Financial Management and Corporate Finance
Core concepts
Corporate finance rests on three decisions: investment (which projects to fund), financing (debt versus equity mix), and dividend policy (how much cash to return). Candidates must be fluent with the time value of money, net present value, cost of capital, the weighted average cost of capital (WACC), leverage and financial risk, working-capital management, and the trade-off between risk and return. Understand capital structure theory in outline: the Modigliani-Miller irrelevance result, the tax shield from debt, and the offsetting costs of financial distress.
Common traps
Questions often test whether you know that NPV is preferred to IRR when projects are mutually exclusive or cash flows are unconventional, because IRR can give multiple answers or misrank projects. Another trap is mixing up the cost of debt (interest rate) with the after-tax cost of debt, which is interest times (1 minus the tax rate). Watch for confusion between accounting profit and cash flow; only incremental, after-tax cash flows belong in an appraisal. Sunk costs must be excluded, while opportunity costs must be included.
Worked rule of thumb
A firm has 60 percent equity costing 14 percent and 40 percent debt costing 9 percent before tax, with a 30 percent tax rate. After-tax cost of debt is 9% x 0.7 = 6.3%. WACC = (0.6 x 14%) + (0.4 x 6.3%) = 8.4% + 2.52% = 10.92%. Accept projects whose return exceeds 10.92%. Rule of thumb: always use market values and after-tax costs when computing WACC.