ICAB PL Financial Management cheat sheet

Financial Management

• Net present value equals the sum of each period's cash flow discounted at the required rate minus the initial outlay; accept projects with NPV greater than zero, since they add shareholder value.

• Internal rate of return is the discount rate at which NPV equals zero; accept a project when IRR exceeds the cost of capital, and rank mutually exclusive projects by NPV, not IRR, when the two conflict.

• The profitability index equals present value of future cash flows divided by initial investment; it is useful for ranking projects under capital rationing, where the goal is maximizing NPV per unit of scarce capital.

• Weighted average cost of capital equals (E/V) times cost of equity plus (D/V) times after-tax cost of debt, where V equals D plus E; the after-tax cost of debt is the pre-tax rate multiplied by one minus the tax rate.

• The capital asset pricing model states cost of equity equals risk-free rate plus beta times the market risk premium; beta measures systematic risk only, since unsystematic risk is diversifiable and not compensated.

• Payback period is the time to recover the initial outlay from cumulative cash flows; it ignores cash flows after the cutoff and the time value of money, so it is a liquidity screen rather than a value measure.

• Operating leverage rises with fixed operating costs and financial leverage rises with fixed financing costs; the degree of total leverage equals the percentage change in earnings per share divided by the percentage change in sales.

• Working capital management compares the cost of holding cash and inventory against the cost of shortages; the cash conversion cycle equals days inventory outstanding plus days sales outstanding minus days payables outstanding.