Financial Management: Value, Cost of Capital and Working Capital
What the exam tests
Financial Management tests time value of money, capital budgeting, cost of capital, leverage, working capital and dividend policy. The examiner expects the decision rule and the reason behind it.
Core rules
- NPV discounts incremental after-tax cash flows at the weighted average cost of capital; accept if NPV is positive. IRR is the discount rate giving zero NPV; it can mislead when cash flows change sign more than once.
- WACC = Ke × E/V + Kd × (1 − t) × D/V, using market values for weights.
- CAPM: Ke = risk-free rate + beta × (market return − risk-free rate).
- Operating leverage = contribution ÷ EBIT; financial leverage = EBIT ÷ profit before tax; combined leverage is the product.
- EOQ = √(2 × annual demand × order cost ÷ holding cost per unit per year).
Worked example
A project costs ₹100,000 and generates ₹40,000 annually for four years; WACC is 10%. The four-year annuity factor is 3.1699, so PV = ₹126,796 and NPV = ₹26,796. Accept. At 20% the factor is 2.5887, giving PV ₹103,548; at 22% it is 2.4936, giving ₹99,744. Interpolating gives IRR ≈ 21.9%, consistent with the positive NPV at 10%.
Traps
- Discounting accounting profit instead of cash flow.
- Including sunk costs or apportioned overheads.
- Using book values rather than market values in WACC.
- Forgetting the tax shield on debt.
- Assuming IRR is reliable with non-conventional cash flows.