June 2024
Lights, camera, action! Sunil Bhandari directs you as you learn the script that will get you a pass in the Advanced Financial Management exam.
You probably thinking that I am about to write about a film or a play. Not quite (though after my recent trip to India, I would love to be a Bollywood actor!).
What I want to emphasise in this article is that for those studying or planning to study ACCA AFM, keep in mind the topics and skills that repeat over and over again. They are very important, and this is why I call them the leading actors in ACCA AFM.
So, who are these leading actors?
Net present value (NPV)
All ACCA students (as well as those who are qualified) will be familiar with NPV. It is a major part of ACCA FM and is tested in every exam in that paper. It is only natural that this continues in AFM. However, there are wider issues to accrue for in my exam.
AFM students will still be expected to ascertain the NPV for domestic projects as they did in FM. However, AFM candidates also have to be comfortable with foreign projects (FX NPV). In addition, the adjusted present value (APV) is a version of NPV when projects are predominantly or exclusively financed using debt.
When talking about NPV within ACCA AFM it is not only about project appraisal. It’s also about the extensive use of the spreadsheet ‘NPV function’. This replaces the need to compute the discount factors. It allows students to jump from ascertaining the project cash flows to the final NPV.
But the spreadsheet NPV function is used in different parts of ACCA AFM.
Bond valuation is regularly tested in ACCA AFM, especially as part of questions on cost of capital.
The NPV function takes the future cash flows received by the bond holder and using the yield to maturity (YTM) as the discount rate produces the bond value. This again eliminates the need to use discount factors.
Finally, the NPV function is also used in business valuations. The entity value is present value of future free cash flows to the company discounted at the current weighted average cost of capital (WACC). Alternatively, the equity value is the present value the future free cash flows to equity discounted using the cost of equity (Ke).
In both these cases, the NPV function comes into play here to save lots of time.
Free cash flows
Talking about free cash flows, here we have another leading actor in AFM.
As mentioned above, there are two types of free cash flows. Free cash flows to the company (FCFCo) and free cash flows to equity (FCFe).
These appear in several parts of the AFM syllabus. When talking about NPV above, the cash flows used to ascertain the NPV of a project are the future FCFCo. Also, as stated, one of the business valuation methods uses future FCFCo.
The FCFe also appears twice within ACCA AFM.
Firstly, as a part of dividend policy. The FCFe is the dividend capacity value for a particular year. This is the maximum dividend that can be paid by the company.
The FCFe, along with the cost of equity, are used to find the value of the equity as part of business valuations.
Internal rate of return (IRR)
The IRR is defined as the discount rate that leads to an NPV of nil. In FM, it is part of investment appraisal as an alternative project appraisal method. The same applies in AFM.
In both FM and AFM there is a spreadsheet ‘IRR function’ that can compute the IRR for a string of future cash flows. However, in FM this can only be used for the Section C questions. Also, the old interpolation method still appears there.
This is not the case in AFM, the IRR function is dominant.
The IRR function is also used within the section on bond finance. If given the bond price and the future bond cash flows, the IRR function can be used to find the yield to maturity (YTM) of the bond. This YTM can then be converted into the cost of debt by simply multiplying the YTM by (1 – tax rate).
Finally, in AFM the IRR has a variant that counteracts the weaknesses of the standard IRR. This is the modified IRR. And guess what, in AFM we have a ‘MIRR function’ to make things easier once again for the students.
Conclusion
So, for those studying ACCA AFM or planning to, you are now aware of the key players, the leading actors that appear in many parts of this film. I am not saying the other actors like risk management are not important. Far from that. But the lead actors have more words to say in the ACCA AFM film.
- Sunil Bhandari, ACCA AFM Tutor at FME Learn Online
