2B. Corporate Finance: Part 2 Unit 2

PART 2
PART 2 UNIT 2
2
2B. Corporate Finance
Module
1 B.1. Risk and Return 3
2 B.2. Long-Term Financial Management: Part 1 17
3 B.2. Long-Term Financial Management: Part 2 33
4 B.3. Raising Capital 55
5 B.4. Working Capital Management: Part 1 73
6 B.4. Working Capital Management: Part 2 91
7 B.5. Corporate Restructuring 103
8 B.6. International Finance 123

NOTES
2–2 © Becker Professional Education Corporation. All rights reserved.

1
MODULE
B.1. Risk and Return

Part 2
Unit 2
This module covers the following content from the IMA Learning Outcome Statements.
CMA LOS Reference: Part 2—Section B.1. Risk and Return
The candidate should be able to:

a. calculate rates of return
b. identify and demonstrate an understanding of systematic (market) risk and
unsystematic (company) risk
c. identify and demonstrate an understanding of credit risk, foreign exchange risk,
interest rate risk, market risk, industry risk, and political risk
d. demonstrate an understanding of the relationship between risk and return
e. distinguish between individual security risk and portfolio risk
f. demonstrate an understanding of diversification
g. define beta and explain how a change in beta impacts a security's price
h. demonstrate an understanding of the capital asset pricing model (CAPM) and calculate
the expected risk-adjusted returns using CAPM
1 Rates of Return LOS 2B1a
The rate of return refers to the measure of the cash flows from an investment compared with
the amount of the investment. The return on an investment (both the expected return and
actual return) is crucial to the investment decision.
1.1 Annual Return

Definition: Annual returns include two components: capital return and income return.
Capital return is the change in value of the underlying investment from one period to the
next period.
Computation: Returns are generally calculated over a 12-month (annual) period. The
formula for calculating annual return is:
Ending value – Beginning value + Income

Annual return =
Beginning value
© Becker Professional Education Corporation. All rights reserved. Module 1 2–3

1 B.1. Risk and Return PART 2 UNIT 2
Ending value – Beginning value

Capital return =
Beginning value
Income return includes dividends, interest, or royalties earned on that underlying investment
during the period.
Income
Income return =
Beginning value
The total return is capital return plus income return over either the life of an investment or a
specified period. The total return for a single year is equal to the annual return described above.
Ending value – Beginning value + Income

Total return = Capital return + Income return =
Beginning value
Example 1 Calculating Return
Facts: On January 1, Year 1, an investor paid €1,000 for 500 shares of stock worth €1,700
on December 31, Year 1. During the year, dividends were paid at €0.50 per share.
Required: Calculate the capital return, income return, and total annual return.
Solution:
€1,700 ending value – €1,000 beginning value
Capital return = = 0.70 = 70%
€1,000 beginning value
500 shares × €0.50 dividend per share

Income return = = 0.25 = 25%
Beginning value
The total return is:
Ending value – Beginning value + Dividend income
Total return =
Beginning value
€1,700 – €1,000 + €250

Total return = = 0.95 = 95%
€1,000
Total return = 70% capital return + 25% income return = 95%
2–4 Module 1 © Becker Professional Education Corporation. AllB.1. Risk

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PART 2 UNIT
1 2 B.1. Risk and Return
1.2 Holding Period Return

Definition: The holding period return is the return earned over either a specified increment
of time or a period of time.
Computation: The annualized rate of return is calculated by multiplying the holding period
return by the number of holding periods in a year.
Example 2 Annualizing Rates of Return
Facts: An investor paid €1,000 for 500 shares of a stock on January 1, Year 1, and sold them
for €1,200 on June 30, Year 1. During the first six months of the year the investor received
€125 in dividends.
Required: Calculate the annualized return.
Solution:
€1,200 €1,000 €125
selling – purchase + dividend
Six-month holding price price income
= = 0.325 = 32.5%
period return €1,000 purchase price
The annualized return = 32.5% six-month holding period return × 2 six-month holding
periods in a year = 65%.
Note that the annual holding period return may be the same as the total return if the
evaluation period is one year.
1.3 Geometric Return

