CA (Chartered Accountancy) Intermediate: Auditing and Financial Management Flashcards

24 sample cards from the Intermediate: Auditing and Financial Management deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. State the scope and key objectives of Financial Management.

   Scope covers three key decisions: (1) Investment (capital budgeting) decisions, (2) Financing decisions (capital structure), and (3) Dividend decisions (with liquidity/working capital as a supporting decision). The objectives are profit maximisation and, more importantly, wealth (shareholder value) maximisation, i.e., maximising the market value of equity shares.

2. Why is wealth maximisation considered superior to profit maximisation as a financial objective?

   Wealth maximisation considers the time value of money, accounts for risk and uncertainty, uses cash flows rather than ambiguous accounting profit, and focuses on long-term shareholder value. Profit maximisation ignores timing of returns and risk, and the term 'profit' is vague (gross/net, short/long term).

3. State the future value and present value formulas for a single cash flow.

   Future value: $$FV = PV \times (1 + i)^{n}$$ Present value: $$PV = \frac{FV}{(1 + i)^{n}}$$ where $i$ is the interest/discount rate per period and $n$ is the number of periods.

4. Give the formula for the present value of an ordinary annuity.

   $$PV = A \times \left[\frac{1 - (1 + i)^{-n}}{i}\right]$$ where $A$ is the periodic annuity amount, $i$ is the discount rate per period, and $n$ is the number of periods.

5. Give the formula for the future value of an ordinary annuity.

   $$FV = A \times \left[\frac{(1 + i)^{n} - 1}{i}\right]$$ where $A$ is the periodic payment, $i$ is the interest rate per period, and $n$ is the number of periods.

6. State the formula for the present value of a perpetuity and a growing perpetuity.

   Perpetuity: $$PV = \frac{A}{i}$$ Growing perpetuity: $$PV = \frac{A}{i - g}$$ where $A$ is the first cash flow, $i$ is the discount rate, and $g$ is the constant growth rate (with $i > g$).

7. Express the relationship between risk and return, and define the components of required return.

   Required return = Risk-free rate + Risk premium. Higher risk demands a higher expected return. As per CAPM: $$E(R_i) = R_f + \beta_i \,[E(R_m) - R_f]$$ where $R_f$ is the risk-free rate, $\beta_i$ is the systematic risk of asset $i$, and $E(R_m)$ is the expected market return.

8. State the formula for the cost of equity using the Dividend Growth (Gordon) Model.

   $$K_e = \frac{D_1}{P_0} + g$$ where $K_e$ is the cost of equity, $D_1$ is the expected dividend next year, $P_0$ is the current market price per share, and $g$ is the constant dividend growth rate.

9. State the formula for the cost of redeemable debt (before tax, approximation method).

   $$K_d = \frac{I + \frac{(RV - NP)}{n}}{\frac{RV + NP}{2}}$$ where $I$ is annual interest, $RV$ is redemption value, $NP$ is net proceeds, and $n$ is the number of years to redemption. The after-tax cost = $K_d \times (1 - t)$.

10. State the formula for the Weighted Average Cost of Capital (WACC).

    $$WACC = K_e \cdot \frac{E}{V} + K_d(1-t) \cdot \frac{D}{V} + K_p \cdot \frac{P}{V}$$ where $E$, $D$, $P$ are market values of equity, debt and preference, $V = E + D + P$, $K_e$, $K_d$, $K_p$ are respective costs, and $t$ is the tax rate.

11. State the after-tax cost of debt formula and explain why tax is adjusted.

    $$K_d(\text{after tax}) = K_d \times (1 - t)$$ Interest on debt is a tax-deductible expense, so it provides a tax shield. The effective cost to the firm is therefore reduced by the tax saving, making debt cheaper than its nominal interest rate.

12. Define 'optimum capital structure'.

    The optimum capital structure is the combination of debt and equity that minimises the firm's overall cost of capital (WACC) and thereby maximises the market value of the firm (and shareholder wealth). At this point the marginal benefit of additional debt (tax shield) equals the marginal cost (financial distress/bankruptcy risk).

