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Pancyprian Accounting study materials
Pancyprian Accounting study resources

Pancyprian Accounting: Financial Management: Appraisal, Cost of Capital and Working Capital

Pancyprian Accounting · Work through your exam, one topic at a time.

All guide sections

Financial Management: Appraisal, Cost of Capital and Working Capital

Financial Management tests the numerical decisions a finance function makes: whether to invest, how to fund, and how much cash to tie up in working capital. The examiner rewards candidates who use the correct cash flows and the correct discount rate and who can say why the answer changes.

Investment appraisal

  • Relevant cash flows are incremental and after tax; include the tax saved by capital allowances, working capital invested and released, and any opportunity cost. Exclude sunk costs, apportioned fixed overhead and financing flows such as interest and dividends.
  • NPV discounts those flows at the WACC; accept if positive. IRR is the rate at which NPV is zero; accept if above the WACC. Payback ignores cash flows after the cut-off and the time value of money. ARR uses accounting profit, not cash.

Cost of capital

  • Cost of equity by CAPM: Rf + beta x (market return - Rf). Or by the dividend growth model: D1/P0 + g.
  • Cost of debt is the post-tax interest cost, i x (1 - t), using market values.
  • WACC = E/V x Ke + D/V x Kd(1 - t).

Working capital and funding

  • Cash operating cycle = inventory days + receivable days - payable days. A lengthening cycle is a warning of overtrading.
  • Funding sources for Cyprus companies include retained earnings, bank term loans, invoice discounting, leasing and state or EU-supported financing schemes.

Worked example

Equity market value EUR 6m, debt EUR 4m, cost of equity 12%, pre-tax cost of debt 7%, tax 12.5%. WACC = 0.6 x 12% + 0.4 x 7% x (1 - 0.125) = 7.2% + 2.45% = 9.65%. A project with an IRR of 9% must be rejected even though it is profitable in accounting terms, because it does not cover the cost of the funds used.

Traps that cost marks

Using book values instead of market values for the weights; omitting the tax shield on debt; discounting nominal cash flows at a real rate; deducting interest inside project cash flows and then discounting at the WACC, which double-counts financing; and presenting payback as if it measured profitability.