Introductory Corporate Finance: Introduction to Corporate Finance - The Financial, Managers Job Capital Budgeting Capital Structure Working Capital Management

What This Is

The Financial Manager's Job encompasses three critical areas: Capital Budgeting, Capital Structure, and Working Capital Management. These functions are essential for a company's long-term success, as they determine how to allocate resources, manage risk, and optimize profitability. For instance, consider Tesla's decision to invest $1 billion in its Gigafactory 1, which enabled the company to reduce battery costs and increase production. This investment decision reflects a combination of capital budgeting, capital structure, and working capital management.

Key Formulas & Models

• WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital; used as discount rate.
  • wd: weight of debt
  • rd: cost of debt
  • T: corporate tax rate
  • wps: weight of preferred stock
  • rps: cost of preferred stock
  • we: weight of equity
  • re: cost of equity
• DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage; measures EBIT sensitivity to sales.
  • Q: sales
  • P: price per unit
  • V: variable costs per unit
  • F: fixed costs
• Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures a company's ability to sustain growth.
  • ROE: return on equity
  • Retention Ratio: percentage of earnings retained
• FCF = EBIT - Taxes + Depreciation - Capital Expenditures – free cash flow; measures a company's ability to generate cash.
  • EBIT: earnings before interest and taxes
  • Taxes: income taxes
  • Depreciation: non-cash expenses
  • Capital Expenditures: investments in assets
• WACC = (E/V) × Re + (D/V) × Rd × (1-T) – alternative WACC formula.
  • E: market value of equity
  • V: market value of the firm
  • Re: cost of equity
  • D: market value of debt
  • Rd: cost of debt
  • T: corporate tax rate
• DFL = EBIT - Taxes + Interest – degree of financial leverage; measures EBIT sensitivity to interest rates.
  • EBIT: earnings before interest and taxes
  • Taxes: income taxes
  • Interest: interest expenses
• EBITDA = EBIT + Depreciation + Amortization – earnings before interest, taxes, depreciation, and amortization.
  • EBIT: earnings before interest and taxes
  • Depreciation: non-cash expenses
  • Amortization: non-cash expenses
• Cash Conversion Cycle = DSO + DIO - DPO – measures a company's working capital efficiency.
  • DSO: days sales outstanding
  • DIO: days inventory outstanding
  • DPO: days payable outstanding

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC):
   • Determine the weights of debt, preferred stock, and equity
   • Determine the costs of debt, preferred stock, and equity
   • Calculate WACC using the formula WACC = wd × rd(1-T) + wps × rps + we × re
2. Calculate the degree of operating leverage (DOL):
   • Determine the sales, price per unit, variable costs per unit, and fixed costs
   • Calculate DOL using the formula DOL = Q(P-V) / (Q(P-V)-F)
3. Calculate the sustainable growth rate:
   • Determine the return on equity (ROE) and retention ratio
   • Calculate the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio)
4. Calculate the free cash flow (FCF):
   • Determine the earnings before interest and taxes (EBIT), taxes, depreciation, and capital expenditures
   • Calculate FCF using the formula FCF = EBIT - Taxes + Depreciation - Capital Expenditures

Common Mistakes

1. Mistake: Using book value instead of market value for WACC.
   • Correction: Use market value to reflect the current market conditions.
   • Counterexample: If a company has a high book value but low market value, using book value would result in an incorrect WACC.
2. Mistake: Ignoring flotation costs when calculating WACC.
   • Correction: Include flotation costs to reflect the true cost of raising capital.
   • Counterexample: If a company ignores flotation costs, the WACC would be lower than the actual cost of capital.
3. Mistake: Confusing sunk cost with opportunity cost.
   • Correction: Sunk cost is a past investment, while opportunity cost is the potential future benefit.
   • Counterexample: If a company invests in a project with a sunk cost of $100,000, the opportunity cost is the potential future benefit of $150,000.
4. Mistake: Using the wrong formula for WACC.
   • Correction: Use the correct formula WACC = wd × rd(1-T) + wps × rps + we × re.
   • Counterexample: If a company uses the wrong formula, the WACC would be incorrect, leading to suboptimal investment decisions.

Exam / CFA Tips

1. Tip: Be careful when using the Modigliani-Miller (M&M) propositions, as they assume different scenarios.
   • Tricky distinction: M&M Proposition I assumes no taxes, while M&M Proposition II assumes taxes.
2. Tip: Understand the difference between IRR and NPV ranking.
   • Tricky distinction: IRR ranks projects based on their internal rate of return, while NPV ranks projects based on their net present value.
3. Tip: Be aware of the dividend irrelevance theorem.
   • Tricky distinction: The dividend irrelevance theorem states that a company's dividend policy does not affect its stock price.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and taxes of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = EBIT - Taxes + Interest = $10,000,000 - $2,500,000 + $2,000,000 = $9,500,000

Last-Minute Cram Sheet

1. WACC = wd × rd(1-T) + wps × rps + we × re – weighted average cost of capital.
2. DOL = Q(P-V) / (Q(P-V)-F) – degree of operating leverage.
3. Sustainable Growth Rate = ROE × (1 - Retention Ratio) – measures a company's ability to sustain growth.
4. FCF = EBIT - Taxes + Depreciation - Capital Expenditures – free cash flow.
5. WACC = (E/V) × Re + (D/V) × Rd × (1-T) – alternative WACC formula.
6. DFL = EBIT - Taxes + Interest – degree of financial leverage.
7. EBITDA = EBIT + Depreciation + Amortization – earnings before interest, taxes, depreciation, and amortization.
8. Cash Conversion Cycle = DSO + DIO - DPO – measures a company's working capital efficiency.
9. In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
10. The dividend irrelevance theorem states that a company's dividend policy does not affect its stock price.