Corporate Finance and Risk Management
Corporate Finance and Risk Management tests investment, financing and risk decisions using cash flows, risk-adjusted returns and hedging logic.
Core rules
- Appraise projects on incremental after-tax cash flows, excluding sunk costs and financing flows; include working capital and terminal cash flows.
- WACC = proportion of equity × cost of equity + proportion of debt × pre-tax cost of debt × (1 − tax rate). CAPM: cost of equity = risk-free rate + beta × market risk premium.
- Use a discount rate matching project risk; systematic risk is relevant because investors can diversify unsystematic risk.
- Value shares using dividend growth or free cash flow models; compare with market price and state assumptions.
- Manage FX and interest-rate risk with forwards, futures, options or swaps; ERM addresses risk appetite, aggregation and controls. VaR is not a maximum loss.
Worked example
Debt is 40% at 8% pre-tax, equity 60% at 14%, tax 30%. WACC = 0.4 × 8% × 0.7 + 0.6 × 14% = 2.24% + 8.4% = 10.64%. A project costs LKR 1,000m and yields LKR 180m after-tax annually for 10 years. Annuity factor at 10.64% is about 5.98, so PV is LKR 1,076m and NPV is LKR 76m. Accept if the project’s risk matches the WACC and qualitative factors are satisfactory.
Traps
Discounting accounting profit; including interest in project cash flows and then using WACC; using a company-wide WACC for a different-risk division; treating VaR as worst-case; and hedging without identifying the exposure.