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CCFA: Corporate Finance and Capital Structure

CCFA · Work through your exam, one topic at a time.

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Corporate Finance and Capital Structure

Corporate Finance and Capital Structure tests capital budgeting, cost of capital, leverage effects, and payout decisions. The exam favors WACC construction, NPV versus IRR conflicts, Modigliani-Miller intuition, and the trade-off between tax shields and financial distress.

Core rules

  • WACC = (E/V) × Re + (D/V) × Rd × (1 - tax rate). Use market-value weights, after-tax cost of debt, and a Re from CAPM or a bond-yield-plus-risk-premium approach.
  • CAPM: Re = risk-free rate + beta × equity risk premium. Beta must match the project's business risk; using the firm's beta for a new industry overstates or understates the hurdle rate.
  • NPV is the primary decision rule because it measures value added in currency and assumes reinvestment at the cost of capital. IRR assumes reinvestment at IRR and can fail with non-conventional cash flows or scale differences.
  • Modigliani-Miller without taxes says capital structure does not change firm value; with taxes, debt adds a tax shield, but distress costs and agency costs offset it.
  • Payout policy: dividends are sticky, buybacks are flexible, and clientele effects mean policy changes can signal management's view of intrinsic value.

Worked example

A project costs 500,000 and produces perpetual annual EBIT of 120,000. The tax rate is 25%, debt is 200,000 at 6%, equity is 300,000, and Re is 12%. After-tax EBIT is 90,000; assume depreciation, capex, and working capital changes are zero. WACC = 0.6 × 12% + 0.4 × 6% × 0.75 = 7.2% + 1.8% = 9.0%. NPV = 90,000 / 0.09 - 500,000 = 1,000,000 - 500,000 = 500,000. The project adds value. If the project's risk differed from the firm's, the 9% rate would be the wrong discount rate.

Traps

  • Sunk costs are excluded from incremental cash flow; allocated overhead is included only if it is incremental.
  • Do not deduct interest expense in project cash flows when the discount rate is WACC; financing is captured in the rate.
  • IRR can rank a small high-return project above a large value-creating one; use incremental IRR or NPV.
  • A tax shield is valuable only if the firm is profitable enough to use it.