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ACCA AFM practice questions

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Question 1Financial management environment and role of the senior financial adviser

Which stakeholder group is primarily concerned with the going-concern status and long-term solvency of a company rather than its share price performance?

  1. Sell-side equity analysts
  2. Marketing agencies
  3. Long-term lenders Correct answer.
  4. Equity day traders

Explanation

Long-term lenders such as bondholders and banks focus on covenant compliance, interest cover and the ability to repay principal, which depend on going-concern status and solvency. Other groups are more focused on short-term valuation or commercial relationships.

Question 2Financial management environment and role of the senior financial adviser

Agency theory in corporate governance is best described as the conflict that arises because:

  1. regulators own the equity of listed companies
  2. shareholders and bondholders always share identical objectives
  3. employees are the residual claimants of the company
  4. managers may pursue their own interests ahead of shareholders' interests Correct answer.

Explanation

Agency theory addresses the separation of ownership and control, where managers (agents) may act in their own interest rather than in the interest of shareholders (principals). Mechanisms such as incentive schemes and monitoring are used to align interests.

Question 3Financial management environment and role of the senior financial adviser

A company's board wishes to strengthen independent oversight of executive pay. Which mechanism most directly addresses this objective?

  1. An increase in the dividend payout ratio
  2. A larger executive bonus pool
  3. An independent remuneration committee reporting to the board Correct answer.
  4. A share buyback programme

Explanation

An independent remuneration committee is a governance mechanism designed to set executive pay objectively and reduce conflicts of interest. The other options affect capital structure or distributions, not pay-setting oversight.

Question 4Financial management environment and role of the senior financial adviser

Which of the following is a primary objective of the International Integrated Reporting Framework?

  1. To regulate the issuance of new equity securities
  2. To set prudential capital requirements for banks
  3. To prescribe uniform tax accounting for multinational groups
  4. To improve the communication of how an organisation creates value over time Correct answer.

Explanation

Integrated reporting focuses on communicating how an organisation creates value over the short, medium and long term through its use of six capitals. It is not a tax, prudential or securities-issuance standard.

Question 5Financial management environment and role of the senior financial adviser

Which of the following best describes the role of the audit committee in a listed company?

  1. To manage the company's day-to-day treasury operations
  2. To negotiate collective bargaining agreements with unions
  3. To oversee financial reporting and the independence of external auditors Correct answer.
  4. To set the company's operational strategy

Explanation

The audit committee, composed mainly of independent non-executive directors, oversees financial reporting integrity, internal controls and auditor independence. Operational and strategic matters are executive responsibilities.

Question 6Financial management environment and role of the senior financial adviser

A financial adviser is asked to evaluate whether a proposed acquisition creates value for shareholders. Which measure most directly reflects the return generated above the cost of capital?

  1. Gross profit margin
  2. Economic value added Correct answer.
  3. Earnings before interest and tax
  4. Dividend cover

Explanation

Economic value added measures profit after deducting a charge for capital employed, so it captures value creation above the cost of capital. The other measures do not incorporate a capital charge.

Question 7Financial management environment and role of the senior financial adviser

Which of the following is the most appropriate description of the principal-agent relationship between a company's shareholders and its board?

  1. Shareholders and directors are co-owners with identical information
  2. Directors are employees of the shareholders with no fiduciary duty
  3. Directors delegate decision-making authority to shareholders
  4. Shareholders delegate decision-making authority to directors who act on their behalf Correct answer.

Explanation

Shareholders as principals delegate authority to directors as agents to manage the company. This creates potential conflicts of interest and information asymmetry that governance mechanisms seek to mitigate.

Question 8Financial management environment and role of the senior financial adviser

A company is considering adopting a stakeholder-inclusive approach to governance. Which of the following best reflects this approach?

  1. Maximising short-term profit regardless of wider impact
  2. Prioritising bondholder interests over all other stakeholders
  3. Delegating all ethical decisions to external regulators
  4. Considering the legitimate interests of employees, customers and communities alongside shareholders Correct answer.

