Corporate Finance and Financial Management
Core concepts
Corporate finance questions test the time value of money, capital budgeting, cost of capital and financing decisions. You must be fluent with present and future value, annuities and perpetuities, net present value (NPV), internal rate of return (IRR), payback and discounted payback, and the profitability index. Understand the weighted average cost of capital (WACC) and how it combines the cost of equity and the after-tax cost of debt.
Financing and risk
Know the sources of finance (equity, debt, retained earnings, leasing), gearing and its effect on risk, and the trade-off between return and risk. Working capital management-cash conversion cycle, receivables and payables policies, inventory levels-is frequently examined.
Traps
Discount rates must match the cash flow: use an after-tax WACC for after-tax cash flows. Sunk costs are excluded; opportunity costs are included. IRR can mislead when comparing projects of different scale or with non-conventional cash flows-prefer NPV. Watch for whether cash flows are in nominal or real terms; discount nominal flows at a nominal rate.
Worked example
WACC: equity 60% at 12%, debt 40% at 8% with a 25% tax rate. After-tax cost of debt = 8% x (1 - 0.25) = 6%. WACC = (0.60 x 12%) + (0.40 x 6%) = 7.2% + 2.4% = 9.6%. A project with positive NPV at 9.6% adds value.
Rule of thumb
Accept projects with positive NPV; NPV and IRR agree for conventional, independent projects, but NPV is the decision rule when they conflict.