would lead to increases in Photo Art’s annual (end of year) relevant cash
inflows of $125,000 for the next five years, and $160,000 per annum thereafter (in perpetuity).
Calculate the net present value of the acquisition from the point of view of the Photo Art photographic
studio. On the basis of your calculations, are the shareholders of Photo Art expected to benefit from
the acquisition? (5.5 marks)

PART 3
The Eastern Suburbs Desalination Plant Corporation wishes to estimate its current weighted average cost of
capital (i.e. the cost of capital associated with its existing assets). The firm is currently financed with debt,
preference shares and ordinary equity. The firm faces a company tax rate of 30% and there is no dividend
imputation. The following information is available.

Debt: The firm currently has 20,000 bonds on issue, each with a face value of $1,000 and a maturity date in 5
years’ time. These bonds pay interest annually with a coupon rate of 7% per annum, and their current yield to
maturity is 7.6% per annum.

Preference Shares: The firm currently has 37,000 preference shares on issue and the current market price of
these shares is $35 per share. The par value of each preference share is $40 and the annual preference
dividend is fixed at 7% of this par value.

Ordinary Shares: 400,000 ordinary shares are currently on issue and the current ordinary share price is $12.50
per share. Constant ordinary share dividend growth of 2% per annum is expected in the future and the next
annual dividend payment due in one year’s time is expected to be $0.80 (80 cents) per ordinary share.

Given the above information, calculate the firm’s current weighted average cost of capital.
(Round your answer to the nearest 0.01 per cent) (12.5 marks)

SPR 17 Page 4 of 12
PART 4
This part consists of 3 separate sub-parts, (a), (b) and (c).

(a) A certain company’s bonds have a face value of $10,000, a coupon rate of 5%, and mature in 10 years’
time. If the current yield to maturity is 6% and the bonds pay annual coupons, what is the current price
of these bonds? Also state whether the bond is selling at a premium or at a discount. (4.5 marks)

(b) Suppose an individual subject to a 30 per cent marginal rate of income tax has 2,100 shares in a
company that is paying a partially franked dividend of 30 cents per share, with a franking ratio of 0.8
(i.e. 80%). The individual is a resident for taxation purposes. If the company tax rate is 30 per cent:
(i) What tax credit can the individual claim due to the partially franked dividends?
(2 marks)
(ii) What is the tax on the taxable income (i.e. the grossed up dividend) due to the partially franked
dividend? (2 marks)
(iii) What tax, if any, is payable by the individual out of the cash dividend payment received?
(1 mark)

(c) State briefly what is meant by the efficient market hypothesis in relation to financial markets. Also state
two implications of the efficient market hypothesis. (3 marks)

PART 5
This part consists of 3 separate sub-parts, (a), (b) and (c).

(a) Suppose we have the following comparison of cash flows for the second year of operation of a
particular project (in dollars):
Project Project Not
Implemented Implemented
Sales Revenue 15,000 10,000
Cash operating costs 5,000 4,500
Depreciation 2,000 1,000

Assuming the firm is subject to a 36% tax rate, calculate the relevant year 2 incremental net cash flow
associated with the project for capital budgeting purposes. (3 marks)

(b) The Melba Fashion company has an annual cost of goods sold of $3,600.000 of which $2,281,250
represents purchases of production inputs. The firm has an average inventory value of $576,000 and
the value of annual sales is $8,449,020 with sales made at a constant rate. The firm’s average
payment period (APP) for production inputs is 28 days, and its average collection period (ACP) is 25
days. When answering the following, assume there are 365 days in a year.

(i) Calculate the firm’s operating cycle (OC) and cash conversion cycle (CCC). (2 marks)
(ii) Calculate the average amount of resources the firm has invested in the cash conversion cycle
on each day. (2 marks)
(iii) If the firm pays 10% per annum for its financing, by how much would the firm’s annual profits
increase if it could simultaneously and without cost increase its average payment period for
production inputs by 4 days and decrease its average collection period by 5 days (everything
else unchanged)? (2 marks)

(c) Under the assumptions of the Miller-Modigliani capital structure irrelevance model, the cost of
borrowing of firms is constant, regardless of their level of debt. Give two specific reasons why this
would not be the case in reality. (3 marks)

END OF EXAM PAPER

SPR 17 Page 5 of 12
 LIST OF FORMULAE

Variable Definitions
n = number of years or, in annuity formulae, the number of payments
m = number of times interest is compounded per year
r = rate of return
i = interest rate applied to each year or, in annuity formulae, the effective rate per compounding and
payment period
g = rate of growth
PMT = payment each period
PV = principal or present value
FVn = future value or compound amount after n years
Pt = price at time t
Ct or CFt = any cash flow (i.e. dividends, net cash flow) associated with ownership of the asset at
time t.
r j = required return on asset j
b j = beta coefficient of asset/portfolio j
RF = risk free rate of return
rm = required return on the market portfolio
I = annual interest payment
M = par (face) value of a bond
Dt = dividend for period t
Dp = dividend for period t

