Introductory Corporate Finance: Introduction to Corporate Finance - What is Corporate Finance Role of Financial, Manager Investment Financing Dividend Decisions

What This Is

Corporate finance is the study of how companies raise, invest, and manage funds to maximize shareholder value. Financial managers play a crucial role in making investment, financing, and dividend decisions that impact a company's financial performance. For example, consider Tesla's decision to invest in electric vehicle production, which requires significant funding and affects its dividend payout. In 2020, Tesla raised $5 billion in debt financing to support its growth plans, which helped the company expand its production capacity and increase its market value.

Key Formulas & Models

• WACC = wd × rd(1-T) + wps × rps + we × re: weighted average cost of capital; used as discount rate.
• wd: proportion of debt
• rd: cost of debt
• T: tax rate
• wps: proportion of preferred stock
• rps: cost of preferred stock
• we: proportion of equity
• re: cost of equity
• DOL = Q(P-V) / (Q(P-V)-F): degree of operating leverage; measures EBIT sensitivity to sales.
• Q: quantity sold
• P: price per unit
• V: variable costs per unit
• F: fixed costs
• DFL = (EBIT - Interest) / EBIT: degree of financial leverage; measures EBIT sensitivity to interest rates.
• EBIT: earnings before interest and taxes
• Interest: interest expenses
• Sustainable Growth Rate = ROE × (1 - Retention Ratio): measures a company's ability to sustain growth through internal financing.
• ROE: return on equity
• Retention Ratio: proportion of earnings retained
• FCFF = EBIT × (1 - Tax Rate) - Capital Expenditures - Change in Working Capital: free cash flow to the firm; measures a company's ability to generate cash.
• EBIT: earnings before interest and taxes
• Tax Rate: corporate tax rate
• Capital Expenditures: investments in property, plant, and equipment
• Change in Working Capital: changes in accounts receivable, inventory, and accounts payable
• FCFE = FCFF - Capital Expenditures - Change in Net Debt: free cash flow to equity; measures a company's ability to generate cash for shareholders.
• FCFF: free cash flow to the firm
• Capital Expenditures: investments in property, plant, and equipment
• Change in Net Debt: changes in debt and cash
• Dividend Payout Ratio = Dividends / Earnings: measures a company's ability to distribute earnings to shareholders.
• Dividends: cash distributed to shareholders
• Earnings: net income
• Cost of Equity = rRF +-× (rM - rRF): measures the required return on equity.
• rRF: risk-free rate
• ?: beta coefficient
• rM: market return
• IRR = (FV - PV) / PV: internal rate of return; measures the rate of return on an investment.
• FV: future value
• PV: present value

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC):
2. Determine the proportion of debt, preferred stock, and equity
3. Calculate the cost of debt, preferred stock, and equity
4. Apply the WACC formula
5. Calculate the degree of operating leverage (DOL):
6. Determine the quantity sold, price per unit, variable costs per unit, and fixed costs
7. Apply the DOL formula
8. Calculate the degree of financial leverage (DFL):
9. Determine the earnings before interest and taxes (EBIT) and interest expenses
10. Apply the DFL formula
11. Calculate the sustainable growth rate:
12. Determine the return on equity (ROE) and retention ratio
13. Apply the sustainable growth rate formula
14. Calculate the free cash flow to the firm (FCFF):
15. Determine the earnings before interest and taxes (EBIT), tax rate, capital expenditures, and change in working capital
16. Apply the FCFF formula
17. Calculate the free cash flow to equity (FCFE):
18. Determine the free cash flow to the firm (FCFF), capital expenditures, and change in net debt
19. Apply the FCFE formula

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value to reflect the current market price of the company's securities.
• Counterexample: A company with a high book value but low market value would result in an incorrect WACC calculation.
• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs to reflect the true cost of raising capital.
• Counterexample: A company that ignores flotation costs would overestimate its WACC and make suboptimal investment decisions.
• Mistake: Confusing sunk cost with opportunity cost.
• Correction: Recognize that sunk costs are irreversible and do not affect future decisions.
• Counterexample: A company that invests in a project with a sunk cost would overestimate its profitability and make suboptimal decisions.

Exam / CFA Tips

• Tip: Be able to distinguish between M&M Proposition I (no taxes) and M&M Proposition II (with taxes).
• Why: M&M Proposition I assumes no taxes, while M&M Proposition II assumes taxes, which affects the firm's capital structure.
• Tip: Understand the difference between IRR and NPV ranking.
• Why: IRR measures the rate of return, while NPV measures the present value of cash flows.
• Tip: Be able to calculate the sustainable growth rate and explain its implications.
• Why: The sustainable growth rate measures a company's ability to sustain growth through internal financing.

Quick Practice Problem

A company has EBIT of $10M, interest of $2M, and a tax rate of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (EBIT - Interest) / EBIT = ($10M - $2M) / $10M = 0.8

Explanation: The DFL measures the sensitivity of EBIT to interest rates. A DFL of 0.8 indicates that a 1% increase in interest rates would decrease EBIT by 0.8%.

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. DFL = (EBIT - Interest) / EBIT: degree of financial leverage.
4. Sustainable Growth Rate = ROE × (1 - Retention Ratio): measures a company's ability to sustain growth through internal financing.
5. FCFF = EBIT × (1 - Tax Rate) - Capital Expenditures - Change in Working Capital: free cash flow to the firm.
6. FCFE = FCFF - Capital Expenditures - Change in Net Debt: free cash flow to equity.
7. Dividend Payout Ratio = Dividends / Earnings: measures a company's ability to distribute earnings to shareholders.
8. Cost of Equity = rRF +-× (rM - rRF): measures the required return on equity.
9. IRR = (FV - PV) / PV: internal rate of return.
10. 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.