Explanation

A stakeholder-inclusive approach recognises that long-term value creation depends on maintaining constructive relationships with a range of stakeholders. It does not mean ignoring shareholders but balancing their interests with those of others.

Question 9Financial management environment and role of the senior financial adviser

A company's board is reviewing its governance code compliance. Which of the following is most consistent with the 'comply or explain' principle?

  1. A company must obtain regulatory approval for every board appointment
  2. A company may ignore the code if it is profitable
  3. A company may depart from a code provision provided it explains the reasons to shareholders Correct answer.
  4. A company must comply with every provision of the code without exception

Explanation

'Comply or explain' allows flexibility: companies either comply with code provisions or explain departures to shareholders, who then judge the appropriateness. It is not a rule that permits arbitrary non-compliance.

Question 10Financial management environment and role of the senior financial adviser

An analyst observes that a company's return on capital employed exceeds its weighted average cost of capital. Which conclusion is most consistent with value-based management principles?

  1. The company's share price is necessarily undervalued
  2. The company is generating a positive economic spread and creating value Correct answer.
  3. The company should immediately increase its gearing
  4. The company must reduce its dividend to preserve cash

Explanation

When return on capital employed exceeds the cost of capital, the economic spread is positive, indicating value creation under value-based management. Other conclusions about dividends, valuation or gearing do not follow from this relationship alone.

Question 11Financial management environment and role of the senior financial adviser

A senior financial adviser is preparing a report for non-executive directors on the company's cost of capital. Which of the following is the most appropriate use of the cost of capital in this context?

  1. As the maximum amount of debt the company may issue
  2. As the guaranteed return promised to equity investors
  3. As the minimum return required by providers of finance for investment appraisal Correct answer.
  4. As the accounting profit margin targeted by management

Explanation

The cost of capital represents the minimum return that providers of finance require and is used as the discount rate in investment appraisal. It is not a promised return, a profit margin or a debt capacity limit.

Question 12Financial management environment and role of the senior financial adviser

Which of the following best explains why a company might voluntarily disclose sustainability information beyond statutory requirements?

  1. To guarantee a lower cost of debt
  2. To reduce information asymmetry with investors and enhance reputation with stakeholders Correct answer.
  3. To avoid compliance with listing rules
  4. To eliminate the need for an external audit

Explanation

Voluntary sustainability disclosure can reduce information asymmetry, build trust with investors and other stakeholders, and support reputation and access to capital. It does not remove audit requirements or guarantee financing benefits.

Question 13Financial management environment and role of the senior financial adviser

A company operates in a jurisdiction where the board must include independent non-executive directors. Which of the following best explains the purpose of this requirement?

  1. To reduce the company's tax liability
  2. To provide objective challenge to executive management and protect minority shareholders Correct answer.
  3. To increase the number of board members for prestige
  4. To allow executives to delegate all decisions to outsiders

Explanation

Independent non-executive directors provide objective oversight, challenge executive proposals and help protect the interests of shareholders, including minorities. Their role is not about prestige, delegation of all decisions or tax.

Question 14Financial management environment and role of the senior financial adviser

A financial adviser is assessing the ethical implications of a proposed transaction. Which framework is most appropriate for systematically evaluating the impact on different parties?

  1. A review of the company's marketing plan
  2. A stakeholder impact analysis considering rights, fairness and consequences Correct answer.
  3. A discounted cash flow valuation only
  4. A sensitivity analysis of interest rates only

Explanation

Ethical evaluation requires considering the rights, fairness and consequences for affected parties, which a stakeholder impact analysis supports. Purely financial or operational analyses do not capture ethical dimensions.

Question 15Financial management environment and role of the senior financial adviser

Which of the following best describes the concept of 'enlightened shareholder value'?

