ACCA FM · Chapter 10
Sources of finance, Islamic finance and dividend policy MCQs with Answers
11 multiple-choice questions on Sources of finance, Islamic finance and dividend policy for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A company's shares are trading at $4.00 cum rights. It announces a 1 for 4 rights issue at $3.20 per share. What is the theoretical ex-rights price (TERP)?
- A) $3.36
- B) $3.60
- C) $3.84
- D) $4.80
Show answer & explanation
Answer: C) $3.84
TERP = (market value of existing shares + cash raised) / total shares after the issue = (4 x $4.00 + 1 x $3.20) / 5 = $19.20 / 5 = $3.84. A simple average of the two prices ($3.60) ignores the ratio of old to new shares.
Question 2
A company makes a 2 for 5 rights issue at $2.50 per share when its share price is $3.50 cum rights. What is the theoretical value of the rights attaching to EACH EXISTING share (to the nearest cent)?
- A) $0.29
- B) $0.40
- C) $0.71
- D) $1.00
Show answer & explanation
Answer: A) $0.29
TERP = (5 x 3.50 + 2 x 2.50) / 7 = 22.50 / 7 = $3.2143. Value of a right per new share = TERP - issue price = 3.2143 - 2.50 = $0.7143. Each existing share carries 2/5 of a right, so value per existing share = 0.7143 x 2/5 = $0.2857, or $0.29 to the nearest cent.
Question 3
Assuming the market price falls to the theoretical ex-rights price, which action by a shareholder will REDUCE their wealth following a rights issue (assuming no payment is received for rights not taken up)?
- A) Selling all of the rights
- B) Doing nothing and allowing the rights to lapse
- C) Taking up some rights and selling the remainder
- D) Taking up all of the rights
Show answer & explanation
Answer: B) Doing nothing and allowing the rights to lapse
If the shareholder takes up the rights, the fall in value of the existing shares is offset by the gain on the new shares bought below market value. If the rights are sold, the sale proceeds offset the fall in share value. If the rights lapse with no compensation, the shareholder suffers the fall in share price with nothing to offset it, so wealth falls.
Question 4
In Islamic finance, which arrangement involves a financial institution buying an asset and selling it to the customer at an agreed mark-up, with payment deferred?
- A) Musharaka
- B) Ijara
- C) Murabaha
- D) Mudaraba
Show answer & explanation
Answer: C) Murabaha
Murabaha is a form of trade credit: the bank purchases the goods and resells them to the customer at cost plus an agreed mark-up, payable later in instalments or a lump sum. The mark-up is fixed in advance and is not interest because it relates to the sale of an asset. Ijara is leasing, while Mudaraba and Musharaka are profit-sharing partnerships.
Question 5
Which Islamic finance instrument is the equivalent of a lease, where the financier retains ownership of the asset and receives rental payments?
- A) Ijara
- B) Mudaraba
- C) Sukuk
- D) Murabaha
Show answer & explanation
Answer: A) Ijara
Under Ijara the financial institution buys the asset and leases it to the customer for a rental. Ownership, and the risks of ownership, remain with the financier, which is why the rental return is acceptable under Sharia principles. It can be structured as the equivalent of either an operating or a finance lease.
Question 6
Which of the following best describes Sukuk?
- A) Short-term trade credit with a fixed mark-up
- B) Certificates giving investors ownership of an underlying tangible asset, with returns derived from that asset
- C) A partnership in which both parties contribute capital and share profits and losses
- D) Interest-bearing bonds issued by Islamic banks
Show answer & explanation
Answer: B) Certificates giving investors ownership of an underlying tangible asset, with returns derived from that asset
Sukuk are the Islamic equivalent of bonds. Because paying interest is prohibited, Sukuk holders own a share of an underlying asset or business and receive a return generated by that asset, such as rental income. They therefore carry some of the asset's risk, unlike conventional bondholders.
Question 7
What is the key difference between Mudaraba and Musharaka contracts?
- A) Mudaraba is used for short-term trade finance, whereas Musharaka is used for bonds
- B) Mudaraba is a lease, whereas Musharaka is a sale with deferred payment
- C) In Mudaraba one party provides all the capital and the other provides expertise, whereas in Musharaka both parties contribute capital
- D) In Mudaraba the return is fixed, whereas in Musharaka it varies with profits
Show answer & explanation
Answer: C) In Mudaraba one party provides all the capital and the other provides expertise, whereas in Musharaka both parties contribute capital
Both are profit-sharing arrangements. In Mudaraba, the capital provider supplies all the finance and the entrepreneur manages the business; profits are shared in agreed proportions and financial losses are borne by the capital provider. In Musharaka, both partners contribute capital (similar to a joint venture) and share profits and losses.
Question 8
According to Modigliani and Miller's dividend irrelevance theory, which of the following is correct?
- A) Companies should pay out all their earnings as dividends
- B) Investors always prefer dividends to capital gains because dividends are less risky
- C) A higher dividend payout always increases the share price
- D) In a perfect capital market, the value of a company depends on its investment decisions, not on its dividend policy
Show answer & explanation
Answer: D) In a perfect capital market, the value of a company depends on its investment decisions, not on its dividend policy
MM argued that in a perfect market with no taxes or transaction costs, shareholders are indifferent between dividends and capital gains because they can create 'home-made dividends' by selling shares. Company value is therefore determined by the returns on its investments. The 'bird in the hand' argument that investors prefer dividends is the opposing view.
Question 9
A company that has paid steadily rising dividends for many years announces an unexpected cut in its dividend. Its share price falls sharply. Which theory best explains this reaction?
- A) The clientele effect
- B) The signalling (information content) effect of dividends
- C) Modigliani and Miller's dividend irrelevance theory
- D) The pecking order theory
Show answer & explanation
Answer: B) The signalling (information content) effect of dividends
Because investors have less information than directors, they interpret dividend changes as signals of management's view of future prospects. An unexpected cut is read as bad news about future earnings, so the share price falls. The clientele effect relates to investors choosing companies whose dividend policies suit their needs.
Question 10
What is a scrip dividend?
- A) A dividend paid in cash out of retained earnings
- B) A dividend paid by a subsidiary to its parent company
- C) A dividend paid by issuing additional shares to shareholders instead of cash
- D) A one-off dividend paid when a company is liquidated
Show answer & explanation
Answer: C) A dividend paid by issuing additional shares to shareholders instead of cash
A scrip dividend gives shareholders new shares in place of a cash dividend, usually at their option. It allows the company to retain cash for investment while still rewarding shareholders. It slightly reduces gearing because equity increases without any cash outflow.
Question 11
A small unlisted company wishes to raise equity finance for expansion but cannot access the stock market. Which of the following sources is MOST appropriate?
- A) Issuing commercial paper
- B) A rights issue to the general public
- C) A placing of shares on the main stock exchange
- D) Business angels or venture capital
Show answer & explanation
Answer: D) Business angels or venture capital
Small and medium-sized entities often face a funding gap because they are too small for a stock market listing. Business angels (wealthy individuals) and venture capital providers invest equity in such businesses, usually seeking a significant stake and an exit route. Commercial paper is short-term debt available only to large, creditworthy companies.