Corporate Finance and Funding
What the domain tests
Corporate finance and funding tests capital structure decisions, cost of capital, funding instrument choice, debt covenants, working capital finance, and project appraisal. The exam expects you to calculate a hurdle rate, interpret covenant headroom, and match funding tenor to asset life.
Core rules and concepts
- WACC. WACC = (E/V) × Re + (D/V) × Rd × (1 - tax rate), using market values and after-tax cost of debt. It is the minimum return for projects of average risk.
- NPV and IRR. NPV uses incremental after-tax cash flows, including working capital and capital expenditure, and discounts at the risk-adjusted WACC. IRR can mislead when project scale or cash flow timing differs.
- Funding sources. Revolving credit, term loans, bonds, commercial paper, leasing, and equity differ in commitment, maturity, security, covenants, and refinancing risk. Match short-term assets with short-term funding.
- Covenants. Leverage, interest cover, and minimum liquidity covenants constrain debt capacity. Calculate headroom on the covenant definition, including permitted EBITDA addbacks.
- Credit ratings and debt capacity. Ratings agencies assess business risk, financial risk, and financial policy. Debt capacity depends on sustainable cash flow and asset backing.
Worked example
Equity market value is $600m, debt $400m, cost of equity 10%, pre-tax cost of debt 5%, and tax 25%. WACC = 0.6 × 10% + 0.4 × 5% × 0.75 = 6.0% + 1.5% = 7.5%. A project with an 8% return clears the hurdle before considering project-specific risk and covenants. If book weights were used (equity $300m, debt $400m), WACC would fall to about 6.4%, understating the hurdle and risking overinvestment.
Traps that cost marks
Using book rather than market weights; forgetting the tax shield; relying on IRR when projects differ in scale; ignoring fees and refinancing risk; accepting EBITDA addbacks that flatter covenant headroom; and funding long-term assets with short-term debt.