Corporate finance Study Guide

📖 Core Concepts Corporate Finance: Managing a firm’s funding, capital structure, and resource allocation to maximize shareholder value. Capital Budgeting: Long‑term project evaluation using discounted cash‑flow (DCF) methods (NPV, IRR, etc.). Capital Structure: Mix of debt, equity, and preferred stock that finances a firm; governed by tax shields, bankruptcy risk, and market signals. Working Capital Management: Short‑term asset‑liability coordination (cash, receivables, inventory, payables) to maintain liquidity and profitability. Dividend Policy: Decision framework for returning cash to shareholders (dividends, share buybacks) versus retaining earnings. Real Options: Value of managerial flexibility (e.g., expand, abandon) treated like financial options in project valuation. Modigliani‑Miller (MM) Theorem: In a perfect market, firm value is independent of its capital structure; leverage raises the cost of equity. Pecking‑Order Theory: Firms prefer internal financing, then debt, and issue equity only as a last resort. --- 📌 Must Remember NPV Formula: $NPV = \displaystyle\sum{t=0}^{n} \frac{CFt}{(1+r)^t}$ Hurdle Rate: Minimum acceptable return; usually the firm’s WACC (weighted‑average cost of capital). IRR Rule: Accept project if $IRR >$ hurdle rate; remember IRR can be multiple or non‑existent for non‑standard cash flows. Trade‑off Theory: Optimal debt level balances tax shield ($\text{Tax Rate} \times \text{Debt Interest}$) against bankruptcy costs. MM Proposition II (with taxes): $rE = r0 + (r0 - rD) \frac{D}{E}(1-Tc)$, where $rE$ = cost of equity, $rD$ = cost of debt, $D/E$ = leverage, $Tc$ = corporate tax rate. Cash Conversion Cycle (CCC): $CCC = DIO + DSO - DPO$ DIO = Days Inventory Outstanding DSO = Days Sales Outstanding DPO = Days Payables Outstanding Residual Dividend Policy: Pay dividends only after financing all positive‑NPV projects with retained earnings. Signaling Hypothesis: An increase in dividends signals management’s confidence in future earnings. --- 🔄 Key Processes Capital‑Budgeting Decision Forecast incremental cash flows (revenues, costs, tax shields). Choose discount rate (hurdle rate = firm’s WACC). Compute NPV using the formula above. Run sensitivity analysis – vary one input (e.g., sales volume) while holding others constant. Run scenario analysis – create “best”, “base”, “worst” sets of assumptions; recalc NPV for each. If flexibility exists, build a decision tree with probabilities → calculate expected values → compare to NPV. Determining Optimal Capital Structure (Trade‑off) Estimate tax shield benefit = $Tc \times \text{Interest Expense}$. Estimate bankruptcy cost (direct + indirect) as a function of debt level. Find debt level where incremental tax shield = incremental bankruptcy cost → optimal $D^$. Working‑Capital Management – Cash Conversion Cycle Compute DIO = $\frac{\text{Average Inventory}}{\text{COGS}} \times 365$. Compute DSO = $\frac{\text{Average Accounts Receivable}}{\text{Net Sales}} \times 365$. Compute DPO = $\frac{\text{Average Accounts Payable}}{\text{COGS}} \times 365$. CCC = DIO + DSO – DPO; aim to minimize CCC. Dividend Decision (Residual Policy) Forecast net income and required capital for positive‑NPV projects. Pay out Retained Earnings – Required Capital as dividend; if negative, retain all earnings. --- 🔍 Key Comparisons Debt vs. Equity Debt: Fixed interest, tax‑deductible, senior claim, increases financial risk. Equity: No mandatory payments, residual claim, dilutes ownership, no tax shield. Capital Budgeting vs. Working Capital Management Horizon: Long‑term (years) vs. short‑term (days‑months). Reversibility: Projects are often irreversible; WC decisions are often reversible. Dividend vs. Share Repurchase Dividends: Regular cash payout, taxable as ordinary income for many shareholders. Buybacks: Reduce share count → EPS rise, can be tax‑efficient, flexible timing. MM Theorem vs. Trade‑off Theory MM: Capital structure irrelevant in perfect markets. Trade‑off: Real‑world frictions (taxes, bankruptcy) make structure matter. Pecking‑Order