F3: Financial Strategy

• Topic 01

  Formulation of Financial Strategy

  54 questions
• Topic 02

  Investment Decisions

  48 questions
• Topic 03

  Financing Decisions

  62 questions
• Topic 04

  Corporate Valuation

  47 questions

A few questions from this unit, with the answer and a full explanation. The complete bank is available when you start practising.

1. A project has year 1 cash flows of £120,000 in nominal terms. Inflation is expected to be 4% per annum. What is the real cash flow for year 1, and which discount rate should be used?

   • A
     Real cash flow is £110,769, calculated by removing two years of inflation
   • B
     Real cash flow is £120,000, and it should be discounted using the real discount rate
   • C
     Real cash flow is £124,800, and it should be discounted using the nominal discount rate
   • D
     Real cash flow is £115,385, and it should be discounted using the real discount rate
     Correct answer
   Explanation

   The real cash flow is calculated by deflating the nominal cash flow: £120,000 / 1.04 = £115,385. Real cash flows must be discounted using the real discount rate to maintain consistency. The fundamental rule in NPV is: nominal cash flows with nominal rates, OR real cash flows with real rates - never mix the two approaches.

2. When adjusting inventory for a revalued NAV calculation, a company has finished goods with a book value of £5 million. Market analysis shows these goods can be sold for £5.8 million, but selling costs would be £0.9 million. The company also has £0.6 million of obsolete inventory that can only be sold for scrap at £0.1 million. What is the correct treatment of these inventory items?

   • A
     Value finished goods at £4.9 million and write off obsolete inventory completely, total £4.9 million
   • B
     Value finished goods at £5.8 million and obsolete inventory at £0.6 million, total £6.4 million
   • C
     Value finished goods at £4.9 million NRV and obsolete inventory at £0.1 million NRV, total £5.0 million
     Correct answer
   • D
     Value all inventory at book value of £5.6 million
   Explanation

   In revalued NAV, inventory must be adjusted to net realisable value (NRV), which is selling price less costs to sell. Finished goods NRV = £5.8m - £0.9m = £4.9m. Obsolete inventory NRV = £0.1m (scrap value). Total adjusted value = £4.9m + £0.1m = £5.0m. This represents what the inventory would actually generate if liquidated.

3. Empirical evidence shows that more profitable firms tend to have lower gearing ratios, while the trade-off theory predicts the opposite (more profitable firms should use more debt to exploit larger tax shields). Which statement BEST explains this apparent contradiction?

   • A
     Profitable firms choose lower gearing because their shareholders prefer dividends over capital gains
   • B
     The pecking order theory better explains the observed negative correlation between profitability and gearing: profitable firms generate more internal funds and have less need to borrow, regardless of tax shield benefits
     Correct answer
   • C
     Profitable firms have lower gearing because they pay higher tax rates, eliminating the tax shield
   • D
     Both theories predict the same relationship between profitability and gearing
   Explanation

   This is one of the most important empirical puzzles in corporate finance. The trade-off theory predicts a positive relationship between profitability and gearing: more profitable firms have more taxable income to shield and lower probability of financial distress, so they should use more debt. However, empirical evidence consistently shows a negative relationship: more profitable firms use less debt. The pecking order theory explains this: profitable firms generate substantial internal cash flows and can fund investment without borrowing, so their gearing naturally decreases over time. This empirical regularity is often cited as evidence favouring the pecking order over the trade-off theory, though both theories capture different aspects of financing behaviour.