T or TR = effective company income tax rate

Pri = probability of state of nature i occurring
MPacquiring  market price per share of the acquiring firm
MPtarget  market price per share of the target firm
RE  ratio of exchange

mn
 i 
FVn  PV 1    PV  FVIFi m,mn (compound amount)
 m
( mn )
 i 
PV  FVn 1    FVn  PVIFi m,mn (present value)
 m
m
 i 
EAR  1    1 (effective annual rate of interest)
 m
PMT [(1  i )n  1]
FVAn   PMT  FVIFAi ,n (future value of ordinary annuity)
i
PMT [1  (1  i ) n ]
PVAn   PMT  PVIFAi ,n (present value of ordinary annuity)
i

SPR 17 Page 6 of 12
  PMT [(1  i )n  1] 
FVAn (due)  (1  i )    (1  i )  PMT  FVIFAi ,n
 i 
 PMT [1  (1  i ) n ] 
PVAn (due)  (1  i )    (1  i )  PMT  PVIFAi ,n
 i 
PMT
PVA   PMT  PVIFAi , (present value of perpetuity)
i
P1  P0  C1
r (return earned on a particular asset over a given period from time 0 to 1)
P0
n
r   ri Pri (expected return where there is a discrete probability distribution of returns)
t 1

n
r   (r
i 1
i  r )2 Pri (standard deviation of returns where there is a discrete probability distribution of

returns)
n

r i
r  i 1
(sample/historical mean return)
n
n

 (r i  r )2
r  i 1
(sample/historical standard deviation of returns)
n 1
r
cv  (coefficient of variation of returns)
r
rp  w1212  w 2222  2w1w 2 1,2 12 (standard deviation of returns to a portfolio of 2 assets)
r j  RF  b j (rm  RF ) (security market line)
I [1  (1  rd ) n ] M
B0  I  PVIFArd ,n  M  PVIFrd ,n   (value of bond)
rd (1  rd )n
D1
P0   D1  PVIFArs , (share value, constant dividend)
rs
D0 (1  g ) D1
P0   (share value, constant dividend growth)
rs  g rs  g
D0 (1  g1)t
N
1  DN (1  g2 ) 
P0      (share value, variable dividend growth)
t 1 (1  rs ) (1  rs )N 
t
 s
r g 2 
n
CFt  n

NPV    CF0    CFt  PVIFr ,t   CF0
t 1 (1  r )
t
 t 1 

NPV
ANPV  (annualized net present value)
PVIFAr ,n

ra  w i ri  w prp  ws rs (weighted average cost of capital), where ri  rd (1 T )

 T 
Tax credit  dividend  R   franking ratio (dividend imputation tax credit)
 1  TR 

SPR 17 Page 7 of 12
 FC
Q (break-even sales volume)
P  VC
% Changein EBIT
DOL  (degree of operating leverage)
% Changein sales (revenue)
Q  (P  VC )
DOL  (degree of operating leverage)
Q  (P  VC )  FC
% Changein EPS
DFL  (degree of financial leverage)
% Changein EBIT
EBIT
DFL  (degree of financial leverage)
 1 
EBIT  I   Dp  
 1 T 
% Change in EPS
DTL   DOL  DFL (degree of total leverage)
% Change in sales revenue

VL  VU  TD (value of financially leveraged firm under Miller-Modigliani capital structure irrelevance

assumptions, except for existence of corporate taxes)

amount paid per share of target company

Ratio of Exchange 
market price per share of acquiring company
Price paid per share of the ta rget firm MPacquiring  RE
MPR  
market price per share of the target firm MPtarget

Operating and cash conversion cycle formulae:

OC  AAI  ACP
365
AAI 
(Annual) Cost of Goo ds Sold
Average Inventory
Average Accounts Receivable
ACP 
Annual Credit Sales
365
CCC  OC  APP
Average Accounts Payable
APP 
Annual Credit Purchases
365
Resources invested in the CCC = Inventory + Accounts receivable – Accounts payable

SPR 17 Page 8 of 12
ANSWERS

PART 1

(a)
(i) The diagram refers to a put option from the option buyer’s point of view.

