Corporate Finance 

Berk and DeMarzo organise corporate finance around three decisions: what assets to buy (investment), how to pay for them (financing), and how much cash to return to shareholders (payout). Every other topic — governance, reporting, capital structure, options, M&A, valuation — is a tool for making those three decisions correctly. The unifying rule is NPV: take projects whose incremental cash flows, discounted at the opportunity cost of capital, create value.

NPV = Σ CF_t / (1 + r)^t  −  Initial investment
IRR: the r that makes NPV = 0; accept if IRR > hurdle rate
Payback: years to recover initial outlay; ignores time value and tail cash flows
Profitability index = PV of future cash flows / Initial investment

The NPV rule is robust because it measures value creation directly. IRR is popular for communicating a percentage return, but it fails when cash flows change sign more than once or when projects are mutually exclusive — a higher IRR can hide a lower NPV. Payback is a liquidity screen, not a value metric. Profitability index helps rank projects under a capital constraint, but the constraint itself is usually softer than it looks.

Corporate governance exists because managers, shareholders and debtholders do not share the same interests. Agency costs arise when managers empire-build, shirk, or invest in pet projects with negative NPV. Boards, concentrated ownership, debt covenants, executive pay and the market for corporate control are the mechanisms that align incentives. Graham's presidential address stresses that the clean models are a starting point; the real world adds taxes, behavioural biases, financial frictions and institutions that vary across countries and time.

Free cash flow problem: managers retain cash and over-invest when growth opportunities are poor
Debt as discipline: mandatory interest payments reduce discretionary cash
WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc)
Project cost of capital ≠ firm WACC when project risk differs from average firm risk

Corporate reporting is the language of those decisions. The income statement, balance sheet and cash flow statement are linked by the fundamental identity and by the change in retained earnings. A consultant who cannot trace a transaction through all three statements cannot build a reliable model. Reporting quality matters because accrual accounting gives managers discretion: revenue recognition, depreciation choices, inventory methods and off-balance-sheet vehicles can all shift reported earnings without shifting cash.

Capital budgeting puts the NPV rule into practice. Estimate incremental revenues, costs, taxes, working capital and capex; choose a discount rate that reflects project risk; compute NPV, IRR and payback; then stress-test with sensitivity and scenario analysis. The cost of capital is usually the most fought-over number: CAPM gives the equity cost, the debt cost is observable from yields or credit spreads, and the weights should be target-market-value weights, not book weights.

Long-term financial planning links the investment plan to the sources of funds. If a firm grows faster than its internal cash generation and target leverage allow, it needs external equity or debt. The sustainable growth rate — ROE times retention — is the speed limit of growth without changing capital structure. Financial planning is not a forecast; it is a consistency check between strategy, operations and the balance sheet.

Sustainable growth rate = ROE × retention ratio
External financing needed = ΔAssets − ΔSpontaneous liabilities − Retained earnings
Retention ratio = 1 − payout ratio
Plowback drives future earnings; payout returns cash shareholders can reinvest themselves

Capital structure is where the textbook meets reality. Modigliani–Miller says value is independent of financing in a perfect world; the real debate is about which market imperfection matters most. The trade-off theory weighs the tax shield of debt against expected distress costs. Pecking order theory says firms prefer internal funds, then debt, then equity, because issuing equity signals overvaluation. Graham's evidence shows that firms do not always optimise taxes, that leverage is more influenced by market timing and institutional factors than by a single target, and that the 'right' debt ratio varies by industry, profitability and volatility.

Payout policy is the mirror of investment policy. If a firm has no positive-NPV projects, returning cash is the right answer. Dividends are sticky and signal stability; buybacks are flexible and signal undervaluation. In perfect markets payout is irrelevant; in practice it conveys information, affects leverage, and has tax consequences. The key interview insight is that a buyback raises EPS mechanically but only creates value if the shares were undervalued.

Options, real options and risk management extend NPV by recognising that managers can adapt. A real option is the right, but not the obligation, to make a future investment decision — to expand, abandon, delay or switch. Option pricing is useful because standard NPV ignores flexibility; it can also be abused by calling every uncertainty an option. Risk management with forwards, futures, swaps and options does not eliminate risk but converts it into a known cost, which stabilises cash flows and protects investment capacity.

Mergers and acquisitions are capital-budgeting decisions applied to whole companies. The acquirer pays a control premium in exchange for synergies, governance changes or strategic optionality. Accretion/dilution analysis compares pro-forma EPS, but the value test is whether the present value of synergies exceeds the premium paid. Valuation methods — DCF, comparable companies, precedent transactions — answer different questions and should be triangulated, not chosen to justify a predetermined answer.

Premium paid = Offer price / Target pre-bid price − 1
Synergy value = PV(revenue synergies) + PV(cost synergies) − integration costs
Value created for acquirer = Synergy value − Premium paid
Accretion = pro-forma EPS rises; dilution = pro-forma EPS falls