📘 Study Unit 1: B.1.

Financial Risk and Return — Notes

🔍 Definition of Risk
 Risk = Possibility of an unfavorable event occurring.
 Financial Risk = Risk tied to the financial health of a company.

⚠️Types of Financial Risk

1. Capital Access Risk
o Inability to access capital (equity or long-term debt).
2. Liquidity Risk
o Lack of sufficient cash or liquid assets to meet short-term obligations.
3. Customer/Receivables Concentration Risk
o Risk that:
 A large customer is lost.
 A major receivable becomes uncollectible.
4. Market Volatility Risk
o Risk from changes in:
 Foreign currency rates
 Interest rates
 Commodity prices
5. Investment Loss Risk
o Value of investments may decline.
6. Compliance Risk
o Risk of penalties due to:
 Violations in accounting standards
 Financial reporting issues
 Regulatory breaches
 Tax non-compliance

💡 Special Case: Interest Rate Risk with Bonds

 When a company issues bonds:
o If future interest rates fall, it ends up paying more interest than needed.
o This is a costly timing risk.

💸 Raising Capital Risk

 Risk that:
o Capital won’t be available.
o Or, it won’t be available at a reasonable cost.

📉 Investment Risk (for investors)

 Defined as the possibility of a decrease in investment value.
🔁 How Returns Are Earned by Investors
1. Price Appreciation:
o Value of investment increases → Can be sold for profit.
2. Ongoing Returns While Held:
o Dividends (for stocks)
o Interest (for bonds)
o Capital gain (from price increase in either)

📊 Risk-Return Trade-off
 Higher risk → Higher required return.
 Investors expect to be compensated for taking on risk.

📚 Example: ABC Company Bonds

 U.S. Treasury bill rate = 2% (risk-free benchmark)
 ABC Company must offer more than 2% return to attract investors.
Investors' Required Returns:
Risk
Investor Required Return
Assessment
Andrew Low 2.5%
Polina Moderate 3.5%
Marcus High 9%
If ABC sets bond return at 4%:
 Andrew & Polina will buy.
 Marcus will not buy.
📌 Key Insight:
 Each investor sets their own required return based on personal risk perception.

📈 Investor Behavior: Risk Aversion

 Most investors are risk-averse.
 More risk → More return required.
 Two investors can view the same investment differently based on their risk tolerance.

📌 Note on Risk-Free Rate

 U.S. Treasury securities are considered risk-free.
 The short- to intermediate-term Treasury return is often used as the risk-free rate in finance.

📉 Market Risk Premium

 Market Risk Premium =
Expected return on the market portfolio
– Risk-free rate (Treasury return)
Example:
 Expected market return = 8%
  Treasury rate = 2%
 → Market Risk Premium = 6%

🧩 Types of Risk
1. Pure Risk
o Only possible outcomes: Loss or No Loss
o Example: Insurance
o No opportunity for gain.
2. Speculative Risk
o Outcome can be gain or loss.
o Applies to investing.
o Key concern in investment decisions.

📊 Investment Risk Analysis

 Actual return may differ from expected return:
o Positively or negatively
o This variability = Speculative risk
 Management must address speculative risk in investment decisions.

🏢 Company Investments Examples

 Securities (stocks, bonds)
 New projects (e.g., machines or plants)
 Acquisitions (e.g., buying another company or starting a subsidiary)
🔁 All have risk of actual ≠ expected return

📚 Portfolio vs. Individual Investment Risk

 Individual Investment Risk = Risk from a single asset/project
 Portfolio Risk = Risk from the entire collection of investments
o Will be discussed in detail later

🧠 Extra Concept Clarification

🔸 Why Do Investors Need Higher Returns for Higher Risk?
Think of it like this: Would you risk ₹1,000 for a 1% return if there's a 50% chance you could lose it? No
way.
 The higher the uncertainty, the higher the reward must be to make the risk worthwhile.

🔸 Real-world Example of Market Risk Premium

 If investing in a mutual fund vs. Treasury bond:
o Mutual fund has more risk.
o So investors want higher return = market risk premium.

🔸 Pure vs. Speculative Risk Example:

Type Example Outcome Possibilities
Pure Risk Fire damaging warehouse Loss or No Loss
Buying stock of a new tech
Speculative Risk Gain or Loss
firm

🧠 Memory Aids:
 PR vs SR = Pure Risk → Only Loss, Speculative Risk → Loss or Gain
 Risk-Return Rule = More Risk → More Reward Required
 Capital Risk = Can’t Get Cash (equity or debt)
 Liquidity Risk = Can’t Pay Bills Now
📘 CMA Part 2: Study Unit 1 — Financial Risk and Return (Detailed Notes)
📚 Covers: Types of Financial Risk, Return, Risk-Return Relationship

🔍 What is Financial Risk (for Investors)?

 Financial risk = Possibility of losing money on an investment.
 It is broad and includes:
o Systematic (market-wide) risks
o Unsystematic (specific) risks

🧭 Two Main Categories of Investment Risk

1️⃣ Systematic Risk (Market Risk)
 Definition: Risks that affect all investments, caused by economy-wide events.
 Cannot be avoided even through diversification.
 Remains in a fully diversified portfolio.
🔗 Examples of Systematic Risk:
Type Description
Risk from market-wide movements; not linked to the individual company. Ex:
Market Risk
Market crash.
Risk of investment value changing due to market interest rate changes. Especially
Interest Rate Risk
affects fixed-income instruments.
Purchasing Power
Inflation reduces real value of money/investment returns.
Risk
Foreign Exchange
Risk from currency fluctuations before international transaction settles.
Risk
📝 Remember:
Systematic = Cannot be diversified away. It's macro-level risk.

2️⃣ Unsystematic Risk (Company-Specific Risk)

 Definition: Risk specific to a company or industry.
 Can be eliminated/reduced through diversification.
🔗 Examples of Unsystematic Risk:
Type Description
Risk borrower won’t pay principal/interest. Ex: Corporate bond default.
Credit (Default) Risk
→ Higher perceived risk = Higher return demanded.
Liquidity (Marketability) Difficulty selling investment for market value. Requires discount =
Risk higher risk.
Risk due to fluctuating earnings (EBIT). Influenced by:
- Demand volatility
Business Risk - Input price changes
- Selling price changes
- Operating leverage
Industry Risk Risk affecting entire industry. Ex: Disruption by new technology.

💡 What is Diversification?
 Spreading investments across different assets/sectors to reduce unsystematic risk.
 Systematic risk cannot be reduced this way.

💰 Return: Definition and Components

 Return = Income earned on an investment.
 Comes from:
1. Capital appreciation (price increase)
2. Dividends (stocks)
3. Interest (bonds)

📏 Annual Rate of Return Formula

Annual Rate of Return=Return Received for One YearAverage Amount Invested\text{Annual Rate of
Return} = \frac{\text{Return Received for One Year}}{\text{Average Amount
Invested}}Annual Rate of Return=Average Amount InvestedReturn Received for One Year

🔄 Two Key Rules When Calculating Annual Return

1. Annualize partial-period income:
o 6 months → Multiply by 2
o 1 month → Multiply by 12
2. Use Average Balance invested:
o If investment amount changes during the period, calculate average balance for the
return period.

📊 Examples for Practice:

🔸 Example 1:
 Invested: $10,000
 Earned: $500 in 1 year
 Return = $500 / $10,000 = 5%
🔸 Example 2:
 Invested: $10,000 for 6 months
 Earned: $250
 Annualized return = ($250 × 2) / $10,000 = 5%
🔸 Example 3:
 $10,000 invested for 3 months
 Then $6,000 for next 3 months
 Income for 6 months = $200
 Average balance = (($10,000×3) + ($6,000×3)) / 6 = $8,000
 Annualized return = ($200×2) / $8,000 = 5%
🧠 Concept Clarity:
Annual Rate of Return = "What if I earned that income rate for a whole year?"

📈 Relationship Between Risk and Return

"No reward without risk"
 Higher Risk → Higher Required Return
 Lower Risk → Lower Return Accepted
📌 Decision Rules for Investors:
Scenario Investor Will Choose
Same return, different risk Lower-risk asset
Same risk, different return Higher-return asset
🧠 Key Concept:
Investors aim to maximize return for a given level of risk or minimize risk for a given return.

📘 Study Unit 1: B.1. Financial Risk and Return — Notes

🔍 Definition of Risk
 Risk = Possibility of an unfavorable event occurring.
 Financial Risk = Risk tied to the financial health of a company.

⚠️Types of Financial Risk

1. Capital Access Risk
o Inability to access capital (equity or long-term debt).
2. Liquidity Risk
o Lack of sufficient cash or liquid assets to meet short-term obligations.
3. Customer/Receivables Concentration Risk
o Risk that:
 A large customer is lost.
 A major receivable becomes uncollectible.
4. Market Volatility Risk
o Risk from changes in:
 Foreign currency rates
 Interest rates
 Commodity prices
5. Investment Loss Risk
o Value of investments may decline.
6. Compliance Risk
o Risk of penalties due to:
 Violations in accounting standards
 Financial reporting issues
 Regulatory breaches
 Tax non-compliance

💡 Special Case: Interest Rate Risk with Bonds

  When a company issues bonds:
o If future interest rates fall, it ends up paying more interest than needed.
o This is a costly timing risk.

💸 Raising Capital Risk

 Risk that:
o Capital won’t be available.
o Or, it won’t be available at a reasonable cost.

📉 Investment Risk (for investors)

 Defined as the possibility of a decrease in investment value.

🔁 How Returns Are Earned by Investors

1. Price Appreciation:
o Value of investment increases → Can be sold for profit.
2. Ongoing Returns While Held:
o Dividends (for stocks)
o Interest (for bonds)
o Capital gain (from price increase in either)

📊 Risk-Return Trade-off
 Higher risk → Higher required return.
 Investors expect to be compensated for taking on risk.

📚 Example: ABC Company Bonds

 U.S. Treasury bill rate = 2% (risk-free benchmark)
 ABC Company must offer more than 2% return to attract investors.
Investors' Required Returns:
Risk
Investor Required Return
Assessment
Andrew Low 2.5%
Polina Moderate 3.5%
Marcus High 9%
If ABC sets bond return at 4%:
 Andrew & Polina will buy.
 Marcus will not buy.
📌 Key Insight:
 Each investor sets their own required return based on personal risk perception.

📈 Investor Behavior: Risk Aversion

 Most investors are risk-averse.
  More risk → More return required.
 Two investors can view the same investment differently based on their risk tolerance.

📌 Note on Risk-Free Rate

 U.S. Treasury securities are considered risk-free.
 The short- to intermediate-term Treasury return is often used as the risk-free rate in finance.

📉 Market Risk Premium

 Market Risk Premium =
Expected return on the market portfolio
– Risk-free rate (Treasury return)
Example:
 Expected market return = 8%
 Treasury rate = 2%
 → Market Risk Premium = 6%

🧩 Types of Risk
1. Pure Risk
o Only possible outcomes: Loss or No Loss
o Example: Insurance
o No opportunity for gain.
2. Speculative Risk
o Outcome can be gain or loss.
o Applies to investing.
o Key concern in investment decisions.

📊 Investment Risk Analysis

 Actual return may differ from expected return:
o Positively or negatively
o This variability = Speculative risk
 Management must address speculative risk in investment decisions.

🏢 Company Investments Examples

 Securities (stocks, bonds)
 New projects (e.g., machines or plants)
 Acquisitions (e.g., buying another company or starting a subsidiary)
🔁 All have risk of actual ≠ expected return

📚 Portfolio vs. Individual Investment Risk

 Individual Investment Risk = Risk from a single asset/project
 Portfolio Risk = Risk from the entire collection of investments
o Will be discussed in detail later
🧠 Extra Concept Clarification
🔸 Why Do Investors Need Higher Returns for Higher Risk?
Think of it like this: Would you risk ₹1,000 for a 1% return if there's a 50% chance you could lose it? No
way.
 The higher the uncertainty, the higher the reward must be to make the risk worthwhile.

🔸 Real-world Example of Market Risk Premium

 If investing in a mutual fund vs. Treasury bond:
o Mutual fund has more risk.
o So investors want higher return = market risk premium.

🔸 Pure vs. Speculative Risk Example:

Type Example Outcome Possibilities
Pure Risk Fire damaging warehouse Loss or No Loss
Buying stock of a new tech
Speculative Risk Gain or Loss
firm

🧠 Memory Aids:
 PR vs SR = Pure Risk → Only Loss, Speculative Risk → Loss or Gain
 Risk-Return Rule = More Risk → More Reward Required
 Capital Risk = Can’t Get Cash (equity or debt)
 Liquidity Risk = Can’t Pay Bills Now
📘 CMA Part 2: Study Unit 1 — Financial Risk and Return (Detailed Notes)
📚 Covers: Types of Financial Risk, Return, Risk-Return Relationship

🔍 What is Financial Risk (for Investors)?

 Financial risk = Possibility of losing money on an investment.
 It is broad and includes:
o Systematic (market-wide) risks
o Unsystematic (specific) risks

🧭 Two Main Categories of Investment Risk

1️⃣ Systematic Risk (Market Risk)
 Definition: Risks that affect all investments, caused by economy-wide events.
 Cannot be avoided even through diversification.
 Remains in a fully diversified portfolio.
🔗 Examples of Systematic Risk:
Type Description
Risk from market-wide movements; not linked to the individual company. Ex:
Market Risk
Market crash.
Risk of investment value changing due to market interest rate changes. Especially
Interest Rate Risk
affects fixed-income instruments.
Purchasing Power Inflation reduces real value of money/investment returns.
Risk
Foreign Exchange
Risk from currency fluctuations before international transaction settles.
Risk
📝 Remember:
Systematic = Cannot be diversified away. It's macro-level risk.

2️⃣ Unsystematic Risk (Company-Specific Risk)

 Definition: Risk specific to a company or industry.
 Can be eliminated/reduced through diversification.
🔗 Examples of Unsystematic Risk:
Type Description
Risk borrower won’t pay principal/interest. Ex: Corporate bond default.
Credit (Default) Risk
→ Higher perceived risk = Higher return demanded.
Liquidity (Marketability) Difficulty selling investment for market value. Requires discount =
Risk higher risk.
Risk due to fluctuating earnings (EBIT). Influenced by:
- Demand volatility
Business Risk - Input price changes
- Selling price changes
- Operating leverage
Industry Risk Risk affecting entire industry. Ex: Disruption by new technology.

💡 What is Diversification?
 Spreading investments across different assets/sectors to reduce unsystematic risk.
 Systematic risk cannot be reduced this way.

💰 Return: Definition and Components

 Return = Income earned on an investment.
 Comes from:
1. Capital appreciation (price increase)
2. Dividends (stocks)
3. Interest (bonds)

📏 Annual Rate of Return Formula

Annual Rate of Return=Return Received for One YearAverage Amount Invested\text{Annual Rate of
Return} = \frac{\text{Return Received for One Year}}{\text{Average Amount
Invested}}Annual Rate of Return=Average Amount InvestedReturn Received for One Year

🔄 Two Key Rules When Calculating Annual Return

1. Annualize partial-period income:
o 6 months → Multiply by 2
o 1 month → Multiply by 12
2. Use Average Balance invested:
o If investment amount changes during the period, calculate average balance for the
return period.
📊 Examples for Practice:
🔸 Example 1:
 Invested: $10,000
 Earned: $500 in 1 year
 Return = $500 / $10,000 = 5%
🔸 Example 2:
 Invested: $10,000 for 6 months
 Earned: $250
 Annualized return = ($250 × 2) / $10,000 = 5%
🔸 Example 3:
 $10,000 invested for 3 months
 Then $6,000 for next 3 months
 Income for 6 months = $200
 Average balance = (($10,000×3) + ($6,000×3)) / 6 = $8,000
 Annualized return = ($200×2) / $8,000 = 5%
🧠 Concept Clarity:
Annual Rate of Return = "What if I earned that income rate for a whole year?"

📈 Relationship Between Risk and Return

"No reward without risk"
 Higher Risk → Higher Required Return
 Lower Risk → Lower Return Accepted
📌 Decision Rules for Investors:
Scenario Investor Will Choose
Same return, different risk Lower-risk asset
Same risk, different return Higher-return asset
🧠 Key Concept:
Investors aim to maximize return for a given level of risk or minimize risk for a given return.

🧮 Ranking of Investments by Risk (From Lowest to Highest)

Rank Investment Type Description
1️⃣ U.S. Treasury Securities Risk-free benchmark
2️⃣ First Mortgage Bonds Secured with top-priority collateral
3️⃣ Second Mortgage Bonds Secured, but second in claim after first mortgage
4️⃣ Income Bonds Pay interest only if company has sufficient income
5️⃣ Debenture Bonds Unsecured bonds (no collateral)
6️⃣ Preferred Stock Fixed dividends, less risky than common stock
Convertible Preferred Can convert to common shares; riskier than regular
7️⃣
Stock preferred
8️⃣ Common Stock Highest risk — residual claim in bankruptcy
📝 Important Note:
 Actual risk depends on specific terms.
o A strong income bond might be less risky than a weak subordinated debenture.
 This ranking is general and used for exam comparison purposes.
🧠 Quick Recap: CMA-Friendly Summary
Concept Systematic Risk Unsystematic Risk
Affects All Assets? ✅ Yes ❌ No
Can be Diversified Away? ❌ No ✅ Yes
Inflation, War, Market Company Strike, Credit
Examples
Crash Default
Key Mitigation Tool None Diversification

✅ Key Exam-Ready Takeaways

 Systematic = Market-wide risk, can’t diversify away.
 Unsystematic = Company/industry-specific, can be diversified away.
 Know the order of risk for investment instruments.
 Understand how to annualize return based on time held.
 CMA loves to test on risk vs. return logic — especially investor choice scenarios.
📘 CMA Part 2: Study Unit 2 — Capital Asset Pricing Model (CAPM)

🧠 Purpose of CAPM
 CAPM estimates the required rate of return on a security, based on its systematic (market)
risk.
 It helps determine the minimum return investors expect for the risk taken.
🔑 Investor's Required Rate of Return = The minimum return needed to justify investment risk.
CAPM assumes that investors:
 Are rational and risk-averse
 Will only invest in riskier assets if compensated with higher returns

📏 CAPM Formula
Required Return=Rf+β×(Rm−Rf)\text{Required Return} = R_f + \beta \times (R_m -
R_f)Required Return=Rf+β×(Rm−Rf)
Where:
Symbol Meaning
RfR_fRf Risk-free rate (e.g., U.S. Treasury rate)
RmR_mRm Expected market return (e.g., S&P 500)
Rm−RfR_m - R_fRm−Rf Market risk premium
β\betaβ Beta — measure of systematic risk
Minimum return an investor requires given the asset's
Required Return
risk

🧮 What is Beta (β)?

Beta = Measurement of how much a security’s returns move relative to the market.
Beta
Meaning Interpretation
Value
= 1.0 Same as market Security moves exactly with the market
> 1.0 More volatile Security moves more than market (aggressive)
0<β<1 Less volatile Security moves less than market (defensive)
=0 No correlation Return is independent of the market
Negative
<0 Security moves opposite to the market
correlation
📝 Example:
 If a stock has a beta of 1.25, and the market increases by 8%, the stock is expected to increase
by 10% (8% × 1.25).

📉 Types of Securities by Beta

Security Type Beta Risk Level
Defensive Stock < 1.0 Lower volatility
Market-average
= 1.0 Same risk as market
Stock
Aggressive Stock > 1.0 Higher volatility
Risk-Free Asset = 0 No systematic risk
Hedging Asset < 0 Moves opposite to market
🔎 Negative Beta Stocks:
Could hedge during downturns but underperform in rising markets → leads to opportunity cost +
inflation risk.

📈 Understanding Systematic Risk in CAPM

 CAPM only focuses on systematic risk, not unsystematic risk.
 Systematic risk cannot be diversified away.
 Investors should be compensated only for systematic risk (unsystematic risk can be avoided via
diversification).

📊 Key Notes on Beta

 Beta is based on historical data — how a security’s returns co-varied with the market.
 CAPM uses beta as the only risk input.
 You do not need to calculate beta for the exam — it will be given.

🧪 CAPM Example Question

Assume:
 Risk-free rate Rf=4%R_f = 4\%Rf=4%
 Market return Rm=10%R_m = 10\%Rm=10%
 Stock Beta β=1.5\beta = 1.5β=1.5
What is the investor’s required rate of return?
=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%= 4\% + 1.5 \times (10\% - 4\%) = 4\% + 1.5 \times 6\% =
4\% + 9\% = \boxed{13\%}=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%

📚 Key Terms to Remember

Term Definition
Risk-Free Rate Return on a security with no risk (usually Treasury bills)
Market Return Expected return from the overall market
Rm−RfR_m - R_fRm−Rf: Extra return expected over risk-
Market Risk Premium
free
Beta (β) Measure of a security’s volatility compared to the market
Required Return Minimum return investor needs given the risk

📝 CAPM Summary for Exam

Concept Key Point
Used for Estimating required return
Based on Systematic risk only
Key input Beta (provided on exam)
Risk-free
Treasury securities
proxy
Formula Rf+β(Rm−Rf)R_f + \beta(R_m - R_f)Rf+β(Rm−Rf)
Beta = 1 Market-matching risk
Beta > 1 More volatile than market
Beta < 1 Less volatile than market
Beta < 0 Moves opposite market
📘 CMA Part 2 – Study Unit 2: B.1 – Capital Asset Pricing Model (CAPM) – Part 2

📊 Market Portfolio (Rm): What Does It Represent?

 In CAPM, the market portfolio represents all investable stocks, weighted by their market
value.
 In practice, it is approximated by the S&P 500 Index.
✅ Key Facts about the Market Portfolio:
 S&P 500 = Most commonly used benchmark index.
 The expected return for the market (Rm) is often estimated using historical average annualized
returns.
📈 Examples of S&P 500 Average Returns:
Time Period Avg Annual Return
1926–2023 10.30%
1957–2023 10.39%
2013–2023 13.79%
2001–2023 7.78%
💡 On the exam, the market return (Rm) will be given — no need to memorize historical numbers.

📐 CAPM Formula (Repeat & Breakdown)

R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Where:
Symbol Meaning
RRR Investors’ required rate of return
RfR_fRf Risk-free rate (e.g., Treasury bonds)
β\betaβ Beta of the stock (systematic risk)
Expected market return (S&P 500
RmR_mRm
return)

🧠 Understanding Risk Premiums

📌 Market Risk Premium:
Rm−RfR_m - R_fRm−Rf
 This is the extra return investors demand for taking on market risk instead of investing in risk-
free assets.
📌 Stock-Specific Risk Premium:
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
 Adjusts the market risk premium by beta, making it specific to a particular stock's volatility.

🧮 CAPM Example (From Text)

Assume:
 β=0.8\beta = 0.8β=0.8
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%R = 0.5\% + 0.8(6.5\% - 0.5\%) = 0.5\% + 0.8 \
times 6\% = 0.5\% + 4.8\% = \boxed{5.3\%}R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%
✅ This means investors expect 5.3% from this stock, lower than the market's return because its beta is
below 1.0 → less risky.

🔁 How Beta Affects Required Return and Stock Value

🔼 If Beta Increases:
 Required return increases
 Discounted value of stock decreases (intrinsic value ↓)
 Market price likely falls
🔽 If Beta Decreases:
 Required return decreases
 Intrinsic value increases
 Market price likely rises

🧮 Example: Beta Change Impact

If beta increases from 0.8 to 1.1:
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%R = 0.5\% + 1.1(6.5\% - 0.5\%) = 0.5\% + 1.1 \
times 6\% = 0.5\% + 6.6\% = \boxed{7.1\%}R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%
🔺 Investors now demand 7.1%, a higher return because the stock is now riskier than the market (beta >
1).

📚 CAPM Takeaways for the CMA Exam

Concept Summary
Market Portfolio Usually represented by the S&P 500
Expected Market Return
Based on historical average return
(Rm)
CAPM Formula R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Risk-Free Rate (Rf) Usually a short/intermediate Treasury rate
Market Risk Premium Rm−RfR_m - R_fRm−Rf
Stock-Specific Risk
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
Premium
Beta’s Impact ↑ Beta → ↑ Required Return → ↓ Value; ↓ Beta → ↓ Required Return
 → ↑ Value
On Exam Rf, Rm, and Beta will be provided
📘 Smart Notes – Security Market Line (SML) (CMA Part 2 – Study Unit 2: B.1.)

1. Definition of Security Market Line (SML)

 SML = The graphical representation of the Capital Asset Pricing Model (CAPM).
 It shows the predicted investors’ required rate of return for a security, given its level of
systematic risk (beta).
 Helps investors evaluate whether securities are fairly priced, underpriced, or overpriced.

2. Structure of the SML Graph

 X-axis (horizontal): Beta (systematic risk).
 Y-axis (vertical): Required return (investors’ expected/required rate of return).
 Intercept: The SML intersects the y-axis at the risk-free rate (RF) (where beta = 0).
 Slope of SML: Represents the market risk premium = (RM − RF).
👉 Formula:
R=RF+β×(RM−RF)R = R_F + \beta \times (R_M - R_F)R=RF+β×(RM−RF)
Where:
 RRR = Required return for the security
 RFR_FRF = Risk-free rate
 RMR_MRM = Expected return of the market portfolio
 β\betaβ = Systematic risk of the security

3. Important Beta Values

 Beta = 0 → Security has no systematic risk (risk-free asset). Required return = RF.
 Beta = 1 → Security has same risk as the market portfolio. Required return = RM.
 Beta > 1 → Security is riskier than the market, requires higher return.
 Beta < 1 → Security is less risky than the market, requires lower return.

4. Example Values (from graph in text)

 Risk-free rate (RF) = 0.5%.
 Market portfolio expected return (RM) = 4.0%.
 Market risk premium = RM − RF = 4.0% − 0.5% = 3.5%.
 Required returns at different betas (from SML):
Beta (β) Required Return (R)
0.0 0.5%
0.5 2.25%
1.0 4.0%
1.5 5.75%
2.0 7.5%
👉 Example calculation for β = 2.0:
R=0.5%+2.0×(4.0%−0.5%)=7.5%R = 0.5\% + 2.0 \times (4.0\% - 0.5\%) = 7.5\%R=0.5%+2.0×(4.0%
−0.5%)=7.5%
 Risk premium = 7.0% (7.5% − 0.5%).
 Notice: Risk premium doubles when beta doubles → shows linear relationship.

5. Risk Premium Insights

  Market portfolio (β = 1.0): Risk premium = 3.5%.

Key Point: Risk premium ∝ Beta.

 Security with β = 2.0: Risk premium = 7.0% → exactly twice that of market portfolio.


6. Using the SML

 Any individual security can be plotted on the SML using its beta and expected return.
 Comparison of security’s expected return with the SML helps determine:
o Undervalued security → Lies above SML (expected return > required return). Investors
will buy → price rises → return falls until on SML.
o Overvalued security → Lies below SML (expected return < required return). Investors
will sell → price falls → return rises until on SML.
 In equilibrium (efficient market): All correctly priced securities lie exactly on the SML.

7. Example – Stock A and Stock C

 Stock A:
o Beta = 0.5
o Market price gives return = 4%
o Required return (from SML) = 2%
o Since actual return (4%) > required (2%), Stock A lies above SML → undervalued →
good investment.
o Eventually, price will rise until return drops to 2%.
 Stock C:
o Beta = 1.5
o Market price gives return = 2%
o Required return (from SML) = 5.75%
o Since actual return (2%) < required (5.75%), Stock C lies below SML → overvalued →
bad investment.
o Eventually, price will fall until return rises to 5.75%.

8. Exam-Focused Key Points

 Formula to memorize:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Market portfolio always has β = 1.
 SML intercept = RF.
 Slope = (RM − RF).
 If security above SML → undervalued; below SML → overvalued.
 Risk premium increases proportionally with beta.

9. Extra Concept Clarity (Beyond Book)

 Why SML is important:
o Helps in pricing securities relative to risk.
o Guides investors whether to buy, hold, or sell.
o Used in portfolio management and corporate finance for cost of equity calculation.
 Difference from CML (Capital Market Line):
o SML: Considers systematic risk (beta). Applicable to any individual security or
portfolio.
o CML: Considers total risk (σ, standard deviation). Only applies to efficient portfolios.
  Practical application in CMA/Finance:
o Used to estimate cost of equity for valuation models.
o Helps in capital budgeting (discount rate for risky projects).
o Used in performance evaluation (e.g., Jensen’s Alpha compares actual return vs. return
predicted by SML).
📘 Smart Notes – Impact of Changing Market Conditions on the Security Market Line (SML)
(CMA Part 2 – Study Unit 2: B.1. CAPM)

1. SML Recap
 SML (Security Market Line): Shows linear relationship between systematic risk (β) and
investors’ required return (R).
 Formula:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Intercept (y-axis): Risk-free rate (RF).
 Slope: Market risk premium = (RM−RF)(R_M - R_F)(RM−RF).

2. Impact of Changes in Market Conditions on the SML

Changes in RF or market risk premium will shift or tilt the SML.

(A) Change in the Risk-Free Rate (RF)

 If RF increases, the y-intercept of the SML moves upward.
 Example:
o Original RF = 0.5% → intercept = 0.5%.
o New RF = 1.5% → intercept = 1.5%.
 Effect: The entire SML shifts upward in parallel.
 Slope does NOT change (as long as (RM−RF)(R_M - R_F)(RM−RF) is constant).
 Every security’s required return increases by the same amount (in this case, +1%).
👉 Market portfolio (β = 1.0):
 Original required return = 4.0%.
 New required return = 5.0%.
 Increase = same as RF change (+1%).
📊 Graph impact:
 The entire line shifts upward by 1%, but slope remains identical.

(B) Change in Investors’ Risk Aversion

 If investors become more risk averse:
o They demand a higher return per unit of risk.
o This means the market risk premium increases.
o The slope of the SML increases (line gets steeper).
 Effect: Required return increases more sharply as β increases.
👉 Example:
 Before: Required return at β = 1.0 may be 6%.
 After: With more risk aversion, required return at β = 1.0 may rise to 7.5%.
📊 Graph impact:
 Same intercept at RF (since RF is unchanged).
 But slope (tilt) of line becomes steeper, reflecting greater premium for risk.

3. Key Distinctions in Graph Shifts

 Intercept
Market Change Effect on SML Slope (RM − RF)
(RF)
↑ Risk-free rate (RF) Line shifts upward (parallel move) Increases Unchanged
↑ Investor risk Line gets steeper (rotates
Unchanged Increases
aversion upward)

4. Exam-Focused Key Points

 RF affects intercept only.
 Risk aversion affects slope.
 A parallel upward shift occurs when RF changes.
 A steeper line occurs when market risk premium increases.
 Market portfolio (β = 1) always lies on SML — only its position changes with new slope or
intercept.

5. Extra Concept Clarity (Beyond Book)

 Why RF matters:
o Represents the minimum return investors will accept (no risk investment, like T-bills).
o If government bond yields rise, all required returns rise in the market (cost of equity
↑).
 Why investor risk aversion matters:
o Reflects investor psychology and macro conditions.
o During crises (e.g., recession, financial crash), risk aversion rises → investors demand
higher returns for same risk → cost of capital increases for companies.
o During stable periods, risk aversion is lower → flatter SML → cheaper cost of capital.
 Practical Implications in Finance/CMA:
o Corporate Finance: Changes in RF and market risk premium directly impact WACC and
investment decisions.
o Portfolio Management: Helps adjust return expectations when market risk perceptions
change.
o Valuation: If risk aversion increases, stock valuations fall (since required return ↑,
discount rate ↑).
📘 Portfolio Risk and Return
1. Portfolio Basics
 Portfolio = Collection of assets managed as a group.
o Individual investor: mix of stocks, bonds, marketable securities.
o Company: securities, shares, debt, subsidiaries, projects, etc.
 Portfolio management: process of maximizing return for a given risk.
2. Portfolio Theory (Modern Portfolio Theory)
 Aims to build an optimal portfolio balancing risk & return.
 Securities should not be evaluated in isolation but in terms of how their returns move relative to
other securities in the portfolio.
3. Diversification
 Definition: Investing across different securities to reduce risk.
 Unsystematic risk (also: specific, diversifiable, non-market risk):
o Can be minimized by diversification.
o Caused by firm/industry factors → e.g., labor strike, plant fire, competitor patent.
 Systematic risk (market risk):
 o Cannot be diversified away.
o Affects all firms (e.g., inflation, recession, interest rate changes).
 Efficient (Fully Diversified) Portfolio:
o Provides highest return for a given unsystematic risk or lowest unsystematic risk for a
given return.
o Still subject to systematic risk.
Key Note: Diversification reduces unsystematic risk but not systematic risk.

4. Asset Allocation
 Process of selecting the right mix of assets (bonds, stocks, real estate, short/long term, high/low
risk, etc.).
 Proper allocation = balances risk & return.
 Correctly diversified portfolio → portfolio risk is less than the average risk of individual
securities.

5. Correlation in Portfolio Theory

 Correlation: tendency of two variables to move together.
o Positive correlation: move in same direction.
o Negative correlation: move in opposite directions.
o No correlation: movements are unrelated.
 Coefficient of Correlation (r):
o Range = −1 to +1.
o Measures direction & strength of relationship between securities’ returns.
o Calculated using historical returns in Excel, calculator, or statistics software.
Interpretation of r values:
r Value Relationship Type Meaning
+1 Perfect Positive Returns move identically together.
Returns move in same direction, different
0.01 → 0.99 Positive (but imperfect)
magnitudes.
0 No correlation No relationship in movement.
Negative (but
−0.01 → −0.99 Move in opposite directions, not perfectly.
imperfect)
−1 Perfect Negative Returns move exactly opposite (e.g., +7% vs. −7%).
 Diversification tip: Combine securities with low or negative correlation to reduce risk.

6. Efficient Portfolios via Quantitative Tools

 To identify efficient portfolios → use quadratic programming (variation of linear programming).
 Inputs required:
1. Expected return of each stock.
2. Standard deviation (risk measure) of each stock.
3. Correlation coefficient between stock pairs.
 Output = Set of efficient portfolios (best risk/return combinations).

7. Standard Deviation (σ)

 Definition: Statistical measure of variation/dispersion in returns.
 Used as a quantitative measure of risk.
 Higher standard deviation → wider spread of possible returns → riskier investment.
⚡ Extra Concept Clarity
 Systematic risk = cannot diversify (market-wide). Managed via hedging or asset classes (not
diversification).
 Unsystematic risk = diversifiable. Can nearly be eliminated with ~20–30 well-chosen stocks.
 Efficient Frontier: Set of portfolios that maximize return for a given risk (or minimize risk for a
given return).
 Key CMA takeaway: Portfolio risk is not just the sum of individual risks; correlation plays a
critical role.
📘 Long-Term Financial Management
1. Definition
 Long term = more than one year.
 Concerned with how a company finances its assets over the long run.
 Key issue: balance between debt vs. equity financing.

2. Capital Structure
 Capital Structure = mix of long-term debt and equity on a company’s balance sheet.
 Financing sources:
o Short-term → for working capital, seasonal needs.
o Long-term → for permanent assets (plants, equipment, investments).
 Long-term financing is classified into:
o External funds (debt, equity, leasing, etc.).
o Internal funds (retained earnings).

3. External Sources of Long-Term Capital

(a) Long-Term Debt
 Raised through bank loans or debt securities (bonds).
 Debt is rolled over (refinanced) → effectively becomes permanent financing if firm is
creditworthy.
 Bonds:
o Have par value.
o Pay stated interest rate (coupon).
o Borrowers are legally obligated to pay interest + principal.
o Failure to pay = default → possible bankruptcy or seizure of collateral.
(b) Common Stock
 Represents ownership + voting rights.
 Shareholders may:
o Vote on key issues (board, mergers, etc.).
o Receive dividends (only if declared by board).
 Dividends:
o Paid from retained earnings.
o Not guaranteed.
o Some firms pay none (retain all earnings), others follow stable/increasing dividend
policies.
(c) Preferred Stock
 Hybrid security (shares traits of both debt & equity).
 Similar to bonds: pays a fixed dividend % of par value (e.g., 8%).
  Similar to common stock:
o No maturity date.
o Dividend is not obligatory; nonpayment does not trigger bankruptcy.
 Typically, companies try to pay preferred dividends if possible.
CMA Focus: On exams, emphasis is on debt (bonds) and equity (shares) as main sources of external
financing.

4. Internal Sources of Capital

 Retained earnings (profits not distributed as dividends).
 Advantages:
o No direct cash outflow (no interest/dividends).
 Consideration:
o Shareholders expect a return on retained earnings (opportunity cost).

✅ Key Takeaways for CMA:

1. Long-term financial management balances cost, risk, and ownership control.
2. Debt = tax deductible interest, but risk of default.
3. Equity = ownership dilution, dividends optional.
4. Preferred stock = fixed dividend but flexible compared to debt.
5. Retained earnings = cheapest source (no cash cost), but still has implied shareholder return.
📘 Determining the Optimal Capital Structure
 Definition: Mix of long-term debt and equity used to finance assets.
 Goal: Minimize the company’s overall cost of capital.
 Usually achieved through a combination of financing sources.
Factors in Determining Optimal Structure
 Future prospects / business risk: higher risk → conservative financing.
 Equity market conditions: weak markets reduce proceeds from stock issuance.
 Risk tolerance: debt is riskier than equity (default risk, bankruptcy).
 Reputation of issuer & interest rates: weaker creditworthiness → higher debt cost.
 Cost of capital: management must compare the cost of debt, preferred, and equity; CMA exam
requires calculations of cost of each and overall WACC.
Capital Structure Expression
 Usually expressed in percentages (e.g., 40% debt, 10% preferred, 50% common equity).
 Can be based on book values or market values.
 For cost of capital calculations → use market values.
🧮 Ranking of Investments by Risk (From Lowest to Highest)
Rank Investment Type Description
1️⃣ U.S. Treasury Securities Risk-free benchmark
2️⃣ First Mortgage Bonds Secured with top-priority collateral
3️⃣ Second Mortgage Bonds Secured, but second in claim after first mortgage
4️⃣ Income Bonds Pay interest only if company has sufficient income
5️⃣ Debenture Bonds Unsecured bonds (no collateral)
6️⃣ Preferred Stock Fixed dividends, less risky than common stock
Convertible Preferred Can convert to common shares; riskier than regular
7️⃣
Stock preferred
8️⃣ Common Stock Highest risk — residual claim in bankruptcy
📝 Important Note:
  Actual risk depends on specific terms.
o A strong income bond might be less risky than a weak subordinated debenture.
 This ranking is general and used for exam comparison purposes.

🧠 Quick Recap: CMA-Friendly Summary

Concept Systematic Risk Unsystematic Risk
Affects All Assets? ✅ Yes ❌ No
Can be Diversified Away? ❌ No ✅ Yes
Inflation, War, Market Company Strike, Credit
Examples
Crash Default
Key Mitigation Tool None Diversification

✅ Key Exam-Ready Takeaways

 Systematic = Market-wide risk, can’t diversify away.
 Unsystematic = Company/industry-specific, can be diversified away.
 Know the order of risk for investment instruments.
 Understand how to annualize return based on time held.
 CMA loves to test on risk vs. return logic — especially investor choice scenarios.
📘 CMA Part 2: Study Unit 2 — Capital Asset Pricing Model (CAPM)

🧠 Purpose of CAPM
 CAPM estimates the required rate of return on a security, based on its systematic (market)
risk.
 It helps determine the minimum return investors expect for the risk taken.
🔑 Investor's Required Rate of Return = The minimum return needed to justify investment risk.
CAPM assumes that investors:
 Are rational and risk-averse
 Will only invest in riskier assets if compensated with higher returns

📏 CAPM Formula
Required Return=Rf+β×(Rm−Rf)\text{Required Return} = R_f + \beta \times (R_m -
R_f)Required Return=Rf+β×(Rm−Rf)
Where:
Symbol Meaning
RfR_fRf Risk-free rate (e.g., U.S. Treasury rate)
RmR_mRm Expected market return (e.g., S&P 500)
Rm−RfR_m - R_fRm−Rf Market risk premium
β\betaβ Beta — measure of systematic risk
Minimum return an investor requires given the asset's
Required Return
risk

🧮 What is Beta (β)?

Beta = Measurement of how much a security’s returns move relative to the market.
Beta
Meaning Interpretation
Value
= 1.0 Same as market Security moves exactly with the market
> 1.0 More volatile Security moves more than market (aggressive)
0<β<1 Less volatile Security moves less than market (defensive)
=0 No correlation Return is independent of the market
Negative
<0 Security moves opposite to the market
correlation
📝 Example:
 If a stock has a beta of 1.25, and the market increases by 8%, the stock is expected to increase
by 10% (8% × 1.25).

