Financial Management
Core decisions and tools
Financial management covers investment appraisal, financing, working capital and risk. Know time value of money, NPV, IRR, payback and discounted payback, and the limitations of each. Understand the cost of capital: cost of equity via dividend growth and CAPM, cost of debt, and WACC, including the effect of gearing and tax. Know capital structure theories at a conceptual level, dividend policy, and business valuation approaches (asset-based, income-based, market-based). Working capital management requires the cash operating cycle, inventory and receivables management, and the cost of financing working capital.
Traps to watch
- IRR can give multiple answers with non-conventional cash flows and may conflict with NPV on mutually exclusive projects; NPV is preferred.
- Use market values, not book values, in WACC where available.
- Sunk costs are irrelevant; opportunity costs are relevant.
- A longer cash cycle increases financing needs; reducing it releases cash.
- CAPM requires a risk-free rate, beta and market risk premium; mixing nominal and real rates is an error.
Worked example
A project costs 100,000 and generates 40,000 per year for four years; the cost of capital is 10%. Discount factors are 0.909, 0.826, 0.751 and 0.683. Present value of inflows = 40,000 × 3.169 = 126,760. NPV = 26,760, positive, so accept. The IRR exceeds 10%.
Rule of thumb
Discount all relevant incremental cash flows at an appropriate risk-adjusted rate, and prefer NPV when measures conflict.