Part 2: Section B

Corporate Finance

Topic 1.1 Calculating Return

I. Risk and Return

a. An investment's rate of return, or the amount of money earned, depends on the
risk associated with that investment. Risk is the possibility of loss of value. When
investments pose a greater risk, investors require a higher rate of return to
compensate for bearing the greater risk. Thus, investors often face a tradeoff
between risk and reward when evaluating investment options.
b. For example, an investor is likely to expect a greater return for an investment in
an unproven, startup company than from an investment in a well-established
company. The startup company could be considered a higher risk investment
because it has a greater probability for loss of value while also having an
increased potential for gain. The well-established company could be considered a
lower risk investment because it has a lower probability for loss of value while
also having a smaller potential for gain.
c. Risk is often measured by the uncertainty related to a specific investment. One
measure of uncertainty is how variable the return on investment is. For example,
the return on a savings account will typically not vary much over time. In
contrast, the return on the stock of a technology firm could change from small
returns and large returns over time.

Example of Investment Risks

Low-Risk Investments, Lower Returns

Bank savings accounts, money market accounts, government bonds.

High-Risk Investments, Higher Returns

Corporate bonds, stock, mutual funds, exchange-traded funds, real estate.

Time and Risk

Investments that take more time require a higher rate of return. For example, the
U.S. government issues T-bills, which have no default risk and mature within less
than a year. The U.S. government also issues government bonds, which also have
no default risk, but which mature in 10 to 30 years depending on the bond. The
longer investment period on U.S. government bonds means they pay more than
U.S. T-bills, even though both have similar default risk.

d. Investors are often categorized based on their risk preferences. A risk-

averse investor is someone who tries to limit risk exposure and has lower
expectations for returns. A risk-neutral investor is someone who is indifferent
about trying to limit or seek out risk and has balanced expectations for returns.

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A risk-seeking investor is willing to take on greater risk exposure in the hopes of

gaining greater returns.

Examples of Risk Tolerance

Suppose an investor will win $200 if a coin flip is heads and lose $100 if the coin
flip is tails. The investor would expect to gain $50 from this opportunity. This is
determined by multiplying the probability of each outcome by the expected
outcome amount: (50% × $200) + (50% × − $100) = $50. If the investor could
either take the coin flip or a certain amount of cash, then the investor would be:

Risk-Averse Investor

If an investor would only accept any amount less than $50 instead of taking the
coin flip, then the investor is risk averse. This investor will accept less than the
expected value to reduce the risk.

Risk-Neutral Investor

If the investor is willing to take $50 instead of the coin flip, then the investor is
risk neutral.

Risk-Seeking Investor

If the investor would only take an amount greater than $50 instead of the coin flip,
the investor is risk seeking. The investor would rather take his or her chances with
the coin flip instead of accepting the expected value of the investment in hopes of
getting a larger return.

II. Calculating Return

a. Returns are calculated as the amount received from an investment over a given
period of time compared to the initial investment. The period of time over which
an investment return is calculated can be any period of time, from one day to
many years.
b. The rate of return considers two factors related to investor value: first, capital
appreciation, which is an increase in the price of the asset over the investment
period; and second, any income that the investment might pay out such as
dividends or interest payments. The total return is the sum of the capital
appreciation and income divided by the original investment amount.

Calculating Rate of Return

Return=(Capital Appreciation+Income)÷Investment

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Or,

Return=[(Investmentt+1−Investmentt)+Income]÷Investmentt

c. Evaluating risk and possible returns is often done by measuring the returns on a
given investment as a random variable with a probability distribution. The
expected return is the measure of the investment's possible returns multiplied by
the probability of each return occurring. This calculation is done as in the coin-
flip example above, but likely with more possible outcomes each with an assigned
probability.
d. Along with the expected return value, the standard deviation of returns is another
useful statistical measure which shows the variability of returns in relation to the
expected return value. The higher the standard deviation of returns, the greater the
volatility of the investment's returns. Two investments could have the same
expected return, but one could have a higher standard deviation than the other.
The greater standard deviation means that the investment is riskier because the
expected return value is less certain.

Volatility of Returns
The volatility of a return is measured as the standard deviation, which is the dispersion or range
of potential outcomes for the return. The standard deviation is useful because it provides the
probability that an outcome will take place.
A large standard deviation means that the return outcome could take place over a broad range of
outcomes and is less likely to be the expected return value. Thus, the investment is more risky
because the outcome is less certain.
A small standard deviation means that the return outcome is likely to take place closer to the
expected value. Thus, the investment is less risky because the outcome is more certain.
Summary
Investors often face a tradeoff between risk and return. Typically, the greater the risk to the
investor, then the greater the rate of return the investor receives. Risk is also often measured by
the amount of uncertainty related to an investment. Investors are categorized according to their
risk preferences: risk averse, risk neutral, or risk seeking. Calculating returns is done by looking
at the amount received from an initial investment over time (this includes both the increase in the
initial asset and the income paid out) compared to the initial investment. Two key measures are
used in calculating risk and possible returns: expected return value and standard deviations of
returns.

Topic 1.2 Types of Risk

I. Unsystematic (Company) Risk and Systematic (Market) Risk

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a. Unsystematic risk refers to the risk to an investor from owning stock in one

particular company. It is a broad term that encompasses any type of risk that may
affect the returns of a company's stock. Unsystematic risk comes from company-
specific factors such as the company's financial leverage, effectiveness of
business operations, strategy, sales cycle and seasonality, credit risk of customers,
labor stoppages, and overall company management. Each company faces a unique
set of risks. Investors can reduce their exposure to risk arising from one company
by diversifying their equity investments across different industries and companies.
b. A diversified portfolio is one with a mix of investments from different industries.
In a diversified portfolio, the chances of all investments performing very well or
very poorly is small. Thus, a diversified portfolio can effectively eliminate
unsystematic risk.
c. Systematic risk is the risk that arises from high-level economic cycles and
political environments. Systematic risk is affected by macroeconomic factors such
as interest rates, inflation, growth rates of gross domestic product (GDP),
currency exchange rates, government rules and regulations, and public policies.
Investors cannot diversify away systematic risk. Systematic risk is often called
nondiversifiable or market risk. A measure of systematic risk is called beta, which
measures how correlated an individual stock's returns are with the broader market
returns.
II. Portfolio Risk
a. When evaluating a single investment, risk is often measured as the standard
deviation of returns. However, investors normally invest in a variety or portfolio
of assets. In order to measure the risk of assets in a diversified portfolio, other
measures than standard deviation are used. In a diversified portfolio, the only risk
of an individual asset comes from systematic risk. This is measured as the
correlation between returns on an individual asset and the returns of the broader
stock market.
b. Assets whose stock prices move in the same direction are said to have a positive
correlation. Stocks in the same industry will generally move in the same direction
and have a positive correlation. This happens because the macroeconomic factors
related to systematic risk will typically affect companies in the same industry in
similar ways. In contrast, stocks in very different industries, such as a utility stock
and a technology stock, could move in opposite directions and have a negative
correlation.
c. Correlation is measured as a number between −1 and +1. The closer the
correlation is to −1 or +1, the stronger the relationship between the two variables.
A +1 correlation means the two variables move in the same direction and in an
exact measurable amount. A −1 correlation means the two variables move in the
opposite direction and in an exact measurable amount. A zero correlation means
there is no linear relationship between the two variables.
d. Diversified portfolios are typically less risky for a given level of expected returns
than an individual asset. This reduction in risk comes from eliminating the
unsystematic risk associated with an individual asset.

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III. Types of Risk

a. Credit risk or default risk—The risk that a borrower will not repay the investor as
promised. When there is a greater probability that a borrower will default, the
lender will charge a higher interest rate to compensate for the higher risk.
b. Interest rate risk—The risk that market interest rates will vary and impact the
value of interest-bearing securities, such as bonds.
c. Foreign exchange risk or currency risk—The risk that economic value will be lost
due to fluctuations in exchange rates. Companies exporting goods and services
benefit when their home currency weakens relative to a foreign currency. More
goods and services will be purchased by those using a foreign currency because
the goods and services are relatively less expensive. In contrast, companies
importing goods and services benefit when their home currency strengthens
relative to a foreign currency because they can acquire the goods and services for
relatively less money.
d. Industry risk—The risk associated with the factors specific to a given industry.
For example, agricultural companies are likely to face the risk of a drought
negatively affecting their performance, whereas financial companies would not be
as affected by the risk of a drought.
e. Political risk—The risk that political influence and decisions may affect the
profitability and effectiveness of an organization. For example, environmental
regulations may affect the operations and costs of chemical producers and
manufacturing firms.

Summary
There are many types of risk that an organization may face every day. Understanding risk in its
various forms is important to evaluating how it can affect an organization. Unsystematic risk (or
company risk) is related to company-specific factors while systematic risk (or market risk) is
related to macroeconomic factors. Portfolio risk is related to the diversity or lack of diversity of
assets within a particular portfolio. Other types of risk to be familiar with are credit or default
risk, interest rate risk, foreign exchange or currency risk, industry risk, and political risk.

Topic 1.3 Capital Asset Pricing Model

I. Capital Asset Pricing Model (CAPM)

a. The Capital Asset Pricing Model (CAPM) describes the relationship between risk
and expected return. It is used to determine how much return investors require for
an investment given its systematic risk (beta). This is often referred to as the cost
of equity capital. CAPM measures an investment's rate of return as a function of
three market conditions:
i. Risk-free rate of return (Rf)
ii. Market rate of return risk premium (Rm − Rf)

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iii. Beta (β) of the investment, which measures the investment's sensitivity to
changes in the market
b. The risk-free rate typically refers to the current rate of return on a risk-free
security such as U.S. Treasury bill.
c. The market rate of return is expected return of the broader stock market such as
the S&P 500 or Dow Jones Industrial Average. The “premium” refers to the
amount of return expected from the market above and beyond the return that
could be earned from a risk-free security. The premium is the additional return to
compensate investors for bearing greater risk from the stock market.
d. Beta indicates how much, and in what direction, a rational investor expects an
investment to move given a 1% change in the market.

Comparing Betas

Beta (β) = 0: A beta of zero indicates a fixed return with no sensitivity to market
changes, in other words, no systematic risk. An example of a security with a zero
beta is U.S. T-bills, whose value does not change based on stock market changes.

Beta (β) > 1: A beta greater than 1 indicates more systematic risk than the market.
A stock with a beta of 1.5 is expected to increase 1.5% if the market increases
1.0%. Technology stocks often have a beta greater than 1.

Beta (β) < 1: A beta less than 1 indicates less systematic risk than the market. A
stock with a beta of 0.5 is expected to increase 0.5% if the market increases 1.0%.
Utility companies often have a beta less than 1.

Beta (β) = 1: A beta equal to 1 indicates the same systematic risk as the market. A
stock with a beta of 1.0 is expected to increase 1.0% if the market increases 1.0%.
An index fund that tracks the S&P 500 would have a beta close to 1.0.

e. The CAPM is used to calculate the expected return on an investment, given the
level of market risk and sensitivity of the investment relative to the market. The
CAPM's equation is:

Ke=Rf+β(Rm−Rf)

f. where:
i. Ke = Investment's required rate of return or Cost of Equity Capital
ii. Rf = Risk-free rate
iii. Rm = Market rate of return

Example of CAPM
Consider the following information:

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 Rf = 4%
 Rm = 12%
 β = 1.5

Plugging these into the CAPM results in an expected return of:

Ke=Rf+β(Rm−Rf)16%=4%+1.5×(12%−4%)=4%+12%
Summary
The relationship between risk and expected return is described by the Capital Asset Pricing
Model (CAPM) and is used to determine how much return investors require for a particular
investment. This model uses three factors (risk-free rate of return, market rate of return risk
premium, and beta of the investment) to measure an investment's rate of return. The CAPM
equation is: Ke = Rf + β(Rm − Rf).

Topic 2.1 Term Structure of Interest Rates

I. Term Structure of Interest Rates

a. A key feature of debt-based financial instruments, such as bonds, mortgages, or
business loans, is how the interest rate is structured. Each financial instrument
will have a unique structure that is negotiated between the debtholder and the debt
issuer. Furthermore, economic factors will influence the interest rate of each debt
instrument.
b. The term structure of interest rates refers to the relationship between the time
until the principal balance of the debt instrument is due and how much the debt
instrument pays in interest. Term to maturity is the amount of time, whereas yield
to maturity is the interest rate being paid. This relationship is often shown
graphically with a yield curve.

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c. In general, yield curves have an upward slope, which means that longer-term
securities have a higher yield than shorter-term securities. This is a result of time
being a risk factor such that debt instruments whose term to maturity is more
distant have higher risk, or more uncertainty about the future.
d. It is possible to have a downward-sloping yield curve, meaning that shorter-term
securities have a higher yield than longer-term securities. While not as common,
downward-sloping yield curves are often a sign that an economy is going into a
recession.
e. There are three common factors that influence both the shape and level of yield
curves. These factors include: the real rate of interest, the expected rate of
inflation, and the interest rate risk.
i. Real rate of interest is the base interest rate in the economy. It affects the
level, but not the slope, of the yield curve because it is not affected by the
term to maturity. It is affected by individuals’ preferences for saving
versus spending, with the higher rates when the economy is growing and
lower rates when the economy is in recession.
ii. Expected rate of inflation is the belief about whether prices will be
increasing in the future and by how much. It affects the slope of the yield
curve.
iii. Interest rate risk is the uncertainty about future bond prices that arises
from future interest rates being unpredictable. Bond prices move inversely

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with interest rates, meaning that if interest rates go up, bond prices go
down. It affects the shape of the yield curve.

Summary
The structure of the interest rate is a key feature in debt-based financial instruments. The term
structure of interest rates is the relationship between the term to maturity and the yield to
maturity of the debt instrument. This relationship can be shown graphically through the yield
curve, which generally has an upward slope. The shape and level of yield curves are influenced
by the real rate of interest, the expected rate of inflation, and the interest rate risk.