📉 Types of Securities by Beta

Security Type Beta Risk Level
Defensive Stock < 1.0 Lower volatility
Market-average
= 1.0 Same risk as market
Stock
Aggressive Stock > 1.0 Higher volatility
Risk-Free Asset = 0 No systematic risk
Hedging Asset < 0 Moves opposite to market
🔎 Negative Beta Stocks:
Could hedge during downturns but underperform in rising markets → leads to opportunity cost +
inflation risk.

📈 Understanding Systematic Risk in CAPM

 CAPM only focuses on systematic risk, not unsystematic risk.
 Systematic risk cannot be diversified away.
 Investors should be compensated only for systematic risk (unsystematic risk can be avoided via
diversification).

📊 Key Notes on Beta

 Beta is based on historical data — how a security’s returns co-varied with the market.
 CAPM uses beta as the only risk input.
 You do not need to calculate beta for the exam — it will be given.

🧪 CAPM Example Question

Assume:
 Risk-free rate Rf=4%R_f = 4\%Rf=4%
 Market return Rm=10%R_m = 10\%Rm=10%
 Stock Beta β=1.5\beta = 1.5β=1.5
What is the investor’s required rate of return?
=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%= 4\% + 1.5 \times (10\% - 4\%) = 4\% + 1.5 \times 6\% =
4\% + 9\% = \boxed{13\%}=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%

📚 Key Terms to Remember

Term Definition
Risk-Free Rate Return on a security with no risk (usually Treasury bills)
Market Return Expected return from the overall market
Rm−RfR_m - R_fRm−Rf: Extra return expected over risk-
Market Risk Premium
free
Beta (β) Measure of a security’s volatility compared to the market
Required Return Minimum return investor needs given the risk

📝 CAPM Summary for Exam

Concept Key Point
Used for Estimating required return
Based on Systematic risk only
Key input Beta (provided on exam)
Risk-free
Treasury securities
proxy
Formula Rf+β(Rm−Rf)R_f + \beta(R_m - R_f)Rf+β(Rm−Rf)
Beta = 1 Market-matching risk
Beta > 1 More volatile than market
Beta < 1 Less volatile than market
Beta < 0 Moves opposite market
📘 CMA Part 2 – Study Unit 2: B.1 – Capital Asset Pricing Model (CAPM) – Part 2

📊 Market Portfolio (Rm): What Does It Represent?

 In CAPM, the market portfolio represents all investable stocks, weighted by their market
value.
 In practice, it is approximated by the S&P 500 Index.
✅ Key Facts about the Market Portfolio:
 S&P 500 = Most commonly used benchmark index.
 The expected return for the market (Rm) is often estimated using historical average annualized
returns.
📈 Examples of S&P 500 Average Returns:
Time Period Avg Annual Return
1926–2023 10.30%
1957–2023 10.39%
2013–2023 13.79%
2001–2023 7.78%
💡 On the exam, the market return (Rm) will be given — no need to memorize historical numbers.

📐 CAPM Formula (Repeat & Breakdown)

R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Where:
Symbol Meaning
RRR Investors’ required rate of return
RfR_fRf Risk-free rate (e.g., Treasury bonds)
β\betaβ Beta of the stock (systematic risk)
RmR_mRm Expected market return (S&P 500
 return)

🧠 Understanding Risk Premiums

📌 Market Risk Premium:
Rm−RfR_m - R_fRm−Rf
 This is the extra return investors demand for taking on market risk instead of investing in risk-
free assets.
📌 Stock-Specific Risk Premium:
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
 Adjusts the market risk premium by beta, making it specific to a particular stock's volatility.

🧮 CAPM Example (From Text)

Assume:
 β=0.8\beta = 0.8β=0.8
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%R = 0.5\% + 0.8(6.5\% - 0.5\%) = 0.5\% + 0.8 \
times 6\% = 0.5\% + 4.8\% = \boxed{5.3\%}R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%
✅ This means investors expect 5.3% from this stock, lower than the market's return because its beta is
below 1.0 → less risky.

🔁 How Beta Affects Required Return and Stock Value

🔼 If Beta Increases:
 Required return increases
 Discounted value of stock decreases (intrinsic value ↓)
 Market price likely falls
🔽 If Beta Decreases:
 Required return decreases
 Intrinsic value increases
 Market price likely rises

🧮 Example: Beta Change Impact

If beta increases from 0.8 to 1.1:
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%R = 0.5\% + 1.1(6.5\% - 0.5\%) = 0.5\% + 1.1 \
times 6\% = 0.5\% + 6.6\% = \boxed{7.1\%}R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%
🔺 Investors now demand 7.1%, a higher return because the stock is now riskier than the market (beta >
1).

📚 CAPM Takeaways for the CMA Exam

Concept Summary
Market Portfolio Usually represented by the S&P 500
Expected Market Return
Based on historical average return
(Rm)
CAPM Formula R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Risk-Free Rate (Rf) Usually a short/intermediate Treasury rate
Market Risk Premium Rm−RfR_m - R_fRm−Rf
Stock-Specific Risk
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
Premium
↑ Beta → ↑ Required Return → ↓ Value; ↓ Beta → ↓ Required Return
Beta’s Impact
→ ↑ Value
On Exam Rf, Rm, and Beta will be provided
📘 Smart Notes – Security Market Line (SML) (CMA Part 2 – Study Unit 2: B.1.)

1. Definition of Security Market Line (SML)

 SML = The graphical representation of the Capital Asset Pricing Model (CAPM).
 It shows the predicted investors’ required rate of return for a security, given its level of
systematic risk (beta).
 Helps investors evaluate whether securities are fairly priced, underpriced, or overpriced.

2. Structure of the SML Graph

 X-axis (horizontal): Beta (systematic risk).
 Y-axis (vertical): Required return (investors’ expected/required rate of return).
 Intercept: The SML intersects the y-axis at the risk-free rate (RF) (where beta = 0).
 Slope of SML: Represents the market risk premium = (RM − RF).
👉 Formula:
R=RF+β×(RM−RF)R = R_F + \beta \times (R_M - R_F)R=RF+β×(RM−RF)
Where:
 RRR = Required return for the security
 RFR_FRF = Risk-free rate
 RMR_MRM = Expected return of the market portfolio
 β\betaβ = Systematic risk of the security

3. Important Beta Values

 Beta = 0 → Security has no systematic risk (risk-free asset). Required return = RF.
 Beta = 1 → Security has same risk as the market portfolio. Required return = RM.
 Beta > 1 → Security is riskier than the market, requires higher return.
 Beta < 1 → Security is less risky than the market, requires lower return.

4. Example Values (from graph in text)

 Risk-free rate (RF) = 0.5%.
 Market portfolio expected return (RM) = 4.0%.
 Market risk premium = RM − RF = 4.0% − 0.5% = 3.5%.
 Required returns at different betas (from SML):
Beta (β) Required Return (R)
0.0 0.5%
0.5 2.25%
1.0 4.0%
1.5 5.75%
2.0 7.5%
👉 Example calculation for β = 2.0:
R=0.5%+2.0×(4.0%−0.5%)=7.5%R = 0.5\% + 2.0 \times (4.0\% - 0.5\%) = 7.5\%R=0.5%+2.0×(4.0%
−0.5%)=7.5%
  Risk premium = 7.0% (7.5% − 0.5%).
 Notice: Risk premium doubles when beta doubles → shows linear relationship.

5. Risk Premium Insights

 Market portfolio (β = 1.0): Risk premium = 3.5%.

 Key Point: Risk premium ∝ Beta.

 Security with β = 2.0: Risk premium = 7.0% → exactly twice that of market portfolio.

6. Using the SML

 Any individual security can be plotted on the SML using its beta and expected return.
 Comparison of security’s expected return with the SML helps determine:
o Undervalued security → Lies above SML (expected return > required return). Investors
will buy → price rises → return falls until on SML.
o Overvalued security → Lies below SML (expected return < required return). Investors
will sell → price falls → return rises until on SML.
 In equilibrium (efficient market): All correctly priced securities lie exactly on the SML.

7. Example – Stock A and Stock C

 Stock A:
o Beta = 0.5
o Market price gives return = 4%
o Required return (from SML) = 2%
o Since actual return (4%) > required (2%), Stock A lies above SML → undervalued →
good investment.
o Eventually, price will rise until return drops to 2%.
 Stock C:
o Beta = 1.5
o Market price gives return = 2%
o Required return (from SML) = 5.75%
o Since actual return (2%) < required (5.75%), Stock C lies below SML → overvalued →
bad investment.
o Eventually, price will fall until return rises to 5.75%.

8. Exam-Focused Key Points

 Formula to memorize:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Market portfolio always has β = 1.
 SML intercept = RF.
 Slope = (RM − RF).
 If security above SML → undervalued; below SML → overvalued.
 Risk premium increases proportionally with beta.

9. Extra Concept Clarity (Beyond Book)

 Why SML is important:
o Helps in pricing securities relative to risk.
o Guides investors whether to buy, hold, or sell.
o Used in portfolio management and corporate finance for cost of equity calculation.
  Difference from CML (Capital Market Line):
o SML: Considers systematic risk (beta). Applicable to any individual security or
portfolio.
o CML: Considers total risk (σ, standard deviation). Only applies to efficient portfolios.
 Practical application in CMA/Finance:
o Used to estimate cost of equity for valuation models.
o Helps in capital budgeting (discount rate for risky projects).
o Used in performance evaluation (e.g., Jensen’s Alpha compares actual return vs. return
predicted by SML).
📘 Smart Notes – Impact of Changing Market Conditions on the Security Market Line (SML)
(CMA Part 2 – Study Unit 2: B.1. CAPM)

1. SML Recap
 SML (Security Market Line): Shows linear relationship between systematic risk (β) and
investors’ required return (R).
 Formula:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Intercept (y-axis): Risk-free rate (RF).
 Slope: Market risk premium = (RM−RF)(R_M - R_F)(RM−RF).

2. Impact of Changes in Market Conditions on the SML

Changes in RF or market risk premium will shift or tilt the SML.

(A) Change in the Risk-Free Rate (RF)

 If RF increases, the y-intercept of the SML moves upward.
 Example:
o Original RF = 0.5% → intercept = 0.5%.
o New RF = 1.5% → intercept = 1.5%.
 Effect: The entire SML shifts upward in parallel.
 Slope does NOT change (as long as (RM−RF)(R_M - R_F)(RM−RF) is constant).
 Every security’s required return increases by the same amount (in this case, +1%).
👉 Market portfolio (β = 1.0):
 Original required return = 4.0%.
 New required return = 5.0%.
 Increase = same as RF change (+1%).
📊 Graph impact:
 The entire line shifts upward by 1%, but slope remains identical.

(B) Change in Investors’ Risk Aversion

 If investors become more risk averse:
o They demand a higher return per unit of risk.
o This means the market risk premium increases.
o The slope of the SML increases (line gets steeper).
 Effect: Required return increases more sharply as β increases.
👉 Example:
 Before: Required return at β = 1.0 may be 6%.
 After: With more risk aversion, required return at β = 1.0 may rise to 7.5%.
📊 Graph impact:
 Same intercept at RF (since RF is unchanged).
 But slope (tilt) of line becomes steeper, reflecting greater premium for risk.

3. Key Distinctions in Graph Shifts

Intercept
Market Change Effect on SML Slope (RM − RF)
(RF)
↑ Risk-free rate (RF) Line shifts upward (parallel move) Increases Unchanged
↑ Investor risk Line gets steeper (rotates
Unchanged Increases
aversion upward)

4. Exam-Focused Key Points

 RF affects intercept only.
 Risk aversion affects slope.
 A parallel upward shift occurs when RF changes.
 A steeper line occurs when market risk premium increases.
 Market portfolio (β = 1) always lies on SML — only its position changes with new slope or
intercept.

5. Extra Concept Clarity (Beyond Book)

 Why RF matters:
o Represents the minimum return investors will accept (no risk investment, like T-bills).
o If government bond yields rise, all required returns rise in the market (cost of equity
↑).
 Why investor risk aversion matters:
o Reflects investor psychology and macro conditions.
o During crises (e.g., recession, financial crash), risk aversion rises → investors demand
higher returns for same risk → cost of capital increases for companies.
o During stable periods, risk aversion is lower → flatter SML → cheaper cost of capital.
 Practical Implications in Finance/CMA:
o Corporate Finance: Changes in RF and market risk premium directly impact WACC and
investment decisions.
o Portfolio Management: Helps adjust return expectations when market risk perceptions
change.
o Valuation: If risk aversion increases, stock valuations fall (since required return ↑,
discount rate ↑).
📘 Portfolio Risk and Return
1. Portfolio Basics
 Portfolio = Collection of assets managed as a group.
o Individual investor: mix of stocks, bonds, marketable securities.
o Company: securities, shares, debt, subsidiaries, projects, etc.
 Portfolio management: process of maximizing return for a given risk.
2. Portfolio Theory (Modern Portfolio Theory)
 Aims to build an optimal portfolio balancing risk & return.
 Securities should not be evaluated in isolation but in terms of how their returns move relative to
other securities in the portfolio.
3. Diversification
  Definition: Investing across different securities to reduce risk.
 Unsystematic risk (also: specific, diversifiable, non-market risk):
o Can be minimized by diversification.
o Caused by firm/industry factors → e.g., labor strike, plant fire, competitor patent.
 Systematic risk (market risk):
o Cannot be diversified away.
o Affects all firms (e.g., inflation, recession, interest rate changes).
 Efficient (Fully Diversified) Portfolio:
o Provides highest return for a given unsystematic risk or lowest unsystematic risk for a
given return.
o Still subject to systematic risk.
Key Note: Diversification reduces unsystematic risk but not systematic risk.

4. Asset Allocation
 Process of selecting the right mix of assets (bonds, stocks, real estate, short/long term, high/low
risk, etc.).
 Proper allocation = balances risk & return.
 Correctly diversified portfolio → portfolio risk is less than the average risk of individual
securities.

5. Correlation in Portfolio Theory

 Correlation: tendency of two variables to move together.
o Positive correlation: move in same direction.
o Negative correlation: move in opposite directions.
o No correlation: movements are unrelated.
 Coefficient of Correlation (r):
o Range = −1 to +1.
o Measures direction & strength of relationship between securities’ returns.
o Calculated using historical returns in Excel, calculator, or statistics software.
Interpretation of r values:
r Value Relationship Type Meaning
+1 Perfect Positive Returns move identically together.
Returns move in same direction, different
0.01 → 0.99 Positive (but imperfect)
magnitudes.
0 No correlation No relationship in movement.
Negative (but
−0.01 → −0.99 Move in opposite directions, not perfectly.
imperfect)
−1 Perfect Negative Returns move exactly opposite (e.g., +7% vs. −7%).
 Diversification tip: Combine securities with low or negative correlation to reduce risk.

6. Efficient Portfolios via Quantitative Tools

 To identify efficient portfolios → use quadratic programming (variation of linear programming).
 Inputs required:
1. Expected return of each stock.
2. Standard deviation (risk measure) of each stock.
3. Correlation coefficient between stock pairs.
 Output = Set of efficient portfolios (best risk/return combinations).
7. Standard Deviation (σ)
 Definition: Statistical measure of variation/dispersion in returns.
 Used as a quantitative measure of risk.
 Higher standard deviation → wider spread of possible returns → riskier investment.

⚡ Extra Concept Clarity

 Systematic risk = cannot diversify (market-wide). Managed via hedging or asset classes (not
diversification).
 Unsystematic risk = diversifiable. Can nearly be eliminated with ~20–30 well-chosen stocks.
 Efficient Frontier: Set of portfolios that maximize return for a given risk (or minimize risk for a
given return).
 Key CMA takeaway: Portfolio risk is not just the sum of individual risks; correlation plays a
critical role.
📘 Long-Term Financial Management
1. Definition
 Long term = more than one year.
 Concerned with how a company finances its assets over the long run.
 Key issue: balance between debt vs. equity financing.

2. Capital Structure
 Capital Structure = mix of long-term debt and equity on a company’s balance sheet.
 Financing sources:
o Short-term → for working capital, seasonal needs.
o Long-term → for permanent assets (plants, equipment, investments).
 Long-term financing is classified into:
o External funds (debt, equity, leasing, etc.).
o Internal funds (retained earnings).

3. External Sources of Long-Term Capital

(a) Long-Term Debt
 Raised through bank loans or debt securities (bonds).
 Debt is rolled over (refinanced) → effectively becomes permanent financing if firm is
creditworthy.
 Bonds:
o Have par value.
o Pay stated interest rate (coupon).
o Borrowers are legally obligated to pay interest + principal.
o Failure to pay = default → possible bankruptcy or seizure of collateral.
(b) Common Stock
 Represents ownership + voting rights.
 Shareholders may:
o Vote on key issues (board, mergers, etc.).
o Receive dividends (only if declared by board).
 Dividends:
o Paid from retained earnings.
o Not guaranteed.
 o Some firms pay none (retain all earnings), others follow stable/increasing dividend
policies.
(c) Preferred Stock
 Hybrid security (shares traits of both debt & equity).
 Similar to bonds: pays a fixed dividend % of par value (e.g., 8%).
 Similar to common stock:
o No maturity date.
o Dividend is not obligatory; nonpayment does not trigger bankruptcy.
 Typically, companies try to pay preferred dividends if possible.
CMA Focus: On exams, emphasis is on debt (bonds) and equity (shares) as main sources of external
financing.

4. Internal Sources of Capital

 Retained earnings (profits not distributed as dividends).
 Advantages:
o No direct cash outflow (no interest/dividends).
 Consideration:
o Shareholders expect a return on retained earnings (opportunity cost).

✅ Key Takeaways for CMA:

1. Long-term financial management balances cost, risk, and ownership control.
2. Debt = tax deductible interest, but risk of default.
3. Equity = ownership dilution, dividends optional.
4. Preferred stock = fixed dividend but flexible compared to debt.
5. Retained earnings = cheapest source (no cash cost), but still has implied shareholder return.
📘 Determining the Optimal Capital Structure
 Definition: Mix of long-term debt and equity used to finance assets.
 Goal: Minimize the company’s overall cost of capital.
 Usually achieved through a combination of financing sources.
Factors in Determining Optimal Structure
 Future prospects / business risk: higher risk → conservative financing.
 Equity market conditions: weak markets reduce proceeds from stock issuance.
 Risk tolerance: debt is riskier than equity (default risk, bankruptcy).
 Reputation of issuer & interest rates: weaker creditworthiness → higher debt cost.
 Cost of capital: management must compare the cost of debt, preferred, and equity; CMA exam
requires calculations of cost of each and overall WACC.
Capital Structure Expression
 Usually expressed in percentages (e.g., 40% debt, 10% preferred, 50% common equity).
 Can be based on book values or market values.
 For cost of capital calculations → use market values.
🧮 Ranking of Investments by Risk (From Lowest to Highest)
Rank Investment Type Description
1️⃣ U.S. Treasury Securities Risk-free benchmark
2️⃣ First Mortgage Bonds Secured with top-priority collateral
3️⃣ Second Mortgage Bonds Secured, but second in claim after first mortgage
4️⃣ Income Bonds Pay interest only if company has sufficient income
5️⃣ Debenture Bonds Unsecured bonds (no collateral)
6️⃣ Preferred Stock Fixed dividends, less risky than common stock
Convertible Preferred Can convert to common shares; riskier than regular
7️⃣
Stock preferred
8️⃣ Common Stock Highest risk — residual claim in bankruptcy
📝 Important Note:
 Actual risk depends on specific terms.
o A strong income bond might be less risky than a weak subordinated debenture.
 This ranking is general and used for exam comparison purposes.

🧠 Quick Recap: CMA-Friendly Summary

Concept Systematic Risk Unsystematic Risk
Affects All Assets? ✅ Yes ❌ No
Can be Diversified Away? ❌ No ✅ Yes
Inflation, War, Market Company Strike, Credit
Examples
Crash Default
Key Mitigation Tool None Diversification

✅ Key Exam-Ready Takeaways

 Systematic = Market-wide risk, can’t diversify away.
 Unsystematic = Company/industry-specific, can be diversified away.
 Know the order of risk for investment instruments.
 Understand how to annualize return based on time held.
 CMA loves to test on risk vs. return logic — especially investor choice scenarios.
📘 CMA Part 2: Study Unit 2 — Capital Asset Pricing Model (CAPM)

🧠 Purpose of CAPM
 CAPM estimates the required rate of return on a security, based on its systematic (market)
risk.
 It helps determine the minimum return investors expect for the risk taken.
🔑 Investor's Required Rate of Return = The minimum return needed to justify investment risk.
CAPM assumes that investors:
 Are rational and risk-averse
 Will only invest in riskier assets if compensated with higher returns

📏 CAPM Formula
Required Return=Rf+β×(Rm−Rf)\text{Required Return} = R_f + \beta \times (R_m -
R_f)Required Return=Rf+β×(Rm−Rf)
Where:
Symbol Meaning
RfR_fRf Risk-free rate (e.g., U.S. Treasury rate)
RmR_mRm Expected market return (e.g., S&P 500)
Rm−RfR_m - R_fRm−Rf Market risk premium
β\betaβ Beta — measure of systematic risk
Minimum return an investor requires given the asset's
Required Return
risk

🧮 What is Beta (β)?

Beta = Measurement of how much a security’s returns move relative to the market.
Beta
Meaning Interpretation
Value
= 1.0 Same as market Security moves exactly with the market
> 1.0 More volatile Security moves more than market (aggressive)
0 < β < 1 Less volatile Security moves less than market (defensive)
=0 No correlation Return is independent of the market
Negative
<0 Security moves opposite to the market
correlation
📝 Example:
 If a stock has a beta of 1.25, and the market increases by 8%, the stock is expected to increase
by 10% (8% × 1.25).

📉 Types of Securities by Beta

Security Type Beta Risk Level
Defensive Stock < 1.0 Lower volatility
Market-average
= 1.0 Same risk as market
Stock
Aggressive Stock > 1.0 Higher volatility
Risk-Free Asset = 0 No systematic risk
Hedging Asset < 0 Moves opposite to market
🔎 Negative Beta Stocks:
Could hedge during downturns but underperform in rising markets → leads to opportunity cost +
inflation risk.

📈 Understanding Systematic Risk in CAPM

 CAPM only focuses on systematic risk, not unsystematic risk.
 Systematic risk cannot be diversified away.
 Investors should be compensated only for systematic risk (unsystematic risk can be avoided via
diversification).

📊 Key Notes on Beta

 Beta is based on historical data — how a security’s returns co-varied with the market.
 CAPM uses beta as the only risk input.
 You do not need to calculate beta for the exam — it will be given.

🧪 CAPM Example Question

Assume:
 Risk-free rate Rf=4%R_f = 4\%Rf=4%
 Market return Rm=10%R_m = 10\%Rm=10%
 Stock Beta β=1.5\beta = 1.5β=1.5
What is the investor’s required rate of return?
=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%= 4\% + 1.5 \times (10\% - 4\%) = 4\% + 1.5 \times 6\% =
4\% + 9\% = \boxed{13\%}=4%+1.5×(10%−4%)=4%+1.5×6%=4%+9%=13%

📚 Key Terms to Remember

Term Definition
Risk-Free Rate Return on a security with no risk (usually Treasury bills)
Market Return Expected return from the overall market
Rm−RfR_m - R_fRm−Rf: Extra return expected over risk-
Market Risk Premium
free
Beta (β) Measure of a security’s volatility compared to the market
Required Return Minimum return investor needs given the risk

📝 CAPM Summary for Exam

Concept Key Point
Used for Estimating required return
Based on Systematic risk only
Key input Beta (provided on exam)
Risk-free
Treasury securities
proxy
Formula Rf+β(Rm−Rf)R_f + \beta(R_m - R_f)Rf+β(Rm−Rf)
Beta = 1 Market-matching risk
Beta > 1 More volatile than market
Beta < 1 Less volatile than market
Beta < 0 Moves opposite market
📘 CMA Part 2 – Study Unit 2: B.1 – Capital Asset Pricing Model (CAPM) – Part 2

📊 Market Portfolio (Rm): What Does It Represent?

 In CAPM, the market portfolio represents all investable stocks, weighted by their market
value.
 In practice, it is approximated by the S&P 500 Index.
✅ Key Facts about the Market Portfolio:
 S&P 500 = Most commonly used benchmark index.
 The expected return for the market (Rm) is often estimated using historical average annualized
returns.
📈 Examples of S&P 500 Average Returns:
Time Period Avg Annual Return
1926–2023 10.30%
1957–2023 10.39%
2013–2023 13.79%
2001–2023 7.78%
💡 On the exam, the market return (Rm) will be given — no need to memorize historical numbers.

📐 CAPM Formula (Repeat & Breakdown)

R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Where:
Symbol Meaning
RRR Investors’ required rate of return
RfR_fRf Risk-free rate (e.g., Treasury bonds)
β\betaβ Beta of the stock (systematic risk)
Expected market return (S&P 500
RmR_mRm
return)

🧠 Understanding Risk Premiums

📌 Market Risk Premium:
Rm−RfR_m - R_fRm−Rf
 This is the extra return investors demand for taking on market risk instead of investing in risk-
free assets.
📌 Stock-Specific Risk Premium:
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
 Adjusts the market risk premium by beta, making it specific to a particular stock's volatility.

🧮 CAPM Example (From Text)

Assume:
 β=0.8\beta = 0.8β=0.8
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%R = 0.5\% + 0.8(6.5\% - 0.5\%) = 0.5\% + 0.8 \
times 6\% = 0.5\% + 4.8\% = \boxed{5.3\%}R=0.5%+0.8(6.5%−0.5%)=0.5%+0.8×6%=0.5%+4.8%=5.3%
✅ This means investors expect 5.3% from this stock, lower than the market's return because its beta is
below 1.0 → less risky.

🔁 How Beta Affects Required Return and Stock Value

🔼 If Beta Increases:
 Required return increases
 Discounted value of stock decreases (intrinsic value ↓)
 Market price likely falls
🔽 If Beta Decreases:
 Required return decreases
 Intrinsic value increases
 Market price likely rises

🧮 Example: Beta Change Impact

If beta increases from 0.8 to 1.1:
 Rm=6.5%R_m = 6.5\%Rm=6.5%
 Rf=0.5%R_f = 0.5\%Rf=0.5%
R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%R = 0.5\% + 1.1(6.5\% - 0.5\%) = 0.5\% + 1.1 \
times 6\% = 0.5\% + 6.6\% = \boxed{7.1\%}R=0.5%+1.1(6.5%−0.5%)=0.5%+1.1×6%=0.5%+6.6%=7.1%
🔺 Investors now demand 7.1%, a higher return because the stock is now riskier than the market (beta >
1).

📚 CAPM Takeaways for the CMA Exam

Concept Summary
Market Portfolio Usually represented by the S&P 500
Expected Market Return
Based on historical average return
(Rm)
CAPM Formula R=Rf+β(Rm−Rf)R = R_f + \beta(R_m - R_f)R=Rf+β(Rm−Rf)
Risk-Free Rate (Rf) Usually a short/intermediate Treasury rate
Market Risk Premium Rm−RfR_m - R_fRm−Rf
Stock-Specific Risk
β(Rm−Rf)\beta(R_m - R_f)β(Rm−Rf)
Premium
↑ Beta → ↑ Required Return → ↓ Value; ↓ Beta → ↓ Required Return
Beta’s Impact
→ ↑ Value
On Exam Rf, Rm, and Beta will be provided
📘 Smart Notes – Security Market Line (SML) (CMA Part 2 – Study Unit 2: B.1.)

1. Definition of Security Market Line (SML)

 SML = The graphical representation of the Capital Asset Pricing Model (CAPM).
 It shows the predicted investors’ required rate of return for a security, given its level of
systematic risk (beta).
 Helps investors evaluate whether securities are fairly priced, underpriced, or overpriced.

2. Structure of the SML Graph

 X-axis (horizontal): Beta (systematic risk).
 Y-axis (vertical): Required return (investors’ expected/required rate of return).
 Intercept: The SML intersects the y-axis at the risk-free rate (RF) (where beta = 0).
 Slope of SML: Represents the market risk premium = (RM − RF).
👉 Formula:
R=RF+β×(RM−RF)R = R_F + \beta \times (R_M - R_F)R=RF+β×(RM−RF)
Where:
 RRR = Required return for the security
 RFR_FRF = Risk-free rate
 RMR_MRM = Expected return of the market portfolio
 β\betaβ = Systematic risk of the security

3. Important Beta Values

 Beta = 0 → Security has no systematic risk (risk-free asset). Required return = RF.
 Beta = 1 → Security has same risk as the market portfolio. Required return = RM.
 Beta > 1 → Security is riskier than the market, requires higher return.
 Beta < 1 → Security is less risky than the market, requires lower return.

4. Example Values (from graph in text)

 Risk-free rate (RF) = 0.5%.
 Market portfolio expected return (RM) = 4.0%.
 Market risk premium = RM − RF = 4.0% − 0.5% = 3.5%.
 Required returns at different betas (from SML):
Beta (β) Required Return (R)
0.0 0.5%
0.5 2.25%
1.0 4.0%
1.5 5.75%
2.0 7.5%
👉 Example calculation for β = 2.0:
R=0.5%+2.0×(4.0%−0.5%)=7.5%R = 0.5\% + 2.0 \times (4.0\% - 0.5\%) = 7.5\%R=0.5%+2.0×(4.0%
−0.5%)=7.5%
 Risk premium = 7.0% (7.5% − 0.5%).
 Notice: Risk premium doubles when beta doubles → shows linear relationship.

5. Risk Premium Insights

 Market portfolio (β = 1.0): Risk premium = 3.5%.

 Key Point: Risk premium ∝ Beta.

 Security with β = 2.0: Risk premium = 7.0% → exactly twice that of market portfolio.

6. Using the SML

 Any individual security can be plotted on the SML using its beta and expected return.
 Comparison of security’s expected return with the SML helps determine:
o Undervalued security → Lies above SML (expected return > required return). Investors
will buy → price rises → return falls until on SML.
o Overvalued security → Lies below SML (expected return < required return). Investors
will sell → price falls → return rises until on SML.
 In equilibrium (efficient market): All correctly priced securities lie exactly on the SML.

7. Example – Stock A and Stock C

 Stock A:
o Beta = 0.5
o Market price gives return = 4%
o Required return (from SML) = 2%
o Since actual return (4%) > required (2%), Stock A lies above SML → undervalued →
good investment.
o Eventually, price will rise until return drops to 2%.
 Stock C:
o Beta = 1.5
o Market price gives return = 2%
o Required return (from SML) = 5.75%
o Since actual return (2%) < required (5.75%), Stock C lies below SML → overvalued →
bad investment.
o Eventually, price will fall until return rises to 5.75%.

8. Exam-Focused Key Points

 Formula to memorize:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Market portfolio always has β = 1.
 SML intercept = RF.
 Slope = (RM − RF).
 If security above SML → undervalued; below SML → overvalued.
 Risk premium increases proportionally with beta.
9. Extra Concept Clarity (Beyond Book)
 Why SML is important:
o Helps in pricing securities relative to risk.
o Guides investors whether to buy, hold, or sell.
o Used in portfolio management and corporate finance for cost of equity calculation.
 Difference from CML (Capital Market Line):
o SML: Considers systematic risk (beta). Applicable to any individual security or
portfolio.
o CML: Considers total risk (σ, standard deviation). Only applies to efficient portfolios.
 Practical application in CMA/Finance:
o Used to estimate cost of equity for valuation models.
o Helps in capital budgeting (discount rate for risky projects).
o Used in performance evaluation (e.g., Jensen’s Alpha compares actual return vs. return
predicted by SML).
📘 Smart Notes – Impact of Changing Market Conditions on the Security Market Line (SML)
(CMA Part 2 – Study Unit 2: B.1. CAPM)

1. SML Recap
 SML (Security Market Line): Shows linear relationship between systematic risk (β) and
investors’ required return (R).
 Formula:
R=RF+β(RM−RF)R = R_F + \beta (R_M - R_F)R=RF+β(RM−RF)
 Intercept (y-axis): Risk-free rate (RF).
 Slope: Market risk premium = (RM−RF)(R_M - R_F)(RM−RF).

2. Impact of Changes in Market Conditions on the SML

Changes in RF or market risk premium will shift or tilt the SML.

(A) Change in the Risk-Free Rate (RF)

 If RF increases, the y-intercept of the SML moves upward.
 Example:
o Original RF = 0.5% → intercept = 0.5%.
o New RF = 1.5% → intercept = 1.5%.
 Effect: The entire SML shifts upward in parallel.
 Slope does NOT change (as long as (RM−RF)(R_M - R_F)(RM−RF) is constant).
 Every security’s required return increases by the same amount (in this case, +1%).
👉 Market portfolio (β = 1.0):
 Original required return = 4.0%.
 New required return = 5.0%.
 Increase = same as RF change (+1%).
📊 Graph impact:
 The entire line shifts upward by 1%, but slope remains identical.

(B) Change in Investors’ Risk Aversion

 If investors become more risk averse:
o They demand a higher return per unit of risk.
o This means the market risk premium increases.
 o The slope of the SML increases (line gets steeper).
 Effect: Required return increases more sharply as β increases.
👉 Example:
 Before: Required return at β = 1.0 may be 6%.
 After: With more risk aversion, required return at β = 1.0 may rise to 7.5%.
📊 Graph impact:
 Same intercept at RF (since RF is unchanged).
 But slope (tilt) of line becomes steeper, reflecting greater premium for risk.

3. Key Distinctions in Graph Shifts

Intercept
Market Change Effect on SML Slope (RM − RF)
(RF)
↑ Risk-free rate (RF) Line shifts upward (parallel move) Increases Unchanged
↑ Investor risk Line gets steeper (rotates
Unchanged Increases
aversion upward)

4. Exam-Focused Key Points

 RF affects intercept only.
 Risk aversion affects slope.
 A parallel upward shift occurs when RF changes.
 A steeper line occurs when market risk premium increases.
 Market portfolio (β = 1) always lies on SML — only its position changes with new slope or
intercept.

5. Extra Concept Clarity (Beyond Book)

 Why RF matters:
o Represents the minimum return investors will accept (no risk investment, like T-bills).
o If government bond yields rise, all required returns rise in the market (cost of equity
↑).
 Why investor risk aversion matters:
o Reflects investor psychology and macro conditions.
o During crises (e.g., recession, financial crash), risk aversion rises → investors demand
higher returns for same risk → cost of capital increases for companies.
o During stable periods, risk aversion is lower → flatter SML → cheaper cost of capital.
 Practical Implications in Finance/CMA:
o Corporate Finance: Changes in RF and market risk premium directly impact WACC and
investment decisions.
o Portfolio Management: Helps adjust return expectations when market risk perceptions
change.
o Valuation: If risk aversion increases, stock valuations fall (since required return ↑,
discount rate ↑).
📘 Portfolio Risk and Return
1. Portfolio Basics
 Portfolio = Collection of assets managed as a group.
o Individual investor: mix of stocks, bonds, marketable securities.
o Company: securities, shares, debt, subsidiaries, projects, etc.
 Portfolio management: process of maximizing return for a given risk.
2. Portfolio Theory (Modern Portfolio Theory)
 Aims to build an optimal portfolio balancing risk & return.
 Securities should not be evaluated in isolation but in terms of how their returns move relative to
other securities in the portfolio.
3. Diversification
 Definition: Investing across different securities to reduce risk.
 Unsystematic risk (also: specific, diversifiable, non-market risk):
o Can be minimized by diversification.
o Caused by firm/industry factors → e.g., labor strike, plant fire, competitor patent.
 Systematic risk (market risk):
o Cannot be diversified away.
o Affects all firms (e.g., inflation, recession, interest rate changes).
 Efficient (Fully Diversified) Portfolio:
o Provides highest return for a given unsystematic risk or lowest unsystematic risk for a
given return.
o Still subject to systematic risk.
Key Note: Diversification reduces unsystematic risk but not systematic risk.

4. Asset Allocation
 Process of selecting the right mix of assets (bonds, stocks, real estate, short/long term, high/low
risk, etc.).
 Proper allocation = balances risk & return.
 Correctly diversified portfolio → portfolio risk is less than the average risk of individual
securities.

5. Correlation in Portfolio Theory

 Correlation: tendency of two variables to move together.
o Positive correlation: move in same direction.
o Negative correlation: move in opposite directions.
o No correlation: movements are unrelated.
 Coefficient of Correlation (r):
o Range = −1 to +1.
o Measures direction & strength of relationship between securities’ returns.
o Calculated using historical returns in Excel, calculator, or statistics software.
Interpretation of r values:
r Value Relationship Type Meaning
+1 Perfect Positive Returns move identically together.
Returns move in same direction, different
0.01 → 0.99 Positive (but imperfect)
magnitudes.
0 No correlation No relationship in movement.
Negative (but
−0.01 → −0.99 Move in opposite directions, not perfectly.
imperfect)
−1 Perfect Negative Returns move exactly opposite (e.g., +7% vs. −7%).
 Diversification tip: Combine securities with low or negative correlation to reduce risk.

6. Efficient Portfolios via Quantitative Tools

 To identify efficient portfolios → use quadratic programming (variation of linear programming).
  Inputs required:
1. Expected return of each stock.
2. Standard deviation (risk measure) of each stock.
3. Correlation coefficient between stock pairs.
 Output = Set of efficient portfolios (best risk/return combinations).

7. Standard Deviation (σ)

 Definition: Statistical measure of variation/dispersion in returns.
 Used as a quantitative measure of risk.
 Higher standard deviation → wider spread of possible returns → riskier investment.

⚡ Extra Concept Clarity

 Systematic risk = cannot diversify (market-wide). Managed via hedging or asset classes (not
diversification).
 Unsystematic risk = diversifiable. Can nearly be eliminated with ~20–30 well-chosen stocks.
 Efficient Frontier: Set of portfolios that maximize return for a given risk (or minimize risk for a
given return).
 Key CMA takeaway: Portfolio risk is not just the sum of individual risks; correlation plays a
critical role.
📘 Long-Term Financial Management
1. Definition
 Long term = more than one year.
 Concerned with how a company finances its assets over the long run.
 Key issue: balance between debt vs. equity financing.

2. Capital Structure
 Capital Structure = mix of long-term debt and equity on a company’s balance sheet.
 Financing sources:
o Short-term → for working capital, seasonal needs.
o Long-term → for permanent assets (plants, equipment, investments).
 Long-term financing is classified into:
o External funds (debt, equity, leasing, etc.).
o Internal funds (retained earnings).

3. External Sources of Long-Term Capital

(a) Long-Term Debt
 Raised through bank loans or debt securities (bonds).
 Debt is rolled over (refinanced) → effectively becomes permanent financing if firm is
creditworthy.
 Bonds:
o Have par value.
o Pay stated interest rate (coupon).
o Borrowers are legally obligated to pay interest + principal.
o Failure to pay = default → possible bankruptcy or seizure of collateral.
(b) Common Stock
 Represents ownership + voting rights.
 Shareholders may:
o Vote on key issues (board, mergers, etc.).
 o Receive dividends (only if declared by board).
 Dividends:
o Paid from retained earnings.
o Not guaranteed.
o Some firms pay none (retain all earnings), others follow stable/increasing dividend
policies.
(c) Preferred Stock
 Hybrid security (shares traits of both debt & equity).
 Similar to bonds: pays a fixed dividend % of par value (e.g., 8%).
 Similar to common stock:
o No maturity date.
o Dividend is not obligatory; nonpayment does not trigger bankruptcy.
 Typically, companies try to pay preferred dividends if possible.
CMA Focus: On exams, emphasis is on debt (bonds) and equity (shares) as main sources of external
financing.

4. Internal Sources of Capital

 Retained earnings (profits not distributed as dividends).
 Advantages:
o No direct cash outflow (no interest/dividends).
 Consideration:
o Shareholders expect a return on retained earnings (opportunity cost).

