Association of Chartered Certified Accountants (ACCA) Financial Management (FM) Syllabus

Distinguish permanent and fluctuating current assets in working capital funding strategy.

Permanent current assets are the minimum level of current assets needed at all times; fluctuating (temporary) current assets vary with seasonal/cyclical demand above that minimum.

Under the matching (maturity-matching) approach to funding working capital, how are assets financed?

Permanent current assets and non-current assets are financed with long-term funds, while fluctuating current assets are financed with short-term funds.

Define net present value (NPV) and the decision rule for a single project.

NPV is the sum of discounted future net cash flows less the initial outlay. Decision rule: accept the project if NPV is positive (it increases shareholder wealth).

Define the internal rate of return (IRR) and give the linear interpolation formula.

IRR is the discount rate at which NPV = 0. $$IRR \approx a + \frac{NPV_a}{NPV_a - NPV_b}(b - a)$$ where $a, b$ are two discount rates giving NPVs of $NPV_a$ (positive) and $NPV_b$ (negative).

State the formula for the present value of a perpetuity, and a perpetuity growing at rate g.

Ordinary perpetuity: $$PV = \frac{\text{Cash flow}}{r}$$ Growing perpetuity: $$PV = \frac{\text{Cash flow}}{r - g}$$

State the discount factor and annuity factor formulas used in DCF.

Discount factor: $$\frac{1}{(1+r)^{n}}$$ Annuity factor: $$\frac{1 - (1+r)^{-n}}{r}$$

What are two key weaknesses of IRR compared with NPV?

IRR can give multiple rates with non-conventional cash flows, and it can rank mutually exclusive projects incorrectly because it ignores the absolute size/scale of returns (it assumes reinvestment at the IRR).

Distinguish the real method and the money (nominal) method of dealing with inflation in DCF.

Money method: discount money (inflated) cash flows at the money cost of capital. Real method: discount real (current-price) cash flows at the real cost of capital. Both give the same NPV.

State the Fisher equation linking real and money (nominal) interest rates.

$$(1 + i) = (1 + r)(1 + h)$$ where $i$ = money/nominal rate, $r$ = real rate, $h$ = inflation rate.

How are tax-allowable depreciation (capital allowances) and the resulting tax savings treated in DCF appraisal?

Capital allowances are not a cash flow themselves, but the tax saved on them is. The tax saving = allowance $\times$ tax rate, included as a cash inflow (a balancing allowance/charge arises on disposal).

What is the equivalent annual cost (EAC) technique used for?

To choose between assets with different replacement cycles/lives. $$EAC = \frac{\text{PV of costs over one cycle}}{\text{annuity factor for the cycle length}}$$ Choose the option with the lowest EAC.

Explain the technique of capital rationing and the difference between hard and soft rationing.

Capital rationing selects projects to maximise NPV when funds are limited. Hard rationing is externally imposed (capital markets restrict funds); soft rationing is internally imposed by management.

How are divisible projects ranked under single-period capital rationing?

By the profitability index (PI): $$PI = \frac{\text{PV of future cash flows}}{\text{Initial investment}}$$ Rank highest PI first and allocate the limited capital accordingly.

State the payback period and discounted payback decision concepts, and a key drawback of simple payback.

Payback is the time to recover the initial investment from net cash flows; discounted payback uses discounted flows. Key drawback of simple payback: it ignores the time value of money and all cash flows after the payback point.

Define the expected value (EV) used in risk and uncertainty analysis and a key limitation.

$$EV = \sum p_i x_i$$ (probability-weighted average of outcomes). Limitation: the EV may not correspond to any actual possible outcome and ignores the decision-maker's attitude to risk/dispersion.

Distinguish risk from uncertainty in investment appraisal.

Risk exists where outcomes can be assigned probabilities (quantifiable, often from past data); uncertainty exists where outcomes cannot be assigned reliable probabilities.

What is sensitivity analysis and how is the sensitivity margin of a variable calculated?