  1. Directors should ignore shareholder interests entirely
  2. Directors should maximise short-term profit at the expense of stakeholders
  3. Directors should prioritise employee interests over shareholders in all cases
  4. Directors should pursue shareholder value while having regard to long-term relationships with stakeholders Correct answer.

Explanation

Enlightened shareholder value holds that directors should aim to deliver shareholder value but do so by having regard to long-term stakeholder relationships and wider factors. It does not subordinate shareholders entirely or ignore them.

Question 16Financial management environment and role of the senior financial adviser

A company's remuneration committee is designing executive incentive arrangements. Which design feature is most likely to align executive interests with long-term shareholder interests?

  1. An option grant with a very short vesting period
  2. A large annual cash bonus based on short-term profit
  3. Awards of performance shares vesting over several years subject to total shareholder return conditions Correct answer.
  4. A guaranteed bonus regardless of performance

Explanation

Long-term incentive plans with multi-year vesting and performance conditions such as total shareholder return align executives with sustained shareholder value. Short-term or guaranteed bonuses weaken alignment.

Question 17Financial management environment and role of the senior financial adviser

Which of the following best explains the purpose of the UK Corporate Governance Code's provisions on board diversity?

  1. To reduce the number of board meetings
  2. To replace executive directors with non-executives
  3. To encourage boards to reflect a range of perspectives and reduce groupthink Correct answer.
  4. To ensure all directors have identical backgrounds

Explanation

Diversity provisions aim to bring a range of perspectives to board discussion, improve decision quality and reduce groupthink. They do not seek uniformity, fewer meetings or replacement of executives.

Question 18Financial management environment and role of the senior financial adviser

A financial adviser is evaluating a company's capital structure decision. Which of the following best reflects the trade-off theory of capital structure?

  1. Companies should use the maximum possible debt
  2. Capital structure is irrelevant in all circumstances
  3. Companies always prefer equity because it is cheaper
  4. Companies balance the tax benefit of debt against the costs of financial distress Correct answer.

Explanation

Trade-off theory holds that companies balance the tax shield benefit of debt against the rising costs of financial distress as gearing increases. This produces an optimal capital structure rather than an extreme position.

Question 19Financial management environment and role of the senior financial adviser

A senior financial adviser is advising on the disclosure of key performance indicators in the annual report. Which of the following best describes a characteristic of a useful KPI?

  1. It changes each year to remain novel
  2. It is only disclosed to internal management
  3. It is chosen to flatter management performance
  4. It is relevant to the business model and capable of reliable measurement Correct answer.

Explanation

Useful KPIs are relevant to how the business creates value and can be measured reliably and consistently. They should not be selected to flatter management, changed arbitrarily or withheld from external users.

Question 20Financial management environment and role of the senior financial adviser

A company is considering a takeover of a smaller competitor. The board asks the adviser to assess the impact on the company's key stakeholders. Which of the following is the most appropriate first step in a stakeholder impact analysis?

  1. Reduce employee numbers to generate synergies
  2. Set the offer price before any analysis
  3. Immediately announce the transaction to the market
  4. Identify the stakeholders affected and the nature and significance of the impact on each Correct answer.

Explanation

A stakeholder impact analysis begins by identifying affected stakeholders and assessing the nature and significance of the impact. Announcing, pricing or cutting staff before this analysis would be premature.

Question 21Financial management environment and role of the senior financial adviser

A financial adviser is asked to explain why a company might adopt integrated reporting. Which of the following is the most relevant benefit?

  1. It connects financial and non-financial performance in a single narrative about value creation Correct answer.
  2. It removes the need for financial statements
  3. It guarantees a higher credit rating
  4. It replaces the need for stakeholder engagement

Explanation

Integrated reporting links financial and non-financial information to explain how value is created over time. It supplements rather than replaces financial statements, does not guarantee ratings and does not remove the need for engagement.

Question 22Financial management environment and role of the senior financial adviser

A company's board is evaluating whether to adopt a formal risk management framework. Which of the following best describes the role of the board in this context?