✅ Key Takeaways for CMA:

1. Long-term financial management balances cost, risk, and ownership control.
2. Debt = tax deductible interest, but risk of default.
3. Equity = ownership dilution, dividends optional.
4. Preferred stock = fixed dividend but flexible compared to debt.
5. Retained earnings = cheapest source (no cash cost), but still has implied shareholder return.
📘 Determining the Optimal Capital Structure
 Definition: Mix of long-term debt and equity used to finance assets.
 Goal: Minimize the company’s overall cost of capital.
 Usually achieved through a combination of financing sources.
Factors in Determining Optimal Structure
 Future prospects / business risk: higher risk → conservative financing.
 Equity market conditions: weak markets reduce proceeds from stock issuance.
 Risk tolerance: debt is riskier than equity (default risk, bankruptcy).
 Reputation of issuer & interest rates: weaker creditworthiness → higher debt cost.
 Cost of capital: management must compare the cost of debt, preferred, and equity; CMA exam
requires calculations of cost of each and overall WACC.
Capital Structure Expression
 Usually expressed in percentages (e.g., 40% debt, 10% preferred, 50% common equity).
 Can be based on book values or market values.
 For cost of capital calculations → use market values.
📘 Introduction to Cost of Capital
1. Definition of Capital
 Capital = long-term funding from creditors (debt) and owners (equity).
 Debt: usually bonds outstanding, can also be long-term bank debt.
  Equity: preferred stock + common stock + retained earnings.
o Common equity = all equity – preferred equity (includes retained earnings).
2. Investors’ Returns
 Equity investors expect: dividends + share price appreciation.
 Debt investors expect: interest.
 To attract capital, company must offer adequate return for perceived risk.
3. Overall Cost of Capital
 Definition: Weighted average return expected by investors (portfolio of company’s debt +
equity).
 Equal to: average rate of return that investors demand = company’s cost of capital.
 Calculated using market values of debt/equity (not book values).
 Cost of capital fluctuates because:
o investors’ required returns change,
o market values of securities change.
4. Required Return vs. Expected Return
 Both terms often used interchangeably.
 Required return = minimum return investors accept.
 Expected return = weighted average of probable future returns (based on historical or forecast
data).
 In cost of capital context → both treated as “investors’ demanded return.”
5. Importance in Management Decisions
 Managers must know cost of capital for investment planning.
 Rule:
o Do not invest if project return < cost of capital.
o Example: Borrowing at 10% to earn 6% → destroys shareholder wealth.
 Hurdle rate = minimum acceptable return on project.
o Usually equal to company’s cost of capital.
o May be set higher if project has unusual risk.
 Cost of capital = hurdle rate in capital budgeting decisions.

⚡ Extra CMA Exam Insight:

 Market value weights, not book value weights, are tested in WACC calculations.
 Hurdle rate vs. IRR: A project is acceptable only if IRR ≥ hurdle rate (cost of capital).
 Conceptual link: Cost of capital acts as the opportunity cost of financing.

📘 Overall Cost of Capital & WACC

 Overall cost of capital = weighted average of after-tax costs of debt, preferred, and common
equity.
 Formula (conceptual):
WACC=Total After-
Tax Costs of Financing at Investors’ Required ReturnsTotal Market Value of Financing\
text{WACC} = \frac{\text{Total After-Tax Costs of Financing at Investors’ Required Returns}}{\
text{Total Market Value of Financing}}WACC=Total Market Value of FinancingTotal After-
Tax Costs of Financing at Investors’ Required Returns
 Practically:
WACC=∑(wi×ri)WACC = \sum (w_i \times r_i)WACC=∑(wi×ri)
where
o wiw_iwi = market value weight of capital component
 o rir_iri = after-tax cost of capital component
 Always use current market values, not book values.
 Each component’s after-tax cost is calculated separately → then weighted by proportion in
structure.

📘 Debt Financing (Bonds)

1. Bonds as Financing
 Bonds = debt securities sold to investors.
 Represents a loan from bondholders to company.
 Company promises:
o Periodic interest (coupon payments).
o Repayment of par value at maturity.
 Bonds are typically 10+ years maturity.
2. Interest = Cost of Borrowing
 Interest = cost to borrower, return to investor.
 Quoted as annual rates.
 Depends on:
o Investor’s required return.
o Default risk of issuer.
o Risk premium added to risk-free rate.
 Risk-free proxy = U.S. Treasury securities.
 Other factors affecting required return:
o Liquidity: more liquid bonds = lower yield required.
o Tax status:
 Corporate bonds → taxable interest.
 State/local government bonds → may be federally tax-exempt.
3. Bond Instrument Features
 Issued in $1,000 increments (par value).
 Example: $10M issue → 10,000 bonds @ $1,000 par each.
 Investors can buy in multiples of $1,000.
 Bond cash flows = interest + par value repayment.
4. Bond Contract (Indenture) Includes
 Par value (face value) = base for interest calc + repaid at maturity.
 Coupon (stated) interest rate = fixed % of par; interest usually paid semi-annually.
 Issue date = when bonds first sold.
 Maturity date = when issuer repays par + last interest.
 Payment schedule = typically every 6 months.
5. Example – $1,000 Bond @ 8% Coupon
 Par = $1,000.
 Annual interest = $1,000 × 8% = $80.
 Semi-annual = $40 per 6 months.
 10 years = 20 payments of $40 = $800 interest total.
 At maturity → $1,000 repaid + final $40.
 Total received by investor = $1,800.
📌 Sale Price of Bonds
 Bonds are valued at PV of future cash flows (interest + principal).
 Discount rate = market rate of interest on issue date (for similar terms & risk).
 If Market rate = Stated rate → Bond sells at par/face value.
 If Market rate ≠ Stated rate → Bond sells at discount or premium.
 Investor’s effective return = market rate at purchase (always true, regardless of stated rate).

📌 Market Rate vs. Stated Rate

 Market rate > Stated rate → Bond sells at Discount (below par).
 Market rate < Stated rate → Bond sells at Premium (above par).
 Fixed cash flows (coupon doesn’t change), so price adjusts to give correct market yield.
Table form (must memorize):
Market Rate vs. Stated Price vs. Face
Bond Sells At
Rate Value
Higher Lower Discount
Lower Higher Premium

📌 Issuance Costs
 Issuer pays underwriting, legal, accounting, promotion fees.
 Proceeds received = Selling price – Issuance costs.

📌 Discount & Premium

 Discount: Selling Price < Face Value.
o Occurs when Market rate > Stated rate.
o Discount = Face Value – Selling Price.
 Premium: Selling Price > Face Value.
o Occurs when Market rate < Stated rate.
o Premium = Selling Price – Face Value.
 Adjusts so that investor’s yield = current market rate.

📌 Example: Boulder Corporation

 Issue: $1,000,000 bonds, Coupon 4% annually, semi-annual interest, 5 years.
 Market rate = 6% (higher than coupon).
 Bond issued at discount.
Step 1: PV of Principal
 PV factor = 0.744 (3% × 10 periods).
 $1,000,000 × 0.744 = $744,000.
Step 2: PV of Interest Payments
 Interest = $1,000,000 × 4% ÷ 2 = $20,000 each half-year.
 Annuity PV factor = 8.53 (10 periods, 3%).
 $20,000 × 8.53 = $170,600.
Total Issue Price = $914,600.
 Discount = $1,000,000 – $914,600 = $85,400.
 Price per $1,000 bond = $914.60 (quoted as 91.46).
 Investor earns 6% yield (market rate).
Bond Market Quotation Rule:
 Price quoted per $100 of par, two decimal places.
 Example:
o 91.46 → $914.60 per $1,000 bond.
o 103.25 → $1,032.50 per $1,000 bond.
 📌 Special Features of Bonds
1. Restrictive Covenants
 Protect bondholders → limit company’s risky actions.
 May require:
o Maintaining financial ratios.
o Minimum working capital.
o Max dividend payments.
 Make bonds safer → issuer can borrow at lower rate.
 Examples:
o Sinking fund: company sets aside money annually to repay bonds.
o Negative pledge: company cannot pledge assets for other loans if it weakens
bondholders’ security.
2. Redemption Provisions
 Call provision: Issuer can retire bond early at set price.
o Used if market rates fall → issuer refinances at lower cost.
o Good for issuer, bad for investor → investors demand extra return.
 Put provision: Investor can force issuer to repay early (e.g., covenant violation).
o Good for investor → issuer may borrow at lower coupon rate.
3. Conversion Provisions
 Convertibility clause = bond can be converted into issuer’s common stock.
 Good for investors → downside protection if bond price drops.
 Good for issuers → if converted, debt becomes equity (no more interest or repayment
obligation).
4. Options
 Embedded sinking fund option → issuer retires part of bond issue annually.
 Warrants → attached to bond, give holder right to buy shares at fixed price.

📌 Extra Concept Clarity (Important for CMA)

1. Effective Interest Rate (Yield): Always set by market at purchase. Price adjusts to guarantee
this.
2. Discount amortization: Even if issued at discount, issuer must repay full face value → discount
is amortized as extra interest expense.
3. Premium amortization: When issued at premium, extra amount received reduces effective
interest expense.
4. Call vs. Put:
o Call = issuer benefits if interest rates fall.
o Put = investor protection if things go wrong.
5. Convertible Bonds: Dual nature → start as debt, may become equity. Good exam topic for
pros/cons to issuer & investor.
Types of Bonds
 Convertible bonds – Holder can convert into issuer’s common stock; beneficial to holder, may
also benefit issuer (debt → equity).
 Debenture bonds – Unsecured, backed only by company’s creditworthiness; higher risk.
 Mortgage bonds – Secured by specific assets; less risky.
 Subordinated debentures – Unsecured, rank below other debt; very risky in bankruptcy.
 Income bonds – Pay interest only if company earns sufficient income; higher risk.
 Serial bonds – Maturing in installments; issuer repays gradually, investors choose term.
 Zero-coupon bonds – No interest; issued at deep discount.
 Participating bonds – Holder can share in company profits/dividends.
 Indexed bonds – Interest rate linked to index (e.g., inflation).
 International bonds:
o Foreign bonds – Issued outside home country, denominated in local currency.
o Eurobonds – Issued in a currency different from the issuing country’s market; may
involve 3 countries. Advantage: lower interest costs, fewer regulations. Risk: foreign
exchange exposure.

Bonds & Rating Agencies

 Agencies: Moody’s, S&P, Fitch.
 Ratings measure probability of default.
 AAA – negligible risk.
 Investment grade – top 4 categories, low risk.
 Speculative/junk – high risk, high return; often in LBOs/mergers.
 Downgrades → higher cost of capital + stock price drop.
 Risk note: ratings can lag behind reality.

Inflation, Interest Rates & Financial Instruments

 Inflation – sustained rise in prices (↓ purchasing power).
 Interest rates ↔ Inflation:
o Low rates → ↑ borrowing, ↑ spending → ↑ demand > supply → inflation.
o High rates → ↓ borrowing, ↓ spending → slowdown/recession → lower inflation.
 Central bank (e.g., Fed in U.S.) tool: interest rates via open market operations:
o Buys govt. securities → ↑ money supply → ↓ interest rates → ↑ economic activity
(risk: inflation).
o Sells govt. securities → ↓ money supply → ↑ interest rates → ↓ activity → ↓ inflation.
📘 CMA Part 2 – Study Unit 7: Cost of Capital (B.2. Cost of Debt)

1. Interest Rates and Market Prices of Financial Instruments

Key Concept: Inverse Relationship
 When interest rates ↑ → market prices ↓
 When interest rates ↓ → market prices ↑
Why? (Investor Behavior)
1. For Bonds (Fixed Income):
o If rates increase, investors want higher returns.
o Existing bonds with lower fixed coupons become less attractive, so their market prices
fall.
o New bonds are issued at higher rates → old bonds must trade at a discount.
2. For Stocks (Equity):
o If rates increase, bonds become more attractive → investors shift money from stocks to
bonds.
o Stock demand ↓ → stock prices ↓.
o If rates decrease, opposite happens: bonds are less attractive, investors expect better
returns from stocks (capital gains + dividends), so stock prices rise.
📌 Exam Tip: Be prepared to explain why higher interest rates depress both bond and stock
prices (shift of investment preference).
 2. Impact of Income Taxes on Financing Decisions
 Interest on debt is tax deductible → reduces taxable income.
 This lowers the effective cost of debt for the company.
 Therefore, bonds are usually the cheapest source of financing compared to equity.
⚠️But: Too much debt = higher risk perception
 Both debt holders and equity investors demand higher returns → cost of capital increases.
 Effect:
o Higher cost of new debt.
o Higher cost of equity.
o Higher cost of retained earnings.
o Thus, overall WACC (Weighted Average Cost of Capital) increases.
📌 Concept Note:
 Up to a point, debt ↓ WACC (thanks to tax shield).
 Beyond that point, debt ↑ WACC (due to financial distress risk).
 This balance is known as the “optimal capital structure”.

3. Cost of Debt to the Issuer

Definition:
The cost of debt is the interest rate required by investors, adjusted for tax-deductibility.
Key Points:
 Interest expense reduces taxable income → tax savings reduce effective cost.
 Hence, bonds are cheaper than equity (as long as debt levels remain moderate).
 If debt becomes excessive → both debt and equity investors demand higher returns → WACC
↑.

4. Accounting vs. Cost of Capital Perspective

(A) Accounting Perspective
 Based on effective annual interest rate (yield to maturity, YTM) at original issue date.
 Remains fixed for the bond’s life, even if market rates change.
 Interest expense =
o Cash interest (coupon rate × par value), plus amortization of discount or
o Minus amortization of premium.
📌 Note: Accounting focuses on historical rate at issue.

(B) Cost of Capital Perspective

 Based on current market rate (investors’ required return) for similar debt.
 Changes with:
o Market conditions.
o Issuer-specific risk.
 Measured using the market value of debt.
📌 Note: Cost of capital is forward-looking → important for financing decisions.

5. After-Tax Cost of Debt Formula

Cd=C×(1−t)C_d = C \times (1 - t)Cd=C×(1−t)
Where:
 C_d = After-tax cost of debt
 C = Pretax cost of debt (interest rate as decimal)
 t = Marginal tax rate
👉 If tax rate ↑ → after-tax cost ↓.
👉 If tax rate ↓ → after-tax cost ↑.

6. Example: LordsTown Inc.

 1,000 bonds, 8-year maturity, 6% coupon.
 Issued at $917.50 per $1,000 par (discount).
 Effective interest rate (YTM at issue): 7.4%.
 Current market price = $1,017.50 (quoted 101.75).
 Current required market rate = 5.5%.
 Tax rate = 20%.
Calculations:
 Accounting perspective cost (pretax): 7.4%.
o After-tax: 0.074×(1−0.20)=5.9%0.074 \times (1 - 0.20) = 5.9\%0.074×(1−0.20)=5.9%.
 Cost of capital perspective cost (pretax): 5.5%.
o After-tax: 0.055×(1−0.20)=4.4%0.055 \times (1 - 0.20) = 4.4\%0.055×(1−0.20)=4.4%.
📌 Key Insight:
 Coupon rate (6%) and original issue price are irrelevant for cost of capital purposes.
 What matters is current market rate (5.5%).

7. Flotation Costs
 Flotation costs = costs of issuing new debt (e.g., underwriting, legal).
 Usually ignored in cost of capital calculations because:
o Most bonds are privately placed.
o Costs are minimal compared to issue size.
📌 Important for accounting, less so for cost of capital (which uses estimates).

8. Comparison Table: Cost of Debt

After-Tax
Perspective Pretax Rate Principal Value Used
Rate
Effective Amortized book value
Effective
interest rate (original proceeds ±
Accounting rate × (1 −
(YTM at issue amortization of
tax rate)
date) discount/premium)
Current market
Current
Cost of rate (investors’ Current market value of
rate × (1 −
Capital required debt
tax rate)
return)

9. Important Caveat
 Formula Cd=C(1−t)C_d = C(1 - t)Cd=C(1−t) assumes company has taxable income.
 If no taxable income → no tax savings → after-tax cost = pretax cost.

🔑 Extra Conceptual Clarity

 Why debt is cheaper than equity:
o Interest is tax deductible (equity dividends are not).
o Debt has lower risk (fixed claim, priority in liquidation).
 Why debt can become expensive:
 o Too much leverage → higher bankruptcy risk.
o Both bondholders and shareholders demand risk premium.
 Yield to Maturity (YTM):
o Rate of return investors require for holding a bond until maturity.
o Reflects market rate at issue, not coupon.
 Weighted Average Cost of Capital (WACC):
o Mix of cost of equity + cost of debt (after-tax).
o Critical for project valuation and capital budgeting.
📌 Exam Focus:
 Be able to calculate after-tax cost of debt.
 Be able to distinguish between accounting vs cost of capital perspective.
 Understand impact of interest rates & taxes on financing decisions.
📘 CMA Part 2 – Study Unit 8: B.2. Term Structure of Interest Rates

1. Term Structure of Interest Rates

 Definition: The term structure of interest rates describes the relationship between bond yields
(interest rates) and time to maturity, assuming bonds have the same risk characteristics except
maturity.
 Graphical Representation → Yield Curve:
o X-axis = Time to maturity.
o Y-axis = Interest rate (yield).
o The line connecting yields across maturities is the yield curve.
 Purpose: Yield curves provide insights into:
o Investors’ expectations of future interest rates.
o Expectations of economic conditions (e.g., inflation, recession).

2. Typical Yield Curve Shape

 Normal (Upsloping):
o Long-term rates > Short-term rates.
o Why? Investors require higher returns for longer-term investments (greater risk, funds
locked up longer).
 Other Shapes:
o Yield curves can also be downsloping (inverted), flat, or humped depending on market
expectations.

3. Types of Yield Curves

(A) Upsloping Yield Curve (Normal)
 Occurs under normal economic conditions.
 Longer-term bonds → higher rates than shorter-term bonds.
 Rationale: Investors demand higher compensation for greater maturity risk.
 Steeper-than-normal Upslope (Important Insight):
o Indicates expectations of higher future inflation & interest rates.
o Investor behavior:
 Investors prefer short-term debt → so they can reinvest later at higher rates.
 Borrowers prefer long-term debt → to lock in current lower rates.
o Effect on supply & demand:
  Supply of short-term funds ↑, demand for short-term borrowing ↓ → short-
term rates ↓.
 Supply of long-term funds ↓, demand for long-term borrowing ↑ → long-term
rates ↑.
o Net result = Steeper Upsloping Yield Curve.

(B) Downsloping Yield Curve (Inverted)

 Indicates expectation that future interest rates will fall.
 Investor/borrower behavior:
o Borrowers → Prefer short-term debt, expecting to refinance later at lower rates.
o Investors → Prefer long-term debt, to lock in current higher rates.
 Effect:
o High demand + low supply in short-term market → short-term rates ↑.
o High supply + low demand in long-term market → long-term rates ↓.
 Net result = Yield curve slopes downward.
📌 Exam Tip: A downsloping (inverted) yield curve is often seen as a predictor of recession.

(C) Humped Yield Curve

 Occurs during a transition period (expectations shifting from rates ↑ to rates ↓).
 Shape: Rates highest in medium-term maturities, lower at short-term and long-term ends.
 Meaning: Short- and long-term yields align, but medium-term reflects uncertainty.

(D) Flat Yield Curve

 Occurs when market expects no major changes in interest rates.
 Short-term, medium-term, and long-term yields are nearly the same.

4. Visual Representation of Yield Curves

Typical shapes:
 Upsloping (Normal).
 Downsloping (Inverted).
 Flat.
 Humped.
(Seen in graphs: X-axis = maturity, Y-axis = yield.)

5. Yield Curves by Bond Classification

 At any point in time, there are multiple yield curves (one for each risk class of bonds).
 Examples:
o U.S. Treasury securities (lowest risk, lowest return).
o AAA Corporate bonds.
o BBB Corporate bonds.
 Rule: Riskier bonds = higher yield curve (shifted upward).

6. U.S. Treasury Securities (Examples of Bonds by Term)

 Treasury Bills (T-bills):
o Short-term securities.
o Maturities: A few days → 52 weeks.
 Treasury Notes:
 o Intermediate-term securities.
o Maturities: 2, 3, 5, 7, 10 years.
 Treasury Bonds:
o Long-term securities.
o Maturities: 20, 30 years.
📌 Concept: Treasury yield curve = benchmark "risk-free" yield curve (lowest yields).

🔑 Extra Conceptual Clarity

Why Yield Curves Matter in Finance & CMA Exam
1. Investment Decisions:
o Steep yield curve → expectation of growth/inflation → investors may shift strategies.
o Inverted yield curve → signals possible recession.
2. Corporate Financing Decisions:
o Companies choose short-term vs long-term borrowing depending on yield curve shape.
o Example: If inverted, companies might borrow long-term now (since long-term rates are
cheaper).
3. Project Valuation & Discount Rates:
o Yield curve influences cost of capital.
o Longer-term projects are discounted at higher rates under normal yield curve.

📌 Exam Tips
 Know all four shapes of yield curves and what they indicate.
 Be able to explain investor & borrower behavior behind each shape.
 Know how supply/demand shifts affect short-term vs long-term rates.
 Understand Treasury securities maturities (T-bills, notes, bonds).
 Recognize that yield curves differ by credit risk category (Treasury vs Corporate).
📘 CMA Part 2 – Study Unit 9: B.2. Bond Duration

1. Interest Rate Risk & Market Value of Bonds

 Key Rule:
o Interest rates ↑ → Market value of bonds ↓
o Interest rates ↓ → Market value of bonds ↑
 Why? Investors must receive returns equal to current market rates for bonds of similar term &
risk.
 This fluctuation in bond value due to interest rate changes = Interest Rate Risk.

2. Duration – The Best Measure of Interest Rate Risk

 Definition:
o Duration = a time expression that measures a bond’s sensitivity to interest rate
changes.
o It is a weighted average of the times until all cash flows (coupon + principal) are
received.
o Weights = proportion of present value of each cash flow relative to total PV of bond.
 Interpretation:
o Higher duration → Bond price more sensitive to interest rate changes.
o Lower duration → Bond price less sensitive.
 CMA Exam: You don’t need to calculate duration, but you must know:
 o What duration is.
o Factors that affect duration.
o How duration impacts interest rate risk.

3. Factors Affecting Duration

1. Time to Maturity (Main Factor):
o Longer maturity → Higher duration → Greater sensitivity (more risk).
o Short-term securities (e.g., money market instruments) → little to no effect from rate
changes.
o Long-term corporate bonds → highly affected.
o As maturity date approaches → Duration decreases → Sensitivity falls.
2. Coupon Rate (Nominal Interest Rate on Bond):
o Higher coupon → Lower duration.
o Why? More cash is received earlier (reduces the impact of final repayment).

4. Using Duration in Portfolio Management

 Diversification by Duration (Duration Hedging):
o Mix short-term, intermediate-term, and long-term bonds.
o Reduces overall sensitivity to interest rate moves.
o Better than holding only long-term bonds.
 Portfolio Duration:
o Weighted average of durations of bonds in the portfolio (weights based on market
value).
o Lower portfolio duration = Lower overall interest rate risk.

🔑 Extra Clarity on Duration

 Rule of Thumb:
o 1% change in interest rates → Bond price will change approx. by the bond’s duration %.
o Example: Bond with duration of 5 → 1% rise in interest rates causes ~5% price drop.
 Practical Insight:
o Duration is like the “elasticity” of bond prices with respect to interest rates.
 CMA Angle:
o Expect questions on comparing risk levels of bonds with different maturities/coupons.

📘 CMA Part 2 – Study Unit 10: B.2. Equity Financing

1. Two Types of Equity Securities

1. Common Stock (all companies issue).
2. Preferred Stock (only some companies issue).

2. Common Stock
 Residual Ownership:
o Common shareholders get paid last (after creditors & preferred stockholders) in
liquidation.
 Cost of Common Stock:
o Highest among financing sources (due to highest risk).
o No guaranteed return → but unlimited upside (dividends + capital appreciation).
 Rights of Common Shareholders:
o Voting Rights:
 Vote on issues (especially electing Board of Directors).
 Can assign proxy if not attending annual meeting.
o Dividends:
 Right to receive if declared (not guaranteed).
o Preemptive Rights:
 Right to buy proportionate share of new issues to avoid dilution.
 If not exercised → ownership diluted.
o Residual Assets:
 Share in leftover assets after liquidation once creditors & preferred holders are
paid.

3. Par Value of Shares

 Definition:
o Arbitrary amount set by company when issuing shares.
 For Common Stock:
o Usually small amount (represents legal capital).
o Legal capital cannot be distributed as dividends.
o Par value = maximum liability of shareholders if company liquidates.
o Par value ≠ market price.
o Accounting treatment:
 Common Stock account credited with par value.
 Excess received credited to Additional Paid-In Capital (APIC).
 For Preferred Stock:
o Used to calculate dividend amount.

4. Preferred Stock
 Hybrid Security: Shares features of bonds and common stock.
 Cost of Preferred Stock: Higher than bonds (more risk).

(A) Preferred Stock vs Bonds

 Similarities with Bonds:
1. Usually no voting rights.
2. Pays a fixed annual dividend.
3. Dividend = % of par value (like interest).
4. Higher liquidation claim than common stock.
5. Often issued with bond-like features (convertibility, callability, etc.).

(B) Preferred Stock vs Common Stock

 Similarities with Common Stock:
1. Dividends must be declared by board before payment.
2. Failure to pay dividends ≠ breach of contract (no bankruptcy).
3. Dividends are not tax-deductible.
4. In liquidation: Preferred < Bondholders, but > Common stockholders.

(C) Characteristics of Preferred Shares

1. Callable/ Redeemable:
o Company can buy back shares at call price (may include call premium).
2. Convertible:
o Option to convert into common shares (usually to gain voting rights).
3. Participating:
o Can earn extra dividends if company profits exceed expectations.
o May share in common dividends too.
4. Voting Rights (Special Cases):
o Some preferred shares gain voting rights (e.g., when cumulative dividends are unpaid).

(D) Dividends on Preferred Stock

 Fixed % of par value.
 Examples:
o Par $25, dividend 6% → $1.50 annually.
o Par $50, dividend 6% → $3 annually.
 Types of Preferred Dividends:
o Cumulative:
 Dividends accumulate if unpaid.
 Must be fully paid before common dividends.
 “Dividends in arrears” are disclosed in financial statements (not a liability).
o Non-Cumulative:
 Missed dividends are lost forever.

📌 Exam Tips (High-Probability Areas)

 Duration:
o Longer maturity = higher duration = more sensitive.
o Higher coupon = lower duration.
o As maturity approaches → duration falls.
 Common Stock:
o Highest cost of financing.
o Key rights: vote, dividends (if declared), preemptive rights, residual claim.
 Preferred Stock:
o Hybrid → know similarities to both bonds & common stock.
o Cumulative vs Noncumulative is often tested.
o On exam: If problem doesn’t say “cumulative,” assume it’s noncumulative.
📘 CMA Part 2 – Study Unit 11: B.3. Dividend Policy & Treasury Stock

1. Dividends – Basics
 Definition: Dividends are payments made to shareholders, usually from retained earnings.
 Forms of Dividends:
1. Cash dividend (most common).
2. Property dividend (distribution of assets such as inventory).
3. Stock dividend (new shares instead of cash).

2. Cash Dividends
 Normal case: Paid out of retained earnings (return on investment).
 Liquidating dividend: Paid when no retained earnings exist → return of shareholder capital.
 🔑 Shareholder returns come in two forms:
1. Cash dividends.
2. Capital gains (increase in stock price).
 If company retains earnings instead of paying dividends, investors expect higher stock price
growth.

3. Dividend Policy
 Definition: Rules a company follows to decide how much dividend to pay.
 Objective: Maximize shareholder wealth.
 Two approaches:
1. Active Policy:
 Management believes dividends send a message to the market (financial
signaling).
 Dividend decisions used strategically to show profitability & stability.
2. Passive Policy:
 Management believes dividends don’t influence stock value much.
 No special effort to set policy.

4. Dividend Stability & Signaling

 Dividends are more stable than profits (management avoids frequent changes).
 Decreasing dividends = negative signal (investors see weakness).
 Unusually high profits (non-recurring):
o Company may not raise dividend (to avoid later cutbacks).
 Increasing dividends: Only if management expects sustainable future profits.

5. Factors Affecting Dividend Policy

1. Stability of Earnings – Stable companies can afford higher payout.
2. Financing Policy – Companies that avoid borrowing retain more earnings → lower dividends.
3. Liquidity / Cash Needs – Cash must be available for dividend payments.
4. Available Investment Projects – Profitable projects reduce funds for dividends.
5. Debt Service Obligations – Heavily indebted firms → lower dividends.
6. Ability to Borrow – Firms with strong credit can pay higher dividends.
7. Past Dividend Rate – Shareholders expect consistency; history matters.
8. Growth Needs – Fast-growing firms retain more cash → lower dividends.
9. Corporate Tax Rates – Higher taxes reduce distributable profits.
10. Shareholder Tax Position –
 High-income investors → prefer capital gains (lower taxes).
 Retirees/lower-income investors → prefer dividends (income stream).

6. Common Dividend Practices

 Regular Dividends (annual/quarterly):
o Expected by shareholders → factored into stock price.
o Failure to pay → sharp price decline & loss of investor confidence.
 Stable/Constant Dividend:
o Even if profits fall, dividends may be maintained using past retained earnings.
 Gradual Increases:
o Many companies increase dividends slowly to meet shareholder expectations.
 Market Reaction:
 o Dividend cuts or increases strongly influence share price.
📘 Introduction to Cost of Capital
1. Definition of Capital
 Capital = long-term funding from creditors (debt) and owners (equity).
 Debt: usually bonds outstanding, can also be long-term bank debt.
 Equity: preferred stock + common stock + retained earnings.
o Common equity = all equity – preferred equity (includes retained earnings).
2. Investors’ Returns
 Equity investors expect: dividends + share price appreciation.
 Debt investors expect: interest.
 To attract capital, company must offer adequate return for perceived risk.
3. Overall Cost of Capital
 Definition: Weighted average return expected by investors (portfolio of company’s debt +
equity).
 Equal to: average rate of return that investors demand = company’s cost of capital.
 Calculated using market values of debt/equity (not book values).
 Cost of capital fluctuates because:
o investors’ required returns change,
o market values of securities change.
4. Required Return vs. Expected Return
 Both terms often used interchangeably.
 Required return = minimum return investors accept.
 Expected return = weighted average of probable future returns (based on historical or forecast
data).
 In cost of capital context → both treated as “investors’ demanded return.”
5. Importance in Management Decisions
 Managers must know cost of capital for investment planning.
 Rule:
o Do not invest if project return < cost of capital.
o Example: Borrowing at 10% to earn 6% → destroys shareholder wealth.
 Hurdle rate = minimum acceptable return on project.
o Usually equal to company’s cost of capital.
o May be set higher if project has unusual risk.
 Cost of capital = hurdle rate in capital budgeting decisions.

⚡ Extra CMA Exam Insight:

 Market value weights, not book value weights, are tested in WACC calculations.
 Hurdle rate vs. IRR: A project is acceptable only if IRR ≥ hurdle rate (cost of capital).
 Conceptual link: Cost of capital acts as the opportunity cost of financing.

📘 Overall Cost of Capital & WACC

 Overall cost of capital = weighted average of after-tax costs of debt, preferred, and common
equity.
 Formula (conceptual):
WACC=Total After-
Tax Costs of Financing at Investors’ Required ReturnsTotal Market Value of Financing\
text{WACC} = \frac{\text{Total After-Tax Costs of Financing at Investors’ Required Returns}}{\
 text{Total Market Value of Financing}}WACC=Total Market Value of FinancingTotal After-
Tax Costs of Financing at Investors’ Required Returns
 Practically:
WACC=∑(wi×ri)WACC = \sum (w_i \times r_i)WACC=∑(wi×ri)
where
o wiw_iwi = market value weight of capital component
o rir_iri = after-tax cost of capital component
 Always use current market values, not book values.
 Each component’s after-tax cost is calculated separately → then weighted by proportion in
structure.

📘 Debt Financing (Bonds)

1. Bonds as Financing
 Bonds = debt securities sold to investors.
 Represents a loan from bondholders to company.
 Company promises:
o Periodic interest (coupon payments).
o Repayment of par value at maturity.
 Bonds are typically 10+ years maturity.
2. Interest = Cost of Borrowing
 Interest = cost to borrower, return to investor.
 Quoted as annual rates.
 Depends on:
o Investor’s required return.
o Default risk of issuer.
o Risk premium added to risk-free rate.
 Risk-free proxy = U.S. Treasury securities.
 Other factors affecting required return:
o Liquidity: more liquid bonds = lower yield required.
o Tax status:
 Corporate bonds → taxable interest.
 State/local government bonds → may be federally tax-exempt.
3. Bond Instrument Features
 Issued in $1,000 increments (par value).
 Example: $10M issue → 10,000 bonds @ $1,000 par each.
 Investors can buy in multiples of $1,000.
 Bond cash flows = interest + par value repayment.
4. Bond Contract (Indenture) Includes
 Par value (face value) = base for interest calc + repaid at maturity.
 Coupon (stated) interest rate = fixed % of par; interest usually paid semi-annually.
 Issue date = when bonds first sold.
 Maturity date = when issuer repays par + last interest.
 Payment schedule = typically every 6 months.
5. Example – $1,000 Bond @ 8% Coupon
 Par = $1,000.
 Annual interest = $1,000 × 8% = $80.
 Semi-annual = $40 per 6 months.
 10 years = 20 payments of $40 = $800 interest total.
 At maturity → $1,000 repaid + final $40.
 Total received by investor = $1,800.
📌 Sale Price of Bonds
 Bonds are valued at PV of future cash flows (interest + principal).
 Discount rate = market rate of interest on issue date (for similar terms & risk).
 If Market rate = Stated rate → Bond sells at par/face value.
 If Market rate ≠ Stated rate → Bond sells at discount or premium.
 Investor’s effective return = market rate at purchase (always true, regardless of stated rate).

📌 Market Rate vs. Stated Rate

 Market rate > Stated rate → Bond sells at Discount (below par).
 Market rate < Stated rate → Bond sells at Premium (above par).
 Fixed cash flows (coupon doesn’t change), so price adjusts to give correct market yield.
Table form (must memorize):
Market Rate vs. Stated Price vs. Face
Bond Sells At
Rate Value
Higher Lower Discount
Lower Higher Premium

📌 Issuance Costs
 Issuer pays underwriting, legal, accounting, promotion fees.
 Proceeds received = Selling price – Issuance costs.

📌 Discount & Premium

 Discount: Selling Price < Face Value.
o Occurs when Market rate > Stated rate.
o Discount = Face Value – Selling Price.
 Premium: Selling Price > Face Value.
o Occurs when Market rate < Stated rate.
o Premium = Selling Price – Face Value.
 Adjusts so that investor’s yield = current market rate.

📌 Example: Boulder Corporation

 Issue: $1,000,000 bonds, Coupon 4% annually, semi-annual interest, 5 years.
 Market rate = 6% (higher than coupon).
 Bond issued at discount.
Step 1: PV of Principal
 PV factor = 0.744 (3% × 10 periods).
 $1,000,000 × 0.744 = $744,000.
Step 2: PV of Interest Payments
 Interest = $1,000,000 × 4% ÷ 2 = $20,000 each half-year.
 Annuity PV factor = 8.53 (10 periods, 3%).
 $20,000 × 8.53 = $170,600.
Total Issue Price = $914,600.
 Discount = $1,000,000 – $914,600 = $85,400.
 Price per $1,000 bond = $914.60 (quoted as 91.46).
 Investor earns 6% yield (market rate).
 Bond Market Quotation Rule:
 Price quoted per $100 of par, two decimal places.
 Example:
o 91.46 → $914.60 per $1,000 bond.
o 103.25 → $1,032.50 per $1,000 bond.

📌 Special Features of Bonds

1. Restrictive Covenants
 Protect bondholders → limit company’s risky actions.
 May require:
o Maintaining financial ratios.
o Minimum working capital.
o Max dividend payments.
 Make bonds safer → issuer can borrow at lower rate.
 Examples:
o Sinking fund: company sets aside money annually to repay bonds.
o Negative pledge: company cannot pledge assets for other loans if it weakens
bondholders’ security.
2. Redemption Provisions
 Call provision: Issuer can retire bond early at set price.
o Used if market rates fall → issuer refinances at lower cost.
o Good for issuer, bad for investor → investors demand extra return.
 Put provision: Investor can force issuer to repay early (e.g., covenant violation).
o Good for investor → issuer may borrow at lower coupon rate.
3. Conversion Provisions
 Convertibility clause = bond can be converted into issuer’s common stock.
 Good for investors → downside protection if bond price drops.
 Good for issuers → if converted, debt becomes equity (no more interest or repayment
obligation).
4. Options
 Embedded sinking fund option → issuer retires part of bond issue annually.
 Warrants → attached to bond, give holder right to buy shares at fixed price.

📌 Extra Concept Clarity (Important for CMA)

1. Effective Interest Rate (Yield): Always set by market at purchase. Price adjusts to guarantee
this.
2. Discount amortization: Even if issued at discount, issuer must repay full face value → discount
is amortized as extra interest expense.
3. Premium amortization: When issued at premium, extra amount received reduces effective
interest expense.
4. Call vs. Put:
o Call = issuer benefits if interest rates fall.
o Put = investor protection if things go wrong.
5. Convertible Bonds: Dual nature → start as debt, may become equity. Good exam topic for
pros/cons to issuer & investor.
Types of Bonds
 Convertible bonds – Holder can convert into issuer’s common stock; beneficial to holder, may
also benefit issuer (debt → equity).
 Debenture bonds – Unsecured, backed only by company’s creditworthiness; higher risk.
 Mortgage bonds – Secured by specific assets; less risky.
 Subordinated debentures – Unsecured, rank below other debt; very risky in bankruptcy.
 Income bonds – Pay interest only if company earns sufficient income; higher risk.
 Serial bonds – Maturing in installments; issuer repays gradually, investors choose term.
 Zero-coupon bonds – No interest; issued at deep discount.
 Participating bonds – Holder can share in company profits/dividends.
 Indexed bonds – Interest rate linked to index (e.g., inflation).
 International bonds:
o Foreign bonds – Issued outside home country, denominated in local currency.
o Eurobonds – Issued in a currency different from the issuing country’s market; may
involve 3 countries. Advantage: lower interest costs, fewer regulations. Risk: foreign
exchange exposure.

Bonds & Rating Agencies

 Agencies: Moody’s, S&P, Fitch.
 Ratings measure probability of default.
 AAA – negligible risk.
 Investment grade – top 4 categories, low risk.
 Speculative/junk – high risk, high return; often in LBOs/mergers.
 Downgrades → higher cost of capital + stock price drop.
 Risk note: ratings can lag behind reality.

Inflation, Interest Rates & Financial Instruments

 Inflation – sustained rise in prices (↓ purchasing power).
 Interest rates ↔ Inflation:
o Low rates → ↑ borrowing, ↑ spending → ↑ demand > supply → inflation.
o High rates → ↓ borrowing, ↓ spending → slowdown/recession → lower inflation.
 Central bank (e.g., Fed in U.S.) tool: interest rates via open market operations:
o Buys govt. securities → ↑ money supply → ↓ interest rates → ↑ economic activity
(risk: inflation).
o Sells govt. securities → ↓ money supply → ↑ interest rates → ↓ activity → ↓ inflation.
📘 CMA Part 2 – Study Unit 7: Cost of Capital (B.2. Cost of Debt)

1. Interest Rates and Market Prices of Financial Instruments

Key Concept: Inverse Relationship
 When interest rates ↑ → market prices ↓
 When interest rates ↓ → market prices ↑
Why? (Investor Behavior)
1. For Bonds (Fixed Income):
o If rates increase, investors want higher returns.
o Existing bonds with lower fixed coupons become less attractive, so their market prices
fall.
o New bonds are issued at higher rates → old bonds must trade at a discount.
2. For Stocks (Equity):
 o If rates increase, bonds become more attractive → investors shift money from stocks to
bonds.
o Stock demand ↓ → stock prices ↓.
o If rates decrease, opposite happens: bonds are less attractive, investors expect better
returns from stocks (capital gains + dividends), so stock prices rise.
📌 Exam Tip: Be prepared to explain why higher interest rates depress both bond and stock
prices (shift of investment preference).

2. Impact of Income Taxes on Financing Decisions

 Interest on debt is tax deductible → reduces taxable income.
 This lowers the effective cost of debt for the company.
 Therefore, bonds are usually the cheapest source of financing compared to equity.
⚠️But: Too much debt = higher risk perception
 Both debt holders and equity investors demand higher returns → cost of capital increases.
 Effect:
o Higher cost of new debt.
o Higher cost of equity.
o Higher cost of retained earnings.
o Thus, overall WACC (Weighted Average Cost of Capital) increases.
📌 Concept Note:
 Up to a point, debt ↓ WACC (thanks to tax shield).
 Beyond that point, debt ↑ WACC (due to financial distress risk).
 This balance is known as the “optimal capital structure”.

3. Cost of Debt to the Issuer

Definition:
The cost of debt is the interest rate required by investors, adjusted for tax-deductibility.
Key Points:
 Interest expense reduces taxable income → tax savings reduce effective cost.
 Hence, bonds are cheaper than equity (as long as debt levels remain moderate).
 If debt becomes excessive → both debt and equity investors demand higher returns → WACC
↑.

4. Accounting vs. Cost of Capital Perspective

(A) Accounting Perspective
 Based on effective annual interest rate (yield to maturity, YTM) at original issue date.
 Remains fixed for the bond’s life, even if market rates change.
 Interest expense =
o Cash interest (coupon rate × par value), plus amortization of discount or
o Minus amortization of premium.
📌 Note: Accounting focuses on historical rate at issue.

