Sources of Finance, Capital Structure and Investment Appraisal
Sources and their features
Know internal versus external, short versus long term, and debt versus equity finance. Compare ordinary shares, preference shares, debentures, unsecured notes, leases, retained earnings, bank overdrafts and trade credit on cost, risk, control, flexibility and security. Understand matching: short-term assets funded by short-term finance, long-term assets by long-term finance.
Capital structure
Candidates must explain the trade-off between cheaper debt and rising financial risk, the effect of gearing on earnings per share and on shareholder risk, and why an optimal structure minimises weighted average cost of capital. Know how to compute WACC using market values and after-tax cost of debt.
Investment appraisal
Be able to calculate payback, discounted payback, net present value, profitability index and internal rate of return, and to discuss their strengths and weaknesses. Remember to use incremental cash flows, include working capital and salvage value, exclude sunk costs and financing costs embedded in the discount rate, and apply the correct tax and depreciation timing.
Traps to watch
Do not discount the initial outlay; do not use accounting profit instead of cash flow; do not mix nominal cash flows with a real discount rate; and remember that IRR can give multiple answers with non-conventional cash flows, so NPV is preferred.
Worked example
A project costs $100,000, returns $40,000 annually for four years, and the cost of capital is 10%. The annuity factor is 3.170, so the present value is $126,800 and NPV is $26,800, which is positive and acceptable. Rule of thumb: accept a project when NPV is positive or IRR exceeds the cost of capital.