Business Finance and Economics: Valuation, Cost of Capital and Markets
This domain tests quantitative finance - time value, appraisal, cost of capital - alongside the economics that shape the firm's environment: demand, market structure, policy and exchange rates.
Investment appraisal
- Discount incremental after-tax cash flows, excluding sunk costs and including working capital and opportunity costs.
- NPV is the primary criterion; IRR can mislead with non-conventional cash flows (multiple IRRs) or when comparing projects of different scale.
- Payback ignores cash flows after the cut-off and the time value of money; it is a liquidity screen, not a value measure.
Cost of capital
- Cost of equity via CAPM: Ke = Rf + β(Rm − Rf).
- WACC = (E/V) × Ke + (D/V) × Kd × (1 − t), using market values and the after-tax cost of debt.
Worked example: WACC
Capital structure 60% equity at a cost of 14%, 40% debt at 8% pre-tax, tax 25%. After-tax Kd = 8% × (1 − 0.25) = 6%. WACC = 0.60 × 14% + 0.40 × 6% = 8.4% + 2.4% = 10.8%. Use 10.8%, not the 12% that would result from ignoring the tax shield, as the discount rate for a project of average business risk.
Economics
- Price elasticity of demand = % change in quantity ÷ % change in price; demand is elastic when the absolute value exceeds 1, and a price cut then raises revenue.
- Market structures: perfect competition (price taker, P = MR), monopoly (downward-sloping demand, MR below price), oligopoly (interdependence), monopolistic competition (differentiation).
- Policy: expansionary monetary policy lowers rates and stimulates demand; fiscal policy works through spending and taxation; exchange rates respond to interest differentials and trade flows.
Traps that cost marks
- Discounting pre-tax cash flows at an after-tax WACC, or using book rather than market weights.
- Ignoring the tax shield on debt, or applying a company WACC to a project in a different risk class.