HOCK CMA FlashCards P2 PDF

CMA Part 2 CMA Part 2
Section A: Financial Statement Analysis Section A: Financial Statement Analysis

Section A: Financial Statement
Analysis
What is the Who are

objective of external direct users of
financial reporting? financial information?
© 2010 HOCK international 1 © 2010 HOCK international 2

Who are the Who are

indirect users of internal users of
financial information? financial information?

What are some of the

Who are external users
reasons people need
of financial information?
financial information?

The objective of external financial reporting is to provide
Direct users are individuals who are directly affected by
people who need to make decisions with useful informa-
the results of a company. They include investors and
tion that they can use to make those decisions.
potential investors, employees, management and suppli-
ers and creditors. These are individuals who are at risk of
Rules and standards are in place to protect outside users
losing financially because of their relationship with the
by ensuring that the information is accurate, useful and
company.
understandable.
Internal users include:

1) Management and the board of directors, who require
financial information in order to control the business,
allocate its resources, evaluate its performance, and Indirect users are those people or entities that advise or
plan for its future; and represent direct users. They include financial analysts and
advisors, stock markets and regulatory exchanges.
2) Employees, who may use financial information to ne-
gotiate wages and benefits.
Internal users will have only direct interests.
External users are people who are outside the firm who
need information to make decisions about whether or not
to start, continue, or change their relationship to the firm.
Some of the reasons that people need financial informa-
They may have direct interests or indirect interests.
tion are:
External users with direct interests include present
1) Make investment decisions;
and potential investors who decide whether to purchase,
2) Extend credit or not; hold, or sell the stock; suppliers who need to determine
3) Assess areas of strength and weakness within the whether to do business with the firm; and creditors who
company; need to determine whether the company is in compliance
with loan covenants and make decisions about the exten-
4) Evaluate performance of management; or
sion of credit to the company.
5) Determine if the company is in compliance with regu-
External users with indirect interests include those
latory requirements.
people or entities that advise or represent direct users.
They include financial analysts and advisors, stock mar-
kets and regulatory exchanges.
What level of What are the

knowledge is a user five financial statements
of financial information in US GAAP that are used in
presumed to have? financial statement analysis?

Define the balance sheet,

including its purpose,
What is the purpose of notes
the nature of the accounts
to the financial statements?
included in it, and the theory
behind the balance sheet.

What are limitations Define current assets and

of the balance sheet? list six general examples.

In U.S. GAAP, there are five financial statements that are
used in financial statement analysis: Users of financial information are presumed to:
1) Balance Sheet (also called the Statement of Financial 1) Have a reasonable understanding of business and
Position) economic matters; and to
2) Income Statement 2) Have a willingness to study with reasonable dili-
gence the financial information that is presented.
3) Statement of Cash Flows
This distinction between users of financial information and
4) Statement of Comprehensive Income
others is a very important distinction.
5) Statement of Changes in Stockholders’ Equity
The balance sheet, also called a statement of finan-

cial position, provides information about an entity’s
assets, liabilities and owners’ equity as well as their rela-
tionships to each other at a point in time. The balance
sheet is a picture of what the company owns and owes at
a particular point in time (usually the end of a period). The notes to the financial statements are also con-
sidered an integral part of the financial statements, but
The balance sheet presents assets, liabilities and
are not an actual financial statement.
equity. It presents them in what is called the proprie-
tary theory. This means that net assets are viewed as
The purpose of the notes is to provide informative dis-
belonging to the owner or proprietor.
closures that are required by GAAP.
Balance sheet accounts are permanent accounts. They
are not closed out at the end of an accounting period but
rather, their balances are cumulative. They just keep on
accumulating transactions and changing with each trans-
action.
Current assets are assets that will be converted into Limitations of the balance sheet exist because it reports a
cash or sold or consumed within 12 months or within company’s financial position but not its value. The causes
one operating cycle if the operating cycle is longer of this issue include:
than 12 months. This means that an asset that will be 1) Many assets are not reported on the balance sheet,
converted in 18 months may be classified as a current even though they do have value and will generate
asset, but all assets that will be converted in less than 12 future cash flows (employees, processes, competitive
months will always be classified as current assets. advantages. etc).
Examples of current assets include: 2) Values of certain assets are measured at historical
1) Cash cost, not market value, replacement cost, or their
2) Cash equivalents value to the firm.
3) Inventories 3) Judgments and estimates are used in determining

many of the items reported in the balance sheet.
4) Receivables
4) Most liabilities are valued at the present value of cash
5) Short-term investments maturing in less than one flows at the date the liability was incurred, not at the
year present value of cash flows at the current market
6) Prepaid expenses interest rate.
Define current liabilities and

Define noncurrent assets and
list examples of commonly
list four general examples.
reported current liabilities.

Define noncurrent liabilities Define owner’s equity and

and list examples of list the three different
commonly reported categories of owner’s equity
noncurrent liabilities. for corporations.

Explain what the

income statement is, Define revenues and explain
including the time period the 5 primary methods
covered and the nature of of revenue recognition.
the accounts included therein.

Current liabilities are liabilities that will be settled within
one year or during the operating cycle if it is longer than
one year. They will require either the use of current assets
or the creation of other current liabilities to be settled.
Examples of current liabilities are: Noncurrent assets are those assets that will not be
1) Accounts payable converted into cash within one year or during the operat-
2) Trade notes payable ing cycle if the cycle is longer than one year.
3) Dividends payable
Examples of current assets include:
4) Unearned revenues
5) Obligations that, by their terms, are due on de- 1) Long-term investments and funds
mand, even if the “term” of the obligation is greater 2) Property, plant and equipment (fixed assets)
than one year
3) Intangible assets
6) Short-term (30-, 60-, 90-day, etc.) notes
7) Current portion of long-term debt 4) Other noncurrent assets (deferred tax assets, long-
Current liabilities do not include: term prepayments and receivables, etc)
1) Debts to be paid by funds that are in accounts classi-
fied as noncurrent
2) The parts of short-term obligations that are intended
to be refinanced by long-term obligations
Owner’s equity is the amount of the company’s assets

owned by and owed to the owners. If the company were Noncurrent liabilities are those liabilities that will not
to liquidate, this is the amount that would theoretically be be settled within one year or the operating cycle if the
distributable to the owners. operating cycle is longer than one year.
Owners’ equity for corporations is split into three different Examples of noncurrent liabilities are:
categories:
1) Long-term notes or bonds payable
1) Capital contributed by owners from the sale of
shares. 2) Liabilities from capital leases
2) Retained earnings - profits of the company that 3) Pension obligations

have not been distributed through dividends. 4) Deferred tax liabilities
3) Accumulated other comprehensive income items 5) Obligations under warranty agreements
- specific items that are not included in the income 6) Advances for long-term commitments to provide
statement but are included in equity and adjust the goods and services
balance of equity, even though they do not flow to
equity by means of the income statement as retained 7) Long-term deferred revenue
earnings do.
Revenues are inflows of assets or a reduction of

liabilities as a result of delivering goods or providing ser-
vices that are the entity’s main or central operations. The income statement is created using the accrual
Revenue is recognized using the following methods method of accounting and applying this method to histor-
depending upon the circumstances: ical transactions.
1) Revenues are usually recognized when the earnings
The income statement gives the results of operations for a
process (the provision of goods or services to the
period of time and is like a movie recording the events
customer) is complete and an exchange has
of the business for that period of time. This is in contrast
taken place. The exchange does not need to include
to the balance sheet, which provides information as of
cash, but may include a promise to pay in the future
one moment in time.
(a receivable).
2) Percentage-of-completion – for long-term con- The accounts that are used to record revenues, expenses,
tracts. gains and losses are temporary accounts. This means that
3) Production basis – for agricultural products and pre- they are closed to a permanent account (retained
cious metals. earnings) at the end of each period (fiscal year), and so at
4) Installment basis – used when we are not certain of the start of each period, the balance in the income state-
the collectability of the account. ment accounts is 0.
5) Cost-recovery basis – used there is uncertainty
about cash collection.
Define expenses and explain

Define gains in the
the three primary methods
income statement.
of expense recognition.

Define losses in the What are limitations of

income statement. the income statement?

What are the three main

What is the purpose of the categories of activities
Statement of Cash Flows (SCF)? that are presented in the
Statement of Cash Flows?

Expenses are outflows of assets or the incurrence of lia-
bilities as a result of delivering goods or providing services
that are the entity’s main or central operations.
Gains are increases in equity as a result of transactions
that are not part of the company’s main or central opera- Expenses are recognized based upon one of the following
tions and that do not result from revenues or investments three methods:
by the owners of the entity. 1) Cause and effect – cost of goods sold are recognized
when the item is sold.
Gains can be classified as either operating or non-oper- 2) Systematic and rational allocation – such as depre-
ating, depending on the events they are related to. ciation.
3) Immediate recognition – if an expense will not
provide future benefit, it is immediately recognized.
Most of the limitations of the income statement are

caused by its periodic nature. At any particular financial
statement date, buying and selling will be in process and
some transactions will be incomplete. Therefore, net
income for a period involves estimates, and these esti-
mates affect the company’s performance for the period.
Other limitations that reduce the usefulness of the income Losses are decreases in equity as a result of transactions
statement for predicting amounts, timing and uncertainty that are not part of the company’s main or central opera-
of cash flows include: tions and that do not result from expenses or distributions
1) Net income is an estimate that reflects a number of made to owners of the entity.
assumptions.
Losses can be classified as either operating or non-op-
2) Income numbers are affected by the accounting
erating, depending on the events they are related to.
methods employed.
3) Income measurement involves judgment.
4) Items that cannot be measured reliably are not
reported in the income statement.
5) Only events that produce reportable revenues and
expenses are included.
The primary purpose of the SCF is to provide informa-

tion regarding receipts and uses of cash for the com-
pany during a period of time so that users of the financial
statements are able to assess:
1) The ability of the company to generate positive
The three main categories of activities in the State-
future cash flows and meet obligations as they
ment of Cash Flows are:
come due;
1) Operating activities
2) The reasons for differences between net income
2) Investing activities and net cash receipts and payments;
3) Financing activities 3) The liquidity, solvency and financial flexibility of
the company;
4) The effect of investing and financing transac-
tions on the company’s financial position; and
5) The company’s need for external financing.
Explain what types of activities Explain what types of activities

are included as are included as
operating activities in the investing activities in the
Statement of Cash Flows. Statement of Cash Flows.

Explain what types of activities What are the

are included as two methods to prepare the
financing activities in the Statement of Cash Flows and
Statement of Cash Flows. how do they differ?

Describe the Describe the

direct method for the indirect method for the
Statement of Cash Flows. Statement of Cash Flows.

Any item that is not classified as an investing or fi-
nancing activity is an operating activity:
1) Operating activities are generally part of the com-
pany’s main business activities.
Investing activities are those activities that the com-
pany undertakes to generate a future profit or return. 2) They generate revenues and expenses.
Transactions that cause gains or losses are generally not
Events that are investing activities are:
considered operating activities.
1) Purchasing and selling fixed assets. The following specific items are classified as operating
2) Making and collecting loans to other parties. activities:
3) Acquiring and disposing of stock of other compa- 1) Interest paid on bonds and other debt (loans,
nies. leases, mortgages, etc.).
4) Acquiring and disposing of debt instruments. 2) Interest received and dividends received from
debt and equity investments.
5) Acquiring and disposing of available-for-sale or
3) Cash paid for taxes and cash received back as a tax
held-to-maturity securities.
refund.
4) Cash flows from the purchase, sale and maturity of
trading securities usually will be classified as oper-
ating activities, not investing activities.
Financing activities are activities to raise capital to fi-

nance the business.
Events considered financing activities include:
The two methods to prepare the statement of cash flows
are the direct method and the indirect method. Both 1) Issuance of stock.
are acceptable under U.S. GAAP, and a company can 2) Treasury stock transactions.
choose the method it uses. However, it must use the same 3) Paying dividends (Note that dividends paid are fin-
one from one period to the next (this is consistency). ancing activities, but dividends received are operat-
The two different methods differ only in the presenta- ing activities.).
tion of the operating activities section. 4) Issuing debt (bonds).
The investing and financing activity sections are prepared 5) Obtaining and repaying a loan.
in the same manner and look exactly the same under both 6) Repayment of debt obligations – This includes the
methods of preparation. principal amount of a lease or mortgage for fixed
assets (interest on leases is included in operating
Despite this difference in presentation, the end total of activities).
cash flows from operating activities will be the same under
Normally, cash flows from taxes paid and received are
each method.
classified as operating activities. But cash flows relating to
income tax expense associated with share-based com-
pensation are classified as financing activities.
The direct method shows each item that affected cash

flow, such as cash collected from customers.
Under the indirect method to prepare the SCF, we make Each item is calculated by starting with the relevant
all of the adjustments to net income from the income item on the income statement (i.e., sales revenue for
statement. cash collected from customers) and adjusting it using
the balances in the relevant balance sheet ac-
The adjustments that are made will be the same as they count(s) at the beginning of the period and at the end of
are for the direct method: adjustments for changes in bal- the period covered by the income statement (i.e., ac-
ance sheet accounts and the elimination of noncash and counts receivable for cash from customers).
non-operating activity transactions. We also make adjustments to each individual line to
Both SCF methods result in the same cash from operating take out noncash (depreciation) activity and non-op-
activities. Only the approach differs: erating activity transactions (such as the gain on the
1) Under the direct method, each individual line in the sale of fixed assets).
income statement is adjusted. Both SCF methods result in the same cash from operating
activities. Only the approach differs:
2) Under the indirect method, the net income figure is 1) Under the direct method, each individual line in the
adjusted. income statement is adjusted.
2) Under the indirect method, the net income figure is
adjusted.
Define comprehensive income

What are limitations of the and explain how this
Statement of Cash Flows? activity is reported in
the financial statements.

What are the

Describe the Statement of
four types of transactions
Changes in Stockholder’s
that are currently defined as
Equity and how it is
other comprehensive
generally used by companies.
income items?

What are
What are
vertical common size and
five general limitations
horizontal trend financial
of financial statements?
statements?

Comprehensive income includes all transactions of the
company except for those transactions that are The primary limitation of the SCF is that it should be inter-
made with the owners of the company (such as dis- preted together with the other financial statements, espe-
tribution of dividends or share sales). cially the balance sheet.
Comprehensive income is the change in equity (net The SCF does not show that, for example, a positive oper-
assets) of an entity during a period from transactions and ating cash flow was achieved by lengthening the time pay-
other events and circumstances from non-owner sources. ables remained outstanding, i.e., by not paying the
Comprehensive income includes everything on the income payables when due. That is important information for the
statement plus some things that do not appear on the interpretation of the statement of cash flows and for ana-
income statement. Therefore, it is more inclusive than tra- lyzing the company financial condition.
ditional net income. These items are not included in net The indirect method has an additional limitation. It does
income but they are included in comprehensive income. not show the sources and uses of operating cash individu-
Accumulated Other Comprehensive Income is a line ally but shows only adjustments to accrual-basis net
in the equity section of the balance sheet which includes income. This approach could cause difficulty to understand
these items that are not reflected on the income state- the information presented.
ment.
The items that are considered other comprehensive

The Statement of Changes in Stockholders’ Equity income items are expressly stated in the standards.
reports the changes in each stockholder’s equity account The four items currently in this group include:
and in total stockholders’ equity during the year. It also
1) Foreign currency translation adjustments,
reconciles the beginning balance in each account with the
ending balance. 2) Gains or losses and prior service costs or credits
related to a defined benefit pension plan that have not
Since stockholders’ equity accounts are permanent
been recognized as components of net periodic benefit
accounts that keep on accumulating their balances from
cost,
year to year, information about the sources of changes in
the separate accounts is required to make the financial 3) Unrealized holding gains or losses on avail-
statements sufficiently informative. able-for-sale securities, and
Most companies use the Statement of Changes in Stock- 4) The effective portion of the gain or loss on a derivative
holders’ Equity approach to provide the required informa- designated as a cash flow hedge.
tion about the components of Accumulated Other These four items may be shown as either net of tax or not
Comprehensive Income. net of tax. However, if they are not shown net of tax, the
tax effects of these items must be disclosed separately.
Limitations of financial statements include:

1) Measurements are made in terms of money. Quali-
tative aspects of a firm are not included.
A simple vertical common-size financial statement cov-
2) Information supplied by financial reporting involves
ers one year’s operating results and expresses each com-
estimation, classification, summarization, judg-
ponent as a percentage of a total. This means that fixed
ment, and allocation.
assets will not be stated as a dollar amount, but may be
3) Financial statements primarily reflect transactions that
stated as a percentage of total assets.
have already occurred; many aspects are based
on historical cost.
Horizontal trend analysis is used to evaluate trends over
a period of several years for a single business. The first 4) Only transactions from the entity being reported
year is the base year, and amounts for subsequent years upon are reflected in their financial reports. However,
are presented not as dollar amounts but as percentages of transactions of other entities (competitors, etc) may
the base year amount, with the base year assigned a be very important.
value of 100%, or 100. Also called index number trend 5) Financial statements are based on the going-con-
series analysis. cern assumption. If that assumption is invalid, the
appropriate attribute for measuring financial state-
ment items is liquidation value, not historical
cost, fair value, net realizable value, etc.
List and explain the

What do
five main types of financial
liquidity ratios
ratios used to perform
measure?
financial statement analysis.

What is the
What is
current ratio and
net working capital?
how is it calculated?

What is the What is the

quick ratio and cash ratio and
how is it calculated? how is it calculated?

Financial ratios are classified into five different categories
Liquidity reflects the ability of a firm to meet its short-
based upon what they are measuring:
term obligations using its assets that are most readily
1) Liquidity ratios - the ability of the firm’s cash re-
converted into cash.
sources to meet its short-term cash obligations.
Assets convertible into cash within a short time period are 2) Leverage, or capital structure and solvency
called liquid assets. They are identified in financial state- ratios - the firm’s ability to satisfy its longer-term
ments as current assets. debt and investment obligations by looking at the mix
Current assets may also be referred to as working cap- of its financing sources.
ital since they represent the resources needed for the 3) Activity ratios - a firm's ability to manage its current
day-to-day operations of the firm's long-term, capital assets (accounts receivable and inventory) and cur-
investments. rent liabilities (accounts payable) efficiently.
4) Profitability analysis - measures the firm’s profit in
A company needs short-term assets to finance its short-
relation to total revenue, or the amount of net
term obligations for daily operations. A company should
income from each dollar of sales and its return on
maintain a level of short-term assets sufficient to pay its
invested assets.
current obligations. However, at the same time the com-
5) Market ratios and earnings per share analysis,
pany does not want to have too much invested in short-
or shareholder ratios, which describe the firm’s fi-
term assets because these assets do not provide any
nancial condition in terms of amounts per share of
return on investment.
stock.
Net working capital is calculated as the difference

The current ratio is the most commonly used measure of
between current assets and current liabilities.
short-term liquidity, as it relates current assets to the
claims of short-term creditors. Whereas net working cap- A company’s working capital bridges the gap between the
ital expresses this relationship as a net dollar amount, the production process and the collection of cash from the
current ratio expresses the relationship as a ratio. The sale of the item. The
current ratio is calculated as: amount of liquidity a company needs depends upon the
Current Assets length of its operating cycle. The operating cycle is the
Current Liabilities period from the time cash is committed for investment in
goods and services (the purchase of inventory, not the
Companies with an aggressive financing policy will have
payment for inventory) to the time that cash is received
lower current ratios, and conservative financing policies
from the investment (from the collection on the sale of the
result in higher current ratios.
inventory).
The cash ratio is another derivation of the current ratio,

but it is even more conservative than the quick ratio. It
measures the ratio between cash and current liabilities. The quick ratio is a more conservative version of the cur-
However, in this measure of cash we include cash equiva- rent ratio. The quick ratio measures the firm’s ability to
lents and short-term securities. It is calculated as: pay its short-term debts using its most liquid assets.
Cash + Cash Equivalents + Short-Term Securities Owned Inventory is not included in this calculation because if a
Current Liabilities company uses inventory to pay its liabilities, then there
will be no way for the company to generate future cash
Cash equivalents are very liquid, short-term debt instru- flows. Therefore, inventory should not be used to pay off
ments with a maturity date of less than 90 days when they short-term liabilities.
were acquired. These represent the short-term investments
a company makes to invest excess cash for short periods The quick ratio is calculated as:
until it is needed. Short-term securities may be classified Cash
on the balance sheet as available-for-sale, held-to-ma- + Cash Equivalents
turity, or trading securities, depending upon manage- + Net Receivables
ment’s intentions, as long as they are convertible to cash + Short-term Securities
within one year or the operating cycle, whichever is longer. ÷ Current Liabilities
These additional items are included because they are very,
very close to being converted into cash.

cash flow ratio and net working capital ratio
how is it calculated? and how is it calculated?

What is meant by What is

liquidity of current liabilities? capital structure?

What is What is
solvency? financial leverage?

The net working capital ratio compares net liquid
assets (net working capital) to total capitalization (total
assets). It measures the firm’s ability to meet its obliga- The cash flow ratio measures how many times greater
tions and expand by maintaining sufficient working cap- than the current liabilities the cash flow generated by
ital. operations is. If a company has positive working capital
This ratio is particularly meaningful: but it is not generating enough cash from operations to
1) when compared with the same ratio in previous years. settle its obligations as they become due, it means the
Consistent operating losses will cause net working company is borrowing to settle current liabilities. Over the
capital to shrink relative to total assets. long term, this will lead to solvency problems, because
2) If net liquid assets are shrinking over time relative to there is a limit to how much financing can be obtained.
total assets, this is a valuable indicator of possible Therefore, it is much better if the company can generate
future business failure. adequate cash flow from its operations to settle its current
3) If working capital is negative, this ratio will also be liabilities.
negative. A negative net working capital ratio is a sign It is calculated as follows:
of serious problems.
Annual Cash Flows from Operations
The ratio is calculated as follows: Average Current Liabilities
Net Working Capital
Total Assets
The term liquidity of current liabilities refers to the

quality of current liabilities, which includes:
1) How urgent is the payment of the current liabilities?
Tax liabilities must be paid when due, no matter what
Capital structure is how a firm chooses to finance its else has to be paid, and thus they have top priority.
business. This is the debt-equity question. Should the Payroll liabilities also have a priority claim on cash
company obtain financing by issuing debt (bonds) or inflows. Liabilities to suppliers with whom there is a
equity (shares)? Or if both, in what proportion? long-standing relationship may have more latitude
and can sometimes be delayed.
Equity represents ownership, and it does not need to be
repaid. Debt must be repaid, either as interest and prin- 2) There can be unrecorded liabilities that have a
cipal paid together or interest only with the principal due claim on current funds.
at the maturity date. 3) A violation of loan covenants constitutes a default
and as such, renders a long-term debt due and pay-
able immediately. Failure to remain current with
loan payment obligations is also a default that
renders long-term debt currently due and payable.
Financial leverage is the use of debt to increase earnings. Solvency is the ability of the company to pay its long-
The expense of using debt to finance operations is inter- term obligations as they come due. As liquidity is the abil-
est. Interest is a fixed charge because unlike dividends, ity to pay short-term obligations, solvency is the ability to
interest must be paid whether the firm is profitable or not. pay long-term obligations.
The use of financing that carries a fixed charge is called
financial leverage. The composition of a company’s capital structure is an
important part of solvency analysis. In addition to capital
Financial leverage is a part of solvency analysis. Financial structure, solvency depends upon successful operations,
leverage magnifies the effect of both managerial success since profits are the source of interest and principal pay-
(profits) and failure (losses). When financial leverage is ments. Therefore, solvency analysis also involves analysis
being used, an increase in Earnings Before Interest and of earnings and the ability of those earnings to cover
Taxes (EBIT) will cause an even greater increase in net necessary company expenditures, including the required
income, and vice versa. debt service.
How is the
What are the advantages
financial leverage
of financial leverage?
ratio calculated?

Define trading on equity and

What is the degree of
explain the situations where
financial leverage and
this financial strategy
may not be successful.

How is the
What is
degree of operating
operating leverage?
leverage calculated?

The financial leverage ratio is calculated as follows:
Total Assets
Common Equity
Common equity is total equity minus preferred stock The advantages of financial leverage are:
minus any minority interest. 1) If the interest expense paid on the debt capital is less
This ratio indicates the amount of leverage (use of debt) than the return earned from the investment of the
that a firm has, and therefore also the amount of risk that debt capital (or less than Return on Assets), the ex-
the company has. The more debt the company has, cess return benefits the equity investors.
the higher this ratio will be. As a company increases 2) Interest is tax-deductible, which effectively reduces it
its debt, it is incurring more fixed charges of interest that as an expense.
must be paid. The more fixed charges, the less income
will be available for distribution and also the higher the
risk that the company will not be able to service its debt
and will default on it.
Trading on the equity means that the company is using

financial leverage in an effort to achieve increased returns.
Another measure of financial leverage is degree of fi- Trading on the equity may or may not be successful:
nancial leverage. The degree of financial leverage is the
factor by which net income changes when compared to a 1) If a leveraged company’s Return on Assets is greater
change in earnings before interest and tax, since interest than its after-tax cost of debt (Return on Common
on debt is a fixed expense. Equity is higher), it is said to be successfully trad-
ing on the equity. Common shareholders will bene-
Degree of financial leverage can be calculated in two fit.
ways:
2) If a leveraged company’s Return on Assets is less
% Change in Net Income than its after-tax cost of debt, it is said to be unsuc-
% Change in Earnings Before Interest and Taxes cessfully trading on the equity. Common sharehold-
ers will be hurt.
or
Remember that “trading on the equity” is only a term that
Earnings Before Interest and Taxes is used to mean that a company is borrowing money to
Earnings Before Taxes invest. Goal is that the investment will earn a greater
return than the company is paying in interest, so that the
company is making money by borrowing.
Just as financial leverage uses debt financing and the fixed

expense of interest to generate greater returns for equity
investors, operating leverage uses all fixed expenses to
generate greater returns for equity investors. Operating
Like degree of financial leverage, degree of operating lev- leverage is the percentage of a company’s total expenses
erage can be calculated two ways: that is represented by fixed expenses. Higher fixed ex-
% Change in Operating Income penses as a proportion of total expenses results in higher
% Change in Sales operating leverage.
or Until a company’s contribution margin (sales minus all

Contribution Margin variable expenses) is adequate to cover its fixed
Operating Income expenses, the company will operate unprofitably. Once
fixed expenses are covered, increases in the contribution
margin as a result of increases in sales flow straight to the
bottom line, dollar for dollar. This magnifies the effect that
increased sales has on profits.
What is the total debt to How is the debt to

total capital ratio and equity ratio calculated and
how is it calculated? what does it measure?

What is the long-term debt What is the fixed assets

to equity ratio and to equity capital ratio and
how is it calculated? how is it calculated?

What is the net tangible

What is the total liabilities
assets to long-term debt
to net tangible assets ratio
ratio and how is it
and how is it calculated?
calculated?

The total debt to total capital ratio is calculated:
Current Liabilities + Long-Term Liabilities
Total Liabilities + Total Equity
The debt to equity ratio is calculated:
Here, total capital is defined as the total of liabilities plus
Total Liabilities
capital, or in other words, the same thing as total assets.
Total Equity
The Total Debt to Total Capital Ratio measures the propor-
In the Debt to Equity ratio, total liabilities is all liabilities, tion of the company’s total assets that are financed by
while total equity consists of all stockholders’ equity in- creditors and thus the firm’s long-term debt payment abil-
cluding preferred equity. This ratio is a comparison of how ity. Creditors would like this ratio to be as low as possible
much of the financing of assets comes from creditors and because it indicates a lower chance of default on the
how much comes from owners, in the form of equity. interest payments that the company will owe. Therefore,
the higher this ratio is, the higher the company’s cost of
debt will be, because creditors will demand compensation
for the increased risk they are bearing.
The fixed assets to equity capital ratio measures the In the long-term debt ratio, the debt figure used is
relationship between fixed assets and equity. It indicates long-term debt only. Current liabilities, including current
the proportion of equity that is committed to fixed assets maturities of long-term debt, are excluded.
and thus is not available for operating funds. A ratio below
This ratio measures how much long-term debt a company
1.00 indicates a favorable liquidity position. Alternatively,
has compared to its total equity.
if this ratio is greater than 1.00, this means that not only
is all of the equity committed to fixed assets, but debt has A ratio in excess of 1:1 indicates more reliance on long-
been used to finance some of the firm’s assets. term debt financing than on equity financing.
It is calculated as follows: The ratio is calculated as follows:
Net Fixed Assets Total Debt ! Current Liabilities

Total Equity Total Equity
The net tangible assets to long-term debt ratio

measures the coverage provided by assets for the com-
pany’s long-term obligations. By including only net
The total liabilities to net tangible assets ratio is tangible assets, the numerator in this ratio excludes
another means of measuring the relationship between a intangible assets that may have questionable liquidation
company’s debt and its investment in operating assets. values. Net working capital is included in net tangible as-
It is calculated as follows: sets. The ratio assumes that the tangible assets have liq-
uidation values equal to their net book values, which may
Total Liabilities not be the case.
Total Assets - Intangible Assets - Total Liabilities
It is calculated as follows:
Total Assets ! Intangible Assets ! Total Liabilities
Long-term Debt
What is What is the earnings to

times interest earned fixed charges ratio and
and how is it calculated? how is it calculated?

What is the
What is cash flow
accounts receivable
to fixed charges and
turnover ratio and

How is the What is the

number of days of sales inventory turnover ratio
in receivables calculated? and how is it calculated?

The fixed charge coverage ratio, also called the earn-
ings to fixed charges ratio, includes all fixed charges,
including operating lease obligations. It is calculated as:
Earnings Before Fixed Charges and Taxes
Fixed Charges The times interest earned ratio, also called tht interest
Fixed Charges include all contractually committed interest coverage ratio, compares the funds available to pay
and principal payments on both leases and debt. interest (i.e., earnings before interest and taxes) with the
amount of interest expense on the income statement. This
The numerator, Earnings Before Fixed Charges, is calcu- ratio gives an indication of how much the company has
lated as: available for the payment of its fixed interest expense.
EBIT (Earnings Before Interest and Taxes)
+ Add back operating lease payments expensed
= Earnings Before Fixed Charges and Taxes Earnings Before Interest and Taxes
Interest Expense
The denominator, Fixed Charges, is calculated:
Interest expense on loans and capital leases
+ Principal payments on loans and capital leases
+ Total payments on operating leases
= Total Fixed Charges
The cash flow to fixed charges ratio shows how much

operating cash flow the company has to pay contractual
obligations. It is calculated:
Adjusted Operating Cash Flow
The accounts receivable turnover ratio is used to Fixed Charges
measure the number of times receivables “turn over” dur- The numerator, adjusted operating cash flows, is:
ing a year’s time. Thus, it tracks the efficiency of a firm’s Cash flow from operations
accounts receivable collections and indicates the amount + Fixed Charges
of investment in receivables that is needed to maintain + Tax Payments
the firm’s level of sales. = Adjusted Operating Cash Flow
It is calculated as follows: Fixed charges that decrease operating cash flow are
added back. Fixed charges that do not decrease operat-
Net Annualized Credit Sales
ing cash flow are not added back. The denominator, Fixed
Average Accounts Receivable
Charges, is calculated:
Interest expense on loans and capital leases
+ Principal payments on loans and capital leases
+ Total payments on operating leases
= Total Fixed Charges
The inventory turnover ratio calculates how many

times during the year the company sells its average level The days of sales in receivables is another measure of
of inventory. the how efficiently the company is collecting its accounts
It is calculated as follows: receivable. It tells us how many days an average receiv-
able is held before it is collected.
Annualized Cost of Sales
Average Inventory
If a company has a high inventory turnover ratio, it can 365, 360 or 300
mean the company is using good inventory management Receivables Turnover
and is not holding excessive amounts of inventories. How- or
ever, it can also mean that the company is not holding
enough inventory and is losing sales if prospective cus- Average Accounts Receivable
tomers are unable to make purchases because items are Average Daily Sales
out of stock.
How is the number

Define the operating cycle
of days of sales in
and the cash cycle.
inventory calculated?

What is the
How is the number
accounts payable
of days of purchases
turnover ratio and
in payables calculated?


total asset turnover ratio fixed asset turnover ratio
and how is it calculated? and how is it calculated?

The days of sales in inventory is another measurement
of the efficiency of inventory management. This ratio cal-
The operating cycle of a company is the amount of time culates the number of days that the average inventory
between the acquisition of inventory and the receipt of item remains in stock before it is sold. This number should
cash from the sale of the product. This is slightly different be low but not too low, because if it is too low, the com-
from the cash cycle. pany risks lost sales by not having enough inventory on
hand.
The cash cycle, or net operating cycle, is the length of It is calculated as follows:
time it takes to convert an investment of cash in inventory
back into cash, recognizing that some purchases are 365, 360 or 300
made on credit. Thus, the cash cycle is the time between Inventory Turnover
the payment for the inventory and the receipt of cash
or
from the sale of the inventory.
Average Inventory
Average Daily Cost of Sales
The accounts payable turnover ratio represents the

number of times payables “turn over” during a year’s
time.
Note that the numerator of this ratio represents a full
year’s credit purchases. If the period being analyzed is for
The days of purchases in payables is calculated as fol- less than one year, the amount of credit purchases should
lows: be annualized (i.e., one quarter’s credit purchases should
be multiplied by 4, and so forth).
Average Accounts Payable
Average Daily Purchases If this ratio is decreasing over time, it is an indication that
the company is paying its payables more slowly. This
could indicate liquidity problems.
The ratio is calculated as follows:
Annual Credit Purchases
Average Accounts Payable
The total asset turnover ratio is an overall activity

The fixed asset turnover ratio measures the amount of
ratio. It relates total sales to total assets.
sales revenue the company is generating from the use of
its fixed assets. The total asset turnover ratio measures the amount of
sales revenue the company is generating from the use of
Since this ratio relates an income statement item to a bal-
all of its assets. It provides a means to measure the over-
ance sheet item, the denominator (the Assets amount)
all efficiency of the company’s use of all of its investments,
should be an average for the same period represented by
as represented by both short-term assets and long-term
the sales amount.
assets.
This ratio is calculated as follows:
Sales
Sales
Average Net Plant, Property and Equipment
Average Total Assets
What is the
How is gross operating profit margin
profit margin calculated? percentage ratio


net profit margin EBITDA margin
percentage ratio percentage ratio

How do you calculate How is the

return on assets and return on common
what does this ratio measure? equity calculated?

The operating profit margin percentage measures
how much of the sales revenue that the firm keeps as
operating income.
Operating income includes revenues and expenses of the
company’s principal operations and related income taxes. Gross profit margin is revenues less cost of goods sold.
It does not include revenues and expenses that result It is frequently reported as a percentage, or ratio.
from secondary or auxiliary activities of the company or
gains and losses that are infrequent or unusual. It also It is calculated as follows:
does not include gains or losses from discontinued opera- Net Sales - Cost of Goods Sold
tions or extraordinary items or income tax expense on Net Sales
these other activities.
The Operating Profit Margin Percentage is calculated as:
Operating Income
Net Sales
EBITDA (Earnings Before Interest, Taxes, Depreci-

ation and Amortization) is calculated by taking op-
The net profit margin percentage ratio measures how
erating income before taxes (EBIT) and adding back
much of the sales that the firm keeps as net income.
depreciation and amortization expenses.
Net income includes revenues and expenses of the com-
EBITDA is used to analyze a company's operating profit-
pany from all sources (except for comprehensive income
ability before non-operating expenses such as interest and
items, which are reported directly in equity).
other non-core operating expenses and before non-cash
charges such as depreciation and amortization. The net profit margin percentage is calculated as:
The EBITDA Margin Percentage is calculated as: Net Income
Net Sales
EBITDA
Net Sales
The formula for return on assets is:

Net Income
The return on common equity is calculated as follows: Average Total Assets
Net Income ! Preferred Dividends This ratio essentially measures how much return the com-
Average Common Equity pany receives on the capital it has invested in assets. The
higher this ratio, the better, or more effectively, the com-
pany is using its assets.
What are examples of the

What is the
limitations of the book
book value per share ratio
value per share ratio
as a financial valuation tool?


market to book ratio price/earnings ratio

What is included in the What is the time period

income available to to include in the earnings
common shareholders (IAC) per share calculation
for the earnings per share for the 4 main types
calculations? of share transactions?

Book value per share has limitations as a valuation
tool because it is affected by valuation measures that are
The book value per share ratio is total assets minus all
based on GAAP:
liabilities and claims of securities that are senior to the
1) GAAP’s definition of what constitutes an asset or a common stock, such as preferred stock, divided by the
liability may not coincide with economic reality. number of common shares outstanding.
2) Assets may be recorded at historical cost rather
than current market value. Claims that are senior to the common stock can include
3) Book values of fixed assets are impacted by accu- more than preferred stock. They can include claims that
mulated depreciation, which is subject to esti- are not recorded on the balance sheet, such as cumulative
mations of useful life and choice of depreciation preferred dividends in arrears, liquidation premiums
methods. (additional amounts that would need to be paid to retire
4) Intangible assets such as goodwill may be of preferred stock), or any other asset preferences that
uncertain value. preferred shares are entitled to.
5) The assets and corresponding liabilities for off-bal- The ratio is calculated as follows:
ance sheet activities such as operating leases are
not included. Common Stockholders’ Equity –
Thus, a firm’s book value and book value per share do not Senior Claims Not on Balance Sheet
Number of Common Shares Outstanding
equal its market value and market value per share, nor do
they equal the fair value of the firm’s net assets.
The market to book ratio is calculated as follows:

The P/E Ratio gives an indication of what shareholders
Market Price of a Share
are paying for continuing earnings per share. Investors
Book Value of a Share
view it as an indication of what the market considers to be
the firm’s future earning power. This ratio should be greater than 1.0 for the simple fact
It is calculated as follows: that the market value of the share takes into account fair
market value, while the book value of the share takes into
Market Price of a Share account only the book value. Given that assets that
Diluted Earnings Per Share appreciate in value are not written up in the accounting
The P/E ratio is greatly influenced by where a company is books, the fair market value of a share should be more
in its cycle. A company in a growth stage will usually have than the book value of a share.
a high P/E ratio because of the market’s expectations of The market/book ratio will be higher if the market expects
future profits. Companies with low growth generally have abnormally high earnings in the future; and it will be
lower P/E ratios. lower if the market expects abnormally low earnings in
the future.
The time period to include in the earnings per share

calculation for the 4 main types of share transactions
are:
1) Shares issued during the year (It does not matter
Income available to shareholders is the amount of
if the shares are previously unissued shares or treas-
earnings that was available for distribution to common
ury shares): only the time period they are outstanding
shareholders.
after being issued.
2) Shares reacquired by the company during the
year: only the time period before they are reac- Net Income
quired. ! Noncumulative preferred dividends declared
! Cumulative preferred dividends earned
3) Shares issued as a part of a stock split: The en-
= Income Available for Common Shareholders
tire year – and all prior periods presented as a com-
parative.
4) Shares issued as a stock dividend: the entire year
– and all prior periods presented as a comparative.
What is What are the 5 steps

Basic Earnings Per Share to calculate the
and how is it calculated? diluted earnings per share?