(B) Cost of Capital Perspective

 Based on current market rate (investors’ required return) for similar debt.
 Changes with:
o Market conditions.
o Issuer-specific risk.
 Measured using the market value of debt.
📌 Note: Cost of capital is forward-looking → important for financing decisions.

5. After-Tax Cost of Debt Formula

Cd=C×(1−t)C_d = C \times (1 - t)Cd=C×(1−t)
Where:
 C_d = After-tax cost of debt
 C = Pretax cost of debt (interest rate as decimal)
 t = Marginal tax rate
👉 If tax rate ↑ → after-tax cost ↓.
👉 If tax rate ↓ → after-tax cost ↑.

6. Example: LordsTown Inc.

 1,000 bonds, 8-year maturity, 6% coupon.
 Issued at $917.50 per $1,000 par (discount).
 Effective interest rate (YTM at issue): 7.4%.
 Current market price = $1,017.50 (quoted 101.75).
 Current required market rate = 5.5%.
 Tax rate = 20%.
Calculations:
 Accounting perspective cost (pretax): 7.4%.
o After-tax: 0.074×(1−0.20)=5.9%0.074 \times (1 - 0.20) = 5.9\%0.074×(1−0.20)=5.9%.
 Cost of capital perspective cost (pretax): 5.5%.
o After-tax: 0.055×(1−0.20)=4.4%0.055 \times (1 - 0.20) = 4.4\%0.055×(1−0.20)=4.4%.
📌 Key Insight:
 Coupon rate (6%) and original issue price are irrelevant for cost of capital purposes.
 What matters is current market rate (5.5%).

7. Flotation Costs
 Flotation costs = costs of issuing new debt (e.g., underwriting, legal).
 Usually ignored in cost of capital calculations because:
o Most bonds are privately placed.
o Costs are minimal compared to issue size.
📌 Important for accounting, less so for cost of capital (which uses estimates).

8. Comparison Table: Cost of Debt

After-Tax
Perspective Pretax Rate Principal Value Used
Rate
Effective Amortized book value
Effective
interest rate (original proceeds ±
Accounting rate × (1 −
(YTM at issue amortization of
tax rate)
date) discount/premium)
Current market
Current
Cost of rate (investors’ Current market value of
rate × (1 −
Capital required debt
tax rate)
return)

9. Important Caveat
 Formula Cd=C(1−t)C_d = C(1 - t)Cd=C(1−t) assumes company has taxable income.
 If no taxable income → no tax savings → after-tax cost = pretax cost.

🔑 Extra Conceptual Clarity

 Why debt is cheaper than equity:
o Interest is tax deductible (equity dividends are not).
o Debt has lower risk (fixed claim, priority in liquidation).
 Why debt can become expensive:
o Too much leverage → higher bankruptcy risk.
o Both bondholders and shareholders demand risk premium.
 Yield to Maturity (YTM):
o Rate of return investors require for holding a bond until maturity.
o Reflects market rate at issue, not coupon.
 Weighted Average Cost of Capital (WACC):
o Mix of cost of equity + cost of debt (after-tax).
o Critical for project valuation and capital budgeting.
📌 Exam Focus:
 Be able to calculate after-tax cost of debt.
 Be able to distinguish between accounting vs cost of capital perspective.
 Understand impact of interest rates & taxes on financing decisions.
📘 CMA Part 2 – Study Unit 8: B.2. Term Structure of Interest Rates

1. Term Structure of Interest Rates

 Definition: The term structure of interest rates describes the relationship between bond yields
(interest rates) and time to maturity, assuming bonds have the same risk characteristics except
maturity.
 Graphical Representation → Yield Curve:
o X-axis = Time to maturity.
o Y-axis = Interest rate (yield).
o The line connecting yields across maturities is the yield curve.
 Purpose: Yield curves provide insights into:
o Investors’ expectations of future interest rates.
o Expectations of economic conditions (e.g., inflation, recession).

2. Typical Yield Curve Shape

 Normal (Upsloping):
o Long-term rates > Short-term rates.
o Why? Investors require higher returns for longer-term investments (greater risk, funds
locked up longer).
 Other Shapes:
o Yield curves can also be downsloping (inverted), flat, or humped depending on market
expectations.

3. Types of Yield Curves

(A) Upsloping Yield Curve (Normal)
 Occurs under normal economic conditions.
 Longer-term bonds → higher rates than shorter-term bonds.
 Rationale: Investors demand higher compensation for greater maturity risk.
 Steeper-than-normal Upslope (Important Insight):
o Indicates expectations of higher future inflation & interest rates.
o Investor behavior:
 Investors prefer short-term debt → so they can reinvest later at higher rates.
 Borrowers prefer long-term debt → to lock in current lower rates.
o Effect on supply & demand:
 Supply of short-term funds ↑, demand for short-term borrowing ↓ → short-
term rates ↓.
 Supply of long-term funds ↓, demand for long-term borrowing ↑ → long-term
rates ↑.
o Net result = Steeper Upsloping Yield Curve.

(B) Downsloping Yield Curve (Inverted)

 Indicates expectation that future interest rates will fall.
 Investor/borrower behavior:
o Borrowers → Prefer short-term debt, expecting to refinance later at lower rates.
o Investors → Prefer long-term debt, to lock in current higher rates.
 Effect:
o High demand + low supply in short-term market → short-term rates ↑.
o High supply + low demand in long-term market → long-term rates ↓.
 Net result = Yield curve slopes downward.
📌 Exam Tip: A downsloping (inverted) yield curve is often seen as a predictor of recession.

(C) Humped Yield Curve

 Occurs during a transition period (expectations shifting from rates ↑ to rates ↓).
 Shape: Rates highest in medium-term maturities, lower at short-term and long-term ends.
 Meaning: Short- and long-term yields align, but medium-term reflects uncertainty.

(D) Flat Yield Curve

 Occurs when market expects no major changes in interest rates.
 Short-term, medium-term, and long-term yields are nearly the same.

4. Visual Representation of Yield Curves

Typical shapes:
 Upsloping (Normal).
 Downsloping (Inverted).
 Flat.
 Humped.
(Seen in graphs: X-axis = maturity, Y-axis = yield.)

5. Yield Curves by Bond Classification

 At any point in time, there are multiple yield curves (one for each risk class of bonds).
 Examples:
o U.S. Treasury securities (lowest risk, lowest return).
o AAA Corporate bonds.
o BBB Corporate bonds.
 Rule: Riskier bonds = higher yield curve (shifted upward).

6. U.S. Treasury Securities (Examples of Bonds by Term)

 Treasury Bills (T-bills):
o Short-term securities.
o Maturities: A few days → 52 weeks.
 Treasury Notes:
o Intermediate-term securities.
o Maturities: 2, 3, 5, 7, 10 years.
 Treasury Bonds:
o Long-term securities.
o Maturities: 20, 30 years.
📌 Concept: Treasury yield curve = benchmark "risk-free" yield curve (lowest yields).

🔑 Extra Conceptual Clarity

Why Yield Curves Matter in Finance & CMA Exam
1. Investment Decisions:
o Steep yield curve → expectation of growth/inflation → investors may shift strategies.
o Inverted yield curve → signals possible recession.
2. Corporate Financing Decisions:
o Companies choose short-term vs long-term borrowing depending on yield curve shape.
o Example: If inverted, companies might borrow long-term now (since long-term rates are
cheaper).
3. Project Valuation & Discount Rates:
o Yield curve influences cost of capital.
o Longer-term projects are discounted at higher rates under normal yield curve.

📌 Exam Tips
 Know all four shapes of yield curves and what they indicate.
 Be able to explain investor & borrower behavior behind each shape.
 Know how supply/demand shifts affect short-term vs long-term rates.
 Understand Treasury securities maturities (T-bills, notes, bonds).
 Recognize that yield curves differ by credit risk category (Treasury vs Corporate).
📘 CMA Part 2 – Study Unit 9: B.2. Bond Duration

1. Interest Rate Risk & Market Value of Bonds

 Key Rule:
o Interest rates ↑ → Market value of bonds ↓
o Interest rates ↓ → Market value of bonds ↑
 Why? Investors must receive returns equal to current market rates for bonds of similar term &
risk.
 This fluctuation in bond value due to interest rate changes = Interest Rate Risk.

2. Duration – The Best Measure of Interest Rate Risk

 Definition:
o Duration = a time expression that measures a bond’s sensitivity to interest rate
changes.
 o It is a weighted average of the times until all cash flows (coupon + principal) are
received.
o Weights = proportion of present value of each cash flow relative to total PV of bond.
 Interpretation:
o Higher duration → Bond price more sensitive to interest rate changes.
o Lower duration → Bond price less sensitive.
 CMA Exam: You don’t need to calculate duration, but you must know:
o What duration is.
o Factors that affect duration.
o How duration impacts interest rate risk.

3. Factors Affecting Duration

1. Time to Maturity (Main Factor):
o Longer maturity → Higher duration → Greater sensitivity (more risk).
o Short-term securities (e.g., money market instruments) → little to no effect from rate
changes.
o Long-term corporate bonds → highly affected.
o As maturity date approaches → Duration decreases → Sensitivity falls.
2. Coupon Rate (Nominal Interest Rate on Bond):
o Higher coupon → Lower duration.
o Why? More cash is received earlier (reduces the impact of final repayment).

4. Using Duration in Portfolio Management

 Diversification by Duration (Duration Hedging):
o Mix short-term, intermediate-term, and long-term bonds.
o Reduces overall sensitivity to interest rate moves.
o Better than holding only long-term bonds.
 Portfolio Duration:
o Weighted average of durations of bonds in the portfolio (weights based on market
value).
o Lower portfolio duration = Lower overall interest rate risk.

🔑 Extra Clarity on Duration

 Rule of Thumb:
o 1% change in interest rates → Bond price will change approx. by the bond’s duration %.
o Example: Bond with duration of 5 → 1% rise in interest rates causes ~5% price drop.
 Practical Insight:
o Duration is like the “elasticity” of bond prices with respect to interest rates.
 CMA Angle:
o Expect questions on comparing risk levels of bonds with different maturities/coupons.

📘 CMA Part 2 – Study Unit 10: B.2. Equity Financing

1. Two Types of Equity Securities

1. Common Stock (all companies issue).
2. Preferred Stock (only some companies issue).
 2. Common Stock
 Residual Ownership:
o Common shareholders get paid last (after creditors & preferred stockholders) in
liquidation.
 Cost of Common Stock:
o Highest among financing sources (due to highest risk).
o No guaranteed return → but unlimited upside (dividends + capital appreciation).
 Rights of Common Shareholders:
o Voting Rights:
 Vote on issues (especially electing Board of Directors).
 Can assign proxy if not attending annual meeting.
o Dividends:
 Right to receive if declared (not guaranteed).
o Preemptive Rights:
 Right to buy proportionate share of new issues to avoid dilution.
 If not exercised → ownership diluted.
o Residual Assets:
 Share in leftover assets after liquidation once creditors & preferred holders are
paid.

3. Par Value of Shares

 Definition:
o Arbitrary amount set by company when issuing shares.
 For Common Stock:
o Usually small amount (represents legal capital).
o Legal capital cannot be distributed as dividends.
o Par value = maximum liability of shareholders if company liquidates.
o Par value ≠ market price.
o Accounting treatment:
 Common Stock account credited with par value.
 Excess received credited to Additional Paid-In Capital (APIC).
 For Preferred Stock:
o Used to calculate dividend amount.

4. Preferred Stock
 Hybrid Security: Shares features of bonds and common stock.
 Cost of Preferred Stock: Higher than bonds (more risk).

(A) Preferred Stock vs Bonds

 Similarities with Bonds:
1. Usually no voting rights.
2. Pays a fixed annual dividend.
3. Dividend = % of par value (like interest).
4. Higher liquidation claim than common stock.
5. Often issued with bond-like features (convertibility, callability, etc.).

(B) Preferred Stock vs Common Stock

 Similarities with Common Stock:
1. Dividends must be declared by board before payment.
2. Failure to pay dividends ≠ breach of contract (no bankruptcy).
3. Dividends are not tax-deductible.
4. In liquidation: Preferred < Bondholders, but > Common stockholders.

(C) Characteristics of Preferred Shares

1. Callable/ Redeemable:
o Company can buy back shares at call price (may include call premium).
2. Convertible:
o Option to convert into common shares (usually to gain voting rights).
3. Participating:
o Can earn extra dividends if company profits exceed expectations.
o May share in common dividends too.
4. Voting Rights (Special Cases):
o Some preferred shares gain voting rights (e.g., when cumulative dividends are unpaid).

(D) Dividends on Preferred Stock

 Fixed % of par value.
 Examples:
o Par $25, dividend 6% → $1.50 annually.
o Par $50, dividend 6% → $3 annually.
 Types of Preferred Dividends:
o Cumulative:
 Dividends accumulate if unpaid.
 Must be fully paid before common dividends.
 “Dividends in arrears” are disclosed in financial statements (not a liability).
o Non-Cumulative:
 Missed dividends are lost forever.

📌 Exam Tips (High-Probability Areas)

 Duration:
o Longer maturity = higher duration = more sensitive.
o Higher coupon = lower duration.
o As maturity approaches → duration falls.
 Common Stock:
o Highest cost of financing.
o Key rights: vote, dividends (if declared), preemptive rights, residual claim.
 Preferred Stock:
o Hybrid → know similarities to both bonds & common stock.
o Cumulative vs Noncumulative is often tested.
o On exam: If problem doesn’t say “cumulative,” assume it’s noncumulative.
📘 CMA Part 2 – Study Unit 11: B.3. Dividend Policy & Treasury Stock

1. Dividends – Basics
 Definition: Dividends are payments made to shareholders, usually from retained earnings.
 Forms of Dividends:
 1. Cash dividend (most common).
2. Property dividend (distribution of assets such as inventory).
3. Stock dividend (new shares instead of cash).

2. Cash Dividends
 Normal case: Paid out of retained earnings (return on investment).
 Liquidating dividend: Paid when no retained earnings exist → return of shareholder capital.
🔑 Shareholder returns come in two forms:
1. Cash dividends.
2. Capital gains (increase in stock price).
 If company retains earnings instead of paying dividends, investors expect higher stock price
growth.

3. Dividend Policy
 Definition: Rules a company follows to decide how much dividend to pay.
 Objective: Maximize shareholder wealth.
 Two approaches:
1. Active Policy:
 Management believes dividends send a message to the market (financial
signaling).
 Dividend decisions used strategically to show profitability & stability.
2. Passive Policy:
 Management believes dividends don’t influence stock value much.
 No special effort to set policy.

4. Dividend Stability & Signaling

 Dividends are more stable than profits (management avoids frequent changes).
 Decreasing dividends = negative signal (investors see weakness).
 Unusually high profits (non-recurring):
o Company may not raise dividend (to avoid later cutbacks).
 Increasing dividends: Only if management expects sustainable future profits.

5. Factors Affecting Dividend Policy

1. Stability of Earnings – Stable companies can afford higher payout.
2. Financing Policy – Companies that avoid borrowing retain more earnings → lower dividends.
3. Liquidity / Cash Needs – Cash must be available for dividend payments.
4. Available Investment Projects – Profitable projects reduce funds for dividends.
5. Debt Service Obligations – Heavily indebted firms → lower dividends.
6. Ability to Borrow – Firms with strong credit can pay higher dividends.
7. Past Dividend Rate – Shareholders expect consistency; history matters.
8. Growth Needs – Fast-growing firms retain more cash → lower dividends.
9. Corporate Tax Rates – Higher taxes reduce distributable profits.
10. Shareholder Tax Position –
 High-income investors → prefer capital gains (lower taxes).
 Retirees/lower-income investors → prefer dividends (income stream).

6. Common Dividend Practices

 Regular Dividends (annual/quarterly):
 o Expected by shareholders → factored into stock price.
o Failure to pay → sharp price decline & loss of investor confidence.
 Stable/Constant Dividend:
o Even if profits fall, dividends may be maintained using past retained earnings.
 Gradual Increases:
o Many companies increase dividends slowly to meet shareholder expectations.
 Market Reaction:
o Dividend cuts or increases strongly influence share price.
o 7. Residual Dividend Policy
o Definition: Dividend is paid only if funds remain after financing all investment opportunities.
o Assumption:
o Investors prefer the company to reinvest if it can earn more than shareholders could on their
own.
o Nature: Passive policy.

o
o Example (Residual Dividend Policy)
o CAB Systems → Maintains D/E ratio = 0.5:1 (1/3 debt, 2/3 equity).
o Net income = $150,000
o New Project = $120,000
o Funding breakdown:
o Debt (1/3) = $40,000
o Equity (2/3) = $80,000 (from retained earnings)
o Dividend capacity = $150,000 – $80,000 = $70,000
o If project required $225,000 → Debt = $75,000, Equity = $150,000.
o All NI ($150,000) needed → No dividends available.
o If project requires even more equity → Company must issue new stock.

o
o 8. Reasons for Not Paying Dividends
o Rapid Growth Phase – Cash needed to finance expansion.
o Economic Downturn Expected – Cash conserved for safety.

o
o 🔑 CMA Exam Focus
o Types of dividends: Cash (regular & liquidating), property, stock.
o Dividend policy types: Active vs passive; residual policy.
o Factors affecting dividend policy: Know the full list (common MCQ area).
o Residual dividend calculations: Be ready for simple math (like CAB example).
o Signaling effect: Dividend cuts = bad news, stable/increasing dividends = positive signal.
o Growth vs Mature companies:
o Growth firms = low/no dividends.
o Mature firms = stable/high dividends.
o 📘 CMA Notes – Dividend Policy & Stock Splits

o
o 1. Stock Dividends
o Definition: A dividend paid in shares of the company instead of cash.
o Purpose: Provides a return to shareholders while conserving cash.
o Common for companies in growth stage.
o Example:
o Declares 5% stock dividend → 1 share for every 20 owned.
o If shareholder owns 2,000 shares → receives 100 extra shares.
o Effects on Company & Shareholders:
o More shares outstanding → EPS ↓ and book value per share ↓.
o Market price per share usually falls proportionally to stock dividend %.
o No dilution of ownership: Each shareholder still owns the same % of company.
o Total market capitalization unchanged.
o Important Clarifications:
o Not a distribution of assets.
o Creates no liability for the company.
o Not taxable income to recipients.
o 🔑 Exam Pointer: Stock dividends reduce EPS but do NOT change ownership %, total value, or
market capitalization.
o
o 2. Liquidating Dividends
o Definition: Dividend declared when company has no retained earnings.
o Represents return of shareholders’ capital, not profit distribution.
o Accounting Treatment:
o Reduces Paid-in Capital (APIC), not retained earnings.
o Partially liquidating dividend = mixture of normal dividend (RE) + liquidating dividend (APIC).
o Example:
o Dividend = $20,000.
o Retained Earnings = $8,000.
o First $8,000 reduces RE.
o Remaining $12,000 reduces APIC.
o 🔑 Exam Pointer: Liquidating dividend = reduction of contributed capital, not profit.
o
o 3. Dividend Payment Process
o Applies to both common & preferred stock.
There are 4 important dates:
o Declaration Date
o Board votes & approves dividend.
o Creates a liability: Dividends Payable.
o Announces date of record & payment date.
o Date of Record
o Determines who is eligible to receive dividend.
o Usually ~1 month after declaration.
o Ex-Dividend Date
o Most important date for investors.
o Anyone buying on or after this date does NOT get dividend.
o Seller on/after this date still gets dividend.
o Stock price typically drops by the dividend amount on this date.
o ✅ Example: Dividend = $2 per share. If stock trades at $50 before ex-div date → price falls to
~$48 on ex-div date.
o Payment Date
o Dividend is distributed.
o Entry: Debit Dividends Payable, Credit Cash.
o Conceptual Note:
o Dividends are better long-term indicators of company stability than net income (because net
income can fluctuate with one-time events).
o
o 4. Stock Splits
o Definition: Increase in number of shares without changing market capitalization.
o E.g., 2-for-1 split → 100 shares become 200, price halves.
o Effects:
o Par value per share ↓ (adjusted).
o No accounting entry, just memorandum.
o Total capitalization unchanged.
o Shareholder % ownership unchanged.
o EPS ↓ (more shares).
o Example:
o 500,000 shares, $3 par, price $60 → Mkt Cap = $30M.
o 3-for-1 split → 1,500,000 shares @ $20 each.
o New par = $1.
o Mkt Cap remains $30M.
o Key Difference from Stock Dividend:
o Stock split adjusts par value, stock dividend does NOT.
o
o 5. Reverse Stock Splits
o Definition: Opposite of stock split — decreases shares outstanding, increases price.
o Example:
o 1-for-2 reverse split.
o Before: 200 shares @ $10 = $2,000.
o After: 100 shares @ $20 = $2,000.
o Market capitalization unchanged.
o Purpose:
o Often used to raise per-share price (e.g., to meet stock exchange listing requirements).
o
o 🔍 Extra Conceptual Clarity (Exam-Oriented)
o Stock Dividend vs Stock Split
o Both: More shares, unchanged ownership %, unchanged total mkt cap.
o Difference:
o Stock dividend: NO par value change.
o Stock split: Par value reduced.
o Liquidating Dividend vs Cash Dividend
o Cash dividend → RE ↓.
o Liquidating dividend → APIC ↓ (capital return).
o Ex-Dividend Date Importance
o Determines “who gets the dividend.”
o Price adjustment is a crucial testable concept (stock drops by dividend amount).
o Why Firms Use Stock Splits
o Psychological — makes stock appear “affordable” to retail investors.
o Improves liquidity of shares (more shares outstanding).
o 📘 CMA Notes – Dividend Policy, Treasury Stock & Related Concepts
o
o 1. Stock Dividends
o Definition: A dividend paid in company’s own shares instead of cash.
o Purpose: Provides a return to shareholders while conserving cash (helpful when company wants
to reinvest cash for growth).
o Example:
o 5% stock dividend = 1 share for every 20 shares held.
o Shareholder with 2,000 shares → gets 100 new shares.
o Effects on Company:
o More shares outstanding →
o Lower EPS (Earnings per share).
o Lower Book Value per share.
o Lower Market Price per share (falls in proportion to dividend issued).
o Effects on Shareholders:
o Ownership % remains same.
o Total value of holdings unchanged:
o Owns more shares, but each is worth less.
o Example: 100 shares @ $50 = $5,000 → After 10% dividend → 110 shares @ ~$45.45 = $5,000.
o Important Notes:
o Stock dividend does not distribute assets.
o Declaration of stock dividend does not create liability.
o Not taxable income to shareholder.
o Market capitalization of company unchanged.
o ✅ Exam Tip: Stock dividend ≠ cash dividend (no liability, no asset reduction, no taxation).
o
o 2. Liquidating Dividends
o Normal dividends: Paid from retained earnings.
o Liquidating dividend: Paid when no retained earnings available → Return of capital, not profit.
o Accounting Treatment:
o Reduces Paid-in Capital (APIC), not retained earnings.
o Partially Liquidating Dividend:
o Example: Dividend declared = $20,000.
o Retained earnings = $8,000.
o $8,000 → normal dividend (reduces RE).
o $12,000 → liquidating dividend (reduces APIC).
o ✅ Exam Tip: Watch whether dividend reduces RE (normal) or APIC (liquidating).
o
o 3. Dividend Payment Process (applies to common & preferred stock)
o Four Important Dates:
o Declaration Date:
o Board approves dividend.
o Creates liability: Dividends Payable.
o Company announces: Declaration date, Record date, Payment date.
o Date of Record:
o Determines who owns shares & gets dividend.
o Usually ~1 month after declaration.
o May adjust estimates of total dividends payable.
o Ex-Dividend Date:
o Set a few days before record date (settlement period).
o Key Rule:
o Buy before ex-date → eligible for dividend.
o Buy on/after ex-date → not eligible.
o Sell on/after ex-date → still get dividend.
o Market behavior:
o Price rises before ex-date (includes dividend value).
o Price drops on ex-date by dividend amount.
o Bigger dividend = bigger price adjustment.
o Payment Date:
o Company pays dividend.
o Entry: Debit Dividends Payable → Credit Cash.
o 📌 Concept Clarity:
o Net Income = can fluctuate (non-recurring events).
o Dividends = better long-term stability signal of company’s strength.
o
o 4. Stock Splits
o Definition: Each share split into more shares (no cash involved).
o Example: 2-for-1 → 100 shares → 200 shares.
o Effect:
o Price per share falls proportionally.
o Market capitalization unchanged.
o Ownership % unchanged.
o Accounting:
o No journal entry.
o Par value per share reduced.
o Memo entry made (par ↓, shares outstanding ↑).
o 📌 Stock Dividend vs. Stock Split:
o Stock dividend → no change in par value.
o Stock split → par value reduced.
o Example:
o 500,000 shares @ $3 par.
o Market price = $60.
o Total market cap = $30M.
o 3-for-1 split →
o 1,500,000 shares @ $20 market price.
o New par = $1.
o Market cap = $30M (unchanged).
o Reverse Stock Split:
o Opposite of split → fewer shares outstanding, higher price per share.
o Example: 1-for-2 → 200 shares @ $10 = $2,000 → becomes 100 shares @ $20 = $2,000.
o Total market cap remains unchanged.
o ✅ Exam Tip: Both splits and dividends keep total equity & ownership % unchanged.
o
o 5. Treasury Stock
o Definition: Shares repurchased by company after being issued.
o Not an asset → reduces equity.
o Treasury shares are issued but not outstanding.
o Key Points:
o Treasury shares:
o No dividends.
o No voting rights.
o Not included in shares outstanding count.
o Reasons to Repurchase:
o Increase EPS (fewer shares outstanding).
o Reduce supply → increase market price.
o Shares for mergers/acquisitions.
o Fund employee stock ownership plan (ESOP).
o Company believes stock undervalued (investment).
o Reuse for stock dividends, resale, or share-based payments.
o Important Note:
o Treasury shares → no dividends, no voting.
o If resold/reissued → become outstanding again.
o
o 🌟 Extra Concept Clarifications (CMA Exam-Oriented)
o EPS Dilution in Stock Dividend:
o EPS goes down, but investor ownership % unchanged. This is why analysts don’t see stock
dividends as true dilution.
o Liquidating Dividend vs. Normal Dividend:
o Normal = profit distribution.
o Liquidating = capital return → signals possible financial weakness.
o Ex-Dividend Date:
o Most tested in CMA → You must know who gets dividend (buyer or seller) depending on
transaction date.
o Stock Split vs. Dividend:
o Trick question: Both leave total capitalization unchanged → must distinguish par value
treatment.
o Treasury Stock Accounting:
o Two methods (Cost method vs. Par value method). CMA usually expects Cost method
knowledge.
o 📘 CMA Notes – Stock Rights, Warrants, ADRs
o
o 1. Stock Rights (Preemptive Rights)
o Definition: Right to buy stock directly from the issuing company at a set price before a given
expiration date.
o Purpose: Protect existing shareholders by allowing them to maintain their proportional
ownership when new shares are issued.
o Legal Basis: May be granted by corporate charter or required by state law.
o Key Points:
o Usually 1 right per share owned.
o Rights required to buy 1 new share = depends on % increase in shares.
o Rights are transferable.
o Subscription period: Typically 3 weeks or less.
o Example:
o Company increases shares by 5%.
o Each shareholder gets 1 right per share.
o 20 rights needed for 1 new share.
o A shareholder with 100 shares gets 100 rights → can buy 5 new shares → ownership % remains
constant.
o Choices for Rights Holder:
o Exercise the rights (buy new shares).
o Sell the rights (they trade separately).
o Let the rights expire.
o Ex-Rights Concept:
o Ex-rights date: last date to buy stock with rights attached.
o If stock is sold before ex-rights date → buyer gets rights.
o If sold after → seller keeps rights.
o
o 2. Valuing Stock Rights
o Theoretical (intrinsic) value depends on:
o Market price of stock
o Subscription (offer) price
o Number of rights needed
o (A) Rights-On Formula (rights still attached to stock):
o Vr=P0−Pnr+1V_r = \frac{P_0 - P_n}{r + 1}Vr=r+1P0−Pn
o P₀ = market price with rights attached
o Pₙ = subscription price
o r = rights required per new share
o Vᵣ = value of one right
o Example (Medina Co.):
o 5,000,000 shares @ $50.
o Wants $100M → 2.5M new shares @ $40.
o 1 right/share issued = 5M rights.
o 2 rights = 1 new share.
o Calculation:
o Vr=50−402+1=103=3.33V_r = \frac{50 - 40}{2+1} = \frac{10}{3} = 3.33Vr=2+150−40=310=3.33
o
o (B) Ex-Rights Formula (rights trade separately):
o Vr=(Pex−Pn)rV_r = \frac{(P_{ex} - P_n)}{r}Vr=r(Pex−Pn)
o Example (Medina Co.):
o Market drops to $46.67 after ex-rights.
o Vr=46.67−402=3.33V_r = \frac{46.67 - 40}{2} = 3.33Vr=246.67−40=3.33.
o Stockholder selling ex-rights gets $46.67 (stock) + $3.33 (right) = $50 total (same as before).
o
o 3. Employee Stock Options (ESOs)
o Definition: Rights given to employees to buy shares at a set exercise/strike price.
o Purpose: Compensation + incentive to increase share price.
o Capital impact: Company raises capital when employees exercise options.
o Comparison with Market Options:
o Market-traded options = between investors (company not involved).
o ESOs = directly from company → new shares issued → capital inflow.
o
o 4. Stock Warrants
o Similar to rights/options → right to buy stock at a set price for a defined period.
o Key differences from rights:
o Usually attached to bonds or preferred stock.
o Not based on current ownership.
o Longer maturity (years vs. weeks for rights).
o Warrants & Bonds:
o Detachable warrants: Can be separated and traded independently. Issuer must allocate bond
price between bond and warrants (based on fair value).
o Nondetachable warrants: No value separate from bond → all price allocated to bond.
o Standalone warrants: Sometimes given to partners/investors to “sweeten” deals.
o Capital Impact: Company gets capital only if warrants are exercised (same as rights & ESOs).
o
o 5. American Depository Receipts (ADRs)
o Definition: Certificates issued by U.S. banks representing ownership in shares of a foreign
company.
o Purpose: Allow foreign companies to trade in U.S. markets without SEC registration.
o Mechanism:
o Foreign company deposits shares with a bank.
o Bank issues ADRs representing those shares.
o ADRs trade on U.S. secondary markets.
o Benefit: Simplifies U.S. investment in foreign companies + allows foreign firms to access U.S.
capital markets.
o
o 🔑 Exam-Oriented Clarifications & Tips
o Rights vs. Warrants:
o Rights = short-term, offered to existing shareholders, protect ownership.
o Warrants = long-term, usually with bonds, sweetener for investors.
o ESO vs. Market Options: CMA exam tests the difference → ESOs = capital inflow, market options
= no capital inflow.
o ADR exam trick: U.S. investors can buy foreign companies without dealing with foreign
exchanges.
o Formula to memorize:
o Rights-on: P0−Pnr+1\frac{P_0 - P_n}{r+1}r+1P0−Pn
o Ex-rights: Pex−Pnr\frac{P_{ex} - P_n}{r}rPex−Pn
o 📘 Study Unit 13: B.2. Calculation of the Value of a Share
o 🔑 Big Picture
o A company issues shares → raises capital (willing to pay dividends/interest).
o Investors → must see enough return for risk → decide max price to pay.
o CMA exam questions:
o Find investors’ required rate of return (R).
o Find max price investor will pay (P0).
o Find cost of capital to company.
o
o 1️⃣ Intrinsic Value of a Share
o Intrinsic value (theoretical value) = what the stock should be worth based on fundamentals.
o Market price ≠ Intrinsic value → this difference drives buy/sell decisions.
o Based on present value of all future expected cash flows (dividends + sale price) discounted at
investors’ required rate of return (R).
o 👉 Key: Use INVESTORS’ required rate of return (not company’s).
o Different investors → different R → different valuations.
o But models use average R for all market participants.
o
o 2️⃣ Valuation Models
o Models depend on dividend assumptions.
o (a) Zero Growth (Constant Dividend) Model
o Used for Preferred stock or common stock with fixed dividend.
o Formula:
o P0=DRP_0 = \frac{D}{R}P0=RD
o Where:
o P0P_0P0 = Intrinsic value today
o DDD = Annual dividend
o RRR = Investors’ required rate of return
o Example 1:
o Pref. share pays $1.00 dividend.
o R = 5%.
o P0=10.05=20P_0 = \frac{1}{0.05} = 20P0=0.051=20
o Intrinsic value = $20 (below $25 par).
o If R ↓ to 4%:
o P0=10.04=25P_0 = \frac{1}{0.04} = 25P0=0.041=25
o Value rises to par.
o ⚡ Exam Tip: Value moves opposite to required return. If R ↑ → Value ↓.
o
o (b) Dividend Growth Model (Constant Growth Model / Gordon Growth Model)
o Used for common stock with growing dividends.
o Assumption: Dividends grow at a constant % rate forever.
o Formula:
o P0=D1R−GP_0 = \frac{D_1}{R - G}P0=R−GD1
o Where:
o D1D_1D1 = Next dividend = Last dividend × (1 + g)
o RRR = Required rate of return
o GGG = Dividend growth rate
o Example 2:
o Last dividend = $1.10.
o Growth = 5%. → D1=1.10×1.05=1.155D_1 = 1.10 × 1.05 = 1.155D1=1.10×1.05=1.155.
o R = 12%.
o P0=1.1550.12−0.05=16.50P_0 = \frac{1.155}{0.12 - 0.05} = 16.50P0=0.12−0.051.155=16.50
o If R ↑ to 15%:
o P0=1.1550.15−0.05=11.55P_0 = \frac{1.155}{0.15 - 0.05} = 11.55P0=0.15−0.051.155=11.55
o ⚡ Exam Tip: Dividend growth model is sensitive to (R – G). Small changes → big price shifts.
o
o (c) Dividends + Expected Future Stock Price Model
o Used when growth rate not given, but future stock price (P1) is given.
o Formula:
o P0=D1+P11+RP_0 = \frac{D_1 + P_1}{1 + R}P0=1+RD1+P1
o Where:
o P1P_1P1 = Expected price after 1 year
o D1D_1D1 = Next dividend
o RRR = Required rate of return
o ⚡ Common in CMA MCQs where dividend growth isn’t given but P1 is provided.
o
o (d) Using CAPM with Dividend Models
o If R (required return) is not given → use CAPM.
o R=Rf+β(Rm−Rf)R = R_f + β (R_m - R_f)R=Rf+β(Rm−Rf)
o Where:
o RfR_fRf = Risk-free rate
o βββ = Stock beta
o RmR_mRm = Market return
o Example 3:
o β = 0.8, Rf = 0.5%, Rm = 5%.
o R=0.005+0.8(0.05−0.005)=0.041=4.1%R = 0.005 + 0.8(0.05-0.005) = 0.041 =
4.1\%R=0.005+0.8(0.05−0.005)=0.041=4.1%
o Last dividend = $1.00, Growth = 2%.
→ D1=1.00×1.02=1.02D_1 = 1.00 × 1.02 = 1.02D1=1.00×1.02=1.02.
o P0=1.020.041−0.02=48.57P_0 = \frac{1.02}{0.041 - 0.02} = 48.57P0=0.041−0.021.02=48.57
o ⚡ Exam Tip: Always calculate next dividend (D1), not last dividend.
o
o (e) Zero Growth + CAPM
o Same as (a), but R is found using CAPM.
o Example 4:
o β = 0.8, Rf = 0.5%, Rm = 5%.
o R=0.005+0.8(0.05−0.005)=0.041=4.1%R = 0.005 + 0.8(0.05 - 0.005) = 0.041 =
4.1\%R=0.005+0.8(0.05−0.005)=0.041=4.1%
o Dividend = $1.00, no growth.
o P0=10.041=24.39P_0 = \frac{1}{0.041} = 24.39P0=0.0411=24.39
o
o (f) Two-Stage Dividend Discount Model
o Used when dividend grows at one rate for some years, then shifts to another rate.
o Solve in two parts:
o PV of dividends during high-growth period.
o PV of stock price at end of high-growth (using Gordon model with new growth rate).
o ⚡ Common for MCQs & Essays.
o
o (g) Relative/Comparable Valuation
o Not based on cash flows.
o Uses multiples (P/E ratio, EV/EBITDA, etc.) of comparable public companies to value a private
company.
o ⚡ Likely to appear in essay questions (more conceptual than numerical).
o
o 3️⃣ Key Takeaways for CMA
o Zero Growth → Pref. stock (constant dividend).
o Constant Growth → Common stock with growing dividends.
o If growth rate unknown but P1 given → Div + P1 Model.
o If R not given → use CAPM.
o CAPM is essential → make sure you can calculate required return quickly.
o Exam trick: Always check if the dividend given is last year’s (D0) or next year’s (D1). Adjust if
needed.
o
o 📘 Study Unit 13: B.2. Valuation Models (Advanced)
o
o 5️⃣ Two-Stage Dividend Discount Model
o Used when high growth → slows to normal growth.
o Steps:
o PV of dividends during high-growth period (each separately discounted).
o Terminal value at end of high-growth period = Gordon Growth Model with new growth rate.
o Pt=Dt+1R−gP_t = \frac{D_{t+1}}{R - g}Pt=R−gDt+1
o Discount terminal value back to present.
o Add both parts = intrinsic value.
o Fastgrowth Example Recap:
o D1=1.00,g=20%D_1 = 1.00, g = 20\%D1=1.00,g=20% for 3 yrs, then 7% thereafter, R=14%R =
14\%R=14%.
o Step 1: PV of 3 dividends = $2.77.
o Step 2: Year 4 dividend = 1.44×1.07=1.541.44 × 1.07 = 1.541.44×1.07=1.54.
o Step 3: Terminal value = 1.54/(0.14−0.07)=22.001.54 / (0.14 - 0.07) =
22.001.54/(0.14−0.07)=22.00.
o Step 4: Discount back 3 yrs: 22×0.675=14.8522 × 0.675 = 14.8522×0.675=14.85.
o Step 5: Add: 2.77+14.85=17.622.77 + 14.85 = 17.622.77+14.85=17.62.
o ✅ Intrinsic Value = $17.62.
o ⚡ Exam Tip: Always split into fast-growth part + constant growth part. Students often forget to
discount the terminal value!
o
o 6️⃣ Present Value of Expected Future Cash Flows
o Use when dividends or selling price don’t fit Gordon/Two-stage model.
o Simply:
o P0=∑CFt(1+R)tP_0 = \sum \frac{CF_t}{(1+R)^t}P0=∑(1+R)tCFt
o Where CFt=CF_t =CFt= dividend(s) + selling price (if applicable).
o Example (GYM Corp):
o Cash flows: $1.00 (Yr1), $1.10 (Yr2), $1.21 + $15 (Yr3).
o Discount @ 10%.
o Yr1: 1/1.10=0.911 / 1.10 = 0.911/1.10=0.91
o Yr2: 1.10/1.21=0.911.10 / 1.21 = 0.911.10/1.21=0.91
o Yr3: (1.21+15)/1.331=12.18(1.21 + 15)/1.331 = 12.18(1.21+15)/1.331=12.18
o Total PV ≈ $14.00.
o ⚡ Exam Tip: If you see dividends + a buyout/expected sale → this model applies.
o
o 7️⃣ Relative or Comparable Valuation Models
o Based on multiples of comparable companies.
o Used for both public & private companies.
o (a) Price/Earnings (P/E) Ratio
o P0=Risk-adjusted P/E ratio×EPSP_0 = \text{Risk-adjusted P/E ratio} × \text{EPS}P0=Risk-
adjusted P/E ratio×EPS
o Example: EPS = $3, Industry P/E = 10–15.
o If high risk → use lower end (e.g., 10.7).
o Value = 10.7×3=3210.7 × 3 = 3210.7×3=32.
o
o (b) Market/Book Ratio
o P0=Risk-adjusted M/B ratio×Book Value per ShareP_0 = \text{Risk-adjusted M/B ratio} × \
text{Book Value per Share}P0=Risk-adjusted M/B ratio×Book Value per Share
o
o (c) Price/Sales Ratio
o P0=Risk-adjusted P/S ratio×Sales per ShareP_0 = \text{Risk-adjusted P/S ratio} × \text{Sales per
Share}P0=Risk-adjusted P/S ratio×Sales per Share
o ⚠️Weakness: ignores profitability.
o
o (d) Using Multiple Comparables
o Analysts often combine P/E, M/B, and P/S → get a valuation range.
o Risk position determines whether to use low end or high end of comparable multiples.
o ⚡ Exam Tip:
o If company = higher risk → apply lower multiples.
o If company = lower risk → apply higher multiples.
o
o 🎯 CMA Exam Insights
o Most tested formulas:
o Constant Growth Model (Gordon).
o Two-Stage Dividend Discount Model.
o PV of Expected Cash Flows (when selling price is given).
o P/E Ratio valuation.
o Common traps:
o Forgetting to use D1 (next dividend) instead of D0.
o Forgetting to discount terminal value in two-stage model.
o Applying wrong multiple (EPS for P/E, BV for M/B, Sales for P/S).
o 📘 CMA Part 2 – Study Notes
o Study Unit 14: B.2. Cost of Capital – Cost of Preferred Stock
o 1. Cost of Capital & Equity Basics
o Cost of equity = average rate of return required by investors.
o Investors calculate the worth of a share to them → this becomes the company’s cost of raising
that equity.
o Used in WACC (Weighted Average Cost of Capital) calculations.
o
o 2. Cost of Preferred Stock
o Preferred stockholders receive fixed dividends, usually expressed as a % of par value.
o A. Cost of Existing Preferred Stock
o Dividend basis: Most preferred shares pay dividend as % of par value.
o Example: Par = $50, Dividend = 5% → $2.50 annual dividend.
o Dividend declared by Board of Directors, but usually very reliable.
o Important: Dividends = distribution of income, not tax-deductible (unlike interest expense).
o Formula:
o Cp=Annual Cash Dividend per ShareCurrent Market Price of Preferred StockC_{p} = \frac{\
text{Annual Cash Dividend per Share}}{\text{Current Market Price of Preferred Stock}}Cp
=Current Market Price of Preferred StockAnnual Cash Dividend per Share
o Numerator (dividend) = fixed (set at issuance).
o Denominator (market price) = fluctuates → cost of preferred stock changes over time.
o 🔹 Example – Steeler Corp.
o Preferred stock outstanding = 28,000 shares.
o Par value = $100, Market price = $98.
o Annual dividend = 5% of $100 = $5.
o Cp=598=0.051=5.1%C_{p} = \frac{5}{98} = 0.051 = 5.1\%Cp=985=0.051=5.1%
o ✅ Interpretation: Investors require 5.1% return on Steeler’s preferred stock (higher than 5%
coupon due to price drop).
o
o B. Cost of Newly Issued Preferred Stock
o Difference: Denominator = Net Proceeds per share, not market price.
o Net Proceeds = Selling Price – Flotation Costs.
o Formula:
o Cnp=DPnC_{np} = \frac{D}{P_n}Cnp=PnD
o Where:
o CnpC_{np}Cnp = Cost of new preferred stock.
o DDD = Annual dividend per share.
o PnP_nPn = Net proceeds per share = issue price – flotation costs.
o 🔹 Example – ROG Corp.
o Issuing 20,000 preferred shares.
o Par = $50, Annual dividend = 5% = $2.50.
o Issue price = $35, Flotation costs = $3 → Net proceeds = $32.
o Cnp=2.5032=0.078=7.8%C_{np} = \frac{2.50}{32} = 0.078 = 7.8\%Cnp=322.50=0.078=7.8%
o ✅ Interpretation: Cost of new preferred stock = 7.8%, higher than coupon due to flotation costs.
o
o ⚖️Key Distinction (Exam Point)
o Existing Preferred Stock → denominator = Current Market Price.
o New Preferred Stock → denominator = Net Proceeds (Issue Price – Flotation Costs).
o
o 🔑 Extra Concept Clarity (Preferred Stock)
o Why dividends are not tax-deductible?
o Because they are paid from after-tax profits → unlike interest expense which reduces taxable
income.
o This makes preferred stock more expensive than debt financing.
o Why market price matters?
o For existing stock, investors trade at market price → cost reflects current return expected by
investors, not par value.
o Impact of Flotation Costs (New Issue):
o Reduces proceeds → increases cost of capital.
o Companies must consider flotation costs before deciding to issue new preferred stock.
o Practical Use:
o Cost of preferred stock is used in WACC (Weighted Average Cost of Capital).
o If cost is higher than alternative financing sources → company may prefer debt or retained
earnings.
o
o Study Unit 15: B.2. Cost of Capital – Cost of Common Equity
o 1. Sources of Common Equity
o Two ways a company raises equity:
o Retained Earnings → profits reinvested instead of paying dividends.
o New Common Stock → issuing additional shares.
o Both are equity → investors expect the same required return.
o Difference:
o Retained earnings → no flotation costs.
o New stock → flotation costs incurred.
o
o 2. Cost of Retained Earnings (Existing Common Equity)
o Not a cash cost (unlike dividends/interest).
o Economic meaning = opportunity cost to shareholders.
o If company retains earnings → shareholders expect adequate return.
o If not, they’d prefer dividends to invest elsewhere.
o Example:
o Company earns 9% on assets.
o Alternative investment = 7%. → Shareholders happy with retention.
o Alternative = 12%. → Shareholders prefer dividend distribution.
o ✅ Conclusion: Cost of retained earnings = investors’ required rate of return = depends on
company risk.
o
o 3. Models to Calculate Cost of Retained Earnings
o Two primary methods:
o Dividend Growth Model (DGM) – when dividends are paid.
o Capital Asset Pricing Model (CAPM) – when dividends not paid.
o
o 4. Dividend Growth Model (DGM)
o Also known as Dividend Discount Model / Constant Growth Model.
o Formula:
o Cre=D1P0+gC_{re} = \frac{D_1}{P_0} + gCre=P0D1+g
o Where:
o CreC_{re}Cre = Cost of retained earnings = investors’ required return.
o D1D_1D1 = Next expected annual dividend per share.
o P0P_0P0 = Current market price of common stock.
o ggg = Expected annual dividend growth rate.
o ⚠️Important: Always use future dividend (D1). If given past dividend (D0), adjust:
o D1=D0×(1+g)D_1 = D_0 \times (1+g)D1=D0×(1+g)
o If dividends are not growing → g=0g = 0g=0.
o
o 🔹 Example – FED Corp.
o Shares outstanding = 90,800.
o Par value = $1 (irrelevant for cost calc).
o Market price = $21.
o Last dividend = $0.75. Growth = 4%.
o Next dividend = $0.75 × 1.04 = $0.78.
o Cre=0.7821+0.04=0.0371+0.04=0.0771=7.71%C_{re} = \frac{0.78}{21} + 0.04 = 0.0371 + 0.04 =
0.0771 = 7.71\%Cre=210.78+0.04=0.0371+0.04=0.0771=7.71%
o ✅ Interpretation: FED must provide at least 7.71% return to shareholders for them to keep
investing.
o
o 5. Exam Tip (Very Important)
o Dividend Growth Model always uses next dividend (D1).
o If exam gives:
o Past dividend → multiply by (1 + g).
o Future dividend → use directly.
o
o 🔑 Extra Concept Clarity (Common Equity)
o Why cost of retained earnings matters?
o Retained earnings = “free” in accounting sense, but not in finance.
o Opportunity cost → shareholders expect return equal to alternative investments.
o DGM Assumptions:
o Dividends grow at constant rate indefinitely.
o Growth rate (g) < cost of equity (otherwise formula invalid).
o Stock price reflects value based on dividend expectations.
o Practical Limitation:
o Not useful if company does not pay dividends.
o Sensitive to estimates of growth rate.
o 📘 CMA Study Notes – Cost of Equity & WACC
o 1. Capital Asset Pricing Model (CAPM)
o Purpose: Used to estimate the cost of equity (both retained earnings & new equity) when
dividends are not paid.
o Formula:
o R=Rf+β(Rm−Rf)R = R_f + \beta (R_m - R_f)R=Rf+β(Rm−Rf)
o Where:
o RRR = Required return (cost of equity)
o RfR_fRf = Risk-free rate (usually government bonds)
o β\betaβ = Beta (systematic risk compared to market)
o RmR_mRm = Expected market return
o (Rm−Rf)(R_m - R_f)(Rm−Rf) = Market risk premium
o Interpretation:
o If Beta < 1 → Stock is less risky than market → Required return < Market return.
o If Beta > 1 → Stock is riskier than market → Required return > Market return.
o ✅ Example (Company Y):
o Beta = 0.90
o Risk-free rate = 1%
o Market return = 8%
o R=0.01+0.90(0.08−0.01)=0.01+0.063=0.073=7.3%R = 0.01 + 0.90(0.08 - 0.01) = 0.01 + 0.063 =
0.073 = 7.3\%R=0.01+0.90(0.08−0.01)=0.01+0.063=0.073=7.3%
o Risk premium = 0.90×(8%−1%)=6.3%0.90 \times (8\% - 1\%) = 6.3\%0.90×(8%−1%)=6.3%.
o Total required return = Risk-free rate (1%) + Risk premium (6.3%) = 7.3%.
o Exam tip: CAPM works well for existing or retained equity.
o Do not use it for IPOs or when flotation costs/underpricing are significant.
o 7. Residual Dividend Policy
o Definition: Dividend is paid only if funds remain after financing all investment opportunities.
o Assumption:
o Investors prefer the company to reinvest if it can earn more than shareholders could on their
own.
o Nature: Passive policy.