  1. To delegate risk oversight entirely to external auditors
  2. To set risk appetite and oversee the effectiveness of the risk management framework Correct answer.
  3. To eliminate all business risk
  4. To personally manage all operational risks

Explanation

The board sets the risk appetite and oversees the risk management framework, while management implements it. The board does not manage risks personally, delegate entirely to auditors or seek to eliminate all risk.

Question 23Financial management environment and role of the senior financial adviser

A financial adviser is evaluating a proposal to increase board independence by appointing additional non-executive directors. Which of the following is the most significant potential limitation of this measure?

  1. Independence may be compromised if appointees have existing commercial or personal ties to executives Correct answer.
  2. Independent directors increase the company's cost of capital
  3. Non-executive directors are legally responsible for daily operations
  4. Non-executive directors always lack relevant business experience

Explanation

The effectiveness of independent directors depends on genuine independence; existing ties can compromise objectivity. Non-executives can bring relevant experience, do not directly raise the cost of capital and are not responsible for daily operations.

Question 24Financial management environment and role of the senior financial adviser

A company is considering whether to publish an integrated report alongside its annual financial statements. Which of the following best explains how the two documents differ in focus?

  1. The financial statements explain stakeholder relationships, while the integrated report focuses only on cash
  2. The integrated report explains value creation across multiple capitals, while financial statements focus on financial position and performance Correct answer.
  3. Both documents are required to follow identical measurement bases
  4. The integrated report replaces the financial statements entirely

Explanation

An integrated report explains how an organisation creates value over time using multiple capitals, whereas financial statements focus on financial position and performance under accounting standards. They serve complementary purposes.

Question 25Financial management environment and role of the senior financial adviser

A financial adviser is assessing the ethical implications of a proposed restructuring that will make significant numbers of employees redundant. Which of the following considerations is most consistent with a principles-based ethical approach?

  1. Whether the restructuring maximises short-term profit regardless of process
  2. Whether the process is fair, transparent and treats affected employees with respect Correct answer.
  3. Whether the decision can be kept secret from employees
  4. Whether the board can avoid all communication with unions

Explanation

A principles-based ethical approach emphasises fairness, transparency and respect for affected parties. Profit alone, secrecy or avoidance of communication would conflict with these principles.

Question 26Financial management environment and role of the senior financial adviser

A senior financial adviser is explaining the role of the financial manager within a company's governance structure. Which of the following best describes the treasurer's function, as distinct from the controller's?

  1. Setting the company's overall corporate strategy
  2. Designing executive remuneration packages
  3. Managing cash, liquidity, banking relationships and funding Correct answer.
  4. Preparing statutory accounts and managing the external audit

Explanation

The treasurer is responsible for the management of cash, working capital, funding and financial risk, while the controller handles accounting, reporting and control. The split is a standard way of describing the finance function's internal division of duties.

Question 27Financial management environment and role of the senior financial adviser

An unlisted company wants to raise new equity from a small group of institutional investors without a public offering. Which of the following best describes this method of raising finance?

  1. A bonus issue
  2. An initial public offering
  3. A private placement of shares Correct answer.
  4. A rights issue

Explanation

A private placement involves issuing shares directly to selected investors rather than offering them to the public. It avoids the cost and disclosure of a public listing.

Question 28Financial management environment and role of the senior financial adviser

A company operates in a highly competitive market where technology changes rapidly. Its board is reviewing the choice between a mechanistic and an organic organisational structure. Which of the following is most consistent with an organic structure?

  1. Strict reliance on formal written procedures
  2. Flexible roles and decentralised decision-making Correct answer.
  3. Rigid job descriptions and centralised authority
  4. A tall hierarchy with many management layers

Explanation

Organic structures suit dynamic environments: they feature flexible roles, lateral communication and decentralised decisions. Mechanistic structures, by contrast, rely on rigid roles, hierarchy and formal rules.

Question 29Financial management environment and role of the senior financial adviser

A senior financial adviser is asked to explain why financial markets are said to be 'semi-strong form efficient'. Which of the following best describes this concept?

