Financial Management: Objectives, Time Value, Appraisal and Working Capital
What this domain tests
Financial management asks how a firm raises funds, allocates them to projects and manages short-term liquidity so that shareholder wealth is maximised. Candidates must be fluent in the objective of the firm, the time value of money, investment appraisal, the cost of capital and working-capital management, because questions often combine two or three of these ideas in a single scenario.
Core concepts to master
Know the difference between profit maximisation and wealth maximisation: profit ignores timing, risk and cash flow, whereas wealth maximisation discounts expected cash flows at a risk-adjusted rate. Be able to compute present and future values for single sums and annuities, including perpetuities and growing perpetuities. For appraisal, understand NPV, IRR, payback, discounted payback and the profitability index, and know that NPV is theoretically superior because it measures absolute value added and handles non-conventional cash flows better than IRR. Understand the weighted average cost of capital (WACC), the capital asset pricing model, and the separation of relevant and irrelevant (sunk, committed, allocated) cash flows. In working capital, know the operating cycle, the cash conversion cycle, and the trade-off between liquidity and profitability.
Traps examiners set
Watch for financing costs already captured in the discount rate, so do not deduct interest again in project cash flows. Ignore sunk costs and allocated overheads but include opportunity costs and incremental working capital. Remember that IRR can give multiple answers or mislead when comparing projects of different scale. Tax is usually paid in the year the cash flow arises unless the question states otherwise, and depreciation is not a cash flow but its tax shield is.
Worked rule of thumb
A project costs 100,000, yields 60,000 for two years, and the discount rate is 10%. Discount factors are 0.909 and 0.826. PV of inflows = 54,540 + 49,560 = 104,100, so NPV = 4,100 and the project is accepted because NPV is positive. Always state the decision rule explicitly.