Topic 2.2 Bonds

I. Features of Bonds
a. Bonds are the primary form of long-term debt financing for government
institutions and corporations. Bonds can be understood as a contractual obligation
to repay a principal amount plus interest over time. The issuer of a bond agrees to
repay the principal amount, referred to as the face value or par value of the bond,
at a future date. Many bonds also require the payment of periodic interest
payments over the life of the bond, referred to as the coupon rate.
b. An indenture is the contract made between a bondholder and bond issuer. The
indenture delineates the key features of a bond such as the maturity date, when
interest payments are to be made, how interest will be calculated, and other
features. The other features could specify whether the bond is callable—the
bondholder can ask for the bond to be paid earlier than the maturity date—
or convertible—exchanges debt-obligations for equity shares in a company.
c. Bonds can also have covenants, which place restrictions on activities of a bond
issuer. Covenants are used to help protect the financial interest of
bondholders. Negative or restrictive covenants limit the bond issuer from certain
activities, whereas positive or affirmative covenants require the bond issuer to
meet specific requirements.
d. Bonds can be backed by collateral, which is the property or asset the bond issuer
will forfeit to the bondholder if the bond issuer can no longer repay the debt.
Some bonds require that a sinking fund be used which requires the bond issuer to
make periodic payments in order to repay the bond principal.
e. Bonds can vary greatly in their duration. Short-term bonds typically have a
maturity date 2 to 5 years into the future. Medium or intermediate-term bonds
have a maturity date 5 to 10 years into the future. Long-term bonds have a
maturity rate more than 10 years into the future.
II. Bond Ratings
a. Bonds are often rated by credit rating agencies. The ratings help investors assess
the riskiness of bonds. Moody's, S&P, and Fitch ratings are the three major rating

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agencies for bonds. They provide a grade or rating to a bond which indicates the
credit quality of the bond issuer.
b. Highly rated bonds are known as investment-grade bonds. These bonds are
perceived to be safer because the bond issuer is highly likely to be able to pay
interest payments and ultimately repay the bond principal. An example of the
most highly rated bond, an AAA rating, is U.S. Treasury bonds. Higher rated
bonds have lower interest rates due to the lower amount of default risk.
c. Low-rated bonds are known as junk bonds. These bonds have a higher default
risk. Junk bonds have higher interest rates to compensate investors for the
increased likelihood that the bond issuer may not be able to make interest
payments or repay the bond principal.
d. Bond ratings refer to a specific bond issuance. A single company may have
several bond issuances, each of which will receive a bond rating. While a single
company's bonds are likely to be similarly rated, they may receive different
ratings based on the bonds— characteristics, such as time to maturity and coupon
rate.
e. Credit rating agencies assess the credit quality of bonds based on factors such as
the company's financial position, the future financial outlook, and any collateral
securing a bond. If a company has positive cash flows and prospects of continued
favorable financial performance, the bonds will receive a higher rating. If a bond
is backed by collateral, it lowers the riskiness of the bond because the bondholder
could seize the collateral if needed.
f. A bond rating can change over the lifetime of the bond. As circumstances change
for a company, either favorably or unfavorably, the rating agencies may update
their ratings. Macroeconomic factors may also come into play if they affect a
company's ability to repay its debt.
g. Bond rating example: see exhibit below.

Exhibit 8.4 Corporate Bond Rating Systems

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III. Bond Yields

a. Bonds pay a stated interest rate, or coupon rate. However, the value of a bond can
change daily with interest rate fluctuations in the market.
b. Bonds are bought and sold in the market. Often they are sold at
a discount or premium to the stated face value of the bond. While the structure
and amounts of the bond's interest and principal payments will not change,
investors can adjust the value at which they sell the bond to make its effective
interest rate different. Bonds sold above par value are premium bonds, which
takes place when the market interest rate is below the coupon rate of the bond. In
contrast, bonds sold below par value are discount bonds, which takes place when
the market interest rate is above the coupon rate.
c. Yield to maturity is the discount rate at which the bond's principal and interest
payments are equal to the price of the bond. Bonds are sold at a discount or
premium in order to create a desired yield to maturity.
IV. Debt Issuance
a. When companies issue debt, the debt may be either secured or unsecured debt.
A secured bond means that the principal is backed by the companies— assets as
collateral. For example, a bond to finance a new factory may have the factory
itself as collateral. If the company cannot repay the debt, the debt issuer has the
right to seize ownership of the factory. An unsecured bond does not have
collateral, but rather is simply backed by the company's promise to repay the debt.
In the event of default on unsecured debt, the only recourse available to the debt
issuer is legal action.
b. In the event of a company's bankruptcy, the company's debt is ranked in order to
determine who will be paid first. Secured debtholders are paid first from the
collateral backing the loans they made. If the company has any remaining funds,
either from asset holdings or liquidation of assets, then unsecured debtholders are
paid alongside any other general creditors that the company may have.
c. Organizations have the ability to refinance debt by paying off existing debt and
issuing new debt. When determining whether to refinance debt, organizations
should consider the following factors:
i. Credit rating—Credit ratings change over time. If a company's credit
rating has improved, it may be able to issue debt at lower interest rates.
ii. Macroeconomic conditions—Interest rates change in the global economy
in expansionary and recessionary periods. If market interest rates have
changed, a company may be able to refinance at lower interest rates than
its current debt is at.
iii. Cash position—When a company needs cash for a project, investment, or
general expenses, it can raise money in various ways, including issuing
debt, issuing new equity (stock ownership), or internally generated funds
(retained earnings). Companies often chose to use debt-financing when
they can obtain favorable interest rates and loan conditions.
iv. Covenants—Existing covenants on a company's debt may have restrictions
on the company's debt-to-assets and debt-to-equity ratios. These

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restrictions may prevent the amount which a company can take on in

additional debt.
v. Earnings—Companies must make money to repay debt. Income coverage
ratios, such as the times interest earned ratio, indicate the company's
ability to pay interest expense from operating income.
vi. Risk—Companies vary in their risk appetite for debt. Having a highly
leveraged company, that is, one with a high amount of debt compared to
equity, can be financially rewarding inasmuch as the debt obligations can
be met. However, this can also pose a high amount of risk of default, and
ultimately, bankruptcy, if the company cannot generate cash flow to make
payments.

Summary
Bonds are a contractual obligation to repay a principal amount plus interest over time and are a
primary form of long-term debt financing for government institutions and corporations. Bonds
have specific covenants, can be backed by collateral, and vary greatly in duration. Bond ratings
help investors assess the riskiness of bonds. They pay a stated interest rate but can be sold at a
premium or a discount to the stated face value of the bond. When issuing debt, a company may
issue either secured or unsecured debt.

Topic 2.3 Stock

I. Common Stock
a. Ownership shares in a company are referred to as equity or stock. Common stock
is the most important type of stock and represents the true ownership of the firm.
Common stockholders have ownership rights which include:
i. Right to vote—Can vote on corporate matters such as election of board of
directors, approving mergers or acquisitions, and approval of executive
compensation plans.
ii. Preemptive right—If a company issues additional shares to raise capital,
current stockholders are allowed to purchase new shares proportional to
the shares they currently own. This allows owners to maintain the same
ownership percentage.
iii. Dividends—Stockholders have the right to receive dividends, if they are
paid. Unlike bondholders who hold a contractual obligation to receive
interest payments, common stockholders do not have a contractual right
for dividends to be paid. In other words, companies do not have to pay
dividends.
iv. Residual claim—In the event a company is liquidated, the stockholders
have the right to all remaining assets after creditors and preferred
stockholders have been paid.

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b. The common stock account on the balance sheet is comprised of two accounts.

The first is the Common Stock account, which is listed at the par value of the
stock issued. The par value is typically listed as $1 and has nothing to do with the
actual amount per share at which the stock was issued. The Additional Paid-in
Capital account is the amount of money received from issuing stock above and
beyond the par value.
c. Stock may be purchased in the primary or secondary capital market. The primary
market, also known as an initial public offering (IPO), refers to the first time at
which a company offers ownership in the company to the general public through
stock exchanges. The company receives the cash proceeds from an IPO. The
secondary market refers to the buying and selling of a company's stock on a stock
exchange. The company is not directly involved and does not receive any
proceeds from secondary market exchanges. Rather, the ownership shares and
money are exchanged between investors.
II. Preferred Stock
a. Preferred stock is a unique financial instrument that has characteristics of both
common stock and debt. Preferred stock is like debt because it has a fixed
dividend amount that does not change with the company's earnings. However, as
with common stock, companies are not required to pay a preferred stock dividend
in a given financial period.
b. That being said, preferred stock dividends are cumulative, which means that if a
dividend was skipped, it must be made up in the future before dividends can be
paid to common stockholders.
i. Example—Consider a preferred stock that pays a dividend of $10 per year.
If the company has not paid the dividend in the last two years, then the
company must pay preferred stockholders $20/share ($10 × 2 years)
before it can pay a common stock dividend.
c. Preferred stockholders do not have voting rights unless certain pre-specified
events take place. For example, if a company defaults on a loan or cannot pay a
preferred stock dividend, this may trigger voting rights for preferred stockholders.
d. In the event of a liquidation, preferred stockholders are paid after bondholders but
before common stockholders.
e. Preferred stock often has previsions to convert shares of preferred stock into
shares of common stock. The terms of conversions are established at the initial
offering of the preferred stock.

Summary
Ownership shares in a company are referred to as equity or stock. Common stock represents true
ownership of the firm and common stockholders have certain ownership rights such as right to
vote, preemptive right, no contractual right to dividends, and residual claim in the event of
liquidation. Stocks can be purchased in the primary market (initial public offering) and in the
secondary market (the stock market). Preferred stock is unique as it has characteristics of both
common stock (no requirement to pay dividends in a given financial period) and debt (fixed
dividend amount that does not change with earnings).

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Topic 2.4 Other Financial Instruments

I. Options
a. Options are the most common and best-understood derivatives, with the value of
the option deriving from another item, such as a stock price or a commodity price.
An option is a contract between parties where the option buyer has the right, but
not the obligation, to buy or sell a given amount of the underlying asset. The
buyer of an option pays the seller or writer of an option a premium or fee in order
to buy the right to exercise the contractual agreement at a future date.
b. Important terms and definitions for understanding options:
i. The underlying asset of an option is the asset upon which the value of the
option is based. The underlying asset may be tangible (such as a building
or stock) or intangible (such as an interest rate or the value of a stock
index).
ii. A call option allows the owner to buy the underlying asset at a specified
price.
iii. A put option allows the owner to sell the underlying asset.
iv. A short position is taken when an investor expects the price of a stock to
fall.
v. A long position is taken when an investor expects the price of a stock to
rise.
vi. The strike (or exercise) price is the fixed value at which the owner can
buy or sell the underlying asset.
vii. Exercise date is the last day on which the buyer can exercise the option.
An American option contract allows the owner to exercise the option at
any time during the option period. In contrast, a European option is
allowed to be exercised only on the maturity date. Most options that are
traded on exchanges are American options.
viii. In the money means that an owner of an option will benefit from
exercising the option.
ix. Out of the money means that an owner of an option will not benefit from
exercising the option.

Example of a Call Option

Consider an investor who paid a $3 premium for a stock call option. If the strike price is
$30, then the value of the option would be as follows:

a. If the stock is at $30, the stock price is at the money. The option holder does not
gain or lose value by exercising the option. The net loss to the investor is $3.
b. If the stock is at $35, the option holder exercises the option because it is in the
money and gains $5. The net gain to the investor is $2.

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c. If the stock is at $20, the option holder does not exercise the option because it is
out of the money. The option holder loses the $3 premium but does not lose the
$10 if he or she exercised the option to buy at $30.

Example of a Put Option

Consider an investor who paid a $3 premium for stock put option. If the strike price is
$30, then the value of the option would be as follows:

d. If the stock is at $30, the stock price is at the money. The option holder does not
gain or lose value by exercising the option. The net loss to the investor is $3.
e. If the stock is at $35, the option holder does not exercise the put option because it
is out of the money. The net loss to the investor is $3.
f. If the stock is at $20, the option holder exercises the put option because it is in the
money. The option holder will gain $10 from exercising the option and selling at
$30 instead of the market price of $20. The net gain to the investor is $7.
o Forwards and Futures

a. A forward contract between two parties requires one party to buy or sell a

specified asset on a specified day at a predetermined price. Unlike options where
a premium is paid for the option contract, no initial payment is made in a forward
contract upon signing the contract. A forward contract legally obligates the parties
to act according to contract terms.
b. Much like an option, the underlying asset may be tangible (stock, currency,
commodity) or intangible (interest rate, stock market index). The delivery price is
the contractually obligated price in the contract. Delivery of the underlying asset
occurs on the contract's delivery date.
c. The party who will buy the underlying asset under contract terms is considered to
have a long position. The party who will deliver the underlying asset is considered
to have a short position. The payoff structure for a forward contract depends on
the underlying asset's change in value. The buyer of the underlying asset gains
value when the underlying asset's price rises and loses value when the underlying
asset's price falls. Thus, companies who plan to buy an asset in the future and
believe that the asset's price could increase can reduce their costs by entering into
a forward contract to lock in the asset's price.
d. A futures contract is similar to a forward contract, but the parties execute the
contract differently. Forward contracts are agreements made directly between two
parties. Futures contracts, on the other hand, are agreements actively traded on
organized exchanges. Thus, the counterparty is generally unknown in a futures
contract.
e. Futures contracts usually do not carry the expectation of actual delivery of a
physical asset, but rather parties exchange the monetary value of the contract.
This usually takes place as a daily settling up of the monetary values among the

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parties. This money is not paid directly to the parties but is paid through an
exchange-regulated clearinghouse.

