Strategic Financial Management: Value, Risk and Finance
Value and the cost of capital
NPV is the decision rule. IRR is the discount rate at which NPV = 0 and assumes reinvestment at the IRR, so it can mislead on scale or where cash flows change sign - prefer NPV or MIRR. WACC uses market values and after-tax debt: WACC = [E/(D+E)]Ke + [D/(D+E)]Kd(1−t). CAPM prices only systematic risk: Ke = Rf + β(Rm − Rf); unsystematic risk is diversifiable and unrewarded. Understand business versus financial risk, gearing and the interest tax shield, MM propositions (with tax, value rises with debt until bankruptcy and agency costs bite - trade-off theory), and pecking-order behaviour.
Valuation and deals
Free cash flow valuation, P/E and dividend-based multiples, adjusted present value where leverage changes, and real options for managerial flexibility. In M&A weigh synergies, premium paid, financing mix and integration risk.
Traps
- Weights are market values, never book values.
- Appraise a divisional project at its risk: take a proxy beta, ungear and regear.
- Relevant cash flows exclude sunk costs and apportioned fixed overhead, and include opportunity costs, working capital and tax allowances.
- Do not deduct interest in project cash flows when discounting at WACC - that double-counts financing.
- Be consistent on inflation: nominal cash flows with a nominal rate.
Worked example
Ke = 4% + 1.2 × 6% = 11.2%. Kd is 7% pre-tax, so 5.6% after 20% tax. With 60:40 equity:debt, WACC = (0.6 × 11.2) + (0.4 × 5.6) = 6.72 + 2.24 = 8.96%.