Concept Guide: WACC, Capital Budgeting, and Project Cash Flow
Chapters 10–12 only. This version follows the FIN301 concept-guide style: each concept sentence is followed by a short reason and a common trap.
How to use this page
- Read the concept sentence first.
- Then read why it is correct.
- Then check the common trap.
- Use the filter box for fast review.
Note: this version removes the self-check / quiz style. It is a clean concept guide for exam review.
Chapter 10 WACC
Big picture
Chapter 10 explains the weighted average cost of capital. It combines the after-tax cost of debt and the cost of equity using capital weights, and it is commonly used as the discount rate for average-risk projects and firm-level DCF.
Key terms
- WACC
- Cost of debt (Kd)
- After-tax cost of debt
- Cost of equity (Ke or rs)
- CAPM
- Dividend discount model (DDM)
- Market value weights
- Flotation cost
- Risk-free rate
- Market risk premium
- Beta
- Retained earnings
- New common stock
How this page is set up
- Each concept sentence is followed by Why this is correct.
- Then a short Common trap.
- This version is kept simple for quick review.
Core equations
| Idea | Equation / meaning |
|---|
| WACC | WACC = wd·Kd(1 − T) + we·Ke |
| CAPM cost of equity | Ke = rRF + β(rM − rRF) |
| DDM cost of equity | Ke = D1/P0 + g |
| DDM with flotation | Ke,new = D1 / [P0(1 − F)] + g |
| After-tax cost of debt | Kd,after-tax = Kd(1 − T) |
| Bond-yield idea | Bond price = PV(coupons) + PV(par) |
Concept guide (10)
1
WACC is the firm’s blended required return from debt holders and equity holders, weighted by their share of financing.
Why this is correctA firm uses multiple capital sources, so the overall discount rate should reflect the required return from each source and the proportion each source contributes.
Common trapTreating WACC as only the cost of debt or only the cost of equity.
2
The after-tax cost of debt is used in WACC because interest expense creates a tax shield.
Why this is correctInterest reduces taxable income, so the effective cost of debt to the firm is lower than the before-tax borrowing rate.
Common trapForgetting the (1 − T) adjustment when computing debt’s contribution to WACC.
3
The cost of debt is based on the current required return on the firm’s debt, not the old coupon rate printed on an existing bond.
Why this is correctThe coupon rate is fixed at issuance, but investors today care about the current yield required for comparable debt risk.
Common trapUsing the coupon rate directly as Kd without solving for the bond yield.
4
CAPM estimates the cost of equity using market risk, not total stand-alone volatility.
Why this is correctCAPM prices systematic risk through beta, so the required return rises when the stock has greater sensitivity to market movements.
Common trapPlugging standard deviation into CAPM instead of beta.
5
The DDM cost of equity works only when the stock price, dividend forecast, and growth assumptions are consistent with a stable-growth setting.
Why this is correctThe Gordon setup assumes dividends grow at a roughly constant rate, so the formula is most useful when that assumption is reasonable.
Common trapUsing a constant-growth DDM for a firm with no dividends or highly unstable growth.
6
When new common stock is issued, flotation costs make the cost of new equity higher than the cost of retained earnings.
Why this is correctThe firm receives net proceeds below the full market price, so it must earn a higher return on the capital raised.
Common trapUsing the same DDM formula for retained earnings and new stock even when flotation costs are given.
7
WACC should usually use market-value weights rather than book-value weights.
Why this is correctMarket values better reflect the current opportunity cost of capital and the value investors place on each financing source today.
Common trapAutomatically using accounting book values when the problem gives market values or market cap.
8
A firm’s WACC is appropriate only for projects with risk similar to the firm’s average existing operations.
Why this is correctIf a project is much riskier or safer than the firm’s typical business, it should be discounted at a rate adjusted for that project’s own risk.
Common trapUsing the same WACC for every project no matter how different the project’s risk is.
9
For a semiannual bond, the coupon, discount rate, and number of periods all need timing adjustment.
Why this is correctSemiannual cash flows mean half-size coupons arrive twice as often, so both the periodic rate and the number of discounting periods must match that timing.
Common trapDividing the coupon by 2 but forgetting to divide the rate by 2 or double the number of periods.
