Finance: Valuation, Risk, and Return Essentials
What you must understand
Finance questions centre on time value of money, risk–return relationships, and valuation. Master these building blocks: present value and discounting, net present value (NPV) versus internal rate of return (IRR), cost of capital (WACC), CAPM (expected return = risk-free rate + beta × market risk premium), and diversification (systematic versus unsystematic risk). Know the difference between nominal and real returns and how inflation erodes purchasing power. Understand bond pricing (price moves inversely to yield), equity valuation, and the efficient market hypothesis in its weak, semi-strong, and strong forms.
Traps that appear in questions
- Using IRR when cash-flow signs change, producing multiple or misleading IRRs-prefer NPV for ranking.
- Forgetting that NPV assumes reinvestment at the cost of capital, while IRR assumes reinvestment at IRR.
- Confusing beta (systematic risk) with standard deviation (total risk); diversification removes only unsystematic risk.
- Mixing nominal and real figures; always match the discount rate to the cash-flow basis.
- Assuming a higher coupon means a higher price in all rate environments-price still moves inversely with yield.
Rule of thumb and worked example
Rule of thumb: Discount nominal cash flows at a nominal rate and real cash flows at a real rate-never cross them. For quick CAPM, expected return = Rf + β × (Rm − Rf).
Worked example: Risk-free rate 3%, market return 8%, beta 1.2. Expected return = 3% + 1.2 × (8% − 3%) = 3% + 6% = 9%. If a project's IRR is 10%, it clears the hurdle; if only 8%, it does not. Cross-checking with NPV confirms the decision.