Corporate finance appears in RBI Grade B Paper III, SEBI Grade A Paper 2 and NABARD finance papers, both as MCQs and short numericals. This guide explains each idea in plain words with a small worked example.
Time value of money
A rupee today is worth more than a rupee tomorrow, because today’s rupee can be invested to earn interest.
| Concept | Formula |
|---|---|
| Future value (FV) | FV = PV × (1 + r)ⁿ |
| Present value (PV) | PV = FV ÷ (1 + r)ⁿ |
| Annuity | Equal payments at regular intervals (EMI, SIP) |
| Perpetuity | PV = Cash flow ÷ r |
| Rule of 72 | Years to double money ≈ 72 ÷ interest rate (%) |
Example: ₹1,000 invested at 10% for 2 years → FV = 1,000 × 1.21 = ₹1,210. Money doubles at 8% in about 72 ÷ 8 = 9 years.
Capital budgeting (choosing long-term projects)
| Method | How it works | Decision rule |
|---|---|---|
| Payback period | Years needed to recover the initial investment | Shorter is better; ignores time value and later cash flows |
| Accounting Rate of Return (ARR) | Average profit ÷ Average investment | Higher is better; uses profits, not cash flows |
| Net Present Value (NPV) | PV of cash inflows − Initial investment | Accept if NPV > 0 (best method) |
| Internal Rate of Return (IRR) | Discount rate at which NPV = 0 | Accept if IRR > cost of capital |
| Profitability Index (PI) | PV of inflows ÷ Initial investment | Accept if PI > 1 |
Example: A project costs ₹1,00,000 and gives ₹60,000 at the end of years 1 and 2. Cost of capital is 10%.
- PV of inflows = 60,000 ÷ 1.10 + 60,000 ÷ 1.21 = 54,545 + 49,587 = ₹1,04,132
- NPV = 1,04,132 − 1,00,000 = ₹4,132 (positive, so accept); PI = 1.04
When NPV and IRR give different rankings (mutually exclusive projects), NPV is preferred, because it assumes reinvestment at the cost of capital.
Cost of capital
| Source | Cost |
|---|---|
| Cost of debt (after tax) | Interest rate × (1 − tax rate) |
| Cost of preference shares | Preference dividend ÷ Net proceeds |
| Cost of equity (Gordon / dividend growth model) | Ke = D₁ ÷ P₀ + g |
| Cost of equity (CAPM) | Ke = Rf + β × (Rm − Rf) |
| WACC | Weighted average of all sources by their share in capital |
Example (WACC): 60% equity at 14%, 40% debt at 10% interest, tax 25%.
- After-tax cost of debt = 10% × 0.75 = 7.5%
- WACC = 0.6 × 14% + 0.4 × 7.5% = 8.4% + 3% = 11.4%
Beta (β) measures how much a share moves with the market: β > 1 is more volatile than the market; β = 1 moves with it.
Capital structure and leverage
| Theory | Key idea |
|---|---|
| Net Income approach | More debt lowers WACC and raises firm value |
| Net Operating Income approach | Capital structure does not matter |
| Traditional approach | There is an optimum mix of debt and equity |
| Modigliani–Miller (1958) | Without taxes, value is unaffected by capital structure; with taxes, debt adds value (tax shield) |
| Pecking order theory | Firms prefer internal funds, then debt, then new equity |
| Leverage | Formula | Measures |
|---|---|---|
| Operating leverage (DOL) | Contribution ÷ EBIT | Business risk (fixed operating costs) |
| Financial leverage (DFL) | EBIT ÷ EBT | Financial risk (fixed interest) |
| Combined leverage (DCL) | DOL × DFL = Contribution ÷ EBT | Total risk |
Dividend policy
| Theory | Key idea |
|---|---|
| Walter’s model | If return on investment (r) > cost of capital (k), retain earnings; if r < k, pay out |
| Gordon’s model | “Bird in the hand”: investors prefer certain dividends now |
| Modigliani–Miller | Dividend policy is irrelevant to firm value in perfect markets |
Working capital management
| Term | Meaning |
|---|---|
| Gross working capital | Total current assets |
| Net working capital | Current assets − Current liabilities |
| Operating cycle | Raw material → WIP → finished goods → debtors → cash |
| Cash conversion cycle | Inventory days + Debtor days − Creditor days |
| Bank finance methods | Tandon Committee (MPBF); cash credit, overdraft, bill discounting; factoring and TReDS for MSME bills |
Exam-ready one-liners
- FV = PV × (1 + r)ⁿ; Rule of 72 gives doubling time.
- Accept a project if NPV > 0, IRR > cost of capital, or PI > 1.
- IRR is the discount rate at which NPV is zero.
- Payback ignores the time value of money.
- After-tax cost of debt = Interest × (1 − tax rate).
- CAPM: Ke = Rf + β(Rm − Rf).
- DOL = Contribution ÷ EBIT; DFL = EBIT ÷ EBT.
- MM theory: without taxes, capital structure and dividends do not affect firm value.
Related reading
Quiz: test yourself
Formulas follow standard finance textbooks. Practise numericals with a simple calculator for speed.