AFM 373: Cases and Applications in Corporate Finance

John D'Amato

Estimated study time: 22 minutes

Table of contents

Sources and References

Primary textbook — Berk, J., DeMarzo, P. Corporate Finance, 5th ed., Pearson, 2020.
Supplementary texts — Brealey, R.A., Myers, S.C., Allen, F. Principles of Corporate Finance, 13th ed., McGraw-Hill, 2020; Damodaran, A. Investment Valuation, 3rd ed., Wiley, 2012; Ross, Westerfield, Jaffe, Jordan Corporate Finance, 13th ed., McGraw-Hill, 2022.
Online resources — Aswath Damodaran’s NYU Stern lecture pages; HBS Working Knowledge case library; Journal of Applied Corporate Finance; CFA Institute Refresher Readings on Corporate Finance and Equity Valuation.

These notes synthesize the technical apparatus required to work through practitioner cases in corporate finance, organized around the decision problems managers face — how to finance operations, measure performance, allocate capital, structure the balance sheet, issue securities, pay out cash, value businesses, and restructure them.

Chapter 1: Corporate Governance, Managerial Objectives, and Value Creation

Corporate finance begins with purpose. The orthodox answer is that publicly traded firms should maximize the risk-adjusted present value of cash flows to equity — shareholder wealth maximization. This is defensible because shareholders are residual claimants: creditors, employees, suppliers, and tax authorities have prior claims, so maximizing the residual tends to maximize the pie while meeting all prior obligations.

The stakeholder view counters that employees, customers, regulators, and communities have claims not captured in explicit contracts. Enlightened shareholder maximization reconciles the two: long-run value cannot be sustained if key stakeholders are systematically exploited, so their interests enter as constraints rather than objectives.

Agency conflicts and governance

Because managers are agents of dispersed shareholders, incentives drift. Classic agency problems include empire building, perquisite consumption, over-diversification, and reluctance to disgorge free cash flow. Governance mechanisms — independent boards, block holders, activist investors, the market for corporate control, and performance-based compensation — realign incentives, though option-based pay introduces its own distortions such as risk-shifting and accounting manipulation.

Agency cost. The sum of monitoring costs borne by principals, bonding costs borne by agents, and the residual loss in firm value that remains because the agent's incentives are not perfectly aligned with the principal's.

Measuring value creation

Managers need scorecards that reward genuine value creation rather than accounting profit. Economic value added subtracts a capital charge from after-tax operating profit. Market value added is the difference between the market value of securities and the book value of invested capital — a cumulative stock measure. Together they link operating decisions to shareholder wealth.

Example — EVA as a bonus metric. A division has NOPAT of 80 million dollars, invested capital of 400 million dollars, and WACC of 10 percent. EVA equals 80 minus 40, or 40 million dollars. A bonus pool tied to EVA gives managers sharp incentives to grow NOPAT and return capital the business cannot deploy productively.

Chapter 2: Forecasting Financing Needs

Every strategic decision raises the question of whether the firm has enough cash to execute it. The standard tool is the pro-forma statement — a forward projection of the income statement, balance sheet, and cash flow statement built on explicit operating assumptions combining accounting identities with behavioral assumptions about how line items scale with activity.

Percent-of-sales method

The simplest forecasting technique assumes variable items — cost of goods sold, operating working capital, and many operating assets — move proportionally with sales. Fixed costs and long-lived assets are lumpy step functions held constant until capacity binds. The difference between forecast assets and forecast liabilities plus equity becomes the plug: external financing needed.

External financing needed (EFN). Assuming assets scale with sales at rate \(g\), spontaneous liabilities grow at the same rate, and retained earnings equal the net margin times new sales times retention, \[ \mathrm{EFN} = A^* \cdot g - L^* \cdot g - p\,S_1(1-d) \]

where \(A^*\) are assets that scale with sales, \(L^*\) spontaneous liabilities, \(p\) net margin, \(S_1\) next-period sales, and \(d\) the payout ratio.