It measures how much a variable can change before the NPV becomes zero (the decision reverses). $$\text{Sensitivity} = \frac{NPV}{\text{PV of the variable}} \times 100\%$$

Distinguish between debt and equity finance in terms of risk and reward to the investor.

Debt holders receive fixed interest, rank ahead on liquidation and bear lower risk; equity (ordinary) shareholders receive variable dividends, rank last on liquidation and bear higher risk for higher potential return.

List three short-term and three long-term sources of finance for a company.

Short-term: overdraft, trade credit, short-term bank loans/factoring. Long-term: ordinary shares (equity), preference shares, long-term loans/bonds (debentures), and retained earnings.

What is a rights issue and how is the theoretical ex-rights price (TERP) calculated?

A rights issue offers new shares to existing shareholders pro rata. TERP = (value of shares before + cash from rights) / total number of shares after the issue.

State the dividend valuation/growth model formula for the cost of equity.

$$K_e = \frac{D_0(1+g)}{P_0} + g$$ where $D_0$ = current dividend, $g$ = growth rate, $P_0$ = ex-div market price per share.

State the Capital Asset Pricing Model (CAPM) formula for the cost of equity.

$$K_e = R_f + \beta(E(R_m) - R_f)$$ where $R_f$ = risk-free rate, $\beta$ = equity beta, $E(R_m)$ = expected market return, and $(E(R_m)-R_f)$ is the market risk premium.

State the formula for the cost of irredeemable debt and the cost of preference shares.

Irredeemable debt (after tax): $$K_d = \frac{I(1-T)}{P_0}$$ Preference shares: $$K_p = \frac{D_p}{P_0}$$ where $I$ = annual interest, $T$ = tax rate, $D_p$ = preference dividend, $P_0$ = market price.

State the formula for the Weighted Average Cost of Capital (WACC).

$$WACC = \frac{V_e}{V_e + V_d}K_e + \frac{V_d}{V_e + V_d}K_d(1-T)$$ where $V_e, V_d$ are market values of equity and debt.

How is the cost of redeemable debt calculated, and what does it equal?

It is the IRR of the after-tax cash flows: the market price (outflow now) against interest (net of tax) and the redemption value. It equals the after-tax yield to maturity of the bond.

Distinguish systematic (market) risk from unsystematic (specific) risk, and which one beta measures.

Systematic risk affects all companies and cannot be diversified away; unsystematic risk is company-specific and can be eliminated through diversification. Beta measures only systematic risk.

What does the traditional view of capital structure say about WACC and gearing?

There is an optimal level of gearing at which WACC is minimised (and firm value maximised); beyond that point the rising costs of equity and debt cause WACC to rise again — a U-shaped WACC curve.

Summarise Modigliani and Miller's capital structure propositions without and with tax.

Without tax: capital structure is irrelevant — WACC and firm value are constant regardless of gearing. With tax: the tax shield on debt means WACC falls and firm value rises as gearing increases, suggesting ~100% debt is optimal.

What is the asset (ungeared) beta formula used to de-gear and re-gear betas?

$$\beta_a = \beta_e \frac{V_e}{V_e + V_d(1-T)} + \beta_d \frac{V_d(1-T)}{V_e + V_d(1-T)}$$ (often the debt beta $\beta_d$ is assumed zero).

State the residual theory of dividends.

Dividends should only be paid out of profits remaining (the residual) after all positive-NPV investment projects have been financed; dividends are a passive residual of the investment decision.

What is the dividend irrelevancy theory (Modigliani and Miller on dividends)?

In a perfect market, dividend policy does not affect shareholder wealth; shareholders are indifferent between dividends and capital gains because they can create 'home-made dividends' by selling shares.

State the dividend growth model formula for valuing a share (and a whole equity).

$$P_0 = \frac{D_0(1+g)}{K_e - g}$$ where $D_0$ = current dividend, $g$ = constant growth rate, $K_e$ = cost of equity.

