In plain English
Companies have a limited pot of money and unlimited ideas. Corporate finance is the discipline of ranking the ideas by how much value each krona creates.
The advanced view
Value additivity means projects can be valued independently and summed, so the firm is a portfolio of NPVs. The discount rate belongs to the project's systematic risk, so a low-risk utility inside a tech group is financed at group WACC but valued at utility risk. Real-option thinking adds the value of waiting, staging and abandoning, which conventional NPV understates for irreversible, uncertain investments.
Corporate finance answers three questions: what to invest in (capital budgeting), how to fund it (capital structure) and how much to return to shareholders (payout policy). Capital budgeting applies NPV to real decisions — estimate incremental cash flows, discount at the project's cost of capital, accept if NPV > 0. Incremental means ignoring sunk costs, including opportunity costs, and accounting for cannibalisation of existing products.
Cost of capital
WACC = (E/V) × Re + (D/V) × Rd × (1 − Tc) CAPM: Re = Rf + β × (Rm − Rf) Levered beta: βL = βU × [1 + (1 − Tc) × D/E]
Capital structure: Modigliani–Miller (1958) says structure does not affect firm value in a perfect market. In reality it does, because of taxes (interest is deductible, creating a tax shield), bankruptcy costs and agency conflicts. Trade-off theory balances the tax benefit of debt against expected distress costs. Pecking order theory says firms prefer internal funds, then debt, then equity, because issuing equity signals management thinks the stock is overvalued.
Payout policy: dividends versus buybacks. Miller–Modigliani says payout is irrelevant in perfect markets. In practice dividends signal stability while buybacks are flexible and tax-efficient. The signalling hypothesis explains why cutting a dividend hammers the stock — it signals management no longer expects to sustain earnings.
Essential vocabulary
- Beta (β)
- Sensitivity to market movements. β = 1 moves with the market; β > 1 is more volatile. Feeds CAPM.
- Equity risk premium
- Extra return demanded for holding stocks over risk-free bonds. Typically estimated at 4–6%.
- Tax shield
- Value of the tax deductibility of interest, roughly Tc × Debt for perpetual debt.
- Agency costs
- Costs of conflicting interests between managers, shareholders and debtholders. Debt disciplines free cash flow; too much debt causes risk-shifting.
Intuition
Capital budgeting is one question repeated: does this use of capital earn more than the capital costs? Everything else — WACC, hurdle rates, options to defer — is machinery for answering it honestly. The discount rate belongs to the project's risk, not to the company that happens to fund it.
Common pitfalls
- ×Applying a company-wide WACC to a project with very different risk.
- ×Including sunk costs or allocated overhead that does not change with the decision.
- ×Ignoring the value of waiting when uncertainty is high and the investment is irreversible.
- ×Weighting debt and equity at book value rather than market value.
Worked example — WACC
Step 1 of 5
- 1Equity 600 at 11%, debt 400 at 6%, tax 25%
Why it works
NPV works because it prices the alternative: the discount rate is literally the return shareholders could get elsewhere at the same risk. A positive NPV therefore means the project beats the capital market, which is the only benchmark that matters. IRR fails as a ranking tool because it implicitly reinvests interim cash at the IRR itself, an assumption the market does not offer.
How it is used — two projects, one budget
Step 1 of 5
- 1A: outlay 100, NPV +18, IRR 22%. B: outlay 400, NPV +45, IRR 15%. Hurdle 10%.
Deeper
Deeper: NPV vs. IRR, and why unlevering beta matters
IRR is the discount rate at which NPV is zero. It fails in three known ways: non-conventional sign changes give multiple IRRs, it implicitly assumes reinvestment at the IRR, and it ranks projects by percentage rather than by value created. When IRR and NPV disagree on mutually exclusive projects, NPV wins.
Project discount rates should reflect the project's risk, not the company's. Take the comparable firms' levered betas, unlever each at its own leverage — βU = βL ÷ [1 + (1 − t) D/E] — take the median, then relever at the target capital structure. Using the parent's WACC for a riskier division is a standard corporate value-destruction mechanism.
Must know cold
- ✓NPV = Σ CF_t ÷ (1 + r)^t − investment; take every positive-NPV project.
- ✓IRR assumes reinvestment at the IRR; NPV assumes reinvestment at the cost of capital.
- ✓Unlever and relever beta when the project's leverage differs from the firm's.
- ✓Sunk costs are irrelevant; opportunity costs and cannibalisation are not.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Project X: −100 now, +60, +60. Project Y: −100 now, +0, +140. WACC 10%. Which do you pick, and what does IRR say?
Exercise 2
Comparable has βL 1.4, D/E 0.8, tax 25%. Your project will run at D/E 0.3. What beta do you use?