CIMA F3 - Financial Strategy

Given

Market value of equity E=$7mE = \$7mE=$7m

Market value of debt D=$5mD = \$5mD=$5m

Total value V=D+E=12mV = D+E = 12mV=D+E=12m

WACC (geared) =9.375%= 9.375\%=9.375%

Tax rate T=15%T = 15\%T=15%

Let gearing in terms of D/ED/ED/E:

g=DE=57=0.7143g = \frac{D}{E} = \frac{5}{7} = 0.7143g=ED​=75​=0.7143

Under Modigliani & Miller with tax, the relationship between WACC of a geared firm (WACC_g) and the ungeared cost of equity kuk_uku​ is:

WACCg=ku [1+g(1−T)]1+g\text{WACC}_g = \frac{k_u \,[1 + g(1-T)]}{1+g}WACCg​=1+gku​[1+g(1−T)]​

Rearrange for kuk_uku​:

ku=WACCg⋅1+g1+g(1−T)k_u = \text{WACC}_g \cdot \frac{1+g}{1+g(1-T)}ku​=WACCg​⋅1+g(1−T)1+g​

Substitute:

g=0.7143g = 0.7143g=0.7143

1+g=1.71431+g = 1.71431+g=1.7143

g(1−T)=0.7143×0.85=0.6071g(1-T)=0.7143 \times 0.85 = 0.6071g(1−T)=0.7143×0.85=0.6071

1+g(1−T)=1.60711+g(1-T)=1.60711+g(1−T)=1.6071

ku=0.09375×1.71431.6071≈0.10=10%k_u = 0.09375 \times \frac{1.7143}{1.6071} \approx 0.10 = 10\%ku​=0.09375×1.60711.7143​≈0.10=10%

So the ungeared cost of equity is 10%.

In CIMA F3, the evaluation of mergers and acquisitions focuses on whether shareholder wealth is increased through strategic and operational synergies, rather than accounting or cosmetic effects. When assessing benefits, CIMA emphasises real economic advantages arising from the acquisition.

A. Access to technical expertise ✔ Correct

This is the most significant benefit in this scenario. Company Q operates in a highly technical service industry and derives much of its value from human capital. CIMA F3 explicitly recognises that acquiring skilled employees and specialist knowledge constitutes a knowledge-based synergy, which can enhance innovation, service quality, and competitive advantage for the acquirer.

D. Gain economies of scale ✔ Correct

Both companies operate in the same industry, making economies of scale highly achievable. CIMA F3 identifies cost synergies—such as shared infrastructure, reduced overheads, and improved purchasing power—as a primary motive for horizontal acquisitions. These efficiencies directly enhance shareholder value.

E. Improve earnings per share (EPS) ✔ Correct

Although CIMA warns that EPS growth alone does not guarantee value creation, it remains a likely outcome where genuine synergies and earnings growth exist. Given Company Q’s consistent earnings growth and Company M’s ability to apply its listed-company resources, EPS enhancement is a plausible benefit to shareholders.

Why the other options are incorrect

B. Reduction of risk through diversification ✘ Incorrect

CIMA F3 states that diversification benefits arise mainly from unrelated acquisitions. As both firms operate in the same industry, shareholders gain little additional risk reduction.

C. Improved asset backing due to intangible assets ✘ Incorrect

Intangible assets—especially human capital—are generally not acceptable collateral for borrowing. CIMA F3 highlights that asset backing depends primarily on tangible, transferable assets.

✅ Final Answer:

A, D, E\boxed{A,\ D,\ E}A, D, E​

You can send the next CIMA F3 question whenever you’re ready.

Current price = $5.00

Rights discount = 20% → Issue price = 5 × 0.8 = $4.00

Funds required = $20m

Number of new shares:

20m4=5m shares\frac{20\text{m}}{4} = 5\text{m shares}420m​=5m shares

Currently 20m shares in issue, so ratio:

5m20m=14\frac{5\text{m}}{20\text{m}} = \frac{1}{4}20m5m​=41​

So terms = 1 new share for every 4 existing → A.

Company A has low cash and already relatively high gearing (40%).

Least feasible: adding more debt (A) or using existing low cash (C).

Debt-for-share exchange (E) is not a standard realistic takeover consideration.

Most feasible:

B. Share for share exchange – no extra cash or debt needed.

D. Cash offer funded by a rights issue – raises equity, not more gearing.

Answer: B and D

Verified Answer: = B

This is exactly what statement B describes: “Dividends are paid only if no further positive NPV projects are available.” Under this policy, if the firm has many profitable projects, dividends may be low or even zero; if investment opportunities are scarce, dividends may be higher because more earnings are surplus.

Statement A is too vague: all companies must cover operational needs before paying dividends, so that does not uniquely describe a residual policy.

Statement C describes an extreme retention policy where all earnings are reinvested, which is not the same as residual dividends (where some surplus can be paid out).

Statement D refers to a stable dividend policy, where a constant or smoothly growing dividend per share is targeted, regardless of short-term earnings volatility.

Therefore, the best description of a residual dividend policy in F3 terms is B.

Director A – You can issue bonds without having listed equity, but a “public issue” of bonds still involves heavy regulation and doesn’t remove the need for disclosure. This is not what the question is really getting at → treat as not correct.

Director B – AIM still has regulatory requirements; they are lighter, not non-existent → incorrect.

Director C – Rights issues are for existing shareholders of (normally) listed companies; an unlisted company cannot raise unlimited equity this way → incorrect.

Director D – Listing improves marketability and visibility and generally increases the ability to raise both equity and debt → correct.

Director E – Listed status makes shares more easily tradable and the company more visible, so it becomes a more likely takeover target → correct.

Answer: D and E.

For WWW (geared 1:3 debt:equity):

D/E=1/3D/E = 1/3D/E=1/3

Let E=3xE = 3xE=3x, D=xD = xD=x ⇒ V=4xV = 4xV=4x

E/V=3/4=0.75E/V = 3/4 = 0.75E/V=3/4=0.75, D/V=1/4=0.25D/V = 1/4 = 0.25D/V=1/4=0.25

Cost of debt Kd=6%K_d = 6\%Kd​=6%

Unlevered cost relation:

Ku=EVKe+DVKdK_u = \frac{E}{V}K_e + \frac{D}{V}K_dKu​=VE​Ke​+VD​Kd​ 0.15=0.75Ke+0.25×0.060.15 = 0.75K_e + 0.25 \times 0.060.15=0.75Ke​+0.25×0.06 0.15=0.75Ke+0.0150.15 = 0.75K_e + 0.0150.15=0.75Ke​+0.015 0.75Ke=0.135⇒Ke=0.1350.75=0.18=18%0.75K_e = 0.135 \Rightarrow K_e = \frac{0.135}{0.75} = 0.18 = 18\%0.75Ke​=0.135⇒Ke​=0.750.135​=0.18=18%

Answer: B. 18.0%