Financial Management: Investment, Financing and Cost of Capital
Financial Management tests financing, investment and working-capital decisions, with valuation and risk as the connecting ideas.
Core rules
- NPV discounts incremental after-tax cash flows at the project or company cost of capital; accept positive NPV.
- WACC = proportion of equity x cost of equity + proportion of debt x after-tax cost of debt, using market values.
- CAPM: cost of equity = risk-free rate + beta x market risk premium.
- Working capital: cash conversion cycle = inventory days + receivable days - payable days; shorten it without damaging operations.
- Gearing increases financial risk and can raise the cost of equity; tax relief on debt lowers the after-tax cost of debt.
- Match nominal cash flows with nominal rates, and real flows with real rates.
Worked example
Market value of equity is NGN 600m; debt is NGN 400m. Cost of equity is 18%; pre-tax cost of debt is 14%; tax is 30%. WACC = (600/1,000 x 18%) + (400/1,000 x 14% x (1 - 0.30)) = 10.8% + 3.92% = 14.72%. Use 14.72% for a project of similar business and financial risk. If the project is riskier, adjust the discount rate or use a project-specific WACC.
Traps
Using book values instead of market values; forgetting the tax shield; using the coupon rate when the market yield differs; mixing real cash flows with nominal discount rates; and accepting a project because its IRR is high when scale and timing make NPV negative.