CPA Intermediate Level

Financial Management flashcards

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What are the three decisions of financial management?

Investment decision: which long-term assets and projects to commit funds to, and how much working capital to hold. Financing decision: where the funds come from, the mix of equity and debt and the specific instruments. Dividend decision: how much of the profit to pay out to shareholders and how much to retain to fund growth.

What is the Fisher relation, and what is the rule for discounting real and nominal cash flows?

(1 + n) = (1 + r) x (1 + i), where n is the nominal rate, r the real rate and i expected inflation. Discount nominal flows at the nominal rate or real flows at the real rate, never mixed. Where flows inflate at different rates, only the nominal method works. Example: 15% nominal with 8% inflation gives 1.15 / 1.08 - 1 = 6.48% real, not 7%.

What is the NPV decision rule, and why does it serve shareholder wealth maximisation?

NPV = present value of the cash inflows at the cost of capital, less the initial outlay. Accept if positive. A positive NPV is the amount by which the project raises the value of the firm, so in an efficient market the share price rises by the NPV per share once the project is announced and believed. Accepting every positive-NPV project maximises the value of the firm.

How is the weighted average cost of capital calculated, and why are market values used?

WACC = (E / V) x ke + (P / V) x kp + (D / V) x kd(1 - T), where V = E + P + D at market values. Market values reflect what investors require today; book values are a historical accident. It is the discount rate for a project of the same business risk as the firm, financed in the same proportions.

How is the working capital operating cycle calculated, and how does management shorten it?

Operating cycle = inventory days + receivable days - payable days. It measures how long each shilling of working capital is tied up between paying for materials and receiving cash from customers. Shorten it by turning stock faster, collecting sooner and paying later, within the limits customers and suppliers will accept.

What is the difference between the primary and the secondary market, and why does an issuer care about the secondary market?

Primary: new securities are issued and the issuer receives the funds (an IPO, a rights issue, a Treasury bill auction). Secondary: existing securities are traded between investors and the issuer receives nothing. Investors subscribe only for securities they can later sell, and the secondary price signals the cost at which the issuer can raise more.

What is Gordon's dividend growth model, and when is it valid?

P0 = D1 / (ke - g) = D0 x (1 + g) / (ke - g). Growth can be estimated as g = b x r: the retention ratio times the return on reinvested funds. Valid only if growth is constant and below the cost of equity.

What does Modigliani and Miller's dividend irrelevance proposition say?

In a perfect capital market, with no taxes or transaction costs and a fixed investment policy, the value of the firm depends only on its earning power and investment decisions, not on its payout. A shareholder who wants cash can sell shares (a home-made dividend); one who wants growth can reinvest the dividend. Any effect of dividends on value must come from a market imperfection: taxes, issue and dealing costs, information signals or clientele effects.

How does correlation affect the return and risk of a two-asset portfolio?

The expected return is always the weighted average of the two assets' expected returns. The standard deviation equals the weighted average only at a correlation of +1. Below +1 it is lower, and the lower the correlation the greater the reduction. At -1 the right weights remove the risk entirely.

What is riba, and how may an Islamic financier earn a return?

Riba is any predetermined increase on a loan of money or on an exchange of like for like; all interest is riba, whatever its rate. A return may be earned only by sharing risk: a markup on a sale (murabaha), rent on a leased asset (ijara), a share of a venture's profit (mudaraba, musharaka) or a fee for a service (wakala). The financier may never lend cash and be repaid more cash.

What is the agency problem, and what are agency costs?