F3 Exam Dumps : Financial Strategy

Company B (all equity):

Cost of equity = asset return = Ku = 17%

Company A:

Gearing D:E = 1:2 → D/E = 0.5

Pre-tax cost of debt Kd = 7%

Tax rate T = 30%

Levered cost of equity with tax:

Ke=Ku+DE(1−T)(Ku−Kd)K_e = K_u + \frac{D}{E}(1 - T)(K_u - K_d)Ke​=Ku​+ED​(1−T)(Ku​−Kd​) Ke=17%+0.5×0.7×(17%−7%)=17%+0.5×0.7×10%=17%+3.5%=20.5%K_e = 17\% + 0.5 \times 0.7 \times (17\% - 7\%) = 17\% + 0.5 \times 0.7 \times 10\% = 17\% + 3.5\% = 20.5\%Ke​=17%+0.5×0.7×(17%−7%)=17%+0.5×0.7×10%=17%+3.5%=20.5%

✅ Correct: A. 20.5%

We’re looking for long-term changes that would improve a company’s credit rating (i.e. reduce perceived credit risk and increase capacity to service debt):

A. Increase in interest cover (EBIT / interest) → higher coverage, safer for lenders → positive.

B. Decrease in (Net debt)/(EBITDA) → lower leverage relative to earnings → positive.

C. Increase in free cash flow from operations → more internally generated cash to pay interest and repay debt → positive.

D. Decrease in (Book debt)/(Book equity) is also a good sign in reality, but the question restricts us to three; exam focus is usually on coverage and cash flow-based ratios, so A, B and C are the best three.

E. Decrease in dividend cover (earnings / dividend) means paying a larger proportion of earnings out as dividends → less retained profit and weaker protection for creditors → negative for credit rating.

So the three most likely to improve the rating: A, B, C.

When valuing an unlisted company using a P/E ratio from a similar listed company, we normally reduce the proxy P/E to reflect the extra risk and reduced attractiveness of the unlisted investment.

A. Relative lack of marketability – Unlisted shares are harder to sell and usually take longer to realise, so investors demand a higher return, i.e. a lower P/E. ✔

B. Lower level of scrutiny and regulation – Unlisted companies face less disclosure and governance requirements, so information risk is higher. Greater risk ⇒ lower valuation multiple ⇒ reduced P/E. ✔

C. Smaller and less established – Unlisted companies tend to be smaller, less diversified and less stable, so investors again expect a higher return, implying a lower P/E. ✔

D. Control premium not included – If the proxy P/E excludes a control premium but you are valuing a controlling stake, you would increase the P/E, not reduce it. ✘

E. Higher forecast earnings growth – Higher expected growth justifies a higher P/E, not a lower one. ✘

F. One-off profit item in latest earnings – This should be dealt with by adjusting the earnings, not by cutting the P/E multiple. ✘

So the three factors justifying a reduction in the proxy P/E are A, B and C.