Example of a Forward Contract

Many firms use forward contracts to remove the volatility and risk associated with
changes in commodity prices. Consider an airline firm that wants to fix the price of its jet
fuel. In order to do so, it enters a 90-day forward contract with a jet fuel supplier on June
1. On September 1, the supplier will deliver the fuel to the airline at the price specified in
the contract. The value of the forward contract is as follows:

a. If the jet fuel price rises between June 1 and September 1, the airline gains value
and the supplier loses value because the supplier must deliver the fuel to the
airline at the forward contract price.
b. If the jet fuel price falls between June 1 and September 1, the airline loses value
and the supplier gains value. The airline would have to pay a higher price than the
market price.
o Swaps

a. A swap is an agreement between two parties to exchange future cash payments

related to underlying assets.
b. Examples of types of commonly used swaps:
i. Currency swap is an agreement to exchange cash in one currency for cash
in another currency at some future date.
ii. Interest rate swap is an agreement to exchange cash flows from one type
of interest rate structure for cash flows in another type of interest structure.
The most common interest rate swap is to swap cash flows from a variable
rate of interest for cash flows of a fixed rate of interest. Interest rate swaps
are extremely customized between parties and can be based on many
different interest rates.
iii. A credit default swap requires one party to indemnify (or reimburse) the
other party in the event of default by a third party. Credit default swaps act
similar to insurance. For example, two banks may enter into a credit
default swap agreement for one of Bank A's debtors. Bank A would make
payments to Bank B as a premium for the credit default swap. If the debtor
defaults, then Bank B would pay Bank A the amount of the lost value. One
of the most well-known credit default swaps is for mortgage-backed
securities.
b. Leases
a. Leases are contracts where an asset's owner grants a second party the use of the
asset for a specified time period in exchange for periodic payments. The lessee
(the non-owner) is obligated to make lease payments as specified in the contract.
b. Leases, for financial accounting purposes, come in two forms. Operating
leases place the burdens of ownership on the owner (the lessor). The lessor

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maintains the asset on its balance sheet while the lessee simply records an
operating expense for the lease payments. Capital leases essentially transfer the
risk of ownership to the lessee, in which case the lessee will pay for maintenance,
insurance, and other costs of ownership. The lessee will also record the lease as an
asset and corresponding liability on its balance sheet.
c. Warrants
a. Warrants are long-term options for the holder to purchase stock directly from the
issuing corporation. Warrants are similar to options, but warrants are issued by a
company, whereas options are issued by stock exchanges. A warrant contract
allows the holder to purchase stock at a specified price, quantity, and future time.
If the stock price rises beyond the price in the warrant contract, holders will earn
value by exercising the warrants.

Summary
There are various financial instruments used by companies and investors besides stock and
bonds. Options are a derivative that derives its value from another item such as a stock price or
commodity price. A forward contract is between two parties where one party is required to buy
or sell a specified asset on a specified day. A futures contract is similar to a forward contract but
is actively traded on organized exchanges and does not usually include physical assets. A swap is
an agreement to exchange future cash payments related to underlying assets. Leases are contracts
where an asset's owner grants a second party use of the asset in exchange for payments. Leases
come in two forms: operating and capital. Finally, warrants are long-term options for the holder
to purchase stock.

Topic 2.5 Taxes and Capital Structure

I. Effect of Taxes on Capital Structure Decisions

a. Capital structure is the mix of debt and equity that a company uses to finance its
activities. Taxes can play a significant role in the decision process of whether to
finance projects or investments with debt or with equity. Taxes can change the
level, timing, and risk of free cash flow available to investors, and as such, can
influence firm value.
b. Payments made to equity holders and debtholders are treated differently for tax
purposes. Companies can deduct interest payments on debt on their taxes, but
cannot deduct dividend payments. This tax shield for interest payments reduces
the cost of debt. This can result in a lower cost of capital to the firm. It follows
that companies’ decisions about capital investments could be influenced if their
cost of capital is lower.
c. When firms have higher leverage (i.e., more debt), it can lead to higher firm value
because the tax-deductible interest payments reduce the amount of income
reported for tax purposes. This leads to lower tax payments and higher after-tax
free cash flow.

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d. Issuing debt is generally less expensive than issuing stock. This is because the
underwriting fees charged to facilitate raising capital are lower for debt than
equity.

Example of Tax Shield Benefits

Capital structures with debt can affect a firm's after-tax cash flows because interest payments are
tax deductible. Consider a firm with no debt and annual earnings before interest and taxes
(EBIT) of $100. If the current tax rate is 35%, then the firm will pay $35 in taxes and have $65
available as after-tax cash flow.
If the firm takes out $1,000 of debt at 5% interest, it will pay $50 per year in interest, in which
case the firm will have taxable income of $50 ($100 EBIT − $50 interest). Assuming the same
tax rate of 35%, the firm will pay $17.50 in taxes. The firm's tax payments have essentially been
cut in half. Because the firm has greater free cash flow, the firm's value increases.
Summary
Taxes can affect decisions about a company's capital structure. Capital structure is the mix of
debt and equity a company chooses to use to finance its activities. Interest payments on debt can
be deducted from taxes, whereas dividend payments cannot. Additionally, companies with higher
leverage (more debt) can have a higher firm value because of the tax-deductible interest
payments. Finally, issuing debt is generally less expensive than issuing stock. All of these factors
may influence a company's decisions about capital investments.

Topic 2.6 Cost of Capital

I. Defining the Cost of Capital

a. Firms incur costs in order to raise funds for their business activities. Firms raise
funds from two primary sources: (1) debt and (2) equity. The cost of capital for a
firm will depend on the proportion of the source of its funds and their respective
costs. The cost of capital for a firm is the required rate of return the firm must
earn in order to satisfy or meet investors’ and debtholders’ expectations.
b. A firm's cost of debt is the amount of interest the firm must pay to service its debt.
Cost of debt generally refers to a firm's long-term debt, meaning that debt which
has a maturity of longer than one year. A firm's debt can come in various forms
such as lines of credit, bank loans, or bonds.
c. The cost of debt is determined after-tax because interest payments are tax
deductible. For example, if the average of a firm's various debt obligations is 10%
and the current interest rate is 35%, then the firm's cost of debt is equal to 6.5%
because 35% of the interest payments are tax-deductible.
d. A firm's cost of equity is the amount a firm pays to equity holders to compensate
them for their investment. The return does not need to be in cash, as with
debtholders, but could come in the form of stock price appreciation or dividends.
The cost of equity is a blended average of return required of each type of equity

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holder, such as common stockholders and preferred stockholders. A firm's cost of

equity is commonly determined using the Capital Asset Pricing Model. Other
valuation models, such as the Dividend Growth Model, can be used. CAPM is
most commonly used in practice.
e. The weighted-average cost of capital (WACC) is the blended average of the
different types of capital used to finance a firm.
II. Calculating the Weighted-Average Cost of Capital
a. Once a firm's cost of debt and cost of equity are determined, the costs are
weighted proportionate to the amount of each component to determine the
weighted-average cost of capital. The WACC is sometimes referred to as a
firm's hurdle rate or discount rate, which is the amount of return on a project,
investment, or business operations the company must earn in order to satisfy its
debt and equity holders.

WACC=(Proportion of Debt×Rd×(1−Tax Rate)+(Proportion of Equity

Category×Re)

Where:

 Proportion of Debt = Debt ÷ (Debt + Equity)

 Proportion of Equity Category = Equity ÷ (Debt + Equity)
 Rd = Cost of Debt
 Re = Cost of Equity

Example

Consider a company with the following capital structure and costs:

 20% Debt with a cost of debt of 10%

 10% Preferred stock with a 5% dividend
 70% Common stock with cost of equity of 12%

If the income tax rate is 35%, the company's weighted-average cost of capital is
10.2%, calculated as follows:

WACC=[20%×(10%×(1−35%)]+(10%×5%)
+(70%×12%)=0.013+0.005+0.084=0.102

III. Marginal versus Historical Cost of Capital

a. A firm's marginal cost of capital is the cost of each new dollar in capital raised.
When making decisions about future projects or investments, the marginal cost of

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capital should be used instead of the historical cost of capital. Firms change over
time concerning their capital structure, profitability, growth, risk, and more.
Historical cost of capital rates may not adequately reflect changes in these factors.
As such, a forward-looking determination should be made of the cost of capital
when making decisions and evaluations of future projects and investments. The
basic calculations remain the same, but are made with future projections rather
than relying on historical rates and calculations.
IV. Use of Cost of Capital in Investment Decisions
a. Firms often use the cost of capital as an evaluation tool to determine if a project or
investment will increase firm value. Such an approach can make sense at times,
but each project should be evaluated with some cautions. First, WACC should
only be used if the new project has a similar risk profile as the firm's current
projects upon which the calculation of WACC was based. Second, WACC should
only be used if the new project has the same capital structure—financing mix—as
the firm as a whole.

Summary
Cost of capital is the required rate of return that a firm must earn in order to satisfy or meet
investors’ and debtholders’ expectations and is a critical factor in investment decisions. Debt and
equity are the two primary sources of funds used by a firm. The weighted-average cost of capital
(WACC) is the blended average of the different types of capital used and is often used to help
make future decisions for a company.

Topic 2.7 Valuing Debt and Equity

I. Discounted Cash Flow Valuation Method

a. The discounted cash flow (DCF) method is based on the principle that the value of
any asset is the present value of its future cash flows. The DCF method takes into
account the time value of money, which is that a dollar today is worth more than a
dollar in the future. This is because a dollar today can earn interest to increase its
value in the future. The DCF also takes into account the risk involved with
investing a dollar. The discount rate used in the DCF method thus compensates
investors for their time and risk. The rate used for the discount rate in DCF
models depends on the type of asset being valued.
b. In order to value any asset using the DCF method, the following steps are taken:
i. Estimate the expected future cash flows.
ii. Determine the discount rate to be used.
iii. Calculate the present value of the future cash flows.
II. Bond Valuation
a. Valuing bonds using the DCF method is straightforward because the cash flows
are known both in magnitude and in timing. When bonds are issued, their
principal value and coupon rate are specified. With the cash flows known, the

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remaining piece of information needed is the discount rate. For bonds, this is
usually the market interest rate for bonds with similar time to maturity and credit
ratings.
b. When the market interest rate and a bond's coupon rate are the same, the bond will
sell at par value. When a bond has a coupon rate below the market interest rate, it
will sell as a discount bond in order to make the bond's cash flows yield the
higher market interest rate. In contrast, when a bond has a coupon rate above the
market interest rate, it will sell as a premium bond in order to make the bond's
cash flows yield the lower market interest rate.
III. Common Stock Valuation Using DCF
a. The DCF method can also be used to value common stock. However, valuation of
common stock is more complex for three reasons.
i. The expected cash flows from the stock, known as dividends, are less
certain both in size and in timing. Dividends are subject to approval by
boards of directors. Without the obligatory payment of dividends as with
interest payments for bonds, estimating the expected cash flows is more
difficult with common stock.
ii. Common stock does not have a final maturity date as with bonds.
Common stock is true perpetuity in that the owners never have to redeem
the asset for cash.
iii. The discount rate used in a DCF for common stock is not directly
observable. The cost of capital can be estimated, but it is more difficult to
group common stock in risk classes than with bonds.
b. Common stock can be valued using a firm's stock price, estimated growth rate,
and current dividend. The obvious restriction of this method is that if a firm does
not pay a dividend, this valuation method will not work. This valuation method is
known as the Dividend Discount Model (DDM), which is essentially a DCF
model.
c. The DDM values a stock based on the present value of future cash flows. The
DDM considers these factors in the analysis of stock value:
i. Cash flow—dividends paid to stockholders
ii. Expected holding period of the stock
iii. Pattern of dividend growth, which may be one of the next patterns:
1. Constant dividend (zero growth)
2. Constant growth of dividend
3. Variable growth of dividend
d. The Zero-Growth Dividend Model assumes that dividends will not increase over
time. In which case, the value or price of a stock is expressed by the following
equation:

P0=Constant Dividend÷Discount Rate.

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e. For example, if a firm pays a constant dividend of $5 and the required rate of
return or discount rate is equal to 10%, then the price of the stock per share is
equal to $5 ÷ 10% = $50 per share.
f. The Constant Growth Dividend Model assumes that dividends will increase over
time at an equal growth rate, in which case the value or price of a stock can be
expressed with the following equation:

P0=Dividend1÷(Discount Rate−Dividend Growth Rate).

g. In other words, the price of a stock is equal to next period's dividend divided by
the difference between the required rate of return and the growth rate of the
dividends. For example, if a firm paid a $5 dividend in the current period, has
plans to increase dividends by 5% each period, and has a required rate of return of
10%, then the price of the stock per share is equal to ($5 × 1.05) ÷ (10% − 5%) =
$105 per share.
h. When a firm has a variable growth dividend, the valuation technique requires that
future dividends be projected on a year-to-year basis. Each of these projected
dividends is then discounted to the present value. The valuation model also
requires a terminal value, which is assumed to have a constant growth in the
dividend into the future. Thus, the valuation model for a variable growth dividend
is a combination of discounting individual dividends and the constant-growth
dividend model. The general equation for a variable growth dividend is as
follows:

P0=[D1÷(1+R)]+[D2÷(1+R)2]+…+[D3÷(1+R)3]+[Pt÷(1+R)t]

i. Where:
j. Pt can be determined by [Dt+1 ÷ R − g]
k. D = Dividend
l. R = Discount rate or required rate of return
m. g = Dividend growth rate
n. For example, consider a firm that plans to pay a dividend of $2.00 in period 1,
$4.00 in period 2, and $5.00 in period 3. Thereafter, the firm plans to have a
dividend growth rate of 5%. If the firm has a required rate of return of 15%, then
the value of the stock at period 3 is equal to:

P3=[D3+1÷R−g]=($5×1.05)÷(15%−5%)=$52.50.

o. We can now calculate the present value of the stock as follows:

P0=[D1÷(1+R)]+[D2÷(1+R)2]+[D3÷(1+R)3]+[P3÷(1+R)3]P0=[$2.00÷(1+15%)]
+[$4.00÷(1+15%)2]+[$5.00÷(1+15%)3]+[$52.50÷(1+15%)3]P0=$1.74+$3.03+

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$3.29+$34.52=$42.58

IV. Common Stock Valuation using Relative Methods

a. Stocks can also be valued with other methods than the DCF. These methods rely
on comparisons or ratios. In order to be effective, comparison firms must be
chosen careful so that they are similar in factors such as industry, product
offerings or services, and size.
b. Three of the most common valuation ratios are the following:
i. Price-to-earnings (P/E) ratio
ii. Market-to-book (M/B) ratio
iii. Price-to-sales (P/S) ratio
V. Preferred Stock Valuation
a. Preferred stock can be valued similar to bond valuation because it has a fixed cash
flow. Thus, the DCF model can be used to map out the future cash flows and
discount them back to present value. In this sense, preferred stock can be treated
like an annuity and calculated as follows:

P0=Dividend÷Required Rate of Return

 For example, a $100 stock paying a 7% dividend with a 10% required rate of return has
the equation of

P0=($100×7%)÷10%=$7÷10%=$7
0
Bond Valuation Example
Consider a $1,000,000 bond that pays annual interest payments of 5% for 10 years. What is the
present value of this bond? The first step is to map out the cash flows.

