Finance: Time Value, Capital Budgeting and Cost of Capital
What you must understand
Finance questions combine time value of money, investment appraisal, risk and return, cost of capital and working capital management. You should be able to discount cash flows, compute net present value and internal rate of return, distinguish relevant from irrelevant cash flows, calculate weighted average cost of capital using market-value weights, and explain how credit, inventory and cash policies affect liquidity and profitability.
Common traps
- Including sunk costs or allocated fixed overheads that do not change with the decision.
- Forgetting the depreciation tax shield: depreciation is not a cash flow, but the tax saved is.
- Mixing nominal cash flows with a real discount rate, or vice versa.
- Using book values instead of market values for WACC weights.
- Assuming IRR is always reliable. It can give multiple answers when cash-flow signs change, and it can conflict with NPV for mutually exclusive projects. NPV is preferred because it measures value added.
- Ignoring working-capital investment and terminal recovery in project cash flows.
- Treating interest payments as operating cash flows when calculating WACC-based NPV.
Worked example: WACC
Equity market value is 600 million and debt market value is 400 million, so total value is 1,000 million. Cost of equity is 15%, pre-tax cost of debt is 10%, and tax is 30%. After-tax cost of debt is 10% x (1 - 0.30) = 7%. WACC = (600/1,000 x 15%) + (400/1,000 x 7%) = 9.0% + 2.8% = 11.8%. Use 11.8% to discount project cash flows that have similar risk to the firm.
Rule of thumb
A project creates value when its NPV is positive at a discount rate reflecting its risk. If NPV and IRR disagree, follow NPV.