  1. Prices reflect only past price movements
  2. Prices reflect all publicly available information Correct answer.
  3. Prices reflect all information, public and private
  4. Prices are set by a single dominant market maker

Explanation

Semi-strong form efficiency means share prices rapidly incorporate all publicly available information, so fundamental analysis cannot reliably generate abnormal returns. Private information is only reflected under strong form efficiency.

Question 30Financial management environment and role of the senior financial adviser

A company's board is considering the use of a stock exchange listing to raise capital. Which of the following is most likely to be a disadvantage of obtaining a listing?

  1. Increased disclosure requirements and loss of privacy Correct answer.
  2. Reduced access to capital markets
  3. Lower public profile for the company
  4. Reduced liquidity for existing shareholders

Explanation

A listing brings greater transparency obligations, such as periodic reporting and disclosure of price-sensitive information, which reduces the privacy of the company's affairs. Listing generally improves access to capital, profile and liquidity.

Question 31Financial management environment and role of the senior financial adviser

A financial adviser is explaining the role of a company's audit committee to a new non-executive director. Which of the following is the most appropriate description of its responsibilities?

  1. Setting the company's dividend policy
  2. Overseeing external audit, internal controls and financial reporting Correct answer.
  3. Determining the remuneration of executive directors
  4. Negotiating major bank facilities

Explanation

The audit committee oversees the integrity of financial reporting, the effectiveness of internal controls and the relationship with the external auditor. It does not set dividend policy, negotiate funding or set executive pay.

Question 32Financial management environment and role of the senior financial adviser

A company is considering issuing preference shares rather than ordinary shares to raise finance. Which of the following best describes a typical feature of preference shares?

  1. Voting rights that always exceed those of ordinary shares
  2. A dividend that varies with the company's profits
  3. A fixed dividend that ranks ahead of ordinary dividends Correct answer.
  4. A guaranteed repayment of capital at a set date

Explanation

Preference shares normally carry a fixed dividend that is paid before any dividend on ordinary shares. They typically carry restricted voting rights and may be irredeemable.

Question 33Financial management environment and role of the senior financial adviser

A senior financial adviser is advising a company on the principal financial objective it should adopt. Which of the following is most consistent with maximising shareholder wealth?

  1. Maximising the company's sales revenue
  2. Minimising the company's cost of debt
  3. Maximising short-term accounting profit
  4. Maximising the long-run market value of the firm Correct answer.

Explanation

Maximising shareholder wealth is best pursued by maximising the long-run market value of the firm, which reflects expected future cash flows and risk. Accounting profit, sales and cost of debt are intermediate measures that do not capture long-run value.

Question 34Financial management environment and role of the senior financial adviser

A company's finance director is reviewing the agency costs that arise between managers and shareholders. Which of the following is most likely to reduce these agency costs?

  1. Dispersing share ownership across many small investors
  2. Allowing managers to set their own remuneration without oversight
  3. Linking a portion of executive pay to long-term share performance Correct answer.
  4. Removing independent directors from the board

Explanation

Performance-related pay aligns managers' incentives with those of shareholders, reducing the divergence of interests that creates agency costs. Monitoring mechanisms, such as independent directors, also help.

Question 35Financial management environment and role of the senior financial adviser

A financial adviser is comparing the roles of the three main international accounting-standard setters and regulatory bodies. Which of the following bodies is responsible for issuing International Financial Reporting Standards?

  1. The International Accounting Standards Board Correct answer.
  2. The Basel Committee on Banking Supervision
  3. The International Federation of Accountants
  4. The International Organisation of Securities Commissions

Explanation

The International Accounting Standards Board (IASB) issues International Financial Reporting Standards. The other bodies deal with professional accountancy, banking supervision and securities regulation respectively.

Question 36Financial management environment and role of the senior financial adviser

A company is considering whether to use a sale-and-leaseback arrangement for its head office building. Which of the following best describes the main financial effect of such a transaction?