 At time 1 through 10, there will be a $50,000 cash flow as interest payments are made.
 At time 10, there will be a $1,000,000 cash flow to repay the principal.

Par-Value Bond
By definition, a par value bond means the present value of the cash flows is equal to the face
value of the bond, or $1,000,000.
Discount Bond
If the market interest rate is 8%, then the price of the bond will be reduced below face value so
that the cash flows yield 8%. The price of the bond can be calculated as follows:

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 Determine the present value of the 10-year stream of $50,000 cash flows. Using a present
value table, the annuity factor at 8% for 10 years is 6.7101. Then, multiply $50,000 by
6.7101 to get $335,505.
 Determine the present value of the repayment of the $1,000,000 principal at year 10.
Using a present value table, the discount factor at 8% for 10 years is 0.4632. Then,
multiply $1,000,000 by 0.4632 to get $463,200.
 Finally, add the two values together ($335,505 + $463,200) to determine the present
value price of the bond: $798,705.

Premium Bond
If the market interest rate is 2%, then the price of the bond will be increased above face value so
that the cash flows yield 2%.

 Determine the present value of the 10-year stream of $50,000 cash flows. Using a present
value table, the annuity factor at 2% for 10 years is 8.9826. Then, multiply $50,000 by
8.9826 to get $449,130.
 Determine the present value of the repayment of the $1,000,000 principal at year 10.
Using a present value table, the discount factor at 2% for 10 years is 0.8203. Then,
multiply $1,000,000 by 0.8203 to get $820,300.
 Finally, add the two values together ($449,130 + $820,300) to determine the present
value price of the bond: $1,269,430.

Note: Present value calculation can also be performed using a financial calculator or spreadsheet
software. The answers using these tools will vary slightly from answers determined using present
value tables due to rounding differences.
Summary
The valuation of debt and equity can be done using various different techniques. A common
method is the discounted cash flow (DCF) method, which is based on the principle that the value
of any asset is the present value of its future cash flows. Bonds and preferred stock can use the
DCF method for valuation purposes. The valuation of common stock is more complex. The
Dividend Discount Model is the most commonly used valuation method for common stock. The
three most common variations of this model are the Zero-Growth Dividend Model, the Constant
Growth Dividend Model, and the Variable Growth Dividend Model.

Topic 2.8 Valuing Options

I. Valuing Options
a. Option values are readily and easily determined when the option expires. The
value is simply the difference between the exercise price and the value of the

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underlying asset. Whether an option is a put or call option determines if the option
is in the money for the option holder.
b. Options are much more difficult to value prior to the expiration date. This is
because the value of the underlying asset at the option expiration date can change
over time. In this situation, the following five factors affect the value of an option:
i. Current price of the underlying asset
ii. Exercise price
iii. Volatility of the value of the underlying asset
iv. Time until the option expires
v. Risk-free rate of interest

These five factors mean that the value of an option will depend on current spread
between the underlying asset's value and the exercise price, how likely the
underlying asset is to change in price, how long until the option is exercised, and
the time value of money.

Two popular models used to value options are the Black-Scholes model (BSM)

and the binomial model. Calculations using these models are not required for the
CMA exam, but an understanding of the models’ assumptions is expected.

c. The Black-Scholes model (BSM) is a popular method for pricing options. The
BSM's key assumptions include:
i. The stock pays no dividends during the option's life.
ii. The option is a European option, which means the option can be exercised
only on the maturity date.
iii. The stock is traded in an efficient market.
iv. There are no transaction costs, taxes, or commissions.
v. The risk-free rate exists, is constant across the life of the option, and is the
same for all maturity dates.
vi. The underlying stock's returns are normally distributed.
d. The binomial model values an option through a different, but still complex,
mathematical computation. The model is based on a binomial tree where there are
a number of decision points. The key assumptions of the binomial model are:
i. The investor is risk neutral.
ii. The underlying stock's price can only either decrease or increase with time
(in other words, the stock cannot remain constant).
iii. The possibility of arbitrage (immediate buying and selling of the asset in
different markets to earn a profit) is zero.
iv. The market is perfectly efficient.
v. The duration of the option is shortened.

Summary
Options are easily valued after the expiration date but are much more difficult to value prior to
the expiration date. The value of an option is affected by the following factors: current price of

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the underlying asset, exercise price, volatility of the underlying asset, time until the option
expires, and risk-free rate of interest. The Black-Scholes model and the binomial model are two
popular models for valuing options.

Topic 3.1 Financial Markets and Regulation

I. Financial Markets
a. Financial markets exist to facilitate the flow of money from investors (those
looking to obtain a return on capital) and users (those seeking to obtain capital in
order to fund business operations). The assets being exchanged on financial
markets can include stocks, bonds, options, commodities, and more.
b. A primary market is a market in which new security issues, either debt or equity,
are sold directly to investors. A key characteristic of primary markets is that
issuance of the new security results in new money for the issuing firm. Primary
markets are often less accessible for everyday investors because they are
wholesale markets taken up by large institutional investors.
c. A secondary market is a market in which owners of securities can sell them to
other investors. Secondary markets are more familiar to most people.
i. Examples of secondary markets for stocks include the New York Stock
Exchange, NASDAQ, London Stock Exchange, Euronext, Hong Kong
Stock Exchange, Shanghai Stock Exchange, and many other exchanges
throughout the world.
ii. Examples of secondary markets for commodities (oils, metals, food, etc.)
include the Chicago Mercantile Exchange, Hong Kong Mercantile
Exchange, London Metal Exchange, and many others.
iii. Examples of secondary markets for futures include the Chicago Board of
Trade and New York Board of Trade while for options the major market is
the Chicago Board Options Exchange.
d. A money market is a specific type of secondary market wherein short-term debt
instruments, meaning those with a maturity within one year, are traded. The
largest money markets are in New York City, London, and Tokyo. Money
markets exchange large amounts of money, with a $1 million minimum
transaction limit. Money market instruments are highly liquid, almost like cash.
The advantage of a money market instrument is that it can earn a higher interest
rate than regular cash holdings while maintaining a high level of liquidity.
e. A few key terms to understanding financial markets:
i. Marketability—How easily a security can be converted into cash.
Financial exchanges facilitate greater marketability for financial
instruments.
ii. Liquidity—The ability to convert an asset into cash quickly without loss of
value. This term is similar to marketability, but carries additional meaning
in that when a security is sold, its value is preserved.

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iii. Broker—Market specialists who facilitate exchanges between buyers and

sellers. They receive a commission fee as a market matchmaker. Brokers
do not bear any risk of ownership.
iv. Dealer—Market specialists who facilitate exchanges by buying and
selling securities from their own holdings. Dealers do bear risk of
ownership. Dealers gain profit by selling securities at prices above that
which they paid themselves to acquire the securities.
II. Regulation
a. Insider trading is an illegal practice where individuals with confidential or
nonpublic information trade on investments for profits. In many cases, company
management or influential investors with significant ownership percentages have
access to information the public does not have. If these individuals trade on
investments with this knowledge, they have broken the law and are subject to
fines, jail time, or both.
b. Firms have blackout period policies that specify when employees holding
company shares are forbidden to buy or sell. These periods are often around the
time of quarter-end or month-end closings, when management has knowledge
about a company's financial performance that has not yet been released to the
public.
c. In the United States, when corporate insiders buy and sell securities of their own
firm, they must report their trades to the Securities and Exchange Commission.
This practice is legal; however, it can become illegal if trades are made while the
individual has material, nonpublic information. The illegal practice also includes
“tipping,” which takes place when an insider provides information that is material
and nonpublic to another individual who proceeds to trade based on that
information.

Summary
Financial markets exist to facilitate the flow of money from investors and users. They come in
various forms and sizes. Primary markets sell debt or equity directly to investors and are usually
less accessible to everyday investors. Secondary markets are familiar to most people and are a
market where owners of securities sell to other investors. Regulation on financial markets
includes restrictions on insider trading and blackout period policies for employees holding
company shares.

Topic 3.2 Market Efficiency

I. Market Efficiency
a. Markets depend on information between buyers and sellers. In an ideal state, the
price of a security would reflect its true value, or the future cash flows an investor
can reasonably expect to receive. In order for this to take place, the price of a
security would need to incorporate all available information about the size,

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timing, and riskiness of the cash flows. Furthermore, as new information becomes
available, the price would need to adjust accordingly. When prices appropriately
reflect the knowledge and expectations of all investors, the market is said to
be efficient. Public markets help facilitate more efficient markets by allowing
investors to observe transaction prices and volume while also allowing them to
inexpensively trade in the market if desired.
b. The Efficient Market Hypothesis (EMH) is an underlying theory about how well
markets are able to reflect information in security prices. The degree to which this
theory applies is often described in three forms.
i. Strong-Form Efficiency—Security prices reflect all available information.
This form is more of an ideal than reality. If this form held true, then it
would not be possible to earn returns greater than market averages based
on private information.
ii. Semistrong-Form Efficiency—Security prices reflect all public
information but not all private information. For examples, investors who
have private information could acquire such information through analysis
of the firm or discussions with a firm's customers. This form is a
reasonable representation of how most large stock markets function.
iii. Weak-Form Efficiency—Securities prices reflect all past information but
not all private or public information. Under this form, investors could not
earn returns greater than market averages based on historical patterns in
security prices, but rather only by trading based on public or private
information.

Summary
A financial market is efficient when prices appropriately reflect the knowledge and expectations
of all investors. Investors are able to observe transaction prices and volumes as well as
inexpensively trade through the use of public markets. The Efficient Market Hypothesis (EMH)
is a theory about how well markets are able to reflect information in security prices and has three
forms (strong, semi-strong, and weak) which describe how well the theory applies.

Topic 3.3 Financial Institutions

I. Financial Institutions
a. Financial institutions play a significant role in the flow of cash through the
financial system. They provide cash from debt and equity issuances in the primary
exchange market while also facilitating secondary exchange markets where debt
and equity holders trade securities. The graphic below shows the flow of cash
through the financial system:

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Parrino, R., Kidwell, D., and Bates, T. (2015). Fundamentals of Corporate

Finance, 3rd Edition. Hoboken, NJ: John Wiley & Sons, p. 39. ISBN: 978-1-118-
84589-9.

II. Credit Rating Agencies

a. Credit rating agencies provide assessments of the risk that a company will default
on its debt obligations. They play an important role in financial markets by
reducing information asymmetry—where one party in a transaction has more
information than the other party—between firms and debtholders. When firms
issue new public debt, they obtain a credit rating on that issuance. The credit
rating communicates to investors the riskiness of the debt and helps determine an
appropriate interest rate.
b. Moody's, S&P, and Fitch ratings are the three major credit rating agencies.
See Part 2, Section B.2.2 Types of Financial Instruments: Bonds for related
information about credit ratings.
III. Investment Banks
a. Investment banks are banks whose specialty is helping companies sell new debt
and equity in the primary markets. Investment banks can sometimes also play a
role as brokers and dealers, creating their markets and profiting from trading
securities.
b. Origination is the process by which investment banks ready a security for sale,
either debt or equity. Investment bankers help companies determine the feasibility
of selling debt or equity with regards to the amount and type of capital. As part of
this process, the investment bank helps companies obtain a credit rating for the

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security (if debt), establishes the sale date, obtains necessary legal approvals, and
creates the securities.
c. Underwriting is the process by which investment banks help a company complete
the sale of a security. Typically, this takes place by the investment bank buying
the new security from the company and then reselling the security to investors.
This two-step process allows the company to obtain a fixed price for the security
while allowing the investment bank to benefit from the potential of selling the
security for higher than it paid. The spread between these two prices is referred to
as the underwriting spread. Investment banks bear a risk in the underwriting
process that they will not be able to sell the security at the price they paid.
d. Commercial banks are banks that offer financial services such as checking
accounts, savings accounts, lines of credit, and term-loans. Government
regulations have varied over time as to whether commercial banks could engage
in investment banking activities. Investment banking carries higher risk than
traditional financial services. To protect the financial system, these two types of
banking have been separated at times. However, regulations have also been
passed to eliminate the distinction. Following current legislation is the best way to
know whether commercial banks are presently allowed to engage in investment
banking activities.

Summary
Financial institutions are key intermediaries between firms and investors by providing cash from
debt and equity issuances in the primary market and also by facilitating secondary exchange
markets. Credit rating agencies help reduce information asymmetry between firms and
debtholders. Investment banks specialize in helping companies sell new debt and equity in
primary markets by providing origination and underwriting services. Commercial banks offer
financial services.

