CS Advanced Level

Finance for Decision Making flashcards

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Why is wealth maximisation preferred to profit maximisation as the goal of a firm?

Profit maximisation targets the highest accounting profit, and ignores risk, the timing of returns and cash flow. Wealth maximisation targets the highest market value of shareholders' investment, which accounts for risk and timing, so it can reject a strategy that flatters one year's profit but destroys value later.

Give examples of long, medium and short-term sources of finance, and what each usually funds.

Long term: ordinary shares, preference shares, debentures and long-term loans, funding fixed assets or major investment. Medium term: term loans and leasing, typically three to ten years, funding intermediate assets such as equipment. Short term: bank overdrafts, trade credit and commercial paper, funding working capital.

Name the six categories of ratios, with one example of each.

Profitability: gross margin, net margin, return on equity. Liquidity: current ratio, quick ratio. Efficiency: inventory turnover, receivables turnover. Capital structure (gearing): debt-to-equity. Coverage: interest cover. Equity: earnings per share, dividend yield.

How are the break-even units and the break-even sales value worked out?

Break-even units = fixed costs / (selling price per unit - variable cost per unit). Break-even sales value = break-even units x selling price per unit. Example: price KES 500, variable cost KES 300, fixed costs KES 600,000: contribution KES 200, break-even 3,000 units or KES 1,500,000 of sales.

What are the formulas for the future value and the present value of a single sum?

FV = PV x (1 + i)^n, compounding a sum forward. PV = FV / (1 + i)^n, discounting a sum back. i is the rate per period and n the number of periods. Example: KES 200,000 for 5 years at 10% grows to 200,000 x 1.6105 = KES 322,102.

How does the dividend growth model value an ordinary share?

Value = D1 / (ke - g), where D1 = D0 x (1 + g) is next period's dividend, ke the shareholders' required return and g the constant growth rate of dividends. Example: D0 KES 3, g 5%, ke 15%: D1 = 3.15, value = 3.15 / 0.10 = KES 31.50.

What is the formula for the weighted average cost of capital (WACC)?

WACC = (E / V) x ke + (D / V) x kd x (1 - T). E, D and V are the market values of equity, debt and total capital (V = E + D); ke is the cost of equity, kd the pre-tax cost of debt and T the corporate tax rate. Weight by market values, and apply the tax adjustment to debt only.

What do NPV, IRR and the profitability index each need to show for a project to be accepted?

NPV: positive (present value of the cash flows less the initial outlay, at the WACC). IRR: above the cost of capital (IRR is the rate at which NPV is zero). PI: above 1 (present value of future cash flows / initial outlay). All three express the same accept decision, a useful check on your arithmetic.

How is the operating cycle calculated, and why are payable days subtracted?

Operating cycle (days) = inventory days + receivable days - payable days. Supplier credit finances part of the cycle at no direct cost, so it shortens the time the firm's own cash is tied up. Example: 45 + 60 - 30 = 75 days.

State Walter's model, and how it decides between retaining and distributing earnings.

P = [D + (r / ke) x (E - D)] / ke, where D and E are dividend and earnings per share, r the firm's return on retained earnings and ke shareholders' required return. If r is above ke, retain more; if r is below ke, distribute more.

Distinguish the managerial, routine and emerging functions of finance.