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Free ACCA Advanced Financial Management Practice Questions & Answers
396 exam-style Advanced Financial Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 1
What does NPV stand for and what does a positive NPV indicate?
Select an option first.
Correct answer: B — Net Present Value; the project is expected to add value to the firm above the required rate of return
Explanation: B is correct. NPV = present value of all future cash inflows minus the initial investment, discounted at the cost of capital. A positive NPV means the project earns more than the minimum required return and adds value to shareholders. A is wrong — positive NPV creates value, not destroys it. C confuses NPV with accounting profit. D confuses NPV with payback period.
Question 2
What is the Internal Rate of Return (IRR)?
Select an option first.
Correct answer: B — The discount rate that makes the NPV of a project equal to zero
Explanation: B is correct. IRR is the break-even discount rate — if the IRR exceeds the cost of capital, the project should be accepted. A describes the accounting rate of return (ARR), not IRR. C describes the borrowing rate. D describes the dividend growth rate.
Question 3
What is the decision rule for accepting a project when using the IRR method?
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Correct answer: C — Accept if IRR is greater than the cost of capital (hurdle rate)
Explanation: C is correct. The decision rule: if IRR > cost of capital (hurdle rate), the project generates a return above the minimum required and should be accepted. A reverses the rule. B uses an arbitrary threshold not related to the cost of capital. D would mean no excess return is generated.
Question 4
What is a key limitation of the IRR method compared to NPV?
Select an option first.
Correct answer: B — IRR may give multiple solutions when cash flows change sign more than once, and it can give misleading rankings for mutually exclusive projects
Explanation: B is correct. IRR has two main weaknesses: (1) multiple IRRs can arise with non-conventional cash flows (more than one sign change), and (2) it can rank mutually exclusive projects differently from NPV. NPV is theoretically superior. A is wrong — IRR can be more complex to calculate. C is wrong — IRR inherently reflects time value. D describes a specific scenario where NPV is harder to use.
Question 5
What is the Modified Internal Rate of Return (MIRR) and why was it developed?
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Correct answer: B — A modified IRR that assumes reinvestment at the cost of capital rather than the project's IRR, giving a single, more realistic return measure
Explanation: B is correct. The conventional IRR implicitly assumes reinvestment of interim cash flows at the IRR itself, which is unrealistic. MIRR assumes reinvestment at the cost of capital, eliminating multiple IRR problems and providing a single, more realistic return. A is wrong. C and D describe adjustments not central to MIRR.
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Question 6
What is the formula for the payback period?
Select an option first.
Correct answer: B — Initial investment divided by annual net cash inflow (for equal annual flows)
Explanation: B is correct. Payback period = Initial investment ÷ Annual net cash inflow (when flows are equal). For uneven flows, cash flows are cumulated until the investment is recovered. A uses profit not cash flow. C describes something else. D gives a different calculation.
Question 7
What is the main weakness of the payback period as an investment appraisal technique?
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Correct answer: B — It ignores the time value of money and all cash flows after the payback point
Explanation: B is correct. Payback ignores: (1) the time value of money (£1 received today is worth more than £1 received in three years), and (2) all cash flows occurring after the payback point is reached (e.g., a large terminal value). A is wrong — payback is very simple. C is wrong. D is wrong — payback needs no discount rate (which is also a weakness).
Question 8
What is the Accounting Rate of Return (ARR)?
Select an option first.
Correct answer: A — Average annual operating profit divided by average investment, expressed as a percentage
Explanation: A is correct. ARR = Average annual accounting profit ÷ Average investment × 100. It uses accounting profit (not cash flows) and ignores the time value of money. B is not ARR. C describes a profitability index concept. D gives total profit per year, not the ratio.
Question 9
What is the 'profitability index' (PI) and when is it useful?
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Correct answer: B — The ratio of the present value of cash inflows to the initial investment — useful for ranking projects when capital is rationed
Explanation: B is correct. PI = PV of cash inflows ÷ Initial investment. A PI > 1 means the project adds value. It is most useful when capital is rationed and projects must be ranked to maximise total NPV. A describes excess return. C is a product-level metric. D is a different ratio.
Question 10
What is 'capital rationing' and how does it affect investment decisions?
Select an option first.
Correct answer: B — A situation where a firm faces limits on the amount of capital it can invest, requiring it to rank and select projects to maximise total NPV within the budget
Explanation: B is correct. Capital rationing: limited capital forces the firm to choose among positive NPV projects. Hard rationing = external limit (lenders won't provide more capital). Soft rationing = internal limit set by management. Ranking by PI or NPV per £ of capital invested helps maximise total value. A and C are different concepts. D is not capital rationing.
Question 11
What is the difference between 'hard' and 'soft' capital rationing?