Positive EFN forces external debt or equity issuance; negative EFN yields excess cash for debt reduction, buybacks, or dividends.

Sustainable growth rate

The rate of growth financeable without new equity or leverage change follows from the identity that ROE times retention equals book-equity growth at constant D/E:

\[ g^* = \dfrac{\mathrm{ROE}\cdot b}{1 - \mathrm{ROE}\cdot b} \]

where \(b\) is retention. Firms growing faster than \(g^*\) must lever up, issue equity, improve margins, or reduce working capital intensity. The formula diagnoses, it does not prescribe — high-growth firms should exceed \(g^*\) when NPV-positive projects exist.

Example — sustainable growth diagnosis. A retailer forecasts 15 percent sales growth with ROE of 12 percent and retention of 60 percent, giving \(g^* \approx 7.8\) percent. Without higher leverage, better working capital efficiency, or new equity, the expansion cannot be funded internally.

Good practice stresses the model across plausible driver ranges and reports an envelope around the base case rather than a single point.

Chapter 3: Cost of Capital and Performance Measurement

Once a firm knows it needs capital, it must know what capital costs. The weighted average cost of capital is the conventional discount rate for projects of average firm risk and ordinary leverage.

CAPM and equity beta

The capital asset pricing model states that expected equity returns are linear in systematic risk:

\[ r_E = r_f + \beta_E(\mathbb{E}[r_m] - r_f) \]

Betas are typically estimated from five years of monthly returns against a broad index, with shrinkage toward one.

Levering and unlevering beta

Observed equity betas conflate asset risk with leverage. To build a cost of capital for a project whose financing differs from the firm’s — or to average peer betas with different capital structures — one unlevers, averages, then re-levers. Under Hamada’s assumption that debt is risk-free and the tax shield has debt-like risk,

\[ \beta_E = \beta_A\bigl[1 + (1-\tau_c)D/E\bigr]. \]

WACC

With the cost of equity and after-tax cost of debt,

\[ r_{\mathrm{WACC}} = \dfrac{E}{V}r_E + \dfrac{D}{V}r_D(1 - \tau_c) \]

where \(V = D + E\) is enterprise value at target weights. Market-value weights reflect the economic opportunity cost to current claimants. Emerging-market projects often require a country risk premium; small-cap size premiums are increasingly scrutinized.

Hamada equation. Under Modigliani–Miller with a constant tax rate and risk-free debt, \(\beta_L = \beta_U[1 + (1-\tau_c)D/E]\).

EVA and ROIC

Performance measurement applies the cost of capital backward-looking:

\[ \mathrm{EVA} = \mathrm{NOPAT} - r_{\mathrm{WACC}}\cdot\mathrm{InvestedCapital}, \]

equivalently

\[ \mathrm{EVA} = (\mathrm{ROIC} - r_{\mathrm{WACC}})\cdot\mathrm{InvestedCapital}. \]

Positive spreads create value; negative spreads destroy it. Tracking ROIC against WACC distinguishes profitable growth from growth that merely consumes capital below cost.

Example — levered cost of equity. A comparable firm has equity beta 1.2, D/E of 0.5, tax rate 25 percent. Unlevered beta is \(1.2/[1 + 0.75\times 0.5] \approx 0.873\). Re-levering at target D/E of 1.0 gives \(0.873\times 1.75 \approx 1.528\). With risk-free rate 3 percent and equity premium 5.5 percent, \(r_E \approx 11.4\) percent.

Chapter 4: Capital Budgeting in Practice

Capital budgeting translates strategy into discounted cash flow arithmetic. The method of record is net present value: forecast incremental free cash flows, discount at a rate reflecting project risk, compare to the outlay. Positive NPV adds shareholder value.