o
o Example (Residual Dividend Policy)
o CAB Systems → Maintains D/E ratio = 0.5:1 (1/3 debt, 2/3 equity).
o Net income = $150,000
o New Project = $120,000
o Funding breakdown:
o Debt (1/3) = $40,000
o Equity (2/3) = $80,000 (from retained earnings)
o Dividend capacity = $150,000 – $80,000 = $70,000
o If project required $225,000 → Debt = $75,000, Equity = $150,000.
o All NI ($150,000) needed → No dividends available.
o If project requires even more equity → Company must issue new stock.

o
o 8. Reasons for Not Paying Dividends
o Rapid Growth Phase – Cash needed to finance expansion.
o Economic Downturn Expected – Cash conserved for safety.

o
o 🔑 CMA Exam Focus
o Types of dividends: Cash (regular & liquidating), property, stock.
o Dividend policy types: Active vs passive; residual policy.
o Factors affecting dividend policy: Know the full list (common MCQ area).
o Residual dividend calculations: Be ready for simple math (like CAB example).
o Signaling effect: Dividend cuts = bad news, stable/increasing dividends = positive signal.
o Growth vs Mature companies:
o Growth firms = low/no dividends.
o Mature firms = stable/high dividends.
o 📘 CMA Notes – Dividend Policy & Stock Splits
o
o 1. Stock Dividends
o Definition: A dividend paid in shares of the company instead of cash.
o Purpose: Provides a return to shareholders while conserving cash.
o Common for companies in growth stage.
o Example:
o Declares 5% stock dividend → 1 share for every 20 owned.
o If shareholder owns 2,000 shares → receives 100 extra shares.
o Effects on Company & Shareholders:
o More shares outstanding → EPS ↓ and book value per share ↓.
o Market price per share usually falls proportionally to stock dividend %.
o No dilution of ownership: Each shareholder still owns the same % of company.
o Total market capitalization unchanged.
o Important Clarifications:
o Not a distribution of assets.
o Creates no liability for the company.
o Not taxable income to recipients.
o 🔑 Exam Pointer: Stock dividends reduce EPS but do NOT change ownership %, total value, or
market capitalization.
o
o 2. Liquidating Dividends
o Definition: Dividend declared when company has no retained earnings.
o Represents return of shareholders’ capital, not profit distribution.
o Accounting Treatment:
o Reduces Paid-in Capital (APIC), not retained earnings.
o Partially liquidating dividend = mixture of normal dividend (RE) + liquidating dividend (APIC).
o Example:
o Dividend = $20,000.
o Retained Earnings = $8,000.
o First $8,000 reduces RE.
o Remaining $12,000 reduces APIC.
o 🔑 Exam Pointer: Liquidating dividend = reduction of contributed capital, not profit.
o
o 3. Dividend Payment Process
o Applies to both common & preferred stock.
There are 4 important dates:
o Declaration Date
o Board votes & approves dividend.
o Creates a liability: Dividends Payable.
o Announces date of record & payment date.
o Date of Record
o Determines who is eligible to receive dividend.
o Usually ~1 month after declaration.
o Ex-Dividend Date
o Most important date for investors.
o Anyone buying on or after this date does NOT get dividend.
o Seller on/after this date still gets dividend.
o Stock price typically drops by the dividend amount on this date.
o ✅ Example: Dividend = $2 per share. If stock trades at $50 before ex-div date → price falls to
~$48 on ex-div date.
o Payment Date
o Dividend is distributed.
o Entry: Debit Dividends Payable, Credit Cash.
o Conceptual Note:
o Dividends are better long-term indicators of company stability than net income (because net
income can fluctuate with one-time events).
o
o 4. Stock Splits
o Definition: Increase in number of shares without changing market capitalization.
o E.g., 2-for-1 split → 100 shares become 200, price halves.
o Effects:
o Par value per share ↓ (adjusted).
o No accounting entry, just memorandum.
o Total capitalization unchanged.
o Shareholder % ownership unchanged.
o EPS ↓ (more shares).
o Example:
o 500,000 shares, $3 par, price $60 → Mkt Cap = $30M.
o 3-for-1 split → 1,500,000 shares @ $20 each.
o New par = $1.
o Mkt Cap remains $30M.
o Key Difference from Stock Dividend:
o Stock split adjusts par value, stock dividend does NOT.
o
o 5. Reverse Stock Splits
o Definition: Opposite of stock split — decreases shares outstanding, increases price.
o Example:
o 1-for-2 reverse split.
o Before: 200 shares @ $10 = $2,000.
o After: 100 shares @ $20 = $2,000.
o Market capitalization unchanged.
o Purpose:
o Often used to raise per-share price (e.g., to meet stock exchange listing requirements).
o
o 🔍 Extra Conceptual Clarity (Exam-Oriented)
o Stock Dividend vs Stock Split
o Both: More shares, unchanged ownership %, unchanged total mkt cap.
o Difference:
o Stock dividend: NO par value change.
o Stock split: Par value reduced.
o Liquidating Dividend vs Cash Dividend
o Cash dividend → RE ↓.
o Liquidating dividend → APIC ↓ (capital return).
o Ex-Dividend Date Importance
o Determines “who gets the dividend.”
o Price adjustment is a crucial testable concept (stock drops by dividend amount).
o Why Firms Use Stock Splits
o Psychological — makes stock appear “affordable” to retail investors.
o Improves liquidity of shares (more shares outstanding).
o 📘 CMA Notes – Dividend Policy, Treasury Stock & Related Concepts
o
o 1. Stock Dividends
o Definition: A dividend paid in company’s own shares instead of cash.
o Purpose: Provides a return to shareholders while conserving cash (helpful when company wants
to reinvest cash for growth).
o Example:
o 5% stock dividend = 1 share for every 20 shares held.
o Shareholder with 2,000 shares → gets 100 new shares.
o Effects on Company:
o More shares outstanding →
o Lower EPS (Earnings per share).
o Lower Book Value per share.
o Lower Market Price per share (falls in proportion to dividend issued).
o Effects on Shareholders:
o Ownership % remains same.
o Total value of holdings unchanged:
o Owns more shares, but each is worth less.
o Example: 100 shares @ $50 = $5,000 → After 10% dividend → 110 shares @ ~$45.45 = $5,000.
o Important Notes:
o Stock dividend does not distribute assets.
o Declaration of stock dividend does not create liability.
o Not taxable income to shareholder.
o Market capitalization of company unchanged.
o ✅ Exam Tip: Stock dividend ≠ cash dividend (no liability, no asset reduction, no taxation).
o
o 2. Liquidating Dividends
o Normal dividends: Paid from retained earnings.
o Liquidating dividend: Paid when no retained earnings available → Return of capital, not profit.
o Accounting Treatment:
o Reduces Paid-in Capital (APIC), not retained earnings.
o Partially Liquidating Dividend:
o Example: Dividend declared = $20,000.
o Retained earnings = $8,000.
o $8,000 → normal dividend (reduces RE).
o $12,000 → liquidating dividend (reduces APIC).
o ✅ Exam Tip: Watch whether dividend reduces RE (normal) or APIC (liquidating).
o
o 3. Dividend Payment Process (applies to common & preferred stock)
o Four Important Dates:
o Declaration Date:
o Board approves dividend.
o Creates liability: Dividends Payable.
o Company announces: Declaration date, Record date, Payment date.
o Date of Record:
o Determines who owns shares & gets dividend.
o Usually ~1 month after declaration.
o May adjust estimates of total dividends payable.
o Ex-Dividend Date:
o Set a few days before record date (settlement period).
o Key Rule:
o Buy before ex-date → eligible for dividend.
o Buy on/after ex-date → not eligible.
o Sell on/after ex-date → still get dividend.
o Market behavior:
o Price rises before ex-date (includes dividend value).
o Price drops on ex-date by dividend amount.
o Bigger dividend = bigger price adjustment.
o Payment Date:
o Company pays dividend.
o Entry: Debit Dividends Payable → Credit Cash.
o 📌 Concept Clarity:
o Net Income = can fluctuate (non-recurring events).
o Dividends = better long-term stability signal of company’s strength.
o
o 4. Stock Splits
o Definition: Each share split into more shares (no cash involved).
o Example: 2-for-1 → 100 shares → 200 shares.
o Effect:
o Price per share falls proportionally.
o Market capitalization unchanged.
o Ownership % unchanged.
o Accounting:
o No journal entry.
o Par value per share reduced.
o Memo entry made (par ↓, shares outstanding ↑).
o 📌 Stock Dividend vs. Stock Split:
o Stock dividend → no change in par value.
o Stock split → par value reduced.
o Example:
o 500,000 shares @ $3 par.
o Market price = $60.
o Total market cap = $30M.
o 3-for-1 split →
o 1,500,000 shares @ $20 market price.
o New par = $1.
o Market cap = $30M (unchanged).
o Reverse Stock Split:
o Opposite of split → fewer shares outstanding, higher price per share.
o Example: 1-for-2 → 200 shares @ $10 = $2,000 → becomes 100 shares @ $20 = $2,000.
o Total market cap remains unchanged.
o ✅ Exam Tip: Both splits and dividends keep total equity & ownership % unchanged.
o
o 5. Treasury Stock
o Definition: Shares repurchased by company after being issued.
o Not an asset → reduces equity.
o Treasury shares are issued but not outstanding.
o Key Points:
o Treasury shares:
o No dividends.
o No voting rights.
o Not included in shares outstanding count.
o Reasons to Repurchase:
o Increase EPS (fewer shares outstanding).
o Reduce supply → increase market price.
o Shares for mergers/acquisitions.
o Fund employee stock ownership plan (ESOP).
o Company believes stock undervalued (investment).
o Reuse for stock dividends, resale, or share-based payments.
o Important Note:
o Treasury shares → no dividends, no voting.
o If resold/reissued → become outstanding again.
o
o 🌟 Extra Concept Clarifications (CMA Exam-Oriented)
o EPS Dilution in Stock Dividend:
o EPS goes down, but investor ownership % unchanged. This is why analysts don’t see stock
dividends as true dilution.
o Liquidating Dividend vs. Normal Dividend:
o Normal = profit distribution.
o Liquidating = capital return → signals possible financial weakness.
o Ex-Dividend Date:
o Most tested in CMA → You must know who gets dividend (buyer or seller) depending on
transaction date.
o Stock Split vs. Dividend:
o Trick question: Both leave total capitalization unchanged → must distinguish par value
treatment.
o Treasury Stock Accounting:
o Two methods (Cost method vs. Par value method). CMA usually expects Cost method
knowledge.
o 📘 CMA Notes – Stock Rights, Warrants, ADRs
o
o 1. Stock Rights (Preemptive Rights)
o Definition: Right to buy stock directly from the issuing company at a set price before a given
expiration date.
o Purpose: Protect existing shareholders by allowing them to maintain their proportional
ownership when new shares are issued.
o Legal Basis: May be granted by corporate charter or required by state law.
o Key Points:
o Usually 1 right per share owned.
o Rights required to buy 1 new share = depends on % increase in shares.
o Rights are transferable.
o Subscription period: Typically 3 weeks or less.
o Example:
o Company increases shares by 5%.
o Each shareholder gets 1 right per share.
o 20 rights needed for 1 new share.
o A shareholder with 100 shares gets 100 rights → can buy 5 new shares → ownership % remains
constant.
o Choices for Rights Holder:
o Exercise the rights (buy new shares).
o Sell the rights (they trade separately).
o Let the rights expire.
o Ex-Rights Concept:
o Ex-rights date: last date to buy stock with rights attached.
o If stock is sold before ex-rights date → buyer gets rights.
o If sold after → seller keeps rights.
o
o 2. Valuing Stock Rights
o Theoretical (intrinsic) value depends on:
o Market price of stock
o Subscription (offer) price
o Number of rights needed
o (A) Rights-On Formula (rights still attached to stock):
o Vr=P0−Pnr+1V_r = \frac{P_0 - P_n}{r + 1}Vr=r+1P0−Pn
o P₀ = market price with rights attached
o Pₙ = subscription price
o r = rights required per new share
o Vᵣ = value of one right
o Example (Medina Co.):
o 5,000,000 shares @ $50.
o Wants $100M → 2.5M new shares @ $40.
o 1 right/share issued = 5M rights.
o 2 rights = 1 new share.
o Calculation:
o Vr=50−402+1=103=3.33V_r = \frac{50 - 40}{2+1} = \frac{10}{3} = 3.33Vr=2+150−40=310=3.33
o
o (B) Ex-Rights Formula (rights trade separately):
o Vr=(Pex−Pn)rV_r = \frac{(P_{ex} - P_n)}{r}Vr=r(Pex−Pn)
o Example (Medina Co.):
o Market drops to $46.67 after ex-rights.
o Vr=46.67−402=3.33V_r = \frac{46.67 - 40}{2} = 3.33Vr=246.67−40=3.33.
o Stockholder selling ex-rights gets $46.67 (stock) + $3.33 (right) = $50 total (same as before).
o
o 3. Employee Stock Options (ESOs)
o Definition: Rights given to employees to buy shares at a set exercise/strike price.
o Purpose: Compensation + incentive to increase share price.
o Capital impact: Company raises capital when employees exercise options.
o Comparison with Market Options:
o Market-traded options = between investors (company not involved).
o ESOs = directly from company → new shares issued → capital inflow.
o
o 4. Stock Warrants
o Similar to rights/options → right to buy stock at a set price for a defined period.
o Key differences from rights:
o Usually attached to bonds or preferred stock.
o Not based on current ownership.
o Longer maturity (years vs. weeks for rights).
o Warrants & Bonds:
o Detachable warrants: Can be separated and traded independently. Issuer must allocate bond
price between bond and warrants (based on fair value).
o Nondetachable warrants: No value separate from bond → all price allocated to bond.
o Standalone warrants: Sometimes given to partners/investors to “sweeten” deals.
o Capital Impact: Company gets capital only if warrants are exercised (same as rights & ESOs).
o
o 5. American Depository Receipts (ADRs)
o Definition: Certificates issued by U.S. banks representing ownership in shares of a foreign
company.
o Purpose: Allow foreign companies to trade in U.S. markets without SEC registration.
o Mechanism:
o Foreign company deposits shares with a bank.
o Bank issues ADRs representing those shares.
o ADRs trade on U.S. secondary markets.
o Benefit: Simplifies U.S. investment in foreign companies + allows foreign firms to access U.S.
capital markets.
o
o 🔑 Exam-Oriented Clarifications & Tips
o Rights vs. Warrants:
o Rights = short-term, offered to existing shareholders, protect ownership.
o Warrants = long-term, usually with bonds, sweetener for investors.
o ESO vs. Market Options: CMA exam tests the difference → ESOs = capital inflow, market options
= no capital inflow.
o ADR exam trick: U.S. investors can buy foreign companies without dealing with foreign
exchanges.
o Formula to memorize:
o Rights-on: P0−Pnr+1\frac{P_0 - P_n}{r+1}r+1P0−Pn
o Ex-rights: Pex−Pnr\frac{P_{ex} - P_n}{r}rPex−Pn
o 📘 Study Unit 13: B.2. Calculation of the Value of a Share
o 🔑 Big Picture
o A company issues shares → raises capital (willing to pay dividends/interest).
o Investors → must see enough return for risk → decide max price to pay.
o CMA exam questions:
o Find investors’ required rate of return (R).
o Find max price investor will pay (P0).
o Find cost of capital to company.
o
o 1️⃣ Intrinsic Value of a Share
o Intrinsic value (theoretical value) = what the stock should be worth based on fundamentals.
o Market price ≠ Intrinsic value → this difference drives buy/sell decisions.
o Based on present value of all future expected cash flows (dividends + sale price) discounted at
investors’ required rate of return (R).
o 👉 Key: Use INVESTORS’ required rate of return (not company’s).
o Different investors → different R → different valuations.
o But models use average R for all market participants.
o
o 2️⃣ Valuation Models
o Models depend on dividend assumptions.
o (a) Zero Growth (Constant Dividend) Model
o Used for Preferred stock or common stock with fixed dividend.
o Formula:
o P0=DRP_0 = \frac{D}{R}P0=RD
o Where:
o P0P_0P0 = Intrinsic value today
o DDD = Annual dividend
o RRR = Investors’ required rate of return
o Example 1:
o Pref. share pays $1.00 dividend.
o R = 5%.
o P0=10.05=20P_0 = \frac{1}{0.05} = 20P0=0.051=20
o Intrinsic value = $20 (below $25 par).
o If R ↓ to 4%:
o P0=10.04=25P_0 = \frac{1}{0.04} = 25P0=0.041=25
o Value rises to par.
o ⚡ Exam Tip: Value moves opposite to required return. If R ↑ → Value ↓.
o
o (b) Dividend Growth Model (Constant Growth Model / Gordon Growth Model)
o Used for common stock with growing dividends.
o Assumption: Dividends grow at a constant % rate forever.
o Formula:
o P0=D1R−GP_0 = \frac{D_1}{R - G}P0=R−GD1
o Where:
o D1D_1D1 = Next dividend = Last dividend × (1 + g)
o RRR = Required rate of return
o GGG = Dividend growth rate
o Example 2:
o Last dividend = $1.10.
o Growth = 5%. → D1=1.10×1.05=1.155D_1 = 1.10 × 1.05 = 1.155D1=1.10×1.05=1.155.
o R = 12%.
o P0=1.1550.12−0.05=16.50P_0 = \frac{1.155}{0.12 - 0.05} = 16.50P0=0.12−0.051.155=16.50
o If R ↑ to 15%:
o P0=1.1550.15−0.05=11.55P_0 = \frac{1.155}{0.15 - 0.05} = 11.55P0=0.15−0.051.155=11.55
o ⚡ Exam Tip: Dividend growth model is sensitive to (R – G). Small changes → big price shifts.
o
o (c) Dividends + Expected Future Stock Price Model
o Used when growth rate not given, but future stock price (P1) is given.
o Formula:
o P0=D1+P11+RP_0 = \frac{D_1 + P_1}{1 + R}P0=1+RD1+P1
o Where:
o P1P_1P1 = Expected price after 1 year
o D1D_1D1 = Next dividend
o RRR = Required rate of return
o ⚡ Common in CMA MCQs where dividend growth isn’t given but P1 is provided.
o
o (d) Using CAPM with Dividend Models
o If R (required return) is not given → use CAPM.
o R=Rf+β(Rm−Rf)R = R_f + β (R_m - R_f)R=Rf+β(Rm−Rf)
o Where:
o RfR_fRf = Risk-free rate
o βββ = Stock beta
o RmR_mRm = Market return
o Example 3:
o β = 0.8, Rf = 0.5%, Rm = 5%.
o R=0.005+0.8(0.05−0.005)=0.041=4.1%R = 0.005 + 0.8(0.05-0.005) = 0.041 =
4.1\%R=0.005+0.8(0.05−0.005)=0.041=4.1%
o Last dividend = $1.00, Growth = 2%.
→ D1=1.00×1.02=1.02D_1 = 1.00 × 1.02 = 1.02D1=1.00×1.02=1.02.
o P0=1.020.041−0.02=48.57P_0 = \frac{1.02}{0.041 - 0.02} = 48.57P0=0.041−0.021.02=48.57
o ⚡ Exam Tip: Always calculate next dividend (D1), not last dividend.
o
o (e) Zero Growth + CAPM
o Same as (a), but R is found using CAPM.
o Example 4:
o β = 0.8, Rf = 0.5%, Rm = 5%.
o R=0.005+0.8(0.05−0.005)=0.041=4.1%R = 0.005 + 0.8(0.05 - 0.005) = 0.041 =
4.1\%R=0.005+0.8(0.05−0.005)=0.041=4.1%
o Dividend = $1.00, no growth.
o P0=10.041=24.39P_0 = \frac{1}{0.041} = 24.39P0=0.0411=24.39
o
o (f) Two-Stage Dividend Discount Model
o Used when dividend grows at one rate for some years, then shifts to another rate.
o Solve in two parts:
o PV of dividends during high-growth period.
o PV of stock price at end of high-growth (using Gordon model with new growth rate).
o ⚡ Common for MCQs & Essays.
o
o (g) Relative/Comparable Valuation
o Not based on cash flows.
o Uses multiples (P/E ratio, EV/EBITDA, etc.) of comparable public companies to value a private
company.
o ⚡ Likely to appear in essay questions (more conceptual than numerical).
o
o 3️⃣ Key Takeaways for CMA
o Zero Growth → Pref. stock (constant dividend).
o Constant Growth → Common stock with growing dividends.
o If growth rate unknown but P1 given → Div + P1 Model.
o If R not given → use CAPM.
o CAPM is essential → make sure you can calculate required return quickly.
o Exam trick: Always check if the dividend given is last year’s (D0) or next year’s (D1). Adjust if
needed.
o
o 📘 Study Unit 13: B.2. Valuation Models (Advanced)
o
o 5️⃣ Two-Stage Dividend Discount Model
o Used when high growth → slows to normal growth.
o Steps:
o PV of dividends during high-growth period (each separately discounted).
o Terminal value at end of high-growth period = Gordon Growth Model with new growth rate.
o Pt=Dt+1R−gP_t = \frac{D_{t+1}}{R - g}Pt=R−gDt+1
o Discount terminal value back to present.
o Add both parts = intrinsic value.
o Fastgrowth Example Recap:
o D1=1.00,g=20%D_1 = 1.00, g = 20\%D1=1.00,g=20% for 3 yrs, then 7% thereafter, R=14%R =
14\%R=14%.
o Step 1: PV of 3 dividends = $2.77.
o Step 2: Year 4 dividend = 1.44×1.07=1.541.44 × 1.07 = 1.541.44×1.07=1.54.
o Step 3: Terminal value = 1.54/(0.14−0.07)=22.001.54 / (0.14 - 0.07) =
22.001.54/(0.14−0.07)=22.00.
o Step 4: Discount back 3 yrs: 22×0.675=14.8522 × 0.675 = 14.8522×0.675=14.85.
o Step 5: Add: 2.77+14.85=17.622.77 + 14.85 = 17.622.77+14.85=17.62.
o ✅ Intrinsic Value = $17.62.
o ⚡ Exam Tip: Always split into fast-growth part + constant growth part. Students often forget to
discount the terminal value!
o
o 6️⃣ Present Value of Expected Future Cash Flows
o Use when dividends or selling price don’t fit Gordon/Two-stage model.
o Simply:
o P0=∑CFt(1+R)tP_0 = \sum \frac{CF_t}{(1+R)^t}P0=∑(1+R)tCFt
o Where CFt=CF_t =CFt= dividend(s) + selling price (if applicable).
o Example (GYM Corp):
o Cash flows: $1.00 (Yr1), $1.10 (Yr2), $1.21 + $15 (Yr3).
o Discount @ 10%.
o Yr1: 1/1.10=0.911 / 1.10 = 0.911/1.10=0.91
o Yr2: 1.10/1.21=0.911.10 / 1.21 = 0.911.10/1.21=0.91
o Yr3: (1.21+15)/1.331=12.18(1.21 + 15)/1.331 = 12.18(1.21+15)/1.331=12.18
o Total PV ≈ $14.00.
o ⚡ Exam Tip: If you see dividends + a buyout/expected sale → this model applies.
o
o 7️⃣ Relative or Comparable Valuation Models
o Based on multiples of comparable companies.
o Used for both public & private companies.
o (a) Price/Earnings (P/E) Ratio
o P0=Risk-adjusted P/E ratio×EPSP_0 = \text{Risk-adjusted P/E ratio} × \text{EPS}P0=Risk-
adjusted P/E ratio×EPS
o Example: EPS = $3, Industry P/E = 10–15.
o If high risk → use lower end (e.g., 10.7).
o Value = 10.7×3=3210.7 × 3 = 3210.7×3=32.
o
o (b) Market/Book Ratio
o P0=Risk-adjusted M/B ratio×Book Value per ShareP_0 = \text{Risk-adjusted M/B ratio} × \
text{Book Value per Share}P0=Risk-adjusted M/B ratio×Book Value per Share
o
o (c) Price/Sales Ratio
o P0=Risk-adjusted P/S ratio×Sales per ShareP_0 = \text{Risk-adjusted P/S ratio} × \text{Sales per
Share}P0=Risk-adjusted P/S ratio×Sales per Share
o ⚠️Weakness: ignores profitability.
o
o (d) Using Multiple Comparables
o Analysts often combine P/E, M/B, and P/S → get a valuation range.
o Risk position determines whether to use low end or high end of comparable multiples.
o ⚡ Exam Tip:
o If company = higher risk → apply lower multiples.
o If company = lower risk → apply higher multiples.
o
o 🎯 CMA Exam Insights
o Most tested formulas:
o Constant Growth Model (Gordon).
o Two-Stage Dividend Discount Model.
o PV of Expected Cash Flows (when selling price is given).
o P/E Ratio valuation.
o Common traps:
o Forgetting to use D1 (next dividend) instead of D0.
o Forgetting to discount terminal value in two-stage model.
o Applying wrong multiple (EPS for P/E, BV for M/B, Sales for P/S).
o 📘 CMA Part 2 – Study Notes
o Study Unit 14: B.2. Cost of Capital – Cost of Preferred Stock
o 1. Cost of Capital & Equity Basics
o Cost of equity = average rate of return required by investors.
o Investors calculate the worth of a share to them → this becomes the company’s cost of raising
that equity.
o Used in WACC (Weighted Average Cost of Capital) calculations.
o
o 2. Cost of Preferred Stock
o Preferred stockholders receive fixed dividends, usually expressed as a % of par value.
o A. Cost of Existing Preferred Stock
o Dividend basis: Most preferred shares pay dividend as % of par value.
o Example: Par = $50, Dividend = 5% → $2.50 annual dividend.
o Dividend declared by Board of Directors, but usually very reliable.
o Important: Dividends = distribution of income, not tax-deductible (unlike interest expense).
o Formula:
o Cp=Annual Cash Dividend per ShareCurrent Market Price of Preferred StockC_{p} = \frac{\
text{Annual Cash Dividend per Share}}{\text{Current Market Price of Preferred Stock}}Cp
=Current Market Price of Preferred StockAnnual Cash Dividend per Share
o Numerator (dividend) = fixed (set at issuance).
o Denominator (market price) = fluctuates → cost of preferred stock changes over time.
o 🔹 Example – Steeler Corp.
o Preferred stock outstanding = 28,000 shares.
o Par value = $100, Market price = $98.
o Annual dividend = 5% of $100 = $5.
o Cp=598=0.051=5.1%C_{p} = \frac{5}{98} = 0.051 = 5.1\%Cp=985=0.051=5.1%
o ✅ Interpretation: Investors require 5.1% return on Steeler’s preferred stock (higher than 5%
coupon due to price drop).
o
o B. Cost of Newly Issued Preferred Stock
o Difference: Denominator = Net Proceeds per share, not market price.
o Net Proceeds = Selling Price – Flotation Costs.
o Formula:
o Cnp=DPnC_{np} = \frac{D}{P_n}Cnp=PnD
o Where:
o CnpC_{np}Cnp = Cost of new preferred stock.
o DDD = Annual dividend per share.
o PnP_nPn = Net proceeds per share = issue price – flotation costs.
o 🔹 Example – ROG Corp.
o Issuing 20,000 preferred shares.
o Par = $50, Annual dividend = 5% = $2.50.
o Issue price = $35, Flotation costs = $3 → Net proceeds = $32.
o Cnp=2.5032=0.078=7.8%C_{np} = \frac{2.50}{32} = 0.078 = 7.8\%Cnp=322.50=0.078=7.8%
o ✅ Interpretation: Cost of new preferred stock = 7.8%, higher than coupon due to flotation costs.
o
o ⚖️Key Distinction (Exam Point)
o Existing Preferred Stock → denominator = Current Market Price.
o New Preferred Stock → denominator = Net Proceeds (Issue Price – Flotation Costs).
o
o 🔑 Extra Concept Clarity (Preferred Stock)
o Why dividends are not tax-deductible?
o Because they are paid from after-tax profits → unlike interest expense which reduces taxable
income.
o This makes preferred stock more expensive than debt financing.
o Why market price matters?
o For existing stock, investors trade at market price → cost reflects current return expected by
investors, not par value.
o Impact of Flotation Costs (New Issue):
o Reduces proceeds → increases cost of capital.
o Companies must consider flotation costs before deciding to issue new preferred stock.
o Practical Use:
o Cost of preferred stock is used in WACC (Weighted Average Cost of Capital).
o If cost is higher than alternative financing sources → company may prefer debt or retained
earnings.
o
o Study Unit 15: B.2. Cost of Capital – Cost of Common Equity
o 1. Sources of Common Equity
o Two ways a company raises equity:
o Retained Earnings → profits reinvested instead of paying dividends.
o New Common Stock → issuing additional shares.
o Both are equity → investors expect the same required return.
o Difference:
o Retained earnings → no flotation costs.
o New stock → flotation costs incurred.
o
o 2. Cost of Retained Earnings (Existing Common Equity)
o Not a cash cost (unlike dividends/interest).
o Economic meaning = opportunity cost to shareholders.
o If company retains earnings → shareholders expect adequate return.
o If not, they’d prefer dividends to invest elsewhere.
o Example:
o Company earns 9% on assets.
o Alternative investment = 7%. → Shareholders happy with retention.
o Alternative = 12%. → Shareholders prefer dividend distribution.
o ✅ Conclusion: Cost of retained earnings = investors’ required rate of return = depends on
company risk.
o
o 3. Models to Calculate Cost of Retained Earnings
o Two primary methods:
o Dividend Growth Model (DGM) – when dividends are paid.
o Capital Asset Pricing Model (CAPM) – when dividends not paid.
o
o 4. Dividend Growth Model (DGM)
o Also known as Dividend Discount Model / Constant Growth Model.
o Formula:
o Cre=D1P0+gC_{re} = \frac{D_1}{P_0} + gCre=P0D1+g
o Where:
o CreC_{re}Cre = Cost of retained earnings = investors’ required return.
o D1D_1D1 = Next expected annual dividend per share.
o P0P_0P0 = Current market price of common stock.
o ggg = Expected annual dividend growth rate.
o ⚠️Important: Always use future dividend (D1). If given past dividend (D0), adjust:
o D1=D0×(1+g)D_1 = D_0 \times (1+g)D1=D0×(1+g)
o If dividends are not growing → g=0g = 0g=0.
o
o 🔹 Example – FED Corp.
o Shares outstanding = 90,800.
o Par value = $1 (irrelevant for cost calc).
o Market price = $21.
o Last dividend = $0.75. Growth = 4%.
o Next dividend = $0.75 × 1.04 = $0.78.
o Cre=0.7821+0.04=0.0371+0.04=0.0771=7.71%C_{re} = \frac{0.78}{21} + 0.04 = 0.0371 + 0.04 =
0.0771 = 7.71\%Cre=210.78+0.04=0.0371+0.04=0.0771=7.71%
o ✅ Interpretation: FED must provide at least 7.71% return to shareholders for them to keep
investing.
o
o 5. Exam Tip (Very Important)
o Dividend Growth Model always uses next dividend (D1).
o If exam gives:
o Past dividend → multiply by (1 + g).
o Future dividend → use directly.
o
o 🔑 Extra Concept Clarity (Common Equity)
o Why cost of retained earnings matters?
o Retained earnings = “free” in accounting sense, but not in finance.
o Opportunity cost → shareholders expect return equal to alternative investments.
o DGM Assumptions:
o Dividends grow at constant rate indefinitely.
o Growth rate (g) < cost of equity (otherwise formula invalid).
o Stock price reflects value based on dividend expectations.
o Practical Limitation:
o Not useful if company does not pay dividends.
o Sensitive to estimates of growth rate.
o 📘 CMA Study Notes – Cost of Equity & WACC
o 1. Capital Asset Pricing Model (CAPM)
o Purpose: Used to estimate the cost of equity (both retained earnings & new equity) when
dividends are not paid.
o Formula:
o R=Rf+β(Rm−Rf)R = R_f + \beta (R_m - R_f)R=Rf+β(Rm−Rf)
o Where:
o RRR = Required return (cost of equity)
o RfR_fRf = Risk-free rate (usually government bonds)
o β\betaβ = Beta (systematic risk compared to market)
o RmR_mRm = Expected market return
o (Rm−Rf)(R_m - R_f)(Rm−Rf) = Market risk premium
o Interpretation:
o If Beta < 1 → Stock is less risky than market → Required return < Market return.
o If Beta > 1 → Stock is riskier than market → Required return > Market return.
o ✅ Example (Company Y):
o Beta = 0.90
o Risk-free rate = 1%
o Market return = 8%
o R=0.01+0.90(0.08−0.01)=0.01+0.063=0.073=7.3%R = 0.01 + 0.90(0.08 - 0.01) = 0.01 + 0.063 =
0.073 = 7.3\%R=0.01+0.90(0.08−0.01)=0.01+0.063=0.073=7.3%
o Risk premium = 0.90×(8%−1%)=6.3%0.90 \times (8\% - 1\%) = 6.3\%0.90×(8%−1%)=6.3%.
o Total required return = Risk-free rate (1%) + Risk premium (6.3%) = 7.3%.
o Exam tip: CAPM works well for existing or retained equity.
o Do not use it for IPOs or when flotation costs/underpricing are significant.
o 2. Cost of New Common Equity
o Similar to Dividend Growth Model, but denominator = Net proceeds (selling price – flotation
costs).
o Formula:
o Cns=D1Pn+gC_{ns} = \frac{D_1}{P_n} + gCns=PnD1+g
o Where:
o D1D_1D1 = Next dividend (use past dividend × (1 + g) if not given)
o PnP_nPn = Net proceeds (issue price – flotation costs)
o ggg = Expected dividend growth
o Why higher than retained earnings?
o Flotation costs reduce proceeds.
o Equity risk is higher than debt → Shareholders demand higher return.
o Exam tip:
o If issue price not given, assume new stock is issued at current market price.

