Corporate Financial Strategy and Risk Management
This domain tests capital-structure decisions, cost of capital, and hedging of financial risks using derivatives, together with risk governance.
Core rules
- Modigliani-Miller without taxes: firm value is independent of leverage; with taxes, value rises by the tax shield (tD), offset by distress costs.
- WACC uses market-value weights and after-tax cost of debt: WACC = (E/V)Ke + (D/V)Kd(1 − t).
- Forwards lock a rate; futures are standardised and margined; options give a right but not an obligation; swaps exchange cash flows.
- A hedge reduces risk but can create opportunity loss; hedge accounting under Ind AS 109 requires documentation and effectiveness.
- VaR estimates a loss threshold over a horizon and confidence level; it says nothing about losses beyond that threshold.
Worked example
Equity is ₹600 crore at 15%, debt ₹400 crore at 9%, tax 25%. After-tax Kd = 6.75%. WACC = 0.6 × 15% + 0.4 × 6.75% = 9% + 2.70% = 11.70%. A project with the same business risk must clear 11.70%; using the pre-tax 9% as the hurdle overstates value. Reasoning: interest is tax-deductible, so the government bears part of the debt cost; market weights reflect current financing. Hedging illustration: a US$100,000 receivable hedged at ₹83.20; if spot at maturity is ₹84.00, the forward forgoes ₹80,000 versus spot, but the cash flow is certain.
Traps
Using book weights; failing to tax-adjust Kd; discounting equity cash flows at WACC; cancelling a hedge and calling it speculation without a policy breach; ignoring counterparty credit risk.