Ch6. ACCA — Financial Management (FM): WACC, NPV & Capital Structure

Cost of Capital

Weighted Average Cost of Capital (WACC)

WACC = [E/(E+D)] × Ke + [D/(E+D)] × Kd × (1−T)

E: Market value of equity
D: Market value of debt
Ke: Cost of equity
Kd: Pre-tax cost of debt
T: Tax rate

Cost of Equity

CAPM: Ke = Rf + β × (Rm − Rf)

Gordon Growth Model: Ke = D₁/P₀ + g

Investment Appraisal

NPV (Net Present Value)

NPV = ∑[CFₜ / (1+r)ᵗ] − Initial Investment

NPV > 0: Accept (increases firm value)
NPV < 0: Reject

IRR (Internal Rate of Return)

The discount rate that makes NPV = 0. Accept if IRR > WACC.

IRR interpolation: IRR ≈ r₁ + [NPV₁/(NPV₁−NPV₂)] × (r₂−r₁)

Payback Period

Time to recover the initial investment from cash flows. Advantage: Simple, liquidity-focused. Disadvantage: Ignores time value of money.

Capital Structure Theory

Modigliani-Miller (MM)

No-tax world (MM 1958):

Firm value is independent of capital structure
VL = VU

With corporate taxes (MM 1963):

Interest tax shield adds value
VL = VU + T × D
Theoretically, 100% debt maximizes value → reality: financial distress costs impose a limit

Trade-off Theory

Optimal capital structure = where tax shield benefit = marginal cost of financial distress

Dividend Policy

MM Dividend Irrelevance

Dividends don’t affect firm value in perfect capital markets.

In Practice

Signaling effect: Dividend increase signals optimism about future earnings
Clientele effect: Investors self-select into stocks with their preferred payout policy
Stability preference: Stable dividends preferred over erratic ones

Working Capital Management

Working Capital = Current Assets − Current Liabilities

Cash Conversion Cycle (CCC): = Inventory days + Receivable days − Payable days

Goal: Minimize CCC → improve liquidity without straining supplier relationships

ACCA FM Exam Key Formulas

Topic	Formula
WACC	[E/(E+D)]×Ke + [D/(E+D)]×Kd×(1−T)
CAPM	Ke = Rf + β(Rm−Rf)
NPV	∑CFₜ/(1+r)ᵗ − Initial investment
MM with tax	VL = VU + T×D
CCC	Inventory days + Receivable days − Payable days

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Next: Strategic Business Reporting (SBR) — advanced group accounting, IFRS 3 business combinations, foreign currency translation, and fair value hierarchy.