o
o 3. Weighted Average Cost of Capital (WACC)
o Definition: Average required return on company’s overall capital (debt + preferred + common
equity), weighted by their market values.
o Formula:
o WACC=(wd×kd(1−T))+(wps×kps)+(wce×kce)WACC = (w_d \times k_d (1 - T)) + (w_{ps} \times
k_{ps}) + (w_{ce} \times k_{ce})WACC=(wd×kd(1−T))+(wps×kps)+(wce×kce)
o Where:
o wd,wps,wcew_d, w_{ps}, w_{ce}wd,wps,wce = Weights of debt, preferred stock, equity (based
on market value)
o kdk_dkd = Before-tax cost of debt (adjusted for tax since interest is deductible)
o kpsk_{ps}kps = Cost of preferred stock
o kcek_{ce}kce = Cost of common equity (from DDM or CAPM)
o TTT = Tax rate
o Steps to Calculate WACC
o Calculate component costs (after-tax for debt).
o Find market values of debt, preferred stock, common equity.
o Determine weights of each source in total market capital.
o Apply formula to get WACC.
o
o ⚖ Example: TAM Corporation
o Book values given:
o Debt = $1,000,000
o Preferred stock = $300,000
o Common stock + paid-in capital = $550,000
o Retained earnings = $1,200,000
o Total = $3,050,000
o Market values:
o Debt = 96% of $1,000,000 = $960,000
o Preferred stock = 12,000 × $25.50 = $306,000
o Common stock = 57,800 × $30 = $1,734,000
o Total market value = $3,000,000
o Component Costs:
o Debt (after tax): 5% × (1 – 0.35) = 3.25%
o Preferred stock: $1 ÷ $25.50 = 3.9%
o Common equity (Dividend Growth Model):
o D1 = $1.25 × 1.04 = $1.30
o P0 = $30
o g = 4%
o Cre=1.3030+0.04=8.33%C_{re} = \frac{1.30}{30} + 0.04 = 8.33\%Cre=301.30+0.04=8.33%
o Weights:
o Debt = $960,000 ÷ $3,000,000 = 32%
o Preferred stock = $306,000 ÷ $3,000,000 = 10.2%
o Common equity = $1,734,000 ÷ $3,000,000 = 57.8%
o Interpretation:
o Most financing is from equity (57.8%), so WACC will be more influenced by equity cost.
o Debt is cheaper (due to tax shield), but risky if overused.
o
o 📌 Key Concept Clarifications
o Retained earnings ≠ “cash in bank” → Already reinvested in assets. It represents opportunity
cost for shareholders.
o Why after-tax cost for debt only? Because interest is deductible, but dividends
(preferred/common) are not.
o Beta importance: Measures systematic risk. A core input for CAPM and thus cost of equity.
o Flotation costs: Always reduce net proceeds → increases cost of new equity.
o Book vs Market value: Always use market value in WACC, since it reflects current investor
expectations.
o 1. Step 3: Weighted Average Cost of Capital (WACC)
o WACC Formula Recap:
o WACC=∑(Weighti×Costi)WACC = \sum (Weight_i \times Cost_i)WACC=∑(Weighti×Costi)
o Weights = Proportion of each component’s market value in total capital.
o Costs = After-tax cost of debt, cost of preferred stock, cost of common equity.
o ✅ TAM Corporation Example (Final Step)
Weighted
Source Weight Cost
Cost
 Debt 0.320 3.25% 0.0104
Preferred
0.102 3.90% 0.0040
Stock
Common
0.578 8.33% 0.0481
Stock
Total
6.25%
WACC
o 📌 Interpretation:
o WACC = 6.25% → Company must earn ≥ 6.25% return on new projects to increase shareholder
wealth.
o
o 2. Marginal Cost of Capital (MCC)
o Definition: The cost of the next unit of new capital to be raised.
o Weighted MCC (WMCC): If multiple sources are used, take a weighted average.
o 🔑 Key Insights:
o WACC = Cost of existing capital.
o WMCC = Cost of new capital.
o Why WMCC rises as financing increases?
o Flotation costs → New securities incur underwriting & issuance fees.
o Higher financial leverage → More debt increases risk → Investors demand higher returns.
o Law of supply & demand → As demand for capital rises, its cost rises.
o ➡ Therefore: Each additional round of financing is more expensive.
o 📊 Rule for investment decisions:
o Use WMCC, not WACC, when evaluating new projects.
o If Project Return < WMCC → Reject (will destroy value).
o Example: If WMCC = 12%, company should not invest in any project with return < 12%.
o
o 3. WACC vs WMCC
WACC WMCC
Cost of all existing financing Cost of next financing round
Historical / average Future / marginal
Relevant for new investment
Relevant for current structure
decisions
Lower (since cheaper sources Always higher (costs rise as capital
included) raised)
o
o 4. Introduction to Derivatives
o Definition: A financial instrument whose value is derived from another asset, liability, or
indicator.
o Examples of underlying assets/indicators:
o Stock prices
o Bond prices
o Commodity prices (oil, wheat, gold)
o Exchange rates
o Interest rates
o Market indices (e.g., S&P 500)
o Key Terms:
o Underlying: The reference variable that determines derivative’s value (e.g., “underlying stock”).
o Notional Amount: The stated quantity on which derivative is based (shares, bushels, $, etc.).
o Payment Provision: Settlement depends on how underlying behaves.
o Settlement Amount: Interaction of notional × underlying value (may be simple multiplication or
more complex).
o
o 5. Hedging with Derivatives
o Hedging = Using derivatives to reduce risk (not necessarily to make profits).
o Works by creating an offsetting transaction:
o If the original transaction → loss, hedge → gain.
o If original transaction → gain, hedge → loss.
o Goal: Reduce volatility, not maximize profit.
o Example:
o Airline buys fuel. If oil prices rise → higher costs.
o It can hedge by buying oil futures contracts.
o If oil rises → futures gain offsets higher fuel cost.
o
o 6. Four Common Derivatives
o Forward Contracts – Customized, private agreements to buy/sell in the future at agreed price.
o Futures Contracts – Standardized version of forwards, traded on exchanges.
o Swaps – Agreements to exchange cash flows (e.g., fixed vs variable interest).
o Options – Right (not obligation) to buy or sell an asset at a fixed price before expiration.
o
o 📌 Extra Concept Clarifications for CMA
o Why WMCC > WACC?
o Existing investors took lower-risk earlier → got cheaper rates.
o New investors face higher leverage/risk → demand higher return.
o WACC is like “average historical interest rate”;
WMCC is like “today’s loan rate if you go borrow more.”
o Derivative Misconception: Not always speculative. Many firms use them only for hedging, not
gambling.
o Exam Tip:
o Use WACC when analyzing performance of existing investments.
o Use WMCC when evaluating new projects.
o Hedging questions often test whether you understand it’s about reducing risk, not increasing
profit.
o 📘 CMA Study Notes – Forward & Futures Contracts
o
o 1. Forward Contracts
o Definition: Agreement between two parties to buy/sell an asset at a specified price on a
specified future date.
o Purpose: Eliminate uncertainty about future prices (hedging).
o Examples: Commodities (potatoes, coffee, oil) or foreign currency.
o ✅ Example (Potato Farmer & Factory)
o Farmer fears price ↓, Factory fears price ↑.
o Forward contract at $20/bushel → locks in certainty.
o If future price = $24 → Factory wins (buys cheaper), Farmer loses.
o If future price = $17 → Farmer wins (sells higher), Factory loses.
o Key: One side gains, the other loses.
o 🔑 Characteristics of Forwards:
o Customized (terms negotiated).
o Not traded on exchanges → Only OTC (over-the-counter).
o No secondary market.
o Credit risk exists (depends on counterparty’s ability/willingness to honor).
o Settlement: Physical delivery at expiration (not daily).
o Risk of default increases when contract price ≠ market price at maturity.
o
o 2. Futures Contracts
o Definition: Like forwards (agreement to buy/sell asset at future date/price) but with
standardization & exchange trading.
o 🔑 Key Features of Futures:
o Traded on organized exchanges.
o Exchange is the counterparty (no credit risk).
o Standardized quantities, assets, prices, & expiration dates.
o Marked-to-market daily:
o Gains credited to trader’s account.
o Losses deducted; margin calls possible.
o Contracts are usually closed out before delivery (via offsetting trades).
o
o 3. Forward vs Futures – Key Differences
Forward Futures
Feature
Contracts Contracts
Trading OTC (private) Exchange-traded
Secondary
None Active
Market
Customization Fully customized Standardized
At expiration Daily mark-to-
Settlement (physical market (delivery
delivery) rare)
High (depends on None (exchange
Credit Risk
counterparty) guarantees)
Initial margin
Collateral None
required
Wide variety of
Users Large companies
participants
o
o 4. Types of Futures
o Commodity Futures
o Agricultural (potatoes, wheat, soybeans, coffee, cocoa, milk, cattle, pork, etc.)
o Metals (gold, silver, copper, aluminum, zinc, etc.)
o Energy (crude oil, gasoline, natural gas, electricity, propane, etc.)
o Forest products (lumber, plywood, pulp).
o Financial Futures
o Debt securities (interest rate futures).
o Currency futures.
o Index futures.
o
o 5. Long vs Short Positions
o Long (Buyer)
o Obligated to buy at contract price at expiration.
o Protected against price increases.
o Short (Seller)
o Obligated to sell at contract price at expiration.
o Protected against price decreases.
o
o 6. Exam Tips
o Forward = customized, OTC, credit risk, settled at maturity.
o Futures = standardized, exchange-traded, marked-to-market, no credit risk.
o Forwards are riskier, but flexible; Futures are safer, but rigid.
o Long protects against rising prices, Short protects against falling prices.
o Hedging vs speculation: Both possible, but hedging is the exam’s main focus.
o 📘 CMA Notes – Study Unit 19 & 20 (Swaps & Options)
o
o 1. Swaps
o 🔹 Definition
o A swap = an agreement between two parties to exchange (swap) payment streams.
o Used to manage interest rate risk or foreign currency risk.
o
o A. Interest Rate Swaps
o Forward contract to exchange future interest payments based on a notional principal (principal
itself not exchanged).
o Usually:
o One pays fixed rate.
o Other pays floating rate (linked to LIBOR, SOFR, or other market rate).
o Purpose → match revenues & expenses characteristics to reduce risk.
o Ex: Fixed revenues but variable debt → swap to fixed interest payments if expecting rates ↑.
o ✔️Example:
o Company A: Fixed revenues but floating debt (risk if rates ↑).
o Solution: Enter swap → pay fixed, receive floating → stabilizes outflows.
o Who uses them?
o Large companies
o Banks
o Hedge funds
o Pension funds
o
o B. Foreign Currency Swaps
o Agreement to exchange cash flows in different currencies.
o May include:
o Interest only, or
o Interest + principal payments.
o Purpose → eliminate exchange rate risk on foreign-denominated loans.
o ✔️Example:
o US Co. issues Euro bonds.
o Euro Co. issues US$ bonds.
o They swap both interest + principal payments.
o Both avoid FX risk.
o
o ⚠️Key Difference
o Interest Rate Swap → same currency, only swap interest.
o Currency Swap → different currencies, swap interest + principal.
o
o ✅ Exam Tip:
Swaps are always about risk management (hedging), not speculation.
o
o 2. Options
o 🔹 Definition
o An option = right (not obligation) to buy or sell an asset at a set strike (exercise) price on or
before expiration.
o American option → exercisable any time before or on expiry.
o European option → exercisable only at expiry.
o
o A. Types of Options
o Call option → right to buy asset at strike price.
o Buyer hopes asset price ↑.
o Seller must sell if exercised.
o Put option → right to sell asset at strike price.
o Buyer hopes asset price ↓.
o Seller must buy if exercised.
o
o B. Option Parties
o Buyer (long position):
o Pays premium.
o Has right to exercise or not.
o Seller (writer, short position):
o Receives premium.
o Must comply if buyer exercises (obligation).
o
o C. Important Terms
o Strike (Exercise) Price → price stated in option contract.
o Option Premium → price paid by buyer to writer.
o Intrinsic Value:
o Call option = Market Price − Strike Price (if positive).
o Put option = Strike Price − Market Price (if positive).
o
o D. Covered vs Naked Options
o Covered Call:
o Writer already owns stock.
o Lower risk → if exercised, stock already in hand.
o Naked Call:
o Writer does not own stock.
o High risk → may need to buy stock at high market price to sell at lower strike price.
o Potentially unlimited loss.
o
o E. Option Positions – Long vs Short
o Forwards/Futures:
o Long = buyer of underlying.
o Short = seller of underlying.
o Options:
o Long = buyer of option (chooses).
o Short = seller/writer of option (obligated).
o
o F. In-the-Money (ITM), At-the-Money (ATM), Out-of-the-Money (OTM)
o Call Option:
o ITM → Market Price > Strike Price.
o ATM → Market Price = Strike Price.
o OTM → Market Price < Strike Price.
o 📌 Value = Market − Strike.
o Put Option:
o ITM → Market Price < Strike Price.
o ATM → Market Price = Strike Price.
o OTM → Market Price > Strike Price.
o 📌 Value = Strike − Market.
o
o ✔️Example (Call Option):
o Stock = $32.
o Call Strike = $30.
o Intrinsic value = $32 − $30 = $2. (In-the-money).
o If stock = $28, option OTM → won’t exercise.
o
o 3. Differences – Forwards/Futures vs Options
Feature Forwards/Futures Options
Binding → must Right, not
Obligation
settle obligation
Delivery or offsetting Only if holder
Settlement
trade exercises
Long vs Buyer/seller of
Buyer/seller of asset
Short option
Buyer pays
Cost No upfront premium
premium
o
o ✅ Key Exam Points / Extra Clarity
o Swaps → risk mgmt (hedging interest/FX).
o Options → asymmetrical → buyer risk = premium, seller risk = unlimited (esp. naked calls).
o American vs European → exam fav question.
o Premium = cost of flexibility.
o Intrinsic Value vs Premium → Premium ≥ Intrinsic Value.
o Covered Call Strategy → income generation + limited risk.
o 📘 CMA Notes – Study Unit 20: Options (Put Options + Valuation)
o
o 1. Put Options (ITM / ATM / OTM)
o 🔹 Reversed from Calls:
o In-the-Money (ITM): Market Price < Strike Price
→ Holder can sell stock above market price → gain.
→ Intrinsic Value = Strike − Market.
o At-the-Money (ATM): Market Price = Strike Price
→ No benefit to exercise (sell at strike = market).
o Out-of-the-Money (OTM): Market Price > Strike Price
→ Loss if exercised → won’t be exercised.
o ✔️Example:
o Market = $28, Strike = $30 → Put is $2 ITM.
o Market = $32, Strike = $30 → Put is OTM, worthless.
o
o 2. Intrinsic Value of Put Options
o Intrinsic Value = Max(0, Strike − Market Price).
o Only exists when Strike > Market (ITM).
o Increases as stock falls further below strike.
o ✔️Example:
o Market = $28, Strike = $30 → Intrinsic = $2.
o Market = $25, Strike = $30 → Intrinsic = $5.
o
o 3. Exiting an Option Position
o For Option Buyers (Call or Put):
o Exercise → use the right (buy if call, sell if put).
o Offset (closing transaction):
o Bought Call → Sell Call (same strike + expiry).
o Bought Put → Sell Put (same strike + expiry).
o Profit/Loss = Sale premium − Purchase premium.
o Let expire → worthless if OTM → Loss = premium paid.
o
o For Option Writers (Sellers):
o Only way to exit early = Offset by buying back the same option.
o Call writer → Buy Call.
o Put writer → Buy Put.
o Almost always at a loss because if they offset, option is usually ITM.
o Writers want options to expire worthless → keep premium.
o Time decay (θ) helps sellers, hurts buyers.
o
o 4. Option Valuation (Premium = Market Price)
o 🔹 Formula:
Option Premium = Intrinsic Value + Time Value (Extrinsic Value).
o
o A. Intrinsic Value
o Call Option: Max(0, Market − Strike).
o Put Option: Max(0, Strike − Market).
o Only ITM options have intrinsic value.
o ATM/OTM options → Intrinsic = 0.
o
o B. Time Value (Extrinsic Value)
o = Premium − Intrinsic Value.
o Represents value of possibility that option becomes profitable before expiry.
o Always ≥ 0.
o Higher when:
o Longer time to expiry → more chance of favorable move.
o Higher volatility → bigger possible price swings.
o Higher interest rates → call options benefit (defer payment).
o ✔️Example:
o Market = $63, Strike = $60, Premium = $3.50.
o Intrinsic = $3.00 (63 − 60).
o Time Value = $3.50 − $3.00 = $0.50.
o
o C. Key Notes
o Time value decreases as expiration approaches (time decay).
o ATM options usually have the highest time value.
o ITM options = Intrinsic + some time value.
o OTM options = all time value (since Intrinsic = 0).
o
o ✅ Quick Exam Clarity
o Put ITM = Market < Strike.
o Premium ≥ Intrinsic Value.
o Buyer’s max loss = Premium paid.
o Seller’s max gain = Premium received.
o Option writers love time decay, buyers hate it.
o ATM option has no intrinsic value → only time value.
o
o 📘 CMA Notes – Hedging Strategies with Puts and Calls
o
o 🔹 Hedging Strategies Using Options
o Definition of Hedging:
A method to reduce risk from adverse movements in:
o Stock prices
o Exchange rates
o Interest rates
o How it works:
o Take an offsetting position in a related security.
o If the original investment loses value → hedge gains value.
o If the original investment gains value → hedge loses value.
o ⚠️Hedge reduces both losses and gains.
o Types:
o Individual stock → hedge with stock options.
o Portfolio of stocks → hedge with index options.
o
o 🔹 Protective Put Purchase (Hedge for a Long Position)
o Scenario:
o Buy 100 shares of ABC at $91.
o Buy 1 put option (Nov $90) for $2 premium.
o Cost basis: $91 + $2 = $93 per share → $9,300 total.
o Protection:
o Guarantees a minimum sale price of $90.
o If stock price falls below $90 → exercise put & sell at $90.
o Maximum loss = $300 ($9,300 – $9,000).
o Outcomes:
o If price < $90 → put gains value, stock loses value. Loss capped at $300.
o If price > $93 → investor starts making profit.
o Breakeven = $93/share.
o Max gain = unlimited (stock price can rise infinitely).
o ✅ Key Formula:
o Max Loss = Premium Paid + (Stock Price – Strike Price, if below)
o Breakeven = Stock Purchase Price + Premium Paid
o
o 🔹 Protective Call Purchase (Hedge for a Short Position)
o Scenario:
o Short 100 shares of XYZ at $48/share.
o Buy 1 call option (Nov $50) at $3 premium.
o Net proceeds: $48 – $3 = $45 per share → $4,500 total.
o Protection:
o If stock price rises above $50 → call option limits losses.
o Maximum loss = $500.
o Outcomes:
o If stock price falls below $45 → investor profits on short sale.
o Breakeven = $45.
o Max gain = $4,500 (if stock goes to $0).
o ✅ Key Formula:
o Max Loss = (Strike Price – Short Sale Price) + Premium Paid
o Breakeven = Short Sale Price – Premium Paid
o Max Gain = Short Sale Price – Premium Paid
o
o 🔹 Key Concepts
o Long Position → Hedge with a Put (“protective put”).
o Short Position → Hedge with a Call (“protective call”).
o Hedge = Insurance:
o Pay a premium (cost).
o Reduces potential loss.
o But also reduces profit (because premium raises breakeven).
o
o 💡 Exam-Oriented Insights
o Protective Put = Insurance for Buyers
o Use when holding stock and want downside protection.
o Loss is capped but upside is unlimited.
o Protective Call = Insurance for Short Sellers
o Use when shorting stock and want protection against price rises.
o Loss is capped but profit potential is limited to stock dropping to zero.
o General Rule:
o Protective put for long → “floor” (minimum guaranteed value).
o Protective call for short → “ceiling” (maximum loss is fixed).
o Important Breakeven Memory Trick:
o Long + Put → Add premium to cost (breakeven ↑).
o Short + Call → Subtract premium from proceeds (breakeven ↓).
o
o 📊 Summary Table for Hedging
Position Hedge Max Loss Max Gain Breakeven
Long Premium + Purchase
Put
Stock + (Stock Price – Unlimited Price +
option
Put Strike) Premium
Short (Strike –
Call (Short Price Short Price –
Stock + Short Price) +
option – Premium) Premium
Call Premium
o 📘 Study Unit 22: B.3. Raising Capital in Privately Held Companies
o 🔹 Why issuing debt/equity may not be viable for small private companies
o High transaction costs for issuing public debt or equity.
o Low market interest in smaller companies’ securities.
o Thus, they rely on alternative financing methods.
o
o 1. Sources of Long-Term Financing (when capital markets are not practical)
o Internal financing: Retained earnings.
o Commercial bank / finance company loans (term loans, mortgages).
o Lease financing (operating or finance leases).
o Venture capital (for young/pre-IPO companies).
o
o 2. Commercial Bank or Finance Company Loans
o Term loans (> 1 year, often for equipment purchases).
o Collateralized loans → lower risk for lender → lower interest rates.
o Commercial real estate loans = mortgages on business property (office, factory, warehouse,
etc.).
o ✅ Key exam angle: Collateral reduces lender’s risk → lowers borrower’s interest cost.
o
o 3. Lease Financing
o A lease = agreement where lessee uses an asset by paying periodic rent to lessor.
o Economic substance: Lessee borrows from lessor & repays through rents.
o Payments spread over time + interest cost added.
o Types:
o Operating lease: Short-term, cancellable, off-balance sheet (for lessee).
o Finance lease: Long-term, non-cancellable, lessee assumes risks & rewards of ownership.
o Advantages of Leasing
o Convenience: Useful for short-term needs.
o 100% financing: No down payment required.
o Fixed payments: Protection against inflation.
o Tax benefits:
o Depreciation tax shield used by lessor if lessee is not profitable.
o Lower lease payments possible.
o Protection against obsolescence: Can swap leased asset for new one.
o Flexibility: Lease terms can be structured to match revenue timing.

o
o Disadvantages of Leasing
o Higher cost: Total outflow may exceed cost of buying with loan/cash.
o Lack of flexibility: Many leases are non-cancellable, obligating payment even if asset/project
fails.

o
o 4. Lease vs. Purchase Analysis
o Decision based on present value (PV) of cash flows.
o Compare:
o PV of lease payments
o vs. Cash price (or loan repayment schedule)
o Example:
o Truck purchase = $100,000 cash.
o Lease = $24,000 per year × 5 years, 5% discount rate.
o PV factor (ordinary annuity, 5 yrs, 5%) = 4.329.
o PV lease = $24,000 × 4.329 = $103,896.
o ✅ Better to buy (saves $3,896 in PV).
o 🔑 Important exam note:
o If payments due at year-end → ordinary annuity.
o If payments due at beginning → annuity due (PV factor adjustment needed).
o
o 5. Leasing vs. Financing a Purchase with Debt
o Compare after-tax cash outflows of leasing vs. loan repayment.
o Use after-tax borrowing rate = (Borrowing rate × (1 − tax rate)).
o Compute Net Advantage to Leasing (NAL) = After-tax outflow (buy) − After-tax outflow (lease).
o Positive NAL → Leasing cheaper.
o Negative NAL → Buying cheaper.
o
o 6. Venture Capitalists (VCs)
o Source of funds for young, private firms before IPO.
o VCs provide money in exchange for equity (ownership %) + board seats.
o Stage financing:
o 1st stage → early funding.
o 2nd stage → after milestone (prototype, growth target, etc.).
o VC involvement: Not passive – provide control, advice, management support, networking.
o Cost of VC capital: Very high, because founders give up equity.
o Exit strategies: IPO, acquisition, or buyout.
o 📌 Note: Company remains privately held even after VC investment (only IPO makes it public).
o
o ⚡ Extra Notes for Concept Clarity
o Collateralized loans lower risk → directly reduces interest rate (CMA exam often tests why
collateral matters).
o Lease vs Buy questions: Always think time value of money (PV).
o Operating vs Finance lease distinction is heavily tested:
o Operating = short, cancellable.
o Finance = long, ownership-like.
o Venture capital: Think of it as high-risk, high-return financing where VCs expect control +
significant future upside.
o Tax aspect in leasing: Key reason why companies with low profits may prefer leasing.
o
o ✅ With this, you have complete notes + exam focus points.
o 📘 Notes: Raising Capital in Publicly Held Companies
o
o 1. Equity Issues in the Primary Market
o 🔹 Initial Public Offering (IPO)
o Definition: First-time sale of common shares to the public.
o Purpose:
o Raises more capital than private owners can provide.
o Access to larger financing sources.
o Provides liquidity to stock (tradable in public markets).
o Establishes company’s market value.
o Participants: Usually offered to institutional investors (pension funds, mutual funds, hedge
funds).
o Secondary Offering: Founders/early investors may sell part of their shares during IPO
(liquidation).
o Consequences of IPO:
o More public information disclosure.
o Control shifts from owners → elected Board of Directors.
o Subject to earnings growth pressures.
o Cost of capital may reduce due to wider investor base.
o Drawbacks:
o Flotation costs: filing fees, attorneys, accountants, underwriters.
o Ongoing costs: SEC compliance, reporting requirements.
o Time-consuming process.
o
o 2. Types of Offerings
o Primary Offering: Newly issued securities sold to public.
o Subsequent (Follow-on) Offering: Additional shares sold after IPO. Can be:
o Newly issued stock.
o Treasury stock (reissued).
o Secondary Offering: Existing shareholders (major holders/insiders) sell their stock. May occur at
IPO or later.
o Market Context:
o Primary Market: Where new issues are sold for the first time.
o IPO Pricing: Determined by investor demand (institutional investors).
o Subsequent Offering Pricing: Based on current market price of stock.
o
o 3. Role of Investment Banks
o Investment banks ≠ commercial banks.
o Functions:
o Deal Design: Advise on capital structure, offering price, bond coupon rate.
o Underwriting: Agree to purchase/resell securities.
o Marketing: Promote securities to investors.
o 🔹 Shelf Registration
o Securities registered with SEC but not immediately issued.
o Requirements:
o Must continuously update registration statement.
o Company must already have registered securities outstanding.
o
o 4. Underwriting the Issue
o Firm Commitment:
o Investment bank buys the securities.
o Absorbs risk of unsold shares.
o Charges fee (underwriting spread = resale price – purchase price).
o Best-Efforts Agreement:
o Bank acts as agent, not principal.
o No guarantee of purchase.
o Types:
o All-or-None: If not all sold → issue canceled.
o Partial Return: Unsold shares returned to issuer.
o
o 5. Debt (Bond) Issues – Primary Market
o Investment bank helps in:
o Assessing market absorption capacity.
o Setting coupon rate & bond features.
o Pricing bonds (based on comparable issues).
o Underwriting or acting in best-efforts capacity.
o Private Placement (Bonds):
o Direct sale to institutional investors (insurance companies, pension funds).
o Avoids underwriting fees.
o More common for bonds than equity.
o
o 6. Debt vs. Equity Financing
o 🔹 Advantages of Bonds (Debt)
o No ownership/control dilution (bondholders are creditors).
o Fixed, known cost (interest).
o Interest is tax-deductible → lowers after-tax cost.
o Flexibility: callable/early retirement possible.
o 🔹 Disadvantages of Bonds (Debt)
o Mandatory payments (interest + principal).
o Risk of default → bankruptcy possible.
o Higher debt levels increase cost of future debt & equity.
o Maturity = large future cash payout (unless refinanced).
o Restrictive covenants in bond indenture (e.g., required ratios).
o
o 🔹 Advantages of Common Stock (Equity)
o No fixed payments required (dividends only if declared).
o No maturity / repayment requirement.
o No restrictive covenants.
o Strengthens equity base → lowers debt/equity ratio → reduces credit risk & borrowing costs.
o 🔹 Disadvantages of Common Stock (Equity)
o Limited authorized shares (corporate charter).
o Dilution: More shares = lower ownership/control + lower value per share.
o Higher issuance cost (equity underwriting fees > debt fees).
o IPO is complex, expensive, and highly regulated.
o Higher investor required return (equity is riskiest security).
o Dividends not tax-deductible → double taxation (corporate income tax + shareholder dividend
tax).
o
o 🔹 Advantages of Preferred Stock
o No voting rights → no dilution of control.
o Fixed dividends (predictable obligation).
o Dividend payments not mandatory (no default risk if unpaid).
o Excess profits reserved for common shareholders.
o No maturity (no repayment required).
o 🔹 Disadvantages of Preferred Stock
o Dividends not tax-deductible (unlike debt).
o Higher cost of capital than debt (due to no tax shield).
o Cumulative dividends → unpaid dividends must be made up before common stockholders get
paid.
o
o 7. Investor Perspective
o Stockholders: Potential returns from dividends + capital gains.
o Bondholders: Only interest (no upside from company’s success).
o Risk:
o Stockholders bear higher risk but higher potential reward.
o Bondholders have fixed, safer income.
o Dilution Impact: Issuing new shares reduces % ownership of existing shareholders.
o Control can still be retained if a group holds ≥ 50.1%.
o
o 🔍 CMA Exam Pointers
o Understand primary vs. secondary vs. subsequent offerings.
o Be able to calculate underwriting spread.
o Compare firm commitment vs. best efforts.
o Know advantages/disadvantages of debt vs. equity vs. preferred stock.
o Be clear on double taxation of dividends.
o Shelf registration = SEC-approved but not immediately issued.
o Dilution = reduced ownership % of existing shareholders when new shares are issued.
o
o ✨ Extra Concept Clarifications:
o Why equity is costlier than debt:
o No tax shield (dividends not deductible).
o Risk premium demanded by equity investors.
o Why flotation costs matter: Especially for IPOs, these can reduce net capital raised significantly.
o Why bonds are cheaper: Predictable payments, tax benefits, no dilution. But high default risk if
overused.
o 📘 Study Unit 24: B.3. Financial Markets
o
o 1. Secondary Markets
o After IPO (initial issuance), securities trade in secondary markets.
o Function: Facilitate trading of existing securities (buyers & sellers meet).
o Requirements for listing:
o Market capitalization
o Number of shares outstanding
o Minimum share price
o Financial strength
o Corporate governance
o Annual listing fees
o Importance of Secondary Markets
o Provide liquidity for investors.
o Give continuous info on market prices.
o Encourage primary market participation (investors know they can liquidate).
o
o 2. Types of Financial Markets
o Capital Markets: Long-term debt & equity.
o Money Markets: Short-term debt (<1 year).
o Stock Exchanges: e.g., NYSE.
o Bond Markets: Corporate + government bonds.
o Federal Funds Market: Banks borrow/lend reserves overnight.
o OTC (Over-the-Counter) Markets: Dealer-driven.
o Foreign Exchange Markets (Forex).
o Derivatives Exchanges: Futures, options.
o
o 3. Market Structures
o 🔹 Exchanges
o Traditionally physical (trading floors).
o Now mostly electronic trading.
o 🔹 Dealer Markets (OTC)
o No central location.
o Dealers act as market makers (buy at bid, sell at ask).
o Profit from bid-ask spread.
o Examples:
o Government bonds, corporate bonds, money market securities.
o Currencies.
o Equities (e.g., Nasdaq).
o 🔹 Brokered Markets
o Brokers connect buyers & sellers.
o Brokers earn commissions (do not take ownership).
o Example: Real estate markets, stock exchanges.
o 🔹 Broker-Dealers
o Can act as brokers (agents) and dealers (principals).
o 🔹 Derivatives Exchanges
o Trade futures & options.
o Exchanges guarantee each trade (act as seller to every buyer, buyer to every seller).
o 🔹 Federal Funds Market
o Banks only.
o Used to meet reserve requirements at Federal Reserve.
o Efficiently redistributes reserves.
o 🔹 Financial Intermediaries
o Facilitate transactions.
o Examples: commercial banks, mortgage companies, thrifts, pension funds, mutual funds,
insurance companies, credit unions, investment banks.
o
o 4. Market Efficiency & Efficient Market Hypothesis (EMH)
o Financing choice can add/detract value → best strategy is needed.
o Market Efficiency = Prices reflect all available info.
o Why Financing Advantages Are Hard to Find
o Competition + efficiency = securities priced fairly.
o Below-market financing opportunities rarely exist.
o The more participants + faster info release → the more efficient the market.
o Behavior of Prices
o Prices fluctuate randomly around intrinsic value due to constant new info.
o Most investors earn normal return (risk-adjusted).
o
o 5. Sources of New Information
o Historical prices & trading volumes
o Used in technical analysis.
o But since available to all, advantage disappears quickly.
o All published information
o Earnings releases, mergers, economic data.
o Used in fundamental analysis.
o Private (inside) information
o Accessible to insiders before public release.
o Trading on it = illegal.
o
o 6. Forms of Market Efficiency
o Weak Form:
o Prices reflect historical data (past prices, volume).
o Technical analysis cannot beat market.
o Empirical evidence supports independence of past changes.
o Semi-Strong Form:
o Prices reflect historical + all public info.
o Prices adjust almost instantly (5–10 mins) to announcements.
o Abnormal profits not sustainable.
o Strong Form:
o Prices reflect all info (public + private).
o Implies even insider trading gives no advantage.
o Evidence: insiders usually make abnormal gains → refutes strong form.
o ✅ Consensus: Markets are reasonably efficient (weak & semi-strong hold, strong is not
realistic).
o
o 7. Insider Trading
o Definition: Using material non-public info for trading.
o Prohibited by: Exchange Act Section 10(b) & Rule 10b5-1.
o Breach of fiduciary duty owed to shareholders.
o Applies not only to officers/directors, but anyone with access to confidential info (brokers,
bankers, lawyers, accountants, analysts, journalists, family, friends, even therapists).
o SEC Enforcement
o Market Abuse Unit uses data analytics & trading pattern analysis.
o Can trace relationships between traders & information sources.
o Penalties
o Fines: Up to 3× profits gained/losses avoided.
o Prison sentences possible.
o
o 8. When Insider Trading is Legal
o Officers, directors, and 10%+ owners can trade if:
o They set up a Rule 10b5-1 trading plan.
o Must report trades to SEC.
o Plan must be adopted in advance of trades.
o SEC 2023 Strengthening (effective Feb 27, 2023)
o To prevent abuse of trading plans:
o Cooling-off periods:
o Directors/Officers: Later of
o 90 days after plan adoption, or
o 2 business days after financial statements release (10-Q/10-K).
→ Max 120 days.
o Others: 30 days.
o Certifications required:
o Not aware of non-public info.
o Plan adopted in good faith.
o Additional disclosures required.
o
o 🔍 CMA Exam Pointers
o Be able to explain secondary vs. primary markets.
o Distinguish exchanges, dealer markets, brokered markets, broker-dealers.
o Understand bid-ask spread concept (dealer profit).
o Know capital vs. money markets.
o EMH: weak vs semi-strong vs strong → and which holds in real life.
o Legal vs illegal insider trading (Rule 10b5-1 trading plans).
o SEC penalties for insider trading.
o
o ✨ Extra Concept Clarity
o Why secondary markets matter: Without them, investors wouldn’t invest in IPOs because of
liquidity risk.
o Why dealers exist: They provide continuous trading (liquidity) even when no natural
buyer/seller is present.
o Why strong-form EMH is unrealistic: Insider trading evidence shows abnormal profits are
possible.
o Efficient market implication for CMA: Can’t consistently “beat the market” → financing
strategies should assume fair pricing.
o 🔹 Working Capital Basics
o Net Working Capital (NWC) = Current Assets – Current Liabilities
o It bridges the gap between:
o Production → Sale → Cash collection
o Components:
o Current Assets: Cash, cash equivalents, short-term investments, A/R, inventory, prepaids
o Current Liabilities: A/P, accruals, short-term financing
o Goal: Ensure enough liquidity to cover obligations without holding excess low-return assets.
o
o 🔹 Working Capital Management
o Objective: Balance between:
o Having enough current assets to pay obligations (avoid insolvency).
o Avoiding excessive current assets (low/no returns → opportunity cost).
o Key tactics:
o Collect receivables quickly
o Pay liabilities slowly
o Use short-term financing (bank loans, factoring)
o
o 🔹 Operating vs. Cash Cycle
o Operating Cycle = Days in A/R + Days in Inventory
o Cash Cycle (Cash Conversion Cycle, CCC) = Operating Cycle – Days in A/P
o Example:
o Inventory = 120 days
o A/R = 40 days
o A/P = 100 days
o Operating Cycle = 120 + 40 = 160 days
o Cash Cycle = 160 – 100 = 60 days
o Negative CCC: Very favorable. Means cash is received before suppliers must be paid.
o
o 🔹 Types of Working Capital
o Permanent WC: Minimum level always needed to run business.
o Temporary WC: Seasonal or cyclical increases (e.g., before peak selling season).
o
o 🔹 Working Capital Policies
o Conservative Policy:
o High WC, high current ratio → safer liquidity, lower returns.
 o Aggressive Policy:
o Low WC, low current ratio → riskier, but higher returns.
o Negative WC: Possible if sales are cash-based and payables terms are long.
o
o 🔹 Changes in Working Capital
o Increase NWC: ↑ Current Assets OR ↓ Current Liabilities
o Decrease NWC: ↓ Current Assets OR ↑ Current Liabilities
o No Change:
o Swap within assets (A/R collected into cash).
o Equal increase/decrease in both current assets & liabilities.
o Increase from operations: Selling inventory (since sale value > cost).
o
o 🔹 Components of WC
o Cash & Cash Equivalents
o Marketable Securities
o Accounts Receivable
o Inventory
o (Prepaids are current assets but not useful for liquidity → included in NWC calc, but not
emphasized in management.)
o
o ✅ Key Idea: Effective WC management = finding the balance between liquidity risk and
profitability opportunity cost.
o

📘 Smart Notes: Study Unit 26 – B.4. Cash

Management

1. Importance of Cash Management

Cash management = one of the most critical processes for any company.

If a company doesn’t have enough cash:

Worst case: Bankruptcy (if shortage persists).

Short term: Forced to borrow at high interest from banks.

🔑 Key requirement:

Short-term perspective: Enough cash to pay obligations when due.

 Long-term perspective: Enough cash to support growth and expansion.

💡 Exam Note: CMA focuses mainly on short-term cash management (day-to-day liquidity).

2. Factors Affecting Cash Holdings

The amount of cash held at any time depends on:

Cash needs in the near future

Driven by inventory turnover speed + accounts receivable collection period.

Slower turnover/collection → more cash needed.

Liquidity risk tolerance

Risk-averse firms → hold more cash.

Aggressive firms → hold less, invest more.

Other liquid assets held

If assets (like marketable securities) can be quickly converted to cash, less cash is
required.

Return on short-term investments

Low interest rates: Opportunity cost of cash is low → firms hold more cash.

