Valuation and capital structure

Area 1: Business Analysis (40-50%)

Your Progress

0 of 399 questions attempted

Topics

Discounted cash flow models
Weighted average cost of capital
Market multiples and asset-based approaches
Fair value measurement scope (ASC 820 vs. other frameworks)

Lessons

Study Frameworks

Cost of Capital and WACC

Weighted Average Cost of Capital

Cost of Debt

Pre-tax rate × (1 − Tax rate)

Interest is tax-deductible (tax shield)

Cost of Preferred Stock

Preferred dividend / Net issuance price

No tax deduction for preferred dividends

Cost of Equity (CAPM)

Risk-free rate + β(Market risk premium)

β measures systematic risk only

Cost of Equity (DDM)

(D₁ / P₀) + g

Requires stable dividend growth

WACC Blends All Sources

wᵈ × rᵈ(1−T) + wᵖ × rᵖ + wᵉ × rₑ

Use market value weights, not book value

DCF Valuation Framework

Discounted Cash Flow Analysis

FCFF Approach

FCFF = EBIT(1−T) + Depr − CapEx − ΔNWC

Discount at WACC → Enterprise value

EV − Debt + Cash = Equity value

FCFE Approach

FCFE = NI + Depr − CapEx − ΔNWC + Net borrowing

Discount at cost of equity → Equity value directly

Terminal Value

Gordon Growth: FCF × (1+g) / (r−g)

Exit multiple: EBITDA × comparable multiple

Typically 60-80% of total value

Market Multiples

P/E = Price / EPS (equity-level)

EV/EBITDA = Enterprise value / EBITDA

P/B = Price / Book value per share

WACC

wᵈ × rᵈ(1−T) + wᵖ × rᵖ + wᵉ × rₑ

Weighted average cost of capital. Use market value weights. Only debt gets the tax shield.

CAPM (Cost of Equity)

rₑ = Rᶠ + β(Rₘ − Rᶠ)

Risk-free rate plus beta times market risk premium. Beta measures systematic risk only.

Gordon Growth Model (DDM)

P₀ = D₁ / (rₑ − g)

Constant-growth dividend discount model. Requires g < rₑ. D₁ = D₀ × (1 + g).

FCFF (Free Cash Flow to Firm)

EBIT(1 − T) + Depreciation − Capital Expenditures − ΔNet Working Capital

Cash flow available to all capital providers. Discount at WACC for enterprise value.

Terminal Value (Gordon Growth)

TV = FCFₙ × (1 + g) / (r − g)

Value of all cash flows beyond the forecast period. Small changes in g or r have outsized impact.

NPV (Net Present Value)

Σ [CFₜ / (1 + r)ᵗ] − Initial Investment

Accept if NPV > 0. Gold standard for capital budgeting. Always preferred over IRR for mutually exclusive projects.

Enterprise Value

Market Cap + Total Debt + Preferred Stock + Minority Interest − Cash

Total acquisition cost. Use with EV-based multiples (EV/EBITDA, EV/Revenue).

Degree of Financial Leverage (DFL)

EBIT / (EBIT − Interest Expense)

% change in EPS for a 1% change in EBIT. Higher DFL = more debt = more financial risk.

Capital Budgeting Methods Comparison

Method	Formula / Rule	Strengths	Weaknesses
NPV	Σ PV of CFs − Investment; Accept if > 0	Accounts for TVM, measures $ value added	Requires estimated discount rate
IRR	Rate where NPV = 0; Accept if > WACC	Percentage return, intuitive	Multiple IRRs possible, reinvestment assumption
Payback	Years to recover investment	Simple, measures liquidity risk	Ignores TVM and post-payback CFs
PI	PV of CFs / Investment; Accept if > 1	Value per $ invested, useful for rationing	Same limitations as NPV

Valuation Multiples — When to Use

Multiple	Formula	Best For
P/E	Stock price / EPS	Profitable companies with stable earnings
EV/EBITDA	Enterprise value / EBITDA	Comparing across capital structures
P/B	Stock price / Book value per share	Asset-heavy industries (banks, REITs)
P/S	Stock price / Revenue per share	Early-stage or unprofitable companies
EV/Revenue	Enterprise value / Revenue	SaaS and high-growth sectors

FCFFFrom EBIT, Cut taxes, Fix for depreciation, Fund reinvestment

Steps to calculate free cash flow to the firm: start with EBIT, subtract taxes, add back depreciation, subtract CapEx and working capital changes.

NIECENPV Is the Exam's Correct Evaluator

When NPV and IRR conflict on mutually exclusive projects, always choose NPV. It maximizes firm value in dollar terms.