State the Gordon growth (earnings retention) model for estimating the dividend growth rate g.

$$g = r \times b$$ where $r$ = accounting rate of return on reinvested funds and $b$ = proportion of earnings retained (the retention ratio).

List the three forms of the efficient market hypothesis (EMH) and the information each reflects.

Weak form: prices reflect all past price/historic information. Semi-strong form: prices reflect all publicly available information. Strong form: prices reflect all information, public and private (insider).

Name two asset-based and two income-based methods of business valuation.

Asset-based: net book value and net realisable (or replacement) value of net assets. Income-based: P/E ratio (earnings) valuation and the dividend valuation model; also discounted cash flow of future free cash flows.

State the P/E ratio method of valuing a company's equity.

$$\text{Equity value} = \text{P/E ratio} \times \text{earnings (profit after tax)}$$ A suitable (often quoted-sector) P/E ratio is applied to maintainable earnings.

State the formula for the value of a redeemable/irredeemable bond using DCF.

The market value = present value of future interest plus redemption value, discounted at the investors' required (gross) yield: $$P_0 = \sum \frac{I}{(1+r)^t} + \frac{RV}{(1+r)^n}$$

Distinguish transaction, translation and economic foreign exchange risk.

Transaction risk: risk on the settlement value of committed foreign-currency cash flows. Translation risk: accounting risk on consolidating foreign assets/liabilities. Economic risk: long-term effect of exchange-rate changes on the present value of future cash flows.

State purchasing power parity (PPP) theory and its formula for the future spot rate.

Exchange rates move to reflect differences in inflation rates. $$S_1 = S_0 \times \frac{1 + h_c}{1 + h_b}$$ where $h_c$ and $h_b$ are the inflation rates of the counter and base currencies.

State interest rate parity (IRP) theory and its forward-rate formula.

The forward exchange rate reflects the differential in the two countries' interest rates. $$F_0 = S_0 \times \frac{1 + i_c}{1 + i_b}$$ where $i_c$ and $i_b$ are the counter and base currency interest rates.

Describe a money market hedge for a future foreign currency payment.

Borrow domestic currency now, convert to the foreign currency at the spot rate, and deposit it so it grows to the amount payable at settlement; the maturing deposit settles the liability, fixing the cost today.

Name three internal techniques for managing foreign exchange transaction risk.

Invoicing in the home currency, matching receipts and payments in the same currency (netting), and leading and lagging payments; also currency-of-billing matching via a currency bank account.

Name three derivative instruments used to hedge foreign exchange transaction risk.

Forward exchange contracts, currency futures, and currency options (also currency swaps).

What is the key difference between hedging with a forward contract and hedging with a currency option?

A forward contract is binding and fixes the rate (no upside benefit); a currency option gives the right but not the obligation to exercise, allowing the holder to benefit from favourable rate movements (for a premium cost).

Describe a forward rate agreement (FRA) used to hedge interest rate risk.

An FRA fixes the interest rate on a notional loan/deposit for a future period. The borrower and bank settle the difference between the FRA rate and the actual reference rate, effectively locking in the borrowing cost.

How does an interest rate cap, floor and collar work to manage interest rate risk?

A cap sets a maximum interest rate (protects a borrower); a floor sets a minimum rate (protects a lender/depositor); a collar combines buying a cap and selling a floor to reduce the net premium cost.

What is an interest rate swap and why might two companies enter one?

An agreement to exchange interest payment obligations (e.g. fixed for floating) on a notional principal. Companies enter swaps to obtain a lower effective borrowing cost by exploiting comparative advantage in different markets, or to manage exposure to rate movements.

State the accounting rate of return (ARR / return on capital employed) formula and decision rule.

$$ARR = \frac{\text{Average annual accounting profit}}{\text{Average (or initial) investment}} \times 100\%$$ Decision rule: accept if ARR exceeds a target rate; a key weakness is that it uses profits, not cash flows, and ignores the time value of money.