DSST Principles of Finance common mistakes
DSST Principles of Finance · Understand the traps and how to avoid them.
Computing a present value with the calculator set to Begin mode because a previous annuity-due problem left the mode on, then reporting a PV that is larger by one period of interest.
The BEGIN/END setting is a persistent global flag on financial calculators, and it is easy to toggle for one annuity-due question and never toggle back; the resulting answer looks plausible, so nothing signals an error.
What to do instead
Before every TVM problem, clear the time value worksheet and explicitly set END mode, then only switch to BEGIN after confirming the problem says payments occur at the start of the period. After solving, sanity-check direction: an annuity due must have a larger PV (or FV) than an otherwise identical ordinary annuity.
Treating the interest rate and the number of periods as mismatched units, e.g., entering an 8% annual nominal rate with 60 monthly payments, or a monthly rate with annual periods.
Exam questions deliberately state a nominal annual rate with monthly or quarterly compounding, and candidates plug the annual figure straight into N and I/Y without converting.
What to do instead
Write the payment frequency first, then convert: I/Y = nominal annual rate divided by compounding periods per year, and N = years times periods per year. If the question asks for an effective annual rate, convert back with (1 + i/m)^m minus 1 before answering.
Confusing IRR with NPV when the two conflict: selecting a project with the higher IRR even though it has the lower NPV at the firm's cost of capital.
IRR is expressed as a percentage and feels easier to compare across projects, and candidates memorize 'higher IRR is better' without the reinvestment-rate and scale caveats.
What to do instead
For mutually exclusive projects, rank by NPV at the given cost of capital, because NPV measures added shareholder value. Use IRR only as a screen, and remember IRR can mislead when project sizes differ or when cash flows change sign more than once (multiple IRRs).
Discounting a capital budgeting project's cash flows at the firm's overall WACC when the project's risk is clearly different from the firm's average, or using the coupon rate on existing debt as the cost of debt.
Textbook problems usually hand over one WACC and expect it to be applied everywhere, and the coupon rate is the most visible debt number on the balance sheet.
What to do instead
Use the marginal, after-tax cost of new debt (yield or current market rate times one minus the tax rate), not the historical coupon. Match the discount rate to project risk: a divisional or project-specific rate when risk differs materially from the firm's existing portfolio.
Calculating the cost of equity with the dividend growth model but using the historical dividend growth rate, or ignoring that the model breaks down when growth approaches or exceeds the required return.
Past growth is easy to compute and looks objective, while sustainable growth requires retention ratio times ROE; candidates also plug g greater than r without noticing the negative denominator.
What to do instead
Use sustainable growth g = retention ratio x ROE unless the question supplies an explicit forecast growth rate. Check that g is less than r; if not, switch to CAPM. Also remember the DGM ignores risk and is sensitive to the assumed g, so state the assumption.
Mixing up the current ratio and the quick ratio by including inventory in the numerator of the quick ratio, or treating a high current ratio as proof of liquidity.
Both ratios come from the same balance sheet line items and the formulas are similar; candidates also assume bigger is always better.
What to do instead
Quick ratio = (cash + marketable securities + receivables) / current liabilities; inventory and prepaids are excluded because they may not convert to cash quickly. Interpret the current ratio alongside inventory turnover and the composition of current assets, since excess inventory inflates it.
Reading a positive net income as positive operating cash flow, or missing that a large increase in accounts receivable reduced cash from operations.
Accrual accounting is the default mental model, and candidates forget that revenue recognized is not cash collected; depreciation and working-capital changes are the usual exam adjustments.
What to do instead
Reconstruct cash flow from operations: net income plus non-cash charges (depreciation, amortization) minus increases in working capital accounts such as receivables and inventory, plus increases in payables. Check the sign on every adjustment against the direction of the balance-sheet change.
Valuing a bond by discounting all cash flows at the coupon rate rather than at the market yield, or assuming a premium bond's price stays at a premium as maturity approaches.
The coupon rate is printed on the bond and is the most salient number, and the pull-to-par effect is a subtlety that is easy to skip.
What to do instead
Discount coupon payments and the par value at the yield to maturity implied by the market. Remember the inverse price-yield relationship: price above par when yield is below coupon, and price converges to par as maturity nears. For semiannual bonds, halve the coupon and yield and double the periods.
Estimating beta or required return from a single stock's total volatility, or assuming diversification eliminates all risk rather than only unsystematic risk.
Standard deviation is the first risk measure taught and is easy to compute, so candidates substitute it for beta; the distinction between systematic and unsystematic risk blurs under time pressure.
What to do instead
Use beta, which measures sensitivity to market movements, in CAPM: required return = risk-free rate + beta times the market risk premium. Total volatility (standard deviation) matters only for a fully undiversified holding; state that diversification removes firm-specific risk but leaves market risk priced.
Answering working capital questions with a formula but ignoring the tradeoff being tested, e.g., recommending the highest possible inventory turnover without considering stockouts, or stretching payables indefinitely.
Candidates treat each ratio as a maximize-or-minimize target instead of recognizing that working capital policy balances carrying costs against shortage costs and supplier relationships.
What to do instead
Frame each recommendation as a tradeoff: higher turnover lowers carrying costs but raises stockout and lost-sales risk; longer payables free cash but can cost early-payment discounts and damage credit standing. Tie the answer back to the cash conversion cycle (inventory days + receivable days minus payable days) and show the net effect.