Practice These Topics(399 questions)

Valuation and capital structure

Area 1: Business Analysis (40-50%)

Your Progress

0 of 399 questions attempted

Topics

Discounted cash flow models
Weighted average cost of capital
Market multiples and asset-based approaches
Fair value measurement scope (ASC 820 vs. other frameworks)

Lessons

Study Frameworks

Cost of Capital and WACC

Weighted Average Cost of Capital

Cost of Debt

Pre-tax rate × (1 − Tax rate)

Interest is tax-deductible (tax shield)

Cost of Preferred Stock

Preferred dividend / Net issuance price

No tax deduction for preferred dividends

Cost of Equity (CAPM)

Risk-free rate + β(Market risk premium)

β measures systematic risk only

Cost of Equity (DDM)

(D₁ / P₀) + g

Requires stable dividend growth

WACC Blends All Sources

wᵈ × rᵈ(1−T) + wᵖ × rᵖ + wᵉ × rₑ

Use market value weights, not book value

DCF Valuation Framework

Discounted Cash Flow Analysis

FCFF Approach

FCFF = EBIT(1−T) + Depr − CapEx − ΔNWC

Discount at WACC → Enterprise value

EV − Debt + Cash = Equity value

FCFE Approach

FCFE = NI + Depr − CapEx − ΔNWC + Net borrowing

Discount at cost of equity → Equity value directly

Terminal Value

Gordon Growth: FCF × (1+g) / (r−g)

Exit multiple: EBITDA × comparable multiple

Typically 60-80% of total value

Market Multiples

P/E = Price / EPS (equity-level)

EV/EBITDA = Enterprise value / EBITDA

P/B = Price / Book value per share

WACC

wᵈ × rᵈ(1−T) + wᵖ × rᵖ + wᵉ × rₑ

Weighted average cost of capital. Use market value weights. Only debt gets the tax shield.

CAPM (Cost of Equity)

rₑ = Rᶠ + β(Rₘ − Rᶠ)

Risk-free rate plus beta times market risk premium. Beta measures systematic risk only.

Gordon Growth Model (DDM)

P₀ = D₁ / (rₑ − g)

Constant-growth dividend discount model. Requires g < rₑ. D₁ = D₀ × (1 + g).

FCFF (Free Cash Flow to Firm)

EBIT(1 − T) + Depreciation − Capital Expenditures − ΔNet Working Capital

Cash flow available to all capital providers. Discount at WACC for enterprise value.

Terminal Value (Gordon Growth)

TV = FCFₙ × (1 + g) / (r − g)

Value of all cash flows beyond the forecast period. Small changes in g or r have outsized impact.

NPV (Net Present Value)

Σ [CFₜ / (1 + r)ᵗ] − Initial Investment

Accept if NPV > 0. Gold standard for capital budgeting. Always preferred over IRR for mutually exclusive projects.

Enterprise Value

Market Cap + Total Debt + Preferred Stock + Minority Interest − Cash

Total acquisition cost. Use with EV-based multiples (EV/EBITDA, EV/Revenue).

Degree of Financial Leverage (DFL)

EBIT / (EBIT − Interest Expense)

% change in EPS for a 1% change in EBIT. Higher DFL = more debt = more financial risk.

Capital Budgeting Methods Comparison

Method	Formula / Rule	Strengths	Weaknesses
NPV	Σ PV of CFs − Investment; Accept if > 0	Accounts for TVM, measures $ value added	Requires estimated discount rate
IRR	Rate where NPV = 0; Accept if > WACC	Percentage return, intuitive	Multiple IRRs possible, reinvestment assumption
Payback	Years to recover investment	Simple, measures liquidity risk	Ignores TVM and post-payback CFs
PI	PV of CFs / Investment; Accept if > 1	Value per $ invested, useful for rationing	Same limitations as NPV

Valuation Multiples — When to Use

Multiple	Formula	Best For
P/E	Stock price / EPS	Profitable companies with stable earnings
EV/EBITDA	Enterprise value / EBITDA	Comparing across capital structures
P/B	Stock price / Book value per share	Asset-heavy industries (banks, REITs)
P/S	Stock price / Revenue per share	Early-stage or unprofitable companies
EV/Revenue	Enterprise value / Revenue	SaaS and high-growth sectors

FCFFFrom EBIT, Cut taxes, Fix for depreciation, Fund reinvestment

Steps to calculate free cash flow to the firm: start with EBIT, subtract taxes, add back depreciation, subtract CapEx and working capital changes.

NIECENPV Is the Exam's Correct Evaluator

When NPV and IRR conflict on mutually exclusive projects, always choose NPV. It maximizes firm value in dollar terms.

Practice These Topics(399 questions)