  1. It raises equity finance without any change in assets
  2. It reduces the company's lease obligations to zero
  3. It releases capital tied up in property while retaining use of the asset Correct answer.
  4. It transfers ownership and use of the property to the buyer

Explanation

A sale-and-leaseback converts an illiquid fixed asset into cash while the company continues to occupy the property as a lessee. The company gives up ownership but retains use, in exchange for future lease payments.

Question 37Financial management environment and role of the senior financial adviser

A financial adviser is asked to explain the concept of 'financial intermediation'. Which of the following best describes the role of a commercial bank in this context?

  1. Pooling deposits and lending them to borrowers while managing risk Correct answer.
  2. Guaranteeing the solvency of all corporate borrowers
  3. Setting monetary policy on behalf of the central bank
  4. Issuing government bonds to fund public spending

Explanation

Banks act as intermediaries by collecting deposits from savers and channelling them to borrowers, transforming maturities and managing credit and liquidity risk. This intermediation function is distinct from monetary policy or sovereign debt issuance.

Question 38Financial management environment and role of the senior financial adviser

A board is reviewing the company's exposure to foreign exchange risk on a large export contract priced in a foreign currency and payable in six months. Which of the following best describes the type of risk being faced?

  1. Translation risk arising from consolidating overseas subsidiaries
  2. Transaction risk arising from the time lag before settlement Correct answer.
  3. Economic risk arising from long-term changes in competitiveness
  4. Interest rate risk arising from variable-rate borrowing

Explanation

Transaction risk arises when a company has a foreign-currency receivable or payable that will be settled at a future date. Translation risk relates to consolidating foreign subsidiaries, while economic risk concerns long-run competitive exposure.

Question 39Financial management environment and role of the senior financial adviser

A company's board is considering adopting a formal treasury policy. Which of the following is the most appropriate purpose of such a policy?

  1. To set limits and controls over the management of financial risk Correct answer.
  2. To guarantee that the company will never make a loss on derivatives
  3. To remove the need for board oversight of treasury activities
  4. To delegate all funding decisions to a single trader

Explanation

A treasury policy establishes the framework, limits and controls within which treasury operates, ensuring risk is managed within board-approved parameters. It cannot eliminate losses and does not remove the need for oversight.

Question 40Financial management environment and role of the senior financial adviser

A senior financial adviser is explaining the difference between debt and equity finance to a client. Which of the following best describes a key characteristic of debt finance?

  1. It usually carries a fixed obligation to pay interest and repay principal Correct answer.
  2. It ranks behind equity in the event of liquidation
  3. It confers ownership and voting rights on the provider
  4. It carries no obligation to make payments if profits fall

Explanation

Debt finance typically involves contractual interest payments and repayment of principal, regardless of profitability. It does not confer ownership and ranks ahead of equity on liquidation.

Question 41Investment appraisal and valuation

A company evaluates a project using net present value. Which of the following best describes the decision rule for an independent project?

  1. Accept the project if its IRR is below the cost of capital
  2. Accept the project if its payback period exceeds a set limit
  3. Accept the project if its accounting rate of return is positive
  4. Accept the project if its NPV is positive Correct answer.

Explanation

A positive NPV means the project's discounted cash inflows exceed the outlay, so it adds value to shareholders and should be accepted. IRR below the cost of capital signals value destruction, and payback or ARR do not measure absolute value creation.

Question 42Investment appraisal and valuation

A firm has a cost of capital of 10%. A project requires an initial outlay of $100,000 and generates a single cash inflow of $121,000 after two years. What is the project's NPV (to the nearest dollar)?

  1. $21,000
  2. $10,000
  3. $0 Correct answer.
  4. $1,000

Explanation

Discounting $121,000 at 10% for two years gives $121,000 / 1.21 = $100,000, equal to the outlay, so NPV is zero. This means the project earns exactly the cost of capital.