Building free cash flow

Free cash flow to the firm equals operating income after tax, plus depreciation, minus capital expenditures and increases in working capital. Only incremental flows matter. Sunk costs are excluded; opportunity costs and cannibalization are included; allocated overheads enter only when truly caused by the project. Inflation is handled consistently — nominal flows at nominal rates or real at real, never mixed.

Terminal value

Most projects use an explicit forecast horizon plus a terminal value. The common form is a Gordon perpetuity capitalizing the first steady-state cash flow at the discount rate minus long-run growth. Because terminal value often dominates NPV, practitioners cross-check against an exit-multiple calculation.

Sensitivity, scenario, and break-even

A single NPV hides decision richness. Sensitivity flexes one input at a time to identify which drivers matter. Scenario analysis varies several inputs coherently to depict optimistic, base, and pessimistic outcomes. Break-even asks how far a driver must move before NPV turns zero; projects needing unrealistic assumptions are suspect.

Real options and simulation

Many projects embed strategic flexibility that static NPV ignores. The option to delay, expand, or abandon can shift the decision materially. Decision trees quantify discrete state spaces; Black-Scholes-style valuation applies when uncertainty is close to geometric Brownian motion. For many interacting uncertainties — commodity prices, exchange rates, volumes, regulatory approval — Monte Carlo simulation traces the full NPV distribution and supports probabilistic risk statements.

Real option. A right, not an obligation, to take a specified managerial action at a future date, whose value derives from underlying uncertainty in cash flows.

Example — option to expand. A pilot factory has standalone NPV of minus 10 million dollars, but strong demand enables a second factory worth plus 40 million dollars while weak demand leaves it at zero. With 40 percent probability of strong demand, the expansion option adds 16 million dollars of expected value, flipping the pilot from reject to accept.

Chapter 5: Capital Structure Policy

Capital structure policy asks how the firm splits claims between debt and equity. The Modigliani–Miller framework is the theoretical backbone; every later theory relaxes an assumption.

Modigliani–Miller propositions

Under perfect capital markets — no taxes, distress costs, information asymmetry, or transaction costs — firm value is independent of capital structure. Proposition I states \(V_U = V_L\). With corporate taxes and a permanent interest tax shield,

\[ V_L = V_U + \tau_c D. \]

Proposition II states that the cost of equity rises linearly with leverage:

\[ r_E = r_0 + (r_0 - r_D)\,D/E, \]

where \(r_0\) is the unlevered cost of capital.

Trade-off and pecking order

The classical empirical adjustment adds expected distress costs — legal fees, lost customers, underinvestment, fire-sale disposals. Optimal leverage is where marginal tax benefit equals marginal distress cost. Firms with stable cash flows and tangible assets can bear more debt; intangible-heavy growth firms less.

Myers and Majluf observe that managers possess private information about firm value. Issuing equity signals overvaluation, producing a financing hierarchy: internal funds first, debt second, equity last. The pecking order explains why profitable firms often have low leverage.

Market timing and practical considerations

Firms issue equity when markets price it richly and repurchase when cheap, suggesting timing windows. Dynamic trade-off models rebalance only when benefits exceed transaction costs, producing realistic persistence in observed deviations.

Operating managers focus on credit ratings, covenants, and financial flexibility. A downgrade raises borrowing costs and can trip covenants. Maintaining investment-grade status often caps leverage below the theoretical optimum. Financial flexibility — the capacity to raise capital quickly — is itself a valuable real option.

MM Proposition I with taxes. Under Modigliani–Miller with corporate taxes and a permanent interest tax shield, the value of the levered firm equals the unlevered value plus the present value of the tax shield, \(V_L = V_U + \tau_c D\).

Example — static trade-off. A firm with unlevered value 500 million dollars, marginal tax rate 25 percent, and distress costs of 10 percent on incremental debt above 200 million dollars chooses debt up to that threshold. Below it, each extra dollar of debt adds 25 cents of shield; above it, distress swamps the shield.

Chapter 6: Securities Issuance

Raising external capital is a menu of products and processes, each with distinct frictions.

