Financial Management: Investment Appraisal and Cost of Capital
Financial management questions reward a disciplined approach: identify the decision, choose the technique, and interpret the result. Core areas are investment appraisal (payback, discounted payback, NPV, IRR, profitability index), cost of capital (cost of equity via dividend growth or CAPM, cost of debt after tax, WACC), working capital management, and risk and return.
The single most tested principle is that NPV is superior to IRR and payback because it uses cash flows, the time value of money and the whole project life, and because it is additive. Know IRR's weaknesses: multiple IRRs with non-conventional cash flows, and the reinvestment assumption. Remember that cash flows, not profits, are discounted, and that sunk costs are excluded while opportunity costs and incremental working capital are included. Tax allowable depreciation (capital allowances) must be handled as a tax shield, not a cash flow in itself.
WACC requires market values, not book values, and the after-tax cost of debt is Kd(1 − t). A classic trap is using the coupon rate instead of the market yield when debt is traded. Another is forgetting that a project in a different risk class should be discounted at a risk-adjusted rate.
Worked example: A project costs 100,000, yields 40,000 annually for four years, and the cost of capital is 10%. The annuity factor for 4 years at 10% is 3.170. PV of inflows = 40,000 × 3.170 = 126,800. NPV = 26,800 - accept. The profitability index is 1.268, confirming value creation per shilling invested.