What is the formula for

What is the formula
calculating the
for calculating the
earnings per share effect
earnings per share effect
of convertible
of convertible bonds?
preferred shares?

What is What is the

Diluted Earnings Per Share earnings yield and
and how is it calculated? how is it calculated?

The calculation of diluted earnings per share requires
the following steps:
1) Calculate basic earnings per share.
2) Calculate the impact of warrants and options and add Basic EPS is the Earnings Per Share for all common
the result to the basic earnings per share. shares that were outstanding during the period.
3) Calculate the earnings per share effect of any convert-
ible bonds or convertible preferred shares. Income Available to Common Shareholders
Weighted Avg. Number Common Shares Outstanding
4) Add any dilutive convertible bonds or convertible pre-
ferred shares to calculate the intermediate diluted
earnings per share.
5) Calculate the final diluted earnings per share.
The earnings per share effect of convertible pre- The earnings per share effect of convertible bonds is
ferred shares is calculated as follows: calculated as follows:
Dividends Earned (cumulative) or Declared (noncumulative) Interest on the Bonds " (1 – Tax Rate)
# of Common Shares the Preferred Shares are Converted Into # of Shares the Bonds are Converted into
Diluted EPS is the Earnings Per Share that would have

resulted if all potentially issuable common shares that
The earnings yield measures the income-producing would be dilutive (i.e., would cause a reduction in the
power of one share of common stock at the current price. earnings per share) had been issued on the first day of
It is the inverse of the P/E Ratio. the period.
Diluted Earnings Per Share To calculate Diluted EPS, begin with Basic EPS. Adjust the
Current Market Price of a Share numerator and the denominator for the effects of all out-
standing securities that could potentially be converted into
common stock and that, if converted, would be dilutive.

dividend yield and dividend payout ratio
how is it calculated? and how is it calculated?

How is the
What is the
Dupont Equation
ratio for shareholder return
for return on assets
calculated?

How is the
What is the
Dupont Equation for
sustainable equity growth rate
return on equity
calculated?

The dividend payout ratio measures the proportion of The dividend yield measures how much of the market
earnings paid out as dividends to common stockholders. price was paid in dividends. Thus, it is the cash return
Generally, a new company or a company that is growing received by a shareholder on one share of stock, based on
will have a low or no dividend payout, because it is retain- the stock’s current price and current dividend. If the com-
ing earnings in the company to finance its growth. pany keeps the dividend payout low in order to retain
The dividend payout ratio can be calculated either on a profits in the company for future growth, the dividend
per share basis or on a whole company basis: yield will be low. If the company is able to invest the
retained earnings profitability, the price of the company’s
Annual Dividend Per Common Share stock should rise, providing return to investors in the form
Basic Earnings Per Share of capital gain rather than in the form of dividends.
And It is calculated as follows:
Total Common Dividends (Annual) Annual Dividends Per Common Share
Income Available to Common Shareholders Current Market Price Per Share
The DuPont Equation breaks up ROA into its two compo-

nents, which are multiplied together to calculate Return on The shareholder return ratio measures the return to
Assets: individual shareholders on their personal investments in
the company’s common stock.
1) Profit Margin on Sales:
It consists of the annual dividends received plus the
Net Income After Interest and Taxes amount of change in the stock price during the year,
Net Sales expressed as a percentage of the stock price at the begin-
2) Asset Turnover Ratio: ning of the year.
Net Sales
Average Total Assets Ending Stock Price – Beginning Stock Price +
Or Annual Dividends Per Share
Beginning Stock Price
Profit Margin on Sales " Asset Turnover Ratio
The sustainable equity growth rate implies the per- The DuPont Equation for return on equity breaks up
centage growth rate that the company can grow per year ROE into three parts that are multiplied together as fol-
without increasing its financing. lows:
The amount of earnings retained by a company is an 1)
indicator of the growth of its common equity (assumes Net Income
equity growth without external financing). To assess Net Sales
equity growth, we assume that a portion of earnings are X
retained and that the dividend payout is constant. 2)
In calculating the sustainable equity growth rate, we Net Sales
look to two sources of internal growth: Average Total Assets
1) Earnings retained X
3)
2) Return earned on those earnings retained.
Average Total Assets
The sustainable equity growth rate is computed as fol- Average Total Equity
lows: Or:
Return on Common Equity (ROCA) x (1 – Dividend Payout Ratio) Profit Margin on Sales " Asset Turnover Ratio " Equity Multiplier
What are the What are the

first 6 limitations next 5 limitations
of ratio analysis? of ratio analysis?

What are the adjustments

to net income necessary
What are the
to calculate cash flows
last 5 limitations
from operating activities
of ratio analysis?
in the Statement of Cash Flows
using the indirect method?

What are the rules to consider

for adjustments to net income What are the six steps that
because of changes in the will always be performed when
value of asset and liability preparing the operating
accounts when calculating activities section of a
operating cash flows in the Statement of Cash Flows
Statement of Cash Flows under the indirect method?
using the indirect method?
1) A ratio by itself is not significant. It must be inter-
7) When we compare a company with other companies, preted in comparison with prior ratios, predetermined
their financial statements will probably classify benchmarks, or ratios of competitors.
items differently. 2) The ability to make use of ratios is dependent upon
8) Many companies are conglomerates, and are the analyst’s ability to adjust the reported num-
made up of many different divisions operating in bers before calculating the ratios and then interpret
different, unrelated industries. This can make it the results.
difficult to compare any two companies. 3) Financial statement analysis cannot give defin-
9) Companies can choose different methods of ite answers.
computing things such as depreciation expense, cost 4) Accounting and the preparation of financial state-
of goods sold, and bad debt expense ments require judgment in making assumptions
10) A company may have poor operating results that are and estimates.
caused by several different, small factors. 5) Ratios’ usefulness depends on the quality of the
11) Traditional ratio analysis focuses on the balance sheet numbers used in their calculation.
and income statement. Cash flow ratios may be 6) The numbers constitute only one part of the informa-
overlooked. tion that should be considered when evaluating a
company. Qualitative aspects are also important.
The adjustments to net income necessary to calcu-

late cash flows from operating activities in the SCF 12) The goal of financial analysis is to make predictions
using the indirect method are: about the future. However, ratio analysis per-
1) Eliminate noncash items from the income state- formed on historical data, may have little to do
ment (for example, depreciation). with what is going on currently at the company.
2) Subtract investing and financing activity events 13) Many financial statement items are based on histor-
whose results are included in the income statement ical cost values. Ratios based on those historical
(these are the gains and losses on the income state- cost values may be less relevant to a decision than
ment). market values.
3) Add back the effect of operating activities not included 14) To be meaningful, a ratio must measure a rela-
in the income statement but with a cash effect. Sub- tionship that is meaningful. Sometimes individual
tract the effect of events included in the income state- ratios may not be meaningful for certain companies.
ment without a cash effect. This includes adjustments 15) Financial statements consist of summaries and
for changes in receivables, payables, inventory, simplifications to classify economic events and
and other assets and liabilities. present information in a form that can be utilized.
4) Cash flows from the purchase, sale and maturity 16) Financial statements deal with monetary amounts
of trading securities usually are classified as oper- but do not reflect the decrease in purchasing power
ating activities, not investing activities. If yes, that is that occurs with inflation.
an adjustment.
There are six steps that will always be performed when

preparing the operating activities section of a state- In the calculation of cash flows from operating activities in
ment of cash flows under the indirect method. They are: the statement of cash flows under the indirect method,
1) Add all depreciation and amortization expense the following rule applies for the treatment of
back to net income. changes in asset and liability balances:
2) Add all non-operating losses on the income state-
Assets
ment back to net income.
3) Subtract all non-operating gains on the income An increase in an asset is a deduction from net income.
statement from net income. A decrease in an asset is an addition to net income.
4) Add and subtract the changes in balance sheet
accounts that are related to operating activities. Liabilities
5) If purchases, sales and maturities of trading securities An increase in a liability is an addition to net income.
are being classified as operating activities, subtract A decrease in a liability is a deduction from net income.
cash used to purchase trading securities and add the
book value of trading securities that were sold. The rule is that assets change net income in the opposite
6) The cash amounts for income taxes paid and way that the account changes, and liabilities change net
interest paid need to be disclosed in a supple- income in the same direction as the account changes.
mental schedule.
What are 4 important factors

influencing net income What is
that must be considered in a earnings quality?
financial statement analysis?

What is What is
earnings persistence? earnings variability?

Define earnings management What are the source,

and give seven common stability and trend
acceptable examples. of revenues?

There are a four important factors influencing net
income that are subject to interpretation, assessment,
and judgment. These factors should be considered in fi-
nancial statement analysis:
Earnings quality relates to the source of the profits of 1) Estimates: Accountants must make estimates that
the company. Increased earnings due to increased sales have a direct impact on income.
and cost controls are of a higher quality than artificial 2) Accounting Methods: A choice often exists between
profits created by inflation of inventory or other asset acceptable accounting methods. An analyst may need
prices. to adjust reported income to compensate for different
methods, particularly when comparing one company
Determinants of earnings quality include the company’s to another.
business environment, its selection and application of 3) Incentives for disclosure: Accountants and auditors
accounting principles and the character of its manage- can be influenced by pressures brought to bear upon
ment. them by users of financial statements.
4) Diversity among users ! Different users of financial
statements have different needs. The analyst may
need to adjust the reported income for these differ-
ences.
Earnings persistence is an important concept related to

income. It is a measure of the constancy of the earnings
Earnings variability, or fluctuation in earnings caused of a company over time. The more constant and the more
by the business cycle, causes stock price fluctuations and persistent a company’s earnings are over time, the
is therefore undesirable. Earnings variability can be meas- greater the market value of the shares of that company
ured using standard variability measures. In addition, will be.
earnings variability can be assessed by determining aver-
age earnings over a period of 5 to 10 years, or by using When determining earnings persistence, unusual, erratic
minimum earnings over a period as a worst-case scenario. and nonrecurring items are excluded. By looking at the
trend of the persistent earnings over time, a more realistic
projection of future earnings can be made.
Earnings management involves using the discretion avail-

able to management to selectively apply acceptable account-
The source of the revenue is especially important when ing principles to achieve a specific earnings amount. Goal is
the analysis is for a diversified company, where the com- to smooth the variability of earnings by shifting earnings
pany has several markets or product lines. Each market or between years. Examples include:
product line will need separate analysis, because each one 1) Understating reported earnings by creating a “re-
will have its own characteristics. The analysis must seg- serve” to call on if future earnings dip.
regate and interpret the contribution of each of the busi- 2) Change accounting methods and assumptions.
ness segments on the company as a whole. 3) Removing the effect of unusual gains and losses
by offsetting them with some other discretionary
If there is a constant source of revenue, a company is in a
income or expense item.
better position than if it needs to go find new sources of
4) Recognizing future period costs in the current
revenue every period. Long-term contracts and long-term period when the current period shows already poor per-
customer relations help secure stability of revenue. formance.
The trend of the revenue is the way in which the level of 5) Write-downs of operating assets to meet the tar-
revenue moves from one year to the next. A consistent geted return on invested capital.
level of growth is preferable to volatility, i.e., some years 6) Timing expense and revenue recognition including
of great growth and some years of great decline. actual timing of transactions.
7) Aggressive accounting used to redistribute earnings
across periods.
What are Explain the terms

7 common categories of book value,
expense classifications market value, and
in the income statement? fair value.

What are the

main implicit costs used
two types of profit.
to calculate economic profit?

Define What are the

off-balance sheet financing two issues regarding
and list foreign exchange fluctuations
four common methods that are important for
of off-balance sheet financing. financial statement analysis?

Book value is the accumulation of accounting entries and
adjustments that have been recorded during the com-
pany’s lifetime. For example, the book value of a piece of
equipment is the original cost less accumulated depreci- Expenses are classified based on the nature of the
ation. And the book value of a firm is its total assets less expense. While different companies will make their own
its total liabilities. classifications, the common categories are:
The market value of a firm is based on the market value 1) Selling expenses
of its securities in the secondary markets. A firm’s market
2) Depreciation expense
capitalization is the price per share of its common stock
on the secondary market multiplied by the number of 3) Maintenance expense
shares outstanding. Market value of a firm’s debt securi- 4) Amortization expense
ties is also their value on secondary markets.
5) General and administrative expenses
Fair value is defined as the price that would be received
6) Financing expenses
to sell an asset in an orderly transaction between market
participants (that is, not a forced liquidation or distressed 7) Income taxes
sale) at the measurement date under current market con-
ditions in the principal or most advantageous market for
the asset or liability.
The main implicit costs that are included in the calcula- There are two different types of profit: accounting
tion of economic profit are: profit and economic profit. Accountants use accounting
1) Interest lost on money that has been invested in the profit, while economists use economic profit.
business instead of elsewhere. Accounting profit is the profit that is calculated on the
2) The level of accounting profit that could be earned by income statement. It is calculated as revenues minus
moving the firm’s productive resources to its next best explicit costs. These are the costs for which the company
alternative use. actually has to make a payment to another party. How-
ever, a company also has implicit costs, and implicit costs
3) Normal profit that the entrepreneur could earn else-
are not included in the calculation of accounting profit.
where. Normal profit is usually defined as the value
of the entrepreneurial skills that an individual has. Economic profit is the amount by which total revenue
This includes the wages that the individual gives exceeds the total economic costs of the company. Total
up by not working at another job. economic costs include all of the explicit (cash) costs that
are paid by the firm as well as the relevant implicit (op-
4) Economic depreciation. Economic depreciation is
portunity) costs.
the decrease in the market value of the equipment
during the period. It is calculated as the market value Note: Economic profit will never be higher than accounting
of the equipment at the beginning of the period minus profit. Although economic profit uses the same revenues
the market value of the equipment at the end of the as accounting profit, it includes more costs because it
period. includes implicit costs as well as explicit costs.
Off-balance sheet financing is any form of funding that

avoids placing owners’ equity, liabilities or assets on a
firm's balance sheet.
Examples include the use of:
There are two issues in accounting for foreign ex- 1) Operating leases to finance acquisition of assets.
change fluctuations: 2) Special-purpose entities (now called variable in-
1) Foreign currency transactions that are denomi- terest entities) which are separate legal entities estab-
nated in a currency other than the currency that lished to perform a narrowly-defined or temporary
the company uses for its accounting records. purpose. Assets and liabilities are carried on that spe-
2) Consolidation of financial statements when a cial entity’s balance sheet and are not consolidated
subsidiary or subsidiaries are located in a different into the primary company.
country or countries and keep their accounting 3) Sale of receivables, also called factoring, in which
records in a different currency from the parent’s cur- the company receives cash immediately in exchange
rency. for giving up the right to collect its receivables.
4) Joint ventures, in which two or more "parent" com-
panies agree to share capital, technology, human
resources, risks and rewards in the formation of a new
entity to be managed under their shared control.

What are the
two potential steps to
three types of currencies
perform when converting
that are relevant in the
foreign financial statements
conversion of foreign currency
into US dollar
financial statements?
financial statements.

What is the method to

remeasure the financial What is the
statements into the remeasurement gain/loss
functional currency and and how is it reported in
what are the exchange rates the financial statements?
to use in this method?

What is the method to

translate the financial What are
statements into the translation gains or losses
reporting currency and and where are they reported
what are the exchange rates in the financial statements?
to use in this method?

When we talk about financial statements of a foreign
There are potentially two steps in the process of convert- entity and converting those financial statements from the
ing foreign financial statements into U.S. dollar financial foreign currency to U.S. dollars, we talk about three dif-
statements: remeasurement and translation. ferent currencies:
1) If the foreign entity’s accounting records are main- 1) The foreign entity’s functional currency. This is the
tained in a local currency that is different from currency of the primary economic environment in
the entity’s functional currency, its account bal- which the foreign entity operates (currency in
ances must first be remeasured to the functional which the entity generates and expends cash).
currency.
2) The foreign entity’s currency of record. This is the
2) After remeasurement, if the functional currency currency that the foreign entity uses to keep its
differs from the reporting currency, the account books. A foreign entity might use one of three differ-
balances are then translated from the functional ent currencies as its currency of record, also: (a) its
currency into the reporting currency. own local currency; (b) its functional currency, other
Note: than its local currency and other than the U.S. dollar;
Remeasure from local currency (currency of record) to or (c) the U.S. dollar.
functional currency. 3) The foreign entity’s reporting currency. This is the
Translate from functional currency to reporting currency. U.S. dollar, when the entity’s financial statements are
being consolidated with those of a U.S. company.
The monetary/nonmonetary method (also called the

Because different exchange rates are used for the differ- temporal method) is used in the remeasurement process.
ent balance sheet and income statement items, there will The following exchange rates are used for the remeasurement
be a difference in the trial balance after the remeasure- process:
ment calculations have been made. Debits and credits in 1) Monetary assets: current rate at the balance sheet
date.
the trial balance will no longer be the same, and the bal-
2) Nonmonetary items (inventories and fixed assets, as
ance sheet will probably not balance. The difference is a
well as the revenues and expenses related to these
remeasurement gain or loss. items): historical rates in effect when each transac-
The remeasurement gain or loss is whatever amount is tion occurred.
necessary to make the debits equal the credits on the 3) Stockholders’ equity (except for changes in retained
remeasured trial balance. earnings from net income or net loss): historical rates
in effect when each transaction occurred.
Any remeasurement gain or loss that results from this
4) Income statement amounts related to nonmone-
process is recognized as a part of income from continu-
tary assets and liabilities (such as cost of goods sold
ing operations on the current period income statement. and depreciation): historical rates in effect when
This remeasurement adjustment must also be made to each transaction occurred.
retained earnings on the balance sheet after remeasure- 5) Other revenues and expenses that occur evenly
ment. throughout the period: a weighted-average rate for
the period.
The translation process uses different exchange Translation must be done using the current rate meth-
rates for different balance sheet, income, and ex- od. The current rate method includes the following ex-
pense items. As a result, the balance sheet will probably change rates:
not balance after translation. The difference is the
translation gain or loss. 1) All balance sheet amounts other than stockholders’
equity: current exchange rate as of the balance
Gains and losses from translation are not recog- sheet date.
nized in the current period’s income statement.
Instead, translation gains and losses are recognized in 2) Owners’ equity amounts, other than changes in
stockholders’ equity as a component of accumulated other retained earnings from net income or loss: historical
comprehensive income in the translated balance sheet. exchange rates in effect when each transaction
occurred.
The accumulated other comprehensive income line on the
balance sheet is a cumulative number (it accumulates 3) All revenues and expenses: may be translated at
from year to year). Therefore, the amount of change in the weighted-average exchange rate for the period.
this balance due to translation gains and losses during the Or, if it is practicable to use the historical rate in effect
period should be disclosed as a component of other com- when each transaction occurred, that may also be
prehensive income for the period. used.
When is a currency defined as

In the remeasurement process
highly inflationary
how does an excess of
and how does this
monetary liabilities over
affect the accounting for
monetary assets impact the
foreign currencies in the

What are the

In the remeasurement process
only situations when the
how does an excess of
monetary/nonmonetary
monetary assets over
(temporal) method
monetary liabilities impact the
for remeasurement into the
functional currency is used?

What are the two methods

possible to adjust the Explain
financial statements for the constant dollar accounting
effects of inflation and who and how it is implemented.
prefers which approach.

A currency is classified as highly inflationary if its cu-
Under the monetary/nonmonetary (temporal) method, if a
mulative three-year inflation rate exceeds 100%.
foreign subsidiary has an excess of monetary liabilities
over monetary assets, then the following relations prevail A highly inflationary currency is not considered stable
(assuming the accounts are being remeasured into U.S. enough to serve as a functional currency. If this occurs,
dollars, and the functional currency is the U.S. dollar): the FASB mandates that the functional currency be
changed to the reporting currency, i.e., to U.S. dollars.
1) If the dollar strengthens versus the local currency,
the balance sheet remeasurement effect is a gain. Thus, converting a foreign entity’s financial statements to
U.S. dollars from such a currency is done as a remeas-
2) If the dollar weakens versus the local currency, the
urement using the monetary/nonmonetary, or temporal,
balance sheet remeasurement effect is a loss.
method (from currency of record to functional currency).
The monetary/nonmonetary (temporal) method is used

only under the following conditions:
1) If the foreign subsidiary’s accounting records are
maintained in a local currency that is different
from the entity’s functional currency, its account
balances must be remeasured. If a foreign subsidiary has an excess of monetary assets
over monetary liabilities, then the following relations
2) If the foreign entity is merely an extension of the
ensue:
parent and, thus, the functional currency is that of
the parent (U.S. dollars) but transactions are recorded 1) If the dollar strengthens versus the local currency,
in the local currency, transactions are remeasured to the balance sheet remeasurement effect is a loss.
the functional currency (U.S. dollars). 2) If the dollar weakens versus the local currency, the
3) In high inflation environments as defined by balance sheet remeasurement effect is a gain.
GAAP: this occurs when a subsidiary’s accounting
records are being maintained in its local currency but
its functional currency has been changed from its local
currency to U.S. dollars due to hyperinflation in the
local currency.
Constant dollar accounting measures general changes

in the price level and reports financial statement elements
in dollars having similar purchasing power from one year The financial statements can be adjusted to remove the
to the next. inflation effects using two methods:
Constant dollar accounting makes use of a general 1) Constant dollar accounting: preferred by financial
price-level index such as the Consumer Price Index that statement users who prefer the financial concept of
measures the prices of a group, or basket, of representa- capital maintenance. Those who prefer the financial
tive goods and services. Monetary assets (cash, etc.) and concept of capital maintenance are concerned with
monetary liabilities (accounts payable, etc.) are treated maintaining the general purchasing power of their
differently from nonmonetary assets and liabilities. invested capital.
The balances of nonmonetary assets and liabilities on the 2) Current cost accounting: preferred by users who are
balance sheet are adjusted for the change in the price concerned with the specific prices that affect a firm’s
index. The balances of the monetary assets and liabilities operations and with the maintenance of the enter-
are not directly adjusted, but their net “purchasing power prise’s physical capital.
gain (loss)” is calculated and plugged into the balance
sheet in the equity section.
What is the definition of

Explain fair value
current cost accounting in accounting standards and
and how it is implemented. how does this concept
impact accounting?

What are
three hierarchies of methods What are the
to determine fair value arguments for using
as required by fair value accounting?
accounting standards?

What are the

arguments against using (BLANK)
fair value accounting?

Current cost accounting means current replacement
cost for the same assets.
Fair value is defined as the price that would be received Current cost measures specific changes in prices of spe-
to sell an asset in an orderly transaction between market cific items:
participants (that is, not a forced liquidation or distressed 1) Nonmonetary items ( inventory and fixed assets) are
sale) at the measurement date under current market con- reported on the balance sheet at the current cost to
ditions in the principal or most advantageous market for replace them.
the asset or liability. 2) Cost of goods sold and depreciation expense are cal-
Fair value accounting, or “mark-to-market” account- culated at current cost.
ing, involves the use of fair values of certain assets and 3) The increases in assets on the balance sheet are un-
liabilities instead of their historical cost values. realized holding gains until the asset is sold. Unreal-
Current accounting standards call for only certain assets ized holding gains apply to unsold inventory and the
and liabilities to be measured at fair value. In addition, the undepreciated portion of fixed assets.
way in which unrealized gains and losses resulting from A basic principle of current cost accounting is that no
fair value measurement are reflected in financial state- profit should be reported as earned until the re-
ments depends on the intended use of the assets and placement of inventory or of productive capacity is
liabilities. provided for. Profit is considered to be cash that can be
distributed without affecting the company’s ability to carry
its normal inventory level of the product(s) sold.
Accounting standards call for fair value to be determined in a

hierarchy of methods, called “Level 1,” “Level 2” and
“Level 3” inputs:
1) Level 1 inputs are unadjusted quoted market prices.
Arguments for fair value accounting include: Quoted prices are to be used when the market for the
security is active.
1) It does not have the limitations associated with histor- 2) Level 2 inputs are based on quoted prices for similar
ical cost accounting; assets or liabilities in active markets, and other rele-
2) Information presented to investors and regulatory vant market data.
authorities has increased relevance and transparency 3) When there is little or no market activity for the
because the reported numbers incorporate informa- assets or liability, Level 3 valuation is used. At Level 3,
tion as of the measurement date rather than as of the fair value is estimated by using a valuation model
original transaction date; that reflects how market participants would reasonably
be expected to price the instrument should the transac-
3) There is a lower likelihood of earnings management tion take place. This mark-to-model value is based in
when fair value accounting is being used. large part on the company’s own assumptions about
pricing that market participants would assign to the
asset or liability.
If Level 1 inputs are not available, accountants are required to
use Level 2 or Level 3 inputs.
Arguments against fair value accounting include:

1) It is not as reliable as the historical cost method,
because historical cost is verifiable.
2) Calculation of fair value can be influenced by sub-
jectivity and bias, when something other than an
observed market value is available and used.
3) Fair values are unreliable when estimates and
measurements used rather than actual transac-
tions.
4) Use of fair value exacerbates the procyclicality of
financial reporting, because when market values
decline, the financial statements of firms affected by
the market’s decline also deteriorate, and a downward
spiral is initiated.
5) Reported financial results become more volatile.
6) Opponents claim that the requirement to report
certain financial assets at fair value was re-
sponsible for the crisis in the securities markets.
Section A: Differences Between U.S. GAAP and IFRS Section A: Differences Between U.S. GAAP and IFRS
Section A: Differences Between
U.S. GAAP and IFRS
What is the difference What is the difference

between U.S. GAAP and IFRS between U.S. GAAP and IFRS
regarding the use of LIFO as regarding the general guideline
an inventory costing method? for valuing inventory?

What is the difference

between U.S. GAAP and IFRS
regarding the treatment of
asset retirement obligations
regarding the reversal of
(ARO) for long-lived assets
inventory write-downs?
that arise during the
production of inventory?


regarding the usage of regarding the preferred
long term contract method of service
accounting for services? revenue recognition?

The difference between IFRS and U.S. GAAP regarding the
general guideline for valuing inventory is:
1) IFRS: Inventory is carried at the lower of cost or net
realizable value. Net realizable value is the best es- The difference between IFRS and U.S. GAAP regarding the
timate of the expected realizable value of the inven- use of LIFO as an inventory costing method is:
tory. It may differ from fair value.
1) IFRS: LIFO is not permitted.
2) U.S. GAAP: Inventory is carried at the lower of cost or
2) U.S. GAAP: LIFO is permitted.
market. Market is defined as current replacement
cost as long as market is not greater than net realiza-
ble value (ceiling) and is not less than net realizable
value reduced by a normal sales margin (floor).
The difference between IFRS and U.S. GAAP regarding

reversals of inventory write-downs is:
1) IFRS: Inventory write-downs are reversed up to the
amount of the original loss when the reasons for the
write-down no longer exist. The reversal of a write-
treatment of asset retirement obligations (ARO) for long-
down is required if certain criteria are fulfilled.*
lived assets that arise during the production of inventory
2) U.S. GAAP: Write-downs of inventory to the lower of is:
cost or market cannot be reversed.
1) IFRS: An ARO that is incurred because the relevant
* The amount of the inventory write-down is reversed into
asset is used to produce inventory is accounted for as
profit and loss when:
a cost of the inventory.
1) The circumstances no longer exist that previously
caused inventories to be written down below cost, or 2) U.S. GAAP: An ARO that is incurred because the rele-
vant asset is used to produce inventory is accounted
2) There is clear evidence of an increase in net realizable
for as a cost of the carrying amount of the related
value (NRV) because of changed economic circum-
property plant and equipment.
stances.
The reversal is limited to the amount of the original write-
down. The new inventory carrying value is the lower of
cost and the revised NRV.

usage of long term contract accounting for services is:
The difference between IFRS and U.S. GAAP regarding the 1) IFRS: Revenue may be recognized using long-term
preferred method of service revenue recognition is: contract accounting, including consideration for the
1) IFRS: Revenue from service contracts is recognized in state of completion, whenever revenues and costs can
the period that the service is rendered, generally be measured reliably, and it is probable that the eco-
using the percentage of completion method. nomic benefits of the activity will flow to the company.
2) U.S. GAAP: Revenue from service contracts is recog- 2) U.S. GAAP: Sometimes service revenue recognition is
nized in the period that the service is rendered, gen- included in industry specific guidance (example:
erally using the straight line method rather than software). Unless permitted otherwise in a indus-
the percentage of completion method. try specific standard, use of long-term contract
accounting is not permitted for non-construction
services.

regarding revenue recognition
regarding the usage of the
for deferred receipts and
completed contract method
the discounting of the
of revenue recognition?
associated cash flows?


regarding the required method
of revenue recognition for
regarding the valuation of
construction contracts if the
a share based transaction
percentage of completion
with non-employees?
of the work cannot be
determined reliably?


regarding the measurement
regarding the recognition
and recognition of
of payroll taxes related to a
share based awards with
share based payment plan?
graded vesting features?

revenue recognition for deferred receipts and the dis-
counting of the associated cash flows is:
1) IFRS: Revenue value is determined by discounting
The difference between IFRS and U.S. GAAP regarding the all future receipts using an imputed rate of interest.
usage of the completed contract method of revenue This type of activity is considered to be a financing
recognition is: agreement. *
1) IFRS: use of the completed contract method is not 2) U.S. GAAP: Discounting is required only in limited
permitted. situations.
2) U.S. GAAP: use of the completed contract method is * IFRS requires the use of the effective interest meth-
permitted. od to recognize the difference between the nominal cash
value to be received and the net discounted cash flow
value used to record the revenue. The difference between
actual cash to be received and the discounted value of the
cash flows is recorded as interest income over the con-
tracted payment term.

required method of revenue recognition if the percentage
of completion of the work cannot be determined reliably
The difference between IFRS and U.S. GAAP regarding the is:
valuation of a share based transaction with non-employ- 1) IFRS: Revenue is recognized using the percentage of
ees is: completion method if certain criteria are met. If the
1) IFRS: Based upon the fair value of the goods or percentage of completion cannot be determined, rev-
services received, and only on the fair value of the enue is limited to recoverable costs incurred
equity instruments in the rare situations when the fair (cost recovery method).*
value of the goods and services cannot be reliably 2) U.S. GAAP: Revenue is recognized using the percent-
estimated. age of completion method only if certain criteria are
2) U.S. GAAP: Based upon the fair value of the goods met. If the percentage of completion cannot be de-
or services received or the equity instruments termined, the completed contract method is
used to settle the transaction – whichever is more used.
reliable. * When the percentage complete is not determin-
able, IFRS requires that revenue is limited to recover-
able costs. No profit is recognized (project outcome is not
determinable). Expenses are recognized as incurred.

measurement and recognition of share based awards with
graded vesting features is:
The difference between IFRS and U.S. GAAP regarding the 1) IFRS: must recognize compensation cost on an accel-
recognition of payroll taxes related to a share based pay- erated basis – each individual tranche must be sep-
ment plan is: arately measured – necessary to reflect the vesting as
it occurs.
1) IFRS: Generally recognized as the compensation
cost is recognized or at the grant date (depend- 2) U.S. GAAP: Company may choose to recognize com-
ing on the terms of the obligation). pensation cost for awards containing only service con-
ditions either on a straight line basis or on an
2) U.S. GAAP: Recognition when the obligating event
accelerated basis, regardless of whether the fair
occurs (generally the exercise of an award).
value of the awards is measured based on the award
as a whole or for each individual tranche. If the result
is the accelerated basis – this acceleration is based
upon the vesting as it occurs.

regarding a share payment
regarding a share based
plan and the recognition of
payment plan with an equity
expense when there is a mod-
repurchase feature based
ification of vesting terms that
upon the employee’s choice?
are improbable to achieve?


regarding the classification of
regarding expense recognition
a share based payment
for the cancellation of a share
transaction that is settled
based payment plan?
in redeemable shares?


regarding the actuarial method regarding the valuation basis
for defined benefit plans? for defined benefit plan assets?

recognition of expense in a share based payment plan for
a modification of vesting terms that are improbable to
achieve is:
1) IFRS: Probability of achieving vesting terms before
and after modification is not considered. Instead com- The difference between IFRS and U.S. GAAP regarding a
pensation cost is the grant-date fair value of the share based payment plan with an equity repurchase fea-
original award together with any incremental ture based upon the employee’s choice is:
fair value at the modification date. The modifica-
1) IFRS: Liability classification is required.
tion results in recognition of any incremental fair
value, but not any reduction in fair value. 2) U.S. GAAP: Liability classification is not required if
2) U.S. GAAP: If an award is modified such that the ser- employee bears risks and rewards of equity ownership
vice or performance condition, which was previously for at least six months from date equity is issued or
improbable to achieve, becomes probable to achieve vests.
as a result of the modification, the compensation cost
is based on the fair value of the modified award
at the modification date. Grant date fair value of
the original award is not recognized. There is no min-
imum compensation cost to recognize.

expense recognition for the cancellation of a share based
payment plan is: The difference between IFRS and U.S. GAAP regarding the
classification of a share based payment transaction that is
1) IFRS: Cancellation by both the employer and the settled in redeemable shares is:
employee/third party results in acceleration of
the unrecognized cost. 1) IFRS: Liability.
2) U.S. GAAP: Cancellation by the employer results in 2) U.S. GAAP: Generally classified as liabilities. How-
acceleration of the unrecognized cost. ever, in certain cases, they may also be classified as
equity.
Cancellation by the employee results in continued cost
recognition over the remaining service period.

actuarial method for defined benefit plans is:
valuation basis for defined benefit plan assets is:
1) IFRS: The projected unit credit method is re-
1) IFRS: Fair value.
quired as the actuarial method for the defined benefit
2) U.S. GAAP: “Market related” value which can be plan in all cases.
either fair value or a calculated value that
2) U.S. GAAP: Different actuarial methods are re-
smoothes the effect of short-term market fluctuations
quired dependent on the characteristics of the
over five years.
benefit calculation of the plan.

between U.S. GAAP and IFRS What is the difference
regarding restrictions on the between U.S. GAAP and IFRS
recognition of post- regarding the recognition of
employment benefit plan expense for past service costs
assets if plan assets exceed under a defined benefit plan?
the defined benefit obligation?


regarding the recognition of
deferred actual gains and
multi-employer benefit plans?
losses for inactive employees?


regarding the timing of
recognition of gains and
regarding termination benefits?
losses for benefit plan
curtailments or settlements?

recognition of expense for past service costs under a The difference between IFRS and U.S. GAAP regarding
defined benefit plan is: restrictions on the recognition of post-employment benefit
1) IFRS: Expense for vested past service costs is plan assets if plan assets exceed the defined benefit obli-
recognized immediately into profit and loss. gation is:
Expense for unvested past service costs is recog- 1) IFRS: The net asset recognized cannot exceed the
nized into profit and loss over the average total of unrecognized past service cost and actuarial
remaining vesting period. losses plus the present value of benefits available
2) U.S. GAAP: Expense for past service costs are recog- from refunds or reduction of future contributions to
nized initially in other comprehensive income. the plan.
Both vested and unvested amounts are then amor- 2) U.S. GAAP: No limitation on the amount of the net
tized into profit or loss over the average remain- asset that can be recognized.
ing service period.

treatment of multi-employer benefit plans* is:
1) IFRS: Either as a defined contribution or defined The difference between IFRS and U.S. GAAP regarding the
benefit plan based on the terms (both contractual recognition of deferred actual gains and losses for inactive
and constructive) of the plan. employees is:
2) U.S. GAAP: Similar to a defined contribution plan. 1) IFRS: Recognized immediately.
* A multi-employer benefit plan is a post-employment 2) U.S. GAAP: Amortized over the remaining life ex-
benefit plan that pools the assets contributed by various pectancy of the inactive employees.
entities to provide benefits to employees of more than one
company.
The difference between IFRS and U.S. GAAP regarding the The difference between IFRS and U.S. GAAP regarding the
timing of recognition of gains and losses for benefit plan treatment of termination benefits is:
curtailments or settlements is:
1) IFRS: No distinction between termination and
1) IFRS: Gains or losses from settlements and cur- post employment benefits. Recognize termination
tailments are recognized when it occurs (company benefits when employer is demonstrably commit-
is demonstrably committed and a curtailment has ted to pay.
been announced). This is generally immediately.
2) U.S. GAAP: Differences exist between termina-
2) U.S. GAAP: Settlement gains or losses are recog- tion and post employment benefits.
nized when the obligation is settled.
Special termination benefits are generally recognized
Curtailment losses are recognized when curtailment is when they are communicated to employees unless
probable of occurring and the effects are reasonably employees will render service beyond a “minimum reten-
estimable. tion period” in which case the liability is recognized ratably
Curtailment gains are recognized when the curtailment over the future service period. Contractual termination
occurs (generally when the impacted employees are ter- benefits are recognized when it is probable that
minated or the plan amendments are adopted. This could employees will be entitled and the amount can be
happen after the company is demonstrably committed and reasonably estimated. Voluntary termination bene-
a curtailment is announced). fits are recognized when the employee accepts the offer.

regarding the initial valuation
computer software
of development costs?
development costs?


regarding gain recognition
regarding intangible
from the sale and leaseback
asset revaluation?
of land and buildings?


regarding revaluation of regarding the residual value
long-lived assets? of long-lived assets?

initial valuation of development costs is:
The difference between IFRS and U.S. GAAP regarding the 1) IFRS: Internal development expenditures are capi-
treatment of software development costs is: talized when technical and economic feasibility of a
1) IFRS: No separate guidance exists addressing com- project can be demonstrated in accordance with spe-
puter software development costs. cific criteria. Some of the criteria include: intent to
2) U.S. GAAP: Separate guidance exists for software complete the asset, and ability to sell the asset in the
development costs. Expenditures related to computer future. These capitalization criteria are applied to all
software developed for external use are capitalized internally developed intangible assets.
once technological feasibility is established in 2) U.S. GAAP: Internal development expenditures are
accordance with specific criteria. Expenditures related expensed as incurred unless there is a separate
to software developed for internal use are only standard that requires capitalization. Special capitali-
capitalized during the application development zation criteria apply to software developed for internal
stage. use and software developed for sale to third parties.
These criteria differ from the general criteria under
IFRS.

gain recognition from the sale and leaseback of land and The difference between IFRS and U.S. GAAP regarding
buildings is: intangible asset revaluation is:
1) IFRS: Immediate gain recognition from the sale 1) IFRS: Revaluation to fair value of intangible assets
and leaseback of an asset is possible if the sales other than goodwill is permitted for a class of intan-
price is reasonable compared to fair value and the gible assets. Revaluation requires reference to an ac-
lease is classified as an operating lease. tive market for the specific type of intangible.
2) U.S. GAAP: Immediate gain recognition from the 2) U.S. GAAP: Revaluation of intangible assets is not
sale and leaseback of an asset is generally prohib- permitted.
ited unless the leaseback is considered to be “minor.”

residual value of long lived assets is: The difference between IFRS and U.S. GAAP regarding
revaluation of long-lived assets is:
1) IFRS: The residual value of the asset is the current
net selling pricing assuming the asset was already 1) IFRS: Revaluation is permitted for an entire class of
at the disposal age and in the condition expected at assets if performed on a regular basis. A company
the end of its useful life. must choose the accounting policy for the asset class
(cost or revaluation) and apply it consistently to all
Residual value may be adjusted upwards or
assets in the asset class. If the company chooses to
downwards.
revalue, the revaluation must be done to fair value.
2) U.S. GAAP: The residual value of the asset is the dis- The new carrying value going forward will be the re-
counted present value of expected proceeds on valuated amount less subsequent accumulated depre-
the future disposal of the asset. ciation and impairment losses.
Residual value may only be adjusted down- 2) U.S. GAAP: Revaluation is not permitted.
wards.

regarding component regarding major inspection
depreciation of or overhaul costs of
long-lived assets? long-lived assets?


regarding the eligible regarding the treatment
expenditures for capitalization of investment income
of borrowing costs related to related to borrowing
a long-lived asset? for a long-lived asset?


regarding the required regarding the valuation
procedures to determine principle for an
if asset impairment exists? asset impairment?

major inspection or overhaul costs of long-lived assets is:
1) IFRS: Generally included in the cost of the asset The difference between IFRS and U.S. GAAP regarding
and depreciated over the remaining life of the asset. component depreciation of long-lived assets is:
2) U.S. GAAP: A choice exists: 1) IFRS: Component depreciation is required if com-
a) Expense as incurred, ponents of an asset have differing patterns of usage
and economic value to the company.
b) Include in the cost of the asset and depreciate
over the remaining life of the asset, or 2) U.S. GAAP: Component depreciation is permitted.
c) Defer and amortize over the period till the next
overhaul date.

treatment of investment income related to borrowing for a
eligible expenditures for capitalization of borrowing costs
long-lived asset is:
related to a long-lived asset is:
1) IFRS: Borrowing costs are offset by investment
1) IFRS: Eligible borrowing costs include interest, mis-
income earned on those borrowings that are invested
cellaneous ancillary costs and exchange rate dif-
short term pending expenditure for the assets.
ferences from foreign currency borrowings that are
2) U.S. GAAP: Borrowing costs are not offset by regarded as an adjustment of interest.
investment income earned on those borrowings
2) U.S. GAAP: Eligible borrowing costs include only
that are invested short term pending expenditure for
interest.
the assets.

required procedures to determine if asset impairment
The difference between IFRS and U.S. GAAP regarding the exists is:
valuation principle for an asset impairment is:
1) IFRS: One-step approach is performed to determine
1) IFRS: The impairment value is the difference between existence of impairment. Impairment testing is
the carrying amount of the asset and the recover- performed if evidence of impairment exists.
able amount. The recoverable amount is the higher
2) U.S. GAAP: Two-step approach is performed to
of 1) the fair value less costs to sell and 2) the value
determine existence of impairment.
in use (the present value of future cash flows in use
including the residual value). a) First, a recoverability test is performed (carrying
amount of the asset is compared to the sum of
2) U.S. GAAP: The impairment value is the difference
future undiscounted cash flows generated through
between the carrying amount of the asset and its fair
the use and eventual sale of the asset).
value (undiscounted cash flows of the asset or asset
group). b) Secondly, if it is determined that the asset value
is not recoverable from future cash flows, impair-
ment testing must be performed.

between U.S. GAAP and IFRS What is the difference
regarding the use of between U.S. GAAP and IFRS
discounted cash flows in regarding the accounting for
the calculation of an asset an asset impairment loss?
impairment value?


