Financial Strategy (F3)

Answer: B. Free cash flow to the firm represents cash generated by operations that is available to all providers of finance — both debt and equity holders — before financing costs are deducted, so it should be discounted at the weighted average cost of capital (WACC), which blends the required returns of both groups in proportion to how the firm is actually financed. The cost of equity alone would be the appropriate discount rate for free cash flow to equity specifically (cash flow remaining after debt obligations), not for free cash flow to the firm as a whole. The risk-free rate is inappropriate because free cash flow to the firm is subject to genuine business and financial risk, not certainty. The historic dividend growth rate is a growth assumption input, potentially relevant to a separate dividend-based valuation model, not a discount rate for a DCF valuation of firm-level free cash flow.

Answer: A. Underwriting transfers the risk of an undersubscribed issue from the company to the underwriter: if shareholders and the market do not take up all the new shares on offer, the underwriter is contractually obliged to purchase the shortfall, guaranteeing the company receives the finance it needs, in return for an underwriting fee. It does not remove the need to set a subscription price — the price is still fixed in advance and is central to the underwriting agreement. Shareholders are never legally obliged to take up rights; they can let them lapse or sell them in the market, which is precisely the risk underwriting is designed to cover. Underwriting does not convert the transaction into a bonus issue, which involves no cash subscription at all and is an entirely different mechanism.

Answer: B. Systematic (market) risk arises from economy-wide factors affecting all companies and cannot be diversified away, so investors require compensation for bearing it, reflected in beta and the CAPM formula. Unsystematic (specific) risk arises from factors unique to an individual company and can be reduced or eliminated by holding a diversified portfolio of shares, so a rational, well-diversified investor does not need to be compensated for it. There is no general rule that unsystematic risk always exceeds systematic risk — this varies by company and cannot be assumed. Systematic risk, being market-wide, cannot be eliminated even in a very large, diversified portfolio, let alone with just two shares. CAPM is built on the assumption that investors hold well-diversified portfolios, not single shares, which is precisely why only systematic risk is priced.