Corporate Finance
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Introductory Corporate Finance: Introduction to Corporate Finance - Financial Markets and Institutions, Primary vs. Secondary Markets Money vs. Capital Markets

What This Is

Financial markets and institutions are the backbone of corporate finance, enabling companies to raise capital and invest in growth opportunities. The primary market is where companies issue new securities to raise capital, while the secondary market is where existing securities are traded among investors. Understanding the differences between money markets (short-term debt) and capital markets (long-term equity and debt) is crucial for corporate finance professionals and investors alike. For example, consider Tesla's decision to issue a $5 billion bond in the primary market to finance its expansion into electric vehicles.

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: 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: quantity sold
• 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: proportion of earnings retained by the company
• DFL = EBIT / (1 - Tax Rate) – debt-free leverage; measures EBIT sensitivity to sales.
• EBIT: earnings before interest and taxes
• Tax Rate: corporate tax rate
• IRR = NPV / (-Initial Investment) – internal rate of return; measures the rate of return on an investment.
• NPV: net present value
• Initial Investment: initial outlay required for the investment
• NPV = ?(CFt / (1 + r)^t) – net present value; measures the present value of future cash flows.
• CFt: cash flow at time t
• r: discount rate
• t: time period
• Cost of Equity = rRF +-× (rM - rRF) – cost of equity; measures the required return on equity.
• rRF: risk-free rate
• ?: beta coefficient
• rM: market return
• Beta = Cov(Ri, Rm) / ?m^2 – beta coefficient; measures a stock's systematic risk.
• Ri: return on stock i
• Rm: market return
• ?m: market volatility

Step-by-Step Calculation

1. Calculate the weighted average cost of capital (WACC) using the formula WACC = wd × rd(1-T) + wps × rps + we × re.
2. Determine the degree of operating leverage (DOL) using the formula DOL = Q(P-V) / (Q(P-V)-F).
3. Calculate the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).
4. Compute the debt-free leverage (DFL) using the formula DFL = EBIT / (1 - Tax Rate).
5. Calculate the internal rate of return (IRR) using the formula IRR = NPV / (-Initial Investment).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
• Correction: Use market value for WACC to reflect the current market price of the company's securities.
• Counterexample: If a company's market value is $10 billion and its book value is $5 billion, using book value would result in an incorrect WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
• Correction: Include flotation costs in the WACC calculation to reflect the true cost of raising capital.
• Counterexample: If a company incurs $100 million in flotation costs, ignoring these costs would result in an incorrect WACC.
• Mistake: Confusing sunk cost with opportunity cost.
• Correction: Distinguish between sunk costs (irrecoverable costs) and opportunity costs (foregone benefits).
• Counterexample: If a company invests $1 million in a project that fails, the sunk cost is $1 million, but the opportunity cost is the potential return on investment.

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 states that firm value is independent of capital structure, while M&M Proposition II shows that value increases with debt due to the interest tax shield.
• Tip: Understand the difference between IRR and NPV ranking.
• Why: IRR ranking prioritizes projects with higher IRRs, while NPV ranking prioritizes projects with higher NPVs.
• Tip: Be able to calculate the sustainable growth rate using the formula Sustainable Growth Rate = ROE × (1 - Retention Ratio).

Quick Practice Problem

A company has EBIT of $10 million, interest $2 million, and tax 25%. Compute the debt-free leverage (DFL).

Answer: DFL = $10 million / (1 - 0.25) = $13.33 million Explanation: The company's debt-free leverage is $13.33 million, indicating that its EBIT is sensitive to sales.

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. DFL = EBIT / (1 - Tax Rate) – debt-free leverage.
5. IRR = NPV / (-Initial Investment) – internal rate of return.
6. NPV = ?(CFt / (1 + r)^t) – net present value.
7. Cost of Equity = rRF +-× (rM - rRF) – cost of equity.
8. Beta = Cov(Ri, Rm) / ?m^2 – beta coefficient.
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. Ignoring flotation costs when calculating WACC can result in an incorrect WACC.