I wrote a few days ago about waking up every morning and feeling anxious about the finance exam, which will take place in another 25 days. I found the perfect solution - I sat down and solved some of the questions from previous exams.
The lecturer pointed out a few questions from previous papers; these were so old that there was no printed solution, which actually is a good thing as one can't cheat. I solved about 80% of the questions correctly, and asked her (the lecturer) on Friday about the points which I wasn't sure about. I'm going to sit down either tonight and tomorrow night and resolve the questions, thus reinforcing the techniques which I need. She will demonstrate how to solve the questions on Tuesday and I want to be super-prepared.
I point out that during the Marketing course, we 'solved' the same exam question again and again until we had it down perfectly and could reproduce the answer from memory. There, the answer took five pages of A4 paper, filled with writing. Solving a finance question is much shorter.
It has become clear what the tactics are: first of all, one has to find the cost of capital which to be used, which is the weighted cost of equity and debt (WACC). There are two ways of calculating the cost of equity and two ways of calculating the cost of debt; in both cases there is one simple method (SML) and one slightly more complicated method (dividends and yield to maturity). I knew the simple methods but wasn't too familiar with the more complicated methods; this has now been rectified.
Then one has to lay out a cash flow table. This isn't complicated but it can be finicky. Once the cashflow is known along with the cost of capital, then one can calculate the net present value (NPV). These are the basics of every question.
The questions which will be answered on Tuesday have the same characteristic in that one has to compare two projects with different lengths. In these cases, it's not enough to calculate the NPV; one also has to calculate the average cost per year. It's not correct to divide the NPV by the number of years that the project runs; one has to perform another calculation on the NPV in order to calculate the annual payment. The lecturer tells me that one will still be able to calculate which project is better if one performs simple division, but that the figure won't be right.
One question was about two machines, one having a life time of four years and the other seven. Another question was about renewing the parquet floor of a basketball court (four and eight years); this latter question can also be solved by changing the cash flow so that there is a second investment after five years. Put simply, which is better - investing $1,000 in a washing machine which will last eight years, or $600 in a washing machine which lasts four years and will then have to be bought again?
Once one has finished with these questions, the examiners always twist the knife a little and change the scenario. How would the washing machine answer change if there is 3.5% annual inflation? What would happen if the more expensive washing machine lasts nine years instead of eight?
As one can easily get confused about inflation, I think it wise to note a few things here. One can either work with nominal figures (no adjustment for inflation) or real figures (adjusted for inflation), although of course one has to know whether the figures are nominal or real. Rule of thumb: unless otherwise explicitly noted, all figures are nominal. Thus, if we have to pay $600 for a washing machine now and there is 3.5% annual inflation, then in four years time we will have to pay 600 X 1.035 X 1.035 X 1.035 X 1.035 = $668.5; this is the figure than one puts into the cash flow whilst leaving the cost of capital unchanged. The other way of doing this is by leaving the price at $600 and reducing the cost of capital by 1.035 to the power of four, but this seems to be less intuitive even though mathematically it is exactly the same.
Anyway: the pressure is relieved and I am confident.
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