ICAB PL Financial Management flashcards

33 cards. Read the term and the definition here. The deck at the top of this page is optional.

Net present value

Sum of future cash flows discounted at the required rate of return, less the initial investment. A positive NPV signals the project earns more than the cost of capital and adds shareholder wealth.

Internal rate of return

The discount rate that makes a project's net present value equal to zero. A project is acceptable when its IRR exceeds the required rate of return, the firm's cost of capital.

Profitability index

Present value of a project's future cash flows divided by its initial investment. Values above one indicate acceptance, and the index ranks projects efficiently when capital is rationed.

Payback period

The number of years required for cumulative cash inflows to equal the initial outlay. It measures liquidity and risk exposure but ignores the time value of money and cash flows after payback.

Discounted payback period

The time needed for cumulative discounted cash inflows to recover the initial investment. It corrects the plain payback method for the time value of money but still ignores value created after the cutoff.

Weighted average cost of capital

The blended required return on a firm's debt and equity, weighted by their market value proportions. Debt is included at its after-tax cost because interest is tax deductible.

Cost of equity

The return shareholders require on their investment in the firm. It is commonly estimated with the capital asset pricing model or the dividend growth model and exceeds the after-tax cost of debt.

Capital asset pricing model

Expected return equals the risk-free rate plus beta multiplied by the market risk premium. Beta captures systematic risk, the only risk investors are compensated for holding in a diversified portfolio.

Beta coefficient

A measure of a security's sensitivity to movements in the overall market. A beta of one moves with the market; above one is more volatile, below one is less volatile.

Systematic risk

Market-wide risk from factors such as interest rates, inflation, and recessions. It cannot be eliminated by diversification, so the market prices it and it drives the cost of equity.

Unsystematic risk

Firm-specific risk such as strikes, product failures, or lawsuits. Diversified investors can eliminate it, so it is not rewarded with a higher expected return in equilibrium pricing models.

Capital rationing

A situation where a firm has more acceptable projects than capital to fund. Managers then select the combination of projects that maximizes total net present value within the budget constraint.

Relevant cash flow

An incremental after-tax cash flow that changes only if a project is accepted. It excludes sunk costs, allocated overhead, and financing costs, and includes opportunity costs of resources used.

Sunk cost

A cost already incurred that cannot be recovered regardless of the decision. It must be excluded from project appraisal because it does not change between accepting and rejecting.

Opportunity cost

The value forgone when a resource is used in one project instead of its next best alternative. It is a relevant cash outflow even though no cash payment is actually made.

Incremental cash flow

The difference in the firm's total cash flows with and without the project. Project appraisal uses these marginal amounts rather than the average or total cash flows of the business.

Operating cash flow

Cash generated from normal operations, often computed as earnings before interest and tax plus depreciation minus tax, or as net profit plus non-cash charges such as depreciation.

Depreciation tax shield

The tax saving created by deducting depreciation, equal to the depreciation charge multiplied by the tax rate. It is a real cash benefit even though depreciation itself is not a cash outflow.

Operating leverage

The proportion of fixed versus variable operating costs. High operating leverage magnifies the effect of sales changes on operating profit, raising both potential returns and business risk.

Financial leverage

The use of fixed-cost debt finance in the capital structure. It magnifies the effect of operating profit changes on earnings per share but increases financial risk and the chance of distress.

Degree of total leverage

The percentage change in earnings per share divided by the percentage change in sales. It combines operating and financial leverage and measures overall sensitivity of shareholder returns to sales.

Break-even point

The sales volume at which total revenue equals total cost, so operating profit is zero. In units it equals fixed costs divided by contribution per unit.

Contribution margin

Sales revenue minus variable costs. It measures the amount each sale contributes toward covering fixed costs and then generating profit, and it drives break-even and leverage calculations.

Cash conversion cycle

Days inventory outstanding plus days sales outstanding minus days payables outstanding. It measures how long cash is tied up in operations before collection from customers.

Net working capital

Current assets minus current liabilities. A positive figure indicates short-term liquidity, while excessive balances may signal idle cash or slow-moving inventory that reduces returns.

Dividend growth model

Cost of equity equals next year's dividend per share divided by current share price, plus the expected dividend growth rate. It suits stable dividend-paying firms but assumes constant growth.

Dividend policy irrelevance

The proposition that, under perfect markets and fixed investment policy, dividend policy does not affect firm value because shareholders can create homemade dividends by selling shares.

Pecking order theory

The financing preference ranking internal funds first, then debt, then new equity. It reflects information asymmetry, since issuing equity signals managers believe shares are overvalued.

Modigliani-Miller proposition

Without taxes, capital structure does not change firm value. With corporate taxes, debt increases value through the interest tax shield, offset in practice by rising financial distress costs.

Interest tax shield

The tax saving from deducting interest payments, equal to interest expense multiplied by the corporate tax rate. It is the main reason debt lowers the weighted average cost of capital.

Financial distress costs

Direct and indirect costs of bankruptcy risk, including legal fees, lost customers, and supplier pressure. They offset the tax benefit of debt and create an optimal capital structure.

Sensitivity analysis

A technique that varies one input at a time to see how much net present value changes. It identifies which assumptions the project decision is most exposed to.

Scenario analysis

An appraisal technique that recalculates project value under coherent sets of assumptions, such as best, base, and worst cases, capturing how variables move together rather than one at a time.