Definition: Compounding occurs in investing when an asset's earnings generate additional
earnings. Each year, the change in the asset's value along with any income earned will
establish a new base on which the next year's return is computed.
An arithmetic average is simply the summation of all percentage returns divided by the
number of returns. This overstates the true return because it does not account for year-
over-year compounding. For shorter periods of time and lower investment amounts, the
arithmetic average can serve as a reasonable proxy for the true return. For longer periods of
time and higher investment amounts, the geometric average is most appropriate because it
more accurately accounts for the effects of compounding.
Computation: The formula for calculating the geometric average is as follows:
Geometric: average = n (1 r1 )(1 r2 ) ... (1 rn ) 1
Or:
[(1 + r1)(1 + r2) … (1 + rn)]1/n − 1

Example 3 Arithmetic and Geometric Average Returns
Facts: An investor invests $10,000 and earns the following capital returns each year over
four years:
Year 1: 10 percent
Year 2: (25 percent)
Year 3: 21 percent
Year 4: 6 percent
Required: Calculate the arithmetic return and the geometric return. Determine the value
for the investment at the end of four years.
Solution:
The arithmetic return is calculated as follows:
Arithmetic return − (0.10 − 0.25 + 0.21 + 0.06) / 4 = 0.03 or 3%
The incorrect value of the investment, if the arithmetic return is used, is $11,255.08:
Incorrect value at end of Year 4 = $10,000 beginning value × (1.03)4 = $11,255.08
The geometric return is calculated as follows:

Geometric 4
(1.10) (0.75) (1.21) (1.06) 1 0.0142296 1.42296%
average
The correct value of the investment, if the geometric return is used, is $10,581.45:
Value at end of Year 4 = $10,000 beginning value × (1.0142296)4 = $10,581.45
To determine the value in the investment account manually, the value is adjusted each year
based on that year's return:
$10,000 value at beginning of first year × 1.10 = $11,000 value at end of first year
$11,000 value at end of first year × 0.75 = $8,250 value at end of second year
$8,250 value at end of second year × 1.21 = $9,982.50 value at end of third year
$9,982.50 value at end of third year × 1.06 = $10,581.45 value at end of fourth year
1.4 Stated Interest Rate

Definition: The stated interest rate (sometimes referred to as nominal interest rate)
represents the rate of interest charged before any adjustment for compounding or
market factors.
Computation: The stated interest rate is the rate shown in the agreement of indebtedness
(e.g., a bond indenture or promissory note).

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PART 2 UNIT
Example 4 Stated Interest Rate
Facts: A $10,000 promissory note states that payments will be made quarterly at a
10 percent interest rate per annum.
Required: Calculate the stated interest rate. Hint: You do not need a calculator.
Solution: Stated rate = 10 percent
1.5 Effective Interest Rate

Definition: The effective interest rate represents the actual finance charge associated with a
borrowing after reducing loan proceeds for charges and fees related to a loan origination.
Computation: The effective interest rate is computed by dividing the amount of interest
paid based on the loan agreement by the net proceeds received.
Example 5 Effective Interest Rate
Facts: A $10,000 promissory note has a stated rate of 10 percent per annum and is due
in one year. The bank charges a loan origination fee of $75 and the state in which the
loan is made levies a $50 documentary stamp charge. Taxes and fees are taken from
loan proceeds.
Required: Compute the effective interest rate.
Solution:
Interest paid (10,000 × 10%) $ 1,000
Divided by net proceeds (10,000 – 75 – 50) ÷ 9,875
Effective interest rate 10.13%
1.6 Annual Percentage Rate

Definition: The annual percentage rate represents a noncompounded version of the
effective annual percentage rate described and computed below. The annual percentage
rate is the rate required for disclosure by federal regulations.
Computation: The annual percentage rate is computed as the effective periodic interest
rate times the number of periods in a year. Annual percentage rate emphasizes the amount
paid relative to funds available.

