Finance: Time Value, Risk and Return, and Appraisal
Finance questions reward candidates who can select the right technique and defend it. Understand the time value of money: future value, present value, annuities and perpetuities. Be able to compute the cost of capital, including the cost of debt (after tax), cost of equity using the dividend growth model and CAPM, and the weighted average cost of capital using market values rather than book values.
Investment appraisal is central: payback, accounting rate of return, net present value, internal rate of return and profitability index. Know the decision rules and the weaknesses of each. Working capital management, cash budgets and the operating cycle also appear. Risk and return questions test diversification, the security market line and the distinction between systematic and unsystematic risk.
Traps include mixing nominal and real cash flows, forgetting tax shields on capital allowances, discounting at the wrong rate, and using book weights in WACC. Another trap is treating sunk costs or allocated fixed overheads as relevant cash flows.
Worked example: after-tax cost of debt
A bond with a 10% coupon is issued at par; tax is 30%. The after-tax cost of debt is 10% x (1 - 0.30) = 7%. Rule of thumb: interest is tax-deductible, so always apply the tax shield to the cost of debt, and use market values when weighting.