Corporate finance
Match financing to the cash needs and risks of the business. Compare required returns, capital structure, working-capital timing and funding flexibility. A lower borrowing rate alone does not make a financing strategy better.
Three financing checks
- Cash conversion cycle
- Inventory days + receivable days - payable days.
- Cost of capital
- Weight the required returns of debt and equity consistently.
- Funding maturity
- Compare the duration of the cash need with the repayment obligation.
A shorter cash cycle or cheaper borrowing can introduce supply, service or refinancing risk.
See the decision
Shorter cash cycle, same sales
Inventory days are 48, receivable days 32 and payable days 25. A process change reduces inventory days to 40 without changing service, sales or the other cycle inputs. Assume annual cost of goods sold is $730,000.
Cash conversion cycle, days
- Before55 days
- After47 days
The example releases $16,000 from average inventory and shortens the modeled cycle by eight days. Confirm service and supply risks before adopting the policy.
How to apply these ideas
1. Risk and return
Identify the risk borne by each capital provider.
Debt has contractual payments and priority; equity bears residual risk. Required returns depend on that risk and market conditions. A project should be assessed with a rate appropriate to its cash flows rather than whichever funding source looks cheapest.
Watch for: Using the debt coupon as the hurdle rate for every project.
2. Capital structure
Evaluate taxes, distress risk and financing flexibility together.
Debt can provide a tax shield when the deduction is usable, but higher leverage can raise required returns and constrain future borrowing. Use consistent market-value weights when estimating WACC under the standard model.
Watch for: Assuming more debt always lowers total capital cost.
3. Working capital
Link inventory, receivables and payables to cash timing.
The cash conversion cycle measures the gap between paying suppliers and collecting customers under the defined conventions. Reducing inventory or extending payables may release cash but can damage service or supplier relationships.
Watch for: Optimizing the cash cycle without considering operational consequences.
4. Financing maturity
Assess refinancing risk as well as interest cost.
Short-term borrowing can be cheaper yet expose permanent assets to rollover risk. Match financing to the expected need and test a stress case. Liquidity reserves and committed facilities can have value even when they lower apparent short-run returns.
Watch for: Financing every long-lived asset with repeatedly rolled short-term debt.
Study the topic
Corporate finance: explanations and applications
Connect risk, required return, funding choices and working capital. This is the parent guide for cost of capital and working-capital applications; project cash-flow appraisal belongs to investment decisions.
By MiloPrep editorial team. Original teaching explanations and illustrative cases; official curriculum references are listed below.
Separate the return calculation from the risk judgment
A holding-period return combines income received with the change in asset value, divided by the initial investment. Expected return is a probability-weighted average of possible returns. Risk concerns the dispersion and adverse outcomes around that expectation. Two assets can have the same expected return and very different downside exposure.
Diversification reduces some asset-specific risk when returns do not move together perfectly. It does not remove every common market exposure. Under CAPM, the required equity return is the risk-free rate plus beta multiplied by the market risk premium. Beta measures sensitivity within that model; it is not a complete description of liquidity, operational or total return risk.
Understand what each financing claim promises
Debt generally creates contractual interest and principal obligations, while common equity is a residual claim without a promised dividend. Preferred shares can have distinct payment and priority terms. Compare maturity, covenants, security, dilution and flexibility alongside the quoted rate. A cheaper instrument with restrictive covenants may constrain a valuable future decision.
Bond prices and required yields move in opposite directions for otherwise unchanged cash flows. A long-dated instrument is generally more sensitive to changes in required yield than a comparable shorter-dated one. A yield curve describes rates across maturities, but it is not a guarantee of future short-term rates. Issuance costs and market access also affect practical financing choices.
| Source | Potential advantage | Cost or constraint to examine |
|---|---|---|
| Short-term credit | Flexibility for seasonal needs | Rollover and floating-rate exposure |
| Long-term debt | Longer funding horizon | Covenants, distress risk and interest obligations |
| Common equity | No contractual principal repayment | Dilution and investors’ required return |
| Retained earnings | Internal financing without a new issue | Still has an equity opportunity cost |
| Trade credit | Financing embedded in purchasing | Discount forgone and supplier relationship |
Calculate a consistent weighted cost of capital
WACC combines component required returns using consistent capital weights. For debt and common equity, the simplified expression is wd × kd × (1 - T) + we × ke, when the debt tax deduction is usable. Derive weights from the stated target or market-value capital base. Retained earnings are not free capital simply because no cash dividend is paid.
Match the discount rate to the risk and tax basis of the cash flows. A company-wide WACC can be unsuitable for a project with materially different operating risk. Increasing debt can initially provide tax benefits while also increasing distress risk and the required returns of debt and equity. Holding those component rates fixed and selecting maximum debt does not demonstrate an optimal capital structure.
Manage the operating cycle and cash conversion cycle
The operating cycle combines inventory days and receivable days. The cash conversion cycle subtracts payable days to reflect supplier financing. A shorter cycle can reduce financing needs, but a reduction in inventory can create stockouts and slower supplier payment can damage supply or forfeit valuable discounts. Assess the policy’s total economic effect.
Cash planning should distinguish recurring operating needs, seasonal variation and contingency reserves. Receivable management combines credit approval, terms, collection and bad-debt consequences. Inventory policy balances ordering, holding and shortage costs under demand and supply assumptions. A single turnover target cannot replace a service-level and risk assessment.
