Business finance and capital structure
This domain tests investment appraisal and financing decisions: does a project create value, what discount rate applies, and how much debt should the firm carry?
Core concepts
- Time value: FV = PV(1 + r)^n; annuity and perpetuity factors convert streams to present values.
- Appraisal: NPV discounts at the cost of capital and is preferred because it measures value added in absolute terms; IRR is the rate where NPV = 0 and assumes reinvestment at the IRR itself; payback ignores the time value; profitability index suits capital rationing.
- Cost of capital: WACC = (E ÷ V) × Ke + (D ÷ V) × Kd × (1 − t), using market values. Ke from CAPM (Rf + β × market risk premium) or the dividend growth model (D1 ÷ P0 + g).
- Leverage: operating gearing = contribution ÷ EBIT; financial gearing = EBIT ÷ profit before tax; combined gearing multiplies the two.
- Capital structure: Modigliani–Miller with no tax says structure is irrelevant; with tax, debt adds value through the interest tax shield, offset in practice by financial distress and agency costs (trade-off theory); pecking order prefers retained earnings, then debt, then equity.
- Dividends: residual theory, MM irrelevance, signalling, and clientele effects.
Worked example
Equity 600m, debt 400m, Ke 15%, Kd 10%, tax 29%. WACC = 0.6 × 15% + 0.4 × 10% × 0.71 = 9% + 2.84% = 11.84%. A project costs 100m and yields 30m a year for five years: annuity factor ≈ 3.62, PV ≈ 108.6m, NPV ≈ +8.6m, so accept. Note that Kd is used net of tax, and weights are market values.
Traps that cost marks
Discounting at the pre-tax cost of debt; using book rather than market weights; comparing an IRR to the wrong hurdle; including sunk costs or ignoring working capital and tax in project cash flows.