(ii) The strike/exercise price is $9 per share. In this case:

Intrinsic value of option  Max(9  10,0)  1,000  0

(iii) Overall net profit  (9  6)(1,000)  1(1,000)  3,000  1,000  $2,000

(b)
FC 180,000
(i) Break-even point    300,000 bags
P  VC 1.50  0.90
(ii)
Interest expense  0.08(0.40)(625,000)  $20,000

Bags Sold 350,000 400,000 450,000

Sales Revenue 525,000 600,000 675,000
Operating Costs 495,000 540,000 585,000
EBIT 30,000 60,000 90,000
Interest 20,000 20,000 20,000
Earnings before tax 10,000 40,000 70,000
Earnings after tax 7,000 28,000 49,000
EPS 0.35 1.40 2.45

(iii)
Q  ( P  VC ) 400,000  (1.50  0.90)
DOL   4
Q  ( P  VC )  FC 400,000  (1.50  0.90)  180,000

EBIT 60,000
DFL    1.5
EBIT  I 60,000  20,000

DTL  DOL DFL  4 1.5  6

(iv)
Total leverage refers to the potential use of fixed costs, both operating and financial, to magnify the effect of
changes in sales on the firm’s EPS

PART 2

(a)
Business risk is “the risk to the firm of being unable to cover its operating costs”. A firm’s business risk can be
measured as the variability of the returns to the firm’s assets. If a firm’s assets are totally equity financed, the
risk borne by the firm’s shareholders will be equivalent to the firm’s business risk.

Financial risk is “the risk to the firm of being unable to cover required financial obligations (interest, lease
payments, preference share dividends)”. Alternatively, financial risk is the additional risk borne by ordinary
shareholders resulting from the use of debt (and preference shares and leasing) to finance some of the firm’s
assets.

SPR 17 Page 9 of 12
(b)
 The project has the same business risk as the firm’s existing assets.
 Investment in the project will not change the financial risk faced by the firm’s shareholders. This
essentially means financing the project will not change the capital structure of the firm.

(c)

125,000 [1  (1.08) 5 ] 160,000  1 

NPV      1,500,000  $360,255.15
0.08 0.08  (1.08)5 

Given that the NPV of the acquisition is positive, the acquisition is expected to be beneficial to Photo Art’s
shareholders.

PART 3

Debt:
Existing bonds
rd  0.076 n  5 I  0.07(1,000)  70

Market value of each existing bond

70 [1  (1.076) 5 ] 1,000
 
0.076 (1.076) 5
 $975.79

Therefore the total market value of debt  975.79 (20,000)  $19,515,800

The after-tax cost of the firm’s debt is then given by

ri  rd (1  T )  0.076(1  0.3)  0..0532 (5.32%)

Preference shares:

Market value of existing preference shares  37,000(35)  $1,295,000

Per share preference dividend  0.07(40)  $2.80

Therefore
Dp 2.8
rp    0.08 (8.0%)
Pp 35

Ordinary shares:

Market value of existing ordinary shares  400,000 (12.50)  $5,000,000

Solving the Gordon model equation for rs
D1 0.80
rs  g  0.02  0.084 (8.4%)
Ps 12.50

The total current value of the firm  19,515,800  1,295,000  5,000,000  $25,810,800
Hence
19.515.800 1,295,000 5,000,000
WACC  (5.32)  (8)  (8.4)  6.0511% (6.05%)
25,810,800 25,810,800 25,810,800

SPR 17 Page 10 of 12
PART 4

(a)
n  10 i  0.06 Pn  10,000 I  0.05 (10,000)  500
 n 1  Pn
B0  I  t 

 t 1 (1  i )  (1  i )
n

I [1  (1  i ) n ] Pn
 
i (1  i ) n
500 [1  (1  0.06) 10 ] 10,000
 
0.06 (1  0.06)10
 3,680.04  5,583.95
 $9,263.99

The bond is selling at a discount.

(b)

(i)
Total cash dividend  0.30  2,100  $630

 TR   0.3 
Tax credit  dividend     franking ratio  630     0.8  $216
 1  TR   1  0.3 
(ii)
Tax on taxable income due to partially franked dividends  0.30 (630  216)  $253.80

(iii)

Tax payable out of cash dividend  253.80  216  $37.80

(c) See text/summary notes.

PART 5

(a)

Project Project Not

Implemented Implemented Increment
Sales 15,000 10,000 5,000
Cash operating costs 5,000 4,500 500
Depreciation 2,000 1,000 1,000
Pre-tax income 8,000 4,500 3,500
Taxes (36%) 2,880 1,620 1,260
Net operating income 5,120 2,880 2,240
Cash flow 7120 3,880 3,240

Thus the relevant incremental cash flow is 3,240.

(b)

(i)
365
OC  AAI  ACP   25  58.4  25  83.4 days
3,600,000 576,000

SPR 17 Page 11 of 12
CCC  OC  APP  83.4  28  55.4 days

(ii)
Amount invested in cash conversion cycle
 inventory  accounts receivable - accounts payable
 576,000  (25 365)(8,449,020)  (28 365)(2,281,250)
 576,000  578,700  175,000
 $979,700

(iii)
Increase in annual profit  0.1(4 365)(2,281,250)  0.1(5 365)(8,449,020)  $14,074

(c) See text/summary notes.

SPR 17 Page 12 of 12