(BLANK)
regarding the reversal of
asset impairment losses?

Section B: Corporate Finance Section B: Corporate Finance
Section B: Corporate Finance
What are three

What is return on
important rules that
an investment and how
must be followed
is the annual rate of return
when calculating the
on an investment calculated?
annual rate of return?

The difference between IFRS and U.S. GAAP regarding the The difference between IFRS and U.S. GAAP regarding the
accounting for an asset impairment loss is: use of discounted cash flows in the calculation of an asset
1) IFRS: An impairment loss on a revalued asset is impairment value is:
charged directly to the revaluation reserve in 1) IFRS: The cash flows used to assess recoverability of
other comprehensive income to the extent that depreciable and amortizable assets are discounted
it reverses a previous revaluation surplus using a market related rate that reflects the current
related to the same asset. Any excess is recog- market assessment of risk specific to the asset at the
nized in profit or loss. current date.
2) U.S. GAAP: An impairment loss is booked directly to 2) U.S. GAAP: The cash flows used to assess recoverabil-
profit and loss. Revaluation upward of assets is not ity of depreciable and amortizable assets are not dis-
possible. counted.

reversal of asset impairment losses is:
1) IFRS: Long-lived assets must be reviewed annually
for evidence of reversal. If appropriate, previous loss
may be reversed up to a maximum of the newly
estimated recoverable amount or the initial carrying
amount adjusted for depreciation.
2) U.S. GAAP: Loss reversal is not permitted.
Return is income received by an investor on an invest-

ment. Rate of return is expressed as a percentage of the
When calculating an annual rate of return on an invest- principal amount invested.
ment, there are three very important rules that must be
followed: The amount of return on an investment is a function of
three things:
1) When the income received is for an investment that
was held for less than one full year, the amount of 1) Amount invested,
income must be annualized. 2) Length of time that amount is invested, and
3) The rate of return on the investment
2) The “amount invested” in the calculation must be the
average balance of the amount invested during Depending on the type of investment, all of those things
whatever period of time the funds were invested, up can vary.
to one year. Rates of return are always quoted as annual rates. In
3) If the funds were invested for less than one full year, other words, what percentage of the amount invested
we assume that the average balance during the would be earned if the investment were held for one full
period the funds were invested was the average bal- year?
ance for one full year, even though the investment The formula for the annual rate of return is:
was not held for a full year.
Return Received for One Year’s Investment
Average Balance of Amount Invested
What are interest rate risk,

What is risk? reinvestment rate risk and
purchasing power risk?

What are default risk,

What is political risk
liquidity risk an
for investments?
exchange rate risk?

What are business risk What are systematic and

and total risk? unsystematic risk?

Interest rate risk (price risk) is the risk that the value of
the investment will change over time resulting from changes
in the market rate of interest. The longer the maturity period
of the investment, the greater the interest rate risk as there is Risk can be classified as either pure risk or speculative
a longer investment horizon to be affected by the changes in risk.
interest rates. Therefore, prices of long-term bonds are more 1) Pure risk is defined as the chance that an un-
sensitive/volatile to interest changes than short-term bonds. wanted and detrimental (harmful) event will
Reinvestment rate risk means that invested money can’t take place. Insurance is designed to address pure
be put into in another investment that will provide the same, risk, because pure risk yields only a loss.
or a higher, level of return. This impacts short-term more 2) Because investments have the possibility (or even
than long-term bonds. As interest rates decline, the funds
expectation) of return, pure risk is not the risk that we
from the original investment cannot be reinvested upon
are concerned with in financial analysis. Instead we
maturity at the same higher rate as the original investment.
are concerned with speculative risk. In investing,
The sooner a bond matures, the sooner this reinvestment
must occur, so short-term bonds carry more reinvestment speculative risk is defined as the variability of
rate risk. actual returns from expected returns, and this
variability may be a gain or a loss.
Purchasing power risk is the risk that the purchasing
power of a fixed amount of money will decline as the result of
an increase in the general price level (inflation).
Political risk is the risk that something will happen in a

Default risk is the risk that a borrower of money will not
country that will cause an investment’s value to change,
be able to repay their debt as it becomes due. The higher
or even to become worthless. The government of a coun-
the lender determines the default risk, the greater the
try may change its policies, and this could affect invest-
interest rate that he will charge. Securities that are issued
ments in the country.
by stable governments will have the lowest level of default
Political risks include the obvious risks of government risk.
expropriation (government seizure of private property
Liquidity risk is the possibility that an investment cannot
with some minimal compensation offered which is gener-
be sold (converted into cash) for its market value.
ally not an adequate amount); and war (which can affect
Whenever an investment must be discounted significantly
employee safety and create additional costs to ensure
in order to be sold, the investment has a high level of
employees’ safety).
liquidity risk.
Political risks also include blockage of fund transfers;
As its name implies, exchange rate risk is the risk that a
inconvertible currency (the government of the host
transaction that has been denominated in a foreign cur-
country will not allow its currency to be exchanged into
rency will be impacted negatively by changes in the ex-
other currencies); government bureaucracy, regula-
change rate. This occurs when the company must spend
tions and taxes; and corruption (such as bribery being
more of their own currency to settle the transaction as a
used by local firms that firm doing business in that coun-
result of changes in the exchange rate.
try must compete with to get contracts).
Systematic risk is risk that all investments are subject Business risk is the variability of the firm’s earnings
to. It is caused by factors that affect all assets. Examples before interest and taxes (or operating income). Business
would be inflation, macroeconomic instability such as risk depends on many factors such as:
recessions, major political upheavals and wars. Systematic
1) The variability of demand over time,
risk cannot be diversified away, and so it remains even in
a fully diversified portfolio. 2) The variability of the sales price over time,
3) The variability of the price of inputs to the product
Unsystematic risk is risk that is specific to a particular over time, and
company or to the industry in which the company oper-
4) The degree of operating leverage that the firm has.
ates. An example of unsystematic risk is a strike that halts
production at one company or at all the companies that Total risk is the risk of a single asset taken by itself and
employ members of the union that has gone on strike. not set off against any other investments. It is defined as
Unsystematic risk can be reduced through appropriate the variability of the asset’s relative expected returns. It is
diversification of investments in a portfolio. also sometimes called standalone risk.
What is market risk? What is industry risk?

What are the

What does the
two ways that
variance of return
investment risk
measure?
is measured?

What does the What does the

standard deviation of return coefficient of variation
measure? measure?

Industry risk is risk that is specific to a particular in-
dustry. For example, a few years ago there were only a Market risk is a type of systematic risk. It is the risk that
few companies supplying a specific component that was an investment that is traded on a market has simply
required in solar electricity panels. The component was in because it is traded on a market, and thus it is subject to
high demand, the price was high, and profits were high. market movements. Market risk refers to the fluctuations
The high profits encouraged other companies to get into in the price of a stock or option.
the field. This caused the supply to increase and the price
to decrease. Then another, newer, technology emerged, As a general rule, an individual stock’s price will rise when
and the demand and the price for this specific component the market rises, and it will fall when the market falls. This
fell even further. The prices of the stocks of companies in risk has nothing to do with conditions in the company but
that industry declined sharply. That was a risk that all only with conditions in the market. Like systematic risk,
companies in that particular industry were subject to and market risk cannot be diversified away.
affected by.
Risk can be measured in either:

1) Absolute terms, or
The variance is another measure of the variability of pos-
2) Relative terms.
sible outcomes. The variance is the square of the
standard deviation. When calculating standard deviation The absolute measure of risk is usually expressed by
with a discrete probability distribution, we determine the means of the standard deviation of probable expec-
variance first, and then take the square root of the vari- ted future returns.
ance to get the standard deviation. The relative measure of risk (i.e., the amount of risk
when compared with the risk of other assets) is expressed
by the coefficient of variation.
The coefficient of variation is used to measure the risk

of securities relative to their expected returns and to com-
pare the risks of the different securities. The standard deviation of returns measures the dis-
persion of all the possible returns about their mean (and
The coefficient of variation is calculated as the standard the mean is the expected return). This measurement of
deviation divided by the expected return. It meas- dispersion is done both above and below the mean.
ures the level of risk for each unit of return that may be
expected. The larger the standard deviation for a particular invest-
ment is, the greater the variation among possible returns
It is used because different investments will seldom have is and thus, the riskier the investment. This is logical
the same expected returns. Using standard deviation because if there is a great degree of uncertainty as to
alone to compare the risk of different investments can what the expected outcome of the investment will be,
lead to misleading conclusions when the investments have there is greater risk.
different expected returns as well as different standard
deviations.
What is the
Capital Asset Pricing Model
What is the formula in the
(CAPM) and how is it used
to estimate an investor’s
(CAPM)?
expected rate of return
on an investment?

How is beta in the

What do different
(CAPM) used to measure
betas mean?
the risk of an individual
stock investment?

What are the five What is the

primary ways to Arbitrage Pricing Theory (APT)
interpret the beta of to calculate the return
an individual stock? on an investment?

The capital asset pricing formula is:
r = rF + !(rM " rF)
where:
The capital asset pricing model (CAPM) is frequently used
r = Cost of Retained Earnings (based upon investors’
to estimate the investors’ expected rate of return on a
required rate of return)
security or a portfolio of securities.
rF =Risk-free rate of return
# = Beta coefficient The CAPM uses the security or portfolio’s risk and the
rM =Market rate of return market rate of return to calculate the investors’ required
return.
The risk-free rate (rF) is the rate of return on an invest-
ment in a riskless asset (approximated by the return on The theory behind the CAPM is that investors will price
very short-term U.S. Treasury bills). investments so that the expected return on a secu-
rity or a portfolio will be equal to the risk-free rate
The market rate of return (rM) is the required return on
plus a risk premium proportional to the risk, or beta, for
the average stock in the market.
that investment.
(rM – rF) is the market risk premium. It measures the
additional return (above the risk-free rate) that investors
demand to invest in stocks, which are generally riskier,
versus bonds.
A stock whose returns are perfectly correlated to the

returns of the market (meaning that the return of the
The market risk of an individual security is meas- security is always the same as the market) has a beta of
ured by its beta coefficient. The CAPM uses the secu- 1.0.
rity or portfolio’s risk, the market rate of return and the A beta of less than 1.0 means that the individual
risk-free rate to calculate the investors’ required return. security is less volatile than the market as a whole. For
The theory behind the CAPM is that investors will price example, if the market return increases by 12% and the
investments so that the expected return on a security or a security’s return increases by only 4%, the security has a
portfolio will be equal to the risk-free rate plus a risk beta of 0.33. This means that the return of the stock is
premium proportional to the risk, or beta, for that invest- 33% of the return of the market.
ment. A risk free security has a beta of 0.
According to the CAPM, an investment’s beta measures A beta greater than 1.0 means that the individual
its sensitivity to changes in the market (measured by security is more volatile than the market as a whole.
some benchmark). For stocks, the benchmark may be any For example, if the return increases 20% when the mar-
of a number of stock indexes. ket return increases by 8%, the security has a beta of 2.5.
This means that the return of the individual stock will be
250% of the return of the market.
Arbitrage Pricing Theory (APT) is a multifactor theory The greater the beta of an individual security, the more
based on the idea that in a competitive financial market, the return on that security varies in proportion to
arbitrage will assure equilibrium pricing according to risk the variation in return of the benchmark index that it
and return. Arbitrage is simultaneously purchasing and is compared with.
selling the same asset in different markets where its price
The five primary interpretations of a stock’s beta are:
is different in order to profit from the unequal prices.
1) A beta greater than 1.0 means that the individual
Arbitrage Pricing Theory looks at common risk factors to
security has historically been more volatile than the
calculate the correct price for a security. The goal of using
market as a whole.
that information is to identify securities that are under-
priced and can be purchased and immediately resold for a 2) A beta of less than 1.0 but greater than zero means
higher price. that the individual security has historically been less
volatile than the market.
The APT formula, if there are two risk factors, is:
3) A beta of exactly 1.0 means that the individual
R = rf +!1k1 + !2k2 security has historically moved in lockstep with the
market as a whole. Note that the market has a beta
Where: R = Expected rate of return
of exactly 1.0.
rf = Risk-free rate
4) A risk-free security has a beta of zero.
#1,2 = Individual factor beta coefficients
k1,2 = Individual factor risk premiums 5) A negative beta (less than zero) means the security
(Required Returns for factor – rf) has historically moved counter to the market.
What are
What is the four common factors
Fama-French that result in
Three-Factor Model? business risk
for the company?

What is
What is the formula for
operating leverage
degree of operating leverage
and how does it
if only one year of
impact business risk
income is available?
of a company?

How do you calculate What is the

the business risk financial risk
of a company? of a company?

The Fama-French Three Factor Model is similar to the
Arbitrage Pricing Theory. It is a method to calculate the
expected return and risk from an individual security based
Business risk is the variability of the firm’s earnings upon three factors:
before interest and taxes (i.e., its operating income, or 1) Market factor: the return on a market index minus the
EBIT). risk-free rate of return.
Several factors give rise to business risk: 2) Size factor: the return on small-firm stocks minus the
1) The variability of demand over time. return on large-firm stocks.
2) The variability of the sales prices over time. 3) Book-to-market factor: the return on high book-to-
market ratio stocks minus the return on low book-to-
3) The variability of the price of inputs to the product
market stocks.
over time.
The formula to calculate the expected return and/or the
4) The degree of operating leverage that the firm has.
expected risk premium is:
r ! rf = +bmarket (rmarket factor) +
bsize (rsize factor) + bbook-to-market (rbook-to-market factor)
Operating leverage is the relationship between the %

change in revenue (volume) and the % change in operat-
ing profit (or earnings before interest and taxes - EBIT).
The proportion of fixed costs in a firm’s total cost structure
controls the firm’s operating leverage. If the firm has fixed
operating costs (costs that do not vary with changes in
If only one year of income is available, the following for- volume) and revenue increases, operating profit will in-
mula can be used to calculate the degree of operating crease by a greater % than revenue increases.
leverage:
A firm’s degree of operating leverage (DOL) is one part of
Contribution Margin the firm’s overall business risk. DOL is not the source of
Operating Income (EBIT) the variability in the firm’s earnings. But the DOL is im-
portant, because it magnifies the impact of the other
factors on the variability of the firm’s operating profits.
The DOL is calculated as follows:
% Change in Operating Income (EBIT)
% Change Revenue
The increased volatility of net income caused by fixed

interest expense is called financial risk. Business risk is measured by calculating the variability
of a firm’s operating income using the coefficient of vari-
Financial risk includes two aspects:
ation.
1) The risk that the firm will not be able to pay its
interest and other obligations when they become due The technique is used to calculate the amount of business
because of lack of cash flow. risk that a company is subject to. We measure the varia-
bility of a company’s operating income by calculating the
2) The increased variability in earnings per share caused
standard deviation of the operating income forecast. If the
by the use of debt and requirement to pay interest on
standard deviation of the forecasted operating income is
the debt.
small, then the forecast is fairly certain to be achieved.
As the firm increases the proportion of fixed cost financing But if the standard deviation of the operating income fore-
to total financing in its capital structure, its fixed cash out- cast is large, there is a lot of potential variability and
flows for interest expense will increase. As a result, the uncertainty about it.
possibility that the firm becomes insolvent (unable to pay
its obligations) increases. The formula for the coefficient of variation of a firm’s oper-
Fixed interest costs have the same effect on the firm’s net ating income is:
income as fixed operating expenses have on the firm’s Standard Deviation of Forecasted Operating Income (EBIT)
operating income. They increase the volatility of that net Expected Value of Forecasted Operating Income
income.
How do you calculate the

What is financial leverage and
degree of financial leverage
how do you calculate the firm’s
if only one year of
degree of financial leverage?
income is available?

What is portfolio risk and

how does it impact the
How do you measure the
risk and calculation of
firm’s financial risk?
the expected return of
of an investment?

What is diversification
What is the type of risk that
and how does it impact
cannot be diversified away?
risk in a portfolio of assets?

Financial leverage is the use of debt to increase the
profitability of the company. It exists because of the pres-
ence of fixed financing costs – primarily interest on the
firm’s debt. As the volume of revenue and the level of
operating profit increase (or decrease), these fixed financ-
ing amounts remain constant. This is important because
If only one year of income is available, the following for- interest expense must be paid or the firm will default and
mula can be used to calculate the degree of financial risk liquidation by the bankruptcy courts. The more fixed
leverage: financing costs that a company has, therefore, the greater
Operating Income (EBIT) the risk of default for the company.
Earnings Before Taxes (EBT) The more fixed financing costs a company has, the more
its net income will increase (or decrease) as earnings be-
fore interest and taxes (EBIT) change.
The formula for the degree of financial leverage is:
% Change in Net Income
% Change in Operating Income (EBIT)
Portfolio risk is the risk of several assets when held in

combination. The combination of assets is called a portfo-
lio.
The expected return of a portfolio is the weighted aver- Financial risk is calculated by comparing the:
age of the expected returns of the assets held in the port- 1) Coefficient of variation of net income if there
folio. The weights are each asset’s proportion of the total were no interest expense (in other words, the
portfolio. firm’s business risk) with
However, the risk of a portfolio is not an average of the 2) the coefficient of variation of net income when
risk of the individual securities in the portfolio. Whether interest expense is present (which is the firm’s
the portfolio’s risk is higher or lower than the average of total risk).
the individual assets’ risks will depend on the structure of The difference is the amount of financial risk. As such,
the portfolio and how the returns of the individual assets the firm’s financial risk is a figure that is “backed into.”
move in relation to each other.
Correlation is the term used to describe how the returns
of two investments tend to move in respect to each other.
The process of combining assets to reduce risk is called

diversification. Asset allocation is the process of se-
lecting assets to combine in a portfolio to achieve the best
The risk that cannot be diversified away is called market risk/return tradeoff possible through diversification. When
risk, systematic risk, and undiversifiable risk. a sufficient number of assets have been combined to
achieve the full benefits of diversification, the portfolio is
Market risk, also called systematic or undiversifiable risk, called a “fully diversified” or “efficient” portfolio. This
is created by the fact that economic cycles affect all busi- means that the portfolio gives the highest rate of return
nesses, and publicly-held investments are traded in a for a particular level of risk or the lowest level of risk for a
market that can go up and down with economic news. In particular rate of return.
addition, market risk includes a certain amount of risk Risk reduction is achieved in a portfolio when the securi-
caused by imperfect correlations between and among ties held are not correlated with one another.
securities that are intended to offset one another. Market The portion of an individual asset’s risk that can be min-
risk cannot be diversified away, and all stocks are subject imized in a diversified portfolio is called diversifiable,
to it. unsystematic or non-market risk. This type of risk can
be minimized because it is caused by factors that are
unique to the asset, not things that affect the market as a
whole.
What does portfolio theory

How do you measure
state about managing risk
risk in a diversified portfolio
in a diversified portfolio
of investments?
of investments?

What is the covariance

What is the
of investments in a portfolio
correlation coefficient
and how does it help to
and what does it measure?
manage the portfolio’s risk?

How is the variability

How is the variability of
of an investment
a portfolio determined?
project determined?

Portfolio theory deals with the balancing of the risk and
Risk in a portfolio is measured by determining the the rate of return of investments and the selection of the
variability of the portfolio’s returns and how much the investments in the portfolio.
returns of any two investments tend to move in respect to The portfolio attempts to manage this balance of risk and
each other. The more the individual securities’ returns return through proper asset allocation. Individual in-
move in different directions, the more the variability of the vestments selected for inclusion in a portfolio should have
portfolio’s returns will be reduced. So a portfolio’s risk can characteristics that balance each other. If the portfolio is
be reduced by investing in securities that behave the put together correctly, the risks of the individual securities
opposite of each other. will be inversely related to one another and will therefore
The variability of a portfolio’s returns is measured by its offset each other to some extent when taken as a portfo-
variance and standard deviation. lio.
Calculating the variance and the standard deviation of a This means that the risk of the whole is less than (or
portfolio requires using the variances of the returns of the at least should be less than) the risks of the indi-
securities in it, the correlation coefficients or the co- vidual securities in the portfolio.
variances of every possible combination of two securities Asset allocation is the process of taking the amount that
in the portfolio, and the standard deviations of the indi- is to be invested and distributing the investments among
vidual securities. bonds, stock, real estate, and other investments in order
to achieve the correct balance of risk and return.
The degree of correlation in the returns of any two secu-

rities is measured by their coefficient of correlation, or
Covariance is a statistical measure of the amount by correlation coefficient.
which two securities’ returns move together. The variable for this is r and its value is between !1 and
1) A positive covariance means that the two returns +1.
move together. 1) A correlation coefficient of +1 means that the two
2) A negative covariance means that the two returns securities’ returns have in the past always moved
move in opposite directions. together, in the same direction and to the same
3) A covariance of zero means that the two returns are extent.
completely unrelated to one another and they do not 2) A correlation coefficient of !1 means that the two
vary together in either a positive or negative way. investments’ returns have in the past always moved
Covariances need to be determined between returns for in exactly opposite directions.
all possible combinations of two securities in a portfolio. 3) A correlation coefficient of 0 means that historically,
there has been no relationship between the returns of
the two securities.
The variability of the returns of a portfolio of projects is

measured by the variance and the standard deviation of
the portfolio.
As with liquid securities, the variance and standard devi-
The variability of the returns of an individual project
ation of a portfolio of projects depend upon:
refers to the difference between its actual returns and the
1) The variances of the individual projects within the project’s expected returns.
portfolio,
2) The percentage of total funds invested in each project, A project’s variability of returns is measured by its vari-
and ance or by its standard deviation. The variance is the
square of the standard deviation.
3) The correlation of the projects with one another.
The variance and standard deviation of a portfolio of pro-
jects is calculated in the same manner as it is calculated
for a portfolio of securities.
What is a What is an
natural hedge operational hedge
against foreign against foreign
exchange risk? exchange risk?

What are
international What is capital structure
financing hedges and what are the sources
against foreign of permanent financing?
exchange risk?

What are the

What is considered
eight primary factors
in the determination of the
that make up the
optimal capital structure?
interest rate for a bond?

While there are a number of techniques that can be used Multinational companies with foreign subsidiaries may or
when we have certain knowledge of the direction of future may not be exposed to exchange rate risk.
exchange rates, in most cases we are not able to predict
If a subsidiary’s costs are determined by the global mar-
the future.
ket and its products are sold in the global market, it will
The best policy is one of balancing monetary assets have very little exposure to exchange rate fluctuations. Or,
against monetary liabilities in order to neutralize as much if a subsidiary’s costs are determined by the country in
as possible the effect of exchange-rate fluctuations. A which it is located and its products are also sold in that
company can do this by maintaining a balance be- same country, again, there will be very little exposure to
tween payables and receivables denominated in a exchange rate fluctuations. The foreign subsidiary’s cash
foreign currency. flows will adjust naturally to currency exchange rate fluc-
A firm may also attempt to manage its exchange rate risk tuations; this can act as a natural hedge.
through diversification. By investing in different econ- However, if a subsidiary’s costs are determined in its
omies and currencies, the risk that all of them will drop at local market but its sales are made in the global
the same time is reduced. market, it will be exposed to exchange rate risk.
Or even more simply, a firm can keep foreign-denomi- And if its costs are determined in the global market but its
nated payables or receivables at a minimum level so sales are made in its domestic market, again it will be
as to avoid the risk completely. exposed to exchange rate risk.
The capital structure of a firm includes the long-term

liabilities and equity sections of the balance sheet. This
shows how the company obtained the necessary money to
buy the assets that the company holds. In contrast to the
working capital area, the capital structure relates to the
permanent financing that the firm has.
These sources of permanent financing are:
A firm can borrow in a foreign currency to offset a
1) Long-term debt which generally takes the form of
net receivables position in that currency. Or, a com-
loans from banks or the issuance of securities called
pany with a foreign subsidiary can borrow in the country
“Bonds.”
where the subsidiary is located in order to offset its expo-
2) Preferred stock, and
sure.
3) Common shareholders’ equity made up of :
a) Common stock (the par value of the shares),
b) Additional paid-in capital (this represents the
excess of the sales price of the shares of the stock
over the par value of the shares), and
c) Retained earnings (undistributed company
profits).
The rate of interest of a bond is influenced by eight pri- The optimal allocation of financing between the dif-
mary factors: ferent types of capital takes many different items into
1) Risk-free rate. account. Among these are:
2) Implied inflation factor included in the risk-free rate 1) The future prospects of the company.
(which is always stated in nominal terms). 2) The equity market – if the equity market is doing
3) Credit or default risk of issuer. poorly, the cash received from the sale of stock will be
less than in a period of a strong market.
4) Liquidity of bond.
3) The composition of the company’s assets.
5) Tax status of bond. 4) The amount of risk that the company is willing to
6) Term to maturity: relationship between the matur- accept—debt sources are inherently more risky to the
ity of a security and its rate of return, defined by the firm than equity sources.
term structure of interest rates. 5) The reputation of the issuer (company) and the in-
7) The term of a bond traded in the secondary market terest rate that they would need to pay in order
creates another risk: risk of loss of principal due to be able to issue debt.
to a general increase in market rates which leads 6) The cost of each source of capital – we will turn
to a decline in the market value of the bond. our attention in a later section to the calculation of the
8) Special provisions: an example is a call feature, cost of capital. This is an important topic on the exam,
which gives the issuer the option of buying back the and you need to be able to calculate the costs of cap-
bond prior to its maturity at a given price. ital for different instruments.
What is the calculation How do you convert the

for the nominal yield nominal yield on a debt
on a debt security? security to a real yield?

What does the slope

What are the
of the yield curve say
four major theories
about the market’s
that attempt to explain
expectations about
the slopes of yield curves?
interest rates?

How is the selling price What is the

of a bond calculated? bond premium or discount?

We calculate the nominal yield on a debt security by
starting with the risk-free rate.
However, we do not necessarily have to use the short-
term U.S. Treasury Bill rate for the risk-free rate. Rather,
we can use the rate for the U.S. Treasury security that is
closest in term to the term of the security for which we
Remember that the total, or the appropriate yield, is a
are calculating an appropriate rate. By doing this, we
nominal rate which contains an inflation premium.
eliminate having to consider term to maturity of the issue
To convert a nominal rate to a real yield, we use the as a factor in determining its rate, because that risk
following formula: premium is already built in as part of the risk-free rate we
use as the basis of our calculation.
1 + Nominal Rate ! 1
The formula to make this calculation is:
1 + Inflation Rate
Yield of Treasury security with same term
+ Default premium
+ Liquidity premium
+/- Premium or Discount for tax status
+/- Premium or Discount for special provisions
= Yield of debt security
The slope of the yield curve says the market´s expecta-

There are four major theories that attempt to explain the tions about interest rates:
slopes of yield curves: 1) Upsloping, or Normal, Yield Curve: Normally
1) The Pure Expectations Theory: the shape of the longer-term interest rates will be higher than shorter-
yield curve is determined by expectations in the mar- term interest rates.
ket of future interest rates. 2) Downsloping Yield Curve: If the market expects
2) Liquidity Preference Theory: if investors increase interest rates to decrease in the future, borrowers will
their risk by holding long-term bonds, they will require prefer to borrow short term, while investors will prefer
higher compensation (higher interest rate) for assum- to invest long-term.
ing that increased risk. 3) Flat Yield Curve: If the market expects that interest
3) The Segmented Markets Theory: focuses on cash rates will not change much in the future, the yield
needs of different groups of investors and borrowers. curve will be flat.
Each group chooses securities that meet its forecasted 4) Humped Yield Curve: As expectations change from
cash needs. increasing rates to decreasing rates, the yield curve
4) The Preferred Habitat Theory: a compromise com- may pass through a period where it is humped, or
bining the elements of the Segmented Markets Theory raised in the middle. During this period, long-term
and the Pure Expectations Theory. rates will be about the same as short-term rates, but
medium-term rates will be higher.
If the selling price of the bond is less than the face value
of the bond, it is said that the bond is selling at a dis-
count. This situation arises when the market rate of
The selling price of any bond is calculated by determin-
interest is higher than the interest rate that is stated on
ing the present value of all of the future cash flows
the bond. If the bond were sold at its face value, nobody
of the bond. There are two cash flows that are relevant
would buy the bond because they can receive a larger
to this process:
return from another bond in the marketplace. By reducing
the selling price of the bond (but not the amount of 1) Each of the interest payments, and
interest that is actually paid each period) the effective 2) The repayment of the face amount at maturity.
interest rate of the bond becomes equal to the mar-
This discounting to the present value is done using the
ket rate of interest.
market rate of interest for bonds with similar character-
istics (same maturity, default risk, terms and conditions,
In a situation in which the stated rate of interest on the
etc). The market rate is used because this is the rate of
bond is higher than the market rate of interest, the bond
the investment alternatives available and is therefore the
will be sold at a price above the face value. This higher
minimum return that an investor would require.
price (but still unchanged interest payment) makes the
effective rate of the bond equal to the market rate of the
bond. This is called a premium.
What are the

disadvantages
of issuing bonds?
of issuing bonds?

What are
What are debenture bonds,
restrictive covenants,
income bonds and
call provisions and
serial bonds?
putable bonds?

What are convertible bonds

and how does their
What are mortgage bonds?
convertibility impact
their interest rate?

Disadvantages for the company issuing bonds are: Advantages to the issuer of bonds include:
1) The cost of servicing the bonds because the interest 1) There is no loss of control or ownership. The hold-
is fixed and required. Even in periods of losses and ers of the bonds are not owners and do not have any
low cash balances, the interest must be paid. If it is voice in the running of the company.
not paid on time, the company breaches its contract
2) The total cost of the bonds is limited and known
with the bondholders and defaults on the bond
because the interest rate is constant. Additionally, if
(loan), which can lead to bankruptcy and liquidation of
the company is very successful, the bondholders do
the firm. In comparison to equity, this is a disadvan-
not receive any additional payments above the stated
tage because dividends never have to be paid. There-
interest.
fore, equity provides more flexibility for the company.
2) Increased risk to the firm because of the chance of 3) The interest that is paid on the bonds is tax-de-
default on the debt. As the level of debt grows, the ductible as an expense of the business. This is an
interest rate on the next loan and return required by advantage because dividends that are paid to share-
shareholders will increase. In times of low income or holders are paid after taxes and are not deductible for
poor cash flows, this interest requirement may be- tax purposes.
come too large for the company. 4) If the bonds are callable, or otherwise can be retired
3) The maturity of the debt will result in a large cash early, there is flexibility for the company to elim-
payment that needs to be made at one time in inate the interest payment if there is no longer a
the future. need for the financing.
Debenture bonds are bonds that are not backed by Restrictive covenants limit the actions that a company
any specific asset as collateral. The only backing to may take that may be detrimental to the bondholders.
the bond is the company itself. Because of the lack of spe- These covenants may be related to various ratios, working
cific assets pledged as collateral, only companies that capital amounts or even dividend payments.
have a very high credit rating and a large amount of pub-
lic confidence can issue debenture bonds. Also, to take Some bonds are issued with a call provision, which
into account the additional risk, these bonds will most enables the issuing company to call the bonds (repurchase
likely have a higher interest rate than collateralized bonds. them) at their option. This is very beneficial to the issuer
(and therefore not beneficial to the investor) because the
Income bonds pay interest only if the company issuer can call these bonds (retire them) if the interest
achieves a certain level of income. These bonds are rate in the market falls below the rate that they are pay-
obviously riskier for the purchaser of the bonds because ing in interest on the bonds.
the payment of interest by the issuer is not guaranteed.
Similarly, some bonds may be putable. This is similar to
Serial bonds are bonds issued so that they mature over callable, except that the option to retire the bond belongs
a period of time. Some of the bonds mature each year, to the purchaser of the bond. If certain events occur, or if
which enables the issuer of the bonds to retire the bonds the issuing company violates any bond covenants, the
over this period of time without the need for a single, investor can require that the issuer repurchase the bonds
large cash payment. from them.
Convertible bonds may be converted by the bondholder

Mortgage bonds have specific asset(s) pledged as the into a stated number of shares of common stock anytime
collateral for the loan. This collateral makes the bonds during the bond’s life. This is a very advantageous provi-
less risky to investors because, in the event of default, sion for the holder if the price of the firm’s common stock
the sale of the assets may cover the remainder the firm increases significantly during the bond’s life.
owes and is unable to pay on the bonds. Therefore, mort-
gage bonds carry a slightly lower interest rate than As a result of the significant potential benefit to the holder,
debentures. this provision results in a significant reduction of the
interest rate paid by the bond.
What are What are

(BLANK) (BLANK)
subordinated debentures? zero-coupon bonds?

What are
(BLANK)
indexed bonds?

What are What are the rights

international bonds? of common shareholders?

Zero-coupon bonds do not pay any interest, but they Subordinated debentures are bonds that will not have
sell at a price significantly less than the face value. the first claim to the assets of the company in case of a
The large discount on the sale of the bonds offsets the bankruptcy. This is because these bonds are subordinated
fact that there is no interest payment. In a sense all of the (inferior) to other debts that the company has. In case of
interest is withheld to maturity and paid at that time. The bankruptcy, all superior debts will be settled before subor-
advantage to the issuer is that there is no cash outlay for dinated debentures. Because of this additional risk, subor-
the payment of interest. (This works in much the same dinated debentures will generally pay a higher rate of
way as discounted interest on a bank loan.) interest than unsubordinated debt.
Indexed bonds have an interest rate that is indexed to

some other measure, such as the price index or a general
economic indicator.
Most common shareholders have the following rights:

1) Voting. There are different methods used for voting,
There are two types of international bonds.
but almost all owners of common shares have the
right to vote at the annual shareholders’ meeting. 1) Foreign bonds are issued in a single country (not
While votes are taken on a variety of corporate issues the issuing corporation’s home country) and are usu-
such as mergers, the most significant vote is the elec- ally denominated in the currency of the country where
tion of a Board of Directors to oversee the company they are sold.
management on behalf of the shareholders. 2) Eurobonds are sold in multiple countries but all
2) Dividends if declared, which may or may not be are denominated in a single currency – usually the
paid in a given year. Shareholders may receive but are currency of the issuer’s home country, not the country
not guaranteed dividends by the Board. where the bond is primarily sold. For example, a U.S.
company may issue Eurobonds denominated in U.S.
3) Preemptive rights to purchase new shares issued by
dollars in many countries. Eurobonds may be cheaper
the corporation so that their % of ownership is not
than issuing the bonds in the home country because
diluted by the issuance of new shares, and
there may be lower registration and reporting require-
4) Rights to share in the distribution of residual as- ments related to government regulations.
sets (after the satisfaction of all liabilities) if the com-
pany is liquidated.
What are the

disadvantages of a
of a company issuing
company issuing
common stock?
common stock?

How is preferred stock How is preferred stock

similar to a bond? similar to common stock?


What are cumulative
and disadvantages
preferred dividends?
of issuing preferred stock?

