Financial Management: Investment, Financing, and Working Capital
Core concepts
Financial management covers the three decisions: investment (capital budgeting), financing (capital structure), and dividend policy, plus working capital management. Candidates must understand time value of money, net present value (NPV), internal rate of return (IRR), payback, the cost of capital (weighted average cost of capital, WACC), the capital asset pricing model (CAPM), gearing, and the management of receivables, inventory, and cash.
Traps
Examiners test whether candidates use cash flows rather than accounting profit in NPV, and whether they exclude sunk costs and include opportunity costs. Watch for the treatment of depreciation (add back, and include the tax shield). IRR can give multiple answers with non-conventional cash flows, and NPV is preferred for mutually exclusive projects. In WACC, use market values of debt and equity, and remember that interest is tax-deductible, so the after-tax cost of debt is used.
Worked example
A project costs 100,000 and generates 40,000 per year for four years. At a 10% discount rate, the annuity factor is 3.170, so the present value of inflows is 126,800 and NPV is 26,800. Since NPV is positive, accept the project. If the company's WACC is 10% and the project has similar risk, the WACC is the appropriate discount rate.
Rule of thumb
Accept projects with positive NPV; NPV maximises shareholder wealth.