Summary of Corporate Finance by Berk and DeMarzo

Corporate Finance by Berk and DeMarzo is a comprehensive textbook widely used in MBA and undergraduate finance courses. It covers the core principles and practical applications of financial decision-making within corporations. The book emphasizes valuation as the central concept, consistently applying it across various topics.

Part 1: Introduction to Corporate Finance introduces the basic concepts, goals, and organization of a corporation. It highlights the separation of ownership (shareholders) and control (managers), leading to potential agency problems. The primary goal of a corporation is to maximize shareholder wealth, typically achieved by increasing the value of the firm’s stock. This section also covers the time value of money and how to use present value analysis to make informed decisions.

Part 2: Valuation and the Law of One Price lays the foundation for valuation by emphasizing the Law of One Price: equivalent investment opportunities traded simultaneously in different markets must have the same price. This principle underlies many valuation techniques. The text details calculating present values, future values, and annuities. It introduces concepts such as the Net Present Value (NPV) rule, where investments with positive NPVs increase shareholder wealth and should be accepted. Risk-free rates and discount rates are defined, emphasizing the importance of matching the discount rate to the riskiness of the cash flows.

Part 3: Capital Budgeting delves into the process of analyzing and selecting investment projects. It covers various capital budgeting techniques including NPV, IRR (Internal Rate of Return), payback period, and profitability index. While NPV is presented as the most theoretically sound method, the text acknowledges the practical considerations of other methods. It also addresses issues like forecasting free cash flows, analyzing project risk, and incorporating inflation into the analysis.

Part 4: Risk and Return explores the relationship between risk and return, a fundamental concept in finance. It introduces portfolio theory, diversification, and the Capital Asset Pricing Model (CAPM). The CAPM provides a framework for calculating the required rate of return for an investment based on its beta (a measure of systematic risk), the risk-free rate, and the market risk premium. The book also covers the efficient markets hypothesis, which posits that asset prices fully reflect available information.

Part 5: Cost of Capital and Valuation focuses on determining the cost of capital, a crucial input for capital budgeting decisions. It covers calculating the cost of equity (using the CAPM or dividend discount model), the cost of debt, and the weighted average cost of capital (WACC). The WACC represents the average rate of return a company must earn on its existing assets to satisfy its creditors and investors. It discusses using the WACC to value firms and projects, including the free cash flow valuation model.

Parts 6-9: Capital Structure, Payout Policy, Long-Term Financing, and Short-Term Finance cover more advanced topics, including optimal capital structure decisions (the mix of debt and equity financing), dividend policy, different types of financing options (e.g., issuing bonds or stock), and managing short-term assets and liabilities. The text explores the trade-offs between debt and equity financing, considering factors such as tax shields, financial distress costs, and agency costs. It examines various theories of dividend policy and their implications for shareholder value. Finally, it covers working capital management, focusing on efficient management of inventory, accounts receivable, and accounts payable.