Example 6 Annual Percentage Rate
Facts: A $10,000 promissory note displays a stated rate of 8 percent with interest to be
paid semiannually. The bank charges a $75 loan origination fee and a documentary tax of
$50 is assessed by the state.
Required: Calculate the annual percentage rate.
Solution:
Step 1: Compute the effective periodic interest rate (as per above)
Interest paid (10,000 × 8% × 6/12) $ 400
Divided by available funds (10,000 – 75 – 50) ÷ 9,875
Effective periodic interest rate 4.05%
Step 2: Multiply the effective periodic interest rate by the number of periods in a year
Effective periodic interest rate 4.05%
Periods in a year × 2
Annual percentage rate 8.10%
1.7 Effective Annual Percentage Rate

 Definition: The effective annual percentage rate is the stated interest rate adjusted for
the number of compounding periods per year. The effective annual percentage rate is
abbreviated EAR.
 Computation: The EAR is computed as follows:
Effective annual interest rate = [1 + (i / p)] p – 1

i = Stated interest rate
p = Compounding periods per year
Example 7 Effective Annual Percentage Rate
Facts: A note has an 8 percent stated rate of interest compounded semiannually (two times
per year).
Required: Compute the effective annual percentage rate or EAR.
Solution:
Effective annual interest rate = [1 + (i / p)] p – 1
Effective annual interest rate = [1 + (0.08 / 2)]2 – 1
Effective annual interest rate = [1 + (0.04)]2 – 1
Effective annual interest rate = 1.0816 – 1
Effective annual interest rate = 8.16%

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PART 2 UNIT
2 Investment Risk LOS 2B1b
LOS 2B1c
All investments carry some level of risk. Even even guaranteed government notes are at risk for
currency devaluation. Risk comes from many sources, including both macroeconomic factors
affecting the overall market (increases in interest rates, unemployment rate) and microeconomic
factors (raw materials shortages, price wars).
2.1 Market/Systematic/Nondiversifiable Risk

The exposure of a security or firm to fluctuations in value as a result of operating within an
economy is referred to as market risk. Market risk is sometimes referred to as systematic risk
because it is a risk inherent in operating within the economy. Systematic risk is attributable to
factors such as war, inflation, international incidents, and political events.
Market/systematic risk is also referred to as nondiversifiable risk because it cannot be diversified
away and remains even in a fully diversified portfolio. Compensation for this risk is factored into
models used to forecast expected return.
Illustration 1 Market Risk
The prices on publicly traded stocks generally increase and decrease together with overall
market activity. Although the prices may not increase or decrease identically, they often
move in the same direction. A technology company's stock, for example, might increase in
value on a given day from $37.00 per share to $37.75 per share. This increase in the stock
price is consistent with the overall 2 percent increase in the NASDAQ on that trading day.
2.2 Unsystematic/Firm-Specific/Diversifiable Risk

Diversifiable risk (which is also referred to as nonmarket, unsystematic, or firm-specific risk)
represents the portion of a firm's or industry's risk that is associated with random causes and
can be eliminated through diversification. Diversifiable risk is attributable to firm-specific or
industry-specific events (e.g., strikes, lawsuits, regulatory actions, or the loss of a key account).
Pass Key
It is important to be able to classify risk into two broad categories:

Diversifiable risk =
Unsystematic risk (nonmarket/firm-specific)
and
Nondiversifiable risk =
Systematic risk (market)
Remember the mnemonic DUNS to keep these risk types and their alternative names clear.