Topic 3.4 Initial and Secondary Public Offerings

I. Initial Public Offerings

a. Initial public offerings (IPOs) refer to an event of a firm “going public” or
offering ownership shares in the firm to the general public for the first time. There
are several reasons why a firm can benefit from going public:
i. Size of capital raised—Firms can raise larger amounts of equity capital in
the public equity market than from private sources. The public markets
provide access to millions of investors who can easily participate in
established financial market exchanges.
ii. Ease of additional offerings—Once a firm's stock is publicly listed, it
becomes easier for the firm to raise additional capital through equity
offerings. Investors value the liquidity of publicly held stock and will

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therefore accept lower yields, meaning higher prices paid to the firm
issuing stock.
iii. Funding with control—Firms can determine the proportion of ownership
shares they would like to make available to the public. An entrepreneur
who is in need of additional capital to fund business operations or projects
can sell a portion of the firm in the public market while also maintaining
majority ownership in the firm.
iv. Diversify personal portfolio—Going public allows a firm's stock to trade
on secondary market exchanges. This helps entrepreneurs and business
managers to conveniently sell some of their shares now and then in order
to diversify their own portfolios and to capture gains from appreciated
firm value.
b. Going public can also have drawbacks. The process of an IPO is costly due to
legal fees, auditing fees, consulting fees, and regulatory filing fees. Furthermore,
firms may not always be able to sell stock in an IPO at what they believe is the
firm's value. This happens because less information is known about private firms
and investors may be hesitant to invest when the firm value is uncertain.
c. Going public also requires a firm to comply with disclosure and filing
requirements by the Securities and Exchange Commission (SEC). Among the
many requirements, firms are required to produce detailed financial statements on
a quarterly basis. Firms must also provide disclosures on executive compensation,
strategic initiatives, and other material information that could potentially erode
some of the firm's competitive advantage in the marketplace.
d. The origination process of an IPO involves the firm's management working with
an investment banker to determine how much money the firm needs to raise and
what proportion of the ownership shares will be offered. The firm must also
evaluate its financial performance and future strategic initiatives. Once a firm has
determined it will go public, it must register with the SEC. The first step to
register is a preliminary prospectus that contains detailed information about firm's
business activities and financial performance and position.
e. Once a firm is registered and receives approval from the SEC, it may begin
the underwriting process. Underwriting is the process by which an investment
bank agrees to buy the firm's securities and then resell the securities to investors.
This is often accomplished by a group of investment banks, or underwriting
syndicate, in order to spread out the risk that the securities will not sell at the price
paid by the underwriters. The securities then begin trading as the underwriter sells
the securities to investors.
II. Secondary Public Offerings
a. A secondary public offering or seasoned public offering takes place when a firm
that already has publicly traded securities engages in a sale of additional
securities. The advantage for firms issuing additional securities is that investors
typically will pay higher prices for a second offering as opposed to a first
offering. This is because the stock is better known and has higher liquidity.

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Summary
When a firm offers ownership shares to the general public for the first time, it is called an initial
public offering (IPO). A firm may go public for various reasons such as the ability to raise large
amounts of equity capital, the ease of raising additional capital, the ability to control the
proportion of public ownership, and the ability to trade on the market. Going public can also
have drawbacks such as the high cost of going public, the risk of not selling the stock at the
believed value, and the new disclosure and filing requirements. After an IPO, a firm can offer
additional securities in a secondary public offering.

Topic 3.5 Dividend Policy and Share Repurchases

I. Dividend Policy
a. Organizations pay dividends to shareholders as a means to return profits to them.
When deciding whether to pay a dividend, firms consider several factors,
including the following:
i. Cash Availability—Firms often have cash commitments that necessitate
cash to be used for something besides dividends. This can include debt
principal and interest payments, capital investment projects, and payroll
expenses.
ii. Covenants—Covenant requirements imposed by financial institutions,
such as debt-to-assets ratios, debt-to-equity ratios, or other measures of
liquidity or insolvency, can limit a firm's ability to pay a cash dividend.
iii. Performance—Whether the firm can generate higher returns by investing
in the business compared to what shareholders could earn by investing
money should the dividend be distributed to them. All else being equal, if
a firm can earn its investors higher returns by investing in projects to grow
revenue and profits, it will often simply reinvest cash in the business
instead of paying dividends.
b. Dividends are paid differently to common stockholders and preferred
stockholders. Preferred dividends are paid to owners of preferred stock on a
priority basis compared to common shareholders. Preferred dividends can also be
paid in arrears if they are specified as cumulative preferred stock. This means that
if preferred shareholders are owed dividends for the last two years, both years’
dividends must be paid before dividends are paid to common shareholders.
c. All dividends require approval from the board of directors. The date the company
announces that the board has approved a dividend is called the declaration date.
Included in the dividend announcement will be the ex-dividend date, which is the
first day the stock will trade without the rights to the recently declared dividend.
The record date is two business days after the ex-dividend date and represents the
day on which the investors who are shareholders of record are determined to
receive the dividend. Finally, the dividend is distributed to shareholders on
the payable date, which is usually a couple of weeks after the record date.

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d. Most dividends are paid as a cash dividend. Dividends are taxable to the dividend
recipient.
II. Stock Repurchases
a. Firms can also distribute value to their shareholders by using stock repurchases.
Stock repurchases, also known as treasury stock,take place when a company buys
shares of its own stock on the open market. When a company repurchases its own
shares, those shares are removed from circulation. This reduction in the shares
outstanding means that the remaining owners of the company's stock have a larger
claim on the company's value and dividends.
b. For example, if a firm has 100,000 shareholders and has determined it will pay a
dividend totaling $1,000,000, then each shareholder would receive $10 per share.
If the firm decided to use other cash to repurchase 20,000 shares, resulting in a
new total of 80,000 shares outstanding, then the $1,000,000 dividend would be
$12.50 per share. Thus, if a firm repurchases its stock, the shareholder benefits
from an increase in the firm's share price and from a greater dividend amount.
c. Shareholders can often choose if they want to participate in a company's stock
repurchases. This can happen by the shareholder selling shares on the open
market, which the company in turn buys, or through a tender offer in which the
company announces a price that it will pay for shares.
III. Stock Dividends and Stock Splits
a. A stock dividend takes place when a company distributes new shares to existing
shareholders on a pro-rata basis. This means that each shareholder maintains the
same proportion of ownership.
b. Stock dividends do not change the value of a company's assets. Stock dividends
are simply accounting changes that result in shareholders’ shares being more in
number but worth the same amount.
c. A stock split is similar to a stock dividend, but is larger in scale. In a stock split,
each share is divided into multiple shares.
d. While the value of the company's assets does not change with stock dividends or
stock splits, there are reasons why firms would want to use these accounting
techniques. One often-cited reason is the trading range argument, which is that
firms want to keep their stock within a certain trading range value, say between
$5 and $100. This benefit has not received much support in academic research.
The main benefit is that stock splits send a positive signal about the firm's
outlook.
e. Reverse stock splits, where shares outstanding are reduced as opposed to
increased, often take place when a firm's stock price trades at low values. The
NYSE and NASDAQ have requirements that a stock's price stay above a
specified threshold ($5 and $1, respectively).

Firms pay dividends to shareholders as a means of returning profits to them. Before paying a
dividend a firm must consider cash availability, covenant requirements, and firm performance.
Dividends are paid to preferred stockholders first (including any dividends in arrears on
cumulative preferred stock) and then to common stockholders. Firms can distribute value to their

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shareholders by repurchasing their own shares from the open market (known as stock
repurchases or treasury stock). Stock dividends and stock splits create more shares on the open
market while not changing the value of the company's assets.

Topic 3.6 Lease Financing

I. Lease Financing
a. A lease can be thought of like a rental agreement. A lessee pays the owner of an
asset, the lessor, for the right to use the asset for a specified period. Leases are a
very common form of financing used by most firms. Firms lease assets such as
buildings, office space, furniture, computers, copy machines, vehicles, and
equipment.
b. Firms choose to lease assets because it can be less expensive than purchasing the
asset outright. Leases can reduce a company's tax obligations because operating
lease payments are tax deductible. Leases can also reduce information and
transaction costs associated with buying and selling assets. Many lease
agreements contain a termination clause that allows the lessee to terminate the
contract with 60 to 90 days’ notice. This provision provides the lessee with
greater operational flexibility.
c. Financial accounting rules (GAAP) and tax rules distinguish between two types of
leases:
i. Operating lease—These leases are thought of as rentals.
ii. Capital lease—While termed a lease, these arrangements are more like
purchases. A lease is considered to be a capital lease if any of the
following conditions are true:
1. The lease transfers ownership of the asset to the lessee at the end
of the lease term
2. The lease contains a bargain purchase option, that is, an option to
buy the asset at a low price below the expected market value of the
asset.
3. The lease cannot be canceled for a period that is greater than 75%
of the estimated economic life of the asset.
4. The present value of the minimum lease payments is greater than
90% of the fair market value of the asset.
d. Conflicts can arise between lessees and lessors. For example, the lessee may use
the asset more intensely than the lessor desires or may not maintain the asset as
needed. Lessors can protect themselves against these conflicts by charging
premiums for assets known to be treated poorly, charge a deposit that will not be
returned until the asset is inspected, or place explicit restrictions on the asset's use.
e. While there are nonfinancial reasons to lease or buy an asset, a useful tool in
evaluating the decision to lease or buy is doing a net present value (NPV)

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calculation. The comparison made is the NPV of the incremental cash flows from
leasing compared to current purchase price of the asset.

Example of an (Operating) Lease or Purchase Decision

Consider a firm that needs a machine for its production process. The firm can purchase the
machine outright for $20,000. Alternatively, the firm can lease the machine for $6,000 for five
years. Assume that none of the four conditions for a capital lease is met, so the firm will record
the lease as an operating lease. If the firm has a 25% marginal tax rate and a 10% cost of capital,
should the firm purchase or lease the machine?

 The after-tax cash flows are $4,500 = $6,000 × (1 – 25%).

 Using a present value table, the present value annuity factor for 5 years at 10% is 3.7908.
 The net present value of the lease payments is $17,058.60.

The firm will incur a lower expense by leasing the machine than it would by purchasing the
machine.
Summary
Lease financing is a common way for firms to obtain or use assets. A lease is when a lessee (the
user of the asset) pays a lessor (the owner of the asset) for the right to use the asset for a
specified period. Leases can be less expensive than buying the asset outright and can provide tax
benefits to the lessee. Financial accounting and tax rules classify leases into two types: operating
leases (thought of as rentals) and capital leases (termed a lease but more like purchases). A
useful tool in evaluating lease-or-buy decisions is to do a net present value (NPV) calculation.

Topic 4.1 Working Capital Terminology

I. Working Capital Terms and Definitions

a. The following key terms are important to understanding what working capital is
and how it is managed:
i. Current Assets—Comprised of cash and other assets which a firm expects
to convert to cash within one year or less. These can include marketable
securities, accounts receivable, inventory, and various miscellaneous
accounts such as prepaid expenses. Current assets are sometimes referred
to as Gross Working Capital.
ii. Current Liabilities—Comprised of obligations that a firm expects to pay
within one year or less. These can include short-term notes payable,
current maturities of long-term debt, accounts payable, deferred revenue,
and various miscellaneous accounts such as accrued expenses.
iii. Net Working Capital refers to the difference between Current Assets and
Current Liabilities. Net working capital is a measure of a firm's liquidity.

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When people refer to “working capital,” they are usually referring to “net
working capital.”
iv. Liquidity—The ability to convert assets into cash without a loss of value.
II. Managing Working Capital
a. A firm's working capital management policy is the set of decisions made to
manage the firm's short-term cash inflows and cash outflows. The general goal of
managers is to manage working capital in such a manner that the company can
maintain normal business operations with the smallest possible net investment in
working capital.
b. Firms face tradeoffs with each type of working capital:
i. Cash and Cash Equivalents—Cash on hand means a firm is likely to meet
its financial obligations. Without enough cash, a firm is at greater risk to
not be able to pay its bills. However, cash holdings have low rates of
return and thus holding an excessive amount of cash can be an opportunity
cost to the firm.
ii. Receivables—Extending credit to customers can help increase a firm's
sales. However, evaluating customers’ credit can be costly and accounts
can go uncollected, resulting in losses to the firm.
iii. Inventory—Maintaining large inventories can benefit a firm because the
product will be available when customers want to purchase it and the firm
will have the materials needed for production. However, costs are incurred
to finance, warehouse, and protect inventories.
iv. Payables—Trade credit is appealing because it is a short-term financing
mechanism usually with no interest. However, penalties can be incurred if
not paid on time and future credit may be limited.

Summary
Working capital is a measure of a firm's liquidity and refers to the difference between current
assets and current liabilities. Current assets are cash and other assets expected to be converted to
cash within a year. Current liabilities are obligations that a firm expects to pay within a year.
Firm managers set policies for managing working capital with the general goal of maintaining
normal operating procedures with the smallest net investment in working capital.

Topic 4.2 Cash Management

I. Cash Management
a. Cash management is the process by which a firm collects, invests, and administers
its cash. Accounting, finance, and treasury departments work together to ensure
the organization uses cash efficiently and that cash is available for operating and
capital investment needs.
b. Cash management policies are focused on managing a firm's liquidity needs, that
is, the ability of a firm to convert assets into cash without loss of value when

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needed. Efficient cash management optimizes the timing of cash inflows and cash
outflows.
c. Cash management systems are built around the cash conversion cycle, which is
the period of time over which a firm converts its cash outflows for its products
and services into cash inflows. The diagram below depicts this cycle:

Parrino, R., Kidwell, D., and Bates, T. (2015). Fundamentals of Corporate

Finance, 3rd Edition. Hoboken, NJ: John Wiley & Sons, p. 447. ISBN: 978-1-
118-84589-9.

II. Holding Cash

a. Firms maintain cash balances, sometimes very large cash balances, for a variety
of reasons.
i. The transaction motive means that firms have cash reserves in order to
make payments related to their business operations. Firms pay cash for
materials, labor, operating expenses, and many other expenses. Without
cash to engage in financial transactions, firms struggle to maintain
continuing business operations.
ii. The precautionary motive means that firms have cash reserves for
unexpected or emergency cash needs. Firms can forecast expected cash
needs; however, it is difficult to be accurate in forecasting. Having extra
cash available allows firms to experience unanticipated cash needs without
damaging business operations.
iii. The compliance motive means that firms have cash reserves in order to
comply with cash balance requirements from loans and other bank
services. Referred to as compensating balances, these requirements benefit
the bank providing the loan or service by providing access to the firm's
deposit interest free.

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III. Forecasting Cash Flows

a. A key tool for managing cash flow is to make forecasts of cash inflows and cash
outflows. Anticipating the timing of cash flows can help firms determine their
cash needs and where their cash will be invested. The cash budget is a budgeting
tool that helps firms map out their expected cash collections and cash
disbursements along with any financing needs.
b. When preparing cash flow forecasts, the following are important considerations:
i. Credit Terms Received—The terms such as interest rates and payment-due
dates vendors or suppliers are willing to extend on accounts payable.
These terms affect the timing of cash outflows.
ii. Credit Terms Extended—In like manner, firms extend credit to their
customers. The interest rates and payment-due dates extended to
customers affect the timing of cash inflows.
iii. Payment form—Firms have a variety of options to complete financial
transactions that affect the timing of cash flows. Paying hard cash is the
quickest cash outflow, followed by checks, and then by credit cards. The
variation in processing time from payment type can make a significant
difference in a firm's cash flow management.
iv. Inventory Needed—Inventory represents a more illiquid asset. It requires
cash be invested and then held as inventory until the product is sold. The
average time that inventory is held before being converted into cash
affects the timing of a firm's forecasted cash flows.
IV. Collecting Cash
a. Firms create collection systems to gather and deposit cash. Firms can collect
payments in many forms such as cash, check, debit or credit card, and electronic
transfers.

