Financial Management (FM) Flashcards

A project requires an initial investment of £100,000 and generates equal annual cash inflows of £30,000 for 5 years. The cost of capital is 10%. The cumulative discount factor for 5 years at 10% is 3.791. What is the Net Present Value (NPV)?

Answer: £13,730

NPV = (Annual cash flow × Annuity factor) − Initial investment = (£30,000 × 3.791) − £100,000 = £113,730 − £100,000 = £13,730. The positive NPV of £13,730 means the project earns more than the 10% required return and should be accepted.

Which of the following statements about the weighted average cost of capital (WACC) is correct?

Answer: WACC should use market values of debt and equity as weights

WACC should use market values rather than book values as weights because market values reflect the current economic value of each source of finance. Book values may be outdated. Under Modigliani and Miller with no tax, WACC remains constant regardless of gearing. With tax, increasing debt initially reduces WACC due to the tax shield.

A company has annual credit sales of £1,200,000 and average trade receivables of £200,000. What is the receivables collection period?

Answer: 60.8 days

Receivables collection period = (Average receivables / Credit sales) × 365 = (£200,000 / £1,200,000) × 365 = 0.1667 × 365 = 60.8 days. This means it takes approximately 61 days on average to collect payment from customers.

What does the 'pecking order theory' of capital structure suggest?

Answer: Companies prefer internal financing first, then debt, and equity as a last resort

The pecking order theory (Myers, 1984) suggests companies prefer financing sources with the lowest information asymmetry costs. Retained earnings are preferred first (no external scrutiny), followed by debt (limited disclosure), and finally equity (highest adverse selection costs, potential share price dilution). This explains why profitable firms often have low gearing.

A company is considering offering a 2% early settlement discount to customers who pay within 10 days instead of the normal 30 days. What is the approximate annualised cost of this discount?

Answer: 36.7%

The annualised cost = [d / (100 − d)] × [365 / (normal terms − discount period)] = [2 / (100 − 2)] × [365 / (30 − 10)] = (2/98) × (365/20) = 0.0204 × 18.25 = 0.3724 = 37.2% (approximately 36.7%). The discount appears small but the annualised cost is substantial because payment is accelerated by only 20 days.

Which of the following is a systematic risk that cannot be diversified away?

Answer: A change in interest rates by the Bank of England

Systematic (market) risk affects all companies in the market and cannot be eliminated through diversification. Interest rate changes by the Bank of England affect all businesses through borrowing costs, consumer spending, and investment decisions. The other options are unsystematic (specific) risks that affect individual companies and can be diversified away in a portfolio.