2.3 Credit Risk

Investors who purchase bonds are exposed to credit risk (default risk), which is the risk that the
investor (lender) will not receive interest and/or principal due because the borrower is unable
to make the payments. A direct relationship exists between credit risk and interest rates. The
higher the credit risk, the higher the interest rate required by the lender to compensate the
lender for the risk associated with lending money.
2.4 Foreign Exchange Risk

Investors seeking to diversify by investing either in securities issued by companies in other
countries or in another currency confront foreign exchange risk (currency risk). The value of
the currency in which an investment is denominated could decrease, which would decrease
the purchasing power in the home currency. Exposures due to foreign exchange risks include
transaction, economic, and translation exposures.
2.4.1 Transaction Exposure

Foreign exchange risk is defined, in part, by transaction exposure. Transaction exposure is
defined as the potential that an organization could suffer economic loss or experience economic
gain upon settlement of individual transactions as a result of changes in the exchange rates.
Measurement of transaction exposure is generally done in two steps:
1. Project foreign currency inflows and foreign currency outflows.
2. Estimate the variability (risk) associated with the foreign currency.
Illustration 2 Transaction Exposure
Seattle Import/Export, a U.S. import/export company, imports commodities from Canada

that it pays for in Canadian dollars and exports commodities to Canada for which it receives
Canadian dollars. If Seattle Import/Export anticipated that it would export C$10,000,000
to Canada over the next year while importing C$8,000,000 over the same period, the net
exposure in Canadian dollars is a C$2,000,000 inflow (receivable).
If the current exchange rate is $0.75/C$1, the net exposure in U. S. dollars is $1,500,000
(C$2,000,000 × 0.75). If the rate is anticipated to fluctuate five cents, between $0.70 and
$0.80, the total U.S. dollar fluctuation exposure would be expected to be between
$1,400,000 and $1,600,000.
2.4.2 Economic Exposure

Foreign exchange risk also includes economic exposure. Economic exposure is defined as the
potential that the present value of an organization's cash flows could increase or decrease as a result
of changes in the exchange rates. Economic exposure is generally defined through local currency
appreciation or depreciation and is measured in relation to organization earnings and cash flows.
Currency Appreciation and Depreciation
Currency appreciation (depreciation) refers to the strengthening (weakening) of a currency
in relation to other currencies.
yy Effect of Currency Appreciation
As a domestic currency appreciates in value or becomes stronger, it becomes more
expensive in terms of a foreign currency. As a currency appreciates, the volume of
outflows tends to decline as domestic exports become more expensive. However, the
volume of inflows tends to increase as foreign imports become less expensive.

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yy Effect of Currency Depreciation

As a domestic currency depreciates in value or becomes weaker, it becomes less
expensive in terms of a foreign currency. As a currency depreciates, the volume of
outflows tends to rise as domestic exports become less expensive. However, the
volume of inflows tends to decline as foreign imports become more expensive.
The economic exposure created by domestic currency appreciation or depreciation with
respect to a foreign currency depends on the net inflow or outflow of foreign currency.
2.4.3 Translation Exposure

Foreign exchange risk includes translation exposure, in addition to the transaction and economic
exposures. Translation exposure is the risk that assets, liabilities, equity, or income of a
consolidated organization that includes foreign subsidiaries will change as a result of changes in
exchange rates. Translation exposure is generally defined by the degree of foreign involvement,
the location of foreign subsidiaries, and the accounting methods used and measured in relation
to the effect on the organization's earnings or comprehensive income.
Degree of Foreign Involvement: Translation exposure increases as the proportion of
foreign involvement by subsidiaries increases.
Illustration 3 Translation Risk
Domestic International Inc. has no foreign subsidiaries but is deeply involved in exporting
to neighboring countries. Global International Inc. has 12 foreign subsidiaries which,
combined, make up 65 percent of consolidated revenues. Domestic International has less
translation exposure than Global International because it has no foreign subsidiaries.
Domestic's international business does expose the company to exchange rate risks,
however, in terms of both transaction and economic exposure.
Because of Global International's extensive foreign operations, the parent company
has significant exposure to foreign currency translation exposure, and depending on
the entity's export/import activity, Global International may also be exposed to foreign
exchange transaction and economic risks.
Locations of Foreign Investments: Measurements of financial results of foreign

investments frequently occur in the foreign currency in which the investee company
operates. The exposure of the parent company to translation risk is affected by the stability
of the foreign currency in comparison to the parent's domestic currency. The more stable
the exchange rate, the lower the translation risk. The more volatile the exchange rate, the
higher the translation risk.
2.5 Interest Rate Risk