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Correct answer: B — Hard rationing is an externally imposed limit on capital (e.g., lenders refuse to provide more funds); soft rationing is an internally imposed limit set by management
Explanation: B is correct. Hard rationing: from outside the firm — cannot raise additional capital. Soft rationing: management-imposed budget constraint, even though additional capital might be available. A, C and D are incorrect.
Question 12
When projects are divisible under capital rationing, how should they be ranked?
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Correct answer: B — By NPV per £1 of capital invested (profitability index) in descending order
Explanation: B is correct. For divisible projects (fractions can be undertaken) under single-period capital rationing: rank by PI (NPV per £ of capital invested) to maximise total NPV within the budget. A uses IRR which can give different rankings from NPV. C and D use inferior metrics.
Question 13
What is the discount rate used in NPV calculations?
Select an option first.
Correct answer: B — The weighted average cost of capital (WACC) or an appropriate risk-adjusted rate reflecting the riskiness of the project
Explanation: B is correct. The appropriate discount rate for NPV is a risk-adjusted rate: typically WACC for projects with the same risk as the firm, or an adjusted rate for projects with different risk. A is too specific. C (risk-free) ignores the risk premium. D (dividend yield) is not the correct rate for investment appraisal.
Question 14
What is 'equivalent annual cost' (EAC) and when is it used?
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Correct answer: B — The annualised cost of owning and operating an asset, used to compare assets with different useful lives on a like-for-like basis
Explanation: B is correct. EAC converts the NPV of costs into an equivalent annual payment, enabling fair comparison of assets with different lifespans (e.g., comparing a 3-year vs 5-year machine). A is accounting profit. C is not a recognised technique. D describes the cost of capital.
Question 15
What is the formula for the weighted average cost of capital (WACC)?
Select an option first.
Correct answer: B — WACC = (E/V × Ke) + (D/V × Kd × (1 − t)), where E = equity, D = debt, V = total value, Ke = cost of equity, Kd = pre-tax cost of debt, t = tax rate
Explanation: B is correct. WACC weights the cost of each component (equity and debt) by its proportion of total firm value. Debt cost is tax-adjusted because interest is tax-deductible. A is an unweighted average. C is the CAPM formula for cost of equity. D is the Gordon Growth Model for cost of equity.
Question 16
What is the Capital Asset Pricing Model (CAPM) used to estimate?
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Correct answer: B — The required rate of return on equity (cost of equity) based on the asset's systematic risk
Explanation: B is correct. CAPM: Ke = Rf + β(Rm − Rf). It estimates the required return on equity by adding a risk premium (based on beta × market risk premium) to the risk-free rate. A is market cap. C (total risk) is measured by standard deviation; CAPM only compensates for systematic (market) risk. D is separate.
Question 17
What does 'beta' measure in the CAPM?
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Correct answer: B — The systematic (market) risk of an asset relative to the overall market — a beta of 1 means the asset moves in line with the market, above 1 means more volatile than the market, below 1 means less volatile
Explanation: B is correct. Beta measures sensitivity to market movements (systematic risk only — the non-diversifiable portion). A is total risk (measured by standard deviation, not beta). C (standard deviation) measures total risk. D (correlation) is related but not beta.
Question 18
What is the 'market risk premium' in the CAPM formula?
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Correct answer: B — The difference between the expected market return and the risk-free rate (Rm − Rf) — the extra return investors demand for holding the market portfolio instead of a risk-free asset
Explanation: B is correct. Market risk premium (MRP) = Rm − Rf. It compensates investors for taking on market (systematic) risk. The CAPM formula multiplies MRP by beta to get the individual asset's risk premium. A is just Rf. C is an acquisition premium. D is equity premium over debt (not the MRP).
Question 19
What is an 'equity risk premium'?
Select an option first.
Correct answer: B — The extra return that investors require for investing in equities over the risk-free rate, reflecting the additional risk of equity over government bonds
Explanation: B is correct. Equity risk premium (ERP) = expected return on equities − risk-free rate. Historically, equities have outperformed risk-free assets to compensate investors for higher risk. A, C and D describe different premiums.
Question 20
What is the Gordon Growth Model (dividend growth model) used for?
Select an option first.
Correct answer: B — Estimating the cost of equity (or share value) based on dividends growing at a constant rate: P₀ = D₁ / (Ke − g), where D₁ is next year's dividend, Ke is cost of equity, and g is the constant dividend growth rate
Explanation: B is correct. Gordon Growth Model: P₀ = D₁ / (Ke − g). Rearranging: Ke = D₁/P₀ + g. Also used as the terminal value formula in DCF: TV = FCF × (1+g) / (WACC − g). A is a free cash flow concept. C estimates cost of debt (not equity via dividends). D uses the same formula but for a different purpose.
Question 21
What are the limitations of the Gordon Growth Model?