High interest rates: Opportunity cost of cash is high → firms hold less cash (invest
in securities instead).

Stage of operating cycle

Seasonal businesses: Cash fluctuates.

After peak sales period → more cash.

During slow periods → less cash.

💡 Extra Clarity:

This is about cash balance trade-off: liquidity safety vs. profitability from investing idle
cash.
 Exam Trick: A company with high interest rates in market will reduce cash balances to
invest in higher-return securities.

3. Reasons for Holding Cash

Companies hold cash for four main reasons:

Transaction (medium of exchange):

Cash needed for day-to-day business transactions.

Precautionary motive:

To handle unforeseen events requiring quick cash.

Example: sudden equipment breakdown, lawsuits, emergencies.

Speculative motive:

To quickly seize investment opportunities.

Examples: acquisitions, bulk purchase of discounted inventory.

Compensating balance:

Banks may require minimum balances as part of loan agreements.

💡 Concept Tip:

Precautionary = “just in case.”

Speculative = “just in time (opportunity).”

4. Cash Flow Forecasting

Purpose: Estimate cash inflows and outflows to manage liquidity.

Determining Cash Needs

Depends on:
 AR collection time.

Inventory turnover.

Longer collection/turnover → higher cash balance needed.

Use of Forecasts

To determine if company will have:

Excess cash → available for investment.

Cash shortfall → borrowing required (when, how much, for how long).

Scheduled loan payments must be included in planning.

Forecast Sources

Master budget items (e.g., planned equipment purchases).

Operating data:

Projected sales.

Required inventory levels.

Days receivable collection.

Days payable deferral.

5. Example Format – Short-Term Cash Forecast

Cash Forecast – June 20X2

Cash balance, beginning $xxx

Receipts:

Collections from customers

Sale of equipment

Other receipts
 Interest income
= Total Cash Available

– Disbursements:

Accounts payable (inventory & others)

Payroll

Manufacturing overhead

Nonmanufacturing costs

Equipment purchases

Taxes

Other disbursements
= Total Disbursements

– Minimum cash balance required

= Total Cash Needed

→ Cash Excess (Deficit) $xxx

Financing Section:

Beginning borrowings

New borrowings

Principal repayment(s)

Interest expense paid

= Net financing effect

Cash balance, ending $xxx

💡 Concept Tip: This is essentially a short-term liquidity plan, not the same as the Statement
of Cash Flows (which is a historical report).

6. Cash Flow Management – Daily Goals

Two critical objectives:
 Accelerate inflows (collections).

Delay outflows (disbursements).

This is the golden rule of treasury management.

7. The Concept of Float

Float = time difference between payment initiation and availability of cash.

More relevant when using paper checks.

Two types of float:

Disbursement float: Experienced by the payer.

Collection float: Experienced by the receiver.

👉 Goal:

Company wants to maximize disbursement float (delay outflow).

Company wants to minimize collection float (accelerate inflow).

Components of Collection Float:

Mail float: Time between customer mailing check and company receiving it.

Processing float: Time taken by company to process and deposit payment.

Clearing float: Time bank takes to collect funds and make them usable.

💡 Formula for Freed Cash:

Freed Cash=AverageDailyCollections×Days of Float ReducedFreed \, Cash = Average Daily

Collections \times \text{Days of Float
Reduced}FreedCash=AverageDailyCollections×Days of Float Reduced

Example: If average daily collections = $50,000 and float is reduced by 2 days → $100,000
freed for use.

Real-world update:
 Advances in banking technology (electronic transfers, instant clearing) have significantly
reduced disbursement float opportunities.

🔑 Extra Concept Clarity (Exam-Focused)

Cash management vs. liquidity ratios:

Liquidity ratios (current ratio, quick ratio) show position.

Cash management techniques actively control inflows/outflows to improve position.

Technology impact:

Checks → high float (old days).

Now, ACH transfers, wire payments, online payments → reduced float.

For exam: remember companies must rely more on efficient receivables

management than float tricks.

Exam Trap:

Don’t confuse cash flow forecast (planning tool) with statement of cash flows
(reporting tool).

Forecast = forward-looking. Statement = backward-looking.

CMA Calculation Point:

If float is reduced → one-time release of cash (not recurring each period).

Important for short-term investment decisions.

📘 Smart Notes: Study Unit 26 – B.4. Cash

Management (Part 2)
👉 Focus: Inflows & Outflows

1. Cash Inflow Management (Speeding Collections)

Goal: Collect cash as fast as possible → reduces collection float.

Techniques to Accelerate Inflows

Prompt invoicing

Send invoices immediately (mail or electronic).

Earlier invoice → earlier payment.

Favorable payment terms

Offer early payment discounts (e.g., 2/10, net 30).

Encourages customers to pay quickly.

Electronic systems

EDI (Electronic Data Interchange): Direct computer-to-computer transactions.

EFT (Electronic Funds Transfer): Instant transfer of funds.

Wire transfers: Fast, reliable option (but may be costly).

Accepting credit cards

Merchant receives 97–99% of sale immediately.

Bank assumes collection risk.

Useful to accelerate cash inflows despite transaction fees (1–3%).

Concentration banking

Used by large firms with multiple locations.

Local branches deposit into nearby banks.

Funds regularly transferred to central concentration account → quicker access to

usable cash.

Lockbox system

Customers send payments to regional PO boxes managed by banks.

Banks collect & deposit checks same day.

 Reduces:

Mail float (shorter distance).

Processing float (bank handles processing).

Clearing float (deposited sooner into system).

Customer remittance info still sent to company.

Lockbox Evaluation Formula

Steps:

Compute average daily collections.

Multiply by reduction in float days = one-time increase in available cash.

Multiply by annual interest rate = annual benefit from additional funds.

Compare benefit vs. lockbox cost → adopt only if benefit > cost.

Example – JJF Wholesale

Avg. daily collections = 1,000 × $400 = $400,000.

Reduction in float = 3 days → $400,000 × 3 = $1,200,000 released.

Annual return = $1,200,000 × 3% = $36,000.

Lockbox cost = $32,000.

Decision: Adopt lockbox (benefit > cost).

⚠️Exam Tip: Always consider sensitivity (interest rates, volume, or costs changing may reverse
benefit).

2. Cash Outflow Management (Delaying Payments)

Goal: Delay cash disbursements as long as possible without harming supplier relationships.

Disbursement Float

Time lag between writing a check and funds being deducted from payer’s account.

Components:

Mail float – delivery to payee.

Operational float – payee records & deposits.

Clearing float – bank processing until funds leave payer’s account.

💡 This lag = interest-free loan to the company.

Techniques to Maximize Float

Pay as late as possible (but without damaging relationships or losing discounts).

EFT payments to control exact timing of disbursement.

Credit cards

Use when vendor accepts without fee.

Leverage grace period before settlement.

3. Overdraft Systems
Definition: When withdrawals > account balance and bank honors them.

Essentially a short-term loan from bank.

Banks may:

Transfer from credit line.

Allow negative balance (up to limit).

 Bank regulators monitor usage to avoid credit losses.

4. Supplier Discounts (Cash Discount Periods)

Example terms: 2/10, net 30 → 2% discount if paid within 10 days, otherwise full payment
due in 30 days.

Decision rule: Take the discount if implied cost of not taking it > cost of capital.

Formula – Cost of Not Taking Discount

\text{Cost of not taking discount} = \frac{365}{\text{Total Pay Period – Discount Period}} \

times \frac{\text{Discount %}}{1 - \text{Discount %}}

👉 Always use 365 days unless exam says otherwise.

Example – Organics, Inc.

Invoice = $100, Terms = 3/10, net 30.

If pay in 10 days → $97.

If pay in 30 days → $100.

Cost of not taking discount:

36530−10×397=56.44%\frac{365}{30-10} \times \frac{3}{97} = 56.44\%30−10365×973

=56.44%

Since 56.44% ≫ company’s 3% return on cash, take the discount.

💡 Interpretation: Not taking discount = like paying 56.44% annual interest on a “loan” from
supplier.

5. Exam Strategy Notes

Cash inflow mgmt: Focus on reducing collection float.
 Cash outflow mgmt: Focus on extending disbursement float (but watch discounts).

Lockbox Qs: Always calculate benefit vs. cost.

Discount Qs: The cost of not taking is usually very high → most exam answers: “Take the
discount.”

Float reduction Qs: Freed funds = daily collections × days reduced.

📘 Smart Notes: Study Unit 27 – B.4.

Marketable Securities Management

1. Marketable Securities – Basics

Definition: Securities easily converted into cash with active secondary markets.

Nature:

Highly liquid.

Classified as current assets in working capital.

Serve as temporary investment of excess cash.

Why not just hold cash?

Cash = no/low return.

Marketable securities = return + liquidity.

Purpose of holding marketable securities:

Primary objective: Liquidity (store of value).

Secondary objective: Earn return.

Features required:

Quick conversion to cash (≤ 24 hrs).

Very low risk of value fluctuation.

2. Investment Policy Statement (IPS)
Guides decision makers.

Ensures investments align with company’s risk–return policy and liquidity needs.

3. Common Marketable Securities

3.1 Money Market Instruments (very short-term debt)

Issuers: Governments, corporations, banks.

Features: Safe, low returns, high volume trading.

Types:

Treasury Bills (T-bills)

Issued by U.S. govt. (terms: few days → 52 weeks).

No coupon interest → sold at discount, redeemed at par.

Interest = Par – Purchase Price.

Formula (cash price):

Cash Price=Face Value−Interest Earned\text{Cash Price} = \text{Face Value} - \

text{Interest Earned}Cash Price=Face Value−Interest Earned

Effective Annual Rate (APR):

APR=InterestPrice×365Days to Maturity\text{APR} = \frac{\text{Interest}}{\

text{Price}} \times \frac{365}{\text{Days to Maturity}}APR=PriceInterest
×Days to Maturity365

Example:

Face = $1,000; Price = $980; Interest = $20.

APR = 20980×36590=8.28%\frac{20}{980} \times \frac{365}{90} =

8.28\%98020×90365=8.28%.
 ✅ CMA Tip: T-bill calc shows up often → memorize formula.

Commercial Paper (CP)

Short-term, unsecured debt by large firms.

Denomination: $100,000+.

Sold at discount; paid at maturity.

Higher return vs. CDs (riskier).

Low default risk (issued by creditworthy firms).

BUT: Weak secondary market.

Bankers’ Acceptances (BA)

Bank guarantee of payment → used in international trade.

Can be traded in money markets (at discount).

Negotiable Certificates of Deposit (CDs)

Denomination: $100,000+.

Maturity: 2 weeks → 1 year.

Marketable if issued by major banks.

FDIC-insured (up to $250,000 per depositor, per bank).

Yields lower than CP & BA (because insured = less risk).

Repurchase Agreements (Repos)

Sale of securities with agreement to repurchase at higher price.

Difference = interest.

Effectively a secured short-term loan.

Money Market Funds (MMFs)

Pooled investor funds → invested in MM instruments.

 Goal: Maintain $1 NAV per share.

Not FDIC-insured → small risk of “breaking the buck.”

Sometimes allow limited check-writing privileges.

3.2 Other Marketable Securities

Money Market Deposit Accounts – Bank accounts with limited check-writing, higher
returns vs. savings, FDIC insured.

Federal Agency Securities – Issued by U.S. govt. agencies (not fully govt.-backed).

Eurodollar Deposits – Dollar deposits outside the U.S. (e.g., London banks).

State & Local Govt. Securities – Usually tax-exempt (e.g., tax anticipation notes).

Treasury Notes & Bonds (near maturity) – Normally long-term, but if purchased close to
maturity = short-term substitute.

4. Considerations in Selecting Marketable Securities

Key Risks:

Interest Rate Risk: Value falls when interest rates rise. → Lower for short-term securities.

Default Risk: Issuer may fail to pay interest/principal. → Should be minimal for operating
funds.

Risk–Return Tradeoff

Higher risk → higher required return.

Low risk → low return.

Funds for operations → invest in very low-risk securities.

Liquidity

Must be convertible to cash quickly without significant loss.

Tax Position

Tax-exempt securities (e.g., municipal bonds):

Advantageous only if company has taxable income.

If losses → invest in taxable securities for higher after-tax return.

After-Tax Return Rule: Always evaluate securities on after-tax yield, not nominal.

5. Cash & Marketable Security Management Models

5.1 Baumol Model (like EOQ model)

Determines optimal amount of securities to convert to cash each time.

Balances:

Transaction cost of selling securities.

Opportunity cost of holding idle cash.

Formula:

OC=2bTiOC = \sqrt{\frac{2bT}{i}}OC=i2bT

Where:

OCOCOC = Optimal cash transfer size.

bbb = Fixed transaction cost per conversion.

TTT = Total cash demand (per period).

iii = Opportunity cost (interest rate).

Example (HJK Corp):

T=500,000T = 500,000T=500,000, b=10b = 10b=10, i=4%i = 4\%i=4%.

OC=2×10×500,0000.04=15,811OC = \sqrt{\frac{2 \times 10 \times 500,000}{0.04}} =

15,811OC=0.042×10×500,000=15,811.
 Sales required = 500,000/15,811≈32500,000 / 15,811 \approx 32500,000/15,811≈32.

Frequency = every ~11 days.

✅ Assumptions (not realistic):

Cash demand known & constant.

Costs known & fixed.

Interest rate constant.

5.2 Miller–Orr Model

Provides guidance on optimal cash balance levels.

Sets:

Upper limit.

Lower limit.

Target balance.

Rules:

If balance = upper limit → buy securities to reduce cash.

If balance = lower limit → sell securities to increase cash.

If within corridor → do nothing.

✅ Exam Note: Need only concept; not required to calculate limits.

⚡ CMA Exam Tips & Clarifications

T-bills: Remember formula & APR calculation → classic exam Q.

Discount securities (T-bills, CP, BA): All sold at discount, redeemed at face value.

Negotiable CDs: FDIC insurance = lower yield.

 Risk-Return principle: High yield = high risk → always tie answer back to this tradeoff.

Baumol Model: Think EOQ applied to cash.

Miller-Orr: Corridor method, flexible → realistic alternative to Baumol.

Tax effect: Always convert returns to after-tax equivalents before comparing investments.

📘 Smart Notes – Study Unit 28: Accounts

Receivable Management

1. Why Companies Carry Accounts Receivable

Customers can’t always pay in cash.

Competitors offer credit → must match to stay competitive.

Typical terms: e.g., 2/10, net 30 (2% discount if paid in 10 days; otherwise full in 30).

⚠️If a company required only cash → it would lose sales.

2. Costs of Accounts Receivable

Administrative costs: managing, monitoring, collections.

Opportunity cost: cash tied up in receivables can’t be invested elsewhere.

Credit loss cost: some customers will default → direct write-off.

3. The Trade-Off in A/R Management

Benefit: Increased sales from extending credit.
 Cost: Collection costs, foregone interest, credit losses.

Goal: Grant credit until marginal benefits = marginal costs.

Zero credit losses = possible only if no credit sales → but this means lost sales revenue.

4. Credit Policy
Three Elements:

Credit Standards:

Relaxed → more customers, higher sales, higher defaults.

Strict → fewer customers, lower defaults, lower sales.

Tool: Credit Scoring → points-based system to evaluate creditworthiness.

Credit Terms:

Payment period, discounts for early payment, penalties for late payment.

Discounts → encourage early collections but reduce revenue.

Penalties → discourage late payments.

Collection Efforts:

Aggressive → lower A/R, fewer defaults, higher collection costs.

Lenient → higher A/R, higher defaults, lower collection costs.

5. Impact of Changing Credit Policy Variables

Relaxed Standards:

↑ Sales.

↑ Credit losses.

↑ Collection costs.
 ↑ Default risk (risk of future payment not being received).

Stricter Standards:

↓ Sales.

↓ A/R balance.

↓ Credit losses.

Changes in Credit Terms / Interest Rates:

Longer payment periods or low interest → ↑ credit sales.

Risk: Some customers who would pay cash now use credit → sales unchanged but
risk ↑.

Collection Efforts:

↑ Efforts → ↓ working capital needs, ↓ losses, ↑ costs.

↓ Efforts → ↑ working capital, ↑ losses, ↓ costs.

6. Monitoring Accounts Receivable

Tool: Aging Schedule

Groups A/R by time outstanding: current, <30 days past due, 31–60, 61–90, etc.

Identifies delinquent accounts for targeted action.

7. Exam Tip
Be able to calculate net benefit/cost of a credit policy change:

Change in sales revenue.

Minus change in bad debt expense.

Minus change in collection/discount costs.

 Minus opportunity cost of higher A/R balances.

✅ Always compare incremental benefits vs. incremental costs.

📘 Smart Notes – Study Unit 29: Inventory

Management

1. Importance of Inventory
One of the largest balance sheet items for producers/sellers.

Small % change in inventory cost → large change in COGS → impacts net income.

2. Why Companies Carry Inventory

Retailers: Need stock available for customers (physical or online).

Manufacturers:

Finished Goods: Ready to sell.

Raw Materials: Flexibility in purchasing.

Work-in-Process (WIP): Needed since production takes time.

⚠️Must balance enough inventory vs. excess inventory.

3. Costs of Inventory
Purchasing Costs: Price + shipping; may include lost discounts.

Carrying Costs: Storage, insurance, obsolescence, spoilage, theft, taxes, opportunity cost.

Ordering Costs: Order placement, receiving, inspection, accounting.

 Stockout Costs: Lost contribution margin, lost customer goodwill, extra shipping costs.

Inventory Shrinkage: Difference between book and physical count (theft, errors).

4. Lead Time, Safety Stock, Reorder Point, and Average

Inventory
Lead Time: Delay between placing and receiving an order.

Safety Stock: Extra inventory to protect against stockouts.

↑ If lead time or demand is variable.

↑ If stockout cost is high.

Reorder Point Formula:

Reorder Point=(Average Daily Usage×Lead Time)+Safety Stock\text{Reorder Point} = (\

text{Average Daily Usage} \times \text{Lead Time}) + \text{Safety
Stock}Reorder Point=(Average Daily Usage×Lead Time)+Safety Stock

Average Inventory Formula:

Average Inventory=Order Quantity2+Safety Stock\text{Average Inventory} = \frac{\

text{Order Quantity}}{2} + \text{Safety Stock}Average Inventory=2Order Quantity
+Safety Stock

Example:

Usage = 20/day, Lead Time = 10 days, Safety Stock = 100.

Reorder Point = (20 × 10) + 100 = 300 units.

If order size = 300 → Avg. Inventory = (300 ÷ 2) + 100 = 250 units.

5. Economic Order Quantity (EOQ)

Objective: Minimize total inventory costs (ordering + carrying).

Formula:
 EOQ=2aDkEOQ = \sqrt{\frac{2aD}{k}}EOQ=k2aD

Where:

aaa = Cost per order.

DDD = Annual demand (units).

kkk = Carrying cost per unit per year.

Effects:

↑ Order cost or ↑ demand → ↑ EOQ.

↑ Carrying cost → ↓ EOQ.

Example (Medina Co.):

D = 12,000 units, a = $450, k = $3.

EOQ = √[(2 × 450 × 12,000) ÷ 3] = 1,898 units.

Orders per year = 12,000 ÷ 1,898 ≈ 7.

If demand ↑ to 18,000 → EOQ = 2,324 → 8 orders/year.

If carrying cost ↑ to $4 → EOQ = 2,013 → 9 orders/year.

6. Other Inventory Approaches

Just-in-Time (JIT):

Keep very little inventory.

Requires reliable suppliers & efficient systems.

Benefits: lower carrying cost, less waste.

Risk: higher stockout risk if disruptions occur.

⚡ CMA Exam Insights

 A/R vs. Inventory: Both involve cost-benefit trade-offs (sales ↑ vs. risk/costs ↑).

Credit Policy: Always think in terms of net benefit.

Inventory: EOQ & Reorder Point formulas are exam favorites.

Safety Stock: More variability → more safety stock.

Link: Working capital management = balance liquidity, risk, and profitability.

📘 Smart Notes – Study Unit 29 (continued):

Inventory Management

8. Economic Lot Size (ELS)

Purpose: Same as EOQ, but applied to manufacturing production runs.

Balances batch setup costs vs. carrying cost of finished goods.

Helps determine how much to produce per batch to minimize total cost.

Formula:

ELS=2aDkELS = \sqrt{\frac{2aD}{k}}ELS=k2aD

Where:

aaa = setup cost per batch.

DDD = demand (units of FG per period).

kkk = carrying cost per unit (per same period as DDD).

➡️Difference from EOQ:

EOQ uses ordering cost, ELS uses setup cost.

9. Just-in-Time (JIT) Inventory Management

 Goal: Minimize all inventory (raw, WIP, FG) while still meeting demand.

System type: “Pull system” → production & purchasing respond only to actual demand.

Benefits:

Lower carrying costs.

Lower risk of obsolescence, theft, damage.

Risks/Requirements:

Must have reliable suppliers (timely, frequent, small deliveries).

Must ensure quality → no buffer stock for defects.

Requires long-term supplier relationships.

⚠️Exam Tip:

CMA Part 2 → only needs a high-level description of JIT (details tested in Part 1).

10. Inventory Turnover & Gross Profit Margin Rule

Formulas:

Gross Profit Margin (GPM) = Gross ProfitRevenue\frac{\text{Gross Profit}}{\

text{Revenue}}RevenueGross Profit

Inventory Turnover (IT) = COGSAverage Inventory\frac{\text{COGS}}{\

text{Average Inventory}}Average InventoryCOGS

Rule of Thumb:

IT×GPM≥1.0⇒Inventory is not too [Link] \times GPM \geq 1.0 \quad \Rightarrow \
quad Inventory \text{ is not too high.}IT×GPM≥1.0⇒Inventory is not too high.

Example

Revenue = $1,000,000, COGS = $700,000 → GPM = 30%.

Avg. Inventory = $140,000 → IT = 5.

 Test: 0.30 × 5 = 1.5 ✅ (not too high).

If Avg. Inventory ↑ to $250,000 → IT = 2.8 → Test: 0.30 × 2.8 = 0.84 ❌ (too high).

11. Profitability Profiles (Margin vs. Turnover)

Low Margin / High Turnover

Strategy: Price-focused, high sales volume, fast-moving items.

Example: Discount retailers.

High Margin / Low Turnover

Strategy: Unique products, high service, low sales volume.

Risk: Poor purchasing can cause losses.

Example: Luxury boutiques.

High Margin / High Turnover

Strategy: Narrow, fast-selling product line, higher prices.

Risk: High overhead costs.

Low Margin / Low Turnover

Strategy: Weak (often unsustainable).

Risk: Usually due to poor management or intense price wars.

12. Key Takeaways for CMA Exam

ELS = EOQ for production (replace order cost with setup cost).

JIT = Pull system, minimizes inventory, needs reliable suppliers.

Turnover × GPM ≥ 1.0 → Inventory not excessive.

Profitability Profiles: Know the four combinations.

📘 CMA Part 2 – Section B.4. Short-Term
Financing

1. Short-Term Financing (Overview)

Definition: Focuses on current liabilities (obligations due within 12 months or within the
operating cycle, whichever is longer).

Formula for Net Working Capital (NWC):

Net Working Capital (NWC)=Total Current Assets−Total Current Liabilities\text{Net Working

Capital (NWC)} = \text{Total Current Assets} - \text{Total Current
Liabilities}Net Working Capital (NWC)=Total Current Assets−Total Current Liabilities

Decision Factor: Companies choose short-term financing options based on cost-benefit

analysis:

Costs: interest rates, dealer fees, warehousing fees, other charges.

Most desirable financing: the option with lowest borrowing cost, adjusted for risks
& benefits.

🔎 Concept Clarification:

Short-term financing impacts liquidity. Increasing short-term liabilities reduces working

capital, which may increase risk but provides cash.

Firms must balance liquidity needs with cost of funds.

2. Trade Credit
Definition: Credit obtained by purchasing goods/services on account. Recorded as Accounts
Payable on balance sheet.

Importance:

Largest source of short-term financing for small & medium businesses.

 Spontaneous Financing: arises automatically from the normal course of business (no
separate financing arrangement needed).

Decision Point:

Whether to take early payment discounts.

If cost of not taking discount > cost of short-term borrowing → company should
borrow and take the discount.

If discount is not taken: trade credit becomes a very expensive source of financing.

📌 Example: Vendor Terms

Terms: 2/10, net 30

2% discount if paid within 10 days.

Otherwise, full payment due in 30 days.

Formula: Cost of NOT Taking Discount

\text{Cost of not taking discount} = \frac{\text{Discount %}}{100\% - \text{Discount %}} \times \

frac{365}{\text{Total Credit Period – Discount Period}}

Calculation:

2%100%−2%×36530−10=0.020.98×36520=37.24%\frac{2\%}{100\% - 2\%} \times \frac{365}{30 -

10} = \frac{0.02}{0.98} \times \frac{365}{20} = 37.24\%100%−2%2%×30−10365=0.980.02×20365
=37.24%

Interpretation:

By not paying within 10 days, the buyer is borrowing for 20 days at an annualized
rate of 37.24%.

This is extremely high compared to typical short-term bank loan rates.

Hence, firms should almost always take the discount (if possible).

🔎 Extra Concept Clarification – Trade Credit

 Spontaneous vs. Negotiated Financing:

Spontaneous → occurs naturally (accounts payable).

Negotiated → requires formal agreement (bank loan, factoring).

Why trade credit is expensive if discounts ignored: The implicit cost is annualized,
making it much higher than borrowing from banks.

Exam Tip: Always compare “cost of not taking discount” with “cost of borrowing.” If
discount cost > loan cost → borrow and pay early.

3. Short-Term Commercial Bank Loans

Definition: Loans maturing in < 1 year (commonly 30, 60, 90 days).

Purpose: To finance seasonal working capital needs (e.g., build inventory ahead of peak
season).

Repayment: Loan should be self-liquidating → repaid through cash flow generated from
selling inventory & collecting receivables.

Secured vs. Unsecured Loans

Secured Loan

Backed by collateral (secondary repayment source).

Collateral often: Accounts Receivable or Inventory (via Floating Lien).

Floating lien = security interest in assets that constantly change

(receivables/inventory).

Lender typically lends up to 80% of receivables (depends on risk).

If borrower defaults → lender can seize receivables/inventory, may put firm out of
business.

Once pledged → receivables cannot be sold to factors or used as collateral elsewhere.

Unsecured Loan
 No collateral pledged.

Higher interest rate (to compensate lender’s risk).

Sometimes requires personal guarantee of owners (especially for private

companies).

4. Effective Interest Rate on Bank Loans

Concept: Actual cost of borrowing can be much higher than the stated rate due to:

Compensating balance requirements.

Discounted interest (withholding).

Combination of both.

Effective Annual Rate (EAR):

EAR=Net Annual Interest CostUsable Loan Proceeds\text{EAR} = \frac{\text{Net Annual Interest

Cost}}{\text{Usable Loan Proceeds}}EAR=Usable Loan ProceedsNet Annual Interest Cost

A. Loans with Compensating Balances

Definition: Borrower must maintain a minimum deposit with bank.

Impact: Reduces usable loan funds, increasing effective interest rate.

Types:

Absolute Balance → must always maintain minimum deposit.

Average Balance → allowed to dip below required amount as long as average meets
requirement (more flexible).

Examples:

Loan = $100,000, 6% interest, $20,000 compensating balance.

Interest = $6,000.

Usable funds = $100,000 − $20,000 = $80,000.

 EAR = $6,000 ÷ $80,000 = 7.5%.

If borrower already keeps $10,000 in bank:

Additional balance required = $10,000.

Usable funds = $90,000.

EAR = $6,000 ÷ $90,000 = 6.67%.

If bank pays 2% interest on $10,000 deposit:

Interest earned = $200.

Net Interest = $6,000 − $200 = $5,800.

EAR = $5,800 ÷ $90,000 = 6.44%.

B. Loans with Discounted Interest

Definition: Bank deducts full interest upfront from loan proceeds.

Borrower signs note for full loan amount (face value) and repays face value at maturity.

Formula:

Effective Rate=InterestLoan Amount – Interest Withheld\text{Effective Rate} = \frac{\

text{Interest}}{\text{Loan Amount – Interest
Withheld}}Effective Rate=Loan Amount – Interest WithheldInterest

Example:

$100,000 loan, 4% discounted interest.

Interest = $4,000 withheld.

Usable funds = $96,000.

EAR = $4,000 ÷ $96,000 = 4.17%.

C. Loans with Both Compensating Balance & Discounted Interest

Example: $100,000 loan, 4% discounted interest + 10% compensating balance.

Usable funds = $100,000 − $4,000 − $10,000 = $86,000.

EAR = $4,000 ÷ $86,000 = 4.65%.

5. Factoring Receivables
Definition: Selling receivables to a factor (finance company).

Benefit: Provides immediate cash (no liability like a loan). Factor collects from customers.

Contract Types:

Without Recourse: Factor assumes full risk of uncollectible receivables.

With Recourse: Seller must reimburse factor for uncollectible receivables.

Costs to Seller:

Factor’s Fee (service fee).

Interest on advance.

Allowance for Customer Returns (holdback).

Holdback: Factor retains a portion to cover merchandise returns. After return period ends,
unused holdback is refunded.

Note: No holdback for credit losses — either factor bears risk (without recourse) or seller
reimburses (with recourse).

Advantages:

Immediate cash inflow.

Factor handles collection.

If without recourse → seller eliminates credit risk.

Disadvantage: Cash received < full receivables amount due to fees/charges.

🔎 Concept Clarification – Factoring

Factoring = financing + outsourcing collections.

With recourse → similar to collateralized loan.

Without recourse → true sale of receivables.

Common in industries with long collection periods (textiles, manufacturing).

📘 CMA Part 2 – Section B.4. Factoring

Receivables & Short-Term Financing

1. Benefits of Factoring as Financing

Outsourcing collections: Selling receivables = outsourcing collection activities to the factor.

Efficiency: Factor often collects receivables more effectively because of specialization.

Time & Cost Savings: Company avoids costs and delays of in-house collections → can
focus on core operations.

Without Recourse:

Factor assumes credit risk (bad debts).

Company eliminates credit losses.

But → higher factoring fee.

With Recourse:

Company retains risk of bad debts.

Lower fee but credit losses not eliminated.

🔎 Exam Tip: Factoring “without recourse” = true sale of receivables. Factoring “with recourse”
= essentially a loan secured by receivables.
2. Limitations of Factoring
High fees: Factor’s charges can be expensive.

Cost-benefit concern: Reduction in collection costs + reduced credit risk may not fully
offset factoring fees.

Must compare factoring cost with other financing options (e.g., bank loans).

3. Cash Received in Factoring – Step Process

When receivables are sold, cash proceeds are calculated in steps:

Start with: Face Value of Receivables

Subtract Factor’s Fee → % of receivables (service charge).

Subtract Holdback Allowance → % reserved for potential sales returns.

= Funds Available Before Interest (deposited immediately to seller).

Subtract Estimated Interest:

Interest=Funds Available×Annual Rate×Days365\text{Interest} = \text{Funds Available}

\times \text{Annual Rate} \times \frac{\text{Days}}
{365}Interest=Funds Available×Annual Rate×365Days

(Interest prepaid → reduces proceeds upfront).

Final Proceeds to Seller.

After return period ends → unused holdback is refunded.

If collections are faster than expected → refund part of interest.

If slower → seller pays extra interest.

📌 Example: Factoring Proceeds

Receivables: $150,000
 Factor’s Fee = 4% = $6,000

Holdback = 7% = $10,500

Funds Available Before Interest = $150,000 − $10,500 − $6,000 = $133,500

Interest = $133,500 × 12% × 120 ÷ 365 = $5,267

Proceeds to Seller = $128,233

At return period end: Seller may receive refund of unused holdback ($10,500).

Total Cost of Factoring = $6,000 (fee) + $5,267 (interest) = $11,267.

🔎 Interpretation: Seller sacrifices $11,267 in exchange for immediate liquidity + outsourcing

collections. Must compare this cost with other financing sources.

4. Other Sources of Financing

A. Secured Sources

Revolving Line of Credit

Pre-approved loan facility.

Secured by inventory or receivables.

Borrower can draw up to limit (e.g., $500,000).

Interest charged only on used portion.

May include fee on unused portion.

Example: Line = $500,000, if $250,000 used → interest charged on $250,000, but

small fee on remaining $250,000.

Warehouse Financing

Loan secured by inventory stored at a third-party warehouse approved by lender.

Inventory Financing

Lender owns title to inventory.

 Borrower sells goods as trustee for lender.

Enables firm to buy inventory without upfront cash.

Downside: interest payments reduce profit margin.

Transaction Loan

Loan for specific purchase (e.g., equipment loan, mortgage).

Secured by purchased asset.

Loan proceeds often go directly to seller of asset.

Long-term transaction loans (over 1 year) affect current liabilities only through
current maturities of long-term debt.

Chattel Mortgage

Loan secured by movable personal property (vehicles, machinery, equipment).

May not always be short-term.

B. Unsecured Sources

Trade Credit (Accounts Payable)

Unsecured, spontaneous financing.

Automatically created with purchases.

Accrued Expenses

Wages, taxes, interest, etc. → funds available until payment due.

Another form of spontaneous financing.

Line of Credit (Non-Revolving)

Pre-approved loan, accessed when needed.

Must be repaid before next use.

 Usually short-term; often requires clearing to zero balance annually (e.g., for 30
days).

May be unsecured or secured by floating lien on receivables/inventory.

Commercial Paper (CP)

Short-term, unsecured promissory note.

Issued only by large, creditworthy companies.

Lower cost vs. bank loans (low risk).

Very limited secondary market (short maturity).

Investors usually match CP maturity to their liquidity needs.

Bankers’ Acceptances (BAs)

Used mainly in international trade financing.

Bank guarantees payment to BA holder at maturity.

Importer repays bank + fees.

Reduces counterparty risk for exporters.

Covered in detail in Unit 39.

5. Maturity Matching Approach (a.k.a. Hedging/Self-

Liquidating Approach)
Principle: Match financing maturities with asset maturities.

Short-term assets → Short-term financing.

Long-term assets → Long-term financing.

Example: Seasonal cash needs financed by short-term loans.

Exception: Permanent portion of receivables/inventory is financed by long-term debt or

equity, even though they are current assets.
 Because receivables/inventory are continuously replenished.

Fixed assets (PP&E) → financed by long-term capital.

6. Summary of Working Capital Management – CMA Exam

Essentials
Know terms, risks, returns of short-term marketable securities.

Know short-term financing options & their terms.

Understand ways to speed up collections / manage payables.

Understand factoring costs & benefits.

Understand collateralized financing (pledging receivables/inventory).

Know credit policy choices and their impact on:

Accounts receivable

Net income

Collection procedures

Be able to evaluate credit loss exposure.

Prepare cash forecast:

How much cash to hold.

When financing is needed.

When financing can be repaid.

🔎 Extra Concept Clarifications for CMA

Factoring vs. Bank Loan:

Factoring transfers collection risk & management.

 Bank loan provides funds but firm still manages receivables.

Commercial Paper:

Very low-cost, but limited only to strong companies.

Example exam trick: SMEs cannot issue CP.

Maturity Matching:

Prevents mismatched liquidity (e.g., funding fixed assets with short-term loans =
risky).

Working Capital Strategy:

Aggressive → finance more current assets with short-term debt (risky, low cost).

Conservative → finance with long-term debt/equity (safe, higher cost).

Matching/Hedging → ideal balance.

📘 Study Notes – Corporate Restructuring &

Business Combinations (Unit 33: B.5.)

🔹 Corporate Restructuring
Definition: Decisions about the future form of the business.

Involves:

Choice of legal form (corporation, sole proprietorship, partnership).

Sources of future financing.

Size and scope of company.

Topics include:

Mergers & acquisitions.

Benefits of M&A.
 Defenses against hostile bids.

Divestitures → opposite of combinations; splitting into multiple entities.

🔹 Mergers & Acquisitions (M&A)

Purpose: To achieve expansion (new markets, geographies, capabilities).

Challenge: Complex → legal, financial, operational, tax planning required.

Mergers

Statutory Merger:

Surviving corporation issues stock (or other consideration) to acquire all outstanding
stock of the other.

Acquired corporation dissolves and ceases to exist.

Survivor owns net assets of liquidated corporation.

Target’s operations may:

Continue as a division.

Be sold.

Be liquidated.

Consolidation (Statutory Consolidation):

New corporation formed.

Issues stock to acquire outstanding stock of both old companies.

Old companies cease to exist as legal entities.

New company owns net assets of both.

Boards + stockholders of both must approve.

Acquisitions

Acquisition of shares:

Acquirer buys majority or all voting shares.

Common in hostile takeovers:

Closely held corp: via negotiations with main shareholders.

Public corp: via stock market or tender offer (offer to buy shares at premium
over market).

Target remains separate legal entity (subsidiary).

Acquirer gains controlling interest.

Use of Proxies:

Shareholders give their voting rights to another party.

If majority proxies are obtained → control target without owning shares.

Advantage: No need to purchase shares.

Disadvantage: Control is temporary; shareholders can revoke proxies later.

Acquisition of Assets:

Acquirer buys assets (inventory, receivables, fixed assets).

Not required to assume liabilities.

Requires board + shareholder approval.

Seller may:

Continue (with reduced assets).

Dissolve after sale.

Target does not become an affiliate/subsidiary.

🔹 Types of Mergers/Acquisitions
 Horizontal – Same industry (e.g., two banks merging).

Vertical – Different stages of production/distribution.

Forward Vertical: Acquirer moves toward consumer (e.g., manufacturer +

distributor).

Backward Vertical: Acquirer moves toward raw materials (e.g., beverage co. +
sugar producer).

Conglomerate – Unrelated industries (diversification).

🔹 Reasons for Business Combinations

Economies of Scale

Larger company = cost savings (shared services, eliminate duplicates).

More volume = lower avg. costs.

⚠️Dis-economies of scale can occur if company gets too large (inefficiency).

Complementary Resources (Synergy)

One company has what the other lacks → together more valuable than separate.

Example: Cash-rich firm + product-rich, cash-poor firm → financial synergy.

“2 + 2 = 5” effect.

Sales Enhancement / Technology Gain

Increased market share, market dominance, or access to tech/product line.

Value-added only if sales enhancement is cost effective.

Management Improvements

Poorly managed but fundamentally sound companies can become profitable under
new management.

Tax Benefits
 Net Operating Loss (NOL) carry-forward of unprofitable firm can offset acquirer’s
future taxable income.

Diversification

Especially in conglomerate mergers.

Reduces overall company risk.

Lower Financing Costs

Larger firms generally borrow at lower rates.

BUT: No real gain for shareholders since:

Both companies jointly guarantee debt.

Stockholders’ option to default decreases.

🔹 Extra Concept Clarification (Exam-Focused)

✅ Merger vs. Consolidation vs. Acquisition

Merger: One company survives; other dissolved.

Consolidation: New company formed; old companies dissolved.

Acquisition: Acquirer gains control; target remains separate entity.

✅ Tender Offer vs. Proxy Fight

Tender Offer: Buy shares directly from shareholders at premium.

Proxy Fight: Gain control by convincing shareholders to vote with you.

✅ Synergy in CMA context

Operating synergy: Cost savings (economies of scale).

Financial synergy: Improved financing capability (cash + debt mix).

✅ Risks of M&A

Overestimation of synergy benefits.

 Integration problems (culture clash, operations mismatch).

Legal/regulatory restrictions (anti-trust issues in horizontal mergers).

📌 Quick Recap for Exam

Merger → Survivor + dissolution.

Consolidation → New company formed.

Acquisition → Buy stock/assets; target may remain.

Synergy = Key justification.

Classifications: Horizontal, Vertical (forward/backward), Conglomerate.

Good reasons: Synergy, economies of scale, management improvement.

Questionable reasons: Diversification (stockholders can diversify themselves), lower

financing costs (not true benefit).

Notes – Takeover Defenses & Divestitures

(CMA P2)

1. Hostile Takeover & Defenses

When a company is targeted for acquisition against management’s wishes, it may defend itself
using pre-offer or post-offer defenses.

🔹 Pre-Offer Defenses (before a takeover bid)

Shark Repellant – changes to company charter to make takeovers harder.

Staggered Board Elections – board members elected in staggered terms (e.g., 3 out of 9
directors per year).

Makes it harder for acquirer to quickly gain board control.

Supermajority Merger Approval – requires > majority vote (e.g., 2/3 or 3/4) for mergers.
 Raises threshold for approval.

Fair Merger Price Provisions – acquirer must pay at least a fair price for non-controlling
shareholders.

Often linked to EPS multiples.

May include freeze-out period before deal can proceed.

Golden Parachutes – large payouts to top executives if takeover occurs.

Increases cost of acquisition.

Poison Pills – contractual provisions making takeover unattractive.

