Corporate Finance and Valuation
Domain 5 - Corporate Finance and Valuation
This domain tests capital budgeting, cost of capital, capital structure, payout policy, working capital, and valuation. The exam favors questions that require you to choose the right cash flows and discount rate, then interpret the result.
Core rules
- NPV: Discount incremental after-tax cash flows at the project's required return. Accept positive-NPV projects when capital is available.
- IRR: The discount rate that makes NPV zero. It can mislead when projects differ in scale or timing, and multiple IRRs can appear with unconventional cash flows.
- WACC: Use market-value weights, after-tax cost of debt, and a cost of equity from CAPM or a comparable model. WACC is appropriate only for projects of similar risk to the firm.
- Capital structure: Debt creates a tax shield but raises financial distress costs. The optimal structure trades off these effects.
- Valuation: Free cash flow to the firm is discounted at WACC; free cash flow to equity is discounted at the cost of equity.
Worked example
A firm has 40% debt and 60% equity at market value, pre-tax cost of debt of 6%, tax rate of 25%, and cost of equity of 12%. WACC = 0.60 × 12% + 0.40 × 6% × (1 - 0.25) = 7.2% + 1.8% = 9.0%. A project costs 240 today and returns 100 at the end of each of the next three years. The annuity factor at 9% for three years is 2.5313, so PV = 253.13 and NPV = 13.13. The project adds value. Its IRR is about 12%, above the 9% WACC, which confirms the NPV result for a conventional project.
Traps that cost marks
- Using book-value weights instead of market-value weights in WACC.
- Including financing cash flows in project cash flows.
- Treating sunk costs as incremental.
- Choosing IRR over NPV when projects are mutually exclusive and differ in scale.
- Discounting FCFE at WACC instead of the cost of equity.