Corporate Finance and Capital Budgeting
Corporate Finance and Capital Budgeting tests financing choices, the cost of capital and the selection of long-term projects by discounted cash flow.
Core rules
- Cost of equity comes from CAPM or the dividend growth model (D1/P0 + g). After-tax cost of debt = Kd(1 − t). WACC uses market-value weights.
- Appraisal tools: payback (liquidity, ignores time value), NPV (value added, preferred), IRR (discount rate giving NPV = 0), profitability index (PV of inflows ÷ initial outlay).
- Accept if NPV > 0 or IRR > cost of capital. For mutually exclusive projects of different scale, rank by NPV.
- Relevant cash flows are incremental and after tax; include working capital and salvage value; exclude sunk costs and interest, since financing cost sits in the discount rate.
Worked example
Outlay ₹1,00,000; inflow ₹40,000 p.a. for four years; cost of capital 10%; annuity factor (10%, 4) = 3.170. PV = 40,000 × 3.170 = ₹1,26,800; NPV = +₹26,800, so accept. The IRR is the rate where the annuity factor equals 1,00,000/40,000 = 2.5; interpolating between 20% (2.589) and 24% (2.404) gives roughly 21%, well above 10%.
Traps
Discounting pre-tax cash flows at an after-tax WACC; forgetting recovery of working capital in the terminal year; deducting interest as an operating cash flow; applying IRR mechanically when project sizes differ; ignoring that IRR assumes reinvestment at the IRR while NPV assumes reinvestment at the cost of capital.