Applied Skills FM March/June 2021 Sample Answers

Jul 17, 2026

Uploaded by Theodore

Comprehensive sample solutions for Financial Management (FM) Applied Skills, March/June 2021, focused on cost of equity and gearing impacts on valuation decisions. The material derives project-specific equity beta using a proxy approach, then re-gears to estimate the required cost of equity and explains why using the existing cost of equity would overstate net present value. It also analyzes gearing problems—earnings volatility, increased equity cost, reduced debt capacity, and heightened bankruptcy risk—followed by a structured explanation of the risk–return relationship and how it drives differing required returns for shareholders versus lenders.

LanguageEnglish

CategoryExam

FormatPDF

Pages6

Reading Time15 min

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Answers Applied Skills, FM Financial Management (FM) March/June 2021 Sample Answers Section C Zeddemore Co (a) (i) Current ke: Using Zeddemore’s own equity beta: ke = 4% + 2·3 (10% – 4%) = 17·8% Project specific ke: Need to use the proxy (WCP) to derive a suitable beta as Zeddemore Co’s own beta is not suitable for the new venture due to different risk. Degear the proxy beta first. Asset beta = equity beta x {Ve/(Ve + Vd x (1 – t))} Ve = 100m x $2·60 = $260m Vd = $110m x 0·96 = $105·6m Asset beta = 1·25 x {$260m/($260m + $105·6m x (1 – 0·2))} = 0·94 Now regear using Zeddemore Co’s gearing: Ve = $40m/$0·50 x $1·05 = $84m Vd (Loan notes) = $250m x 0·65 = $162·5m Vd (Loan) = $20m Total Vd = $162·5m + $20m = $182·5m Equity beta = asset beta x {(Ve + Vd(1 – t))/Ve } Equity beta = 0·94 x {($84m + $182·5m x (1 – 0·2))/$84m} = 2·57 ke = 4% + 2·57 x (10% – 4%) = 19·42% (ii) Comment The project-specific cost of equity is higher than the current cost of equity, indicating that a higher return would be needed by shareholders to compensate for the higher risk of the new venture. Appraising the venture using the existing cost of equity, as advised by the commercial director, would therefore result in an over-statement of the venture’s net present value, potentially leading to an incorrect decision being made. (b) Gearing problems Increased earnings volatility High gearing increases the volatility of Zeddemore Co’s earnings as the interest payable is unaffected by any change in the activity level. If Zeddemore Co experiences a reduction in its activity level, the percentage reduction in earnings will be greater than the percentage reduction in activity level. This increased volatility in earnings represents the financial risk of the company. Cost of equity finance Increased volatility of earnings will increase the cost of equity, making equity finance more expensive. The financial risk premium can be seen by comparing the asset beta of 0·94 (ke = 9·64%) with the equity beta of 2·57 (ke = 19·42%) . Debt capacity The gearing level will affect Zeddemore Co’s ability to raise new debt finance and how much debt it can support (debt capacity) . Given its high gearing level, Zeddemore Co may find that it cannot raise any more debt finance. Bankruptcy risk High gearing leads to a high interest obligation for Zeddemore Co and an increased risk of being unable to pay all of its interest following an unexpected reduction in profits/cash flow. This could result in default by Zeddemore Co on its interest payments and subsequent forced liquidation by its lenders. Note: Only three problems were required. (c) Risk-return relationship The risk-return relationship explains why different sources of finance have different costs. An investor’s required rate of return will be determined primarily by the level of risk the investment has. If an investment carries a high level of risk, the investor will require a hig

Jul 17, 2026

Uploaded by Theodore