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CFA1: Corporate Finance

Capital Budgeting

  • Capital budgeting process: to determine and select (the most) profitable long-term projects
  • Capital budgeting process
  1. Idea generation
  2. Analyze project proposals
  3. Create the capital budget for the firm
  4. Monitor decisions and conduct a post-audit
  • Principles
    • based on the changes in after-tax cash flows
    • do not consider sunk costs
    • consider cash opportunity costs
    • consider externalities - cannibalization
    • timing of cash flows critical

Project valuation

  • Net present value (NPV)


  • Internal rate of return (IRR)


  • Payback Period
    • primarily a measure of liquidity
    • ignores measurement, time value of money, cash flows beyond the payback period
    • discounted payback period - computes with discounted cash flows
  • Average accounting rate of return = average net income / average book value
  • Profitability Index

PI = 1 + NPV/CF0

  • NPV Profile: NPV(y-axis) plotted against cost of capital, where y-intercepts are IRR

Cost of Capital

  • Capital budgeting project
    • relevant incremental cash flow includes positive/negative externalities and opportunity cost
    • increase in inventory classified as a cost at time zero
    • interest costs of a loan included in WACC
  • Target capital structure: proportions of debt, preferred stock and equity that the firm expects to achieve over time
  • Marginal Cost of Capital: cost of an additional dollar of capital, WACC of the next dollar of capital raised, slopes upward
  • Optimal Capital Budget: intersection of the investment opportunity schedule with the MCC curve
    • ordering of opportunities for investment in ranks of higher IRR
    • construct a downward sloping investment opportunity schedule
  • Weighted average Cost of capital (WACC)


  • Cost of Debt kd(1-t) = current market YTM (1-tax)
  • Cost of Preferred Stock kps = preferred dividend / market price of preferred
  • Cost of Common Equity
    • Capital Asset Pricing Model (CAPM): kce = RFR + β[E(Rmkt) - RFR]


    • Dividend discount model (DDM): kce = D1/P0 + g


    • Bond yield plus risk premium: kce = bond market yield + risk premium + CRP
    • Country Risk Premium = sovereign yield spread * annualized σ of equity index / annualized σ of sovereign bond market
    • systematic risk
  • Flotation Costs: fees charged by investment bankers when a company raises external equity capital
    • included in the initial outlay
    • decrease NPV by an amount that is unaffected by the discount rate

Working Capital Management

  • Operating cycle = (AR/Sales + COGS/Inventory) * 365
  • Cash conversion cycle = (AR/Sales + COGS/Inventory - AP/purchases) * 365
  • Return on Equity
    • Extended DuPont Expression = OI/revenue * Income before taxes/OI *(1-taxes/income before taxes) * revenues/asset * A/E
  • Cash forecast: to ensure sufficient liquidity, necessary for unforeseen costs, opportunities that may arise
    • short-term CF forecasts constructed b projecting current daily and weekly cash flows
    • medium-term forecasts based on recent average cash receipts and expenditures, or projection models that take recent trends and seasonality
    • long-term forecasts derived from projected income statements and balance sheets for future years
  • Comparable yields
  • Investment policy statement(IPS) - purpose and objective of the investment portfolio
  • Factoring: sale of receivables without recourse; amount the factor will pay depends on the credit quality of credit customer

Corporate Governance

  • Investment Policy Statement
  1. Client identification
  2. Investment objectives
  3. Investor constraints
  4. Performance measurement benchmarks
  • firm's internal controls and the procedures
  • rights and responsibilities of management, the board, and shareholders
  • shareholder interests
  • board act independent of management
  • Audit committee: responsible for evaluating the financial information company provides to shareholders
    • approve or reject the company's proposed non-audit engagements with external auditing firm
    • control audit budget, no restrictions on communication between the committee and internal auditors
  • Form S-1: Registration statement filed prior to the sale of new securities to the public.
  • Form DEF-14A: When a company prepares a proxy statement for its shareholders prior to the annual meeting or other shareholder vote, it also files the statement with the SEC as Form DEF-14A.
  • Form 8-K: Companies must file this form to disclose material events including significant asset acquisitions and disposals, changes in management or corporate governance, or matters related to its accountants, financial statements, or the markets on which its securities trade.
  • Form 144: A company can issue securities to certain qualified buyers without registering the securities with the SEC, but must notify the SEC that it intends to do so.