IPO mechanics and underpricing

IPOs take the firm from private to public. The firm selects a lead underwriter, files a registration statement, conducts a roadshow, collects indications through book building, and prices the offering the night before trading. A lock-up typically blocks pre-IPO holders for 90 to 180 days, and a green-shoe over-allotment lets underwriters stabilize the aftermarket.

IPO shares are typically priced at a discount to first-day close — historically single digits to well above 20 percent in hot markets. Explanations include compensation for the winner’s curse, marketing benefits, and quality signaling. Whatever the cause, underpricing represents money left on the table.

Seasoned equity and debt issuance

Established issuers face a different problem. Announcement effects are typically negative (around minus 2 percent), consistent with pecking-order signaling. Rights offerings, accelerated book builds, and at-the-market programs mitigate the signal.

Debt issuance is organized around credit quality. Investment-grade issuers access deep public markets with tight spreads; high-yield issuers face more covenants, higher coupons, and thinner liquidity. Private placements offer faster execution than registered offerings. Asset-backed structures pool contractual cash flows into tradable tranches.

Bookbuilding. The process by which an underwriter collects non-binding indications of interest from institutional investors, constructs a demand schedule, and sets the offer price at the level that clears the deal with modest oversubscription.

Example — IPO underpricing. A firm issues 10 million shares at 20 dollars each, raising 200 million dollars. The first-day close is 26 dollars. Underpricing is 30 percent, or 60 million dollars transferred from the issuer to allocated investors.

Chapter 7: Dividend Policy and Payout

Payout policy asks how the firm should return cash. The benchmark is Miller and Modigliani’s dividend irrelevance proposition: in perfect markets, the pattern of payouts does not affect firm value because shareholders can reconstruct any preferred stream through home-made dividends.

Taxes and clientele effects

Once dividend taxation differs from capital gains taxation, payout choices matter. When dividends are taxed more heavily, high-bracket investors prefer low-payout firms while tax-exempts are indifferent. Clienteles form, so abrupt policy changes impose reshuffling costs. Empirically, dividend changes carry information: prices react sharply to increases or cuts, supporting a signaling interpretation.

Dividends versus buybacks

Share repurchases now rival or exceed dividends. Buybacks offer flexibility because managers do not view them as implicit commitments. They deliver capital gains rather than ordinary income and can be timed opportunistically. Critics argue they manage EPS or fund option compensation without net return.

Free cash flow and agency

Jensen’s free cash flow hypothesis argues that firms with abundant cash and limited opportunities waste it through empire building. Committing to high payouts — dividends, buybacks, or debt coupons — disciplines management by forcing cash out and requiring a return to capital markets for scrutiny.

Example — dividend signal. A firm raises its stable 0.50 dollar quarterly dividend to 0.65 dollars. The stock jumps 4 percent on announcement, consistent with managers revealing that long-run earnings are permanently higher.

Chapter 8: Valuation Methods

Valuation translates the preceding machinery into a number for a whole business. Three families coexist: discounted cash flow, comparable multiples, and asset-based approaches.

Discounted cash flow with FCFF

The flagship technique is enterprise DCF. Free cash flow to the firm is forecast explicitly for five to ten years, discounted at WACC, and supplemented by terminal value:

\[ V_0 = \sum_{t=1}^{n}\dfrac{\mathrm{FCFF}_t}{(1+r_{\mathrm{WACC}})^t} + \dfrac{TV_n}{(1+r_{\mathrm{WACC}})^n}. \]

Subtracting net debt and non-equity claims (minority interests, pension deficits, preferred) yields equity value and, divided by diluted shares, per-share intrinsic value.

The terminal value captures steady-state value after the explicit horizon. The Gordon form is

\[ TV_n = \dfrac{\mathrm{FCFF}_{n+1}}{r_{\mathrm{WACC}} - g}. \]

The long-run rate \(g\) must respect macroeconomic bounds and the internal consistency \(g = \text{ROIC}\times \text{reinvestment rate}\).

