Corporate Finance: Time Value, NPV and the Cost of Capital
Corporate Finance
Corporate finance questions test whether you can convert a stream of future cash flows into a single decision metric. Start with the time value of money: FV = PV(1+r)^n, and remember that NPV discounts at the opportunity cost of capital, not at the IRR. The NPV rule is the primary decision rule - accept projects with NPV > 0 - because it is additive and measures value created in dollars. IRR is only a rate; it can mislead when projects differ in scale, when cash flows change sign more than once (multiple IRRs), or when comparing mutually exclusive projects (use incremental IRR or, better, incremental NPV).
The discount rate itself comes from WACC: blend the after-tax cost of debt and the cost of equity using market-value weights, not book weights. Cost of equity via CAPM = risk-free rate + beta x equity risk premium. When evaluating a project in a new line of business, relever the beta of comparable pure-play companies to the target's capital structure rather than using the company's existing WACC.
Common traps: mixing nominal cash flows with a real discount rate; discounting at the coupon rate or at the project's own IRR; forgetting to tax-effect interest; including sunk costs; and ignoring changes in net working capital and capex when calculating free cash flow.
Rule of thumb: if a project's IRR sits far above WACC, check the terminal value assumption before celebrating - that is usually where most of the value sits.