Finance and Financial Management
The Finance and Financial Management domain tests time value of money, capital budgeting, cost of capital, working capital and financial analysis. Questions are calculation-heavy, but marks are also awarded for interpreting results and identifying assumptions.
Core rules
- NPV discounts incremental after-tax cash flows at the WACC; accept a project if NPV is positive.
- IRR is the discount rate that makes NPV zero. It can mislead for mutually exclusive projects, non-conventional cash flows or differing scales.
- WACC = (E/V) × Re + (D/V) × Rd × (1 − tax rate), using market values where possible.
- CAPM: Re = risk-free rate + beta × (market return − risk-free rate).
- Cash-flow rules: ignore sunk costs, include opportunity costs, include working capital and its recovery, and include the depreciation tax shield.
- Working capital: cash conversion cycle = days inventory + days receivables − days payables.
Worked example
A company has $60m equity and $40m debt, so V = $100m. Cost of equity is 14%, pre-tax cost of debt 8%, tax 20%. WACC = 0.6 × 14% + 0.4 × 8% × 0.8 = 8.4% + 2.56% = 10.96%. A project with a positive NPV at 10.96% adds value; one with an IRR of 12% but much larger scale may still be rejected if its NPV is lower than a smaller project's.
Traps
Using the coupon rate as the cost of debt; forgetting the tax shield; using book rather than market weights; ignoring working capital; and selecting projects by IRR alone when projects are mutually exclusive.