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

24 sample cards from the Financial Management (FM) deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. 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.

2. 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.

3. 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.

4. 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.

5. 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).

6. 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.

7. 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.

8. 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.

9. 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).

10. 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).

11. 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.

12. 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.

13. 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: $$P_0 = \sum \frac{I}{(1+r)^t} + \frac{RV}{(1+r)^n}$$

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

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

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

20. 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).

21. 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.

22. 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.

23. 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.

24. 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.

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