Corporate Finance
Capital Budgeting and the Cost of Capital
The core is net present value as the decision rule, with IRR, payback, and profitability index as complements. Know the pitfalls: multiple IRRs with alternating cash flows, the scale and timing problems that make IRR mislead relative to NPV, and the reinvestment assumption embedded in each method. Cost of capital requires the weighted average of after-tax debt and equity costs, where the cost of equity comes from CAPM, dividend discount, or bond-yield-plus-risk-premium approaches. Use target weights and market values, not book values.
Leverage, Payout, and Governance
Modigliani-Miller propositions frame the discussion: without taxes and frictions, capital structure is irrelevant; with taxes, debt adds a shield; with financial distress and agency costs, an optimum appears. Candidates should be able to compute the break-even EBIT between an all-equity and a levered plan. Dividend policy questions test the clientele, signaling, and residual-dividend theories, plus share repurchase mechanics and their effect on earnings per share. Corporate governance material covers board independence, conflicting shareholder rights, and the agency problem between managers and owners.
Worked Example
A project costs 500 and returns 200 per year for four years. At a 10% discount rate the annuity factor is 3.170, so the present value is 634 and NPV is +134; accept. If the firm instead finances with 40% debt costing 6% pre-tax and equity costing 12%, with a 25% tax rate, WACC = 0.4 × 6% × 0.75 + 0.6 × 12% = 1.8% + 7.2% = 9.0%. Rule of thumb: discount at WACC only when project risk matches firm risk.