The advantages of issuing common stock are:
The disadvantages of issuing common stock are: 1) Common stock does not have a fixed payment
1) As shares are issued to others, the current share- (like bond interest) that must be made to the holders.
holders lose control over the company. 2) Shares do not mature and do not require a lump
2) There is a limit as to the number of shares that a sum repayment of the principal in the future.
company may issue. 3) There is greater flexibility in the financial structure
3) The cost of issuing the shares may be higher of the firm because there is no interest payment that
than the cost of issuing debt. needs to be serviced and maintained. Additionally, no
4) Since common stock is the riskiest security from an covenants need to be maintained.
investor viewpoint, investors expect the highest 4) The issuance of shares brings additional capital into
return on their investment. the firm, thereby lowering its debt ratios and per-
5) Unlike interest on bonds, the distributions that are ceived risk.
made in the form of dividends are not a tax-de- 5) Investors often prefer common stock because there is
ductible business expense in the U. S. the chance of the significant appreciation of the
value of the stock when the company is successful.
Preferred stock is a hybrid, or cross, between common

stock and bonds. There are five main ways in which
preferred stock is similar to a bond:
Preferred stock is similar to common stock in three
1) Preferred stockholders usually do not vote on issues
ways:
at the Annual Meeting,
1) Not paying dividends during times of financial
2) Preferred stock usually pays a constant annual
distress does not breach the contract and cannot
dividend. Also, these preferred dividends are usually
result in bankruptcy proceedings,
stated as a percentage of par value (covered below in
2) Preferred dividends are paid after interest and cumulative dividends),
taxes. Therefore, they are not tax-deductible from
3) Preferred shareholders receive preference over
the firm’s standpoint, and
common shareholders in the case of asset distrib-
3) In the event of asset distribution in a liquidation, pre- ution in a liquidation,
ferred shareholders are junior to bondholders
4) Preferred shareholders generally receive dividends
and other creditors. However, they are senior to com-
before common stock shareholders, and
mon shareholders.
5) Often, preferred stocks are issued with bond-like
features: call, convertibility, maturity date, sinking
fund, etc.
The main advantages of issuing preferred shares are Cumulative dividends are a type of preferred dividend
that the voting control of the company is not diluted that are earned every year, even if they are not distrib-
and in most cases any unusually high profits are main- uted. This cumulative dividend is a percentage of the face
tained for the common shareholders rather than value of the stock. In a period in which the preferred
needing to be distributed as a dividend to preferred share- cumulative dividends are not paid, they become in
holders. arrears. These preferred dividends in arrears must be paid
before any common dividends can be paid.
The disadvantages of issuing preferred stock are that
the dividends are not tax-deductible and in the case The amount of cumulative dividends in arrears must be
of cumulative dividends, there is still a need to “pay” disclosed in the financial statements of a company
dividends in periods when there are low, or no, because this amount can impact whether or not common
profits. shareholders will be able to receive a dividend.
How is a share valued How is a share valued

using the zero growth using the constant growth
dividend model? dividend model?


a “rights on” regarding
What is a stock right? a stock right and what
timeframe is included
in the rights period?


“ex-rights” regarding
How is a right valued
a stock right and
when the share is
what timeframe is
selling rights-on?
included in the
ex-rights period?

The constant-growth dividend model is used for common
The zero-growth dividend model is used for preferred
shares. The value of a common share under this model is
shares. The value of a preferred share under this model is
calculated as follows:
Next Annual Dividend
Annual Dividend
Investors Required Rate of Return
Investors Required Rate of Return
- Annual Dividend Growth Rate
A stock right is simply the ownership of the right to buy

A stock right is the right to buy newly-issued stock from a share of stock. Rights to buy additional shares are often
the issuing company at a given price. “created” or issued when the common shares of a com-
If a stock right is not exercised by its holder before the pany are originally issued. The most common of these are
expiration date (and the required purchase price paid for called preemptive rights which means: whenever the
the newly-issued stock), then the holder of the right does company issues new common shares, all of the existing
not get the new stock. shareholders have the right to buy the same proportion of
the new shares as the proportion of the company that
Anyone who buys the stock before the ex-rights date will they owned prior to the issuance. This preemptive right
be the owner of the stock on the record date and will prevents their ownership percentage from being diluted as
receive the rights. So after the announcement and the result of more shares being issued.
before the ex-rights date, the stock is sold rights-on.
The buyer does not need to do anything to get the rights It is important to remember that the preemptive right is
when they are issued. The buyer will get them simply applicable only for new issuances of stock. This means
because he or she is the shareholder of record on the shares that are newly registered. If a company has shares
specified record date. In that case, the stock is said to be that have been previously registered, but not sold, there
trading "rights-on." is no preemptive right when they choose to issue these
“old” shares.
Once the stock rights have been issued and the stockhold-
ers as of that date receive them, the rights belong to the
A share is selling rights-on when the rights are still
stockholders who received them.
attached to the share and they will be purchased together.
The formula to calculate the value of a right when it is If a stockholder sells his stock after receiving the rights,
selling Rights-On is: the selling stockholder continues to own the rights. The
rights do not go along with the share. In that case, the
Po - Pn stock is sold “ex-rights.” The former stockholder could
r+1 still exercise the rights and buy the authorized number of
Where: newly-issued shares anytime before the expiration date of
Po= the value of the share with the right still attached the rights.
Pn= the subscription price (sales price) of the share when If the rights are not exercised by their owner, they simply
it is purchased through the rights expire worthless.
r = the number of rights needed to buy one share
The ex-rights period extends from the ex-rights date until
the expiration date of the stock right.
What are
How is a right valued employee stock options
when the share is and warrants and
selling ex-rights? how do they differ
from stock rights?

What are the What are American

three types of stock warrants? Depository Receipts?

What are What are

forward contracts? futures contracts?

Employee stock options and stock warrants are sim-
ilar to a stock right in that each gives their holder the
option to buy a share of stock during a future period
of time at a set (exercise or strike) price. A share is selling ex-rights when the rights are no longer
Warrants and employee stock options differ from stock attached to the share and they may be purchased sepa-
rights, however, in that they may be given to investors rately. The formula to calculate the value of a right when it
who are not already shareholders, since they are not is selling Ex-Rights is:
based on number of shares already held as rights are. Market Value of the Stock, Ex-Rights - Subscription Price
Employee stock options are often distributed to employees Number of Rights Needed to Buy one Share
as a form of compensation. Or warrants may be attached
to debt instruments such as a bond and sold with the
bond.
There are three types of stock warrants:

American Depository Receipts (ADRs) are the method
by which a foreign company can, in a sense, sell shares in 1) Usually, warrants included with bonds are “detach-
the U.S. without having to go through the formal SEC able warrants” meaning that the holder may imme-
share registration process. In an ADR, the foreign com- diately separate the two securities and choose to hold
pany deposits some of its shares with a bank. The bank or sell each independently.
then issues the ADRs, which represent the shares of the 2) A “nondetachable warrant” has no value unless it
foreign company that the bank holds. is attached to the bond.
3) Standalone warrants: sometimes given to business
This process enables a foreign company to participate in
partners to complete or sweeten a business deal.
the U.S. capital market without having to go through all of
They allow the holder to buy stock in the company
the formal procedures.
offering the warrant at a specified price and time.
A futures contract is similar to a forward contract, in A forward contract is an over-the-counter agreement

that it is an agreement to buy or sell a specified quantity between two parties to buy or sell an asset at a certain
of a specified asset on a future date for a specified price. time in the future for a certain price.
The parties to a futures contract have the same long and The party that bought as a protection against a
short positions as the parties to forward contracts: possible increasing price of the underlying asset
has a long position.
The party committing to buy the underlying asset
as a protection against a possible increasing price The party that sold as a protection against a
of the actual financial instrument or physical com- possible declining price of the underlying asset
modity holds a long position. has a short position.
The party committing to sell the underlying asset Usually, the delivery price is such that the initial value of
as a protection against a possible declining price the contract is zero. The contract is settled at maturity by
of the actual financial instrument or physical com- the sale and purchase of the commodity or other asset.
modity holds a short position.
The distinguishing characteristic of a forward contract is
However, futures contracts are different from forward con- that it is not traded on any market or exchange. They are
tracts because they are traded on exchanges. therefore called over-the-counter.
What are the

What are the
four ways that
two types
interest rate risk
of futures contracts?
can be managed?

What are
interest rate future contracts
What is duration hedging?
and how are they used to
hedge interest rate risk?

What are
What is maturity matching
interest rate options
and how is it used to
and how are they used to

An investor in fixed income securities or a financial institu-
tion has a significant amount of interest rate risk. When The two basic types of futures contracts are:
interest rates increase, the market value of fixed rate 1) Commodity futures.
assets held will decrease. 2) Financial futures.
Interest rate risk can be managed by use of: Examples of commodities traded in commodity futures
1) Interest rate futures. markets are agricultural products, metals, energy
2) Duration hedging. products, and forest products.
3) Interest rate options. Examples of financial futures traded are futures contracts
on debt securities (interest rate futures) and stock index
4) Maturity matching (a financial institution can use this futures.
method to hedge its interest rate risk).
Futures contracts are available for interest rate futures to

hedge fixed income securities. Financial futures contracts
Another way to hedge against interest rate risk is to use
on debt securities such as U.S. Treasury securities are
duration hedging. Duration (also called Macaulay Dura-
called interest rate futures. Financial institutions such
tion) is a weighted average of the times until the receipt
as mortgage companies, commercial banks, and insurance
of both interest and principal, weighted according to the
companies use interest rate futures to hedge their expo-
proportion of the total present value of the bond repres-
sure to interest rate movements.
ented by the present value of each cash flow to be re-
ceived. A commercial bank might use interest rate futures as a
short hedge if the bank holds a large amount of fixed-
As duration increases, the volatility of the price of the debt
rate commercial loans as assets but its primary source of
instrument increases. In a sense, duration is a measure of
funds (liabilities) is short-term deposits. This action
the elasticity of the security.
hedges the risk from increasing interest rates.
Duration is lower if the nominal rate on the instrument is
Interest rate futures might also be used by a bank to cre-
higher, because more of the return is received earlier in
ate a long hedge, in order to reduce the financial institu-
the life of the instrument.
tion’s exposure to the possibility of declining interest
rates.
Maturity matching is a technique that can be used by a

financial institution that has both financial assets and fi-
nancial liabilities.
An interest rate option is an option over an instrument
Since the net worth of a financial institution is equal to its such as a bond that gives the buyer, in exchange for the
total assets less its total liabilities, it has been argued that payment of a premium, the right to buy (if a call option)
if a financial institution can equate the duration of its fi- or to sell (if a put option) the specific bond at a specified
nancial assets – its deposits – and the duration of its fi- price, on or before the expiration date of the option.
nancial liabilities – its loans – (i.e., their duration is the
same), the bank can immunize its net worth against fluc- The underlying securities are usually for interest rate
tuations due to changes in interest rates. This is due to futures contracts and are direct obligations of the U.S.
the fact that the total change in value for assets as a re- Government such as Treasury bills, notes, and bonds.
sult of a change in interest rates will be equivalent to the
total change in value for liabilities as a result of the
change.
What are the

What are swaps?
two types of options?

What are call options? What are put options?

What is the
What is an
difference between
option premium
an American option and
a European option?

Swaps are contracts when two parties trade payment
streams, usually payment on debt. An interest rate swap
The two types of options are call options and put takes place when two parties exchange interest payments,
options. one at a fixed rate and one at a floating (or variable) rate
that is pegged to some sort of market rate of interest and
A call option gives the long party (the buyer of the changes whenever the market rate changes.
option) the right to buy the underlying security at the
strike price (i.e., the exercise price) from the short party A swap can also be a currency swap in which two parties
(the seller of the option). exchange the currency that a payment will be made in.
A put option gives the long party (the buyer of the The primary purpose of a swap (either interest rate or
option) the right to sell the underlying security at the currency) is to match the characteristics of the firm’s rev-
strike price to the short party (the seller of the option). enue stream with the characteristics of its payment
stream. For example, if a firm has a revenue stream that
In both cases, the short party (the seller of the option) increases or decreases with the market rate of interest, it
has to comply if the long party decides to exercise the would want its payment stream to also increase or
option. decrease with interest rates. Swapping a fixed rate loan
for a floating rate loan would achieve this goal, and reduce
the firm’s overall risk.
A put option gives the owner (buyer) the right to sell A call option is the most common type of option. It gives
the asset that is covered in the option by the expiration the owner (the buyer) of the option the right but not the
date at the price that is fixed in the option. The writer of obligation to buy the asset that is covered in the option by
the put option has no choice but must obey the will of the the expiration date at the price that is fixed in the option.
owner and thus must buy the asset if the owner decides The writer of the option must obey the will of the owner of
to exercise the option. the option and thus must sell the asset if the owner
decides to exercise the option.
With a put option, the seller of the underlying asset will be
in the long position while the buyer of the underlying
If the exercise price of a call option is lower than the mar-
asset will be in the short position. This is the reverse of
ket price of the asset, the call option is in-the-money. If,
the long and short parties in a call option.
however, the exercise price is greater than the market
The same terms of in-the-money and out-of-the-money price, the option is said to be out-of-the-money as it is
apply for put options, but they are opposite from call not sensible to exercise the option since that would cost
options. This is because a put option has value if the exer- more than buying the asset on the open market. When
cise price is above the market value, and the put option is the exercise and market prices are the same, the option is
therefore in-the-money. at-the-money.
An American option is an option in which the owner has

The option premium is the amount paid for an option by
the right to buy or sell the covered asset at a fixed price
the person who purchases it. The option premium is
at any time before or on the expiration date.
priced on a per share basis. Each option on a stock corre-
sponds to 100 shares. Therefore, if the premium of an
A European option also gives the owner the right to buy
option is priced at 2, the total premium for that option
or sell an asset, but it is exercisable only at the matu-
would be $200 (2 x 100 = $200).
rity date.
What is a covered option? What is a naked option?

What are the

What is open interest? three ways to exit
an option position?

What components
What is the
determine the market
binomial method?
price of an option?

A naked option is a call option for a stock which the
option writer does not hold in his or her portfolio. A covered option is a call option for stock that is held in
A naked call option is much more risky than a covered call the option writer’s portfolio.
option, because if the call option is exercised by the option A person who writes a covered call option on a stock that
holder, the writer will probably lose money. The reason the they already own is obligating him- or herself to sell that
writer will probably lose money is that if the call option is stock at a specific price up until the expiration date.
exercised, it means that the market price has risen above If the market price rises above the strike price, the call
the strike price. Therefore, the writer of the option will option will probably be exercised. The seller of the stock
have no choice but to purchase the stock at the higher will receive only the strike price for the sale, not the
market price and sell it to the option holder at the lower higher market value. However, the seller of the stock will
strike price. Unless the price the writer received for the have also received the sale price for the option, and that
sale of the option offsets the difference, the option writer will partially or fully offset the seller’s loss from having to
will lose money. sell the stock at a price below that of the market.
A naked option would be written by someone who is bet-
Conversely, if the market price declines below the strike
ting that the market price of the stock will go down, not
price, the call option will not be exercised and the seller
up, and that the option will never be exercised, leaving
will continue to own the underlying stock, while keeping
the writer with the income from the sale of the option
the price received for the option as an offset to the market
while not being required to buy the stock in order to sell it
value loss.
to satisfy the call.
Open interest represents the total number of outstand-

ing options contracts for each asset at the end of each
The option owner has three choices to exit the option
day. The net amount of change in the total number of out-
position to make a profit or avoid a loss:
standing options and futures contracts helps investors
1) Exercising the option: the owner chooses to take determine whether money is flowing into or out of the
delivery of (if a call) or to sell (if a put) the underlying instrument.
asset at the option's exercise price, also called the
strike price. Open interest is a factor used by technical analysts.
2) Offsetting the option: offsetting is a method of According to the technical analysts, an increase in open
reversing the original transaction to exit the trade. interest combined with higher volume and higher prices
for a stock is an indication that the upward trend in share
3) Letting the option expire: if an option has not been
prices for the security will continue; whereas a decrease
offset or exercised by its expiration date, the option
in open interest combined with a decrease in volume and
expires worthless.
higher prices for a stock is an indication of an impending
end to the security’s upward trend.
The binomial model takes a risk-neutral approach to The premium is the market price of the option itself at
valuation. It assumes that underlying security prices can any particular time. This is the amount that is paid by the
only either increase or decrease with time until the option buyer to the seller in order to receive the rights conveyed
expires worthless. by the contract. Two of the primary determinants of an
option’s price are its intrinsic value and its time value.
Since it provides a stream of valuations for a derivative for
each “node” during a period of time, it is useful for valuing Total Option Premium = Intrinsic Value + Time Value
American options that can be exercised at any point prior The intrinsic value of an option is the amount by which
to the exercise date (unlike European options which are the option is in-the-money at any point in time.
exercisable only at the expiration date).
The time value represents that portion of an option’s
The model reduces possibilities of price changes, removes premium in excess of its intrinsic value. An option usually
the possibility for arbitrage, assumes a perfectly efficient has an expiration date after which it can no longer be
market, and shortens the duration of the option. It uses exercised. If the option has not been exercised prior to
an iterative (running many times) procedure, allowing for expiration, the option will no longer be available and it will
the specification of “nodes,” or points in time, during the cease to exist. The longer the time before its expiration,
time span between the valuation date and the option’s the more valuable the option is, because there is more
expiration date. time for a favorable price fluctuation.
What are the

What is the differences between the
Black-Scholes method? combined option positions
called strangles and straddles?

How is the
What is the
weighted average cost
put-call parity theorem?
of capital calculated?


How is the cost
effective interest rate on debt
of debt calculated?
in the first year?

A straddle is a call and a put position purchased by the same The Black-Scholes Option Pricing Model is a pricing
investor or sold (written) by the same investor. The main model for a European call option, so it assumes the
characteristics are: option can be exercised only on its expiration date.
1) The call and put have the same strike price. The Black-Scholes model makes a number of assump-
2) Both expire in the same month. tions:
3) Both are on the same stock.
1) The underlying stock does not pay dividends,
4) Both are for the same number of shares.
5) The strike price is at or close to the money. 2) The risk-free rate is known and is constant over the
6) The investor does not own the underlying stock when the entire life of the option,
straddle is set up. 3) The probability distribution of stock prices is lognor-
A strangle is similar to a straddle because they use both put mal,
and call options on the same number of shares of the same
underlying stock. Often the puts and calls have the same 4) The variability of the underlying stock’s return is con-
expiration date. stant,
However, these put and call options have different strike 5) There are no transaction costs for trading the option,
prices. Instead of using strike prices that are at-the-money,
the investor chooses puts and calls with strike prices that are 6) Tax rates are similar for all participants who trade
out-of-the-money: well above or below the underlying options, and
stock’s current price. This costs less but requires the stock to 7) The underlying stock does not pay any cash div-
move more before it is profitable. idends.
The put-call parity theorem states:

if all of the following conditions exist:
1) Market equilibrium for all prices.
The most common way to calculate the cost of cap- 2) Equal exercise prices for put and call options.
ital is on a “weighted average” basis. In order to do this, 3) Same expiration date for put and call options.
one must: then: a person who buys one share of stock, buys one
put option and sells one call option will have a risk-free
1) Calculate the cost of each component (debt, preferred
return on these investments.
stock, common equity) of the firm’s capital structure,
The gain, or loss, from the share and the put should be
and
equal to the loss, or gain, from the call. This equivalency
2) Determine the appropriate weighting to be assigned is expressed in a formula as:
each component. C " P = S0 " X / (1 + rf)T
The formula looks as follows: Where:
C = Call premium
Total Costs of Financing P = Put premium
Total Fair Value of Financing S0= Purchase price of stock
X = Exercise price of the call/put options
rf =Discount rate for exercise price, or risk-free rate
T = Time to expiration (years or fraction of year)
The cost of debt is the interest rate that needs to be paid

(yield demanded by investors), adjusted for taxes. This
adjustment for taxes must be made because interest is a
tax-deductible expense. As such, the actual cost of the
interest is less than the amount of cash paid for interest.
Because of this tax deductibility and their inherently lower
The effective interest rate before tax for the first year risk than equity sources, bonds are generally the lowest
only can be calculated as follows: after-tax cost source of new financing.
Interest expense The formula is as follows:
Cash received from the sale of the bond
Cd = C (1-t)
Where:
Cd= the after tax cost of debt
C = the cost of the debt before taxes
t = the marginal tax rate
What is the
How is the cost
cost of retained earnings
of newly issued
to a company and the
preferred stock
three primary methods
calculated?
to calculate this cost?

How is the cost

How is the cost
of retained earnings
of retained earnings
calculated under the
calculated under the
capital asset pricing model
dividend growth model?
(CAPM)?

How is the cost

What is the
of new common equity
marginal cost of capital?
calculated?

The cost of retained earnings to the company is not a The cost of new preferred stock is calculated in much
cash cost that is paid in the form of dividends or interest. the same way as the cost of debt because most preferred
Rather, it is the opportunity cost of the next best invest- shares pay their dividend in the form of some percentage
ment that was not made by the shareholders. This makes of the face (par) value of the shares. Because preferred
it harder to visualize the cost incurred by the company, dividends are a distribution of income, they are not tax-
but it is the return that the shareholders of the company deductible.
would have received had they gotten all the profit in form As a result of this, the calculation for the cost of preferred
of a dividend and invested that money somewhere else. shares does not include an adjustment for taxes. When
The cost of retained earnings is based upon the risk of the issuing new shares, however, the firm will incur flotation
firm and the investors’ required rate of return. costs including administrative expenses associated with
registration of the security, and investment banking fees
There are three different ways to calculate the cost of paid to brokers who sell the securities. The flotation costs
retained earnings: reduce the proceeds from the sale of the securities.
1) Dividend (Gordon) Growth model. The formula is:
2) Capital Asset Pricing Model (CAPM).
Yearly Dividend
3) Arbitrage Pricing Theory (APT). Net Proceeds from Issuance
Many companies pay little or no dividend to their share-

The dividend (Gordon) growth model uses dividends
holders. In these cases, it is impossible to use the
per share, the expected growth rate, and the market price
dividend valuation models previously described to calcu-
of the share in order to estimate the cost of retained
late the cost of equity capital. Therefore, the capital
earnings. For the company to support a decision not to
asset pricing model (CAPM) is frequently used to
distribute its profits, it must be able to generate a greater
estimate the cost of equity – either retained earnings or
return than the amount calculated by the dividend plus a
new equity. In cases of new equity offerings with substan-
growth rate in the level of dividends paid. This is the
tial flotation costs or under-pricing (like IPOs), using CAPM
same formula used in calculating the cost of new
is not recommended. It uses the following formula:
common equity except the firm does not incur issu-
r = rf + B(rm – rf) ance (flotation) costs to retain earnings.
Where: The formula for calculating the cost of retained earnings

rf = the Risk-Free Rate using the dividend growth model is:
B = Beta
_ The Next Dividend Paid + Annual Dividend Growth
rm= is the Market Rate of Return
Current Common Stock Price
r = the Cost of Retained Earnings
The marginal cost of capital is the cost of the next dol-

lar of capital that is raised. When we calculated the The cost of new external common equity is going to
Weighted Average Cost of Capital, we always used mar- be higher than the cost of retained earnings because
ginal costs, or the cost to acquire new dollars of capital. the process of registering and selling the stock will cost
The concept of marginal weighted average cost of the company money. These flotation (issuance) costs need
capital (MCC or MWACC) is very important in any dis- to be factored into the calculation of the cost of issuing
cussion about optimizing the capital structure. new shares.
It is more expensive for a company to raise money
As a company has more financing outstanding (becomes through the issuance of shares than through debt
larger), its weighted average cost of capital (WACC) will because the shareholders will require an additional return
increase. This is because the company should have used to compensate them for the additional risk of owning
the cheapest sources of financing first. Therefore, the next equity (with no fixed payment) instead of debt. The for-
dollar of financing will be more expensive than the previ- mula to calculate the cost of new common equity is:
ous dollar of financing. Additionally, as a company has
more financing outstanding, the risk to the supplier of the The Next Dividend Paid + Annual Dividend Growth
next financing will be greater. Since the risk is greater The Net Proceeds of the Issue
they will demand a higher return.
What are the What is net

two main sources working capital and
of short-term financing? what does it measure?

What are the different What are the

working capital (WC) two types of
policies? working capital?

What are the

What are the
factors that influence
five main types of
how much cash is
current assets?
held by a company?

The level of working capital that a company has at any The questions of short-term financing relate to the com-
point in time is calculated as: pany’s current liabilities that need to be paid or settled
within 12 months.
Current Assets – Current Liabilities = Net Working Capital
There are two main sources of short-term financing:
There are a number of concerns that a company has that
Bank Loans – The most common source of short-term
are related to working capital. Among these are: the
financing provided by the banks. The issue for the exam is
optimal level of working capital to maintain; the mix of
calculation of the effective interest rate for the loan.
current assets carried; and the timing of the liabilities.
Factoring of Receivables – A company sells its receiv-
Working capital measures the short-term solvency of ables NOW to a bank or another company. If sold with
the firm. This is the ability of the firm to meet its short- without recourse, the risk of not collecting the receivables
term obligations as they come due. transfers to the company that bought the receivables.
The working capital (WC) policy that a firm follows is

based on the amount of working capital that the company
maintains. The more working capital that a company
Because a company may have different cash needs maintains, the less risk of insolvency. However, because
throughout the year, it is possible that it will maintain dif- short-term assets do not provide the highest return,
ferent levels of working capital at different times of the maintaining a high working capital balance causes the
year. The minimum amount of working capital that is company to forego the higher return of longer-term
maintained at all times is called permanent working assets.
capital, and the increases that occur from time to time Level of Risk of Impact on
are called temporary working capital. WC Policies Liquidity Insolvency Returns
Conservative High Low Negative
Aggressive Low High Positive
Negative Very Low Very high Positive
The factors that influence how much cash is held by

a company include:
1) How much cash is needed in the near future.
2) The amount of risk a company is willing to take in
respect to solvency.
3) The level of other short-term assets that a com- The five main classifications of assets that are included in
pany holds. current assets are:
4) The available return on other short-term invest- 1) Cash and Cash Equivalents
ments (Cash is a non-interest bearing asset. If cash 2) Marketable Securities
earns a low interest rate, the opportunity cost of hold-
3) Inventory
ing cash is reduced. However, when there is a high
interest rate, the cost of holding the cash instead of 4) Accounts Receivable
other investments increases. A company may decide 5) Prepaid Expenses
to hold less cash and accept higher solvency risk in
return for a more interest received.
5) At what point in its business cycle it is in (if a busi-
ness is a seasonal business it will have more cash at
the peak periods than at the slow periods).
What are the

Why do companies operating cycle and the
hold cash? cash conversion cycle and
how are they connected?

What is
How can a company
disbursement float
speed cash inflows?
and when does it occur?

How can a company What are the types

delay cash outflows? of marketable securities?

Cash management can be looked at from two different
time perspectives:
The operating cycle is the number of days that inven-
tory is held before it is sold and the number of days that 1) In the short-term it is essential that the company
accounts receivables is held before collection. It repre- has enough cash to pay its debts as they come due.
sents the total number of days the firm has funds invested 2) In the long-term it is critical that the company has
in working capital. enough cash to grow and expand as needed.
There are four main reasons that a company holds cash:
The cash conversion cycle (also called cash flow
cycle) is the operating cycle minus the average age of 1) Medium of exchange for business transactions.
accounts payable. This represents the number of days 2) Precautionary measure for emergency situations.
from when the firm pays for the inventory until when it 3) Speculation to take advantage of bargain purchases
receives the cash from the sale. It is one way of evalua- or other investment opportunities that need to be
ting a company’s cash management. Shortening this cycle acted upon quickly.
without affecting sales can add to the firm’s profitability.
4) Compensating balance to maintain a minimum bal-
ance in its bank account during the period of loan.
Disbursement float is funds spent by a company but not

yet debited to the company bank account.
Disbursement float occurs when a company writes a
check. The check is mailed. When it is received by the
payee, the payee deposits it in their bank. When the
check is deposited in the payee’s bank, it usually takes a A company can accelerate cash inflows through the fol-
day or two before the money is deducted from the com- lowing:
pany’s account due to delays in the clearing system. 1) Mailing invoices as soon as possible.
So disbursement float consists of:
2) Having credit terms that encourage prompt payment.
1) Mail float (time for check to be delivered through the
mail). 3) Using electronic data interchange (EDI).
2) Operational float (time for payee to record the pay- 4) Accepting credit cards.
ment and deposit it in their bank). 5) Using a lockbox system.
3) Clearing float (time for check to clear).
The disbursement float may also be seen as the difference
between what is in the company's bank account according
to the company’s books and what the bank shows to be in
the account.
1) Treasury bills are guaranteed by the U.S. govern-

ment and the interest on them is exempt from state
and local taxation. They are sold with a discount.
2) Certificate of deposits – the longer the period of
the CD, the higher the interest rate.
Negotiable CDs are a denomination greater than A company can slow cash outflows through the follow-
$100,000, and they fall under the regulation of the ing:
Federal Reserve System. 1) Making payments as close to the deadline as possible.
3) Money Market Accounts may be withdrawn at any 2) Making payments using checks.
time without penalty. Interest rate is less than on
CDs. 3) Using “payable through drafts” (PTD).
4) Higher-grade Commercial Paper issued by large 4) Having a zero balancing checking accounts.
companies in denominations > $100,000. They are 5) Using overdrafts.
unsecured. Interest rate is > than on CDs.
5) Other Types – Bankers’ Acceptances, Federal Agency
Securities, Eurodollars, Money Market Mutual Funds,
State and Local Government Securities, Treasury
Notes and Bonds, and Repurchase Agreement.
How is the
What is the
Baumol cash
Baumol cash
management model
management model?
calculated?

What is the What are the main elements

Miller-Or cash of accounts receivable
management model? management?

How are the

What is the impact of receivables turnover
changing credit terms? and average collection
period calculated?

The Baumol cash management model calculates the
The Baumol cash management model is calculated as fol- optimal cash level to receive every time it converts mar-
lows: ketable securities to cash.
Where:
OC!
! 2bT
i
In this formula the assumption is that cash not needed in
the immediate future by the company is held as market-
able securities. So to get more cash the company simply
OC = The optimal level of marketable securities to convert needs to convert these marketable securities into cash.
to cash However, in order to convert these securities to cash,
b = Fixed cost per transaction there is a fixed fee (such as a brokerage fee) that is paid
T = Total demand for cash for the period for each conversion. Also, any time that cash is held, the
i = Interest rate for marketable securities, or the oppor- company gives up the interest that was being earned by
tunity cost lost by holding cash instead of market- the marketable securities. This formula balances the cost
able securities of converting marketable securities into cash with the
interest benefit of holding marketable securities.
The Miller-Orr cash management model attempts to

Managing accounts receivable (AR) is the process of
fix one of the limitations of the Baumol model by address-
balancing the increased sales from extending credit
ing the issue that the demand for cash is not known and is
(accounts receivable) and the cost of extending credit
not constant over time. Similarly, the source of cash is not
(including the costs of bad debts).
known and not constant.
One of the main elements to settle in receivables manage-
The Miller-Orr Model creates an upper limit and a lower
ment is deciding the credit policy (i.e. who will receive
limit for the cash balance that a company holds. As
credit)
long as the cash balance is between these two levels,
The key elements of a company’s credit policy are: there is no need for the company to make any cash trans-
1) Credit Terms: these include the repayment schedule, actions to either increase or decrease the balance. How-
discounts, and the interest that is charged on the out- ever, as soon as the cash balance moves outside of this
standing amount. corridor, the company needs to do something to bring it
back into the corridor.
2) Credit Standards: these are the requirements that
the person must meet in order to receive credit. The model also establishes a cash balance that the com-
pany will move towards whenever it makes a cash trans-
3) Collection efforts: the amount of time and money
action. This point to which it returns the cash balance is,
spent on trying to collect past due accounts before
in a sense, the starting point it uses whenever the cash
writing them off as bad debts
balance gets outside of the corridor.
1) Receivables Turnover is the number of times that If a company relaxes its credit terms (makes it easier
the average accounts receivable is collected through- to receive credit), more people will receive credit and
out the year. It is calculated as: make purchases on credit. This hopefully leads to
increased sales and higher profits. However, the increase
Credit Sales
in receivables can also lead to increased collection costs
Average Accounts Receivable
and higher bad debts. The company must be confident
If this number is too high it may indicate that the that the increase in sales will offset the increased costs
company is not holding enough inventory. On the and bad debts.
other hand, if the number is too low, the company
may be holding too much inventory. It is also possible that the relaxed credit terms will not
lead to increased sales. Customers may simply use credit
2) Average Collection Period is the number of days instead of making cash purchases.
for collection of a receivable. It is calculated as:
If the company makes its credit terms more strict
365
(harder to get credit), it will experience reduced bad debts
The Receivables Turnover
and collection costs. However, there will also be lower
(Note: Some companies use a different number of sales and profits. Again, the company must balance the
days than 365.) costs and benefits of this decision.
What are economic order

What are the goals
quantity and just-in-time
of inventory management?
inventory management?


inventory turnover ratio days of sales in inventory ratio

How is the effective

What is the cost of not
interest rate calculated
taking the cash discount?
for different types of loans?

The Economic Order Quantity (EOQ) calculates the A company should minimize its total inventory costs.
number of units that the company should order each time This includes the costs of holding and ordering inventory
inventory is ordered for the purpose of achieving the and stockout costs (these are the costs of not having
minimum total cost. inventory when a customer wants to buy it).
where
EOQ
! 2aD
K
a = variable cost of placing an order
A small per unit decrease in the cost of holding inventory
can become a very large amount when multiplied by the
number of units held in inventory. There are three main
categories of costs of inventory:
D = periodic demand
K = carrying cost per unit per period Ordering Costs Carrying Costs Stockout Costs
- Placing orders - Storage - Loss in sales
- Receiving orders - Insurance - Lost cash
Just-in-Time (JIT) means that nothing is produced until
- Any setup costs - Security - Lost profit
a customer orders it. The level of inventory that is held at - Taxes - Customer ill will
all stages of production is minimized, thereby the carry- - Depreciation or rent
ing cost of inventory is kept as low as possible. - Opportunity costs
The inventory turnover ratio is used to measure the

The days sales in inventory ratio is used to measure company’s effectiveness in selling its inventory. It calcu-
the company’s effectiveness in selling its inventory. This lates how many times during the year the company sells
ratio calculates the number of days that the average its average level of inventory.
inventory item remains in stock before it is sold. This
number should be low but not too low, because if it is too An increase in cost of sales without an equivalent increase
low, the company is risking lost sales by not having in inventory increases the inventory turnover ratio and
enough inventory on hand. The higher the number, the means inventory is turning over more rapidly. On the
less risk that there is for a stockout, but the more cash is other hand, an increase in inventory without an equivalent
invested in inventory. increase in cost of sales decreases the inventory turnover
ratio and means the inventory is turning over more slowly.
365, 360 or 300
Inventory Turnover Annualized Cost of Sales
Average Annual Inventory
1) Regular (Simple) Interest =

___Interest Paid Payments should be made within the discount period if the
Borrowed Amount cost of not taking the discount (calculated below) is
greater than the firm’s cost of capital.
2) Loan requiring Compensating Balance (CB) =
The cost of not taking the cash discount is calculated
Interest paid – Interest received on additional amount for CB
as follows:
Amount of loan – Additional amount for CB
3) Discounted Interest = 360
(Total period of payment – Period for discount)
Interest Paid
(Borrowed Amount – Interest) *
4) Installment Loan = Discount %
100% - Discount
Interest to be Paid
Average outstanding Amount
What are other sources

What is
of secured and
factoring of receivables?
unsecured financing?

How can the

What are the
maturity matching approach to
three main types
hedging be applied to
of stock exchanges?
working capital management?


primary characteristics primary characteristics
of bond and fixed income of U.S. Government
securities markets? securities markets?

Factoring receivables occurs when the owner sells the
receivables to another party. This enables the owner to
collect on the receivables earlier than if he or she waited
Secured debts involve an asset that is used as collateral to receive the money directly from the customer. The
for repayment of the loan should the borrower default. amount of money that is actually received from the factor
of the receivables is reduced by:
Secured debt includes chattel mortgages, floating liens,
receivables that are pledged, warehouse financing and 1) Factoring Fee – the more risk related to receivables,
inventory financing. the higher the amount.
2) Interest Charge – almost always higher than the
Unsecured debts have no such collateral backing them,
market rate.
so the interest rate paid by the borrower is higher than on
a secured debt. 3) Reserve Amount – if all receivables are collected,
the reserve will then be paid to the seller.
Unsecured debt includes trade credit, repurchase agree-
The cash to be received from factoring is equal to:
ments, accrued expenses, lines of credit, commercial
paper and bankers’ acceptances. Face amount of receivables
– Reserve Amount
– Factors Fee
– Interest on the Amount of Cash to be Received
There are three types of stock exchanges:

1) Specialist systems: stock exchanges such as the
New York Stock Exchange have physical locations
where buyers and sellers of stocks come together. The maturity matching approach to financing current as-
The NYSE uses the specialist system to accomplish sets (also called the hedging or the self-liquidating
trades. Trading of a stock is overseen by a special- approach) matches assets to be financed with financing
ist, who is a facilitator, auctioneer, dealer, and agent. having the same maturity.
2) Electronic exchanges: electronic exchanges, such Permanent working capital need (inventory and accounts
as the NASDAQ (National Association of Securities receivable) is financed by long-term debt or equity under
Dealers Automated Quotations) have no physical loca- the maturity matching approach. Long-term assets, such
tion and specialists. as property, plant and equipment, are financed with long-
term capital as well.
3) Electronic Communications Networks (ECNs):
these are automated stock trading systems separate If the company has seasonal cash needs, for instance, it
from stock exchanges. ECNs are passive order match- would borrow short-term to finance those needs.
ing systems. They do not use specialists. They match
buy and sell orders that have the same prices for the
same number of shares.
The bond markets are dealer markets, because bonds are

Government securities are initially issued in government traded through dealers. Availability and the prices of
auctions. Short-term Treasury bills are auctioned every bonds vary from dealer to dealer. Large bond dealers
Monday, while longer term bills, notes and bonds are auc- maintain an inventory of bonds which may not be avail-
tioned at intervals as necessary. Treasury bills are dis- able through other dealers. Many dealers have websites
counted, which means they are purchased at a discount to where an investor can open an account and then have
their face value, and on their maturity date, the govern- access to their offerings. There are also online bond trad-
ment pays the face value. The difference is interest ing websites that act as electronic exchanges, giving
income and it is not received until the maturity date. accountholders access to several dealers’ inventories.
Treasury Notes and Treasury Bonds are longer term. T-
notes have maturities of from 1-10 years, while T-bonds Bonds are generally quoted on the basis of their yield to
mature in 10 to 30 or 40 years from their original issue maturity. Bond prices are calculated from the yield to
date. Both Treasury notes and Treasury bonds pay a maturity and are quoted as a bid price (the price at which
stated interest rate semi-annually, and are redeemed at a dealer will buy a bond) and the offer, or ask, price (the
their face value at maturity. price at which a dealer will sell the bond). The difference
After original issue, U.S. government securities are traded between the bid and ask prices is the dealer’s compensa-
in the secondary bond and money markets. tion. Therefore, a bond quote consists of a bid yield to
maturity and an ask yield to maturity.
What are the

What are the
primary characteristics
of over the counter (OTC)
of money markets?
financial markets?

