Corporate Finance
What you must know
Corporate finance questions cluster around three ideas: the cost of capital, the capital structure decision, and working capital management. For cost of capital, know that the weighted average cost of capital (WACC) blends after-tax cost of debt with the cost of equity, weighted at market values on a marginal (target) basis. Cost of equity comes from CAPM (risk-free rate + beta × market risk premium) or the Gordon growth model (D1/P0 + g). Know Modigliani-Miller results in a world with taxes (interest is tax-deductible, so debt adds value up to the point where financial distress costs offset the tax shield), the trade-off theory, and pecking order. For working capital, know the cash conversion cycle (days inventory + days receivables − days payables), the cost of carrying versus shortage costs, and short-term financing choices.
Traps that show up
- Forgetting the tax shield on debt: use kd × (1 − t), never the pre-tax rate.
- Using book-value weights or historical debt costs instead of market weights and marginal costs.
- Treating flotation costs as a cash flow inside the project rather than an adjustment to the cost of capital.
- In EBIT-EPS analysis, forgetting that interest is deducted before tax while dividends are not.
- Believing a longer cash conversion cycle is favorable-it ties up cash.
Worked example
Target structure: 40% debt, 60% equity. Pre-tax debt cost 6%, equity cost 12%, tax rate 25%. After-tax debt = 6% × 0.75 = 4.5%. WACC = (0.40 × 4.5%) + (0.60 × 12%) = 1.8% + 7.2% = 9.0%. A project earning 10% after tax creates value; one earning 8% destroys it.
Rule of thumb
Discount at the WACC only when the project's risk matches the firm's; for a clearly different risk profile, use a risk-adjusted rate.