10
A lower WACC increases present value, while a higher WACC reduces present value in project and firm valuation.
Why this is correctWACC is the discount rate. Lower discounting makes future cash flows worth more today, while higher discounting makes them worth less.
Common trapChanging projected cash flows and the discount rate in opposite directions without noticing how strongly valuation depends on WACC.
Chapter 11 Capital Budgeting
Big picture
Chapter 11 studies how firms evaluate long-term projects. The key idea is that good projects add value, and the main decision rule is NPV. The chapter also compares IRR, MIRR, payback, discounted payback, and profitability index.
Key terms
- Capital budgeting
- Net present value (NPV)
- Internal rate of return (IRR)
- Modified IRR (MIRR)
- Profitability index (PI)
- Payback period
- Discounted payback
- Mutually exclusive projects
- Independent projects
- Crossover rate
- Reinvestment assumption
- Non-normal cash flow
How this page is set up
- Each concept sentence is followed by Why this is correct.
- Then a short Common trap.
- This version is kept simple for quick review.
Core equations
| Idea | Equation / meaning |
|---|
| NPV | NPV = Σ [CFt / (1+r)^t] |
| Decision rule | Accept if NPV > 0 |
| IRR | Set NPV = 0 and solve for r |
| MIRR | MIRR = (FV of positives / PV of negatives)^(1/n) − 1 |
| Profitability index | PI = PV of future inflows / Initial outlay |
| Discounted payback | Recover initial outlay using discounted cash inflows |
Concept guide (10)
1
NPV is generally the best capital-budgeting criterion because it measures the dollar value added to the firm.
Why this is correctNPV directly compares the present value of benefits and costs, so it tells whether the project increases shareholder value in dollar terms.
Common trapChoosing a project only because its percentage return looks higher, even when it adds less total value.
2
If NPV is positive, the project earns more than the required return and should be accepted.
Why this is correctA positive NPV means discounted inflows exceed discounted outflows at the project’s required rate, so the project creates value.
Common trapThinking a small positive NPV means the project should be rejected because the number looks small by itself.
3
IRR is the discount rate that makes NPV equal zero.
Why this is correctIRR is the break-even required return: at that discount rate, the project’s present value of inflows exactly matches its present value of outflows.
Common trapCalling IRR the same thing as NPV or treating it as a dollar measure.
4
For independent projects with normal cash flows, NPV and IRR usually give the same accept-reject decision.
Why this is correctWhen the project has one initial outflow followed by inflows, both rules usually agree on whether the project clears the required return hurdle.
Common trapAssuming NPV and IRR must always agree in every possible project comparison.
5
For mutually exclusive projects, NPV is usually preferred when NPV and IRR conflict.
Why this is correctMutually exclusive choices require selecting the project that adds more value, and NPV measures value creation directly.
Common trapAutomatically picking the project with the higher IRR even if it has the lower NPV.
6
MIRR is often preferred to IRR when reinvestment assumptions or multiple IRRs create confusion.
Why this is correctMIRR separates the financing rate for negative cash flows from the reinvestment rate for positive cash flows, which produces one clearer return measure.
Common trapThinking MIRR and IRR must always be identical.
7
Payback is easy to understand, but it ignores time value of money and cash flows that occur after recovery.
Why this is correctRegular payback only asks how quickly the initial outlay is recovered, not whether later cash flows add large value or whether time discounting matters.
Common trapUsing payback as if it were a full value-creation measure.
8
Discounted payback improves on payback by discounting inflows, but it still ignores cash flows after the cutoff point.
Why this is correctDiscounted payback recognizes time value of money, yet it still focuses only on how long recovery takes rather than on total value created.
Common trapAssuming discounted payback and NPV are equivalent because both use discounting.
9
A non-normal cash-flow pattern can create multiple IRRs or make IRR less reliable.
Why this is correctIf the cash-flow signs switch more than once, the NPV profile may cross zero multiple times, which means the project can have more than one IRR.
Common trapAssuming every project must have exactly one IRR.
10
Profitability index is useful when capital is rationed, but by itself it is not always the best rule for mutually exclusive choices.
Why this is correctPI scales value relative to the investment size, which helps rank projects when funds are limited, but NPV still better captures total dollar value created.
