Finance: Time Value, Valuation and Cost of Capital
Core concepts
The finance domain covers the time value of money (compounding, discounting, annuities, perpetuities), investment appraisal (payback, accounting rate of return, NPV, IRR), cost of capital (cost of debt, cost of equity via dividend growth and CAPM, WACC), and business valuation (dividend valuation model, earnings multiples, net asset value). Working capital management and sources of finance (equity vs debt, short vs long term) also appear.
Traps that appear in questions
- Mixing nominal and effective rates: an annual rate of 12% compounded monthly is not 12% effective.
- Using accounting profit instead of cash flows in NPV. Depreciation must be added back, and only incremental cash flows count.
- Forgetting the tax shield on debt: interest is tax-deductible, so after-tax cost of debt = pre-tax rate × (1 − tax rate).
- In IRR, remembering that IRR is the rate where NPV = 0; if the cost of capital is below IRR, accept.
- Market values, not book values, should weight WACC.
Worked rule of thumb
For a perpetuity growing at g: PV = D₁ ÷ (r − g). If next year’s dividend is Ksh 20, r = 12%, g = 4%, value = 20 ÷ 0.08 = Ksh 250. If the market price is Ksh 220, the share is undervalued.
For NPV: discount only relevant cash flows - ignore sunk costs and allocated overheads, include opportunity costs and working capital changes.