vs. Market‑Timing Pecking‑Order: Hierarchy of financing sources based on asymmetric information. Market‑Timing: Firms issue securities when market conditions make them cheap. --- ⚠️ Common Misunderstandings “Higher IRR always means a better project.” IRR ignores scale and timing; a project with high IRR but low NPV can destroy value. “More debt always increases firm value because of the tax shield.” Ignoring rising bankruptcy risk leads to over‑leveraging. “Dividend changes always signal future earnings.” Changes may reflect cash‑flow needs or tax considerations, not just earnings expectations. “Working capital is just cash on hand.” It includes receivables, inventory, and payables; managing the whole cycle is essential. “MM holds true in reality.” Real markets have taxes, transaction costs, and bankruptcy risk, violating MM’s assumptions. --- 🧠 Mental Models / Intuition “Value = Cash Flow × (1 – Discount Rate)⁻¹.” Treat every project like a mini‑firm: discount its cash flows to present value. “Debt as a Discipline Device.” Imagine debt as a timer that forces managers to generate cash; the faster the timer ticks, the more disciplined the spending. “Cash Conversion Cycle = Money‑in‑the‑Well.” Visualize cash flowing out to buy inventory, then back in from sales; the longer it stays in the well, the less you can invest elsewhere. “Real Options = Business Flexibility.” Like a call option on a future expansion—value the upside of waiting or expanding, not just the static NPV. --- 🚩 Exceptions & Edge Cases Zero‑Coupon Bonds: No periodic interest; discount at issuance → treat as deep‑discount debt for tax‑shield calculations. Callable Bonds: Issuer can retire early; incorporate call probability in valuation. Sinking‑Fund Provision: Requires periodic cash set‑aside; reduces default risk, slightly lowers effective cost of debt. Multiple IRRs: Occur with non‑conventional cash‑flow signs; rely on NPV or Modified IRR instead. Negative Working‑Capital Companies (e.g., retailers): A negative CCC can be normal when suppliers finance inventory. --- 📍 When to Use Which NPV vs. IRR: Use NPV for absolute value creation; use IRR only for quick ranking when cash‑flow patterns are conventional. Trade‑off vs. Pecking‑Order: Apply Trade‑off when firm’s target leverage is a strategic decision; use Pecking‑Order to explain observed financing patterns (internal → debt → equity). Real Options: Deploy when projects have significant managerial flexibility (expand, abandon, delay). Dividend vs. Share Repurchase: Choose dividends for steady‑income investors; choose buybacks for tax‑efficiency and EPS boost when shares appear undervalued. Working‑Capital Tools: Use CCC to diagnose liquidity problems; use inventory EOQ (Economic Order Quantity) when ordering costs dominate. --- 👀 Patterns to Recognize “High NPV but low IRR” → Large‑scale, long‑duration projects; focus on absolute value, not rate of return. “Rising leverage + rising cost of equity” → MM Proposition II in action; expect equity cost to climb with debt. “Dividend increase after a profit jump” → Likely signaling; test if earnings are sustainable. “Shortening CCC over quarters” → Effective working‑capital management (better inventory turnover or receivables collection). “Debt issuance after a stock price surge” → Market‑timing behavior (cheapest debt). --- 🗂️ Exam Traps Confusing WACC with hurdle rate: WACC is a starting point; project‑specific risk may require a higher hurdle. Choosing IRR over NPV for mutually exclusive projects: IRR can mislead; NPV gives the correct ranking. Assuming MM means capital structure never matters: Forget taxes and bankruptcy—most exam questions test the with‑tax version of MM. Treating a cash dividend and a share repurchase as identical: They differ in tax treatment, signaling, and impact on EPS. Ignoring the effect of payables on CCC: DPO reduces CCC; forgetting it inflates perceived liquidity problems. Selecting the “most attractive” financing source without hierarchy: Exams often test pecking‑order logic; internal financing should be first. ---