Financial analysis and valuation
The Capital Budget
Discount at a WACC built from CAPM, accept a positive NPV or a profitability index above one, and shield only the cost of debt.
How the exam words it
- -The stem gives an initial outlay and a stream of cash flows with a present-value factor and asks for NPV and the accept-or-reject call.
- -It provides a capital structure with a cost of equity and a pretax cost of debt and asks for WACC.
- -It gives the risk-free rate, beta, and the market return and asks for the cost of equity.
- -It asks for the payback period or the profitability index and whether the project clears the rule.
The playbook
- 1Build the cost of capital first: find the cost of equity with CAPM as risk-free plus beta times the market risk premium, and the after-tax cost of debt as the pretax rate times one minus the tax rate.
- 2Weight each source by its market-value proportion to get WACC, applying the tax shield only to debt, never to equity.
- 3Discount every cash flow at WACC and subtract the initial investment for NPV, accepting the project when NPV is above zero or the profitability index is above one.
- 4For payback, divide the investment by the level annual cash flow, and remember payback ignores the time value of money and any flows after recovery.
The trap
Applying the tax shield to equity, or multiplying beta by the full market return. The shield touches only the cost of debt, and CAPM uses the market risk premium, not the whole return.
How the exam varies it
The same pattern, re-skinned along these axes:
NPV versus IRR versus payback versus the profitability indexCost of equity via CAPM versus the after-tax cost of debtA single discount rate versus a full WACC build-up
Drill this pattern
8 questions of The Capital Budget from across the AUD topics. Clear it by getting 5 right with a streak of 3.