Common trapPicking the highest PI automatically even when another project creates more total value.
Chapter 12 Project Cash Flow and DCF
Big picture
Chapter 12 focuses on how to build project cash flows correctly before applying NPV and the other capital-budgeting tools. The central idea is to value incremental after-tax cash flows, not accounting income, and to include terminal cash flow items such as salvage and recovery of working capital.
Key terms
- Incremental cash flow
- Operating cash flow (OCF)
- Depreciation
- Tax shield
- Net operating working capital (NOWC)
- Sunk cost
- Opportunity cost
- Externality / cannibalization
- Terminal cash flow
- Salvage value
- Book value
- MACRS depreciation
- Free cash flow (FCF)
How this page is set up
- Each concept sentence is followed by Why this is correct.
- Then a short Common trap.
- This version is kept simple for quick review.
Core equations
| Idea | Equation / meaning |
|---|
| Operating cash flow | OCF = EBIT(1 − T) + Depreciation |
| Alternative OCF form | OCF = (Sales − Costs − Dep)(1 − T) + Dep |
| Initial outlay idea | Equipment + installation + ΔNOWC + opportunity costs − after-tax sale of old asset |
| Terminal cash flow | Salvage after tax + recovery of NOWC |
| Tax on sale | Tax effect = (Sale price − Book value) × T |
| Project value rule | Discount incremental project cash flows at the required return |
Concept guide (10)
1
Project analysis uses incremental cash flows, meaning only cash flows that occur because the project is accepted should be included.
Why this is correctThe goal is to measure how the firm changes with the project versus without the project, so only additional cash consequences matter.
Common trapIncluding company-wide fixed costs that will stay the same regardless of the decision.
2
Sunk costs should not be included in project cash flows because they have already been incurred and cannot be changed by the decision.
Why this is correctA sunk cost is in the past, so accepting or rejecting the project now does not change that historical outlay.
Common trapAdding past research or study costs to the initial investment just because they relate to the project.
3
Opportunity costs should be included because using an existing asset for a project gives up what that asset could have earned elsewhere.
Why this is correctIf the firm uses land, space, or an old machine in the project, the project should bear the value of the next best alternative use.
Common trapTreating already-owned assets as free just because no new check is written today.
4
Depreciation is not a cash outflow, but it affects project value because it reduces taxable income and creates a tax shield.
Why this is correctDepreciation lowers taxes paid, which creates a real cash-flow benefit even though depreciation itself is a non-cash accounting expense.
Common trapDropping depreciation completely from the analysis and losing the tax shield effect.
5
Operating cash flow is based on after-tax operating profit plus depreciation, not on net income alone.
Why this is correctProject valuation needs operating cash generation, so analysts start with operating earnings after tax and then add back non-cash depreciation.
Common trapUsing EPS or net income directly as project cash flow.
6
An increase in net operating working capital is a cash outflow at the start, and its recovery at the end is a cash inflow.
Why this is correctMore inventory, receivables, or operating cash tied up in the project uses funds initially, but those funds are typically released when the project ends.
Common trapForgetting to include the recovery of NOWC in the terminal-year cash flow.
7
Terminal cash flow often includes both after-tax salvage value and recovery of working capital.
Why this is correctWhen a project ends, the firm may sell assets and also free up the working capital that had been tied to operations.
Common trapIncluding only salvage value and forgetting working-capital recovery.
8
If an asset is sold for more than book value, taxes are owed on the gain; if sold for less than book value, there can be a tax saving.
Why this is correctThe tax effect depends on the difference between market sale price and book value, not simply on the sale price alone.
Common trapTaxing the full sale proceeds instead of only the gain over book value.
9
Externalities such as cannibalization must be included because a new project can reduce cash flows from existing products.
Why this is correctIf the project steals sales from another company product, the true incremental benefit is smaller than the project’s stand-alone sales number.
Common trapCounting all new project revenue as pure gain without adjusting for lost sales elsewhere in the firm.
10
A project can have strong accounting profit yet still be a bad investment if its incremental cash flows do not cover the required return.
Why this is correctCapital budgeting is about discounted cash flow, not accounting appearance, so value depends on timing, risk, and actual cash generation.
Common trapThinking a project with positive net income must automatically have a positive NPV.