What are
What is commercial paper?
U.S. Treasury Bills?

What are
What are Eurodollars?
bankers’ acceptances?

The money market is a subset of the fixed income mar-
ket. Money market instruments, though, have very short
maturities (less than one year), whereas fixed income
securities are considered to be medium and long-term
(longer than one-year maturities). Money market instru-
ments are short-term borrowings by governments, finan- Over-the-counter (OTC) markets are dealer markets
cial institutions, and large corporations. where transactions are completed by computer or over
Like the bond market, the money market is a dealer mar- the telephone. Over-the-counter markets exist for stocks,
ket, with dealer firms buying and selling securities in their bonds, U.S. Government securities, money market instru-
own accounts and making money on the spread when ments, even derivatives after trading hours—just about
they sell them. Deals are transacted over the telephone or anything that is not traded in an auction exchange.
through electronic networks.
Money market securities include negotiable short-term
securities such as U.S. Treasury bills, commercial paper,
bankers’ acceptances, Eurodollars, and repurchase agree-
ments.
U.S. Treasury bills are U.S. government securities that

Commercial paper is unsecured, short-term notes due mature in one year or less from the date issued. They are
from large, financially sound corporations, usually for the issued with 3-month, 6-month and 1 year maturities.
purpose of financing short-term assets such as accounts Treasury bills are discounted, which means they are pur-
receivable and inventory. chased at a discount to their face value.
Commercial paper is usually issued at a discount and On their maturity date, the government pays the face
reflects current market interest rates. Typically, only very value. The difference is interest income and it is not
creditworthy companies issue commercial paper. Because received until the maturity date.
of the financial soundness of the company issuing it and Treasury bills are the only money market instruments that
short term of the loan, commercial paper is a very safe are issued in small denominations. They can be purchased
investment. in denominations of $1,000, $5,000, $10,000, $25,000,
Commercial paper is usually issued in denominations of $50,000, $100,000, and $1 million.
$100,000 or more. U.S. government securities are essentially risk-free, so
Treasury bills are a very safe investment.
Bankers’ acceptances are used to finance trade-related

transactions, usually international transactions. Importers
use them to finance their purchases and exporters use
them to finance their receivables.
Eurodollars are deposits in banks outside of the U.S. that Bankers’ Acceptances are created for terms of between 30
are denominated in the U.S. dollar. The Eurodollar market days and 180 days. The bank may hold the acceptance in
has expanded because banks outside the U.S. are not as its portfolio or it may sell (rediscount) it in the secondary
highly regulated as U.S. banks are, and so they can oper- market. If the bank holds the acceptance, it is effectively
ate with narrower margins than U.S. banks require. Thus, making a loan to the importer or exporter. If the bank
they may be able to pay higher interest rates. Eurodollar rediscounts the acceptance, it is in effect substituting its
deposits are generally in the millions of dollars and mature credit for that of the importer or exporter, enabling its
in less than 6 months. Thus, smaller investors can invest customer to borrow in the money market.
in this market only through a money market fund. On or before the maturity date, the importer/exporter
pays the bank the face value of the acceptance. If the
bank has rediscounted the acceptance in the market, the
bank receives the face value of the acceptance and pays it
to the holder of the acceptance on the maturity date.
What are the

What are repurchase
agreements (repos)?
of the federal funds market?

What are the

primary characteristics What is market efficiency?
of derivatives markets?

What are the

What are the
four primary sources
three forms of
of capital for
market efficiency?
publicly held companies?

Banks borrow funds from other banks, if necessary, in order
Repurchase Agreements, or repos, are a form of short-
to meet their reserve requirements with the Federal Reserve
term borrowing. An organization that owns government
Bank. The reserve requirement is the amount that a bank
securities (either a dealer or an investor), usually Treasury
must have on deposit with the Federal Reserve Bank each
bills, can use them to borrow short-term. The owner of the T-
day, and each day, it must be a certain percentage of the
bills “sells” them to the lender subject to an agreement to
deposits entrusted to it by its depositors. The federal funds
repurchase them at an agreed future date and an agreed
market is a means of distributing reserves in the banking
future, higher, price. The difference is interest. The purchaser
system.
(the lender) has an asset, and the seller (the borrower) has a
On any given day, individual banks may be either above or liability.
below their desired reserve positions. Reserve accounts bear
The term of a repurchase agreement is usually one day but
no interest, so if a bank has reserves that are in excess of its
may be up to 30 days or more. Since the purchaser (lender)
reserve requirement, it has an incentive to lend them to
receives the government securities as collateral for the loan,
another bank and earn interest on them. Thus, a bank with
repos can provide lenders with low risk loan assets.
excess funds on deposit to cover its reserve requirement
may lend the excess, usually on an overnight basis, to a Securities dealers use repos to finance their securities inven-
bank that does not have enough funds on deposit. tories. They typically use one-day repurchase agreements,
rolling over the repos from one day to the next. The buyers
The borrowing and lending occur in the federal funds market
of repos are usually institutions with short-term funds to
at a competitively determined interest rate known as the
invest such as corporations or money market funds.
federal funds rate.
According to the Efficient Market Hypothesis, financial Derivatives such as futures contracts and options are
markets are efficient. The term market efficiency traded on commodity exchanges such as the New York
means that market prices of securities take into account Mercantile Exchange and the Chicago Board of Trade. The
all knowledge which people have about that market, prices on the exchange are determined in an open, con-
including public information about the economy, the spe- tinuous auction during trading hours on the exchange
cific security, and the market the security is traded in. floor by the members acting on behalf of their customers,
the companies they represent, or themselves. Price move-
Market efficiency and competition among investors in the ments are controlled by supply and demand. The action
capital markets (who are assumed to all have the same process is called open outcry.
knowledge) causes debt and equity issues ultimately to be In the open outcry process, the buyers determine how
priced fairly, eliminating the opportunity to add value to a much they are willing to pay and announce their bids to
project by financing it with, for instance, a below-market the other brokers in the ring. Sellers cry out their offers.
rate debt instrument. This competition in the financial When the minds meet on price and quantity, the cry of
markets, when combined with perfect information on the “sold” or “done” is heard, and the trade is recorded.
part of all investors, will ensure that the debt instrument The exchanges guarantee each trade, ultimately acting as
is priced at the market rate. The more market partic- the seller to every buyer and the buyer to every seller.
ipants there are and the more rapid the release of infor- This is accomplished through a group of member firms
mation is, the more efficient a market should be. called clearing members.
If a publicly-held company requires new capital, it has

four sources of the capital: Economists have classified efficient markets on the basis
1) Retained earnings, or internally-generated funds. of the types of the information that they reflect. They
have classified them into three forms of market efficiency:
2) Bond issues. weak, semi-strong, and strong.
3) Preferred stock issues. 1) Weak-form efficiency says that market prices of
4) Equity (common stock) issues. securities reflect all historical information: price
Bond financing is generally available to a company only movements and trading volume, and that investors
after it has issued equity and attained a credit rating from will not be able to “beat the market” by basing their
one or more of the rating agencies (more about those analysis and strategy solely on past price movements.
later). A brand new company planning to come to market 2) Semi-strong-form efficiency says that security
for the first time usually relies on retained earnings, bank prices reflect not only historical price and trading vol-
loans, and venture capital before raising its first equity ume information but also all other published informa-
issue. If the stock market is weak, many companies will tion.
rely on retained earnings or bond issues. If the stock mar- 3) Strong-form efficiency suggests that security prices
ket is strong, more companies will turn to equities. reflect all possible information, including the private
Debt is generally considered the cheapest source of funds information known only to insiders.
because interest is tax deductible.
What are What is an

investment banks SEC registration statement
and their role for an initial public offering
in the finance system? (IPO) of company stock?

What are the

What actions may the SEC
four common activities
take regarding a company
that take place regarding
registration statement for
a security offering after
an initial public offering
the registration statement
(IPO) of company stock?
has been filed with the SEC?

What are the

What is a stock dividend
important dates in the
and what is a stock split?
payment of dividends?

Investment banks are not banks in the sense that com-
The SEC registration statement is a lengthy document mercial banks are banks. Investment banks are inter-
that describes the proposed stock financing and how the mediaries that bring together businesses in search of new
proceeds will be used; the company’s history; its present capital with investors in search of new investments.
business, including information about its management, The investment bank plays a triple role:
executive and director compensation; its audited financial
statements; and its plans for the future. 1) It helps its customer to design the deal and the secur-
ities.
The registration statement is required unless the offering 2) It underwrites it, or buys the new issue.
is an IPO and it qualifies for exemption. Regulation D of 3) It then markets the issue to the public.
the Securities Act of 1933 grants an issue exemption from
SEC registration if the securities are to be sold exclusively The investment bank advises the company on capital
intrastate (within one state). Or, SEC Rule 144 permits structure, interest rates, anticipated investor de-
sale of restricted securities without registration under the mand, and in setting the offering price for the securi-
1934 Securities and Exchange Act if the purchasers of the ties.
stock are exclusively affiliated persons who acquire the The investment bank, along with attorneys and accoun-
stock in a private transaction. tants, also assists the company with the preparation
of the SEC registration statement.
After the registration statement has been filed with The SEC has 20 days to review the registration statement
after it is filed. The SEC may take the following actions:
the SEC, while it is awaiting approval by the SEC, four
activities take place: 1) If there are substantial deficiencies in the registration
1) The important sections of the registration statement statement, the SEC will issue a letter of deficiency,
which identifies the problems and explains how to cor-
are used to develop the prospectus. The pro-
rect them.
spectus cannot be distributed until the registration
statement is approved by the SEC. However, a pre- 2) The SEC may tell the company to withdraw its offering if
the registration statement has many problems. This is a
liminary prospectus, called a red-herring pro-
“bedbug letter,” and is very rare. It is sent only if the fil-
spectus, may be distributed while awaiting SEC
ing is so deficient that the SEC would have to spend too
approval.
much time to identify the problems and tell the issuer
2) A tombstone ad may be published. A tombstone ad how to correct them.
is an advertisement, usually placed in a business peri-
3) The SEC may initiate stop order proceedings if the
odical, announcing the offering and its dollar amount
registration statement contains untrue statements of
3) After SEC approval of the registration statement, the material fact, omits material facts required, fails to
final prospectus is sent to potential investors. provide required current and historical financial informa-
4) A road show may be arranged. A road show involves tion, or has other major problems.
the investment bankers and company representatives 4) If the SEC does nothing, the registration statement is
making a sales presentation to potential investors. approved as submitted.
In a stock dividend the company issues shares instead There are four dates in a company’s process of paying a
of cash as a dividend. This is a good method for providing dividend.
a return to their shareholders without distributing cash. A
stock dividend may be used by a new company that is try- 1) The declaration date, when the directors of the cor-
ing to conserve its cash for growth, but also wants to poration vote and pass the payment of a dividend.
provide a continuing return to shareholders. As a result of The company makes a journal entry in its accounting
a stock dividend, the company will have lower earnings records recognizing the liability on the declaration
per share (calculated as income divided by the number of date as it is now a liability to the company.
shares outstanding) and a lower book value per share. 2) The date of record, set by the company, when it will
determine which shareholders are eligible for the
A stock split is similar to a stock dividend in that it dividend and which are not.
involves the issuance of new shares without the receipt of 3) The ex-dividend date, when the company records
additional cash. In a stock split, each share is split into a will be updated to reflect the change in owners for
greater number – for example, in a 2-for-1 split, each shareholders who either buy or sell shares in the days
original share results in 2 shares (1 additional) after the immediately preceding the date of record.
split. Since the value of the company is unchanged, a pro-
portional decrease in stock price results. Also, the par 4) The payment date on which the dividend is actually
value of the share is reduced. distributed to the shareholder.
What is a What is treasury stock

dividend reinvestment and why do companies
plan (DRIP)? buy treasury stock?

What are the

What is leasing?
advantages of leasing?

What are the

What are the
four main types
disadvantages of leasing?
of business combinations?

Treasury stock is shares of a company that have been
sold to other parties and then repurchased by the com-
pany. The company has become a holder of its own shares
and may either retire these shares or hold them for sale at A dividend reinvestment program (DRIP) is when
a later time. cash dividends received by the shareholder are automati-
Note: Treasury shares do not receive dividends, do not get cally used to purchase more shares of the company. The
to vote and are not classified as outstanding. Treasury company can provide this program with very little cost as
shares are issued, but are not outstanding. If they are it is essentially a one-time purchase of shares for all of the
later resold or reissued, those shares will again become shareholders and thus any fees, charges or commissions
issued and outstanding. can be divided amongst all of the shareholders.
A company may repurchase treasury shares for a number
of reasons. Among them are: Additionally for the company it is essentially a non-divi-
1) Temporarily provide a market for its shares, dend since the money that was to be paid as the dividend
2) Reconsolidate ownership, is returned to the company through the purchase of
3) As an investment if the company thinks its shares are shares.
undervalued, and
4) use the shares for a stock dividend, to re-sell them, or
to reissue them as share-based payment.
The advantages of leasing are:

1) Convenience of short-term leases.
2) 100% financing at fixed rates. Leasing is an alternative form of financing for a business.
3) Protection against obsolescence. A lease is a contractual agreement between a lessor and
a lessee that gives the lessee the right to use specific
4) Flexibility. property, owned by the lessor, for a specified period of
5) Depreciation tax shields can be used. time in return for stipulated, and generally periodic, cash
6) Alternative Minimum Tax problems. payments (rents).
7) Off-Balance-Sheet-Financing. An essential element of the lease agreement is that the

lessor conveys less than the total interest in the property.
8) A means to avoid budgetary constraints.
The lessor is the owner of the property. The lessee is the
9) Tax deductibility. one using the property and making payments in exchange
10) A means to avoid loan restrictions. for the right to use it.
11) An advantage in the event of bankruptcy.
12) Cancellation options have value.
There are four common types of business combina-

tions: There are some disadvantages to leasing:
1) Merger. 1) Cost.
2) Consolidation. 2) Loss of depreciation, other deductions and salvage

value.
3) acquisition of common stock.
3) Lack of flexibility if the lease is noncancelable.
4) acquisition of assets.
What are the

What are the
main characteristics of
five common types
the merger form of
of mergers?
business combination?


main characteristics main characteristics of the
of the consolidation form common stock acquisition
of business combination? form of business combination?

What are the

What are eight common
main characteristics of the
good reasons for
asset acquisition form
business combinations?
of business combination?

There are five common types of mergers: A merger is executed under the provisions of applicable
1) Mergers that take place between or among firms in state laws. The boards of directors of the companies
the same line of business are called horizontal mer- involved approve a plan for the exchange of voting com-
gers. mon stock (and possibly some preferred stock, cash, or
2) When companies who are at different stages of pro- long-term debt) of one of the corporations (the survivor)
duction and distribution of a product merge, it is a for all the outstanding voting common stock of the other
vertical merger. A vertical merger can be a for- corporation(s). Stockholders of all the companies must
ward or backward vertical merger. approve the terms of the merger.
3) In a forward vertical merger, the acquiring com- In exchange for the outstanding voting common stock of
pany expands forward toward the ultimate consumer. the other company (ies), the survivor issues its common
It may purchase a company that supplies it with a dis- stock to their stockholders at an agreed-upon exchange
tribution network for its products, i.e., it acquires a rate. After the exchange, all of the other corporations are
company that it sells to. dissolved and liquidated. They cease to exist as legal
4) In a backward vertical merger, the acquiring com- entities
pany expands backward toward the source of its raw The survivor does not own the outstanding common stock
materials. For instances, a soft drink company might of the liquidated corporations, because that stock no
purchase a sugar manufacturer. longer exists. Instead the survivor owns the net assets of
5) A conglomerate merger takes place when the com- the liquidated corporations (their assets and their liabili-
panies involved are in unrelated lines of business. ties).
Most hostile takeovers are accomplished by means of an

acquisition of common stock.
A consolidation is executed as per state laws. One corporation (the investor) offers to purchase from
In a consolidation a new corporation is formed to issue its the present stockholders a controlling interest in the vot-
common stock for the outstanding stock of two or more ing common stock of another corporation (the investee).
existing corporations, which then go out of existence. If the target corporation is a closely-held corporation, the
acquisition takes place through negotiations with the prin-
The new corporation acquires the net assets of the former cipal stockholders. If the target corporation is publicly
corporations, whose activities may be continued as divi- held, the stock acquisition takes place through direct pur-
sions of the new corporation, or they may be divested by chase in the stock market or through a tender offer to
the new corporation. The boards of directors of the com- its stockholders.
panies involved work out the terms of the consolidation. If the tender offer results in another company’s acquiring
Stockholders of all the companies must approve the terms a controlling interest in the target’s voting common stock,
in accordance with their corporate bylaws and state laws. the target becomes affiliated with the acquiring com-
The shareholders of the former companies own the stock pany as a subsidiary, but it is not dissolved or
of the new company and the new company owns the net liquidated and it remains a separate legal entity.
assets of all the former companies. The investor corporation owns a controlling interest in the
common stock of what becomes a partially or wholly-
owned subsidiary.
A buyer may acquire from an enterprise all or part of

either the gross assets or the net assets of the other
enterprise In an acquisition of assets, the buyer does
Eight common good reasons for business combinations not acquire any of the selling corporation’s common stock.
include: Unlike the other forms of business combinations, where
1) Economies of scale. the surviving corporation acquires responsibility for all of
2) Complementary resources. the liabilities ! known and unknown ! of the acquired
corporation, the buyer in an acquisition of assets can
3) Use of surplus funds. determine which liabilities of the seller it will assume. Usu-
4) Sales enhancement. ally the buyer assumes some of the seller’s liabilities, such
5) Management improvements. as obligations under contracts for the performance of ser-
vices. Which liabilities will be assumed by the buyer and
6) Communication to the market. which will stay with the seller are part of the negotiation
7) Tax reasons. and the terms of the acquisition agreement.
8) Financial leverage. The selling enterprise may continue its existence as a sep-
arate entity (minus the assets or net assets sold), or it
may be liquidated by its seller following the sale. It does
not become an affiliate of the acquiring company.
What are eleven common

What is a proxy contest? pre-offer company defenses
against hostile takeovers?

What is a
What are eight common
corporate divestiture
post-offer company defenses
and the five common
against hostile takeovers?
forms of divestitures?


of a voluntary of a divestiture involving a
corporate liquidation? partial sell-off of assets?

A proxy is a form that a shareholder uses to give his or
Eleven common pre-offer company defenses against her voting rights to another person. Most votes are cast
hostile takeovers include: by proxy at annual meetings, because few shareholders
1) Staggered election of board members. attend. Proxies are solicited by the company prior to the
2) Changing the state of incorporation. annual meeting. If shareholders are satisfied with the
company management, they usually sign their proxies in
3) Supermajority merger approval provisions. favor of management and allow the company manage-
4) Fair merger price provision. ment to vote their shares.
5) Golden parachutes.
One means of taking over a company without negotiations
6) Poison pills. is called a proxy contest, or proxy fight. In a proxy
7) Poison put. contest, the potential acquirer seeks the support of share-
8) Restricted voting rights. holders at an annual meeting. This is an alternative to
making a tender offer in a hostile takeover. An outside
9) Flip-over rights. group that seeks to take control of a company through a
10) Flip-in rights. proxy contest is required to register its proxy statement
11) ESOPs (employee stock ownership plans). with the SEC so that information it presents will not be
misleading or false.
Corporate restructurings include not only mergers. Some- Eight common post-offer company defenses against
times in order to create value for shareholders, a company hostile takeovers include:
will divest part of the company or even liquidate entirely.
1) Issuing stock.
There are various methods by which a company may
accomplish a divestiture. 2) Pacman defense (or reverse tender).
The five common forms of divestitures are: 3) White knight defense.
1) Voluntary corporate liquidations. 4) Leveraged recapitalization or restructuring.
2) Partial sell-off of assets. 5) Crown jewel transfer.
3) Corporate spin-offs. 6) Going private.
4) Equity carve-outs. 7) Litigation .
5) Tracking stock. 8) Asset restructuring.
An asset sale is the sale of part of one company to

another company. If the sale of a part of the company,
Financial distress is not the only reason a corporate liqui-
such as a business unit, will result in a positive net
dation may occur. A voluntary corporate liquidation
present value to the company when compared with the
can occur because the firm’s assets are more valuable to
present value of the stream of expected cash flows from
shareholders in liquidation than the present value of the
continuing the operation, then it is better that it be sold.
expected cash flows from those assets.
Payment for the sale of a part of the company is usually
received as cash or securities.
If a liquidated firm has debt outstanding, it must be paid
off at face value. If the market value of the debt is below
Usually asset sales enhance shareholder value, for both
face value, this means that bond holders will gain from
the purchasing firm and the selling firm. The productivity
the liquidation, although it will be at the expense of the
of the sold assets increases after the sale, possibly
shareholders who will then receive less.
because the assets are transferred to a company that can
manage them better.

of a divestiture involving a of a divestiture involving an
corporate spin-off? equity carve-out?

What are the

What are the
primary characteristics of a
divestiture involving
leveraged buyout?
tracking stock?

What are the

What is mezzanine financing?
voluntary settlement form of
corporate restructuring?

Equity carve-outs involve the divestiture of a part of the
A spin-off is similar to a partial sell-off.
company, as do spin-offs.
The business unit is not sold for cash or securities.
The difference is that the shares in the new company are
Instead, common stock in the spun-off segment is distrib-
not given to existing shareholders of the parent but rather
uted to company shareholders on a pro rata basis. The
are sold in an initial public offering. The parent company
segment becomes a completely separate company.
usually sells only part of the stock in the carved-out new
company while retaining majority control. The equity As long as shareholders in the parent company receive at
carve-out is a form of equity financing. least 80% of the shares in the new company, the share-
holders have no tax liability at the time of the spin-off.
Shareholders of the carved-out company have claims only
Their basis in their original stock is divided on a pro rata
on cash flows and assets of the carved-out company, not
basis between the two securities and any gain or loss is
on those of the parent company. Information about the
reported only when each of the separate securities is sold.
business and financial conditions of the carved-out subsid-
However, if less than 80% of the stock is distributed, the
iary is more easily available to investors, which may allow
value of the distribution is taxed as a dividend.
its value to be more accurately assessed by the market.
A spin-off gives investors the opportunity to invest in just
After a carve-out, a parent company may later spin off the
one part of the business.
remaining shares of the subsidiary that it is holding.
A leveraged buyout is method of financing the purchase

of a company or a segment of a company using very little
equity.
The main characteristics are of a leveraged buyout are:
1) The purchase is a cash purchase; but a large propor- Instead of a spin-off or a carve-out, a company may issue
tion of the cash offered is financed with large amounts tracking stock, tied to the performance of a particular
of debt. company division.
2) The company or segment being purchased is the bor- This does not involve a corporate divestiture. It is simply
rower, and its assets are the collateral for the debt the creation of a new class of common stock. The sepa-
that finances the purchase. rate classes of common stock lets the company see the
3) a company needs to have stable cash flows, little share price for each business segment and structure
debt, and assets with market values high enough that incentives for each group based on their stock’s perfor-
they can be used as collateral for the borrowings. mance.
The leveraged buyout is considered because a company
wants to divest itself of a division, and that division’s man-
agers want to take over the ownership. Or it may be that
an entire company is purchased in this way.
An LBO may be financed with a combination of senior debt

and junior subordinated debt. The senior debt is secured
Voluntary settlements are work-outs. The debtor works by all the assets of the company and may be provided
with the creditors to get concessions in an attempt to through a large commercial bank, complete with a loan
avoid bankruptcy proceedings. It is in the creditors’ agreement containing protective covenants and other
interests to avoid a bankruptcy, as well as in the debtor’s restrictions. The junior subordinated portion of the debt is
interests, because the creditors may end up getting more another loan, unsecured and with a much higher interest
than they would if the debtor declared bankruptcy. rate and possibly other provisions such as stock warrants.
It is called mezzanine financing, because it is in-be-
tween the senior debt and the equity in priority.
What are the

What are two sections of
three forms of bankruptcy law
voluntary settlements? that deal with
business failures?


differences between a primary characteristics
voluntary and an of a Chapter 7 –
involuntary bankruptcy? liquidation bankruptcy?


top 5 priority creditors top 6 to 10 priority creditors
in a Chapter 7 liquidation? in a Chapter 7 liquidation?

There are three forms of voluntary settlements:
1) Extension: creditors postpone the maturities of their
obligations. Usually the major creditors form a com-
mittee that negotiates with the company. All creditors
must agree.
2) The creditors may also agree to accept a composi-
If informal workout efforts are unsuccessful, the next step
tion, i.e., a partial settlement, and write off the uncol-
is a bankruptcy. Two sections of the bankruptcy law
lectible amounts. The settlement may be in cash or a
deal with business failures:
combination of cash and promissory notes. All credi-
1) Chapter 7, which deals with liquidation. tors must agree. Any creditors who do not agree must
2) Chapter 11, which deals with the reorganization of be paid in full.
the enterprise. 3) Voluntary liquidation: an orderly liquidation of the
company without declaring bankruptcy. It is likely to
be more efficient than a liquidation in bankruptcy
court and less costly. Therefore creditors probably
receive a higher settlement. But all creditors must
agree. A company with many creditors would likely
not be able to achieve that.
A bankruptcy filing may be voluntary or involuntary.

The primary characteristics of a chapter 7 liquida-
tion bankruptcy are: When the debtor files the bankruptcy petition, the pro-
ceeding is voluntary. The filing results in an immediate
1) The purpose of Chapter 7 is to oversee the firm’s
stay preventing creditors from taking further collection
liquidation.
action until the court decides whether the petition has
2) If there is no hope that the company can operate suc- merit. The court can either accept the petition or dismiss
cessfully, liquidation is the only possibility. Usually, it.
small firms make use of Chapter 7.
If the creditors take the initiative, the proceeding is invol-
3) The bankruptcy judge appoints an interim trustee, a untary. Three or more creditors are required to initiate an
disinterested private citizen, to meet with the credi- involuntary bankruptcy. The total amount of their claims
tors. must be a certain minimum amount to initiate bankruptcy.
4) At the first creditors’ meeting, the creditors may elect Their petition must give evidence that the debtor is in
a trustee to replace the appointed interim trustee; or equitable insolvency, i.e., has not paid its debts when
they may keep the court-appointed trustee. due. The bankruptcy court decides whether the petition
has merit. If the court accepts the petition, it orders a
5) The trustee is responsible for selling the assets of the
stay of creditor actions pending a more permanent solu-
property and distributing the proceeds to the credi-
tion. If the court decides the petition does not have merit,
tors.
it dismisses it.
The top 5 priority creditors in a chapter 7 liquidation

are:
The top 6 to 10 priority creditors in a chapter 7 liqui- 1) Secured creditors receive the proceeds of the sale of
dation are: the property pledged to them. If the secured credi-
1) Claims for cash deposits made for goods or services tors’ claims are not fully satisfied by the sale of their
not provided by the debtor, up to a maximum of collateral, the remainder of their claims are treated as
$2,225 per customer (as of April 2004). unsecured claims.
2) Taxes due. 2) Administrative fees, including trustee’s fees and attor-
ney fees, incurred in liquidating the property.
3) Debts to government regulatory agencies such as the 3) Creditor claims that arose in the course of the debtor’s
Pension Benefit Guarantee Corporation. business from the time the case begins until the time
4) Unsecured claims, either filed on time or, if filed late, a trustee was appointed.
filed by creditors who had knowledge of the bank- 4) Unpaid wages earned by employees within 90 days of
ruptcy. the bankruptcy petition, limited to $4,925 per em-
5) Unsecured claims filed late by creditors who had ployee (as of April 2004).
knowledge of the bankruptcy. 5) Claims for unpaid contributions to employee benefit
plans for services rendered within 180 days of the
petition up to a maximum of $4,925 per employee.
What are the

What are the
top 11 to 15 priority creditors
Chapter 11 reorganization
in a Chapter 7 liquidation?
under bankruptcy law?

What is direct What are the benefits of

foreign investment? direct foreign investment?

What is the
coefficient of correlation and
What are the risks of
how is it used in evaluating
direct foreign investment?
the risk of a portfolio
of foreign investments?

A chapter 11 reorganization is an attempt to rehabilitate
the company by changing its capital structure. Equity and
limited-income securities are substituted for debt. The
primary characteristics of a chapter 11 reorganization are:
1) Reorganizations are started like liquidations.
The top 11 to 15 priority creditors in a chapter 7 liquida-
2) Usually, the debtor continues to operate the business,
tion are:
although a trustee may be appointed to assume that
responsibility. 1) Fines and punitive damages.
3) In order to enable the debtor to obtain new financing, 2) Interest accrued on claims after the date the petition
post-petition creditors are given priority over pre-petition was filed.
creditors if the bankruptcy should proceed to liquidation.
4) A reorganization plan must be drawn up and filed with 3) Subordinated debt holders.
the court within 120 days. 4) Claims of preferred shareholders, up to the par value
5) Reorganization plans must be approved by creditors and of the issue.
stockholders.
5) Claims of common shareholders.
6) The plan should be fair, equitable, and feasible to all
parties.
7) Once the bankruptcy court confirms the plan, the terms
are binding for the debtor and all claimholders, even dis-
senting claimholders.
Benefits of direct foreign investment include:

1) New sources of demand.
2) Opportunity to enter profitable markets.
3) Monopolistic advantages.
4) Reaction to trade restrictions. Direct foreign investment (DFI) involves investment by
5) International diversification. a multinational corporation in real assets (land, buildings,
6) Economies of scale. or plants and equipment) in foreign countries and man-
7) Availability of lower cost foreign factors of production. aging those assets by the company directly. It represents
8) Availability of lower cost foreign raw materials. capital movement from one country to another.
9) Availability of foreign technology.
Direct foreign investment includes joint ventures with for-
10) Opportunity to take advantage of exchange rate
eign firms, the acquisition of foreign firms, and establish-
movements.
ing new foreign subsidiaries.
11) Offset exchange rate fluctuations.
12) Decrease demand fluctuations caused by exchange
rate fluctuations.
13) Interest rates in another country may be more favor-
able.
The coefficient of correlation measures the amount of

correlation in the returns of any two investment projects.
When the projects’ returns are not highly correlated (do The risks of direct foreign investment include:
not move in the same direction at the same time), the
portfolio of projects is diversified and risk is reduced. 1) Political risks - risk of government expropriation;
blockage of fund transfers; inconvertible currency;
The value of the correlation coefficient is always between government bureaucracy, regulations and taxes; cor-
!1 and +1. ruption (such as bribery); the attitude of the con-
A correlation coefficient of +1 means that the two pro- sumers in the host country, preferring to purchase
jects’ returns have in the past always moved together, in local products, and a lack of understanding of the
the same direction and to the same extent. business culture in the host country.
A correlation coefficient of !1 means that the two pro- 2) Financial risks - the state of the host country’s econ-
jects’ returns have in the past always moved in exactly omy; exchange rate fluctuation causing fluctuations in
opposite directions. reported financial results and possibly endangering
A correlation coefficient of 0 means that there has been debt covenants.
no historical relationship between the returns of the two
projects.
How is the expected variance

How is the expected return
of a portfolio of two
of a portfolio of international
international investments
investments calculated?
calculated?

What are the How are

different ways in which floating exchange rates
currency exchange rates determined in the short,
are set? medium, and long terms?

What are 6 key points How does a

for understanding a fixed exchange rate
floating exchange impact the trade
rate system? of a country?

To calculate the expected variance of a portfolio of two
international projects, you need to know the following:
1) The weights (w) of Projects A and B in the portfolio
(they must total to 1.00 or 100%).
2) The variances (!2) of Projects A and B. Since the vari-
ance is the square of the standard deviation, if you
have the standard deviations of A and B, you can
The expected return of a portfolio of projects is the square them to get their variances.
weighted average of the expected returns of the projects 3) The standard deviations (!) of Projects A and B. If
held in the portfolio. The weights are each project’s pro- you have the variances of A and B, you can take their
portion, or percentage, of the total portfolio. square roots to get their standard deviations.
4) The correlation coefficient ® between Projects A and
B.
The formula to calculate the Expected Variance of a two-
project portfolio is:
E"# 2p $!w 2A # 2A%w2B # 2B%2wA w B r # A # B
This formula should be memorized.
Floating exchange rates will fluctuate differently over dif-

ferent periods of time: The ways in which currency exchange rates are estab-
In the short term, exchange rates are affected by the lished are:
interest rates in the two countries whose currencies 1) Floating - Currencies are allowed to be bought and
are determining the exchange rate. Since interest rate sold freely without government intervention. The price
changes are commonly found in the news, another influ- of each currency will be determined solely by the sup-
ence in the short term on the floating exchange rate is the ply and demand in the foreign exchange market.
news media. Economic agents react to the announce-
2) Fixed - The exchange rate for a particular currency is
ments about interest rates and shifting perspectives about
fixed by the country’s government, and it will buy and
economic growth. This influence on the exchange rates is
sell its reserves as necessary to maintain this rate.
referred to as ‘news-driven’.
In the medium term, the currency exchange rate is 3) Managed float - A combination of floating and fixed,
determined by the economy within the country relative to the government allows the market to determine the
the economy in other countries. price of its currency, but it will intervene as necessary
In the long term, the price for a particular good should be to keep the rate from fluctuating too much.
the same in any country. This concept is called the pur- Under the gold standard the currency is actually backed
chasing power parity theorem (PPP). It means that by gold. This is a type of fixed exchange rate, but it is no
the prices for similar goods should be similar in any coun- longer used by any countries.
try of the world.
Under fixed exchange rates, a government buys and The following six items are key points to understand
sells its own currency in order to maintain a certain the floating exchange rate system:
exchange rate against other currencies. To do this, the 1) The exchange rate is the price of one currency stated
government needs to accumulate large holdings of other in terms of another currency.
nations’ currencies in order to use them as needed to buy 2) If the dollar appreciates, import prices fall in the USA
its own currency so as to maintain its currency’s value. and prices for US exports rise.
And it sells its own currency to buy other currencies when
necessary to bring the price of its own currency down. As 3) When the dollar depreciates, import prices rise in the
a result, the demand for and the supply of the currency in USA and export prices fall.
the market no longer have to be equal since the govern- 4) Demand for dollars by foreigners reflects demand for
ment makes up any differences from its reserves of cur- US products and investments.
rencies. 5) The supply of dollars to foreigners by US citizens
When the exchange rate is fixed above the equilibrium reflects US demand for foreign goods, services, and
rate, the government will face a deficit in its balance of foreign investments.
payments, because its exports will be too expensive to 6) At the equilibrium exchange rate, the dollars pur-
foreigners, but its citizens can buy a large quantity of chased equal those sold. The dollar value of goods
imports. The opposite is the case when the fixed exchange and services bought by foreigners and sold by U.S.
rate is below the equilibrium rate. citizens will be equal.
What are the 3 key points What is a

regarding a fixed foreign exchange cross rate
exchange rate system? and how is it calculated?

How can
exchange rate risk What are currency swaps?
be managed?

What does it mean when

a foreign currency is selling What is the difference
at a premium or discount between a spot exchange rate
to the spot rate in the and a forward exchange rate?
forward market?

Exchange rate quotations are usually quoted relative to the
U.S. dollar. If a German company wants to buy Japanese
yen, it may need to determine the cross rate using the U.S.
Dollar.
The foreign exchange cross rate is the currency exchange
rate between any two currencies when neither of the curren- Three key points to the fixed exchange rate system are:
cies is the official currency of the country in which the rates 1) The government buys and sells its own currency at a
are quoted. In the U.S., the exchange rate between the euro fixed rate that it determines.
and the British pound sterling is a cross rate,
2) An overvalued currency is one whose exchange rate is
To calculate a cross rate, divide one cross rate by the other
cross rate. Note that this works only when both of the cross held above the free market.
currencies are quoted the same way with the same third 3) An undervalued currency occurs if the fixed exchange
currency. If one or both of the quotes are reversed (1 unit of rate is below free market value.
one of the cross currencies is equal to X units of the third
currency), dividing one exchange rate by the other will not
result in the correct answer. In this case we need to reverse
one or both of the quotes so that the value of the currency
that both of the other currencies are quoted in is equal to 1.
A currency swap is a variation of an interest rate swap.

With an interest rate swap, only interest payments are Natural Hedges - Strategic decisions affecting markets
exchanged, because the principal is the same for both served, pricing, operations or sources, because when a
parties. However, in a currency swap, principal payments subsidiary’s cash flows will adjust naturally to currency
are exchanged too. The principal and interest are in differ- exchange rate fluctuations, this can act as a natural
ent currencies. hedge.
A floating-to-floating currency swap will have interest Operational Hedges (Balancing Monetary Items): main-
payments in floating rates for both parties, but in different taining a balance between payables and receivables
currencies. denominated in a foreign currency neutralizes the effect of
In a fixed-to-floating currency swap, one stream of exchange rate fluctuations.
interest payments will be in currency X and at a fixed rate,
while the other stream will be in currency Y and at a float- International Financing Hedges - borrowing in a for-
ing rate. eign currency to offset a net receivables position in that
Currency swaps can be liability swaps or asset swaps. A currency. Or, a company with a foreign subsidiary can bor-
liability swap is the exchange of interest and principal row in the country where the subsidiary is located in order
payments on one liability for interest and principal pay- to offset its exposure.
ments on another liability. An asset swap is the ex- Currency Market Hedges - forward contracts, futures
change of interest and principal receipts on one asset for contracts, and currency options.
interest and principal receipts on another asset.
In currency markets, the spot rate is the current ex- The spot rate is the exchange rate used for transactions
change rate that is used in transactions that are com- at that point in time (transacted on the spot market) and
pleted at that point in time. Currency for immediate the forward rate is the exchange rate in the forward
delivery is traded in the spot market. market today for currency transactions to be completed
at a future date.
The forward rate is the rate used for transactions that
will be completed at a future date (meaning that the A forward contract is executed between two parties, one
monies will be exchanged in the future). Forward con- agreeing to buy and one agreeing to sell the currency. The
tracts are negotiated in the forward market, and commer- contract specifies the amount of the particular currency
cial banks generally act as counterparties to forward that will be purchased/sold at a specified future date and
contracts for their customers who desire them. at a specified exchange rate. Thus, forward trades involve
the purchase and sale of a currency for future delivery on
The forward rate is not a predictor of the future spot rate.
the basis of exchange rates that are agreed to today.
The forward rate for a currency transaction to take place
30 days in the future is not going to be exactly the same A foreign currency is selling at a forward discount if its
as the spot rate will be 30 days in the future. Nor will it be forward price in USD is lower than its spot price.
what currency traders expect the spot rate to be in 30 If the foreign currency’s forward price in USD is greater
days. than its spot price, it is selling at a forward premium.
What is the formula What are the

to determine the seven common methods
effective financing rate of financing international
on a foreign currency loan? trade transactions?