Collection float is a measure of the time from when a transaction is initiated until
the cash is available for use. For example, when a check is mailed to a firm, the
collection float is broken down as follows:

i. Mail float—The time from when the check is mailed to when the firm
receives the check
ii. Processing float—The time from when the firm receives the check to
when it is deposited
iii. Availability float—The time from when the check is deposited to when the
funds are made available to the organization
b. A lockbox system is an arrangement between a bank and a firm that allows
geographically dispersed customers to send their payments to a post office box
near them. The payments are then collected and processed by the bank. Because
the payment skips the firm's location, the collection float is reduced. In the case of
mailed checks, the bank generally provides photocopies or electronic scans of the
checks along with payment remittance forms to the firm. The primary drawback

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of a lockbox system is the cost of administering the system, which can include
post office box rental fees, account or deposit fees, and processing fees.
c. The net benefit of a lockbox system is the dollar value of reduced mail and
processing float less the costs of the system. A firm benefits from a lockbox by
accelerating cash collections, which allow the firm to earn interest on the cash
sooner than it otherwise would.

Value of a Lockbox

Consider a firm that uses a lockbox system that costs $0.30 per processed check.
The firm receives an average of 100 checks per business day with an average
value of $1,000. The firm estimates the lockbox reduces processing by 2 days. If
there are 270 business days per year and the firm's account receivable costs 5% in
interest to the firm, what is the net benefit of the lockbox system?

Cost of the Lockbox

100checks×$0.30per check×270days=$8,100

Savings from the Lockbox

2days×5%×($1,000per check×100checks)=$10,000

The net benefit to the firm is $1,900 per year by using the lockbox system.

d. Electronic payment systems use digital means to bypass the traditional system of
mailing checks for payment. Automated clearinghouse (ACH) transactions
process and settle payments electronically. In the United States, the Federal
Reserve is the primary ACH operator. Fedwire, operated by the Federal Reserve,
provides financial institutions the ability to transfer funds through their respective
Federal Reserve bank accounts.
e. Firms will often use a concentration banking system. This system transfers all
funds from a variety of regional banks into a single central banking account. It
simplifies the cash management process because firms can focus on one bank
account rather than multiple accounts.
V. Disbursing Cash
a. Organizations use disbursement systems to pay employees, suppliers, tax
agencies, and other external stakeholders. Disbursement float is a measure of the
time between when a firm initiates payment and when the funds are deducted
from the firm's bank account. Disbursement float is similar to collection float, but
it also adds clearing float, which is the time between when the other party
deposits the firm's check and when the amount is officially deducted from the
firm's bank account.

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b. Firms can use a variety of methods to control disbursement activities.

i. A zero-balance account (ZBA) allows a bank to write checks against an
account with no money in it. A daily transfer from the bank's master
account covers any checks written. Firms may have multiple ZBAs for
supplier payments, tax payments, wages, etc. ZBAs allow for
decentralized payables activity and the elimination of excess cash in
multiple bank accounts.
ii. Centralized payables allows a firm to use a single bank account and take
advantage of economies of scale from a single payment location.
iii. A payable through draft (PTD) requires a bank to present the instrument
to the firm for final acceptance. The firm then will deposit funds to cover
the draft. This service incurs higher charges for the firm but allows the
firm greater management over its cash funds.
iv. Electronic commerce (e-commerce) facilitates relationships and
transactions digitally. Processing payments online reduces cycle time and
has lower error rates.

Summary
The process by which a firm collects, invests, and administers its cash is referred to as cash
management. Cash management is a critical component of any business. Firms need to maintain
cash balances in order to make payments related to business operations, to have reserves in case
of unexpected or emergency needs, and to meet compliance requirements. Firms use cash
budgets to help forecast the timing of cash flows. Collection float (the measure of time from the
initiation of a transaction until cash is available) and disbursement float (the measure of time
from when a payment is initiated and when funds are deducted from the firm's bank account)
also influence cash inflow and outflow.

Topic 4.3 Marketable Securities Management

I. Holding Marketable Securities

a. Holding excessive levels of cash is generally discouraged because cash accounts
earn very low rates of interest. As an alternative, firms can invest in short-term
securities to earn additional income while sacrificing little with regards to
liquidity.
b. Firms should consider the following factors when deciding whether to use
marketable securities and what type of marketable security to use:
i. Risk—Marketable securities vary in their risk level. While they generally
have lower risk exposure than stocks or long-term bonds, they do have
more risk compared to a savings account. The yields on marketable
securities are higher than a savings account to compensate for the
additional risk exposure.

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ii. Liquidity—Marketable securities vary in how quickly they can be

converted into cash without loss of value. Their maturity is generally less
than one year, but can be illiquid over short-term periods.
iii. Maturity—Related to liquidity, firms should consider the time to maturity
of marketable securities. Firms should manage marketable securities’
maturity to match the timing of firm's cash needs.
iv. Taxes—Some marketable securities do not require payment of taxes, such
as municipal bonds.
II. Types of Marketable Securities
a. Marketable securities come in various forms. The following table provides
examples of marketable securities:

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Summary
Cash accounts generally earn low interest rates so firms will often invest in short-term
marketable securities that can earn additional income while still being fairly liquid. When
deciding what type of marketable security to use, firms should consider the risk, liquidity,
maturity, and tax requirements related to each security. There are many types of marketable
securities, including U.S. treasury securities, federal agency securities, repurchase agreements,
bankers’ acceptances, commercial paper, negotiable certificates of deposit, Eurodollar deposits,
and short-term municipals.

Topic 4.4 Accounts Receivable Management

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I. Managing Accounts Receivable

a. Firms often extend credit to customers by delivering the product or services now
in exchange for a promise of future payment. This arrangement benefits firms
because it makes it easier and more likely that customers will make purchases,
and depending on the credit terms, the firm can earn interest.
b. The amount of accounts receivable a firm has is affected by several factors,
including the following:
i. Credit Screening—Firms can evaluate customers’ creditworthiness. For
example, firms may require customers have a minimum credit score in
order to receive financing. Firms incur costs for credit screening, and as
such, firms vary in the extent to which they screen customers.
ii. Credit Terms—Firms can determine the interest and term length. Lower
interest rates and longer payment periods will increase the likelihood
customers use credit to finance their purchases. For example, a common
credit term is 2/10, net 30, which means a customer receives a 2%
discount if it pays in 10 days, and it must pay its receivable in 30 days.
iii. Monitoring Collections—Once credit is extended to a customer, the firm
must make efforts to collect the promised money. Firms vary in how
actively they remind customers to pay.
iv. Default Risk—The risk that customers will not pay their bill. This is
related to the initial credit screening, but can also be affected by
subsequent events that affect a customer's ability to pay their bills.
c. The goal of a firm's credit policy is to increase sales while also realizing cash
collections. Firms expect a portion of their credit sales to be uncollectible, but the
firm's credit policy should seek to optimize the tradeoff between increasing sales
and the amount of cash not recovered by collection.
d. The average collection period (or the days’ sales outstanding) measures how
much time passes between a sale and the time a customer pays. A firm can
measure average collection period as a weighted average of the times customers
pay.
i. For example, if 20% of customers pay in 10 days, 60% pay in 30 days, and
20% pay in 60 days, the average collection period is (20% × 10) + (60% ×
30) + (20% × 60) = 2 + 18 + 12 = 32 days.
e. The firm's average balance in receivables is calculated as the Average Daily Sales
× Average Collection Period.
i. For example, if the firm's average collection period is 32 days and average
daily sales are $20,000, the average balance in A/R is ($20,000 × 32 days)
= $640,000.
f. The Accounts Receivable Turnover Ratio measures the number of times the
company cycles its A/R each year. The formula is Annual Net Credit Sales ÷
Average Receivables Balance.
i. For example, if a firm had $7,200,000 in credit sales and had an average
receivables balance of $640,000, the accounts receivable turnover ratio
would be 11.25 = ($7,200,000 ÷ $640,000).

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g. A common tool use to manage accounts receivable is an aging schedule. This

schedule maps out the accounts receivable by how far past the initial sale they are.
It is used to help identify and track delinquent accounts. The older a receivable is,
the greater likelihood that it will not be collected.

Summary
Firms often extend credit to customers by delivering the product or service now in exchange for
a future promise of payment. The amount of accounts receivable a firm has is affected by credit
screening of customers, terms of credit extended by the firm, monitoring of the extended credit,
and the risk of default of payment. Firms expect a portion of their accounts receivable to be
uncollectible. It is important for firms to evaluate and manage their accounts receivable as the
older a receivable is, the greater likelihood that it will not be collected.

Topic 4.5 Inventory Management

I. Managing Inventory
a. Inventory management starts with the purchase of raw materials and ends with the
sale of finished goods. Firms have inventory on hand or in storage facilities for
several reasons, such as the following:
i. Protect against suppliers’ financial uncertainty or shipping delays.
ii. Mitigate the risk of stock-outs because of high demand.
iii. Ensure the firm can operate in an efficient and effective manner.
b. Firms attempt to minimize total inventory cost while carrying sufficient inventory
to maintain operations. This can be a difficult managerial problem due to the
complexity of forecasting sales demand, availability of raw materials, and
production processing. Firms must balance several costs when determining the
optimal inventory level to carry. These costs include the following:
i. Purchasing costs—The actual amount that a firm pays for materials. This
can include shipping and taxes on the goods purchased.
ii. Carrying costs—The warehouse space, handling costs, insurance, taxes,
and depreciation associated with storing inventory.
iii. Ordering costs—The costs of purchasing departments, administrative
support, and other fixed costs associated with placing orders with
suppliers.
iv. Stock-out costs—The lost revenue (an opportunity cost) associated with
not being able to fulfill customers’ orders in a timely manner.
c. Firms spend considerable time and resources to determine the right quantity of
inventory to carry because inventory is a significant investment and can result in
reduced cash flow if not managed well. If a business wants to minimize stock-out
costs, it will incur higher carrying and ordering costs. In contrast, firms seeking to
minimize carrying and ordering costs will risk incurring larger stock-out costs
from not having the right inventory on hand.

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d. The following key terms are important to understanding how firms design their
inventory purchasing and management strategies.
i. Lead-time is the time between when a firm places an order with a supplier
and when the goods arrive at the business.
ii. Safety stock is protection against increased demand and should be
calculated to balance the volatility of demand with the risk the firm wishes
to incur for stock-out costs. It is the amount of inventory a firm has on
hand beyond the projected sales amount.
iii. The reorder point is calculated as:

(Average Daily Demand in Units×Lead Time)+Safety Stock

iv. For example, a firm has daily demand of 1,000 units, requires lead-time of
30 days, and wants a safety stock of 3 days’ worth of inventory.
v. The reorder point is (1,000 × 30 days) + 3,000 units = 33,000 units.
II. Just-in-Time Inventory Management
a. Just-in-time (JIT) systems help firms manage inventory and reduce cost. Firms
contract with suppliers to deliver inventory only on order when the firm requires
it. In other words, JIT can be considered a “pull” inventory system wherein
demand is the trigger for inventory ordering rather than predetermined inventory
levels. The philosophy behind a JIT system is different from traditional inventory
systems in that it regards inventory storage as a non-value-added activity. Thus,
JIT attempts to reduce or eliminate the carrying costs of inventory.
b. JIT systems were pioneered by Japanese firms like Toyota Motor Company. Most
auto manufacturers now employ a JIT system. Firms with JIT systems benefit
from having little to no carrying costs and not having the risk of inventory
obsolescence. However, firms with JIT systems are very dependent upon their
suppliers and their ability to deliver goods as needed.
III. Inventory Turnover
a. Firms can also manage inventory costs by increasing their inventory turnover.
High inventory turnover ratios mean that firms move their inventory from raw
materials to sales more quickly. When firms have high inventory turnover ratios,
they incur fewer overhead expenses in these areas:
i. Fewer employees required to handle and move material
ii. Lower utility costs because the firm requires less space to store inventory
iii. Less depreciation expense or rent expense related to handling equipment,
such as forklifts

Lower overhead expenses from having high inventory turnover means cost of
goods sold will be lower, which in turn improves a firm's gross margin.

IV. Economic Order Quantity

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a. Firms can use the economic order quantity (EOQ) model to calculate the order
quantity that minimizes the total costs incurred to order and hold inventory. If a
firm carries less inventory, it will order more and have higher ordering costs.
Firms carrying more inventory may make fewer orders, but these firms will have
more costs with warehousing, handling, and depreciation required to store and
carry inventory.
b. The formula for EOQ is given as follows:

EOQ=√[(2×Reorder Costs×Sales per Period)÷Carrying Costs]

c. The EOQ model has several key assumptions: (1) demand remains uniform, (2)
ordering costs and carrying costs are constant, and (3) no quantity discounts are
allowed.
d. Calculations using the EOQ are not required on the CMA exam, but an
understanding of the concept and its features is expected.

Summary
A difficult managerial problem is managing inventory that consists of minimizing total inventory
costs while carrying sufficient inventory to maintain operations. When determining optimal
inventory level, firms must balance purchasing costs, carrying costs, ordering costs, and stock-
out costs. Firms use various techniques such as just-in-time inventory management, inventory
turnover calculations, and the economic order quantity model in order to determine the right
quantity of inventory to carry.

