Business Finance and Decision Making
Core concepts
Business finance tests how organisations raise funds and choose between investments. Know the sources of finance: equity, debt, retained earnings, leasing, and short-term facilities such as overdrafts and trade credit. Understand the cost of capital, weighted average cost of capital, and the risk-return relationship. Learn investment appraisal: payback, accounting rate of return, net present value, and internal rate of return. Know the time value of money and how to discount cash flows. Understand working capital management: the cash operating cycle, inventory, receivables, and payables policies. Be familiar with gearing, liquidity ratios, and the distinction between profit and cash. Recognise qualitative factors in decisions.
Traps questions set
Payback ignores cash flows after the payback point and the time value of money; ARR uses accounting profit, not cash. NPV is preferred because it uses discounted cash flows and shows absolute value added. Questions often include depreciation in cash flow forecasts; it is a non-cash item, though it may affect tax. Sunk costs and allocated fixed overheads are irrelevant. Watch whether cash flows are stated before or after tax and whether the discount rate is annual while the flows are monthly. Higher gearing raises financial risk and can raise the cost of equity.
Worked example
A project costs 100,000 and returns 60,000 in each of years 1 and 2. At a 10% discount rate, the present value is 60,000/1.10 + 60,000/1.21 = 54,545 + 49,587 = 104,132. NPV is 4,132, so accept. Rule of thumb: accept projects with positive NPV; rank mutually exclusive projects by NPV, not by IRR.