13. Briefly state the Net Income (NI) approach to capital structure.

    Per the NI approach (Durand), capital structure is relevant: as the firm increases cheaper debt, the WACC falls and the total value of the firm rises. It assumes $K_e$ and $K_d$ remain constant as leverage changes, so an all-debt structure would theoretically be optimal.

14. State the key proposition of the Net Operating Income (NOI) approach and MM theory (without taxes).

    NOI approach: capital structure is irrelevant; WACC and firm value remain constant regardless of the debt-equity mix because increased financial risk raises $K_e$, offsetting the cheaper debt. MM (1958, no taxes) reaches the same conclusion through arbitrage: $V_L = V_U$, value depends only on operating earnings and business risk.

15. Define operating leverage (DOL) and give its formula.

    Operating leverage measures the sensitivity of EBIT to a change in sales due to fixed operating costs. $$DOL = \frac{\%\,\Delta EBIT}{\%\,\Delta Sales} = \frac{Contribution}{EBIT}$$

16. Define financial leverage (DFL) and give its formula.

    Financial leverage measures the sensitivity of EPS to a change in EBIT due to fixed financial charges (interest, preference dividend). $$DFL = \frac{\%\,\Delta EPS}{\%\,\Delta EBIT} = \frac{EBIT}{EBIT - I}$$ (where $I$ is interest; preference dividend is grossed up for tax if present).

17. Define combined leverage (DCL) and state its formula.

    Combined leverage measures the total sensitivity of EPS to a change in sales. $$DCL = DOL \times DFL = \frac{Contribution}{EBIT - I} = \frac{\%\,\Delta EPS}{\%\,\Delta Sales}$$

18. What does a high degree of operating leverage indicate about a firm's risk?

    A high DOL indicates a large proportion of fixed operating costs, so EBIT is highly sensitive to changes in sales. This means higher business risk: small changes in sales produce magnified changes in EBIT, beneficial when sales rise but damaging when sales fall.

19. Define 'capital budgeting' and list its main techniques.

    Capital budgeting is the process of evaluating and selecting long-term investment proposals that are consistent with the firm's objective of wealth maximisation. Techniques: Non-discounted (Payback Period, Accounting/Average Rate of Return) and Discounted (Net Present Value, Internal Rate of Return, Profitability Index, Discounted Payback).

20. State the NPV formula and its accept/reject decision rule.

    $$NPV = \sum_{t=1}^{n} \frac{CF_t}{(1+k)^{t}} - C_0$$ where $CF_t$ is cash inflow in year $t$, $k$ is the discount rate, and $C_0$ is the initial investment. Decision rule: accept if $NPV > 0$, reject if $NPV < 0$; for mutually exclusive projects, choose the highest positive NPV.

21. Define the Internal Rate of Return (IRR) and state its decision rule.

    IRR is the discount rate at which the NPV of a project equals zero, i.e., the rate where $$\sum_{t=1}^{n} \frac{CF_t}{(1+IRR)^{t}} = C_0$$ Decision rule: accept the project if $IRR >$ cost of capital (hurdle rate); reject if $IRR <$ cost of capital.

22. Define the Payback Period and state its formula for even cash flows.

    The payback period is the length of time required to recover the initial cash outlay of a project. For even (constant) annual cash inflows: $$\text{Payback Period} = \frac{\text{Initial Investment}}{\text{Annual Cash Inflow}}$$ A shorter payback period is preferred. Its main drawback is that it ignores the time value of money and cash flows beyond the payback period.

23. Compare NPV and IRR: which is preferred for mutually exclusive projects and why?

    NPV is generally preferred. NPV is expressed in absolute money terms and assumes reinvestment at the cost of capital (realistic), while IRR is a percentage assuming reinvestment at the IRR itself (often unrealistic). For mutually exclusive projects, NPV and IRR may give conflicting rankings; NPV is theoretically superior because it directly measures the addition to shareholder wealth.

24. Define the operating cycle / working capital cycle and give the formula for the gross operating cycle.

    The operating cycle is the time elapsed from purchase of raw materials to collection of cash from debtors. Gross Operating Cycle = Raw Material holding period + WIP period + Finished Goods holding period + Debtors (receivables) collection period. Net Operating Cycle = Gross Operating Cycle − Creditors (payables) deferral period.

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