Example: key contracts automatically terminate if ownership changes.

Poison Put – bondholders can demand repayment if hostile takeover happens.

May force target into bankruptcy.

Voting Rights Plans (Restricted Rights) – shareholders above certain % lose voting rights
unless board approves.

🔹 Post-Offer Defenses (after takeover bid starts)

Issuing New Stock – dilutes acquirer’s holdings, increases acquisition cost.

Pac-Man Defense – target tries to acquire the hostile bidder.

Funded by issuing stock or raising cash.

White Knight – target seeks a friendlier bidder to outbid hostile acquirer.

Lockup Provision – target sells key assets (“crown jewels”) or shares to a white knight at
attractive price.

Prevents hostile bidder from accessing them.

Leveraged Recapitalization / Restructuring – company borrows heavily to pay

shareholders a large dividend.

Increases debt load → discourages acquisition (reduces borrowing capacity for

acquirer).

Insiders take dividends in stock, increasing their ownership %.

2. Divestitures (Opposite of M&A)
Divestiture = company sells, spins off, or liquidates part of business to unlock shareholder
value.

🔹 Methods of Divestiture

Voluntary Liquidation – company sells all assets and liquidates if asset liquidation value >
PV of expected future cash flows.

Partial Asset Sale – sale of division/business unit if NPV of sale > NPV of continuing
operations.

Payment usually in cash or securities.

Often increases shareholder wealth.

Spin-Off – business unit becomes independent company.

Shares in new company distributed pro-rata to existing shareholders.

Example: if shareholder owns 1% of Parent Co., they get 1% of new Spin-Off Co.

Managers can receive stock/options in new company = motivation.

Accounting: shareholder reallocates cost basis between old & new stocks.

Equity Carve-Out – parent sells part of subsidiary’s stock via IPO (retains majority control).

Brings in cash (equity financing).

Tracking Stock – new class of stock tied to division’s performance (not separate legal
entity).

Shareholders can invest in division performance without divestiture.

Going Private – public company repurchased by group of investors (often management).

Removes company from stock exchange.

Usually financed with debt → Leveraged Buyout (LBO).

3. Leveraged Buyouts (LBOs)
Definition: Acquisition financed with large debt, little equity.

Borrower: The acquired company itself borrows, pledging assets as collateral.

Requirements for LBO candidate:

Stable cash flows.

Low debt before buyout.

Valuable unencumbered assets.

Management Buyout (MBO): LBO led by company’s own management.

Goal: Turnaround privately → then go public again.

Risk: Excessive debt can lead to bankruptcy.

4. Effects of Divestitures on Shareholder Value

Full Liquidation: Usually → large gains for shareholders.

Partial Divestitures: Typically → small positive gains.

Buyers of sold divisions: Also gain (division is more valuable to them).

📌 Extra Clarifications & CMA Exam

Pointers
✅ Concept Links

Takeover Defenses = often exam-tested. Remember which are pre-offer vs. post-offer.

Golden Parachutes vs. Poison Pills → Both increase acquisition cost, but:

Golden parachutes = payments to executives.

 Poison pills = contractual provisions reducing target value.

Divestitures vs. Spin-offs vs. Carve-outs vs. LBOs:

Divestiture = selling part of business.

Spin-off = free shares of new company to existing shareholders.

Carve-out = IPO of new company, cash raised.

LBO = going private using heavy debt.

✅ Real-world Exam Example

If a company has high debt, is it a good LBO candidate? → No. LBO needs low prior debt +
stable cash flows.

If acquirer offers low price for shares, which defense helps minority shareholders? → Fair
price provision.

If target sells “crown jewels” to friendly buyer, which defense is this? → Lockup provision.

📘 Study Notes: Discounted Cash Flow

Valuation (DCF)
1. Concept of DCF

Purpose: Used to value a business based on future free cash flows (FCF), discounted to
present value (PV).

Key Idea: Value of business = PV of all expected free cash flows (after acquisition).

Only DCF is tested on CMA Exam (other valuation methods like comparables, multiples,
etc., are not tested).

2. Free Cash Flow (FCF)

Definition: Cash generated before interest, after taxes, after capital expenditures.

Formula (when EBIT is given):

 FCF=EBIT(1−tax rate)−(CapEx−Depreciation)±ΔNWCFCF = EBIT(1 - \text{tax rate}) -
(CapEx - Depreciation) \pm \Delta NWCFCF=EBIT(1−tax rate)−(CapEx−Depreciation)
±ΔNWC

Where:

EBIT(1 – t) = After-tax operating profit

CapEx - Depreciation = Net investment in fixed assets

ΔNWC = Increase in non-cash working capital (subtracted) or decrease (added)

⚡ Why FCF, not net income?

Because FCF represents actual cash available to investors; accounting profit includes non-cash
items (e.g., depreciation).

3. Two-Stage Forecasting Approach

Similar to two-stage Dividend Discount Model (DDM).

Stage 1 (Explicit Forecast Period):

Detailed forecast of annual FCF for 3–5 years.

Discount each year’s FCF back to Year 0.

If FCF is constant → use Present Value of Annuity formula.

Stage 2 (Terminal Value / Horizon Value):

Assumes FCF grows at a constant rate forever (perpetuity).

Formula (adapted from Gordon Growth Model):

H=FCFt+1r−gH = \frac{FCF_{t+1}}{r - g}H=r−gFCFt+1

Where:

FCFt+1FCF_{t+1}FCFt+1 = Free cash flow expected for the year

immediately after horizon date

rrr = cost of equity (discount rate)

ggg = constant growth rate of FCF

 Discount Horizon Value back to Year 0.

Business Value = PV(Stage 1) + PV(Stage 2)

If acquiring company assumes liabilities → subtract liabilities (at market value) to get maximum
price to pay.

4. Discount Rate

Use cost of equity of target company (not WACC, unless specified).

CAPM can be used to estimate cost of equity:

r=Rf+β(Rm−Rf)r = R_f + \beta (R_m - R_f)r=Rf+β(Rm−Rf)

Exam Tip: Even if CAPM inputs are given, check if you are required to use CAPM.
Sometimes numbers are given as distractors.

5. Example (Assimilated Stores & Takeover Target)

Given: 5-year forecast of FCF, then growth slows.

Stage 1 PV = $24.27M (Years 1–5 discounted at 15%).

Stage 2 Horizon Value = $248M (calculated at Year 5, using Gordon Growth Model).

Discount Horizon Value to Year 0: $123.30M.

Gross Value = $24.27M + $123.30M = $147.57M.

If liabilities assumed = $20M → Net Value = $127.57M (max price to pay).

6. Key Takeaways

✅ DCF is future-looking → depends heavily on accuracy of cash flow estimates.

✅ Growth rate (g) must be < discount rate (r), otherwise valuation explodes (infinite).
✅ Liabilities matter → always adjust for assumed debt at market value.
✅ FCF is king → always prefer it over net income or EBIT directly.
✅ Stage 2 often drives most of the value (e.g., $123M out of $147M in example).
7. Extra Exam Insights (Concept Clarity 🚀)

Why use cost of equity, not WACC?

Because acquirer is valuing equity cash flows, not the whole firm unless specified. If
exam asks for firm valuation, WACC may be appropriate.

Difference from Dividend Discount Model (DDM):

DDM uses dividends → applicable only if company pays consistent dividends.

DCF uses FCF → works even if company reinvests profits.

When CAPM inputs are given: Double-check whether they’re relevant. If FCF approach
already specifies discount rate, CAPM may just be a trap.

Red Flag in CMA Exams: If you see EBIT, don’t forget to adjust for taxes, CapEx,
depreciation, and working capital!

📘 CMA Notes – Study Unit 37: International

Finance & FDI

🌍 International Finance – Scope

Covers:

Multinational corporations (MNCs)

Foreign direct investment (FDI)

How exchange rates are determined

Managing foreign exchange risk

Using foreign financing to reduce cost of capital

Paying for & financing foreign transactions

💸 Foreign Direct Investment (FDI)
🔹 Definition

FDI = active investment in real assets (land, buildings, plants, equipment) in another
country.

Made by an individual or company from a different country.

Involves direct management control of assets (unlike portfolio investments).

Ways:

Buying a company abroad

Expanding operations in a foreign country

Joint ventures

Establishing new foreign subsidiaries

Key Distinction:

FDI = ownership + management control (active).

Foreign Portfolio Investment (FPI) = investment in foreign securities (passive, no control).

🔹 Benefits of FDI

Cheaper / abundant resources (materials, labor).

Access to technology & managerial expertise.

Local job creation & career opportunities.

Dividends (profit repatriation) + proximity to customers.

Political stability (especially in developed countries).

Core motivation = increased profitability + maximized shareholder value.

Goal = higher revenue, lower costs, or both.

🔹 Risks of FDI

Country Risk

Combination of political + financial risk.

May force exit/divestment if risk worsens.

🔸 Political Risks:

Government expropriation (seizure of assets).

Blockage of fund transfers or inconvertible currency.

Heavy bureaucracy, strict regulations, high taxes.

Corruption (bribery, unfair competition).

War/conflict → safety & security costs.

Consumer nationalism (preference for local products).

Cultural differences → mismanagement if not handled well.

🔸 Financial Risks:

State of economy affects demand.

High interest rates → slow growth → reduced demand.

Low interest rates → stimulate growth → higher demand.

Exchange Rate Risk

MNCs operate in multiple currencies.

Fluctuations can:

Increase costs, or

Reduce revenues (profits shrink).

Exam Tip: FDI = high return potential BUT requires careful risk-return analysis.
🌐 Diversification & Risk Reduction
International diversification can actually reduce total risk.

Why? Because economies & returns across countries aren’t perfectly correlated.

✅ Example:

If sales fall in one country due to recession, sales may rise in another with a booming
economy.

Portfolio theory: adding projects with uncorrelated/negatively correlated returns reduces

variance & standard deviation of overall returns.

Result:

More stable cash flows.

Lower overall volatility.

Leads to lower cost of capital (less risk for investors).

🏢 Multinational Corporations (MNCs / MNEs)

🔹 Definition

Large companies with operations in more than one country.

Major part of both host & home country economies.

Generally → positive effect on global economy through:

Economies of scale

Efficient distribution

Greater product availability at lower prices

But → impacts on home vs. host countries differ.

🔹 Impact on Home Country

✅ Positive:

Higher MNC profits → higher tax revenue.

Exports improve balance of trade.

Attracts supporting businesses → ecosystem growth.

❌ Negative:

Job loss if production shifts abroad.

Domestic trade loss.

Reduced competition (dominant MNCs discourage new entrants).

🔹 Impact on Host Country

✅ Positive:

Local job creation.

Inflow of capital & technology.

Exports improve host country’s balance of trade.

Presence of one MNC attracts more FDI.

❌ Negative:

Profit repatriation: most cash flows go back to home country.

Dominance of MNC → suppresses local small businesses.

📝 Extra Concept Clarity (Exam Boost)

FDI vs FPI → FDI = control (active), FPI = no control (passive).

Country Risk = Political + Financial risk → ALWAYS mentioned in CMA case questions.
 Exchange Rate Risk is transactional, translational, or economic exposure (explained
later in your book).

International Diversification is similar to portfolio diversification → reduces variance of

returns.

MNC Impacts: Always analyze in terms of home country vs. host country (exam trick)

📘 CMA Part 2 – Study Unit 38: B.6. Foreign

Currency Exchange Rates

1. Basics of Currency Exchange

Why needed: For international trade, currencies must be convertible into one another.

Conversion: Happens at the prevailing exchange rate between two currencies.

Types of exchange rate systems:

Fixed exchange rate → determined by government.

Floating exchange rate → determined purely by market forces.

Managed float → combination of market forces + government intervention.

👉 Concept clarity:

Think of exchange rates like the price of money. If you’re buying euros with dollars, the
exchange rate is the price of one euro in terms of dollars.

Fluctuations occur constantly due to supply and demand (like stock prices).

2. Exchange Rate Definition

Exchange rate = Number of units of Currency B required to buy 1 unit of Currency A.

Major currency pairs (USD, EUR, JPY, etc.) are not constant; they change daily and even
minute-to-minute.
 Determined by supply & demand in currency markets.

3. Currency Quote Format

Quoted as: BASE / QUOTE

Base Currency = first currency, always valued at 1 unit.

Quote Currency = how many units are needed to buy 1 unit of base currency.

Convention (fixed order for quoting):

EUR – GBP – AUD – NZD – USD – ANY OTHER CURRENCY

👉 Example:

EUR/USD = 1.36 → means 1 EUR = 1.36 USD

AUD/NZD = 1.08 → means 1 AUD = 1.08 NZD

4. Example of Quotes on Exchange

Table Snapshot

Pair Last High/Low Change

EUR/USD 1.36189 1.36573 / 1.35961 -0.00077 ↓
USD/JPY 104.536 104.742 / 104.165 +0.33100 ↑

Interpretation:

EUR/USD = 1.36189

1 EUR = 1.36189 USD (direct quote in the U.S.).

Reverse rate: 1 ÷ 1.36189 = 0.73427 EUR per USD.

USD/JPY = 104.536

1 USD = 104.536 JPY (indirect quote in the U.S., because base is USD).

Reverse rate: 1 ÷ 104.536 = 0.00957 USD per JPY.

👉 Concept clarity:

Direct Quote: Foreign currency expressed in terms of domestic currency (e.g., 1 EUR = 1.36
USD in the U.S.).

Indirect Quote: Domestic currency expressed in terms of foreign currency (e.g., 1 JPY =
0.00957 USD in the U.S.).

5. Reverse Exchange Rate

To find reverse rate → take reciprocal (1 ÷ quoted rate).

Example: EUR/USD = 1.3668

Means 1 EUR = 1.3668 USD.

Reverse: 1 USD = 0.7316 EUR.

6. Foreign Currency Cross Rates

Cross Rate: Using a third currency (usually USD) to calculate exchange rate between two
currencies that are not frequently traded directly.

Steps to calculate Cross Rate:

Ensure third currency is the base (value = 1) in both quotes. If not, take reciprocal.

Divide exchange rate of one thinly traded currency (with third currency) by exchange rate of
the other (with same third currency).

Result = cross rate.

Example:

USD/AWG = 1.7898 (USD → Aruban florin)

USD/BZD = 1.99 (USD → Belize dollar)

Cross Rate (AWG/BZD) = 1.99 ÷ 1.7898 = 1.1119

→ 1 AWG = 1.1119 BZD
7. Cross Rate Table
Shows all exchange rates among selected currencies.

Includes both direct and reverse values.

Example (simplified):

1 AWG 1 USD 1 BZD

# AWG per 1 FCU -- 1.7898 1.1119
# USD per 1 FCU 0.5587 -- 0.5025
# BZD per 1 FCU 0.8994 1.9900 --

👉 Note: Always check which currency = 1 unit in table (labels matter).

👉 Reciprocal check: 1.7898 ↔ 0.5587

8. Exchange Rate Changes Over Time

Terms:

Appreciation = Currency A becomes stronger (buys more of Currency B).

Depreciation = Currency A becomes weaker (buys less of Currency B).

👉 Important: If Currency A appreciates vs. B, then Currency B must depreciate vs. A.

9. Effect of Appreciation & Depreciation

Case 1: U.S. Dollar Appreciates vs. GBP

Imports (U.S. buys from U.K.) → Cheaper → Increase.

Exports (U.K. buys from U.S.) → More expensive → Decrease.

Balance of trade → Negative effect.

Case 2: U.S. Dollar Depreciates vs. GBP

 Imports (U.S. buys from U.K.) → More expensive → Decrease.

Exports (U.K. buys from U.S.) → Cheaper for U.K. → Increase.

Balance of trade → Positive effect.

Summary Table

Currency Movement Imports Exports Balance of Trade

Appreciates ↑ ↓ Negative
Depreciates ↓ ↑ Positive

⚠️Exam Tip: Appreciation → ↑ Imports, ↓ Exports; Depreciation → ↓ Imports, ↑ Exports.

🔑 Extra Concept Clarity (Important for CMA)

Why exchange rates change:

Inflation differences, interest rates, political stability, speculation, central bank

intervention. (Covered in later sections, but keep in mind).

Impact on companies:

Exporters prefer weak domestic currency (makes their goods cheaper abroad).

Importers prefer strong domestic currency (makes foreign goods cheaper).

Real-world example:

If USD strengthens vs. INR, Indians importing from the U.S. will pay more rupees
per dollar, so imports cost more. But U.S. consumers buying Indian goods pay
fewer dollars, so Indian exports rise.

📘 CMA Part 2 – Study Unit 38: B.6. Foreign

Currency Exchange Rates (continued)

1. Measuring Appreciation / Depreciation of a Currency

Formula for Appreciation/Depreciation Rate of Currency A vs Currency B
Rate=Units of B per 1 A (later date)−Units of B per 1 A (earlier date)Units of B per 1 A (earlier
date)\text{Rate} = \frac{ \text{Units of B per 1 A (later date)} - \text{Units of B per 1 A (earlier
date)} }{ \text{Units of B per 1 A (earlier
date)} }Rate=Units of B per 1 A (earlier date)Units of B per 1 A (later date)
−Units of B per 1 A (earlier date)

Step Process:

Express exchange rates so that Currency A = 1 unit.

If exchange is quoted as “1 B = … A”, take reciprocal (1 ÷ rate).

Compare how many units of B can be bought with 1 A at both dates.

If A buys more B later → A appreciated.

If A buys less B later → A depreciated.

👉 Key Rule: If one appreciates, the other must depreciate by (almost) the same % (signs
opposite).

Example: EUR vs USD

Quotes:

January: EUR/USD = 0.606 → 1 EUR = 0.606 USD

February: EUR/USD = 0.667 → 1 EUR = 0.667 USD

Evaluating Euro (A = EUR, B = USD):

Jan: 1 EUR = 0.606 USD

Feb: 1 EUR = 0.667 USD

Result: Euro appreciated because 1 EUR buys more USD.

% Appreciation = 0.667−0.6060.606=10.07\frac{0.667 - 0.606}{0.606} =

10.07%0.6060.667−0.606=10.07

Evaluating USD (A = USD, B = EUR):

Convert quotes so 1 USD = ? EUR.

Jan: 1 ÷ 0.606 = 1.65 EUR

 Feb: 1 ÷ 0.667 = 1.50 EUR

Result: USD depreciated because 1 USD buys fewer EUR.

% Depreciation = 1.50−1.651.65=−9.09\frac{1.50 - 1.65}{1.65} = -

9.09%1.651.50−1.65=−9.09

👉 Positive % = Appreciation, Negative % = Depreciation.

2. Spot vs Forward Market

Spot Rate = current exchange rate for immediate delivery.

Forward Rate = rate for future delivery (via forward contracts).

Forward Contracts:

Traded over-the-counter (OTC) (not on exchanges).

Banks usually act as counterparties.

3. Interest Rate Parity (IRP) Theorem

Explains the relationship between spot rate and forward rate.

Key Idea: The difference is caused by interest rate differentials between two countries.

👉 Rules:

If foreign interest rate > domestic rate → forward foreign currency sells at a discount.

If foreign interest rate < domestic rate → forward foreign currency sells at a premium.

Why?

If no premium/discount existed, investors could arbitrage: borrow in low-interest

country, invest in high-interest country, lock in exchange via forward contract →
risk-free profit.

Market adjusts forward rates so arbitrage = 0.

Example of IRP Arbitrage

Country A interest = 5%

Country B interest = 7%

Investor borrows 10,000 in A, converts to B, invests.

Simultaneously sells forward the future B-currency proceeds at spot rate.

At maturity → earns 200 extra units.

⚠️But IRP ensures forward discount/premium cancels out, so gain = same as domestic interest
rate.

4. Forward Discount vs Premium

Forward Discount: Forward rate < Spot rate

Forward Premium: Forward rate > Spot rate

👉 Quick check:

Spot > Forward → Discount

Spot < Forward → Premium

Example: USD/INR

Spot: 1 USD = 60.000 INR

Forward (60 days): 1 USD = 60.199 INR

U.S. interest = 4%, India interest = 6%

Convert to “1 INR in USD”:

Spot: 1 ÷ 60.000 = 0.0167 USD

 Forward: 1 ÷ 60.199 = 0.0166 USD

Result: Forward < Spot → INR at forward discount.

5. Calculating % Forward Discount/Premium

Formula (annualized):

Forward Premium/Discount (%)=Forward rate – Spot rateSpot rate×No. of forward periods in 1

year\text{Forward Premium/Discount (\%)} = \frac{\text{Forward rate – Spot rate}}{\text{Spot
rate}} \times \text{No. of forward periods in 1
year}Forward Premium/Discount (%)=Spot rateForward rate – Spot rate×No. of forward periods
in 1 year

Steps:

Express both spot & forward so Currency A = 1 unit.

If Forward > Spot → Premium.

If Forward < Spot → Discount.

Example: INR vs USD

Spot = 0.0167 USD/INR

Forward = 0.0166 USD/INR

% Discount (for 60 days):

0.0166−0.01670.0167=−0.006=−0.6\frac{0.0166 - 0.0167}{0.0167} = -0.006 = -
0.6%0.01670.0166−0.0167=−0.006=−0.6

Annualized (6 × 60-day periods):

-0.006 × 6 = -3.6% annualized discount

👉 Negative = Discount, Positive = Premium.

6. How Banks Make Money in FX

 Banks quote two prices:

Bid Price = what bank pays to buy a currency.

Ask Price = what bank charges to sell a currency.

Bid-Ask Spread = Bank’s profit.

Example: EUR/USD 1.3600 (bid) / 1.3610 (ask) → spread = 0.0010 = 10 “pips”.

⚠️In study examples, single price (midpoint) is often used to simplify.

7. Ways Exchange Rates Are Determined

Floating Rate – supply & demand only.

Fixed Rate – set by government.

Managed Float – market sets rate, but government occasionally intervenes.

Pegged Rate – one country ties its currency to another (e.g., many Gulf countries peg to
USD).

🔑 Extra Concept Clarity

Forward discount/premium ≠ gain/loss.

It’s just an adjustment due to interest rate parity.

In theory, forward rate = spot rate × (1 + domestic rate) / (1 + foreign rate).

Why important for CMA:

Multinationals hedge future receivables/payables using forwards.

Understanding discount/premium = key for decision making.

Real-world example:

If Indian rupee trades at forward discount, it means market expects rupee

depreciation in future.
Floating Exchange Rates (Free Floating)
Definition:
A floating exchange rate is a rate determined by market forces—supply and demand for
currencies. Example: the U.S. dollar operates under a free floating system.

Mechanism of Floating Exchange Rates

Demand for Domestic Currency:

Foreigners need domestic currency (e.g., USD) to buy goods, services, or invest in the
country.

If demand for U.S. goods/services/investments increases → demand for USD rises →

USD appreciates.

Example:

1 USD = 0.75 EUR initially

Higher demand → 1 USD = 0.85 EUR

USD appreciates, can buy more euros.

Supply of Domestic Currency:

Residents need foreign currency to buy foreign goods/services or invest abroad.

More supply of USD in foreign exchange → USD depreciates.

Example:

1 USD = 0.75 EUR initially

Higher supply → 1 USD = 0.65 EUR

USD depreciates, can buy fewer euros.

Equilibrium:

Exchange rate balances demand from foreigners and supply from domestic residents.

Extreme short-term fluctuations may occur, but long-term market forces push it toward
equilibrium.
Key Points on Floating Exchange Rates

Effect of Appreciation of USD: Imported goods cheaper, exports more expensive.

Effect of Depreciation of USD: Imported goods costlier, exports cheaper.

Demand for USD: Reflects foreign demand for U.S. products/investments.

Supply of USD: Reflects U.S. demand for foreign products/investments.

Factors Affecting Supply, Demand, and Exchange Rates

Relative Inflation Rates:

Higher inflation → currency depreciates

Lower inflation → currency appreciates

Relative Interest Rates:

Higher interest → currency appreciates (attracts foreign capital)

Lower interest → currency depreciates

Relative Income Levels:

Higher income → more imports → more domestic currency supplied → depreciation

Lower income → less imports → currency may appreciate

Expectations of Future Exchange Rates:

Expect appreciation → buy currency → causes actual appreciation

Expect depreciation → sell currency → causes actual depreciation

Government Controls:

Central banks may intervene directly by buying/selling currency.

To depreciate: sell domestic currency, buy foreign

 To appreciate: buy domestic currency, sell foreign

Can also influence rates indirectly through interest rates or policy measures.

Example: Inflation Effect on Exchange Rate

Beginning: 1 Currency A = 10 Currency B

Inflation: A = 8%, B = 4%

Year-end exchange rate:

Year-end rate=1+Inflation B1+Inflation A×Initial rate=1.041.08×10=9.63\text{Year-end rate}

= \frac{1 + \text{Inflation B}}{1 + \text{Inflation A}} \times \text{Initial rate} = \frac{1.04}
{1.08} \times 10 = 9.63Year-end rate=1+Inflation A1+Inflation B×Initial rate=1.081.04
×10=9.63

Interpretation: Currency A depreciated (can buy fewer units of B); Currency B appreciated.

Purchasing Power Parity (PPP) Theorem

Definition:

Relative price of a good should be the same in all countries when expressed in a common
currency.

Exchange rates adjust to equalize prices of identical goods internationally.

PPP Formula:

Exchange Rate=Foreign Price LevelDomestic Price Level\text{Exchange Rate} = \frac{\

text{Foreign Price Level}}{\text{Domestic Price
Level}}Exchange Rate=Domestic Price LevelForeign Price Level

Example:

Tablet: Canada = 799 CAD, USA = 599 USD

PPP exchange rate=799/599≈1.334\text{PPP exchange rate} = 799 / 599 \approx

1.334PPP exchange rate=799/599≈1.334
 If actual rate = 1.3206 → close enough to PPP. Arbitrage possible but small and often limited
by transaction costs.

Limitations of PPP:

Ignores transaction costs, tariffs, taxes, transport costs.

Assumes free movement of goods and perfect competition, which is unrealistic.

Summary: Floating Exchange Rate Key Insights

Determined by market supply & demand.

Appreciation/depreciation depends on inflation, interest rates, income levels, expectations,

and government actions.

PPP explains long-term exchange rate adjustments based on relative price levels.

Short-term fluctuations can be extreme; long-term equilibrium is driven by market

fundamentals.

2) Fixed Exchange Rates

Definition:
A fixed exchange rate is set and maintained by the government, either constant or allowed to
fluctuate within a narrow range. If the rate moves outside the range, government intervention
stabilizes it.

Mechanism of Fixed Exchange Rates

Government buys/sells its own currency to control supply and demand.

Government maintains rate close to free-floating equilibrium rate.

If demand for domestic currency rises → sell domestic currency, buy foreign currencies.

If supply of domestic currency rises → buy domestic currency, sell foreign currencies.

Requirements for Government:

Large holdings of foreign currency reserves to buy its own currency when needed.
 Large holdings of own currency to sell when domestic currency is too high.

Effects of Misalignment

Overvalued Currency (Fixed Rate > Free Market Rate)

Exports expensive → lower demand from foreign buyers.

Imports cheap → higher domestic demand.

Result: Trade deficit; need to use foreign reserves to buy own currency.

Risk: Reserve depletion → may require devaluation.

Undervalued Currency (Fixed Rate < Free Market Rate)

Exports cheap → high foreign demand.

Imports expensive → low domestic demand.

Result: Trade surplus; accumulation of foreign reserves.

Risk: Excessive reserves → may allow currency to revalue.

Extreme Fixed Rate: Common Currency

Example: Euro adoption by EU countries.

Most extreme fixed system → no internal exchange rates; 1 euro = 1 euro.

Ensures constant comparability of prices across countries.

3) Managed Float Exchange Rates

Definition:
A managed float system blends floating and fixed systems:

Exchange rates are market-determined but

 Government intervenes to prevent excessive fluctuations.

Example:

Strong export demand → currency appreciates → foreign buyers reduce purchases →

currency depreciates.

Government intervenes to stabilize currency → manages range → managed float.

4) Pegged Exchange Rate System

Definition:

Country pegs its currency to a foreign currency or basket of currencies.

Common in smaller countries to stabilize trade or debt payments.

Mechanism:

Central bank sets target rate.

Actual rate fluctuates within a set range around target.

Government intervenes as needed to maintain peg.

Risks:

If pegged rate differs too much from free market equilibrium → difficult to maintain → may
fail.

Managing Exchange Rate Risk

Problem:

International transactions involve currency exchange, introducing risk due to fluctuating

exchange rates.

Between contract and payment, rates may change → potential gains or losses.

Methods to Manage Risk:

 Natural Hedges: Match revenue and costs in the same currency.

Operational Hedges: Diversify operations across countries to reduce exposure.

International Financing Hedges: Borrow in foreign currency to offset exposures.

Currency Market Hedges (Derivatives):

Forward Contracts → lock in exchange rate for future transactions.

Futures Contracts → standardized forward contracts traded on exchanges.

Currency Options → right, not obligation, to buy/sell at set rate.

Currency Swaps → exchange currency cash flows between two parties.

Key Takeaways:

Fixed, managed float, and pegged systems differ in degree of government control.

Fixed → government sets exact rate; may face deficits/surpluses.

Managed float → market-driven but government stabilizes.

Pegged → tied to another currency; stability depends on reserves and alignment with market
rate.

Exchange rate risk exists in all systems → hedging strategies are crucial.

Managing Foreign Exchange Risk

1) Natural Hedges

Occur when a company’s revenues and expenses are in the same currency, reducing
exposure to exchange rate fluctuations.

Key Point: Strategic decisions—market choice, pricing, operations, sourcing—can

significantly affect natural hedge effectiveness.

Any remaining exposure can be hedged via operational, financing, or currency-market

instruments.
2) Operational Hedges

Goal: Balance monetary assets and liabilities in a foreign currency to neutralize exchange rate
effects.

Techniques:

Matching Payables & Receivables

Foreign currency receivables gains offset payables losses and vice versa.

Diversification

Invest in multiple currencies/economies → reduces risk that all currencies depreciate

simultaneously.

Minimizing Foreign Transactions

Limiting foreign-denominated transactions reduces exposure.

3) International Financing Hedges

Borrow in foreign currency to offset net receivables in the same currency.

Foreign subsidiaries can borrow locally to hedge exposure in their currency.

4) Currency Market Hedges (Derivatives)

Purpose: Lock in future exchange rates for anticipated cash flows.

Uses:

Hedge foreign payables/receivables.

Speculate on future currency movements.

Protect investments in foreign securities.

A) Currency Forward Contracts

Agreement to buy/sell a currency at a future date at a pre-agreed rate.

 Buy forward: Covers future payables → know domestic currency needed.

Sell forward: Covers future receivables → know domestic currency to receive.

Note: Forward rate ≠ future spot rate, but often used as a forecast.

B) Currency Futures

Similar to forwards but standardized and exchange-traded.

Usually closed before expiration, generating gains/losses that offset spot rate changes.

Example: U.S. company invoicing Germany in euros → futures contract fixes USD/euro rate
30 days ahead.

C) Currency Swaps

Long-term agreements to exchange principal and/or interest payments in different

currencies.

Example: U.S. company with euro bonds swaps with a European company with USD bonds
→ eliminates exchange rate risk.

Benefits:

Hedge long-term currency fluctuation risk.

Potentially lower borrowing costs in favorable foreign markets.

Facilitates international expansion.

Risks:

Counterparty default → financial loss.

Floating interest rate exposure may not be fully hedged if swap fixes rate.

D) Currency Options

Right, not obligation, to buy/sell a currency before a set date.

 Call Option: Buy foreign currency at set price → hedge payables.

Put Option: Sell foreign currency at set price → hedge receivables.

Buyer pays a premium for this “insurance.”

5) Net Profit/Loss on Cross-Border Transactions

Components:

Profit/loss on the sale/purchase at transaction date (based on spot rate).

Gain/loss from spot rate changes during holding period.

Gain/loss from any hedge instrument used during holding period.

✅ Key Takeaways:

Natural hedges rely on strategic operations.

Operational hedges balance currency positions or diversify exposure.

Financing hedges use borrowings to offset currency risk.

Currency market derivatives (forwards, futures, swaps, options) provide precise risk
management.

Effective hedging ensures predictable cash flows and protects profits in international
transactions.

Foreign Financing and International Payments

1) Use of Foreign Financing to Reduce Costs

Companies may borrow in a foreign currency if interest rates are lower than domestic
rates.

Eurocurrency market: Offers several international financing options.

Example:
 A U.S. MNC can borrow in yen at a lower rate than borrowing USD domestically.

Borrow foreign currency → convert immediately to USD for use → repay loan in
foreign currency later.

2) Effective Interest Rate on a Foreign Currency Loan

Factors affecting cost:

Interest rate on the foreign loan (If).

Change in foreign currency value over loan term (Ef).

Formulas:

Effective financing rate:

Rf=(1+If)×(1+Ef)−1Rf = (1 + If) \times (1 + Ef) - 1Rf=(1+If)×(1+Ef)−1

Where:

Rf = effective financing rate

If = foreign loan interest rate

Ef = % change in foreign currency vs domestic currency

Percentage change in currency:

Ef=St+1−SSEf = \frac{S_{t+1} - S}{S}Ef=SSt+1−S

Where:

St+1S_{t+1}St+1 = spot rate at end of period (foreign currency as 1 unit)

SSS = spot rate at start of period

Key Tip: Always quote the foreign currency as 1 unit when calculating
appreciation/depreciation.
Example: Borrowing in Japanese Yen

U.S. MNC borrows ¥242,700,000 at 1% for 1 year → converts to $2,000,000 USD.

Spot rate at loan: 1 USD = 121.35 JPY → 1 JPY = 0.008241 USD

Spot rate at maturity: 1 USD = 117.71 JPY → 1 JPY = 0.008495 USD

Yen appreciation:

Ef=0.008495−0.0082410.008241=3.08%Ef = \frac{0.008495 - 0.008241}{0.008241} =

3.08\%Ef=0.0082410.008495−0.008241=3.08%

Effective interest rate in USD:

Rf=(1+0.01)×(1+0.0308)−1=4.11%≈4.12%Rf = (1 + 0.01) \times (1 + 0.0308) - 1 = 4.11\% \approx

4.12\%Rf=(1+0.01)×(1+0.0308)−1=4.11%≈4.12%

Borrowing abroad can reduce effective interest costs compared to domestic borrowing.

3) International Payments

Payments for international transactions are more complex than domestic transactions.

Buyer risk: Non-delivery or poor-quality goods.

Seller risk: Non-payment by buyer.

Common Methods:

Prepayment

Buyer pays upfront → eliminates seller risk, buyer bears non-delivery risk.

Common for first-time buyers.

Open Account

Payment due on a future date.

Seller bears payment risk → requires trusted, creditworthy buyer.

Sight Draft
 Seller retains title until buyer pays.

Payment triggers transfer of ownership.

Countertrade / Barter

Goods or services exchanged directly without currency.

Useful if currency conversion is difficult or exchange rates unfavorable.

Barter = specific type of countertrade. Rare today due to difficulty in matching

values.

Commercial Letter of Credit (LC)

Buyer’s bank guarantees payment if seller provides required documents (e.g., bill
of lading).

Reduces risk for both buyer and seller.

Bank reimbursed by buyer upon payment.

4) Cross-Border Factoring

Exporter sells trade receivable to a factor (third party).

Eliminates non-payment risk if sold without recourse.

5) Banker’s Acceptances (BA)

Time draft used for financing import/export transactions.

Exporter draws draft on importer’s bank under letter of credit.

Steps:

Exporter ships goods → sends shipping docs + draft to its bank.

Exporter’s bank sends documents to importer’s bank.

Importer’s bank accepts the draft → becomes BA.

 BA payable at a future date (e.g., 90 days).

Exporter can sell BA at discount for immediate cash → BA is marketable security.

Importer repays full face value + fees on maturity.

6) Forfaiting

Similar to factoring but used for large, medium-to-long-term transactions (> $500,000).

Forfaiter assumes responsibility for collecting payment from importer.

Usually requires:

Bank guarantee or letter of credit from importer’s bank.

Allows exporter to transfer medium-term credit risk to the bank.

✅ Key Takeaways:

Foreign financing can reduce borrowing costs if foreign interest rates are favorable.

Always account for currency appreciation/depreciation to calculate effective interest rate.

International payments methods vary by risk:

Prepayment → buyer risk

Open account → seller risk

Letter of Credit → mitigates risk for both

Drafts, factoring, forfaiting → improve liquidity & risk management

Appendix A – Amortization of Bond Discount by Issuer

Scenario:

Boulder Corporation issues $1,000,000 par value bonds on Jan 2, 20X0, maturing Jan 1,
20X5.
 Coupon rate: 4% (semi-annual payments).

Market rate: 6% (higher than coupon → bond issued at discount).

Issue price: $914,600 (discount to par).

Key Points:

Discount Amortization:

Bonds sold below par to yield the market rate (6%).

Discount amortization is recorded as part of interest expense.

Semi-annual interest expense = Cash paid + Discount amortization.

Calculations for Semi-Annual Interest Expense:

Interest Expense: Previous Carrying Value × Market Rate ÷ 2

Cash Interest Paid: Face Value × Coupon Rate ÷ 2

Discount Amortization: Interest Expense – Cash Paid

New Carrying Value: Previous Carrying Value + Discount Amortization

Amortization Schedule (Semi-Annual)

Date Interest Expense Cash Paid Discount Amortization Carrying Value

Jan 2, 20X0 – – – 914,600
Jul 1, 20X0 27,438 20,000 7,438 922,038
Jan 1, 20X1 27,661 20,000 7,661 929,699
Jul 1, 20X1 27,891 20,000 7,891 937,590
Jan 1, 20X2 28,128 20,000 8,128 945,718
Jul 1, 20X2 28,372 20,000 8,372 954,090
Jan 1, 20X3 28,623 20,000 8,623 962,713
Jul 1, 20X3 28,881 20,000 8,881 971,594
Jan 1, 20X4 29,148 20,000 9,148 980,742
Jul 1, 20X4 29,422 20,000 9,422 990,164
Jan 1, 20X5 29,836* 20,000 9,836* 1,000,000

Total Interest Expense: $285,400

Total Cash Paid: $200,000

 Total Discount Amortized: $85,400

*Adjusted for rounding differences.

Key Concept:

Amortization increases carrying value until it equals par at maturity.

Interest expense = cash paid + amortized discount → reflects effective market yield.

Appendix B – Net Benefit/Cost of Change in Credit Policy

Scenario:

PMT Inc. considers relaxing credit terms: average days receivable increases 35 → 60 days.

Effects:

Net credit sales increase by 15%

Credit losses increase from 2% → 3%

Collection costs increase $50,000 → $75,000

Gross Profit Margin: 30%, Tax Rate: 21%, Cost of Capital: 5%

Step 1: Current Policy Calculations

Net Credit Sales: $20,075,000/year

Average Daily Sales: $20,075,000 ÷ 365 ≈ $55,000

Cost of Goods Sold (COGS): $20,075,000 × 0.70 = $14,052,500

Gross Profit: $20,075,000 × 0.30 = $6,022,500

Average Receivables: 35 days × $55,000 ≈ $1,925,000

COGS in Receivables: $1,925,000 × 0.70 = $1,347,500

Financing Cost: $1,347,500 × 0.05 = $67,375

 Credit Losses: $20,075,000 × 0.02 = $401,500

Collection Costs: $50,000

Step 2: Proposed Policy Calculations

Net Credit Sales: $20,075,000 × 1.15 = $23,086,250

Average Daily Sales: $23,086,250 ÷ 365 ≈ $63,250

COGS: $23,086,250 × 0.70 = $16,160,375

Gross Profit: $23,086,250 × 0.30 = $6,925,875

Average Receivables: 60 days × $63,250 = $3,795,000

COGS in Receivables: $3,795,000 × 0.70 = $2,656,500

Financing Cost: $2,656,500 × 0.05 = $132,825

Credit Losses: $23,086,250 × 0.03 = $692,588

Collection Costs: $75,000

Step 3: Net Benefit or Cost

Description Current ($) Proposed ($)

Sales 20,075,000 23,086,250
COGS (70% of Sales) 14,052,500 16,160,375
Gross Profit 6,022,500 6,925,875
Credit Losses 401,500 692,588
Collection Costs 50,000 75,000
Financing Costs 67,375 132,825
Operating Income 5,503,625 6,025,462
Income Tax (21%) 1,155,761 1,265,347
Net Income After Tax 4,347,864 4,760,115

Net Benefit of Proposed Policy:

4,760,115−4,347,864=412,2514,760,115 - 4,347,864 = 412,2514,760,115−4,347,864=412,251

✅ Conclusion:

Relaxing credit policy increases net income after tax by $412,251.

Benefits arise from higher sales despite increased credit losses, collection costs, and
financing costs.