Financial Management - ICAEW Professional Level (Investment appraisal, Business finance, Valuations & Risk Management)

Vocabulary flashcards covering key terms, concepts and formulas from the Financial Management lecture notes (Investment appraisal, Business finance, Valuations, Risk management, and ethics).

Payback Period

The number of years required for a project’s cash flows to recover its initial investment; shorter payback is better.

Accounting Rate of Return (ARR)

Annual percentage return of a project based on accounting profits rather than cash flows.

Net Present Value (NPV)

Sum of the present values of all cash flows, discounted at the cost of capital; positive NPV indicates value creation.

Internal Rate of Return (IRR)

The annual return that makes a project’s NPV zero; used to assess profitability of an investment.

Profitability Index (PI)

Ratio NPV to initial investment; used to rank multiple projects under capital rationing.

Equivalent Annual Cost (EAC)

A single annual cash flow that has the same PV as the project’s actual cash flows; used for replacement decisions.

Incremental Cash Flows

Cash flows that arise as a direct result of accepting a project; relevant for investment decisions.

Relevant Cash Flows

Incremental, future cash flows; exclude sunk costs and non-cash items.

Sunk Costs

Costs already incurred that cannot be recovered; should be ignored in decision making.

Real vs Nominal Cash Flows

Real cash flows exclude inflation; nominal cash flows include inflation; discount rates must align.

Real Rate

Discount rate corresponding to real (inflation-adjusted) cash flows.

Nominal Rate

Discount rate corresponding to nominal (inflation-inclusive) cash flows.

Inflation

A sustained rise in the general price level, eroding purchasing power over time.

Capital Allowances

Tax relief on capital expenditure (e.g., writing down allowances); affects taxable profit.

Tax Shield

Tax deduction benefit from interest payments on debt reducing taxable profits.

Expected Values (EV)

Probability-weighted average outcome used for risk assessment over multiple periods.

Sensitivity Analysis

Examines how much the output variable changes when inputs change; assesses robustness.

Simulation

Techniques (e.g., Monte Carlo) that analyze many input combinations to understand risk.

Adjusted Discount Rate

Higher discount rate used to reflect risk/uncertainty in future cashflows.

Correlation vs Causation

Correlation: association between variables; causation: one variable causes the other.

Confounding Variable

A third factor that affects both variables, creating a spurious association.

Sustainability & ESG

Sustainability: meeting present needs without compromising the future; ESG: environmental, social, governance criteria.

Green Finance

Financing investments with environmental benefits (e.g., green loans, bonds).

Green Loan Principles (GLP)

Framework for green loans: use of proceeds, evaluation/selection, management, reporting.

Sustainability-Linked Loans (SSLs)

Loans priced to reflect borrower’s achievement of sustainability targets (not project-specific).

Green Bonds

Fixed-interest bonds issued to fund climate/environmental projects; often tax-incentivised.

Valuation Methods (Asset-based)

Asset-based approaches value a company from NRV or replacement cost of assets.

Valuation Methods (Income-based)

Value based on earnings or cash flows, e.g., P/E, EY, Dividend Yield, DVM, or EVM.

Price-Earnings Ratio (P/E)

Market price per share divided by earnings per share; used to value equity.

Earnings Yield (EY)

Earnings divided by price; inverse of P/E often used in valuation.

Dividend Valuation Model (DVM)

Ke = D0(1+g)/P0 + g; Gordon Growth Model linking dividends, growth and price.

Dividend Growth Rate (g)

Estimated growth rate of dividends used in DVM; often based on historical trends.

Capital Asset Pricing Model (CAPM)

Ke = rf + β(rm − rf); links expected return to risk (beta) and market return.

Beta (β)

Measures a security’s sensitivity to market movements; levered βe and unlevered βa (asset beta).

Unlevered Beta (βa)

Asset beta; risk of the company excluding capital structure effects.

Levered Beta (βe)

Equity beta; includes financial risk from debt and taxes.

Ungeared Cost of Equity (Ke_u)

Cost of equity calculated using asset beta (βa) to remove gearing effects.

Capital Structure Theories

Traditional view, MM propositions (no tax and with tax) describing WACC vs gearing.

Miller and Modigliani (No Tax)

With no taxes, capital structure does not affect firm value or WACC.

Miller and Modigliani (With Tax)

Debt provides a tax shield; levering up can lower WACC and increase value.

Gearing

Proportion of debt in a company’s capital structure; affects risk and cost of capital.

APV (Adjusted Present Value)

PV of base case + PV of financing side effects (tax shields) when capital structure changes.

WACC (Weighted Average Cost of Capital)

Overall cost of capital; weighted average of the costs of debt, equity, and preference shares.

Project-Specific WACC

A WACC adjusted for a project’s risk when it differs from the company’s usual risk.

Asset Beta (βa) Formula

βa = βe / [1 + D(1−T)/E] (unlever the equity beta to obtain asset beta).

Hedging

Strategy to reduce risk of adverse price movements using forwards, futures, options, or money markets.

Forward Rate Agreement (FRA)

OTC contract fixing a future borrowing rate for a specified period.

Interest Rate Futures

Standardised futures contracts to hedge interest rate risk; multiple maturities.

Options (Call/Put)

Contracts granting right to buy (call) or sell (put) at a set price; used to hedge risk.

Money Market Hedge

Using borrowing and lending in money markets to hedge FX or rate exposure.

Interest Rate Parity (IRP)

Forward rate equals expected future spot adjusted for interest rate differentials.

Purchasing Power Parity (PPP)

Exchange rates should move to equalize price levels across countries over time.

Shareholder Value Analysis (SVA)

Valuation approach focusing on free cash flows and terminal value discounted at WACC.

Valuation of Technology Startups

Valuation challenges due to growth, losses, intangible assets, and market sentiment.

Dividend Policy Theories

Residual theory, clientele effect, irrelevancy (MM), signaling, agency, tax, liquidity.

Ethics in Financial Management

Fundamental principles (confidentiality, objectivity, professional behavior, integrity, competence) and safeguarding from threats.

Data Outliers

Observations that are unusually distant from the rest of the data and may distort results.

Causation vs Correlation

Correlation does not imply causation; beware confounding variables.

ESG Risk Analysis

Environmental, social, governance risks affecting value and sustainability.

Three Levels of Market Efficiency

Weak form, semi-strong form, strong form—different information reflected in prices.

Forecasting in Valuation

Forecast income statements, balance sheets and cash flows; assess retained earnings and reserves.