Corporate Finance and Valuation (Capital Budgeting and Cost of Capital)
What this domain tests
The capital allocation decision and the discount rate used to evaluate it. You will compute WACC, apply CAPM, rank projects by NPV and IRR, and value a share with a dividend discount model or a multiple.
Core rules
- CAPM: required return = risk-free rate + beta × market risk premium.
- WACC = (E/V) × cost of equity + (D/V) × after-tax cost of debt, where after-tax cost of debt = pre-tax yield × (1 − tax rate). Use market-value weights.
- NPV: discount all cash flows at the project's risk-adjusted rate; accept if NPV > 0.
- IRR: the rate making NPV zero; accept if IRR exceeds the hurdle rate. IRR can mislead when projects differ in scale or have non-conventional cash flows.
- Gordon growth: P0 = D1 / (r − g), valid only when g < r.
Worked example
A firm is 60% equity, 40% debt by market value. The risk-free rate is 3.5%, beta is 1.2, the market risk premium is 5.5%, pre-tax debt yield is 6%, and the tax rate is 25%.
- Cost of equity = 3.5% + 1.2 × 5.5% = 3.5% + 6.6% = 10.1%
- After-tax cost of debt = 6% × (1 − 0.25) = 4.5%
- WACC = 0.60 × 10.1% + 0.40 × 4.5% = 6.06% + 1.80% = 7.86%
Now value a share with next year's dividend of $2.00, r = 10.1% and g = 4%: P0 = 2.00 / (0.101 − 0.04) = 2.00 / 0.061 = $32.79. If the share trades at $38, it is above intrinsic value on these assumptions.
Traps
- Using pre-tax cost of debt in WACC.
- Weighting by book value when market values are available.
- Discounting nominal cash flows at a real rate.
- Applying Gordon growth with g greater than r, which produces a meaningless negative price.
- Choosing between mutually exclusive projects on IRR when NPV ranking differs.
Key points
- CAPM: required return = risk-free rate + beta × market risk premium.
- WACC uses market-value weights and the after-tax cost of debt.
- Accept projects with positive NPV; NPV dominates IRR for mutually exclusive choices.
- Gordon growth requires g < r and a sustainable payout assumption.