Principles of Finance
Time value of money
A sum today is worth more than the same sum later because it can earn a return. Future value: FV = PV(1+r)^n. Present value discounts future cash flows. Annuities are equal periodic payments; a perpetuity is PV = payment / r. Compounding frequency matters: more frequent compounding raises the effective rate.
Risk and return
Investors demand higher expected return for higher risk. Diversification reduces unsystematic risk but not market risk. The capital asset pricing model prices equity: required return = risk-free rate + beta × market risk premium. Beta measures sensitivity to the market.
Cost of capital and appraisal
Weighted average cost of capital blends after-tax cost of debt and cost of equity by market weights. Investment appraisal uses net present value (accept if positive), internal rate of return (accept if above the hurdle rate), payback (ignores time value and later cash flows) and profitability index. NPV is preferred because it measures value added in absolute terms.
Traps to watch
- Using the nominal rate to discount when cash flows are in real terms.
- Forgetting the tax shield on debt interest.
- Treating payback as a measure of profitability.
- Confusing IRR with the discount rate - IRR is the rate at which NPV equals zero.
Worked example
Invest 10,000 now; receive 12,100 in two years. PV = 12,100 / 1.10² = 10,000 at 10%, so NPV = 0 and IRR = 10%. Rule of thumb: at the IRR, the project merely repays its cost of capital - it adds no value.