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Correct answer: B — It assumes a constant, perpetual dividend growth rate, which is unrealistic for high-growth or irregular dividend-paying companies. It is also very sensitive to the assumed growth rate and cost of equity
Explanation: B is correct. Limitations: (1) assumes constant perpetual growth (may not reflect reality); (2) highly sensitive to small changes in g or Ke; (3) cannot be used for firms that pay no dividends; (4) inappropriate for firms with growth rates near or above Ke. A describes CAPM inputs. C is incorrect. D is wrong.
Question 22
What is 'free cash flow to the firm' (FCFF)?
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Correct answer: B — Operating cash flow after deducting capital expenditure and changes in working capital but before financing payments — available to all capital providers (equity and debt holders)
Explanation: B is correct. FCFF = EBIT(1−t) + Depreciation − Capital expenditure − Increase in net working capital. It is the cash generated by operations available to both debt and equity holders before financing flows. A is accounting profit. C and D are distribution-related.
Question 23
In a discounted cash flow (DCF) valuation, what is the 'terminal value' and why is it important?
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Correct answer: B — The present value of all cash flows beyond the explicit forecast period, often representing the majority of the firm's total value — typically calculated using the Gordon Growth Model or an exit multiple
Explanation: B is correct. Terminal value (TV): captures the continuing value of the business beyond the detailed forecast period. TV = FCF_{n+1} / (WACC − g). It often represents 60–80% of total DCF value, so the growth assumption is critical. A is liquidation value. C is accounting profit. D is book value.
Question 24
What is 'enterprise value' (EV)?
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Correct answer: B — The total value of the firm to all capital providers: equity market cap + net debt (debt minus cash). EV represents what it would cost to acquire the entire business debt-free
Explanation: B is correct. EV = Market cap + Debt − Cash. EV is capital-structure neutral — it measures the value of the operating business regardless of how it is financed. A is just equity value. C is book value. D is EBIT (an income statement line).
Question 25
What is the EV/EBITDA multiple and why is it commonly used in valuation?
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Correct answer: B — Enterprise value divided by earnings before interest, tax, depreciation and amortisation — commonly used because it is capital-structure and depreciation-policy neutral, allowing comparison across firms with different financing and accounting policies
Explanation: B is correct. EV/EBITDA: EV is capital-structure neutral; EBITDA is independent of depreciation policy and financing. Makes cross-company and cross-border comparisons easier. A describes the P/E ratio concept. C is the price-to-book ratio. D is operating margin.
Question 26
What is the Price/Earnings (P/E) ratio and how is it interpreted?
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Correct answer: B — Market price per share divided by earnings per share (EPS) — shows how much investors are paying for each £1 of earnings. A higher P/E implies higher growth expectations or lower risk
Explanation: B is correct. P/E = Share price ÷ EPS. High P/E: market expects high future growth or the stock is low risk (or overvalued). Low P/E: low growth expectations, higher risk, or undervalued. A is price-to-book. C is dividend per share. D is interest cover.
Question 27
What is the 'price-to-book' (P/B) ratio?
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Correct answer: B — Market price per share divided by book value (net assets) per share — a P/B above 1 indicates the market values the firm above its accounting net assets, reflecting intangibles or expected future profits
Explanation: B is correct. P/B = Market price ÷ Book value per share. P/B > 1 means intangible value, growth prospects, or efficient management. P/B < 1 may indicate distress or undervaluation. A is P/E. C is the earnings yield rearranged. D is price-to-sales.
Question 28
What is 'earnings per share' (EPS)?
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Correct answer: B — Profit after tax attributable to ordinary shareholders divided by the weighted average number of ordinary shares in issue
Explanation: B is correct. EPS = PAT (after preference dividends) ÷ Weighted average ordinary shares. EPS is a key performance metric for listed companies. A is dividend per share. C is revenue per share. D is EBITDA per share.
Question 29
What is 'diluted EPS' and why does it differ from basic EPS?
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Correct answer: B — EPS calculated assuming all potentially dilutive instruments (convertible bonds, options, warrants) have been exercised or converted — it is lower than basic EPS because more shares are included in the denominator
Explanation: B is correct. Diluted EPS is the 'worst case' EPS for existing shareholders, assuming maximum dilution from convertibles, options, and warrants. It is always ≤ basic EPS. A is wrong. C is wrong. D is wrong.
Question 30
What is 'Return on Equity' (ROE)?
Select an option first.
Correct answer: B — Profit after tax divided by total equity, measuring how efficiently management generates profit from shareholders' funds
Explanation: B is correct. ROE = PAT ÷ Total equity × 100. It measures the return generated for shareholders on their equity investment. A uses pre-tax profit and wrong denominator. C uses revenue. D uses EBIT (pre-interest and pre-tax).
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