What is What is
accounts receivable financing cross border factoring
as a means to as a means to
finance international finance international
trade transactions? trade transactions?

What is a
What is a standby
commercial letter of credit
letter of credit?
and what are its risks?

Seven common methods of financing international
trade transactions include: The effective financing rate on a foreign currency loan
1) Accounts receivable financing, can be calculated using the following formula.
2) Cross-border factoring, rf = (1 + if) " (1 + ef) ! 1

3) Letters of credit, Where:
4) Bankers’ acceptances, rf = The effective financing rate
5) Working capital financing, if = The interest rate of the foreign currency loan
ef =The percentage change in the foreign currency unit
6) Forfaiting (medium-term capital goods financing), and against the U.S. dollar
7) Countertrade.
If an exporter agrees to ship goods to an importer without

Factoring involves selling a receivable to a third party, or payment assurance such as a letter of credit, then the
a factor. The exporter can eliminate the risk of the exporter ships under an open account or with a sight
receivable not being paid by the importer if it sells the draft. Either way, the exporter is relying on the importer
receivable without recourse. to make payment – essentially extending credit.
Since the foreign importer is the source of the factor’s After extending credit, the exporter may need the funds
repayment, cross-border factoring is often used. The immediately. In this case, the exporter gets financing from
exporter’s factor works with a correspondent factor in the a bank. This is called accounts receivable financing.
buyer’s country, and the correspondent factor determines The bank makes a short-term loan to the exporter, usually
the importer’s creditworthiness and handles the collection from one to six months, secured by an assignment of the
of the receivable from the buyer. account receivable. The bank makes its loan decision on
Factors generally provide 70% of the face value within 3-5 the basis of the exporter’s creditworthiness and is looking
working days. After final payment is received from the to the exporter as the primary source of repayment. If the
buyer, the factor will pay the remaining 30% to the ex- importer fails to pay the receivable, the exporter is still
porter, less the service fee of 4% to 5%. obligated to repay the loan principal as well as interest
Factors often use export credit insurance because of the that accrues until it is paid in full. Because of the added
risk of the foreign receivable risk in a foreign receivable, export credit insurance is usu-
ally required by the bank and the exporter.
A commercial letter of credit is a guarantee by the

buyer’s bank that the bank will pay for the merchandise,
provided that the seller (exporter) can provide the re-
quired documents in accordance with the terms of the
commercial letter of credit. The required documents are
A standby letter of credit is a guarantee by the buyer’s generally bills of lading and freight documents evidencing
bank saying that if the buyer fails to pay, the bank will shipment of the goods.
pay. It is not usually used as the primary payment The seller is assured of payment when the conditions of
method. the letter of credit are met; and the buyer is assured of
receiving the goods ordered.
The terms of a standby letter of credit are somewhat sim-
pler and easier for the seller to comply with than the However, if any of the documents are not exactly right,
terms of a commercial letter of credit. the buyer can reject the shipment, or the bank may
refuse to make payment.
The buyer has the disadvantage of having their bank tie
up their account or their credit line from the date the let-
ter of credit is accepted until it is either paid, rejected,
expires, or is cancelled.
What is a sight draft What is a time draft

as used in international as used in international
payments? payments?

What is
What is a
working capital financing
banker’s acceptance
as a means to
as used in international
finance international
trade financing?
trade transactions?

What is forfaiting What is countertrade

as used in international as used in international
trade financing? payments?

A draft is a written order by one party (the seller), direct-
ing a second party (the buyer) to make payment to a third
party (the buyer’s bank). Drafts facilitate international A draft is a written order by one party (the seller), direct-
payments through intermediaries such as banks, but the ing a second party (the buyer) to make payment to a third
intermediary banks do not guarantee performance by party (the buyer’s bank). Drafts facilitate international
either party. payments through intermediaries such as banks, but the
intermediary banks do not guarantee performance by
Payment for a time draft is demanded at a specified time either party.
after the buyer accepts the draft and receives the goods.
The exporter instructs the buyer’s bank to release the A sight draft is to be paid by the buyer as soon as he
shipping documents when the buyer accepts the draft. sees it. The exporter gets paid when shipment is made
The buyer writes “accepted” on the draft and is then con- and the draft is presented to the buyer for payment. The
tractually liable to pay. The accepted draft, which is called buyer’s bank does not release the shipping documents to
a trade acceptance, is a promise by the buyer to pay the the buyer until the buyer has made payment, and the
seller at a specified future date. If the buyer does not pay buyer cannot claim the shipment until he has the docu-
the draft on its maturity date, the bank does not have any ments.
obligation to pay. In addition, the buyer can delay pay-
ment by delaying acceptance of the draft.
A banker’s acceptance is a time draft that has been

issued under a letter of credit and has been accepted by
the importer’s bank. The draft represents the exporter’s
demand for payment. The time period of most time drafts
Both importers and exporters may make use of working
is from 30 to 180 days.
capital financing. For the importer, the loan finances the
working capital cycle that includes purchase of inventory,
When the importer’s bank accepts the time draft, a
sale of the inventory and creation of an account receiv-
banker’s acceptance is created. The bank that has accep-
able, and finally conversion of the receivable to cash. For
ted the draft is obligated to pay the amount of the draft to
the exporter, the loan might finance the manufacture of
the holder of the draft on the maturity date. If the ex-
the goods that are to be exported, or it may finance the
porter does not want to wait for payment, the exporter
period from when the sale is made until payment is re-
may sell the banker’s acceptance in the money market.
ceived.
The buyer of the banker’s acceptance will receive the
bank’s payment on the maturity date. Thus, trade financ-
ing for the exporter is provided by the holder of the
banker’s acceptance.
Countertrade or barter may be used if the buyer does

not have access to currency conversion, if exchange rates
are unfavorable, or if the two parties can exchange goods
or services on a mutually satisfactory basis. Types of Forfaiting is the financing of medium-term capital goods
countertrade are: sold internationally. Forfaiting refers to the purchase of
financial obligations such as bills of exchange, without
1) Barter - The exchange of goods or services between recourse to the exporter. The importer issues a promissory
two parties without the use of any currency as a note in favor of the exporter for a period of three to seven
medium of exchange. years. The exporter then sells the note, without recourse,
2) Counterpurchase - The seller gets paid the regular to the forfaiting bank.
amount, and agrees to purchase goods worth the
same amount from the buyer. Forfaiting is similar to factoring in that the forfaiter is
3) Compensation deals - The sale is paid partially in responsible for collecting from the importer/buyer. The
cash and partially in goods, or it may be paid 100% in forfaiting bank must assess the creditworthiness of the
goods. importer, because it is in effect extending to the importer
a medium-term loan.
4) Buy-back - The seller agrees to supply technology,
equipment or raw materials that will enable the recipi-
ent to produce goods.
What must a
What is a transfer price? transfer pricing
system accomplish?

What is the
What are the common
market price
transfer pricing methods?
transfer pricing method?

What is the
What is the
cost of production plus
variable cost
opportunity cost

A transfer pricing system must accomplish the following:
1) It must give senior management the information it
needs to evaluate the performance of the profit cen-
ters.
2) It must motivate the profit center managers to pursue The transfer price is the price that is charged by one
their own profit goals while also working toward the unit of the company to another unit of the same company
success of the company as a whole. for the services or goods produced by the first unit and
“sold” to the second unit. They are used by profit and
3) It must encourage the cost center managers’ effi-
investment centers in order to calculate the costs of
ciency while maintaining their autonomy as profit cen-
services received from service departments and revenues
ters.
when “selling” a product to another department when that
4) It must be equitable, permitting each unit of a com- product has an outside market.
pany to earn a fair profit for the functions it performs.
5) It must meet legal and external reporting require-
ments.
6) It should be easy to apply.
The transfer price is set as the current price of the selling

division’s product in an arms-length transaction. When
there is an external market for the product, this is almost
always the best transfer price to use for profitability and
performance measurement, because it is objective. It sat- The common transfer pricing methods are:
isfies the “arm’s length” requirement by taxing authorities. 1) Market price.
Furthermore, it satisfies the management of the buying
2) Cost of production plus opportunity cost.
company that they are paying a fair price for the goods
and the management of the selling company that they are 3) Variable cost.
receiving a fair price for the goods. 4) Full cost.
5) Cost plus.
However, sometimes there is no external market and thus
a market price is not available. Another drawback is that 6) Negotiation.
each transfer of product entails an element of profit and 7) Arbitrary pricing.
loss. It may be difficult to determine the actual cost of the
final product. Furthermore, intracompany profit must be
eliminated from inventories when consolidated financial
statements and the income tax return are prepared.
The variable cost transfer pricing method uses the

selling division’s variable costs only. This works well of the
The cost of production plus opportunity cost trans-
selling division has excess capacity and when the main
fer pricing method is a calculation that includes not only
objective of the transfer price is simply to satisfy the
the cost of production (called outlay cost), but also the
internal demand for goods. It is not appropriate if the
contribution margin that the selling department is giving
seller is a profit or investment unit, though, because it will
up by selling the product internally rather than externally.
decrease the seller’s profitability. Therefore, when the
Though this approximates a market price, it is not exactly
selling division does not have excess capacity, the selling
a market price because a true market price may only be
division will prefer to sell to an outside customer. However,
set in an arm’s length transaction, which this is not.
a transfer price equal to variable cost does encourage the
buying division to buy the item internally.

full cost cost plus
transfer pricing method? transfer pricing method?


negotiation arbitrary pricing
transfer pricing method? method of transfer pricing?

Section C: Decision Analysis and Risk Management Section C: Decision Analysis and Risk Management
Section C: Decision Analysis and
Risk Management
What is the goal of What are some

decision-making? typical decisions?

The full cost transfer pricing method includes all
materials, labor and a full allocation of overhead. It is the
Under the cost plus transfer pricing method we add full cost of production and is calculated using absorption
some fixed dollar amount or a percentage of costs to the costing.
cost of production to approximate a normal profit markup. The advantages of using full cost are:
It can be used when a market price is not available. 1) It is well understood,
This method may use either standard costs or actual 2) The cost information is easily available in the account-
costs. If standard costs are used, then there will be an ing records, and
opportunity to separate out variances. If actual costs are 3) There is no need to eliminate intracompany profits
used, then there is no motivation for the manager of the from inventories in consolidated financial statements.
producing and selling department to control the depart- The disadvantages of using full cost are that it can result
ment’s costs, because whatever costs are incurred will be in poor decision-making. The transfer price may be higher
passed on to the next department. And if the profit mark- than a third party price. The buying department might
up is a percentage of cost, it actually gives the selling prefer to go outside. However the external price may be
department an incentive to inflate the cost through pro- more than the selling department’s variable cost. Since
duction inefficiencies and excessive allocation of common the fixed cost will be the same whether the part is manu-
costs. factured internally or purchased outside, the consolidated
profit of the firm will be lower if the purchasing depart-
ment buys the item outside.
In order for the negotiation transfer pricing method

to work, each department must be able to determine the
amount of its materials that it buys or the amount of its
output that it sells.
In the arbitrary pricing method of transfer pricing This method is the most useful when the products in a
the transfer prices may simply be set by central manage- market are rapidly changing and the companies need to
ment to achieve tax minimization or some other overall react quickly to changes in the market place. It is also
objective. The advantage to this method is that the price helpful if the units have a conflict: Negotiation can bring a
achieves the objectives that central management con- resolution.
siders most important. The disadvantages far outweigh However, in order to be effective, neither negotiating party
the advantages, however, because this method defeats should have an unfair bargaining position.
the goal of making divisional managers profit conscious. It
A drawback is that negotiation can be time-consuming
hampers their autonomy as well as their profit incentive.
and require frequent revision of prices because of chang-
ing costs and market conditions. Time required for negoti-
ating diverts the attention of division managers away from
more productive activities that would benefit the company,
to activities that benefit the division.
Some typical decisions are:

1) Pricing. Should the price be based upon our costs, or
upon the market target pricing? Will a potential cus-
tomer be profitable enough to justify aggressive pri-
cing? What is the minimum price we can accept?
Decision-making involves selecting among different
2) Alternative manufacturing options. What is the options that are available to a company. A decision-maker
most cost-efficient and best way to manufacture the should select the option that maximizes the benefits
product? What is the most profitable output level? and/or reduces costs to the company. Relevant factors in
Should a one-time special order be accepted? decision-making can be qualitative (characteristics, and
3) Research and development. What new products more difficult to assess) as well as quantitative (numer-
should we be exploring? ical, and easier to assess).
4) Capital budgeting. What new projects and invest-
ments should be implemented and what should be
discontinued?
5) Outsourcing decisions. Should we make or buy?
What are What are

relevant revenues and marginal costs and
relevant costs? marginal revenues?

What are incremental and What are avoidable and

differential costs? unavoidable costs?

What is a What are explicit and

sunk cost? implicit costs?

Relevant revenues and relevant costs are all the
expected future revenues and costs that differ among
alternatives. Only relevant revenues and costs are con-
sidered in the decision-making process. This is because:
1) It is important to focus on the future since nothing
Marginal costs and marginal revenues are the addi-
can be done to change the past. Costs that are the
tion to total cost or the addition to total revenue that re-
result of past decisions and that cannot be changed
sults from a one-unit increase in production. The terms
are called sunk costs. These sunk costs are irrelevant
can also be used in the context of decision analysis to
to the decision process, since no matter which option
refer to the addition to total cost or the addition to total
is taken they will remain the same.
revenue that would result from a project that is under
consideration. 2) If costs or revenues are not different between options,
they do not matter in the process of selecting an
option because they are also the same no matter
what is done. Revenues and costs that do not differ
are irrelevant and are not considered in the decision-
making process.
An avoidable cost is a cost that can be avoided if a par-

ticular option is selected. It is a cost that would go away.
For example, if production is outsourced, the variable cost
to produce the product in-house will go away and be Relevant revenues and costs are further classified as
replaced by the cost to purchase the product externally. incremental revenues and costs or differential rev-
Avoidable costs are relevant costs to the decision-making enues and costs.
process because they will continue if one course of action The terms “incremental” and “differential” are often used
is taken but they will not continue if another course of interchangeably; however, they are not the same.
action is taken.
Incremental revenues and costs are incurred addition-
An unavoidable cost is an expenditure that will not be ally as a result of an activity.
avoided (i.e., will not go away) regardless of which course Differential revenues and costs are those that differ
of action is taken. Continuing the example from above, an between two alternatives.
unavoidable cost would be a payment on a noncancelable
lease for production equipment that would have to con-
tinue to be paid even if production were outsourced.
An explicit cost is a cost that can be identified and

accounted for. Explicit costs represent obvious cash out-
A sunk cost is a cost for which the money has already
flows from a business.
been spent and cannot be recovered. Sunk costs are not
relevant to decision-making because they will not be any
On the other hand, an implicit cost is an implied cost. It
different regardless of what decision is made.
is more difficult to identify, and it does not clearly show up
in the accounting records, although it is there.
What are marginal analysis

and the 6 primary
What are opportunity costs?
marginal measurements
in marginal analysis?

What is marginal revenue? What is marginal cost?

What is marginal product

What is marginal profit?
(or marginal physical product)?

An opportunity cost is the contribution to income that is
forgone by not using a limited resource in its best alter-
native use. Opportunity costs are examples of implicit
Marginal analysis is the process of looking at one more costs.
unit and asking, “what will be the effect of selling/produc- The relevant portion of the opportunity cost is the differ-
ing one more unit?” ence between the contribution to income that could be
The six primary measures in marginal analysis are: earned on the alternative item and the contribution to
income that can be earned on the item to be produced.
1) Marginal revenue.
The opportunity cost is calculated only from the revenues
2) Marginal cost. that would not be received and expenditures that
3) Marginal profit. would not be made for the other available alternatives.
4) Marginal product (or marginal physical product). Also, any interest cost that is part of the opportunity cost
can only be calculated for the period when the cash flows
5) Marginal resources cost. are different between or among the options.
6) Marginal revenue product. Note: Opportunity costs exist only if there is a limitation
on the availability of a resource. If there is no limit, there
is no opportunity cost because all available options can be
selected.
Marginal revenue is the addition to total revenue gained

by producing an additional unit of output.
Marginal cost is the addition to total cost by increasing
production by one unit. The absolute amount of marginal revenue depends upon
the market structure that exists (perfect competition,
monopoly, monopolistic competition, oligopoly).
Marginal Product (or Marginal Physical Product) is the Marginal profit is marginal revenue minus marginal cost.
additional output that is produced from adding one addi- This is the additional profit that the company would get by
tional unit of input. producing and selling one more unit.
What is What is
marginal resource cost? marginal revenue product?

How is marginal revenue

How is marginal revenue
impacted in a
impacted in a
perfect competition
monopoly market structure?
market structure?

How is marginal revenue How is marginal revenue

impacted in a monopolistic impacted in a oligopoly
market structure? market structure?

Marginal revenue product is the change in total rev- Marginal resource cost is the change in total cost that
enue that arises from using one more unit of a resource. results from using one additional unit of a resource.
A monopoly exists when conditions are present in the

industry or economy that permit only one efficient sup- In a perfectly competitive market, there are many
plier in a location. buyers and sellers and customers are indifferent as to
A monopoly has control over the price it charges, in con- which seller they buy from. The product is standardized,
trast to the perfectly competitive firm that must sell its so the same product is available from every seller. Sellers
product at the market price. in a perfectly competitive market can sell as much of their
Although the monopolist controls the price it charges, it product as they want at the market price. If they try to
cannot increase prices and expect to sell the same amount charge more than the market price, they will sell nothing.
of product. The monopolist faces a downward sloping If they drop their price below the market price, they can
demand curve. When it increases its prices, it sells fewer still sell as much of their product as they want. But if they
units. When it decreases its prices, it will sell more units. drop their price below the market price, their revenue will
The marginal revenue curve of a monopolist is below its be lower than it could have been, because they could have
demand curve. As production increases, a monopolist that sold the same amount at the market price and earned
charges the same price for all of its output will have to more revenue.
lower its price in order to get consumers to buy the addi-
tional output. Therefore, in a perfectly competitive market, the mar-
Therefore, the marginal revenue received from pro- ginal revenue from the sale of one more unit is
ducing an additional unit will be less than the price equal to the market price.
received for that unit.
In an oligopoly, there are only a few firms in the market.

Each is affected by what the others do. Participants in an
In a monopolistic competition environment there are
oligopolistic market will exhibit strategic behavior: each
many firms operating in the market and they do not col-
company will consider the impact of its actions on its com-
lude with one another in setting prices. The products pro-
petitors and the expected reaction from them.
duced by the various firms are similar but not identical.
It is theorized that a price decrease by one company There are differences among them. The firms in the mar-
will be matched by others’ price decreases, but a price ket have limited control over prices, even though there
increase by one company will not be followed by the are many firms, because of the differences in the prod-
other companies. ucts. One firm can charge more than another one because
Thus, if one firm increases its price, it will lose volume to of offering more features, and so forth.
the other producers since they will not increase their
prices and will secure more volume. If the other firms did Just as with a monopoly, firms operating under monopo-
not match the lower price, a price decrease by one firm listic competition have marginal revenue curves that are
would allow that firm to capture more market share. below the demand curve. So a firm in monopolistic
competition must also drop its price in order to sell
However, competitors tend to match a price decrease; so
additional units, although this is mitigated some-
any increase in volume that the firm would received would
what by the product differentiation.
not be enough to offset the lower price, and total revenue
will decrease.
When considering the

What are the types of
marginal revenue and
average costs per unit
marginal cost, how should
and how are they impacted
production output be planned
by production levels?
to maximize profits?

What is cost assignment

What is a cost object?
and what does it include?

What are the factors

that determine whether What are variable costs
a cost is classified as and how do they behave?
direct or indirect?

Production output should be planned so that the
Marginal Revenue = Marginal Cost
This is the point of production and sales that will maximize
Average cost per unit is the total cost divided by the profit. Sales beyond this point produce a loss on each
total units produced. additional (marginal) item and will decrease the total
profit of the firm. For a firm in monopolistic competition,
Average total cost can be split into average fixed cost, the marginal revenue from selling another unit declines as
which is total fixed cost divided by the total units pro- volume increases. The marginal cost of production de-
duced, and average variable cost, which is total vari- clines up to a point as production increases, and beyond
able cost divided by the total units produced. that point, it tends to increase.
Average variable cost rises or falls as production in- A firm should expand production so long as the marginal
creases, but average fixed cost declines continuously as revenue from selling another unit exceeds the marginal
production increases, because the total fixed cost is being cost, since selling this additional unit this will cause total
divided by an ever-increasing level of production. profit to increase. Production should stop when marginal
revenue equals marginal cost, because if it expands be-
yond this point, the increasing marginal cost of production
will rise above the marginal revenue, and profit will
decline.
A cost object is any thing or activity that we want to

measure the costs of. It answers the question, “The cost
of what?” The identity of the cost object is important
because it determines whether the related cost is a direct
cost or an indirect cost. Examples of cost objects are a:
Cost assignment means assigning costs to a particular
1) Product
cost object. This is a more general term that includes two
methods of assignment: 2) Batch of like units
1) Tracing direct costs to a particular cost object pro- 3) Customer order
vided that it is feasible and economically justified, and 4) Contract
2) Allocating indirect costs to a cost object. These 5) Product line
indirect costs are allocated according to some prede-
6) Process
termined formula/allocation base.
7) Department
8) Division
9) Project
10) Strategic goal
Several factors determine whether a particular cost will be

classified as direct or indirect:
1) Materiality: It must be economically feasible to trace
a cost to a particular cost object. Therefore, the
greater the amount of the cost, the more likely it is to
be traced as a direct cost to a cost object.
Variable costs are costs that change in total in propor- 2) Available technology: Technology can make it eco-
tion to changes in the level of activity. A variable cost is nomically feasible to trace costs that otherwise might
constant on a per-unit basis. As total production in- be considered indirect. Bar codes are an example of
creases, the total variable costs increase (and vice versa this technology.
for decreases), but the variable cost per unit remains the 3) Organizational design: It is easier to classify a cost
same no matter what the level of production. as direct if the company is organized in a way that a
given facility is used exclusively for a specific cost
object such as a specific product.
4) Contractual arrangements: A production contract
may specify a specific component for use in a product,
which makes it easier to classify that component as a
direct cost of that product.
What are fixed costs Define mixed costs and explain

and how do they behave? the two types of mixed costs.

What is a cost driver? What is an imputed cost?

What are
5 examples of situations
What is a postponable cost?
where marginal analysis
can be used?

In reality, many costs are a combination of fixed and vari-
able elements. These are mixed costs.
Mixed costs area semi-variable or semi-fixed.
A semi-variable cost has both a fixed component and a
variable component. There is a basic fixed amount that
must be paid regardless of activity. And added to that Fixed costs are costs that do not change in total
fixed amount is an amount which varies with activity. within the relevant range. This means that, within the rel-
A semi-fixed cost, also called a step cost, is fixed over evant range, the cost per unit changes as the volume
a given, small range of activity, and above that level of changes, but the total remains the same.
activity, the cost suddenly jumps. It stays fixed again at
the higher range of activity. When the activity moves out The relevant range is the range in which the fixed cost
of that range, it jumps again. remains unchanged.
The difference between a semi-variable and a semi-fixed

cost is that the semi-variable cost starts out at a given
base level and moves upward smoothly from there as
activity increases. A semi-fixed cost moves upward in
steps.
An imputed cost is one that does not show up in the

accounting records and is not a cash outlay, but it repre-
sents a cost that must be considered in decision-making. A cost driver is a factor or behavior that affects costs.
An opportunity cost is a type of imputed cost. For example, a given level of activity or volume over a
given time span may be a cost driver. A change in the
For example, if a business uses space in its own produc- level of activity or volume affects that cost object’s total
tion activities that it could have rented out to a tenant, the costs.
rent that it could have received and did not receive is an
imputed cost.
The types of situations in which marginal analysis

may be used include:
A postponable cost is a cost that may be delayed to a
1) Make-or-buy decisions (insourcing versus outsourc-
future period with very little, if any, effect on the current
ing products and services).
operations and efficiency of the company.
2) Accepting or rejecting a one-time special order.
3) Introduction of a new product or a change in output Example: Training costs may be, and commonly are,
levels of existing products. delayed during a difficult financial period because training
has a long-term rather than a short-term impact.
4) Adding or dropping product lines or divisions.
5) Selling or processing further decisions.
What is the maximum price

What are
that a company would be
make-or-buy decisions
willing to pay for purchasing
and what type of costs are
outside the company in a
considered in this decision?
make or buy analysis?

What is a
How does the direct cost
special order decision
of production impact a
and what are the main issues
special order decision?
to consider in this decision?

How does the level of

What are sell or
operating capacity
process further decisions and
impact a special
when do they usually occur?
order decision?

Make-or-buy decisions usually involve whether the
company should produce something itself or buy it from
Usually, the maximum price that a company would be outside.
willing to pay for purchasing outside the company is: The only costs that need to be considered are the rele-
Total Internal Production Costs vant costs which usually consist of the variable costs
– Unavoidable Costs (Fixed and Variable) and avoidable fixed costs.
= Maximum Price to Pay If the cost to purchase the product from outside is lower
than the avoidable cost of internal production, the com-
Other qualitative considerations are also potentially very pany should buy the product from the outside.
important to the decision. Factors such as quality, reliabil-
ity of delivery, service, flexibility in delivery terms and Other important considerations:
even possibly public relations with the community in which 1) The purchasing costs (purchase price, ordering costs,
the factory is located may all be important factors in the carrying costs, etc.) relating to the purchase from an
decision. Unfortunately, even though these are very outsider are all relevant variable costs and must be
important factors, it is often very difficult to give a mone- included in the cost of purchasing the item.
tary value to them. 2) Only avoidable fixed and variable costs of in-house
production are relevant as a cost of producing the
item internally.
The minimum price charged in a special order decision

must include all of the costs that will be incurred directly
In a special order situation, a company has a request
as a result of this specific order.
for a special, one-time order and it must determine the
These would be the costs that would be avoidable if the minimum price to charge.
company did not produce this order.
There are two factors to consider about this price:
Generally, this includes the variable costs of production –
1) Direct costs of production.
direct materials, direct labor and variable overheads.
2) Level of capacity at which the company is operating.
Nonmanufacturing costs and fixed manufacturing costs
will usually continue, even if this order is not produced.
The minimum price to charge in a special order decision is

affected by the percentage of capacity at which the com-
pany is operating.
If the company is operating at less than full capacity
If the decision is between selling the product “as-is” or and there is sufficient capacity to produce this new order,
processing it further, presumably in order to sell it for a then only the avoidable (direct) costs of production
higher price, the decision is based on the incremental are used to determine the minimum price for the order.
operating income that is attainable beyond the “as-is” If the company is operating at full capacity, it must
point. also include the opportunity cost of producing the order as
This kind of situation may generally be encountered when a cost to be charged to the new order. Because the com-
dealing with two situations: pany is producing at full capacity, it is going to have to not
produce something else in order to produce this special
1) Joint production processes. order. As a result, it will lose the contribution that would
2) Obsolete inventory. have been earned from the other sale. Therefore the com-
pany needs to recover not only the direct (avoidable)
costs of producing this order, but also the contribu-
tion that is lost from the products that are not going
to be sold as a result of accepting this order.
How does a
How does obsolete inventory
joint production process
impact a sell or process
impact a sell or process
further decision?
further decision?

What are the three steps

What are the primary issues
to follow in disinvestment
in a disinvestment decision?
decision process?

What three factors How is pricing impacted

affect the price of a in a market structure of
product or service? perfect competition?

With obsolete inventory, the original cost of the inventory A joint production process results when the same produc-
is a sunk cost and is irrelevant. tion process (and therefore the same costs of that produc-
If the choice is between selling the inventory “as-is” tion process) yields more than one product. With joint
versus re-working it, compare the revenue from selling costs (these are the costs that are shared by the joint
minus the cost of re-working it with the proceeds from production process), the place in the production process
selling the inventory as-is (or the disposal cost, if the where the various products become individually identifi-
inventory has no value). able is called the splitoff point. Costs incurred up to the
It is better to process further or incur additional other splitoff point are joint costs. Costs incurred after the
costs if the sale of the re-worked product at the expected splitoff point are separable costs.
price is certain, and When joint costs have incurred for a product, manage-
1) If incremental revenues for re-worked product minus ment should not consider the joint costs allocated to the
incremental expenses of re-work is greater than the individual products. This is because these are sunk costs.
proceeds would be from selling as-is; or The only factors that are relevant are incremental reve-
2) If there is a disposal cost for the inventory instead of nues and costs after the splitoff point. The increased rev-
any proceeds, the difference between the options will enues attainable by processing further should be balanced
be the sum of the absolute values of the net incre- against the increased costs to process further. The in-
mental revenue minus incremental expense and the crease in net operating income as a result of the addi-
cost to dispose. tional processing is the only basis for the decision.
There are three main steps that a company must follow

in the disinvestment decision process: When making a decision whether to terminate a product,
1) Identify any unavoidable fixed costs that are allo- division or operation, the decision-making process re-
cated to or incurred by the division that would continue quires you to determine what the profit (or cost, depend-
even if the division were terminated. These are the ing on the way the question is posed) would be under
unavoidable costs that would simply be transferred to both the current situation and what it would be if the
another division if this division were terminated. product, division or operation were terminated.
2) Identify any unavoidable variable costs that would
The decision can then be made based upon which option
continue even if the division were terminated. These
provides a greater benefit for the company.
are again the unavoidable variable costs that would be
absorbed by another division after this one is closed. In this decision-making process, it is critical to remember
3) Identify any avoidable costs (both fixed and vari- that some of the fixed costs of the division may not be
able) that will be incurred only if the division continues avoided even if the division is terminated. This is because
to operate and compare this to the revenue of the some of the fixed costs may be allocations of central fixed
division. If the revenue from this division is less than costs or are costs that cannot be terminated (such as a
the avoidable costs of the division, the division should non-cancelable lease). Because those costs will simply be
be terminated. transferred to another division if the division in question is
Note that step 3 calculates the contribution of the divi- terminated, these are not avoidable costs.
sion.
The pricing decision is one of the most important for any

company. In general, the price of a product or service
Sellers in a perfectly competitive market can sell as is dependent upon the three “C” factors:
much as they want at the market price, but they must sell
1) Customers. Customers’ willingness to purchase dif-
at the market price.
ferent quantities of product at various prices (demand
If they try to charge more than the market price, they will curve, utility concept).
sell nothing. If they drop their price below the market
2) Competitors. Prices charged by competitors for com-
price, they can still sell as much of their product as they
peting and substitute products will determine the
want to. But if they drop their price below the market
range within which the price must be set to be com-
price, their revenue will be lower than it could have been,
petitive.
because they could have sold the same amount at the
market price and earned more total revenue. 3) Costs. The price must be high enough to provide a
sufficient return, which means that it must cover all
Therefore, pricing decisions for a firm in a perfectly com-
the costs and allow for some required profit (supply
petitive market are easy – the perfectly competitive firm is
curve concept).
a price taker and simply sells at the market price.
All three of these factors in combination will determine the
price.
How is pricing impacted in a

market structure of
monopoly market structure?
monopolistic competition?


What is the law of demand?
oligopoly market structure?

What are the

What is elasticity of demand? two methods to
calculate price elasticity?

In a market structure of monopolistic competition
there are many firms operating in the market, and they do
not collude with one another in setting prices. The A monopoly has control over the price it charges, in con-
products produced by the various firms are similar but not trast to the perfectly competitive firm that must sell its
identical. There are differences among them. product at the market price. However, even though the
monopolist has control over the price it charges, it cannot
The firms in the market have limited control over prices,
increase prices and expect to sell the same amount of
even though there are many firms, because of the differ-
product.
ences in the products. One firm can charge more than
another one because of offering more features, and so
The monopolist faces a downward sloping demand curve,
forth.
and when it increases its prices, it sells fewer units. Simi-
A firm in monopolistic competition must also drop its price larly, when it decreases its prices, it will sell more units.
in order to sell additional units, although this is mitigated
somewhat by the product differentiation.
In an oligopoly, there are a few firms in the market and

each company considers the impact of its actions on its
competitors and the reaction that it expects from them. A
price decrease by one company will usually be matched by
the others. But a price increase by one company will usu-
ally not be matched by the others.
If one firm increases its price, it will lose market share to
The law of demand states that the price of a product is
the other producers since they will not increase their
inversely (negatively) related to the quantity demanded of
prices. Thus they will obtain more market share. If the
that same product. Therefore, as the price of the product
other firms do not match the lower price, a price decrease
is reduced, the quantity demanded for that same product
by one firm allows that firm to capture more market
will increase, and vice versa.
share. However, competitors tend to match a price de-
crease; so any increase in volume received by that firm
would not be enough to offset the lower price. Total rev-
enue will then decrease.
Given that there is a negative effect to either increasing or
decreasing the price, prices in an oligopoly tend to be
“sticky” (meaning that they do not change easily).
The elasticity of the demand for a particular product or

service will determine how much effect a price increase or
There are two ways to calculate price elasticity: decrease will have on the demand for that product or ser-
1) The percentage method. vice.
2) The midpoint (or arc) method. Elasticity of demand is calculated in general as the per-
centage change in quantity demanded divided by the per-
They produce similar results, however the midpoint
centage change in price.
method is less precise because it relies upon approxima-
tion. The demand for a product is said to be “elastic” (“re-
sponsive”) if a 1% change in the price of the good causes
Further, although the two methods will give a slightly dif-
more than a 1% change in the quantity demanded.
ferent result, the overall effect, whether the outcome is
elastic or inelastic, will be preserved. The demand for a product is said to be “inelastic” (“unre-
sponsive”) if a 1% change in the price of the good causes
less than a 1% change in the quantity demanded.
What is the
What is the percentage method
midpoint (or ARC) method
for calculating price elasticity?
to calculate price elasticity?

How does a price increase

What are the
impact total revenue
4 classifications
when prices are elastic,
of price elasticity?
inelastic, and unitary?

How does a price decrease

impact total revenue
What is the law of supply?
when prices are elastic,
inelastic, and unitary?

The midpoint method is used when we are given differ-
ent numerical and dollar figures for different points on the
demand curve. This method also eliminates the fact that
the percentage method will give different elasticities,
depending upon the direction of the movement along the Under the percentage method we take the % change
curve that is used in the calculation. This method is less in quantity and divide it by the % change in the price of
accurate due to approximation of the midpoint. the product. This method is used if percentages are given.
The Price Elasticity of Demand (Ed) under the midpoint The Price Elasticity of Demand (Ed) under the percentage
method is calculated as follows: method is calculated as follows:
(Q2 – Q1) / [(Q2 + Q1) / 2] Percentage Change in Quantity Demanded
(P2 – P1) / [(P2 + P1) / 2] Percentage Change in Price
Where:
Q1 and Q2 = First and second quantity point
P1 and P2 = First and second price point
The mathematical relationship between price changes and The 4 classifications of price elasticity are:
changes in total revenue is dependent upon the elasticity
1) Ed=0 Perfectly Inelastic: no matter what hap-
of demand.
pens to the price, the quantity that is demanded will
The total revenue formula is: remain the same.
Total Revenue = Price # Quantity 2) Ed<1 Inelastic: any percentage change in price
will result in a smaller percentage change in the
Given this equation, we can see how the elasticity of de-
quantity demanded. Example: a 9% decrease in price
mand will impact the total revenues. If we raise the price,
will cause the quantity demanded to rise by less than
we know that quantity will fall. However, the most impor-
9%.
tant question is whether total revenue will increase or
decrease as a result 3) Ed=1 Unitary Elasticity: any percent change in
price causes the quantity demanded to change by the
A price increase will have the following impact on total
same percent. Example: a 12% price increase causes
revenue based upon the following price elasticity:
the quantity demanded to fall by exactly 12%.
1) Elastic (E > 1): total revenue decreases.
4) Ed>1 Elastic: any percentage change in price re-
2) Inelastic (E < 1): total revenue increases. sults in a larger percentage change in the quantity
3) Unitary Elasticity (E = 1): total revenue is un- demanded. Example: a 2.5% decrease in price causes
changed. the quantity demanded to rise by more than 2.5%.
The mathematical relationship between price changes and

changes in total revenue is dependent upon the elasticity
The law of supply states that in the short run, there is a of demand.
positive relationship between the price of a good or ser-
vice and the quantity supplied. As the price of a good The total revenue formula is:
increases, producers are willing to supply more of the Total Revenue = Price # Quantity
good to the market, causing an increase in the total
quantity supplied. Similarly, as the price of the good A price decrease will have the following impact on total
decreases, producers are willing to supply less of it to the revenue based upon the following price elasticity:
market because of the lower selling price. This causes a 1) Elastic (E > 1): total revenue increases
decrease in the total quantity supplied to the market as 2) Inelastic (E < 1): total revenue decreases
prices fall.
3) Unitary Elasticity (E = 1): total revenue is un-
changed
What is the
What is market equilibrium?
shut-down price?

What are company What are external factors

internal factors that that influence company
influence pricing decisions? pricing decisions?

What are the What are the basic factors

six steps for setting and approaches to general
company pricing policy? pricing policy of a company?

Market equilibrium is defined as the point where the
demand curve intersects with the supply curve. This
The price where the firm is just covering its average vari-
point determines the market price and the quantity that
able cost but where there is nothing extra to put toward
will be exchanged of a good, because at this point of
covering the fixed costs is called the shut-down price.
intersection, the market price (the “equilibrium price”) is
such that the quantity demanded by consumers is exactly
At this price, the firm is indifferent between producing and
equal to the quantity supplied by firms.
not producing. At any price below the shut-down price,
the firm will shut down because there is no output level at
Therefore, the pricing of any product or service is affected
which any variable costs can be covered.
by the demand for and the supply of the product or ser-
vice.
External factors impacting pricing decisions include:

Internal factors that the company takes into considera-
1) The market and demand: The market and demand
tion in setting prices are:
for the product set the upper limit for prices.
1) Marketing objectives: target market and the posi-
2) Competitors’ activities: Competitors’ prices, offers,
tioning the company has chosen for the product will
and possible competitor reactions to the company’s
affect the price.
pricing is another factor to consider. Companies need
to know the prices and the quality of their competi- 2) Marketing mix strategy: pricing decisions need to
tors’ products in order to compare their costs with be coordinated with the other decisions in the market-
their competitors. ing mix – product design, distribution (place), and
promotion plans – to create a consistent marketing
3) Other external factors: Factors such as inflation,
program.
recession, and interest rates affect pricing strat-
egies, because they affect the product costs as well as 3) Costs: the company will want to charge a price that
consumers’ perceptions of the product’s value to covers all of its costs, both fixed and variable, and
them. Resellers’ reactions are also important, be- gives it a fair profit.
cause the company’s price needs to be set so that its 4) Organizational considerations: the company’s
resellers make a fair profit. The government also management needs to decide who has the authority
affects pricing decisions, with taxes and regulations to set prices.
being a concern.
Product pricing will be higher than an amount that would

not produce a profit and lower than one that is too high to
produce adequate demand.
The price floor is product cost. The ceiling is customer per-
ception of the product’s value. The best price is between The company will generally follow a six-step process in
these extremes and is determined by competitors’ prices setting its pricing policy, as shown below:
as well as the internal and external factors. 1) Select the pricing objective.
The basic factors for pricing decisions are:
2) Estimate demand.
1) Product cost,
2) Customer perception of the product’s value, and 3) Estimate costs.
3) Competitors’ prices. 4) Analyze competitors: prices, costs, and offers.
Prices are usually set by a general pricing approach that 5) Determine the pricing method.
includes one or more of these considerations. 6) Decide on a final price.
Three general pricing approaches are:
1) The cost-based approach,
2) The value-based approach, and
3) The competition-based approach.
What is cost-based pricing What is value based pricing

and how is it implemented? and how is it implemented?

