Corporate Financial Strategy and Valuation
What this domain tests
This domain tests capital investment appraisal, cost of capital, capital structure theory and business valuation for strategic decisions such as acquisitions and divestments.
Core rules
- NPV is the primary criterion: it measures value added in absolute terms. IRR can mislead with non-conventional cash flows, lending/borrowing patterns and scale differences.
- WACC: WACC = (E/V) × ke + (D/V) × kd × (1 − t). Use market values, not book values, and after-tax cost of debt.
- CAPM: ke = rf + β × (rm − rf). Use a project-specific beta when project risk differs from the company average.
- Modigliani–Miller: without taxes, capital structure is irrelevant; with taxes, debt creates a tax shield, but financial distress costs offset it. Trade-off theory balances the two.
- Valuation: DCF (FCFF or FCFE), market multiples (P/E, EV/EBITDA) and asset-based methods. Synergy = combined value − sum of standalone values.
Worked example
Equity is $60m at ke 12%; debt is $40m at kd 6%; tax is 25%. WACC = 0.6 × 12% + 0.4 × 6% × 0.75 = 7.2% + 1.8% = 9.0%. A project costs $100m and returns $30m annually for five years. The annuity factor at 9% is 3.890, so PV = $116.7m and NPV = $16.7m. Accept the project if its risk matches the company's.
Traps
Using book values in WACC; forgetting the tax shield on debt; applying company WACC to a higher-risk project; double-counting synergies; and using IRR when cash flows change sign.