Question 43Investment appraisal and valuation

Which method of investment appraisal explicitly incorporates the time value of money?

  1. Net present value Correct answer.
  2. Discounted payback period
  3. Accounting rate of return
  4. Payback period

Explanation

NPV discounts all cash flows to present value using the cost of capital, so it fully reflects the time value of money. ARR and simple payback ignore discounting, and discounted payback only discounts flows up to the payback point rather than capturing all cash flows.

Question 44Investment appraisal and valuation

A project has conventional cash flows (one outflow followed by inflows). If the cost of capital rises, what happens to the project's IRR and NPV respectively?

  1. IRR is unchanged; NPV rises
  2. IRR rises; NPV is unchanged
  3. IRR falls; NPV falls
  4. IRR is unchanged; NPV falls Correct answer.

Explanation

IRR depends only on the project's cash flow pattern, not on the cost of capital, so it stays the same. NPV is the discounted sum of those flows, so a higher discount rate reduces NPV.

Question 45Investment appraisal and valuation

Which of the following is a limitation of the IRR method when comparing mutually exclusive projects?

  1. It may rank projects differently from NPV when project sizes differ Correct answer.
  2. It ignores the scale and timing of cash flows
  3. It always produces a lower ranking than payback
  4. It cannot be calculated for conventional cash flows

Explanation

IRR measures a percentage return and can favour a small high-return project over a larger project that creates more absolute value. NPV is preferred for mutually exclusive choices because it measures value added in absolute terms.

Question 46Investment appraisal and valuation

A project requires an initial investment of $50,000 and yields annual net cash inflows of $20,000 for four years. What is the simple payback period?

  1. 2.5 years Correct answer.
  2. 4.0 years
  3. 2.0 years
  4. 3.0 years

Explanation

Payback is the outlay divided by the constant annual inflow: $50,000 / $20,000 = 2.5 years. Cumulative inflows reach $50,000 halfway through the third year.

Question 47Investment appraisal and valuation

Which of the following best explains why the accounting rate of return (ARR) is considered inferior to NPV for investment appraisal?

  1. It requires the calculation of a discount rate
  2. It uses accounting profit rather than cash flow and ignores timing Correct answer.
  3. It cannot be applied to projects with a finite life
  4. It always overstates the cost of capital

Explanation

ARR is based on accounting profits, which include non-cash items such as depreciation, and it averages returns without discounting. This means it ignores the time value of money and cash flow reality, unlike NPV.

Question 48Investment appraisal and valuation

A company has a debt-to-equity ratio of 1:1 based on market values. The cost of equity is 12% and the pre-tax cost of debt is 6%. The tax rate is 25%. What is the weighted average cost of capital?

  1. 8.25% Correct answer.
  2. 7.5%
  3. 9.0%
  4. 10.5%

Explanation

With equal weights, WACC = 0.5 x 12% + 0.5 x 6% x (1 - 0.25) = 6% + 2.25% = 8.25%. The after-tax cost of debt reflects the tax shield on interest.

Question 49Investment appraisal and valuation

Which of the following best describes the relationship between the weighted average cost of capital and the risk of a project's cash flows?

  1. A riskier project should be discounted at a lower rate
  2. WACC should be used for all projects regardless of risk
  3. The discount rate should reflect the systematic risk of the project's cash flows Correct answer.
  4. The discount rate should equal the risk-free rate for all projects

Explanation

The appropriate discount rate compensates investors for the systematic (non-diversifiable) risk of the project. Using the firm's WACC for a project of different risk misstates value.

Question 50Investment appraisal and valuation

In a capital rationing situation with a single-period constraint, which technique is most appropriate for ranking divisible projects?

  1. Ranking by accounting rate of return
  2. Ranking by profitability index Correct answer.
  3. Ranking by payback period
  4. Ranking by initial outlay

Explanation

The profitability index (NPV per unit of scarce capital) maximises total NPV when capital is limited and projects are divisible. It directs funds to the projects generating most value per dollar invested.