DECA Review: Corporate Finance (Capital Budgeting, Cost of Capital, Dividends)

DECA – Corporate Finance (Capital Budgeting, Cost of Capital, Dividends)

What This Is

Corporate finance is the branch of business that deals with how a company raises, allocates, and returns capital to its owners. For DECA you’ll need to evaluate capital‑budgeting projects, calculate a firm’s cost of capital, and determine the value of a stock using dividend‑based models. Think of your school’s student‑run café deciding whether to buy a new espresso machine, financing the purchase with a mix of a small loan and retained earnings, and then projecting how the new equipment will affect future dividends to the student‑government board.

Key Terms & Formulas

• Net Present Value (NPV) – Σ (CFt / (1 + r)^t) − Initial Investment; positive NPV = accept.
• Internal Rate of Return (IRR) – Discount rate that makes NPV = 0; compare to required return.
• Payback Period – Time needed to recover the initial outlay; simple payback = Initial Cost / Annual Cash Inflow.
• Weighted Average Cost of Capital (WACC) – (E/V)·Re + (D/V)·Rd·(1‑Tc); blends equity and debt costs.
• Cost of Equity (Re) – CAPM: Re = Rf + β·(Rm − Rf).
• Cost of Debt (Rd) – Yield to maturity on existing bonds or interest rate on new borrowing.
• Dividend Discount Model (DDM) – P0 = D1 / (Re − g) for a constant‑growth firm.
• Gordon Growth Model – Same as DDM; assumes dividends grow at a constant rate g forever.
• Retention Ratio (b) – (1 − Payout Ratio); used to estimate growth: g = ROE·b.
• Required Rate of Return – The minimum return investors demand; often the WACC for project evaluation.
• Opportunity Cost of Capital – The return foregone by investing in a project rather than the next best alternative.
• Capital Rationing – Limiting total investment to a budget; prioritize projects by NPV per dollar or IRR.

Step‑by‑Step / Process Flow

1. Identify cash flows – List all incremental outflows (initial cost, installation) and inflows (savings, additional revenue) for each year of the project’s life.
2. Select the discount rate – Use the firm’s WACC for projects of similar risk; if the project is riskier, add a risk premium.
3. Calculate NPV – Discount each cash flow using the chosen rate and subtract the initial outlay.
4. Compute IRR (optional) – Solve for the rate that sets NPV = 0; compare to the required return.
5. Rank projects – If capital is limited, order projects by highest NPV (or NPV per dollar invested) and select until the budget is exhausted.
6. Determine dividend impact – Estimate the increase in earnings, apply the retention ratio to find growth g, then use the DDM/Gordon model to see how the stock price (or school‑government “dividend”) changes.

Common Mistakes

• Mistake: Using the accounting rate of return instead of NPV/IRR.
  Correction: DECA expects cash‑flow‑based valuation; NPV accounts for time value, while accounting rates do not.

• Mistake: Forgetting to tax‑adjust the cost of debt in WACC (ignoring the (1‑Tc) factor).
  Correction: Interest is tax‑deductible, so the after‑tax cost of debt is lower; include (1‑Tc) to avoid overstating WACC.

• Mistake: Applying the Gordon model when dividends are not expected to grow at a constant rate.
  Correction: Verify the “constant‑growth” assumption; if growth is irregular, use a multi‑stage DDM or other valuation method.

• Mistake: Using the payback period as the sole decision rule.
  Correction: Payback ignores cash flows after recovery and the time value of money; always confirm with NPV.

• Mistake: Mixing project‑specific risk with the firm’s overall WACC.
  Correction: Adjust the discount rate upward for higher‑risk projects; otherwise you’ll over‑value risky investments.

Exam Insights

1. NPV vs. IRR traps – DECA often presents two projects where IRR is higher for the lower‑NPV project. Remember that NPV is the decision‑rule; IRR can be misleading when cash‑flow timing differs.
2. WACC components – Expect a question that gives market value of equity, book value of debt, and tax rate; you must convert to market weights before plugging into the WACC formula.
3. Dividend growth – A classic item asks you to compute g using ROE and retention ratio; watch for the “payout ratio” vs. “retention ratio” confusion.
4. Capital rationing scenario – You may be asked to select projects under a $500,000 budget; prioritize by NPV per $1,000 invested rather than just IRR.

Quick Check Questions

1. A company can invest in Project X (initial cost $120,000) that will generate $40,000 per year for 5 years. Its WACC is 10 %. What is the NPV?
   Answer: $9,254 (NPV = –120,000 + Σ 40,000/(1.10)^t ≈ $9,254).
   Explanation: Discount each of the five cash inflows at 10 % and subtract the initial outlay; a positive NPV means accept.

2. If a firm’s ROE is 15 % and its payout ratio is 40 %, what is the sustainable dividend growth rate (g)?
   Answer: 9 % (g = ROE × (1 − payout) = 0.15 × 0.60 = 0.09).
   Explanation: Retention ratio = 1 − 0.40 = 0.60; multiply by ROE.

3. A firm’s market value of equity is $800,000, market value of debt is $200,000, cost of equity 12 %, pre‑tax cost of debt 6 %, and corporate tax rate 30 %. What is the WACC?
   Answer: 10.2 % (WACC = 0.80·0.12 + 0.20·0.06·0.70 = 0.096 + 0.0084 = 0.1042 ≈ 10.2 %).
   Explanation: Use market weights (E/V = 0.80, D/V = 0.20) and apply the after‑tax debt cost.

Last‑Minute Cram Sheet (10 one‑liners)

1. NPV > 0 → accept; NPV < 0 → reject.
2. IRR is the discount rate that makes NPV = 0.
3. WACC = (E/V)·Re + (D/V)·Rd·(1‑Tc).
4. CAPM: Re = Rf + β(Rm‑Rf).
5. Gordon Model: P0 = D1 / (Re – g).
6. Growth rate g = ROE × Retention Ratio (b).
7. Payback ignores cash flows after recovery – never use alone. ⚠️
8. Use market values, not book values, for the weights in WACC.
9. When projects compete for limited funds, rank by highest NPV per dollar invested.
10. If a project’s risk exceeds the firm’s average, add a risk premium to the discount rate. ⚠️