ACCA SP Advanced Financial Management 2 — Questions and Answers
Question 1: A company wishes to acquire a target firm. Which of the following valuation approaches uses the present value of future free cash flows?
- Net asset valuation
- Price/earnings ratio method
- Dividend yield method
- Discounted cash flow (DCF) valuation (Correct answer)
Correct answer: Discounted cash flow (DCF) valuation
DCF valuation estimates the intrinsic value of a firm by discounting projected free cash flows to equity (or free cash flows to firm) at the appropriate cost of capital (WACC or Ke).
Question 2: Which of the following best describes an 'interest rate swap'?
- An agreement to exchange currencies at a future date
- An agreement between two parties to exchange interest payments (fixed for floating) on a notional principal (Correct answer)
- A bond whose coupon is linked to a floating rate
- An option to borrow at a specified rate
Correct answer: An agreement between two parties to exchange interest payments (fixed for floating) on a notional principal
An interest rate swap is a derivative where two parties exchange interest payment streams — typically one party pays a fixed rate and the other pays a floating rate (e.g., SONIA) on the same notional principal.
Question 3: The 'weighted average cost of capital' (WACC) should be used as the discount rate when:
- The project has a significantly different risk from the company's existing business
- The project maintains the company's existing capital structure and business risk (Correct answer)
- The project is financed entirely by new equity
- The project involves acquisition of another company
Correct answer: The project maintains the company's existing capital structure and business risk
WACC is appropriate as a discount rate when the proposed project is of similar risk to the company's existing activities and does not change the capital structure materially.
Question 4: Under pecking order theory, firms prefer to finance new investments using:
- New equity first, then debt, then retained earnings
- Retained earnings first, then debt, then new equity (Correct answer)
- Debt first, then retained earnings, then new equity
- Equal amounts of debt and equity
Correct answer: Retained earnings first, then debt, then new equity
Pecking order theory (Myers & Majluf) argues firms prefer internal financing first (retained earnings), then debt, and finally new equity as a last resort, to minimise information asymmetry costs.
Question 5: A 'credit default swap' (CDS) is best described as:
- A swap exchanging fixed for floating interest payments
- A derivative providing insurance against a borrower defaulting on a debt (Correct answer)
- An option to convert bonds into equity
- A currency swap involving dollar-denominated bonds
Correct answer: A derivative providing insurance against a borrower defaulting on a debt
A CDS is a derivative contract where the protection buyer pays a premium and the protection seller compensates the buyer if a specified credit event (e.g., default) occurs on the reference entity.
Question 6: Which of the following correctly describes the 'Efficient Market Hypothesis' (EMH) in its semi-strong form?
- Share prices reflect only historical price information
- Share prices reflect all publicly available information, including published financial data (Correct answer)
- Share prices reflect all information, including insider knowledge
- Share prices are always equal to intrinsic value
Correct answer: Share prices reflect all publicly available information, including published financial data
Semi-strong form EMH states that share prices immediately and fully reflect all publicly available information. Fundamental analysis cannot generate abnormal returns; only insider information could.
ACCA SP Advanced Financial Management 2
A company wishes to acquire a target firm.
Which of the following valuation approaches uses the present value of future free cash flows?