Finance and Financial Management
What the exam tests
Finance and Financial Management tests time value of money, capital budgeting, cost of capital, leverage, working capital and risk. Questions usually require a numerical decision and a short interpretation.
Core rules
- NPV discounts incremental after-tax cash flows at the project's required return; accept positive NPV.
- IRR is the discount rate giving zero NPV; it can mislead when projects differ in scale or timing.
- WACC weights after-tax cost of debt and cost of equity by market values where possible.
- Sunk costs are irrelevant; opportunity costs and working capital changes are relevant.
- Higher financial leverage raises financial risk and the required return on equity.
Worked example
Equity is 60% of capital at a cost of 15%; debt is 40% at 8% pre-tax; tax is 25%. After-tax cost of debt = 8% × (1 − 0.25) = 6%. WACC = 0.60 × 15% + 0.40 × 6% = 9% + 2.4% = 11.4%. Use 11.4% to discount a project of similar risk. If the project's IRR is 12%, it creates value, but compare NPV rather than IRR alone.
Traps that cost marks
Using pre-tax debt in WACC; including sunk costs; ignoring working capital recovery; comparing IRR with an accounting return; and using book weights when market weights are available.