FCFE, multiples, and sum-of-parts

An alternative values equity directly using free cash flow to equity, discounted at the cost of equity. FCFE is natural for banks and regulated firms but is more sensitive to leverage changes.

Multiples valuation compares targets to peers. Enterprise multiples such as EV/EBITDA sidestep capital-structure differences; equity multiples such as P/E bring in leverage and accounting distortions. The art lies in peer selection — firms with similar growth, margins, capital intensity, and risk. Analysts present a range and locate the target within it.

Conglomerates are valued piece by piece, each segment with its own peer set and discount rate, summed and adjusted for corporate overhead and net debt. Replacement cost or liquidation value serves as a floor for distressed firms and holding companies.

Consistency of FCFF discounting. Using WACC requires that free cash flow be the cash available to all capital providers before interest. Mixing FCFE with WACC, or FCFF with cost of equity, double-counts or omits the financing wedge and biases valuations systematically.

Example — DCF sanity check. A software firm has year-5 FCFF of 120 million dollars, WACC 9 percent, and long-run growth 3 percent. Year-5 terminal value is \(120/(0.09-0.03) = 2{,}000\) million dollars. Discounted to today at 9 percent, that is about 1,299 million dollars, which together with the present value of explicit FCFF yields enterprise value.

Chapter 9: Mergers, Acquisitions, and Restructurings

Corporate transactions reshape firm boundaries and capital structures. The dealmaker’s questions are whether the transaction creates value, how gains split between acquirer and target, and how the deal is financed and structured.

Synergies and bidding

Deals are justified by synergies. Revenue synergies come from cross-selling and pricing power; cost synergies from eliminating overhead and consolidating facilities; financial synergies from debt-capacity gains and tax attributes. Synergies must be discounted, probability-weighted for execution risk, and net of integration costs.

Auctions for public targets invite the winner’s curse: the bidder overestimating synergies wins at a price above true value. Deal discipline requires a walk-away price. The empirical regularity is that target shareholders capture most gains while acquirers break even or lose modestly.

Accretion-dilution and payment method

For stock-financed deals, accretion-dilution asks whether combined EPS exceeds standalone acquirer EPS at the proposed exchange ratio. Accretive deals sell more easily, but the test ignores growth, risk, and balance sheet changes — a deal can be accretive and value-destroying if cheap stock buys a low-quality business.

Cash deals transfer reinvestment risk to target shareholders and concentrate risk at the acquirer. Stock deals share risk and are favored when the acquirer believes its stock is rich or when target value is uncertain. Cash deals tend to receive more favorable announcement returns, consistent with signaling content.

Divestitures, spin-offs, and LBOs

Not every transaction expands the firm. Divestitures and spin-offs shrink it on the premise that a business is worth more outside the parent — sharpened focus, aligned incentives, and tax-free distribution under certain conditions. Leveraged buyouts take firms private using substantial debt; debt-service discipline, concentrated ownership, and active governance drive operating improvements. Distressed restructurings — Chapter 11, debt-for-equity swaps, exchange offers — reset capital structures when obligations cannot be served.

Accretion test. In a stock-financed acquisition, the deal is accretive if post-deal combined EPS exceeds standalone acquirer EPS at the proposed exchange ratio: EPS(combined) > EPS(acquirer).

Example — simple LBO arithmetic. A sponsor acquires a target for 1,000 million dollars using 300 million dollars of equity and 700 million dollars of debt. Over five years EBITDA grows from 100 to 150 million dollars, the exit multiple is 10 times, and debt is repaid to 400 million dollars. Exit enterprise value is 1,500 million dollars, equity value 1,100 million dollars, roughly 3.7 times money before fees.

Mastery of these nine chapters comes not from memorizing formulas but from learning which tools apply to which decisions and where they break down so that judgment can take over.