Valuation and Corporate Finance
This domain tests enterprise and equity valuation, cost of capital, and the value logic behind mergers, acquisitions and payouts.
Core rules
- Keep numerator and discount rate consistent: FCFF discounted at WACC gives enterprise value; FCFE discounted at cost of equity gives equity value directly. Subtract net debt from enterprise value to reach equity value.
- WACC uses market-value weights: WACC = We × Ke + Wd × Kd × (1 − t). Ke from CAPM: Rf + β × market risk premium, or the dividend growth model.
- Terminal value: Gordon growth TV = FCFFₙ₊₁ / (WACC − g) requires g < WACC and g no higher than long-run nominal GDP growth; alternatively an exit multiple, cross-checked against peers.
- Relative valuation: EV/EBITDA is capital-structure neutral; P/E is distorted by leverage and accounting policy. Always adjust for non-recurring items and surplus assets.
- Synergy value = PV of incremental cash flows − premium paid. An acquisition destroys value for the acquirer when the premium exceeds synergy.
- MM dividend irrelevance holds in perfect markets; buybacks return surplus cash with flexibility and may be tax-efficient.
Worked example
Capital structure is 60% equity at Ke 14% and 40% debt at 9% pre-tax, tax 30%. After-tax Kd = 6.3%, so WACC = (0.6 × 14) + (0.4 × 6.3) = 8.4 + 2.52 = 10.92%. With FCFF next year of ₹150 crore and g of 4%, terminal value = 150 / (0.1092 − 0.04) = ₹2,168 crore. Add the PV of explicit-period FCFF, subtract net debt, and divide by shares for intrinsic value. A common follow-up asks what happens if debt rises to 50%: WACC falls but Ke must rise with leverage, so recompute rather than assuming a lower WACC throughout.
Traps
Matching FCFF with cost of equity; using book-value weights; applying a terminal growth rate above WACC or above nominal GDP; and ignoring the integration costs that reduce synergy.