Finance
Core tools
Finance questions revolve around valuation and the cost of capital. You must handle compounding and discounting, annuities and perpetuities, NPV and IRR, payback and discounted payback, WACC, CAPM, dividend growth models, bond pricing, and the gearing debate including Modigliani–Miller with and without tax. Working capital management - the cash conversion cycle, EOQ, and the trade-off between holding and ordering costs - is regularly examined, as are sources of finance and their relative cost and risk.
Traps
- Discounting nominal cash flows at a real rate, or the reverse.
- Ignoring the working capital investment and its later recovery.
- Including sunk costs, or excluding opportunity costs.
- Using book values instead of market values as WACC weights.
- Forgetting the tax shield: after-tax cost of debt = kd(1 − t).
- Believing IRR is always superior to NPV. IRR assumes reinvestment at the IRR itself and can produce multiple answers when cash flows change sign more than once.
Worked example
A project costs KSh 1,000,000 and generates KSh 400,000 a year for four years. The cost of capital is 10% and the four-year annuity factor at 10% is 3.170. PV of inflows = 400,000 × 3.170 = KSh 1,268,000. NPV = KSh 268,000, positive, so accept. If the inflows were uneven you would discount each year individually rather than use an annuity factor.
Rule of thumb: NPV is the decision rule; every other technique is supporting evidence. A positive NPV means the project earns more than the required return, which is what creates shareholder value.