B2 - Financial Management

How a company funds itself (capital structure & WACC). How it keeps the lights on daily (working capital). How we value the business/assets (absolute/relative, fair value). How we decide on big investments (NPV, IRR, payback). How we weigh smaller decisions (marginal analysis). All of it boils down to one question: “Are we creating value above the cost of money?”

What is capital structure?

• Mix of:

  • Debt (short & long term)

  • Equity (common & preferred)

• Used to finance operations and growth

What is WACC (weighted average cost of capital)?

• Used as “hurdle rate” in capital investment decisions

• It is the weighted average after-tax cost of:

  1. Debt

  2. Preferred stock

  3. Common equity

What is “Cost of retained earnings”?

• The opportunity cost of not paying dividends to shareholders for higher retained earnings.

  • Opportunity cost: Don’t pay dividends = higher retained earnings but risks losing shareholders.

Example: If Luna Bikes reinvests $1M of profit into expansion instead of paying dividends, shareholders still “expect” a 10% return on that $1M — that 10% is the cost of retained earnings.

How can cost of retained earnings be calculated?

1. CAPM (Capital Asset Pricing Model)

2. DCF (Discounted Cash Flow)

3. BYRP (Bond Yield + Risk Premium)

What is CAPM (Capital Asset Pricing Model)?

A model that estimates the return investors expect based on how risky a stock is compared to the overall market.

CAPM tells us: the expected return = risk-free rate (if you got something with no risk like a T-Bill) + beta (volatility of stock) × extra reward for taking on market risk.

Ex: 

• Risk-free rate = 3%

• Market return = 9%

• Beta = 1.2

Using CAPM:

• Expected return = 3% + 1.2 × (9% – 3%) = 10.2%

Meaning:

• Investors expect about a 10.2% return to be compensated for the extra risk of this stock.

• If a project or investment can’t earn at least 10.2%, it’s not worth the risk.

What is beta?

• Measures how much a stock’s price moves compared to the overall market.

  • Beta > 1 → Stock is more volatile (riskier)

  • Beta < 1 → Stock is steadier

  • Beta = 1 → Stock moves in line with the market.

What is DCF (Discounted Cash Flow)?

Estimates the return investors expect based on a stock’s dividend payments and growth. It assumes the value of a stock equals the present value of all its future dividends.

• Expected return from investors (Cost of Equity) = (Expected dividend / Current price) + Growth rate 

Example:

• Current stock price = $40

• Next year’s expected dividend = $2

• Expected dividend growth = 5%

Cost of equity (DCF) = (2 ÷ 40) + 5% = 10%

Meaning: investors require about a 10% return to hold the stock — combining the dividend yield (5%) and growth (5%) they expect over time.

What’s the difference between DCF and CAPM?

• They’re two lenses on the same question: “What return do investors expect from us?”

  Both might land near the same number, but:

  • CAPM = risk-based estimate

  • DCF = cash-flow-based estimate

• CAPM looks outward, at the market:

  “How risky is my stock compared to the whole market, and what return should investors demand for that risk?”
  It’s about systematic risk — volatility and market behavior.

• DCF looks inward, at the company’s own dividends:

  “Given what we pay out and how fast those payouts grow, what return do shareholders effectively get?”
  It’s about cash flows and growth expectations.

Example:
If CAPM gives a 10.2% cost of equity (from market risk), and DCF gives 9.8% (from dividends), a company might average or compare them to sanity-check whether their cost of equity feels right.

What is BYRP (Bond Yield + Risk Premium)?

Estimates the cost of equity when market data (like beta) isn’t available.

1. Company’s bond yield (the rate the company pays to borrow money — this is like beta because it tells us how risky banks think the company is).

2. Add a few percent as a risk premium to reflect the extra risk equity investors take by buying the stock.

Example: if bond yield = 6% and risk premium = 4%, cost of equity = 10%. Used by private companies or analysts needing a quick, practical estimate.

What is the optimal capital structure?

Mix of debt/equity that produces the lowest WACC

What is asset structure?

Composition of assets on balance sheet (not financing mix)

Why do lenders use debt covenants?

Protect lender’s position; limit borrower actions that may harm lenders

What is retention ratio?

The portion of net income a company keeps/retains instead of paying out as dividends.

If a company earns $100 and pays $40 in dividends, it keeps $60 — so the retention ratio is 60% (or 0.6).

How do you calculate growth rate (g)?

g = (Retention ratio × ROA) ÷ [1 – (Retention ratio × ROA)]

In plain English:

• ROA tells you how efficiently the company turns assets into profit.

• Retention ratio tells you how much of those profits are reinvested.

• When you multiply them, you’re finding how much new profit the company can generate from reinvested earnings.

• The fraction part adjusts that for compounding — it shows how growth feeds on itself over time.

So the idea is simple:

The more profit you keep and the better you use it, the faster you grow.

Example:
Retention = 60%, ROA = 10%
→ g = (0.6 × 0.10) ÷ [1 – (0.6 × 0.10)] = 0.06 ÷ 0.94 ≈ 6.4% growth

Meaning the company can grow earnings and dividends roughly 6.4% per year if it keeps reinvesting at that rate.

What are key profitability ratios?