What is Explain the

competition based pricing two primary types of new
and how is it implemented? product pricing strategies.

Explain the
primary issue impacting
product mix pricing strategies What is product line pricing?
and list 5 examples of
these strategies.

Value-based pricing (also called buyer-based pricing) Cost-based pricing includes cost-plus pricing, break-
bases prices on buyers’ perceptions of the value of even pricing, and target profit pricing.
the product instead of on the seller’s cost. Value-based The company determines its costs and adds a standard
pricing is the reverse of cost-based pricing. The target markup to the cost to arrive at the price.
price is based on customer perceptions of the value of the In break-even pricing and target profit pricing, the
product. firm determines a price at which it will break even or
The pricing process begins with consumer needs and make a target profit. Target pricing is based on forecasts
value perceptions. The price is set to match that. of total cost and total revenue at various sales volume
More companies are adopting value pricing strategies, and levels.
this has led to introduction of less expensive versions of The drawback to cost-plus pricing is that it ignores cus-
brand-name products. tomer demand and competitor prices.
An important type of value pricing is called everyday low But it persists for several reasons:
pricing. Everyday low pricing is used at the retail level to 1) Sellers are more confident about their costs than
charge an everyday low price with few temporary price about demand. Since the price is tied to cost, they do
reductions. not have to adjust pricing to reflect demand changes.
Another type of pricing is called high-low pricing. It 2) If all companies in an industry use the same pricing
involves charging high everyday prices but offering fre- method, prices are similar and price competition is
quent discounts and sales. minimized.
Two pricing strategies that may be followed when a Customers’ use competitors’ prices to form their perceived
new product is introduced are: value of a product. Going-rate pricing is based almost
1) Market penetration pricing: when a company entirely on competitors’ prices. This does not mean that
wants to penetrate a market quickly and maximize its the company charges the same price as its competitors
market share with a new product, it may set a low ini- charge. Actual prices may be more or less.
tial price with the expectation that high sales volume Going-rate pricing is used frequently. Companies accept
will result. The resulting high sales volume is expected the going price as representative of the price that will
to lead to lower unit costs and higher long-term profit. yield a fair return.
The goal is to win market share, stimulate market
growth and discourage competition. The firm’s strategy may be determined whether its prod-
ucts are homogeneous with (identical to) or nonhomogen-
2) Market skimming: a company unveiling a new tech- eous with (different from) its competitors’ products. If the
nology may set an initial high price to “skim” the mar- industry involves a commodity, i.e., a homogeneous good
ket and then quickly reduce the price to attract new with little differentiation among producers, competing
customers after those who could afford to pay the firms normally all charge the same price.
highest price have purchased. This is often followed
by subsequent lowering of prices, thereby skimming If a company is a market leader faced with lower-priced
maximum revenues from the different market seg- competitors, it can elect to maintain its price while raising
ments. the perceived value or quality of its product.
A product that is part of a product mix where the various

Product-line pricing is a product mix pricing strategy products have related demand and costs and face differ-
whereby a company creates product lines rather than ent amounts of competition needs to be priced so as to
single products. maximize the profits of the entire product mix.
Each successive item in the line offers more features and Product mix pricing strategies include:
costs more. An example could be a jewelry store that of-
fers ladies’ earrings at four price levels: $10 for very low; 1) Product line pricing.
$25 for low; $50 for average; and $100 for high quality. 2) Optional-product pricing.
Price points are used in product-line pricing to establish 3) Captive-product pricing.
levels such as the ladies’ earrings, and customers shop at 4) By-product pricing.
their preferred price point.
5) Product bundle pricing.
What is optional-product What is

(feature) pricing? captive-product pricing?

What is
What is by-product pricing?
product bundling pricing?

What are the key differences What are the

between short-run and primary characteristics of
long-run pricing decisions? short-run pricing?

Optional-product (feature) pricing is a product mix
Captive-product pricing is a product mix pricing pricing strategy whereby optional products, features and
strategy. When a product requires the use of additional or services can be offered along with the main product, such
“captive products,” such as a low-priced razor that re- as a personal computer with a minimum amount of
quires high-priced replacement blades, this is cap- memory and speed advertised at a low price with optional
tive-product pricing. Ink-jet printers are typically priced upgrades available.
low, because the company makes its money on the sale of
ink cartridges for them. Pricing is difficult because the company must decide what
features are included as standard, and which are options.
By-product pricing is a product mix pricing strategy for

Product-bundling pricing is a product mix pricing situations where the production of certain goods such as
strategy when product bundling occurs when a sellers steel or chemicals may result in by-products. These by-
bundles products, features or services together and offers products have no real value to the manufacturer that
the bundle at a price that is lower than the price of the generates them. However, storing and/or disposing of
items if purchased individually. For example, a software them will create additional costs, which will impact the
vendor may create a suite of programs and offer them profitability and thus the price of the main product. In-
together at a reduced price. stead, the manufacturer will try to find a place to sell the
by-products, perhaps to other manufacturers that can use
If the customer has only one option – to purchase the
them as raw materials.
entire bundle or to purchase nothing – that is called pure
bundling.
By-products should be priced at as high a price as pos-
However, if the consumer has a choice between buying sible, but the manufacturer should accept any price that is
the bundle and buying one or more of the bundled items higher than the cost of storing and delivering them to the
individually (at a higher per-unit price), that is called purchaser. Whatever the manufacturer can receive from
mixed bundling. their sale reduces the cost of the main product, and some
by-products can even be profitable in themselves.
Important differences between short-run and long-run

Primary characteristics of short-term pricing are: pricing decisions are:
1) Short-run pricing is opportunistic and more respon- 1) Short-run pricing decisions are influenced by short-
sive to changes in demand than long-run pricing. run conditions that affect the demand and supply,
2) Fixed costs are frequently irrelevant, because they such as capacity or competitors’ prices.
cannot be changed in the short term. This means that 2) In the long run customers prefer stable and predict-
at a minimum the selling price needs to be at least able prices.
the variable costs of production.
3) Both short-run pricing and long-run pricing take into
3) Availability of production capacity plays an important consideration the “three Cs,” customers, competitors
role. If a company has unused (excess) capacity, it and costs. However, their starting points differ.
will be more likely to price its products lower than it
would be if it were operating at 100% capacity. 4) Costs irrelevant for short-run pricing, such as fixed
costs, may be relevant in the long run as they become
4) Another consideration is competitors and what they variable costs. In the long run, all costs are variable.
are bidding. If bidding on a one-time special order, the
company wants to bid a price that covers its incre- 5) Profit margins in long-run pricing decisions are set to
mental costs but is lower than competing bids. earn a return on investment. Short-term decisions
maximize contribution.
List and explain the Define the term target pricing

two approaches to and list the steps to
setting long-run prices. establish a target price.

What are the most common

costs of production that What is the CASB and
are used as a basis for why was it established?
cost-based pricing?

What is life-cycle List and define the

product costing? five product life cycles.

Target pricing is an important form of market-based pricing.
A target price is a price based on knowledge of customer per-
ception of the value of the product or service and what cus-
tomers are willing to pay, as well as knowledge of competitors’
responses.
There are two approaches to setting long-run prices:
Steps in establishing a target price and cost are:
1) The company develops a new product that meets the 1) A market-based approach: The market-based
needs of potential customers. approach starts with the customer and competitor,
2) The company estimates the price that potential customers and then looks at costs.
will be willing to pay, (based on customers’ perceived 2) A cost-based approach (also called cost-plus): The
value for the product) and the projected sales at that cost-based approach looks first at costs and considers
price. customers and competitors secondarily.
3) Pricing would also be based on expected responses from
competitors.
Which strategy an individual company uses generally
depends on what type of market the company is operating
4) The target price then determines what the target cost
per unit needs to be in order to earn the target operating in.
income per unit.
5) Value engineering is then performed to reduce costs by
improving efficiency so that target pricing results in the
planned profits.
The cost-based approach to long-term pricing focuses on

what it costs to manufacture the product and the price
In 1970, the U.S. Congress established the Cost necessary to both recoup the company’s investment and
Accounting Standards Board (CASB) to achieve uni- achieve a desired return on its investment. It is used in a
formity and consistency in cost accounting standards for market where there is product differentiation, such as
contracts and subcontracts with the U.S. government. The automobile manufacturing.
CASB established standards regarding cost measurement, A company using this method calculates the cost of pro-
assignment and allocation in contracts with the U.S. gov- duction and then adds a markup. This markup is a per-
ernment. The standards are applicable only to con- centage of the cost of production.
tracts greater than $500,000.
The company may use whatever it wants as the cost of
This was a result of the fact that the U.S. had often paid production, but the most common costs to use are:
large amounts for simple products because of contracts 1) Total cost.
that were negotiated as cost plus, and the suppliers had 2) Absorption manufacturing costs.
been very liberal in their interpretation of what was a cost.
3) Variable manufacturing costs.
4) Total Variable costs.
Brands, products and technologies all have life cycles.

The stages in a product life cycle are: The product life cycle is the time from the initial re-
1) Product development stage – No sales and no rev- search and development of a product to the point when
enues. The company’s investment costs increase. the company no longer offers customer servicing and sup-
2) Introduction stage – Slow growth and minimal port for the product. Life-cycle costing tracks and accumu-
profits because of the heavy upfront expenses to lates all the costs of each product all the way through the
introduce a new product. value chain. A product’s life cycle usually spans several
3) Growth stage – If the introduction is successful, the years.
product will experience rapid sales growth and
Life-cycle budgeted costs are used in pricing decisions
increasing profits in the growth stage.
because they incorporate costs that might not otherwise
4) Maturity stage – Sales growth usually slows down
be considered. If costs for research and development and
and profits level off or decrease. The company has to
other nonproduction costs such as marketing, distribution,
spend more for marketing to defend the product
and customer service are significant, it is essential to
against the competition.
include them in the product’s cost, along with the direct
5) Decline stage – Sales drop and profits fall.
manufacturing costs, to determine the price.
Some products remain in the maturity stage for a long
time; some enter the decline stage but then cycle back to The price that is set is the price that will maximize life-
the growth stage, perhaps because the company success- cycle operating income.
fully repositions the product.
What are the primary What are the primary

characteristics of an characteristics of a
introduction stage growth stage
product life cycle strategy? product life cycle strategy?


characteristics of a characteristics of a
maturity stage decline stage
product life cycle strategy? product life cycle strategy?

What is the What are the

Boston Consulting Group primary characteristics of the
Growth Share Matrix product classification Star
and its four classifications in the Boston Consulting
of a product life cycle? Group Growth Share Matrix?

The primary characteristics of a growth stage product The primary characteristics of an introduction stage
life cycle strategy are: product life cycle strategy are:
1) Sales increase rapidly but sales efforts are less critical 1) The introduction takes time and sales growth is slow.
since consumer demand is high. The marketing objective is to create trial of the
product.
2) Prices remain steady or they fall slightly.
2) Promotion spending is high to educate consumers to
3) Companies maintain high promotional spending, even try the product.
increasing it slightly to counter the competition’s
efforts, as well. 3) The company produces only basic versions of the
product and focuses sales efforts on buyers who are
4) Profits increase because promotion costs and fixed the most ready to buy, the so-called early-adopters.
manufacturing costs are spread over a larger volume.
4) Pricing may be high, assuming a skim pricing strategy
5) The marketing objective at this stage is to maximize for a high profit margin as the early adopters buy the
market share. product and the firm recoups its development costs.
6) Some advertising will be shifted from the goal of 5) Sometimes penetration pricing is used and intro-
building product awareness to building product con- ductory prices are set low to gain market share
viction and purchase. rapidly.
The primary characteristics of a decline stage product

life cycle strategy are:
1) Technological advances and other factors ultimately
cause sales to decline.
The primary characteristics of a maturity stage product
2) More firms withdraw from the market. The remaining life cycle strategy are: Sales peak during this stage, but
firms cut back their product offerings. They may cut sales growth slows down.
the promotion budget and reduce prices further.
1) Although profits are still high, prices begin to decrease
3) Management needs to identify products in the decline while at the same time promotion costs increase,
stage by monitoring sales, market share, costs and leading to lower profits.
profits, in order to decide whether to maintain, har-
vest, or drop each of the declining products. 2) The marketing objective at this stage is to maximize
profit while defending market share.
4) The marketing objective at this stage is to reduce ex-
penditures and “milk” (make the most of) the brand.
5) Prices will probably be cut. If sales hold up, this
tactic will increase short-term profits.
The Boston Consulting Group developed an analysis of a

A star is in an industry that has a high market growth product’s position in its life cycle called the BCG Matrix
or Growth-Share Matrix. The BCG Matrix was developed
rate, and the product has a high share of the market.
to analyze the life cycles of product lines in order to make
A star generates a lot of cash because it has a high share better decisions about resource allocation.
of its market. However, because the market is growing The BCG Matrix classifies products into four categories
rapidly, the star’s sales are also growing rapidly. As a re- based on the growth of the markets they are in and their
sult, it has a high need for cash for investment. Therefore, market share. They are:
the net amount of cash a star generates is not great.
1) Star
If a star can maintain a high market share, the star will 2) Question Mark
become a cash cow when the market’s growth rate
3) Cash Cow
declines, generating more cash than it consumes.
4) Dogs
Stars are important because they ensure future cash gen- The natural product life cycle is that it begins as a ques-
eration. The company may adjust the price of a star sev- tion mark, then turns into a star, then when the market
eral times, decreasing it to claim market share and as the stops growing, it turns into a cash cow. At the end of its
product’s market share and popularity grow, increasing life cycle, the cash cow turns into a dog. However, if the
the price to maximize revenue. question mark never turns into a star, it goes straight
to dogdom when the market’s growth rate slows.

characteristics of the product characteristics of the product
classification Question Mark classification Cash Cow
in the Boston Consulting Group in the Boston Consulting Group
Growth Share Matrix? Growth Share Matrix?

What are the primary

characteristics of the product What is
classification Dog price discrimination
in the Boston Consulting Group in price setting?
Growth Share Matrix?

What forms
What is
of pricing are illegal
peak-load pricing?
in the United States?

A question mark is a product in an industry with a high
market growth rate, but the product has a low share of
A cash cow is in an industry with a low market growth the market. Because the market is growing rapidly, the
rate, but the product has a high share of the market. question mark’s sales are also growing rapidly, so it will
consume a lot of cash for investment. However, because
Cash cows are in mature markets in which the growth of its low market share, it does not generate much cash.
rate has slowed, but they are market leaders.
A question mark has potential to gain market share to
Cash cows generate more cash than they consume. They become a star and a cash cow when the growth rate of
are regarded as boring, but any company would be glad the market slows. But at the present, a question mark is
to have them. They should be “milked” to extract their a “problem child” because it generates negative net cash.
profits without investing much cash in them.
If the question mark does not attain a greater share of
Investment in a cash cow would be wasted money be- its market, it will turn into a dog when the growth rate of
cause of the slow growth of the industry. the market declines.
The characteristics of a cash cow do not change much, A question mark may or may not be worthy of the addi-
customers know what they are getting, and the price does tional investment that would be required to increase mar-
not change much either. ket share Because a question mark must increase its
market share quickly to avoid turning into a dog, pricing
should be aggressive.
Price discrimination is the practice of charging different

A dog is in a mature industry with a low market growth
prices for the same product to different customers. An
rate, and it has a low share of the market.
example of this is in the airline industry, where a carrier
will charge a lower rate if someone stays over a Saturday A dog does not consume much cash, but it does not gen-
night, than if there is no Saturday night stayover. This erate much cash either. It is usually barely breaking even.
practice usually separates business travelers (whose The investment money tied up in it has little potential, and
demand is inelastic, and therefore who are willing to pay it depresses the company’s Return on Assets.
more for the ticket) from pleasure travelers (whose Dogs should be sold off
demand is elastic) and charges them different prices
Pricing is not a major concern.
depending on the elasticity of their demand.
Under the Robinson-Patman Act, it is illegal for a com-

pany to discriminate between customers based on prices.
Predatory pricing is illegal. This is the practice of pricing

a product below the cost of production in order to drive a
competitor out of business. Peak-load pricing involves charging a higher price for
the same product or service at times when demand is the
Collusive price setting is also illegal. This occurs when greatest. This also reflects supply and demand, because
more than one company acts together to either restrict prices charged when capacity is most in demand will rep-
output or set prices at an artificially high level. resent what competing customers are willing to pay. When
excess capacity is available, prices are lower. This pricing
Dumping occurs when a company exports its product
method is used in the telecommunications, electric utility
into another country and sells it at less than the cost of
and travel industries.
production. Because this is an international act, it is not
necessarily illegal in all countries. However, the recipient
country may pass tariffs or some other retaliatory meas-
ure against the company, industry or country that is doing
the dumping.
What are the assumptions

What is cost-volume-profit
of cost-volume-profit
(CVP) analysis?
(CVP) analysis?

What is the What is the total

unit contribution margin contribution margin
(UCM) in CVP analysis? in CVP analysis?

What is the
What is a contribution
contribution margin ratio
(BLANK) (BLANK)
margin income statement?

The main assumptions in the CVP model are:
Cost-volume-profit analysis (CVP), also called break-
1) Within the relevant range, total costs and total reve-
even analysis, is used primarily for short-run decision-
nues are predictable and exhibit a linear functional
making. CVP analysis is used to calculate the effect on
relationship to output.
profitability of changes in the product mix and in quanti-
2) All costs are either fixed or variable (no mixed, or ties sold.
semivariable, costs).
CVP analysis enables a company to find the level of pro-
3) Total fixed costs, the price per unit, variable cost per
duction and sales, both in units and in dollars, required for
unit, and the selling mix remain constant over the rel-
the company to break even or achieve a specified profit.
evant range (the range of output that is analyzed).
Since prices and costs are reasonably fixed in the short
4) Production is equal to sales (no significant changes in run, the profitability of a product will be most dependent
inventory). upon the quantity sold.
5) The time value of money is ignored.
CVP analysis examines what happens to total revenues,
The above assumptions are difficult to find in reality, so total costs and operating income in response to changes
one has to be aware of the deficiencies of the model. The in the output level, product mix, selling price, variable
results generated by the model are just approximations of costs per unit and fixed costs.
the reality.
The total contribution margin is the total amount of

contribution that is received from all sales.
The unit contribution margin (UCM) is how much of
Total Contribution Margin = the sales price is available to cover fixed costs and also
Unit Contribution Margin * Number of Units Sold available to provide profits after the fixed costs are
covered. It is calculated as follows:
- or -
Selling price per unit – Variable costs per unit
Total Contribution Margin =
Total Revenue – Total Variable Costs
If unit contribution margin is expressed as a percentage of

the sales price, it is the contribution margin ratio, or
Contribution Margin Percentage.
In a contribution margin income statement, the in-
come statement is presented in such a way that it shows The ratio is calculated as follows:
variable costs together and fixed costs together, which Contribution Margin per unit
then shows a key item that does not appear on the stand- Selling Price per unit
ard income statement, contribution margin, as follows:
The Contribution Margin Ratio can also be calculated using
Revenues - Variable costs = Contribution margin total contribution margin and total revenues instead of per
- Fixed costs = Operating Income unit amounts:
Total Contribution Margin
Total Revenue

What is the
number of units to sell in
breakeven point
order to achieve a specific
in CVP analysis?
dollar amount of profit?


How is the breakeven point
number of units to sell in order
found when more than one
to achieve a specific dollar
product is sold?
amount of after-tax profit?

How are product-mix

decisions made when there What is the margin of safety
are constraints on one or and how is it calculated?
more factors of production?

We use the break even formula for units when we want to
calculate the number of units to sell in order to achieve a
specific profit value. The required profit is treated as an
additional fixed cost that must be covered by the con- The breakeven point (BEP) is the point where operating
tribution margin. income is $0. The BEP may be calculated in respect to the
number of units that must be sold or the dollar value of
This makes sense, as management has declared that not
the revenue at which operating income will be $0.
only do all fixed costs need to be covered, but also the
target amount of profit needs to be met. It is treated as BEP in units = Fixed Costs
a fixed cost, as this amount of target profit does not Unit Contribution Margin
change as the level of production changes.
The formula to calculate the number of units to achieve BEP in revenue = Fixed Costs
the specified profit is: Contribution Margin Ratio
Fixed Costs + Required Profit

Contribution Margin Per Unit
When a company sells more than one product we

must assume, for the sake of the CVP model, that there is In order to calculate the number of units to sell in order to
a constant sales mix of products. It is important to know achieve a specific dollar amount of after-tax profit, first we
that for each different product mix there is a different need to convert the after-tax profit to a pre-tax profit.
breakeven point. This is because the contribution from the This is done with the following calculation.
mix will be different in each case. Target after-tax income
(1 – tax rate)
In order to calculate the BEP with multiple products, we
will use a basket that consists of the minimum integer The resulting pre-tax income amount is then used to find
numbers of units of all products sold. Assuming that this the needed revenue or number of units, using the formu-
basket represents a single unit, we can compute the BEP las for the specified profit per unit to achieve a specific
in baskets using a weighted average price and a weighted profit:
average variable cost for the given product mix. Using this Fixed Costs + Target Pre-Tax Income
contribution per basket, we can calculate the BEP point in Contribution Margin Per Unit
baskets as we did for a single unit. After finding the num-
ber of baskets required to break even, we simply multiply Or
the number of baskets by how many of each product are Fixed Costs + Target Pre-Tax Income
in each basket to determine how many units will be sold Contribution Margin Ratio
at the breakeven point.
The margin of safety is a type of sensitivity analysis. It

is the amount of excess budgeted sales over breakeven
sales. It measures the amount that sales can fall and the If a plant is operating at full capacity, decisions about
company can still be profitable, or at worst, break even. what product or products to produce must be made under
Margin of safety is expressed as revenue or units: a situation of constraint. Full capacity means that one
1) Revenue: actual or budgeted revenue minus the or more factors are used at maximum possible load.
breakeven revenue. These situations cannot be changed in the short run. To
2) Units: actual or budgeted sales quantity minus the maximize operational results, we need to treat the con-
breakeven quantity. straints as given and adjust other production variables in
such a way as to “squeeze” maximum benefits. The con-
Margin of Safety = Sales – Breakeven Sales sideration of this limiting factor is called the Theory of
The margin of safety ratio is the margin of safety Constraints.
expressed as a percentage of sales:
When operating at capacity, operating income is maxi-
Margin of Safety mized by maximizing contribution margin per unit of the
Sales resource that is limiting either the production or the sale
The ratio is used to compare the risk of two products or to of products.
assess the risk in one product. The lower the margin of
safety, the higher the risk.
How do you calculate

What is the high-low points
the expected value in
method, what is it used for
a situation with several
and how is it used?
possible outcomes?

What are the four How do volatility and the

common categories of risk? time period impact risk?

What are the

What are the
three common ways
four responses to risk?
of measuring risk?

The high-low points method is often used to separate
fixed costs from variable costs when they are not segre- When there are several possible outcomes, the choice of
gated in the information we have. For this, we use the which outcome to use in a decision model can be deter-
highest and lowest observed values of the cost driver mined by using the expected value of the outcome.
within the relevant range. The expected value is determined by:
1) Calculate the Variable Cost Per Unit by dividing the 1) Identifying the possible outcomes and assigning a
difference between the highest and lowest costs by probability to each possible outcome. All of these
the difference between the highest and lowest pro- probabilities must be between 0 and 1, and must total
duction volumes: to 1;
Difference in Costs = Variable Cost per Unit 2) Multiplying each quantitative outcome by its assigned
Difference in Units probability; and
2) Multiply the Variable Cost Per Unit by the unit volume 3) Summing the results of step #2 above.
at either the highest or the lowest production volume
The sum of the results will be the expected value, which
to get the total variable cost at that level.
will be a weighted average of the possible outcomes,
3) Subtract the total variable cost from the total cost at using each outcome’s probability as its weight. This
that level to get the fixed cost. expected value is then used as the assumption in the
The above approach is only good as long as the assump- decision model.
tions for CVP analysis hold.
Volatility increases risk because there is more uncer-

tainty about the future, and there is a greater chance that The four common categories of risk are:
the future results will be poor. 1) Strategic Risks
2) Operational Risks
The longer the time period considered, or the longer that
a project will last, the greater the risk. Because of the 3) Financial Risks
longer time period, there is a greater time period for 4) Hazard Risks
something to wrong.
Four responses to risk are:

1) Avoiding the risk – eliminating the risk by removing Three common ways of measuring risk are:
the risky event itself from the company.
1) Expected Loss – this is the expected amount of loss
2) Reducing the risk – taking actions to mitigate the given a set of probabilities and possible results.
chance of risk or the amount of loss.
2) Unexpected Loss – this is any loss above the ex-
3) Transferring (sharing) the risk – buying insurance pected loss.
in order to transfer the risk of loss to the insurance
company. 3) Maximum Possible Loss (also called Extreme or
Catastrophic Loss) – this is the maximum loss pos-
4) Exploiting (accepting) the risk – the company sible.
decides that the possibility of return is worth the risk
that is being taken on.
What is inherent risk? What is residual risk?

What are some of the What are the steps in the

benefits of risk management? risk management process?

What is financial risk, and What are risk ranking

how may it be managed? and risk maps?

Residual risk is the amount of risk that remains after Inherent risk is the amount of risk that exists prior to
management has taken its mitigation or risk reducing any risk reducing or mitigating actions by the company. It
actions. There will almost always be some amount of is the amount of risk that is naturally occurring in the
residual risk, no matter how many actions are taken by event. It is often outside the control of management and
management to reduce the risk of an event or project. is due to external factors or influences.
Benefits of risk management include:

1) Increases shareholder value because of the process of
The steps in the risk management process are: minimizing losses and maximizing opportunities.
1) Risk identification and analysis. 2) Fewer disruptions to the operations of the business.
2) Risk evaluation and assessment. 3) Better utilization of the resources of the organization.
3) Risk reporting. 4) Enables quick assessment and grasp of new oppor-
4) Deciding which risks must be addressed and in which tunities.
order (prioritization). 5) Provides better and more complete contingency plan-
5) Residual risk reporting. ning.
6) Ongoing monitoring. 6) Improves the ability of the organization to meet ob-
jectives and achieve opportunities.
7) Enables quicker response to opportunities.
Financial risk management creates economic value to

Risk ranking is a qualitative assessment to determine the company by using financial instruments to manage
which risks are the highest priority. While there may be a exposure to risk, especially credit risk and market risk.
financial element to this assessment, the company should
Among the ways of managing financial risk are:
be taking into a number of factors that are not able to be
quantified, leading to a qualitative assessment as well. 1) Using forward contracts and options to hedge the risk
of either foreign currency value fluctuations or fair
A risk map is a visual depiction of the relative risks. For value fluctuations,
the different events, the probability of the event happen- 2) Having specific investment policies for the investment
ing is on one axis and the amount of loss is on the other. in both short-term and long-term investments,
This provides a visual way of identifying the risks that are
3) Using derivative instruments as a hedge process, and
both more likely to occur and that have a greater dollar
amount at risk should the event occur. 4) Using swaps to hedge an interest rate or fair value of
an asset.
How is
What are value at risk and
enterprise risk management
cash flow at risk?
defined by COSO?


four categories of objectives main components of
that ERM helps achieve? an ERM system?

What is capital adequacy

(BLANK)
and how is it measured?

Based on the properties of a normal distribution, value at
risk provides a quantitative evaluation of the certainty of
Enterprise risk management is a process, effected by a range of results. For example, it is known that in a nor-
an entity’s board of directors, management and other per- mal distribution 95% of the results lie within one standard
sonnel, applied in strategy setting and across the enter- deviation of the mean. Percentages of the population can
prise, designed to identify potential events that may effect be calculated for different standard deviations, enabling a
the entity, and manage risk to be within its risk appetite, company to identify the likelihood of various ranges.
to provide reasonable assurance regarding achievement of
entity objectives. Cash flow at risk provides a similar measure as value at
risk, but it measures the range of cash flows instead of
losses.
The main components of an ERM system are:

1) The internal environment is the atmosphere in the
organization towards risk and risk management. 1) Strategic – the high level goals and objectives that
2) Objective setting. are aligned closely with its mission.
3) Event identification. Events are the internal and 2) Operations – the effective and efficient use of the
external events that must be identified and then clas- resources of the company.
sified. 3) Reporting – the reliability of the reporting that the
4) Risk assessment is the process of analyzing and company dies. While we may think that this focuses
considering the potential likelihood and impact of an on the financial statement reporting of the company,
event. it should actually include any reporting that the com-
pany does.
5) Risk response is what the company will decide to do
in respect to the risks identified. 4) Compliance – insures that the company is in compli-
ance with all relevant laws, rules and regulations, no
6) Control activities are all of the policies and proce- matter what the source of the requirement (internal
dures that are implemented. or external).
7) Information and communication.
8) Monitoring.
Capital adequacy is a measurement that is usually used

by banks. It assesses whether the bank has sufficient cap-
ital (assets) compared to its liabilities.
There are different ways in which the capital adequacy can
be measured:
1) Solvency measures ability of the bank to pay its
long-term obligations.
2) Liquidity measures the ability of the bank to pay its
short-term obligations.
3) Reserves is the amount of cash that the bank must
keep on hand in order to be able to pay its depositors.
4) Sufficient Capital is whether or not the bank has
sufficient capital to properly protect its depositors
from default.
Section D: Investment Decisions Section D: Investment Decisions
Section D: Investment Decisions

What are the
capital budgeting and
five primary methods
what is the objective
of capital budgeting?
in using capital budgeting?

Define the term

What are the steps avoidable cost
in capital budgeting? as used in
capital budgeting.

Define the term Define the term

committed cost common cost
as used in as used in
capital budgeting. capital budgeting.

Five major capital budgeting methods are used:
1) Net present value
Capital budgeting refers to a group of methods used by
2) Internal rate of return
a company to analyze possible projects to invest in.
3) Profitability index
4) Payback method The firm’s objective in using capital budgeting to select
5) Accrual accounting rate-of-return method projects is to maximize the value of its equity and thus,
The time value of money is used in three of the methods, shareholders’ wealth.
Net Present Value, Internal Rate-of- Return and
Profitability Index. The expected net cash flow for each Capital budgeting makes it possible to evaluate the differ-
of the years over the entire life of the project is discounted ent investment opportunities that are available to a com-
to its present value at the beginning of the project. pany and decide which of the available investment
In the Payback Method, future cash inflows are com- opportunities should be pursued.
pared with the initial investment to determine the time to
Thus, capital budgeting is used to make long-term plan-
recoup the initial investment (without considering the time
ning decisions for investments in projects. These projects
value of money).
could be the purchase of fixed assets or any other pur-
The Accrual Accounting Rate-of-Return Method di-
chases or investments that will provide benefit for a period
vides accounting net income by an accounting measure
of time greater than one year into the future.
of investment to calculate an annual average accounting
rate-of-return.
The steps in capital budgeting are:

1) Identification Stage – Identification of the types of
projects necessary for the company to accomplish its
organizational objectives.
2) Search Stage – Alternative capital investments that
will achieve the organizational objectives are
explored.
An avoidable cost is one that can be avoided or elimi-
3) Information-Acquisition Stage – Consideration of the
nated by making a decision not to invest, or to cease
expected costs and benefits (quantitative and quali-
investing. Because these costs may be different among
tative) of alternative capital investments.
options, they will be relevant costs that will need to be
addressed if the costs are different among the options. 4) Selection Stage – Selecting the projects to be imple-
mented on the basis of financial analysis and nonfi-
nancial considerations.
5) Financing Stage – The company obtains the necessary
project funding.
6) Implementation and Control Stage – This is the final
stage in which the project is implemented and mon-
itored over time.
The company has already agreed to and committed itself

to a committed cost, even if the invoicing or delivery of
the product or service has not taken place. A long-term
contract (for rent, for example) is an example of a com-
A common cost is shared by all of the available options
mitted cost. This is similar to a sunk cost in that it can’t
or all divisions and cannot be allocated among them.
be changed, but it is different because the money has not
Because it is the same among all options, it is not rele-
yet been spent. However, it will have a future impact and
vant and should not be taken into account in making a
therefore it needs to be recognized as a cost that needs to
decision between any two different options.
be covered. But if the committed cost cannot be changed
by any current decision, it is not relevant to a process of
deciding among alternatives currently, because it will be
the same no matter which alternative is selected.

cost of capital deferrable cost
as used in (or discretionary cost)
capital budgeting. as used in capital budgeting.


fixed cost opportunity cost


imputed cost expected cash flow

The cost of capital is the weighted average cost of
A deferrable cost is one that can be deferred to future interest on debt (net of tax) and the implicit and explicit
periods without creating a significant impact in the current cost of equity capital. This is the minimum required rate-
period. Marketing and training are often considered defer- of-return for a project in order to not dilute (reduce)
rable costs. shareholders’ interest. This rate is often used in net
present value calculations.
An opportunity cost is a forgone alternative that had to

be dismissed in order to achieve a goal. Opportunity cost
is the cost of the “next best alternative” or the “next
A fixed cost remains constant over the specified level of
highest valued alternative.” It is the price of not only
activity (the relevant range).
some other alternative that should be considered, but also
the highest other opportunity that must be given up in
order to achieve one project.
The annual expected cash flow used in a capital budg-

eting analysis for a given year is the expected value of
the forecasted cash flows for that year, or the weighted
average of all of the possible cash flows. Several possible
cash flows will be projected for each year of a project’s life
and probabilities will be determined for each possible cash
flow for each year. The cash flow amount that will be used
in the capital budgeting analysis for each year is the An imputed cost is an opportunity cost. This is the bene-
expected cash flow, or the weighted average of all the fit that is given up as a result of using the company’s
possible cash flows, weighted according to their probabili- resources elsewhere. It is the benefit of the next best
ties. option. Another definition of an imputed cost is one that is
All expected cash flows in a capital budgeting anal- not stated and must be calculated in some way.
ysis are treated as though they are received at the
end of the year to which they are assigned, even
though in actuality, they will be received through-
out the year. If an exam question says that a particular
cash flow is received at the beginning of a year, we treat
it as if it is received at the end of the previous year for
capital budgeting purposes.
What are What are

differential revenues, incremental revenues,
costs and cash flows? costs and cash flows?

What are
relevant revenues, What is a sunk cost?
costs and cash flows?


Calculating cash flows: annual cash flows
what is included in the from operations
cash flow for Year 0? that are considered in
capital budgeting?

An incremental revenue, cost or cash flow is the addi- A differential revenue, cost or cash flow is the differ-
tional revenue, cost or cash flow from choosing an activity ence in revenue, cost or cash flow between two alterna-
over not choosing any activity. tives.
A sunk cost is one that has already been incurred and

Relevant revenues, costs or cash flows are those rev-
therefore is not a relevant cost. Sunk costs are not
enues, costs or cash flows that vary between one course
taken into account in the decision-making process
of action and another. These are important factors in a
because the money has already been spent, and cannot
decision, because all other (not relevant) revenues, costs
be changed or recovered, no matter what current decision
and cash flows are the same for all options.
is made.
The primary cash flows from operations that are con- Cash flow in Year 0 (before the project begins) includes:
sidered in capital budgeting include:
1) Increased sales. Because of the investment the 1) Initial investment, or the cash outflows made to pur-
company should increase sales. This increase should chase the fixed assets. They include setup, transpor-
lead to an increase in profits. The cash inflow for cap- tation, testing costs and any other related costs.
ital budgeting purposes is the amount of the increased 2) Less any cash received from the disposal of the old
profits (revenues less expenses) that result each year machine, if there is one to dispose. Cash received
from this investment. from the disposal of the old machine reduces the ini-
2) Decreased operating expenses. The new invest- tial investment for the new machine.
ment may result in efficiencies that will lead to lower 3) Initial working capital investment, or the expected
operating costs. The cash inflow for capital budgeting increase in inventory and accounts receivable as a
purposes is the amount of the decreased operating result of the project, less any expected increase in
expenses because of these efficiencies. accounts payable related to the purchased inventory.
3) Another cash investment. It is possible that a fol-
low-up investment must be made after some period of 4) Tax effect related to the disposal of the old machine.
time (extraordinary maintenance, inspection, etc). The difference between the sales price and tax basis
4) Further working capital investment. The company of the sold fixed assets—the gain (loss)—multiplied by
may have another increase in its working capital later the tax rate is subtracted from (added to) cash flow,
in the project’s life. as it decreases (increases) the tax payments.

What is the cash flows at the disposal or
depreciation tax shield completion of a project
and how is it calculated? that are considered in
capital budgeting?

What are the four What are ranking methods

capital budgeting that are commonly used in
screening methods? capital budgeting?

What is the What are the

payback method advantages and disadvantages
for capital budgeting and of the payback method
how is it calculated? of capital budgeting?

