ACCA SP Advanced Financial Management — Questions and Answers
Question 1: The Modigliani-Miller proposition WITH corporate tax suggests that:
- Capital structure is irrelevant to firm value
- Firm value is maximised by 100% debt due to the tax shield on interest (Correct answer)
- Equity is always cheaper than debt
- The optimal gearing is 50% debt and 50% equity
Correct answer: Firm value is maximised by 100% debt due to the tax shield on interest
MM with tax (1963): interest payments attract a tax shield (tax saving = tax rate × debt). This implies firm value rises as debt increases, theoretically favouring full debt financing.
Question 2: Which of the following describes the 'adjusted present value' (APV) method?
- Discounting all cash flows at the WACC
- Valuing a project as if all-equity financed, then adding the present value of financing side effects (e.g., tax shield) (Correct answer)
- Using beta to adjust the cost of equity
- Calculating the IRR of the project's equity cash flows
Correct answer: Valuing a project as if all-equity financed, then adding the present value of financing side effects (e.g., tax shield)
APV = Base-case NPV (all-equity) + PV of financing side effects (mainly tax shield on debt). It is particularly useful for projects with changing capital structures.
Question 3: In the context of options, a 'call option' gives the holder:
- The obligation to sell an asset at the exercise price
- The right, but not the obligation, to buy an asset at the exercise price (Correct answer)
- The obligation to buy an asset at the exercise price
- The right to both buy and sell an asset
Correct answer: The right, but not the obligation, to buy an asset at the exercise price
A call option gives the holder the right (not obligation) to buy the underlying asset at the strike (exercise) price on or before the expiry date. If the market price exceeds the strike, it is exercised.
Question 4: The Black-Scholes model is used to price:
- Bond yields
- European call and put options on non-dividend-paying stocks (Correct answer)
- Forward currency contracts
- Interest rate swaps
Correct answer: European call and put options on non-dividend-paying stocks
The Black-Scholes model derives the theoretical fair price of a European-style option using five inputs: current asset price, strike price, risk-free rate, time to expiry and volatility.
Question 5: Which of the following is a method of hedging foreign currency transaction risk?
- Investing in index-linked gilts
- Entering into a forward exchange contract (Correct answer)
- Increasing trade receivables days
- Issuing additional equity shares
Correct answer: Entering into a forward exchange contract
A forward exchange contract locks in the exchange rate for a future transaction, eliminating the uncertainty of currency movements and hedging the transaction risk.
Question 6: Duration (Macaulay duration) in bond analysis measures:
- The time to the next coupon payment
- The weighted average time to receive the bond's cash flows, used as a measure of interest rate sensitivity (Correct answer)
- The default probability of the bond
- The spread over the risk-free rate
Correct answer: The weighted average time to receive the bond's cash flows, used as a measure of interest rate sensitivity
Macaulay duration is the weighted average time to receipt of a bond's cash flows. Modified duration measures the percentage price change for a 1% change in yield, quantifying interest rate risk.