ROI (Return on Investment); ROA (Return on Assets); ROE (Return on Equity); all use net income in numerator

What is operating leverage?

Sensitivity of profit to sales changes; high fixed costs → higher leverage; greater upside return and downside risk

What is financial leverage?

Degree of debt used in financing; high leverage = higher risk and return

What are the motives for holding cash?

Transaction; speculation; precaution

What are common cash management tools?

Synchronize inflows/outflows; float; overdraft protection; compensating balances

What is accounts receivable management?

Balance credit and collection policies; optimize collection period and days sales outstanding; factoring receivables = faster cash but costly

How is inventory valued?

Lower of cost or market (LCM) or net realizable value (NRV)

What are inventory systems?

Periodic: based on physical counts; perpetual: continuously updated

What are common inventory cost flow methods?

Specific identification; FIFO; LIFO; weighted average; moving average

What is safety stock?

Extra inventory held to reduce risk of stockouts

What is reorder point?

Inventory level at which a new order should be placed

What is EOQ (economic order quantity)?

Optimal order size minimizing total carrying plus ordering costs

What are contemporary inventory management techniques?

MRP (Materials Requirements Planning); JIT (Just-in-Time); Kanban (visual scheduling system)

What is supply chain management (SCM)?

Integration of business processes from customer back to original supplier

What is trade credit?

Short-term financing from vendors (payment 30–45 days later); usually largest source for small firms

What are methods to delay disbursements?

Request deferment from vendor; use bank line of credit

What is a letter of credit?

Bank guarantee of financial obligation

What is a line of credit?

Revolving loan with a bank; renewable at maturity

What are pros and cons of short-term financing?

Pros: lower rates, more liquidity, higher profitability; cons: higher interest rate risk, lower capital availability

What are pros and cons of long-term financing?

Pros: stable capital, less interest rate risk; cons: higher costs, lower liquidity, reduced profitability

What are absolute valuation models?

Intrinsic value = PV of future cash flows

What is an annuity?

Equal cash flows over time

What is a perpetuity?

An annuity that lasts forever

What is the Dividend Discount Model (DDM)?

Intrinsic stock value = PV of expected future dividends

What are relative valuation models?

Compare stock to similar companies using price multiples

What are common price multiples?

P/E ratio (earnings focus); PEG ratio (P/E adjusted for growth); price-to-sales (less manipulable); price-to-cash-flow (cash focus); price-to-book (balance sheet focus)

What is an option?

Contract giving right to buy (call) or sell (put) asset at a set price in set time

What is the Black-Scholes model?

Complex option pricing model; values security at one point in time

What is the binomial model?

Option pricing model considering security over multiple periods

How is a bond valued?

PV of future cash flows discounted for risk

How can tangible assets be valued?

Cost method; market value method; appraisal method; liquidation value

How can intangible assets be valued?

Market approach; income approach; cost approach

What are fair value measurement approaches?

Market, cost, income, or combination

What is the fair value hierarchy?

Level 1: quoted prices; Level 2: observable inputs; Level 3: unobservable inputs

What are stages of capital budgeting cash flows?

Inception (time 0); ongoing periodic inflows/outflows; terminal/disposal value

What are direct vs. indirect cash flow effects?

Direct: immediate inflows/outflows; indirect: related, e.g. tax shield from depreciation

How do you compute after-tax cash flows for a project?

Estimate inflows; subtract noncash deductible expenses; compute tax; subtract tax = after-tax CF

What are DCF (discounted cash flow) methods?

PV of all expected future cash flows using discount rate (e.g., WACC)

What is Net Present Value (NPV)?

PV of inflows – initial investment; positive = accept, negative = reject

What are strengths & limits of NPV?

Strengths: flexible, handles varying returns; limits: doesn’t show rate of return

What is capital rationing?

Allocating limited funds to maximize total NPV

What is the profitability index (PI)?

PI = PV of inflows ÷ initial investment; PI < 1.0 is undesirable

How is NPV used in lease vs. buy?

Compare cash flows of leasing vs. purchasing asset

What is Internal Rate of Return (IRR)?

Discount rate that makes NPV = 0; accept if IRR > hurdle rate

What are IRR limitations?

Unrealistic reinvestment assumption; inflexible with alternating cash flows; only relative measure

What is the payback period method?

Time to recover initial investment (ignores time value of money); pros: simple, liquidity focus; cons: ignores time value, later profitability

What is the discounted payback method?

Uses discounted cash flows; still ignores total profitability

What is EVA (economic value added)?

Excess income after taxes over cost of capital (WACC)

What is expected value in decision-making?

Weighted average of outcomes based on probabilities

What is marginal analysis?

Compares relevant revenues and costs of alternatives; relevant: incremental and opportunity costs; irrelevant: sunk costs

When should a special order be accepted?

If excess capacity: accept if price > variable cost per unit; if full capacity: include opportunity cost of lost sales

What is make vs. buy decision?

Compare insourcing vs. outsourcing; consider only relevant costs; choose lowest cost

What is a sell or process further decision?

Compare incremental revenue vs. incremental cost past split-off; process if revenue > cost, else sell

What is keep or drop a segment decision?

Keep if lost contribution margin > avoided fixed costs; drop if avoided fixed costs > lost contribution margin