Business Finance and Financial Management
Business Finance and Financial Management tests capital allocation and the management of liquidity and risk. Expect time value of money, project appraisal, cost of capital, capital structure, working capital and basic risk management.
Appraisal
Net present value discounts incremental after-tax cash flows at the opportunity cost of capital and is the primary rule: accept positive NPV. IRR is the rate at which NPV is zero; it misleads with non-conventional cash flows, multiple sign changes, or when comparing projects of different scale or life. Payback ignores cash flows after the cut-off and the time value of money; discounted payback partly fixes that but still ignores later value.
Cost of capital
WACC = (E/V) × ke + (D/V) × kd × (1 − t), using market values and consistent weights. Cost of equity from CAPM is rf + β(rm − rf); the beta must match the project's business risk, so use an asset beta and regear for the project's gearing when the project differs from the firm.
Worked example
Debt is 40% of capital at a pre-tax cost of 6%; equity is 60% at a cost of 12%; tax is 25%. After-tax debt cost is 6% × 0.75 = 4.5%. WACC = 0.4 × 4.5% + 0.6 × 12% = 1.8% + 7.2% = 9.0%. A project costing 100,000 with annual cash inflows of 30,000 for five years has an annuity factor of 3.8897 at 9%, giving a present value of 116,691 and an NPV of +16,691. At the firm's weighted average risk, the project adds value.
Working capital
The cash operating cycle is inventory days plus receivable days minus payable days. Factoring, early settlement discounts, just-in-time inventory and tighter credit control shorten it. Overtrading - rapid growth financed by short-term debt - shows as rising receivables and inventory with falling cash.
Traps
Using book values for WACC weights. Forgetting the tax shield on debt. Discounting accounting profit rather than cash flow. Including sunk costs or allocated head office costs. Accepting a project because its IRR exceeds WACC when cash flows are non-conventional. Confusing operating leverage with financial leverage.