Investors who purchase bonds, debt, or other interest-bearing financial instruments are
subject to interest rate risk. Interest rate risk is the possibility that the market interest rate
may change and impact the value of the interest-bearing instrument. The value of a fixed rate,
interest‑bearing instrument decreases as interest rates rise. If interest rates fall, the value of the
fixed-rate, interest-bearing instrument rises.

Illustration 4 Interest Rate Risk
On January 2, Pat paid the local bank $10,000 and the bank issued to Pat a one-year,
noncancelable certificate of deposit paying 5 percent interest. On January 3, the bank
increased its rate for a one-year, noncancelable certificate of deposit from 5 percent to 6
percent. Pat will still receive $500 interest and $10,000 principal on January 2 of the next
year. If Pat had waited one day to purchase the one-year certificate of deposit, Pat would
have received an additional $100 on January 2 of the next year.
The value of Pat's certificate of deposit acquired on January 2 decreases after the January 3,
Year 1, interest rate increase. As of January 3, Year 1, that one-year certificate of deposit for
which Pat paid $10,000 is worth only $9,905.66: $10,500 / 1.06 = $9,905.66.
Proof: On January 3, Year 1, an investor need only pay the local bank $9,905.66 in order to
receive $10,500 in one year at the new rate of 6 percent:
$9,905.66 × 6% interest rate = $594.34
$9,905.66 principal + $594.34 interest = $10,500
An easy method of remembering that a debt instrument's value moves in the opposite
direction as market rates change is to think about how Pat feels about buying the certificate
of deposit on January 2, Year 1, rather than buying the certificate of deposit on January 3,
Year 1. Pat is unhappy. Pat could have earned an extra $100 merely by waiting a day to buy
that $10,000 certificate of deposit at the higher interest rate. To summarize: "Unhappy" =
Loss and loss in value; "Happy" = Gain and gain in value.
2.6 Industry Risk

Industry risk is specific to an industry in which a company operates or otherwise has significant
exposure. Each industry has unique dependencies and exposures to the overall economy, but
companies within each industry are subject to challenges often faced by only that industry.
For instance, the auto industry is constrained by negotiations with labor unions as well as fuel
efficiency standards required by the federal government. Increased industry risk is also seen
in sectors in which the entire industry is performing poorly. Although this circumstance may
provide an opportunity for an innovative company to achieve above-average industry returns,
industry-wide poor performance potentially indicates declining consumer demand and the
resulting adverse impact on the industry as a whole.
2.7 Political Risk

Political risks represent noneconomic events or environmental conditions that are potentially
disruptive to financial operations. Ultimately, political climates or actions can disrupt cash flows.
Although expropriation of productive resources represents the most extreme political risk, other
features of political risk also must be considered, including:
Bureaucracies and related inefficiencies or barriers to trade
Corruption
The host government's attitude toward foreign firms
The attitude of consumers toward foreign firms
Inconvertibility of foreign currency
War

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PART 2 UNIT
3 Balancing Risk and Return LOS 2B1d
Generally, there is a direct relationship between risk and the required rate of return: higher
(lower) levels of risk require higher (lower) expected returns. Investor risk tolerances vary,
ranging from risk-averse to risk-neutral to risk-seeking. Investors who are risk-averse require
lower levels of risk and accept lower levels of return, whereas risk-seekers accept higher risk in
exchange for higher rates of return. If given a choice between two assets that offer the same
rate of return, rational investors will choose the investment with the lower risk. Alternatively,
if investors must choose between two assets with the same level of risk, rational investors will
choose the investment that has the higher rate of return.
3.1 Diversification LOS 2B1e

