Financial Management and Treasury
Financial Management and Treasury tests capital investment decisions, cost of capital, working capital management, and treasury risk controls.
Capital budgeting
- Net present value discounts incremental after-tax cash flows at the weighted average cost of capital. Accept projects with positive NPV; NPV measures the change in shareholder wealth.
- Internal rate of return is the discount rate that makes NPV zero. It can mislead when cash flows are non-conventional or when projects differ in scale or duration.
- Include working capital investment and its later release, salvage proceeds, and tax effects. Exclude financing cash flows when the discount rate already reflects financing.
Cost of capital
- WACC = (E ÷ V) × Ke + (D ÷ V) × Kd × (1 − t), where V = E + D. Use market values and the after-tax cost of debt.
- The capital asset pricing model gives Ke = Rf + β × (Rm − Rf).
- Flotation costs and project-specific risk may require an adjusted discount rate.
Treasury and working capital
- Cash conversion cycle = inventory days + receivable days − payable days. Shortening it releases cash.
- Foreign exchange exposure: transaction exposure affects known foreign currency cash flows; translation exposure affects reported consolidated figures. Tools include forwards, futures, options, swaps, matching, and netting.
Worked example
Market value of equity is 600 and debt is 400, so total value is 1,000. Ke is 12%, pre-tax Kd is 6%, and the tax rate is 25%. WACC = 0.6 × 12% + 0.4 × 6% × (1 − 0.25) = 7.2% + 1.8% = 9.0%. Reasoning: equity and debt are weighted at market value; the interest tax shield reduces the effective cost of debt from 6% to 4.5%, giving a 1.8% debt contribution.
Traps that cost marks
- Discounting at the coupon rate or using pre-tax debt cost in WACC.
- Mixing nominal cash flows with a real discount rate.
- Ignoring working capital and terminal cash flows in NPV.
- Confusing IRR with the accounting rate of return, which ignores the time value of money.