Economics and Finance
Economics and Finance
This domain tests microeconomic reasoning, capital budgeting, asset pricing, and corporate finance. The exam favors calculations that combine a financial decision rule with an economic interpretation.
Core rules and concepts
- Elasticity: %ΔQ/%ΔP; demand is elastic when |ε|>1 and revenue falls when price rises.
- NPV=ΣCF_t/(1+r)^t−initial outlay; accept positive-NPV projects.
- CAPM: E[R_i]=r_f+β_i(E[R_m]−r_f); beta measures systematic risk.
- WACC weights after-tax cost of debt and cost of equity by market values.
- Modigliani-Miller without taxes: capital structure does not change firm value; with taxes, debt adds a tax shield.
- Real versus nominal: (1+nominal)=(1+real)(1+inflation).
- Put-call parity: C−P=S−PV(K) for European options on a non-dividend stock.
Worked example
A project costs 100,000 and returns 60,000 in each of two years. At r=10%, NPV=−100,000+60,000/1.10+60,000/1.21=−100,000+54,545+49,587=4,132. The project is acceptable, but the decision is sensitive to the discount rate: at 12% the NPV becomes negative.
Traps that cost marks
- Discounting nominal cash flows at a real rate.
- Using book values instead of market weights in WACC.
- Including sunk costs in incremental cash flow.
- Using a firm-wide beta for a project in a different line of business.
- Ranking mutually exclusive projects by IRR rather than NPV.