HKICPA QP Module 7 Financial Management cheat sheet

Agency problem: managers (agents) may pursue own goals at shareholders' (principals') expense; mitigated by share options, performance bonuses, threat of takeover, and monitoring.

Wealth maximisation is the primary corporate objective: maximise NPV of expected future cash flows, not accounting profit, because profit ignores timing, risk, and cash.

Stakeholder vs shareholder debate: stakeholder theory weighs employees, customers, creditors, and community; shareholder value theory prioritises residual owners who bear residual risk.

Financial vs managerial finance: financial accounting reports past results to outsiders under accrual rules; management accounting supplies forward-looking, decision-relevant information internally.

Financial intermediaries (banks, funds, insurers) reduce transaction costs and information asymmetry, pooling savings and channelling them to deficit units.

Primary market = new securities issued for cash to the firm; secondary market = trading between investors, providing liquidity and price discovery but no new funds to the issuer.

Efficient market forms (Fama): weak (prices reflect past prices), semi-strong (all public information), strong (all information including private). Implications differ for technical vs fundamental analysis.

Agency costs of debt: shareholders may prefer high-risk projects or dividend payouts after borrowing, transferring wealth from lenders; lenders price this via covenants and higher yields.

Not-for-profit and public-sector bodies pursue value for money: economy (input cost), efficiency (output per input), and effectiveness (achievement of objectives), not profit.

NPV = sum of CFt/(1+r)^t minus initial outlay; accept if NPV > 0. NPV is preferred because it is an absolute measure and assumes reinvestment at the cost of capital.

IRR is the discount rate where NPV = 0; accept if IRR > cost of capital. Multiple IRRs arise when cash flow signs change more than once; use NPV or modified IRR then.

Payback = time to recover initial outlay; ignores cash flows after payback and time value. Discounted payback corrects the latter but still ignores later flows.

Profitability index = PV of future cash flows / initial investment; useful for ranking projects under capital rationing where funds are limited.

Relevant cash flows are incremental and future: exclude sunk costs and allocated fixed overhead; include opportunity costs and working capital changes, releasing working capital at project end.

Tax: use cash tax paid, claim capital allowances on qualifying expenditure (often reducing tax payable), and remember tax cash flows usually lag the accounting period.

Inflation: discount nominal cash flows at a nominal (money) rate, or real cash flows at a real rate; never mix. Fisher: (1+money) = (1+real)(1+inflation).

Replacement decisions: compare equivalent annual cost (EAC) = NPV of one cycle / annuity factor for the cycle life; choose the lowest EAC.

Risk: sensitivity = NPV / PV of the variable's cash flows; scenario and simulation analyse joint changes; CAPM-based risk-adjusted discount rates reflect systematic risk.

Cost of equity (dividend growth): Ke = D1/P0 + g, where g = retention ratio x return on reinvested funds; D1 = D0(1+g).

CAPM: Ke = Rf + beta x (Rm - Rf). Beta measures systematic (non-diversifiable) risk; unsystematic risk is eliminated by diversification and earns no premium.

Cost of debt: Kd after tax = pre-tax yield x (1 - tax rate). For redeemable debt, yield is the IRR of after-tax interest and redemption proceeds against market price.

WACC = (E/V) x Ke + (D/V) x Kd(1-t), using market values of equity and debt, not book values; use marginal (target) weights for new projects.

Modigliani-Miller without tax: firm value is independent of gearing; WACC constant. With tax: debt interest is tax-deductible, so value rises with gearing and WACC falls.

Trade-off theory: tax shield benefits offset by financial distress and agency costs; optimal gearing balances marginal tax benefit against marginal distress cost.

Pecking order: firms prefer internal funds, then debt, then new equity last, because of information asymmetry and issue costs.

Rights issue: TERP = (market value before issue + proceeds) / shares after issue; the discount compensates for dilution and the value of the nil-paid right.

Dividend policy: MM argues irrelevance in perfect markets; in practice, tax, clientele effects, signalling, and agency concerns matter. Residual theory pays dividends only from surplus after funding positive-NPV projects.

Cash operating cycle = inventory days + receivable days - payable days. Shorten it to release cash; each day saved frees daily turnover of cash.

Inventory management: EOQ = square root of (2 x annual demand x order cost / holding cost per unit). Total cost at EOQ balances ordering and holding costs.

Receivables: evaluate credit policy by comparing incremental contribution from extra sales against extra investment in receivables and bad debt costs.

Payables: delaying payment is cheap short-term finance but risks lost early-settlement discounts and supplier goodwill; compare discount forgone with the cost of alternative finance.

Working capital funding policy: aggressive (short-term finance for fluctuating and some permanent assets, higher risk/return), conservative (long-term finance, lower risk), matching (maturity matching).

Treasury: centralised cash management pools funds, nets intercompany flows, and reduces idle balances; functions include liquidity, funding, FX and interest-rate risk, and banking relationships.

Transaction, translation, and economic exposure are the three FX exposures; internal hedging (matching, netting, leading/lagging) is cheaper than external instruments.

FX forwards lock a rate for a known future amount; futures are standardised and margined; options give the right but not obligation, useful for uncertain cash flows.

Interest rate risk: FRAs lock a rate for a future period; interest rate futures and swaps manage longer exposure; swaps exchange fixed and floating payments to match asset and liability profiles.

Cash operating cycle = inventory days + receivable days - payable days. Shorten it to release cash; each day saved frees daily turnover of cash.

Inventory management: EOQ = square root of (2 x annual demand x order cost / holding cost per unit). Total cost at EOQ balances ordering and holding costs.

Receivables: evaluate credit policy by comparing incremental contribution from extra sales against extra investment in receivables and bad debt costs.

Payables: delaying payment is cheap short-term finance but risks lost early-settlement discounts and supplier goodwill; compare discount forgone with the cost of alternative finance.

Working capital funding policy: aggressive (short-term finance for fluctuating and some permanent assets, higher risk/return), conservative (long-term finance, lower risk), matching (maturity matching).

Treasury: centralised cash management pools funds, nets intercompany flows, and reduces idle balances; functions include liquidity, funding, FX and interest-rate risk, and banking relationships.

Transaction, translation, and economic exposure are the three FX exposures; internal hedging (matching, netting, leading/lagging) is cheaper than external instruments.

FX forwards lock a rate for a known future amount; futures are standardised and margined; options give the right but not obligation, useful for uncertain cash flows.

Interest rate risk: FRAs lock a rate for a future period; interest rate futures and swaps manage longer exposure; swaps exchange fixed and floating payments to match asset and liability profiles.