Corporate Finance and Valuation
Capital Budgeting
Corporate finance centers on allocating capital to maximize firm value. Master net present value (NPV), internal rate of return (IRR), payback, and profitability index, and know their decision rules and conflicts. NPV is the preferred criterion; IRR can mislead with non-conventional cash flows or when ranking mutually exclusive projects of different scale. Use the weighted average cost of capital (WACC) as the discount rate for projects of average risk, and adjust for project-specific risk.
Cost of Capital
WACC = (E/V)·Re + (D/V)·Rd·(1−t). Estimate the cost of equity with CAPM: Re = Rf + β·(Rm − Rf). Remember that beta measures systematic risk and that debt tax shields lower the effective cost of debt. A common error is using book weights instead of target market-value weights.
Valuation
For equity valuation, distinguish absolute methods (dividend discount, free cash flow to firm/equity) from relative methods (P/E, EV/EBITDA). Free cash flow to the firm is discounted at WACC; free cash flow to equity at the cost of equity. Terminal value typically uses the Gordon growth model, requiring a growth rate below the discount rate.
Common Traps
- Using IRR when cash flows change sign multiple times.
- Forgetting to subtract capital expenditures and working capital investment in FCF.
- Applying a growth rate above the long-run economy rate in terminal value.
Rule of Thumb
Accept projects with positive NPV; among mutually exclusive projects, choose the highest NPV, not the highest IRR.