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) – (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?+·(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?+?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 + ?(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.