Finance: Cost of Capital, Investment Appraisal and Performance Ratios
What you must know
The finance section tests cost of capital, capital budgeting, ratio and working-capital analysis, and cost-volume-profit behaviour. Build WACC as wd·kd(1−t) + wp·kp + we·ke, with ke from CAPM (rf + β × equity risk premium) or the dividend growth model. Know that NPV is the primary decision rule, with IRR, payback and profitability index as supporting screens. Control the DuPont decomposition of ROE (margin × asset turnover × leverage) and the cash conversion cycle (inventory days + receivable days − payable days). For CVP, break-even units = fixed cost ÷ contribution per unit.
Traps
Questions are built to catch mechanical application. Sunk costs and apportioned head-office overhead are not incremental and must be excluded; opportunity costs must be included. Depreciation is not a cash flow, but its tax shield (depreciation × tax rate) is. Discount nominal cash flows at a nominal rate and real cash flows at a real rate - never mix. Use target market-value weights, not book weights. When discounting at WACC, financing flows such as interest must not appear in the project cash flows. IRR falters on non-conventional cash flows and on mutually exclusive projects of different scale; prefer NPV or incremental IRR. A rising current ratio can signal idle cash and slow-moving inventory rather than strength.
Worked example
A machine costs 500,000 and saves 180,000 pre-tax annually for five years; tax is 25% and WACC is 10%. The after-tax annual saving is 180,000 × 0.75 = 135,000. The five-year annuity factor at 10% is 3.791, so PV = 511,785 and NPV = +11,785. Accept, but flag the thin margin and test sensitivity. Using pre-tax savings would have materially overstated NPV.
Rule of thumb
Ignore a cost if it is sunk; include it if it is forgone.