When an investment project is terminated, there are
number of potential cash flows that are considered in cap- This amount of tax deductible depreciation will be a reduc-
ital budgeting. They include: tion of the company’s taxable income, because depreci-
1) Cash received from the disposal of equipment. ation expense is a tax deductible expense. The amount of
The cash that is received from the sale of any assets tax deductible depreciation will cause an equal reduction
(equipment, machines or the investment project in the company’s taxable income. That will, in turn, cause
itself) is a cash inflow in the final year of the project. a reduction in the amount of tax that will be due. This tax
reduction will not represent an actual cash inflow, but it
2) Recovery of working capital. The initial incre-
reduces the cash outflow of the company for taxes. There-
mental investment and any subsequent investments
fore, the amount of tax savings that occurs as a result of
in working capital are usually fully recouped at the
the depreciation expense is treated as a cash inflow for
end of the project. This is because the final accounts
capital budgeting purposes. The amount of tax savings
receivable will be collected and not replaced with
that results is called the depreciation tax shield. The
other accounts receivable (for this project), the
depreciation tax shield is calculated as follows for each
inventory associated with the project will have been
year of an asset’s life:
sold, and all the related accounts payable paid.
Whenever working capital is recovered, it is a cash Annual Depreciation as Calculated # Marginal Tax Rate
inflow in that year..
Screening methods are used to determine whether an

investment project meets the necessary requirements to
If the company is not able to invest in all the “worthwhile at least be a worthwhile investment. The four screening
projects” after completing screening to separate worth- methods are:
while projects from those that are not, it uses a ranking
method to prioritize the best investments. 1) Payback Period.
The primary ranking method for individual projects is the 2) Net Present Value (NPV).
Profitability Index. 3) Internal Rate of Return (IRR).
NPV can be used as a ranking method as well. NPV is the 4) Accounting Rate of Return (ARR).
best way to select a group of projects when the projects NPV and IRR are collectively called discounted cash flow
are of differing sizes and the amount of available capital is (DCF) methods, while Payback and ARR are undiscounted
limited, in order to select the combination of projects that methods.
will use the maximum amount possible of the available
capital and also maximize shareholder wealth. It is possible that all projects will be acceptable. The com-
pany must then decide which project(s) to pursue. This is
done using the profitability index.
Advantages of the payback method include: Companies use the Payback Method to determine the
1) It is simple and easy to understand. number of periods that must pass before the net after
2) It can be useful for preliminary screening when tax cash inflows from the investment equals (or “pays
there are many proposals. back”) the initial investment cost.
3) It can be useful when expected cash flows in The Payback Method and its variations are screening
later years of the project are uncertain. methods of capital budgeting analysis – meaning we are
4) It is helpful if the firm wants to recoup its invest- determining only whether or not this is a good invest-
ment quickly. ment.
If the incoming cash flows are constant over the life
Weaknesses of the payback method include: of the project, the payback period is calculated as fol-
1) It ignores all cash flows beyond the payback lows:
period.
Initial net investment
2) It does not incorporate the time value of money.
Periodic constant expected cash flow
Interest lost while the company waits to receive
money is not considered. If the cash flows are not constant over the life of the pro-
3) It ignores the cost of capital, so the firm might accept ject, we must add up the cash inflows and determine —
a project for which it will pay more for its capital than on a cumulative basis — when the inflows equal the out-
the project returns. flows.
What are
What is the discounted cash
discounted payback method? flow methods


net present value method internal rate-of-return method
of capital budgeting? of capital budgeting?

What are the

What is a
six types of cash flows that
perpetual annuity
should be considered
and how is the
in a capital budgeting analysis
present value of its
such as a net present
cash flows calculated?
value analysis?

Discounted cash flow (DCF) methods are screening
methods of capital budgeting analysis. They measure all
expected future cash inflows and outflows of a project
using the time value of money concept (money received
today is worth more than money received in any future The Discounted Payback Method (also called the break-
period). even time) is an attempt to deal with the Payback
In a DCF analysis, the earlier that a project is able to gen- Method’s weakness of not considering time value of
erate cash inflows, the better, because cash flows received money concepts.
earlier in a project’s life are worth more than cash flows
received later. The Discounted Payback Method uses the present value of
cash flows instead of undiscounted cash flows to calculate
Discounted cash flow methods focus on the actual cash
the payback period. Each year’s cash flow is discounted
inflows and outflows from the project rather than using
using an appropriate interest rate, and then those dis-
accrual accounting income as the measurement basis.
counted cash flows are used to calculate the payback
This is because we are most interested in the cash return
period.
that we can obtain in the future for a cash outlay now.
There are two main DCF screening methods:
1) Net present value method
2) Internal Rate-of-Return
The Net Present Value (NPV) method calculates the

expected monetary gain or loss from a project by dis-
counting all expected future cash inflows and outflows to
Internal Rate-of-Return (IRR) method calculates the the present point in time using the required rate-of-re-
interest rate (i.e., the discount rate) at which the present turn. A project’s NPV is the present value of the project’s
value of expected cash inflows from a project equals the future expected cash flows minus the initial cash outflow.
present value of expected cash outflows. In other words, The present value of the expected future cash flows is cal-
in the calculation of IRR we are calculating the interest culated by using a discount rate that is the company’s
rate at which the NPV is equal to zero. When evalua- required rate-of-return (RRR):
ting the results of an IRR calculation, the IRR that is
1) The return that the organization could expect to
determined for the project being analyzed is compared
receive in the market for an investment of compar-
with the required rate-of-return (RRR) for the purpose of
able risk, or
deciding whether the project is profitable enough to
undertake. 2) The minimum rate-of-return that the project must
earn in order to justify investment of the resources.
This required rate-of-return is also called the discount
rate, hurdle rate, or opportunity cost of capital.
The six primary types of cash flows to consider in a

capital budgeting analysis such as a net present value
analysis include:
A perpetual annuity is a series of cash inflows that remain 1) Increased revenues,
unchanged and continue forever. 2) Reduced expense,
The present value of a stream of perpetual, equal, cash 3) Tax savings from the depreciation tax shield,
flows (a perpetual annuity) is calculated:
4) Cash proceeds from the sale of the asset at the end
Annual Cash Flow of the project,
Required Rate of Return 5) The tax effect of the gain or loss of the sale of the
assets at the end of the project life, and
6) Working capital cash released at the end of the
project.
What is a
What is the
perpetual growing annuity
weighted average
and how do you calculate
cost of capital (WACC)?
its present value?

What are the

How do you evaluate primary problems with the
the internal rate of return? internal rate of return (IRR)
method of capital budgeting?


What is the accounting
and disadvantages of the
rate of return method
accounting rate of return
method?

The weighted average cost of capital (WACC) is
defined as the opportunity cost of capital for the com-
pany’s existing assets. The WACC is the appropriate dis-
count rate to use in capital budgeting decisions and NPV
calculations as long as the riskiness of the project is
the same as the riskiness of the firm.
A perpetual growing annuity is a series of cash inflows
The proportion of each capital component in the com- that grows annually by the same percentage and contin-
pany’s optimal capital structure (common stock, preferred ues forever.
stock, long-term debt) is multiplied by its cost to obtain
the WACC. The present value of a perpetual growing annuity is calcu-
lated:
For the risk premium to remain unchanged as a result of
the capital expansion project, the following conditions Cash Flow-End of First Year
must be met: Required Rate of Return ! Growth Rate
1) The new assets financed by the new capital do not
change the firm’s operating environment substantially.
2) The new capital is raised in the same proportions as
the existing capital. The firm’s financial risk remains
the same.
The primary problems with the IRR method of capital

budgeting include:
1) Multiple IRRs: a project may result in multiple IRRs
when cash flows are negative in some years. This could
lead to confusion.
2) Mutually exclusive project – different size projects:
When evaluating several projects, it may possible to If the IRR is higher than the required rate of return, or
choose only one. In this situation, use of the IRR method hurdle rate, established by the firm for the project, the
can be misleading if the sizes of the initial investments project is acceptable. If the IRR is lower than the required
are different. Since the IRR is a rate of return, a project rate of return, the project is not acceptable and should not
with a smaller initial investment can show a higher IRR be considered further.
than a project with a larger initial investment, even
though the project with the larger initial investment has a Remember that IRR is a rate, in contrast to NPV, which is
higher NPV. an absolute dollar amount.
3) Mutually exclusive project – different cash flow
patterns: IRR is not reliable for evaluating mutually
exclusive projects when the projects cash flows have dif-
ferent patterns. Cash flows received earlier result in a
higher IRR without considering the overall NPV of the
project.
Accounting Rate of Return (ARR) is a ratio of the

incremental net income to the required investment. It is
Incremental Annual Average After Tax Accounting Net Income
The advantage of the accounting rate of return method Net Initial Investment
is that it is easy to do and to understand.
Since this method uses accrual accounting income, it
The disadvantages of the accounting rate of return
includes depreciation. However, it does not take into
method are:
account the time value of money, and for that reason it is
1) It does not track cash flow. also called the unadjusted rate of return model.
2) It does not incorporate the time value of money. NOTE: Sometimes the average investment figure is used
3) It focuses on operating income instead of cash flow. rather then the total investment. This is usually calculated
as the initial investment divided by 2 because the invest-
ment will have a book value of 0 at the end of the project.
It is the only method based on accounting income
rather than cash flows.
What is the What is the method A

profitability index to calculate the
and when is it used? profitability index?

What is the method B What are important factors

to calculate the to consider when using the
profitability index? profitability index?


real required nominal required
rate of return rate of return
for an investment? for an investment?

When capital resources are limited, the Profitability (or
Excess Present Value) Index can be used to rank cap-
The method A (No negative future cash flows) to ital investment projects according to their attractiveness.
calculate the profitability index is used to determine
The Profitability Index is used to determine the ratio of the
the ratio of the PV of net future cash flows (both inflows
PV of net future cash inflows to the amount of the ini-
and outflows) to the amount of the initial investment.
tial investment outflow. In this calculation, all future
In this calculation all future cash flows are in the numer- cash inflows are in the numerator and all initial cash out-
ator and all initial cash flows are in the denominator. flows are in the denominator.
It is calculated as follows, using the same information There are two different ways to calculate the Profitability
from the NPV calculation: Index The two methods are different only if there is a net
PV of future net cash inflows cash outflow in any year other than at the initial invest-
Net Initial Investment Cash Outflow ment. If there are no negative cash flows during sub-
sequent years of the project, the two methods will yield
the same result.
Important factors to consider when using the profitability

index include that it:
1) Is a benefit/cost ratio representing the ratio of bene- The method B (Negative future cash flows) to calcu-
fits (net cash inflows) to costs (net cash outflows) of a late the profitability index is used when a project is
project. It enables us to compare the benefit/cost expected to have future net cash outflows, such as envi-
ratios of investments with different characteristics. ronmental cleanup expense in the final year of the project.
In this case the present value of the net future negative
2) Expresses profitability in a percentage rather than as
cash flows may be omitted from the numerator of the
a dollar amount. It is useful when comparing mul-
ratio and added to the denominator of the ratio.
tiple investments.
In this method the numerator contains all positive cash
3) When there are multiple independent investment
flows and the denominator contains all negative cash
opportunities, we select the project with the high-
flows.
est Profitability Index.
4) Is a ranking method of investment analysis. The
other methods are screening methods. A screening PV of future net positive cash flows
method helps the company determine if a project is Net Initial Investment +
worth investing in. A ranking method helps the com- PV of future net negative cash flows
pany determine which investment should be made
first.
Nominal required rate-of-return consists of three ele-

ments: The real required rate-of-return is the rate-of-return
1) The risk-free rate-of-return. that is required to cover the risk inherent in an invest-
ment. Like real cash flow, it assumes no inflation.
2) The risk premium.
The real rate-of-return includes two components:
3) An inflation element, which is a premium above the
real rate that is required to offset the expected decline 1) A risk-free rate-of-return when there is no expect-
in purchasing power due to inflation. ed inflation, which is approximated by the rate for
long-term government bonds
Rates of return quoted for financial markets are nominal
rates, because investors demand compensation for both 2) A risk premium, which is required to compensate for
the investment risk that they assume and for the expec- the business risk foreseen.
ted decline in purchasing power. In an inflationary environment, nominal cash flow will be
In an inflationary environment, nominal cash flow will be higher than real cash flow.
higher than real cash flow. In an inflationary environment, nominal returns will be
In an inflationary environment, nominal returns will be higher than real returns.
higher than real returns.
What are the

What are the
five basic principles
five basic characteristics
for estimating after-tax
of relevant project
incremental operating
expected cash flows?
cash flows?

How do you calculate

How do you calculate the the incremental net
initial (year 0) cash flow? cash flows per period
during the project’s life?

How do you calculate the What are the

incremental net cash flow two major types of
in the final year of a project? risk in capital budgeting?

The five basic principles for estimating after-tax incre-
mental operating cash flows are:
1) Sunk costs are ignored. Five basic characteristics of relevant project expect-
2) Opportunity costs should be included. ed cash flows:
3) Requirements for increased net working capital 1) Use expected cash flows, not accounting income.
(project-driven increases in current assets minus pro- 2) Use operating, not financing cash flows.
ject-driven increases in current liabilities) should be
considered as part of the initial investment. At the end 3) Expected cash flows must be determined on an after-
of the project’s life, the working capital investment is tax basis.
returned as a cash inflow. 4) Expected cash flows should be incremental; we ana-
4) An additional increase in net working capital lyze only the difference between expected cash
may be required midway through the project. If so, flows with the project and those without the project.
that is a cash outflow in the year it takes place, 5) Calculation of the depreciation tax shield is always
and both the initial increase and the additional based on the type of depreciation used for tax pur-
increase in working capital are recovered at the end of poses; and 100% of the asset’s cost is always
the project. depreciated, regardless of what type of depreciation
5) If the required rate-of-return includes a premium for (i.e., straight line) is being used for tax purposes.
inflation, then expected cash flows must also be
adjusted for inflation.
The initial (year 0) cash flow is calculated as:

The incremental net cash flows per during the pro- Cost of new asset(s)
ject’s life are calculated as follows: + Capitalized expenditures such as shipping and
installation costs*
Net increase (decrease) in operating revenue +/- Increased (decreased) level of net working capital
+/- Net decrease (increase) in operating expenses, (change in current assets net of change in current
excluding depreciation liabilities)
-/+ Net increase (decrease) in depreciation expense for ! Net proceeds from sale of old asset(s) if the project
tax purposes involves replacement of assets
= Net change in income before taxes +/- Taxes (tax savings) from gain/loss on sale of replaced
-/+ Net increase (decrease) in income taxes old assets
= Net change in income after taxes = Initial cash outflow
+/- Net increase (decrease) in depreciation expense for
tax purposes
= Incremental net cash flow for the period * The asset’s cost plus any other capitalized expenditure
necessary to prepare it for its intended use form the tax
basis of the asset for depreciation for tax purposes.
Estimated future cash flows for an investment project are

usually uncertain. The two main types of risks involved
in capital budgeting are:
The incremental net cash flow in the final year of a
1) Market risk, or systematic risk - the risk that a com- project is calculated as follows:
pany will be affected by changes in the market in
which it operates. These changes will also affect other Annual incremental net cash flow for the period, not
firms. It cannot be diversified away. Market risks including project termination considerations
include: interest rates, inflation, exchange rate risks, +/- Proceeds from sale or (costs of disposal) of asset(s)
business cycles, etc. -/+ Taxes or (tax savings) on gain or loss from disposal of
asset(s)
2) Non-market risk, also called company-specific risk or +/- Recovered net working capital or (increased) net
stand-alone risk - the risk of a project as a separate working capital
entity. It can be diminished by diversification, and for = Final year’s incremental net cash flow
that reason it is also called diversifiable, or unsystem-
atic risk. Non-market risks include liquidity risk, oper-
ating (business) risk, and financial risk.
List and define

What are the techniques
four examples of
used to analyze risk?
nonmarket risk.

What are the

What is a five primary benefits of
decision tree? decision trees for
capital budgeting purposes?

What are the

What is
four main shortcomings of
sensitivity analysis?
decision trees?

Four common examples of nonmarket risk are:
1) Portfolio risk: the risk of its entire portfolio of invest-
ments.
2) Liquidity risk: the risk that the asset cannot be sold
The following techniques are used to analyze risk: quickly enough for its market value. If an asset needs
1) Decision Trees, to be sold at a high discount in order to sell it quickly,
that asset has a high liquidity risk.
2) Sensitivity Analysis,
3) The financing it pursues for a project, which can cause
3) Scenario Analysis, its debt-to-equity ratio to either increase or decrease,
4) Simulation Analysis, could change a company’s financial risk. Addition-
ally, this either increases or decreases risk to its
5) Breakeven Analysis,
shareholders.
6) Present Value Breakeven Analysis, and 4) Business risk: risk of changes in earnings before
7) Adjustments to the discount rate used in discounted interest or taxes when it has no debt. Business risk
cash flow methods to compensate for risk or inflation. depends on a variety of factors, including the variabil-
ity of demand, sales price, and the price of inputs as
well as the amount of the company’s operating lever-
age. The more stable all of these variables, the less
business risk a company will experience.
The benefits of decision trees for capital budgeting pur-

poses are:
1) They are helpful when there is a series of conditional
A decision tree may be constructed to present the pos-
choices.
sible outcomes and their probabilities in a “tree-like” fash-
2) They show the impact of time on decisions. ion. Each branch represents a certain sequence of events
3) They can model uncertainty. and decisions. Thus, the expected outcome for each
branch can be computed and the optimal result found.
4) They produce quantitative results.
5) They are flexible, examining the effects of predictors
one at a time.
The shortcomings of decision trees are:

1) All decision factors must be expressed quantitatively.
Qualitative factors are difficult, if not impossible, to
express and utilize.
2) Decision trees can be a challenge to develop in a
group setting. Because of the frequently subjective
Sensitivity analysis determines how cash flows change nature of the probabilities associated with decision
with the change of one of the underlying variables/ trees, developing and reaching agreement on event
assumptions. Sensitivity analysis is a “what if” technique. probabilities may be difficult.
3) There can be a great number of possible outcomes in
the model, and the decision tree can become
extremely large.
4) All data developed from decision tree analysis must be
subjected to the good judgment of the decision-
maker(s).
What is What is
scenario analysis? simulation analysis?

What is breakeven analysis What is

and what is it used for? present value breakeven?

What is the
What is the
risk-adjusted discount rate
capital asset pricing model?
and what is its purpose?

Simulation analysis computes the various outcomes if
several variables or assumptions change simultaneously.
In simulation analysis, simulations are used to develop Scenario analysis computes the various outcomes if
possible outcomes using statistical methods and comput- several variables or assumptions change simultaneously.
ing the NPV and IRR for each set of outcomes. In scenario analysis, the scenarios are based on macro-
economics, factors specific to the industry, and factors
All the results from all the simulation runs are summarized
specific to the firm. NPV and IRR of the project under each
into average, variance, coefficient of variation, etc., for all
scenario are estimated. The decision to accept or reject
the statistics across all simulation runs. The final decision
the project is based on the NPV and IRR under all the
is based on the summary statistics.
scenarios, not just one.
This is an expensive method and is used only with larger
projects.
Breakeven Analysis is used to estimate the revenue

that will be needed for a project to break even in account-
Present value breakeven is the number of units a com-
ing terms.
pany has to sell as the result of a project in order to arrive
at an NPV of zero for the project.
At the breakeven point: fixed costs + variable costs = rev-
enue.
The discount rate used in discounted cash flow methods of

capital budgeting for a particular project should reflect the
risks involved in the project. The company-wide cost of
capital, which is often used as the discount rate for all of
its projects, may not reflect the risks of a particular pro-
ject. Therefore, adjustments may be made to the discount The Capital Asset Pricing Model is a risk management
rate. tool. It assumes that all assets are held in portfolio rather
than individually. In the portfolio the specific risk associ-
The discount rate should be increased for projects con- ated with each specific investment is eliminated because
sidered to be riskier than average for a company and of the portfolio and therefore the only remaining risk is
lower when the risk of the project is lower than normal: the market risk. As a result, the more sensitive an invest-
Risk Adjusted Discount Rate for Project = ment is to the market, the riskier that asset becomes.
Weighted Average Cost of Capital ± Risk Premium
The amount of the risk premium is determined by man-
agement, based on risk analysis using methods such as
decision trees, scenario analysis, etc.
What are the primary changes

What is the
to make to a capital budgeting
certainty equivalent NPV?
model to adjust for inflation?

What are
How real
areoptions How are
in
real
capital
options
budgeting?
valued? real options valued?

What is the
What is a real option?
value of a real option?

In an inflation environment we need to make adjust-
ments to the capital budgeting process:
1) The discount rate should be increased because
the market will require a higher rate-of-return to com-
pensate for the increased risk of inflation. By raising Certainty equivalent NPV can be used to manage risk
the discount rate, we will decrease the present value by adjusting the cash flows according to the judgment of
of future cash flows. This reduction will make the pro- management. The certainty equivalent NPV uses the
ject less likely to have a positive NPV. smallest certain cash flow in each period that the com-
2) We need to increase the cash flow amounts in the pany expects to receive.
future because inflation will cause the dollar to
be worth less in the future. The amounts of cash This method is difficult to use and you only need to know
(both inflows and outflows) will therefore increase in that it exists.
the future. (If inflation of 5% per year is expected, we
would increase cash flows by 5% each year, com-
pounding the increase each year to recognize the
impact of inflation on the cash flows.)
Real options provide a method of optimizing a real asset

There are three methods that are used to value real (equipment, land, etc.) under conditions of uncertainty in
options: capital budgeting. The choice of the project can be an ini-
tial choice, followed by more choices (options) as more
1) The Black-Scholes Option Pricing Model is the method information becomes available. Examples include:
used to value financial options. It recognizes a con- 1) The option to make follow-on investments if initially
tinuum of possible outcomes for each period. successful;
2) The Binomial Model, which assumes that one of two 2) The option to abandon a project;
outcomes will occur in each period: an upside and a 3) The option to wait and learn more before investing;
downside. and
3) Monte Carlo Analysis, which is simulation analysis. 4) The option to vary the inputs to the production pro-
Several PVs are calculated based on random choices cess, the production methods, or the firm’s output or
of variables. The NPVs are averaged to get an approx- product mix.
imate NPV for the project. The value of the real option These options have value because they limit the downside
is the difference between the conventional Discounted potential of the project. The greater the uncertainty of the
Cash Flow NPV and the averaged approximate NPV underlying project, the greater the value of the real
that resulted from all the simulation runs. options. The worth of a project can be viewed as:
Project Worth = NPV + Real Options Value
The value of a real option is the difference between the A real option is the right, but not the obligation, to
net present value of the project with the real option and acquire the gross present value of future expected cash
the net present value of the project without the real flows by making an investment on or before the date the
option. opportunity expires.
What are 8 examples What are

of qualitative factors four common methods
in capital budgeting decisions? to value common stock?

What is the formula to

What is the restated
value a share of
dividend growth model
preferred stock
that can be used to value
that can be used to
a share of common stock?
value common stock?

What is the
two-stage dividend
What is the P/E model
discount model
to value common stock?
to value common stock and
when is it necessary to use it?

Eight examples of qualitative factors to consider in
capital budgeting decisions include:
1) The investment might improve the quality of products
and services offered.
2) The investment might shorten the time in which
Four common methods to value common stock products and services can be produced and/or de-
include: livered to customers.
1) Valuation formula for preferred stock assuming that 3) The investment might address consumer safety con-
the dividend is not expected to grow. cerns.
4) The investment might be required because of govern-
2) Dividend growth model or constant growth mode.
ment regulations or environmental protection concerns.
3) Two stage dividend discount model. 5) Worker safety might be improved by the investment.
4) P/E Model. 6) The company’s public relations – its image and prestige
– might be impacted positively by the project.
7) The community where the firm operates could be
served by the investment.
8) The owners and/or management might simply want to
make the investment.
The restated Dividend Growth Model formula is:
The formula to calculate the value of preferred stock is:

P0 = d1
r!g Annual Dividend
Investors’ Required Rate of Return
Where:
The result is also the value of a share of common stock if
P0 = the fair value today of a share of stock
the dividend is not expected to grow.
d1 = the next annual dividend to be paid;
r = the investors’ required rate of return
g = the expected growth rate of the dividend.
The restated dividend growth model to value common

stock assumes that a constant growth rate in dividends
will continue indefinitely. This may be true for some
mature companies, but it is frequently not an appropriate
assumption. Sometimes a company is going through a
A simple method of valuing a common stock is by calcu- “growth spurt” where it is growing rapidly. That rapid
lating its P/E, or Price/Earnings, ratio. growth is expected to last for a few years and then slow
down to a more normal growth rate.
The P/E ratio is the price per share of common stock In this situation, the constant growth dividend model must
divided by the earnings per share. The P/E ratio is an be adjusted. This adjustment results in the two-stage
indication of how much investors are willing to pay for a dividend discount model.
stock for each dollar of the company’s earnings.
We adjust the model by dividing the projected dividend
cash flow stream into two parts:
1) The initial fast growth period, and
2) The next period, when normal and sustainable but
lower growth is expected.
Describe the What are the

two commonly used steps to implement the
methods to value market multiple approach
a business. to valuing a business?

What is the concept

How do we define
required rate of return
free cash flow,
when valuing a business
as used to value a business,
and what are the
two ways to calculate it?

What are the

two stages (time frames)
How do companies
that analysts divide cash flows
generally address risk
when valuing a business
in a business valuation?
using the present value of
future cash flows method?

The market multiple approach to valuing a business for
investment purposes uses the market value of businesses
that are similar to the business being valued. There are two commonly used methods of valuing a
business:
1) The values of the other businesses are determined
either by the trading price of publicly-owned compa- 1) The market multiple approach, sometimes called
nies or by the purchase price in a sale of a similar the comparative sales approach. It uses the market
business. value of businesses that are similar to the business
being valued.
2) The price, or value, of the comparable business is
compared to its earnings, cash flow, or other ratios to 2) The discounted cash flow approach, also called the
derive market multiple values for each factor. income approach, involves determining the present
value of the future cash flows of the company to be
3) Those market multiples are then adjusted for the valued. The value of the company is the present value
riskiness of the subject company in comparison with of the expected future cash flows generated by it, dis-
the comparative company(ies) and multiplied by a counted at the required rate of return.
normalized level of expected earnings and cash flow
for the subject company.
In valuing a business, we use free cash flow, which is

The discount rate to be used in calculating the present cash flow before interest but after taxes and after
value of the future cash flows is known as the required capital expenditures. It is the cash flow that remains
rate of return. A firm should invest money in an acquisi- after we subtract from the expected revenues the expec-
tion only if the acquisition provides a return higher than ted operating costs and the capital expenditures required
the required rate of return of stockholders. Thus, the rate to sustain the cash flows. .
should reflect the market’s expected rate of return plus a The formula to calculate free cash flow using EBIT is:
risk premium for this particular investment. EBIT (1 ! tax rate)
The rate should be the cost of equity of the acquired ! (Capital Expenditures ! Depreciation)
firm in order to reflect the riskiness of the acquired firm’s +/- Change in Non-Cash Working Capital
cash flows. = Free Cash Flow
The cost of equity of the firm to be acquired can be ap- Whereby:
proximated by means of either the
1) Earnings Before Interest and Taxes (EBIT) is adjusted
1) Capital Asset Pricing Model (CAPM), or for taxes.
2) Arbitrage Pricing Theory (APT). 2) we adjust for capital expenditures, depreciation, and
change in non-cash working capital.
“Companies adjust for risk by using risk-adjusted dis-

count rates. A company will increase the discount
rate used in NPV calculations for more risky, or uncertain,
investments. A higher discount rate will require higher In valuing a business using the present value of future
expected future cash flows for the company to make the cash flows, analysts usually split the forecasting into
investment, thus making fewer investments acceptable. two stages:
And it will lower the discount rate used for an investment 1) The first stage includes detailed annual forecasts of
that is judged less risky than the company’s present port- financial statement items up to some horizon date.
folio of investments.”
2) The second stage includes forecasts beyond the
If the projected cash flow of the business and/or other horizon date to infinity, using a single growth rate
variables used in the valuation analysis are not very pre- forecast for all years beyond the horizon date.
dictable, we need to assign a risk premium to the cost of Using the two sets of forecasts, then, the present value of
capital/required rate of return used to discount the future all the future cash flows is determined in order to estimate
expected cash flows. By increasing the discount rate, we the firm’s intrinsic value.
will decrease the resulting valuation and may bring the
offering price down to what we consider to be a more
reasonable level.
What is the formula to

calculate the value of cash
What are two important
flows beyond the horizon date
miscellaneous considerations
of the business valuation
to include in the
analysis using the
valuation of a business?
present value of
future cash flows analysis?

Section E: Professional Ethics Section E: Professional Ethics
Section E: Professional Ethics
What are the

Why is the creation
two primary ways
of an ethics based
that organizations
organization culture
impact the ethical behavior
important?
of its members?

What are the benefits to the

company that can be achieved
Why is the creation
if the company views the
of a code of ethics
creation of a values based
important for
organizational culture as an
an organization?
investment in the company
human resources?

It is relatively simple to determine the initial value of the
cash flows to the end of the analysis. Thereafter we need
Two important miscellaneous considerations to include in to determine the value of cash flows that are growing “in
the valuation of a business include: perpetuity.” We can do that, even though we have no end
Income taxes: in sight to the cash flow, if we know the growth rate in the
1) Do tax loss carryforwards exist in the business to be cash flows. Because this determination depends upon an
acquired? annual growth rate forecast, the expected growth rate is
one of the most important inputs into the valuation.
2) Will assets be revalued to their market rate and
depreciated at a higher value? The formula to determine the value of the cash flows
beyond the horizon date, called the Gordon Growth
Real Options:
Model, is a slight adaptation of the constant growth
1) Do real options exist that would transfer to the acquir- dividend discount model.
ing firm?
The present value of cash flows growing “in perpetuity” is
2) If yes, what is the value of the real options to include calculated as follows:
in the valuation of the firm?
Expected Free Cash Flow for the Next Year
Cost of Capital ! Expected Growth Rate
The creation of an ethics based organization culture The modern organization is seen as having respon-
important for the following reasons: sibilities regarding the ethical conduct of their indi-
1) Academic research shows that ethics based management vidual members. We no longer expect that ethical issues
addresses many issues regarding both compliance and impacting the organization are addressed and resolved by
corporate financial performance obligations. This inter- each individual in isolation. Instead we expect that the
locking of goals is achieved by creating an environment organization will be proactive and provide an environment
where “doing the right thing” is expected of all employees where the individual employee is encouraged and feels
all the time. comfortable to behave in an ethical manner consistent
2) Creation of an ethics based organization culture is neces- with the culture of the organization.
sary because the modern corporation cannot control its 1) This expectation means that the organization is
employees behavior as in the past due to globaliza- responsible for creating and defining the ethical
tion and geographic dispersion of operations.
standards of behavior that it expects from its
3) A knowledge based work environment, as exists members.
today in many industries, requires skilled people who
make decisions and interpret guidelines in dynamic 2) The organization must sometimes take respon-
situations where documented policies do not sibility for the actions of its members when un-
always exist. Trust given to employees in an ethical cul- ethical behavior occurs.
ture means the employees are trained to do the right Both of these factors are important for the ethical environ-
thing in ambiguous situations. ment that an organization creates.
The effort to create a values based organizational culture

should be seen as an investment in the human resources A code of ethics is important to the organization and
of the company. The benefits of an investment will lead the organization’s members for several reasons:
to improved financial performance because a values based 1) Senior management is forced to define and document
work environment will result in: its expectations to the rest of this organization.
1) Higher levels of productivity through motivated, en- 2) This requirement then provides a common standard
gaged employees. and understanding of the company’s definition of eth-
2) Better teamwork. ical behavior by creating a reference point for the
company employees.
3) Less fraud through a sense of ownership and identifi-
cation with the company. 3) This reference point provides a framework for decision
making in situations where an explicit company policy
4) Better business processes and higher quality of ser- does not exist.
vices through engaged, committed employees.
What are three sources

What is the
of external pressure
Foreign Corrupt
that impact organizational
Practices Act (FCPA)?
ethical behavior?

How does the

What are the two primary
Sarbanes Oxley (SOX)
requirements for business
legislation explain
from the Foreign Corrupt
why a code of ethics
Practices Act (FCPA)?
is important?

Why is the
How does
tone at the top
ethical behavior impact
an important factor for the
the daily responsibilities
internal control environment
of accounting professionals?
in an ethical organization?

Three sources of external pressure that impact organ-
izational behavior include:
The Foreign Corrupt Practices Act (FCPA) was estab- 1) Legal requirements imposed by governments
lished in the late 1970s as a reaction to numerous publi- and regulatory agencies including the Foreign Cor-
cized scandals in which U.S. companies were making rupt Practices Act (FCPA) and the Sarbanes Oxley
bribes and other questionable payments to foreign officials (SOX) legislation.
in order to obtain or renew business. 2) Peer pressure by professional and business
It created a legal framework to punish both individuals associations. This influence exists, in part, to ad-
and companies for making payments to foreign officials dress these differences between legal and value based
that could be judged as bribes behavior.
It applies to any individual, firm, officer, director, em- 3) Commercial pressures are pushing the modern cor-
ployee, or agent of a firm and any stockholder acting on poration towards rethinking its approach to ethical
behalf of a firm. behavior and values based management. Compliance
with the laws of one country is not enough in an
environment that is characterized by growing globali-
zation and dispersed operations.
Section 406 of SOX refers to a code of ethics for senior

financial officers. It states that companies subject to SEC
guidelines should develop an ethics policy to ensure that
the “tone at the top” of the organization is clearly defined. The two primary requirements for business from the
If no policy is developed, the company must explain why. Foreign Corrupt Practices Act (FCPA) are:
It applies to the company’s principal financial officer and 1) It prohibits payments based upon a corrupt intent to
comptroller or principal accounting officer, or persons per- foreign officials, politicians, or political parties to
forming similar functions. obtain or renew business or to obtain a service that
It defines the code of ethics as a statement of standards the government is otherwise not legally obligated to
that are necessary to promote: provide.
1) Honest and ethical conduct, including the ethical 2) It created the legal requirement that companies
handling of actual or apparent conflicts of interest maintain complete, accurate, and reliable ac-
between personal and professional relationships, counting records that represent, in all material
2) Full, fair, accurate, timely, and understandable disclos- aspects, the complete and true nature of business
ure in the periodic reports required to be filed by the transactions.
company, and
3) Compliance with applicable governmental rules and
regulations.
The tone at the top of the company is the basis for Promotion of an ethical culture is a responsibility of an
internal control within an organization. accounting professional because it impacts core work
responsibilities regarding internal control and risk
The management accountant has to be aware of this
management:
environment in any risk or internal control assessment
that he performs. 1) There is a strong relationship between ethics and
internal controls. A strong framework for corporate eth-
The tone at the top is an important issue because:
ical behavior is necessary for effective internal controls.
1) Leadership by example is a prerequisite to under-
2) Human behavior is a driving factor regarding control
standing the organization’s ethical environment.
systems and the control environment of an organiza-
2) It demonstrates creditability of the ethical environ- tion.
ment if senior management behaves in a manner 3) Risk assessment of the organization needs to consider
consistent with the organization’s stated written val- human behavior as a risk.
ues.
4) The tone at the top of the organization is the primary
3) Managers themselves, as individuals, are also basis of the control environment.
more creditable if they act in the same way that
5) The changing nature of organizations mean that a rules
they expect their subordinates to act.
based compliance culture has limitations compared to
4) Management’s actions also become a reference an ethics based culture. These limitations create risk
point for the rest of the organization – they become because a rules based culture may not be flexible
the role models for the company’s values. enough to address today’s business environment.
What is a Why is ethics training

confidential ethics helpline important for a company
and how does it help and what are examples of
create and maintain an topics to include in a company
ethical business environment? ethics training program?

What are the areas

where management Why is employee training
accountants can help their regarding ethical behavior
organizations to create an important for the organization?
ethics based environment?

What are two approaches

What are three tools to monitoring the
that can be used to status of controls in a
identify process controls company related to the
in a company related to implementation and
ethical or behavioral issues? maintenance of an
ethical environment?

Many organizations create a confidential ethics helpline
to help its people resolve ethical conflicts. The goal is to
create a structured “whistle blowing framework” to help
Ethics training is important to create awareness of the maintain an ethical organizational culture under real world
standards of the company against which individual beha- stresses.
vior will be measured. Academic research shows that this type of structured, con-
Examples of the topics to include in this training include: fidential communication channel is one of the six important
1) Standards for interpersonal behavior within the com- conditions to create a value/ethics based organization.
pany, The approach works because:
1) It provides a forum to help people overcome fear
2) Prohibited business practices,
to speak openly when they see others not behaving
3) Dissemination and understanding of the company appropriately,
core values, 2) There is less need to fear retribution if conflicts
4) How to apply theoretical core values into real life situ- become known, and
ations, and 3) A confidential ethics hotline provides a formal process
5) Providing leadership regarding ethical behavior. to bypass immediate supervisors. This possibility
might help encourage someone to make a confidential
report when their supervisor is the person who is
behaving inappropriately.
Employee training is important for maintaining an eth-

ical organizational culture for several reasons:
1) It ensures that all levels of the company understand
the company’s ethical standards.
2) It provides management with the opportunity to Management accountants can help with the implementa-
demonstrate commitment to the company’s ethical tion of an ethics based environment in the organizations
standards. where they are employed in the following areas:
3) It helps to reinforce the development of an ethical 1) Support development of employee training.
organization culture so that it can become self-sus- 2) Implementation of appropriate internal controls.
taining.
3) Monitoring of the results.
The concept of self-sustaining in this context means that it
is understood and lived by the people of the organization
as a basis for their behavior and decision making when
written company requirements are not available for a situ-
ation.
Three tools that can be used to identify process controls in

a company related to ethical or behavioral issues are:
Two approaches of monitoring will help to monitor the 1) Continual Process Improvement involves the con-
implementation status of an ethical organization. Each stant monitoring of business processes as a basis to
approach involves asking people questions in order to learn from experience and to adapt to new situations
learn what they know and how much they understand before they create major problems.
about the company’s ethical values.
2) Business Process Reengineering is the process of
1) Human Performance Feedback Loop involves analyzing the individual activities of a process as a
including ethics in the performance management pro- basis to determine the most effective way to fulfill the
cess for individual employees. process.
2) Survey Tools involve submitting questions to the 3) Quality Management is based upon the goal to
company’s employees regarding the company ethics avoid mistakes from occurring by identifying and eval-
policies and asking for anonymous written responses. uating risk situations in advance. Once risk situations
are identified, the management accountant develops
alternative strategies to avoid the risk situations.

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CMA Part 2 CMA Part 2

Section A: Financial Statement Analysis Section A: Financial Statement Analysis

What is the Who are

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CMA Part 2 CMA Part 2

Who are the Who are

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CMA Part 2 CMA Part 2

What are some of the

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Internal users include:

What level of What are the

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CMA Part 2 CMA Part 2

Define the balance sheet,

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CMA Part 2 CMA Part 2

What are limitations Define current assets and

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The balance sheet, also called a statement of finan-

3) Inventories 3) Judgments and estimates are used in determining

Define current liabilities and

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CMA Part 2 CMA Part 2

Define noncurrent liabilities Define owner’s equity and

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CMA Part 2 CMA Part 2

Explain what the

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Owner’s equity is the amount of the company’s assets

2) Retained earnings - profits of the company that 3) Pension obligations

Revenues are inflows of assets or a reduction of

Define expenses and explain

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CMA Part 2 CMA Part 2

Define losses in the What are limitations of

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CMA Part 2 CMA Part 2

What are the three main

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Most of the limitations of the income statement are

The primary purpose of the SCF is to provide informa-

Explain what types of activities Explain what types of activities

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CMA Part 2 CMA Part 2

Explain what types of activities What are the

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CMA Part 2 CMA Part 2

Describe the Describe the

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Financing activities are activities to raise capital to fi-

The direct method shows each item that affected cash

Define comprehensive income

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CMA Part 2 CMA Part 2

What are the

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CMA Part 2 CMA Part 2

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The items that are considered other comprehensive

Limitations of financial statements include:

List and explain the

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