Principles of Corporate Finance and Capital Structure
What CB1 tests in corporate finance and capital structure
This domain tests capital budgeting, cost of capital, financing choices and payout policy. You must link investment decisions to cash flow, risk and financing, and recognise when a textbook rule breaks down.
Core rules and concepts
- NPV is the primary investment rule: discount incremental after-tax cash flows at a rate reflecting project risk. IRR can mislead when cash flows change sign or projects differ in scale.
- WACC weights after-tax costs of debt and equity by market values. Use target or market weights, not historical book weights, when they better reflect financing.
- CAPM gives required equity return: risk-free rate plus beta times equity risk premium. Beta measures systematic, not diversifiable, risk.
- Modigliani-Miller says capital structure is irrelevant in perfect markets without tax; with corporate tax, debt creates a tax shield but financial distress and agency costs offset it.
- Pecking order predicts internal funds first, then debt, then equity, reflecting information asymmetry.
Worked example
A project costs 100 and returns 40, 50 and 60 at years 1–3. At 10%, PV = 40/1.1 + 50/1.1² + 60/1.1³ = 36.36 + 41.32 + 45.08 = 122.76. NPV = 22.76, so accept. If the cash flows were riskier, a higher discount rate would lower NPV; the decision depends on the risk-matched rate.
Traps that cost marks
Do not use the coupon or accounting profit as the cost of debt. Do not discount equity cash flows at WACC. Ignore tax only if told to. Remember that a high IRR on a small project may add less value than a lower-IRR large project.