Evaluate restructuring and international exposures
A merger or acquisition can create value through credible operating benefits, but the buyer also pays a price and incurs integration costs. Separate stand-alone value, incremental synergies and the acquisition premium. Financial engineering that changes reported EPS does not necessarily create economic value. Divestitures and restructuring similarly require a comparison of future alternatives, not attachment to historical spending.
Cross-border operations can create transaction exposure on a foreign-currency payment and broader economic exposure through customers, suppliers and competitors. A forward contract can lock an exchange rate for a specified exposure but introduces its own terms and counterparty considerations. Distinguish hedging a known obligation from taking a new currency position, and evaluate interest, currency and country risks together.
Work it through
Worked example: Shorter cash cycle, same sales
Inventory days are 48, receivable days 32 and payable days 25. A process change reduces inventory days to 40 without changing service, sales or the other cycle inputs. Assume annual cost of goods sold is $730,000.
| Measure | Before | After |
|---|---|---|
| Inventory days | 48 | 40 |
| Receivable days | 32 | 32 |
| Payable days | 25 | 25 |
| Cash conversion cycle | 55 days | 47 days |
- 1
Cash cycle = inventory days + receivable days - payable days: 48 + 32 - 25 = 55, then 40 + 32 - 25 = 47.
- 2
At $730,000 / 365 = $2,000 daily cost, an eight-day reduction implies $16,000 less average inventory under these assumptions.
The example releases $16,000 from average inventory and shortens the modeled cycle by eight days. Confirm service and supply risks before adopting the policy.
Work through the alternatives
More worked cases: corporate finance
Original teaching scenarios. Each case states its assumptions, shows the working and explains the limits of the conclusion.
Derive the weights before weighting the returns
Equity market value is $3 million and debt market value $2 million. Cost of equity is 11%, pretax debt cost 6%, and tax rate 25%. Assume fully usable interest deductions and comparable project risk.
| Component | Weight | After-tax cost | Contribution |
|---|---|---|---|
| Equity | 60% | 11% | 6.60 percentage points |
| Debt | 40% | 4.5% | 1.80 percentage points |
| Total | 100% | 8.40% WACC |
- Total capital value is $5 million, so equity weight = 3/5 and debt weight = 2/5.
- Debt cost after tax = 6% × 75% = 4.5%. WACC = 0.6 × 11% + 0.4 × 4.5% = 8.4%.
What the result means: Use the weighted opportunity cost when its assumptions fit the cash flows, not just the 6% borrowing rate.
The apparent free supplier loan has an opportunity cost
A $10,000 invoice offers 2/10, net 40. Compare paying $9,800 on day 10 with $10,000 on day 40. Use a 365-day year and simple annualization.
| Item | Calculation | Result |
|---|---|---|
| Extra financing period | 40 - 10 | 30 days |
| Cost of extra credit | $200 ÷ $9,800 | 2.0408% |
| Simple annualized rate | (2/98) × (365/30) | 24.83% |
- Forgoing the discount finances the $9,800 that would otherwise be paid on day 10, for an extra $200.
- Compare that cost with a comparable available funding source, transaction costs and liquidity constraints. Simple annualization is not an effective compounded annual rate.
What the result means: Trade credit terms can be expensive even when the invoice does not call the extra amount “interest.”
Practice this topic
Check your understanding
Try each short application before opening its explanation. These are original learning checks, not official exam questions or a score prediction.
1. Risk-free return is 3%, beta is 1.2 and the market risk premium is 5%. What is the CAPM equity return?
Show answer and explanation
9%.
3% + 1.2 × 5% = 9%. The risk premium is already the market return minus the risk-free return; do not subtract the risk-free rate twice.
2. Buy for $40, receive a $2 dividend and sell for $43. Ignore costs. What is holding-period return?
Show answer and explanation
12.5%.
Income plus gain is $5; divide by the $40 initial investment. This is a period return, not automatically an annualized return.
3. Inventory days are 50, receivable days 35 and payable days 30. What are the operating and cash cycles?
Show answer and explanation
85 days and 55 days, respectively.
The operating cycle is 50 + 35; supplier financing reduces the cash cycle by 30 days.
Questions about corporate finance
- Is the cash cycle the same as the operating cycle?
- No. The operating cycle is inventory days plus receivable days. The cash cycle deducts payable days to reflect supplier financing.
- Where are capital-project decisions covered?
- Investment decisions covers incremental project cash flows, NPV, IRR and sensitivity. Corporate finance supplies the funding and liquidity context.
Sources and scope
Curriculum mapping: Part 2, Section B, Corporate Finance. The official outline assigns 20% to the entire domain, not to this individual technique. These are selected study notes, not complete curriculum coverage.
Official curriculum references establish scope and expected skills. The explanations, diagrams and numerical cases are independent teaching material from MiloPrep, not official questions or source-validated solutions. Curriculum references checked 2026-10-10.
- IMA Content Specification Outlines (effective September 2024) ↗
Supports: Part 2, Section B, beginning on printed page 10. Domain names, weights and curriculum boundaries.
- IMA Learning Outcome Statements (effective September 2024) ↗
Supports: Part 2, Section B, beginning on printed page 19. The calculations, analysis and professional judgments candidates are expected to perform.
Independent US CMA study material. Not affiliated with or endorsed by IMA. This covers management accounting, not medical-assistant certification or the separate ICMAI qualification.