Corporate Issuers
What you must know
Capital budgeting (NPV, IRR, payback, discounted payback, profitability index), cost of capital (after-tax cost of debt, CAPM-based cost of equity, WACC, marginal cost of capital and break points), capital structure theory (Modigliani-Miller with and without taxes, static trade-off, pecking order), leverage measures (degree of operating and financial leverage), dividend and share-repurchase policy, working capital management, corporate governance, and ESG considerations.
Traps
(1) WACC uses market-value target weights and the after-tax cost of debt, kd x (1 - t). (2) Under MM with taxes, firm value rises by t x D, so more debt always helps in that frictionless-with-tax setting; the static trade-off adds distress costs. (3) A share repurchase raises EPS only if the earnings yield exceeds the after-tax cost of the funds used. (4) Flotation costs raise the effective cost of new equity. (5) Operating leverage magnifies the effect of sales changes on operating income; financial leverage magnifies the effect on net income and EPS.
Worked example
Target weights 60% equity, 40% debt; cost of equity 12%, pre-tax cost of debt 6%, tax rate 25%. WACC = 0.60 x 12% + 0.40 x 6% x 0.75 = 7.2% + 1.8% = 9.0%. Using the pre-tax cost of debt would overstate WACC by 0.6 percentage points.