Topic 4.6 Types of Short-term Credit

I. Sources of Short-term Financing

a. Short-term credit to finance working capital requirements comes from several
sources: (1) trade credit, (2) short-term bank loans, (3) commercial paper, and (4)
accounts receivable financing.
II. Trade Credit
a. Trade credit, or accounts payable, takes place when a firm makes and receives
delivery of a purchase, but does not pay for it upon purchase. Instead, the firm is
extended credit by the counterparty. Often the credit terms for accounts payable
are written as 2/10, net 30; that means the purchasing firm receives of 2%
discount if it pays the bill within 10 days but must pay the full amount within 30
days. Penalties and fees are charged after the 30-day period.
III. Short-term Bank Loans
a. Firms have a variety of financing agreements available from banks.
i. Term loans are payable by a certain date. Common bank loans are
generally term notes. The promissory note that includes the amount,

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maturity, interest rate, and debt covenants is sometimes called

a promissory note.
ii. Lines of credit allow businesses to borrow given amounts to a certain
ceiling level assuming the firm makes minimum payments each month.
Lines of credit sometimes carry commitment fees that a firm must pay on
the unused portion of the credit line. A line of credit may either be
an informal line of credit, which is a verbal agreement that a firm can
borrow an agreed-upon amount of money, or a formal line of credit, which
is an agreement with a legal obligation for the bank to lend an agreed-
upon amount of money.
iii. Secured versus unsecured loans—secured loans are backed by collateral,
meaning that if the borrower defaults on the loan, the bank can seize the
asset serving as collateral for the loan. Secured loans carry lower interest
rates than unsecured loans because the collateral reduces the cost of
default risk to the bank.
IV. Commercial Paper
a. Commercial paper is short-term, unsecured notes payable issued by large firms
with high credit ratings. Commercial paper is usually issued in very large
denominations (usually exceeding $100,000).
b. Pension funds, institutional investors, and insurance companies usually purchase
commercial paper as a secure, low-risk investment.
c. Commercial paper is not secured; however, a related financial instrument
called bankers’ acceptances are short-term notes payable issued by firms yet
backed or guaranteed by a commercial bank.
V. Accounts Receivable Financing
a. Firms finance their accounts receivable in two ways. The first way is by obtaining
a bank loan using the accounts receivable as collateral. The firm is able to
accelerate the availability of cash while waiting to collect on the accounts
receivable. Once collected, the firm pays off the bank loan. If there is a shortfall
in collecting the accounts receivable, the firm is still legally obligated to repay the
full amount of the loan.
b. The second way is to sell the rights to the accounts receivable, referred to
as factoring. Factoring takes place when a bank or financial institution buys a
firm's accounts receivable without recourse. The accounts receivable are sold at a
discount, typically 2% to 5%. The firm benefits because it receives cash more
quickly and discharges the risk of default to someone else. The bank benefits from
the discount received inasmuch as the accounts receivable are collected.
c. The cost of factoring can be quite high. For example, consider a firm with
$10,000 in accounts receivable. The firm sells the accounts receivable to a bank at
a 2% factor. The accounts receivable collection period is one month. This means
that the firm receives $9,800 cash while incurring a $200 expense. This translates
into a simple annual interest rate of 24.48% = ($200 ÷ $9,800) × 12.

Summary

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Firms often use short-term credit to finance their working capital. Trade credit (accounts
payable) occurs when a firm makes and receives delivery of a purchase but does not pay for it
right away. Banks offer various short-term loans such as term loans, formal or informal lines of
credit, and secured loans. Large firms issue commercial paper, which are short-term, unsecured
notes. Finally, firms will sometimes finance their accounts receivable by using their accounts
receivable as collateral for a bank loan or factoring (selling their rights to) their accounts
receivable.

Topic 4.7 Short-term Credit Management

I. Managing Short-term Credit

a. Working-capital needs fluctuate over time. This can happen due to economic
cycles and business seasonality. Firms must develop strategies of how they will
fund working capital needs. Permanent working capital is the minimum level of
working capital that a firm will always have on its books. Fluctuations in working
capital above that amount need to be financed and managed. Three common
alternatives for financing working capital needs are:
i. Maturity matching—This strategy tries to match the maturities of
liabilities to the assets that they fund.
ii. Long-term funding—This strategy uses long-term debt and equity to fund
working capital and fixed assets.
iii. Short-term funding—This strategy uses short-term debt to finance working
capital, and at times, a portion of fixed assets.

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Parrino, R., Kidwell, D., and Bates, T. (2015). Fundamentals of

Corporate Finance, 3rd Edition. Hoboken, NJ: John Wiley & Sons, p.
461. ISBN: 978-1-118-84589-9.

II. Cash Discounts

a. Firms should calculate the cost of not taking a cash discount in payment terms to
determine their ideal disbursement strategy. If a firm can obtain short-term
financing at a lower cost than the cost of the discount, it should take the discount
and obtain the short-term financing required to pay in the discount period.
b. The formula to calculate the cost of not taking a discount is:

(Discount%)÷(100%−Discount%)×(Days in Year)(Total Payment

Period−Discount Period)

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c. For example, if a firm has 2/10, net 30 terms, the cost of not taking the discount
is:

(2%÷98%)×(360)(30−10)=.0204×(360÷20)=36.72%

d. If the firm chooses to finance a payable of $100,000 for 30 days instead of paying
$98,000 for 10 days, it will cost the firm $2,000 (or 36.72%) to finance the
payable for 20 days. Unless the organization is facing severe financial difficulty,
it will be able to obtain short-term financing for less than $2,000 for 20 days.
III. Bank Loan Interest Rates
a. When a firm sets up a line of credit with a bank, it often has commitment fees that
a business must pay on the unused portion of the credit line.
b. For example, consider a firm that is currently using $250,000 of a $1,000,000
credit line. The interest rate is 5% with a 1% commitment fee. The firm must pay
interest of $12,500 ($250,000 × 5%) and a commitment fee of $7,500 ($750,000
Unused × 1%). The total expense on the line of credit is $20,000, which is an
effective interest rate of 8.0% = $20,000 ÷ $250,000.
c. Some financial institutions require compensating balances to be held as part of
loan requirements. Compensating balances are minimum balances that must be
maintained in a bank account to offset the cost of a loan incurred by a bank. For a
loan with a compensating balance, the total borrowing amount is calculated as:

Amount Needed÷(1−Compensating Balance%)

d. For example, consider a firm that needs $500,000 for a project. The bank offers to
fund this loan at 8% with a compensating balance of 20%. The firm must actually
borrow $625,000 = ($500,000 ÷ (1 − 20%). The firm must pay 8% on the full
$625,000 even though $125,000 of it will simply be held in an account at the
bank. The total interest expense on the loan will be $50,000 = $625,000 × 8%.
This makes the effective interest rate 10% = $50,000 ÷ $500,000.

Summary
Economic cycles and business seasonality cause working capital to fluctuate over time.
Fluctuations above the permanent working capital amount must be financed and managed.
Maturity matching, long-term funding, and short-term funding are three alternatives used for
financing working capital needs. If the cost of obtaining short-term financing is lower than the
cost of a discount, a firm should obtain the short-term financing to pay in the discount period.
Firms need to include bank requirements (such as commitment fees and compensating balances)
in their evaluations of short-term debt.

Topic 5.1 Mergers and Acquisitions

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I. Mergers and Acquisitions

a. An acquisition is when one firm buys a controlling interest, which is greater than
50% ownership, in another business. This takes place for several reasons. Firms
may acquire competitors to increase their own market share and limit competition.
Firms may acquire smaller firms with unique capabilities or product offerings to
facilitate growth. Firms may acquire struggling firms with the hope of improving
efficiencies due to their own size, scale, and management techniques. Whatever
the reasons, acquisitions form a critical activity in the financial market.
b. A merger takes places when two firms combine into one. Mergers take several
forms. A horizontal merger is when two firms in the same industry are combined.
A vertical merger is when two companies that make parts for a finished good are
combined. A conglomerate merger is when two companies are combined that are
from different industries.
c. Mergers and acquisitions can be executed through various financial agreements
involving cash, debt, and equity. A firm can pay all cash for another company. A
firm could also exchange ownership shares whereby the owners of the firm being
acquired are paid with shares in the acquiring company. A leveraged buyout is a
merger where the buyer uses debt to finance a significant portion of the
transaction. The assets of the business are collateral for the debt assumed to
execute the leveraged buyout.
II. Defenses against Takeovers
a. Sometimes a firm does not want to be acquired or bought by another firm. In
which case, acquisition targets can implement a number of protective actions
against acquisition.
i. A golden parachute provides very large payouts to executives released as
part of an acquisition. It serves as a defense against takeover because the
acquiring firm would incur significant additional costs to complete the
transaction.
ii. Staggered board of directors is a strategy wherein a firm elects only part
of its board each year. By having staggered terms of service on the board
of directors, it makes it more difficult for shareholders to select a majority
of board members to vote current management out.
iii. The white knight defense involves the targeted company finding a friendly
buyer to outbid the potential acquirer. The firm will still be acquired, but
is able to have input as to who the acquiring firm will be.
iv. Poison pills are provisions that make a potential acquisition target less
attractive. An example would be making all debt redeemable in the event
of an acquisition. Another example is a voting rights plan in which the
acquisition target issues stock with special voting rights to shareholders.
This strategy can allow shareholders of an acquisition target to have
special or unique privileges in the event of a takeover event.
v. A leveraged recapitalization makes a firm less attractive to acquiring
firms by taking out a significant amount of debt and distributing large cash

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dividends to shareholders. The additional debt burden deters other firms

from wanting to acquire the firm.

Summary
Mergers and acquisitions are types of business combinations. Acquisitions are when one firm
buys a controlling interest, which is greater than 50% ownership, in another business. Mergers
take place when two firms combine into one. Mergers can take the form of horizontal mergers,
vertical mergers, or conglomerate mergers. Mergers and acquisitions can take place through
various forms of financial agreements. When a firm does not want to be taken over by another
firm, it can implement protective actions against acquisition.

Topic 5.2 Bankruptcy

I. Bankruptcy
a. A business may be considered insolvent in two ways. First, a business is
technically insolvent when it cannot pay its current liabilities, even though its
assets may exceed its liabilities. A business is legally insolvent when the value of
its liabilities exceeds the value of its assets. Bankruptcy takes place when a firm
officially declares that it is insolvent and cannot pay its obligations.
b. A bankruptcy can take one of two forms.
i. A Chapter 11 bankruptcy, often referred to as a reorganization, allows a
company to restructure its business and continue operating. The firm may
restructure existing loans, cancel or reject certain contracts, and/or seek
new financing with company earnings. A trustee acts as the firm's trustee
to conduct business with creditors. This is often the debtor acting as debtor
in possession. All creditors cease collection efforts during the
reorganization period.
ii. Chapter 7 bankruptcy is a liquidation where the business ceases to exist
and all the assets are sold. The creditors select a trustee to pay the
creditors of the firm under priority of claims. The claims are paid in an
established order as follows:
1. Bankruptcy expenses paid to lawyers, accountants, and consultants
2. Firm expenses incurred after the bankruptcy petition is filed but
before the trustee is selected
3. Unpaid wages (not to exceed $2,000 per employee)
4. Unpaid contributions to benefit plans (not to exceed $2,000 per
employee)
5. Customer layaway deposits (not to exceed $900 per claim)
6. Taxes owed
7. Secured claims (i.e., debt secured by collateral) paid first
8. Unsecured claims paid next
9. Common shareholders paid last if any money remains

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c. Prior to filing bankruptcy, firms often attempt to negotiate terms for their debt
obligations. This can lower debt costs by reducing interest rates or by deferring
payments for a period. Lenders agree to revised debt terms because they stand to
lose even more if the firm files for bankruptcy.
d. Financial distress can often increase a firm's cost because suppliers worry about
not being paid. This can lead to suppliers reducing credit terms or requiring cash
upon delivery. While such measures can protect suppliers from losses, it can also
create greater financial distress on firms and accelerate the road to bankruptcy.

Summary
When a firm officially declares that it is insolvent (unable to pay its current liabilities or the
value of its liabilities exceeds its assets) and cannot pay its obligations, then it declares
bankruptcy. Bankruptcy has two forms: Chapter 11 and Chapter 7. A Chapter 11 bankruptcy is
considered a reorganization while a Chapter 7 bankruptcy is considered a liquidation. Firms
often try to negotiate terms for debt obligations in order to avoid filing bankruptcy.

Topic 5.3 Restructuring and Combining

Restructuring and Combining

a. Companies can reduce or eliminate a portion of the company through a divestiture.

Divestitures can come in various forms. A few of the most common types of divestitures
are the following:
i. Spin-offs—A spin-off takes place when a firm forms a new company out of a
portion of its current divisions or product lines. For example, if firm A decides to
divest itself of one of its divisions, it could create a new firm that will function
independently as its own entity. Spin-offs are typically accomplished by doing an
initial public offering (IPO) for the new firm. Spin-offs often take place when a
firm has become large and diverse, which can create management difficulties.
Spin-offs allow firms to narrow their strategic focus. Another reason spin-offs
take place is if a part of a business has become unprofitable. By spinning-off a
portion of the firm, the remaining firm is no longer burdened by the costs and
upkeep of the spun-off portion of the firm.
ii. Equity carve-outs—This is a similar restructuring to a spin-off, but the firm sells
only a minority interest in the new firm instead of selling the entire ownership
stake. The carve-out does create a new entity that has its own board of directors
and financial statements, but the parent firm retains a controlling interest. Carve-
outs can help a firm monetize the growth in a portion of their company by selling
ownership shares in the market.
iii. Split-ups—This restructuring takes one firm and splits it into two separately run
firms. Each firm is a standalone firm with independent management and boards of
directors. Many split-ups occur because the government is concerned about

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monopolistic behavior. Companies also can split up when company management

and the board of directors believe separate companies will provide greater value
than a single company will.
iv. Tracking stocks—Ownership shares that are issued by a parent company to
monitor the performance of one strategic business unit (SBU). Tracking stocks
typically have limited or no voting rights. Companies use a tracking stock to
measure the performance of a high-growth SBU held inside of a parent company.
While the parent company maintains control of the SBU, the creation of a
tracking stock provides a mechanism for investors to invest in a portion of the
company. All financial results from the SBU are tracked separately from the
parent company's overall financial results, which creates greater transparency for
market participants to evaluate the SBU performance.

Summary
When a company reduces or eliminates a portion of its company it is called a divestiture. Some
of the most common forms of divestitures are spin-offs, equity carve-outs, split-ups, and tracking
stocks.

