Business Finance and Financial Management: Value, Risk and Funding
The objective and the tools
Financial management maximises shareholder wealth, subject to risk and liquidity constraints. The core tools are the time value of money, risk-and-return analysis, and the cost of capital. Be fluent in compounding and discounting, annuities and perpetuities, and net present value (NPV) as the preferred appraisal method because it measures absolute value added. Know internal rate of return (IRR) and its weaknesses (multiple IRRs, reinvestment assumption) and payback and ARR as crude screening tools.
Cost of capital and gearing
Compute the cost of equity (dividend growth model or CAPM), the cost of debt (after tax), and the weighted average cost of capital using market values. Understand how gearing affects both the cost of equity and the WACC, and the trade-off between the tax shield on debt and financial distress costs.
Working capital and financing
Manage the cash conversion cycle: inventory days plus receivable days minus payable days. Evaluate sources of finance - equity, debt, leases, retained earnings - against cost, control, flexibility and maturity matching. Understand dividend policy debates and the signalling and clientele effects.
Traps and rule of thumb
- Using book values instead of market values in WACC.
- Forgetting that interest is tax-deductible, so the after-tax cost of debt is used.
- Comparing projects of different scale by IRR alone.
Rule of thumb: discount cash flows, not profits - add back non-cash items and treat working capital and capital expenditure as cash flows. Worked example: a project needs 100,000 now and returns 60,000 in each of years 1 and 2; at 10%, NPV = 60,000/1.10 + 60,000/1.21 − 100,000 = 54,545 + 49,587 − 100,000 = 4,132, so accept.