Financial Decision Making
Domain 3 - Financial Decision Making. This section tests capital budgeting, cost of capital, risk adjustment, working capital management, valuation and international finance. Expect one discounted cash flow computation plus conceptual items on which method governs when the metrics conflict.
Core rules
- NPV is the primary criterion. IRR can mislead with non-conventional cash flows (multiple IRRs) or when project scale differs; use incremental, after-tax cash flows including working capital and the tax effect on salvage, and include opportunity costs while excluding sunk costs and allocated fixed overhead.
- WACC uses market-value weights and the after-tax cost of debt: kd(1 − t), blended with ke.
- CAPM: ke = rf + β(rm − rf).
- Cash conversion cycle = days inventory outstanding + days sales outstanding − days payables outstanding.
- EOQ = √(2DS/H); the order quantity trades ordering cost against carrying cost.
Worked example
Target capital structure is 40% debt, 60% equity. Pre-tax debt costs 8%, the tax rate is 25%, so after-tax kd = 6%. With rf = 4%, β = 1.2 and a market risk premium of 6%, ke = 4% + 1.2 × 6% = 11.2%. WACC = 0.40 × 6% + 0.60 × 11.2% = 2.4% + 6.72% = 9.12%. A conventional project with an IRR of 10% exceeds the hurdle rate and should be accepted; its NPV discounted at 9.12% is positive.
Traps
- Using book-value weights or the coupon rate as the cost of debt.
- Forgetting the interest tax shield in kd.
- Omitting working capital investment and its later recovery.
- Ranking mutually exclusive projects on IRR when scale differs - NPV governs.
- Treating a sunk feasibility study as an incremental cash outflow.