Topic 5.4 Evaluating Business Combinations

I. Evaluating Mergers and Acquisitions

a. As with any investment, firms must evaluate a potential acquisition or merger to
determine if it will generate an appropriate return on investment. The discounted
cash flow (DCF) method can be used to evaluate whether a proposed business
combination will create value. Similar to valuing an investment or project,
valuing a business combination is comprised of identifying cash inflows and cash
outflows along with determining an appropriate discount rate.
b. Valuing a firm using the DCF does have its drawbacks. Whereas a project
typically has an expected useful life, a firm is considered to have an indefinite
life. The value of a firm's income can be projected for three to five years, but any
projections past that point have a high degree of uncertainty. As such, the value of
a business is estimated as the sum of the following three factors:
i. Present value of future cash flows over a short window of time. This is
typically three to five years.
ii. Present value of all future cash flows thereafter. This is referred to as
the terminal value.
iii. Present value of non-operating assets, which are the cash and other assets
not required to support the business.
c. Business combinations are often done with the strategic goal of increasing
revenues, decreasing costs, or expanding market share. The challenge with
evaluating the potential value creation is in determining how revenue and
expenses will change or grow in the future. The use of what-if analyses can be

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beneficial by evaluating the likelihood of various scenarios and outcomes. Rather

than assuming the proposed model and its assumptions will hold true, a what-if
analysis can identify what circumstances must hold true in order for the project to
create value. This allows the management decision maker to evaluate the riskiness
of a proposed business combination and understand what factors can influence the
success of the merger or acquisition.
d. Examples of revenue-generation synergies from business combinations:
i. Selling more products through the companies’ existing sales channels
ii. Creating new products from technologies developed in the acquired
company
iii. Expanding into new geographic markets
iv. Extending a brand name to new products
e. Examples of cost-saving synergies from business combinations:
i. Closing facilities producing the same or similar products
ii. Reducing employee staff, such as sales teams or administration
iii. Consolidating information systems
iv. Greater centralization of processes and activities, such as accounting
centralized at a single corporate location
f. Businesses must evaluate a variety of quantitative and qualitative factors when
deciding whether to acquire or merge with another company.
g. Examples of quantitative factors to consider when evaluating a business
combination:
i. Increased revenue from new products or markets
ii. Increased margins from better pricing or lower costs of goods due to
quantity discounts
iii. Reduced costs from identifying duplicate departments or processes
iv. Increased return on assets because of decreased duplicate assets
h. Examples of qualitative factors to consider when evaluating a business
combination:
i. Strength of the management team
ii. Fit of the companies' cultures
iii. Brand strength
iv. Specialized expertise in a type of technology or in a business process

Summary
When considering a potential acquisition or merger a firm must evaluate whether it will generate
an appropriate return on investment. The discounted cash flow (DCF) method is often used to
evaluate whether a proposed combination will create value to the firm. What-if analyses are also
used to evaluate how revenues and expenses will change in the future depending on various
assumptions.

Topic 6.1 Fixed, Flexible, and Floating Exchange Rates

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I. Foreign Exchange Rates

a. Foreign exchange rates influence how firms will source and sell their goods and
services. Foreign exchange rates indicate how much of one currency can be
exchanged for one unit of another country's currency.
b. Foreign exchange rates may be fixed, flexible (floating), or managed floating.
i. A fixed exchange rate requires a country to maintain its currency at or
near a benchmark value, such as another country's currency, or the value
of a commodity, such as gold. The benefits of a fixed exchange rate
system include (1) governments cannot take actions to artificially expand
or contract their monetary supply, (2) no incentive to speculate in foreign
exchange rates, and (3) reduced uncertainty exists for businesses working
with foreign currencies.
ii. Flexible or floating exchange rates are set by market supply and demand
for currencies. Most of the world's major currencies are floating
currencies. The benefits from a floating exchange rate include (1)
governments have more freedom to dictate their monetary policies, (2)
trade balances can adjust more readily, allowing for a more flexible
system of trading goods and services, and (3) opportunity to profit off of
exchange rate fluctuations.
iii. A managed floating exchange rate system combines features of the fixed
and floating exchange rate systems. In such a system, governments can
intervene in markets when required, but market forces generally dictate
foreign currency exchange rates. For example, central banks, such as the
U.S. Federal Reserve, can purchase or sell currencies to adjust foreign
exchange rates. Managed floating exchange rates can help prevent or
mitigate economic turmoil from supply and demand; however, these
systems can lack clear rules and policies, which results in more volatile
exchange rates.
c. Factors that influence exchange rates include the following:
i. Inflation rates.
ii. Interest rates.
iii. Public debt—higher levels of debt will make a currency less valuable.
iv. Current account deficits—a negative current account will make a currency
less valuable.
v. Ratio of imports to exports, also called terms of trade or balance of trade.
vi. Political and economic stability.
d. A currency that is less valuable than the currency of the importing country will
make imports less expensive for the importing country. A country with a less
valuable currency will benefit more from exporting to other countries. Countries
with heavy importing activity will lose value in this scenario.
e. A currency that is more valuable than the currency of the importing country will
make importing less expensive for the home country. A country with a more
valuable currency will benefit more from importing from other countries.
Countries with heavy exporting activity will lose value in this scenario.

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Foreign Exchange Rate Example

Suppose a company buys steel for use in manufacturing its products. The price of steel per ton is
660 units of currency in Country A. Alternatively, the company can buy the same amount of
steel from a foreign country, Country B, at the price of 1,320 units of currency in Country B.
The foreign exchange rate between the two countries is 1-to-2.
Now suppose that the price of a ton of steel in the two countries remains the same, but the
foreign exchange rate has changed to be 1-to-1.8. The company will now be required to
exchange 733 units of Country A's currency in order to purchase a ton of steel.

1,320units of Country B's currency÷1.8=733units

Due to the change in the foreign exchange rate, the steel in country B is now more expensive.
Summary
Foreign currency exchange rates indicate how much of one currency can be exchanged for one
unit of another country's currency. Foreign exchange rates can be fixed, flexible (floating), or
managed floating and are influenced by a variety of factors. Companies with heavy exporting or
importing activity need to carefully evaluate foreign exchange rates when deciding which
countries to trade with.

Topic 6.2 Managing Transaction Exposure

I. Managing Transaction Exposure

a. Investors and firms have a variety of options to reduce risk exposure associated
with foreign currency exchange rates. The following instruments are used to
either fix an exchange rate for a transaction or exchange one currency exchange
rate for another.
i. Currency futures are contracts to fix a currency exchange rate at a given
date.
1. For example, an American company importing goods from Europe
may execute a currency futures contract to hedge, or reduce the
risk, against volatility of the euro. An American company could
enter into a futures contract to exchange a set amount of euros for
every U.S. dollar three months from the present date. The futures
contract allows the American company to forecast future cash
flows and financial statements because the futures contract fixes
the currency exchange rate.
ii. Currency swaps occur when two organizations contract to exchange or
“swap” different currencies and assume the foreign exchange risk
associated with the other party's home currency.
1. For example, assume that an American company and a European
company need to borrow funds in the other company's currency.

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However, the two companies may be able to borrow money at

lower rates in their home markets than they can borrow foreign
currency in the other market. A possible solution is for these
companies to borrow money from their local institutions and then
execute a currency swap of their two loans at a prevailing
exchange rate. The companies assume exchange risk in this
transaction, but benefit from lower interest payments on their
loans.
iii. Currency options give organizations the right, but not the obligation, to
buy or sell foreign currency at a contractually obligated price during the
option period.
1. Currency options differ from currency futures because futures
require the company to comply with the terms of the contract.
Options only give the party the right to execute the transaction.
Buyers of currency options pay a premium for the ability to
determine if the option is executed.

Example of Currency Swaps

This example shows how two organizations—one in the United States and one in Europe—can
execute a currency swap to minimize the interest expense associated with borrowing foreign
currency.

  Company A (USA—$) Company B (Europe—€)

Local interest rate 6% 8%
International borrowing interest 12% 10%
rate
USD/EUR exchange rate 1.12 1.12
Currency borrowed $100,000 €100,000
Currency assumed €100,000 $112,000
In this example, Company A will pay $6,000 of interest annually on $100,000. Company B will
pay €8,000 of interest annually on €100,000.
If the companies borrowed the foreign currency, Company A would pay $13,440 of interest
(€100,000 × 12% × 1.12 exchange rate). Company B would pay €8,928 ($100,000 × 10% ÷
1.12) of interest if it borrowed $100,000 as foreign currency. In the swap example, each
company pays less in interest but assumes the foreign exchange risk associated with the other
nation's currency.
Example of Currency Futures
Suppose that an American firm sells a piece of equipment to a European firm for €100,000. The
agreement is such that the European firm will pay for the equipment in 90 days when the
equipment is delivered. At the time of the sale, the exchange rate is €1 = $1.60.

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In order to limit their exposure to exchange rate risk, the American firm can enter into a forward
contract to exchange €1 for $1.58 in 90 days.
If in 90 days the exchange rate is €1 = $1.50, the American firm will benefit from the forward
contract by exchanging €100,000 for $158,000 even though the current exchange rate would
have yielded only $150,000.
If in 90 days the exchange rate is €1 = $1.65, the American firm would still exchange €100,000
for $158,000. The firm does not benefit from the increase in the exchange rate. The forward
contract provided certainty and reduced exchange rate risk, but also removed the potential upside
of the risk.
Reference
Parrino, R., Kidwell, D., and Bates, T. (2015). Fundamentals of Corporate Finance, 3rd Edition.
Hoboken, NJ: John Wiley & Sons, p. 686. ISBN: 978-1-118-84589-9.
Summary
Firms that transact in different currencies than their normal operations face exchange rate risk.
Currency swaps, currency options, and currency futures are a few strategies that investors and
firms use to minimize their exposure to exchange rate risk.

Topic 6.3 Financing International Trade

I. International Capital Budgeting

a. Capital investment projects that take place in international countries make the
determination of future cash flows more complicated. While the tools of capital
budgeting and valuation are similar (e.g., NPV, DCF, etc.), estimating future cash
flows is more difficult.
b. Foreign countries have different tax codes as well as different financial reporting
standards. Estimating the after-tax cash flows requires familiarity with these
systems that may lead firms to incur costs to hire consultants and tax experts.
c. Foreign governments often place restrictions on the amount of cash that can be
moved out of a country. These are commonly referred to as repatriation of
earnings restrictions. The restrictions are put in place by foreign governments to
limit the outflow of capital from their country. In terms of forecasting cash flows,
uncertainty about the limits and policies related to repatriation complicates the
accuracy of estimating future cash flows.
d. Estimating future cash flows in a foreign currency requires an estimate of future
exchange rates. As most major currencies are floating currencies, the current
exchange rate is not a reliable indicator of future exchange rates. Forecast future
exchange rates can be difficult due to the many factors that influence exchange
rates such as politics, inflation, monetary policies, and macroeconomic
conditions.

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e. The stability of a country's political environment is an important consideration

when evaluating foreign business activities. Politics can have a significant effect
on a firm's ability to estimate future cash flows. Foreign governments may change
tax laws, labor laws, tariffs, quotas, and repatriation laws. Practically speaking,
the more uncertainty about a country's political environment, the higher the
appropriate discount rate for capital budgeting purposes should be.
f. Despite the increased difficulty of estimating future cash flows on international
projects, there are significant benefits to international diversification.
II. International Bank Lending
a. Organizations depend on a variety of payment methods to pay for global trade.
These include:
i. Letters of credit are agreements sent from a lender to an exporter on behalf
of an importer guaranteeing the lender will accept a draft for payment
from the importer.
ii. Sight drafts are bills for imports payable upon receipt.
iii. Time drafts are bills that must be paid at a specific time or upon
completion of an obligated action.
iv. Consignment takes place when an exporter sends goods to be sold to an
importer. The importer will pay the exporter once the goods are sold.
v. Open accounts are similar to traditional accounts receivable and payable.
There is a risk of default by the buyer if the buyer does not pay according
to terms.
b. Additional financing methods for international trade:
i. Banker's acceptance letters are short-term financing instruments issued by
a firm and guaranteed by a financial institution. The letters are traded in
secondary markets. A party buying a banker's acceptance can present the
letter for payment at the bank issuing the letter.
ii. Foreign currency accounts can be maintained by a firm in order to pay
bills in that foreign currency.
iii. In countertrading (also known as bartering), goods and services are
exchanged instead of cash.
iv. In forfeiting, the purchaser pays for receivables from an exporter at a
discount for immediate cash. A forfeiting transaction usually includes
these features:
1. A credit period no shorter than 180 days
2. The possibility of settling the transaction in most major currencies
3. A letter of credit, promissory note, or other guarantee made by a
bank

Summary
Firms with international projects face various difficulties that might include any of the following:
different tax codes and financial reporting standards, restrictions on the amount of cash that can
be moved out of a country, forecasting the future exchange rates, and the unknown stability of a
country's political environment. Common methods of financing international trade include letters

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of credit, sight drafts, time drafts, consignment, open accounts, banker's acceptance letters,
foreign currency accounts, countertrading, and forfeiting.

Topic 6.4 Tax Implications of Transfer Pricing

I. Transfer Pricing
a. Transfer pricing is the price at which goods and services are charged when
divisions within the same company transact. Large firms often treat and measure
their divisions as separate entities, in which case the divisions can have economic
transactions with each other as with any customer or supplier. The difference
arises in that ultimately the financial statements are consolidated into one parent
company.
b. Transfer pricing is one of the most significant issues in international tax. When
transfer pricing is used across international borders, it can result in a firm
recording profits in a country with lower tax rates. While this practice of
strategically booking profits in countries with lower tax rates is common, it is
carefully scrutinized by tax authorities and auditors. Transfer prices are typically
set at normal market prices, or at arm's length. In the case that transfer prices are
underpriced or mispriced, it can shift revenues and expenses in illegal ways. Tax
authorities monitor firms engaged in transfer pricing to ensure they are engaging
in and recording arm's-length transactions.

Summary
When divisions within the same company transact, a transfer price must be charged. Tax
authorities monitor carefully to make sure that transfer pricing across international borders is
done at arm's-length transactions in order to avoid the shifting of revenues and expenses in
illegal ways.

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