Corporate Finance – Key Concepts and Notes
1. Time Value of Money
The time value of money (TVM) is a fundamental concept in finance stating that a dollar
today is worth more than a dollar tomorrow. This principle arises from the potential earning
capacity of money. Present Value (PV) and Future Value (FV) calculations, using
discounting and compounding techniques, allow analysts to evaluate investments over
time. The formula FV = PV × (1 + r)^n is central to understanding how money grows under
compound interest.
2. Risk and Return
Risk and return are two sides of the same coin in investment decisions. According to
Modern Portfolio Theory (MPT), investors are compensated for taking systematic risk—the
portion of total risk that cannot be diversified away. The Capital Asset Pricing Model
(CAPM) formalizes this relationship as: E(Ri) = Rf + βi × (E(Rm) − Rf), where βi measures
the sensitivity of a security’s returns to market movements.
3. Cost of Capital
The cost of capital represents the minimum return that investors expect for providing
capital to the firm. It is the weighted average of the costs of debt and equity—the Weighted
Average Cost of Capital (WACC). The formula is: WACC = (E/V) × Re + (D/V) × Rd × (1 −
Tc), where Re is the cost of equity, Rd is the cost of debt, E and D are market values of
equity and debt, V is total capital, and Tc is the corporate tax rate.
4. Capital Budgeting
Capital budgeting is the process of evaluating long-term investment projects to determine
their profitability. Common techniques include Net Present Value (NPV), Internal Rate of
Return (IRR), and Payback Period. NPV remains the most theoretically sound method, as
it measures the value added to the firm by discounting future cash flows to their present
value.
5. Leverage and Dividend Policy
Leverage amplifies both potential gains and losses by using debt financing. Financial
leverage affects the firm’s cost of capital and risk profile. Dividend policy, on the other
hand, determines how profits are distributed to shareholders versus reinvested. According
to Modigliani and Miller (1961), in perfect markets, dividend policy is irrelevant to firm
value; however, in reality, taxes, information asymmetry, and market imperfections make it
relevant.