Corporate Finance
Corporate Finance tests the decisions a financial manager makes: which projects to fund, how to finance them, how much to pay out, and how to manage short-term liquidity and governance. The exam favours NPV logic and WACC arithmetic, wrapped in short scenarios.
Capital budgeting
- Use incremental after-tax cash flows. Exclude sunk costs, include opportunity costs and any cannibalisation of existing sales.
- NPV is the decision rule; IRR can conflict with NPV for mutually exclusive projects of different scale or timing, and NPV wins because it measures value added.
- Payback ignores the time value of money; discounted payback fixes that but still ignores cash flows after the cutoff.
Cost of capital
- WACC = w_d x r_d x (1 - tax rate) + w_p x r_p + w_e x r_e, using market-value weights at target capital structure.
- Cost of equity from CAPM: r_e = r_f + beta x (market return - r_f).
Worked example
Market value of equity 600, market value of debt 400, cost of equity 12%, pre-tax cost of debt 6%, tax rate 25%. Weights: 60% equity, 40% debt. WACC = 0.60 x 12% + 0.40 x 6% x 0.75 = 7.2% + 1.8% = 9.0%. If the project's cash flows yield an IRR of 9.5%, it adds value at a 9.0% hurdle but not if someone mistakenly uses the unadjusted 12% cost of equity as the discount rate.
Leverage and payout
- Operating leverage comes from fixed operating costs; financial leverage from fixed financing costs.
- Without taxes, capital structure does not change firm value; with taxes, the interest tax shield adds value, so levered value = unlevered value + tax rate x debt.
- Under a residual dividend policy, dividends are paid only from earnings left after funding positive-NPV projects at the target capital structure.
Traps that cost marks
- Using the after-tax cost of debt and then applying the tax shield a second time.
- Using book weights or historical weights instead of target market weights.
- Including sunk research spending in the project cash flows.
- Omitting the investment in net working capital or its later recovery.