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Level I CFA® Program exam: Corporate Finance cheat sheet

In this series of revision posts, we ask AB Maximus CFA® Program exam trainers to give you quick tips and essential advice for different chapters in the curriculum. Handy for revision or simply for a last minute review to make sure you’re thoroughly prepared – don't miss the chance to brush up on your knowledge and do a little extra prep!

3 must-know concepts are: deriving the cost of capital, capital budgeting techniques, and the difference between dividends and share repurchase®.

1. Deriving the cost of capital

Remember that cost of capital is the cost of funding a company’s business, which relies on the type of financing used, such as cost of equity, cost of debt, or a combination of both.

Cost of capital is the weighted average of the cost of debt and cost of equity, otherwise known as the hurdle rate – the rate the company needs to exceed before it is profitable – and is affected by factors like operating history and credit worthiness. Therefore, established companies have lower costs of capital than new ones as they have a proven track record to show investors and banks, lenders etc., and can use debt financing. In contrast, newer companies lack collateral and assets, and tend to use equity financing.

The cost of capital is derived by working out the required returns of each component.

Cost of debt is interest rate paid. Remember to calculate the after-tax cost of debt, since interest expense is tax-deductible:

Yield to maturity x (1 - the company’s marginal tax rate)

On the other hand, cost of equity is estimated based on the Capital Asset Pricing Model:

Risk-free rate + (company beta x risk premium)

After calculating the weighted average, you can then use cost of capital to discount future cash flows from potential business projects to estimate their Net Present Value and profitability.

2. Different capital budgeting techniques

Capital budgeting is a planning process for projects on assets with cash flows of a period greater than one year. It tells a company if mutual or independent projects, such as new products, market expansion, or replacement decisions that maintain the business, are worth funding.

Capital budgeting is done via three main techniques: payback period, net present value method and the internal rate of return method.

Calculating the payback period is determining number of years needed to earn back the initial investment for a project, and is suitable for small or simple projects:

total cost of project ÷ cash inflow per year

For mutually exclusive projects, take the project with the shorter number of years as the payback period.

Net Present Value obtained by calculating the difference between the project cost and cash flows generated by that project, using discounted cash flow analysis:

cash outflows (in prevent value) - cash inflows (in present value)

Typically, independent projects are accepted when NPV is positive and rejected when NPV is negative. For mutually exclusive projects, the project with the highest NPV is accepted.

Calculating the Internal Rate of Return (IRR) tells investors the rate of return on a project. The IRR is the discount rate for a project to break even (NPV = 0). For independent projects, projects whose IRR is greater than the cost of capital will be profitable.

However, remember that mutually-exclusive projects may have conflicting IRRs and NPVs, where one project may have a higher IRR, but the other may have a higher NPV.