Owning individual securities exposes an investor to individual security risk, also known as LOS 2B1f
firm-specific or unsystematic risk. Investors can reduce individual security risk by forming a
portfolio of different investments. As an investor combines individual securities or different
asset classes into a portfolio, there will be a portfolio risk.
The key to minimizing portfolio risk is diversification, which reduces risk by combining investments
with different risk profiles. For example, an investment in a company that has cyclical performance
(its returns move with the economy in general, with seasonal fluctuations or other normal industry
cycles) can be combined with an investment in a company that is counter-cyclical (its returns move
in the opposite direction of fluctuations in the industry or economy).
Diversification entails investing in a variety of securities so that a loss in one security will have
a minimal effect on the whole portfolio. Risk reduction can be achieved in a portfolio when the
securities held are not correlated with one another. By properly diversifying the investments in a
portfolio, an investor can minimize risk for a given level of return or maximize return for a given
level of risk.
The expected return for any portfolio is the weighted average of the returns of each investment
in the portfolio.
Rp = W1R1 + W2R2 + … + WnRn

Where:
W1, W2 ... Wn are the weights of each investment in the total portfolio
R1, R2, ... Rn are the expected returns of each investment in the portfolio
Example 8 Calculating Expected Return
Facts: Consider an individual bond with an expected return of 6 percent and an individual
stock with an expected return of 10 percent. The bond and the stock are both equivalent in
value in the portfolio.
Required: Calculate the expected return.
Solution: With both the bond and stock equivalent in value, each will represent 50 percent
of the portfolio's value as a whole. The portfolio has an expected return of 8 percent:
Rp = (0.50)(0.06) + (0.50)(0.10) = 0.08 = 8%

Asset allocation is the process of selecting assets in a portfolio to achieve the best risk/return
trade-off. The assets can include bonds, stocks, derivatives, real estate, alternative investments
(such as precious metals or oil and gas wells) as well as high-risk, low-risk, long-term, short-term,
and other types of investments needed to achieve the correct balance of risk and return. When
sufficient assets have been combined to achieve the full benefits of diversification, the portfolio
is called a fully diversified or efficient portfolio. A fully diversified, efficient portfolio provides
the highest possible rate of return for a level of risk or the lowest possible level of risk for a
particular rate of return.
LOS 2B1h 3.2 The Capital Asset Pricing Model (CAPM)

The capital asset pricing model (CAPM) is used to determine the expected return on an investment
based on its level of risk, factoring in both firm-specific risk and systematic (market) risk.
Rce = Rf + β[Rm − Rf ]
Where:
Rce = Required rate of return on common equity
Rf = Risk-free rate of return
β = Beta of the security
Rm = Market return
Under the CAPM formula, the [Rm − Rf—] term is also known as the market risk premium.
Risk-free rate is the theoretical rate of return on an investment with zero (or very low) risk.
Beta is a numerical representation of the risk of the stock relative to the risk of the overall
market. A beta of 1 means that the stock has the same volatility as the market, and a beta of
greater (less) than 1 means that the stock is more (less) volatile than the market.
Market risk premium is the systematic (nondiversifiable) risk associated with the overall
stock market. The market risk premium is equal to the difference between the overall
market return and the risk-free rate.
Example 9 Capital Asset Pricing Model
Facts: Assume that a firm's beta is 1.25, the risk-free rate is 8.75 percent, and the market
rate of return is 14.25 percent.
Required: Compute the expected return using the capital asset pricing model (CAPM).
Solution: Expected return using the capital asset pricing model (CAPM):
Expected return = Rce = Rf + β[Rm − Rf—]
= 0.0875 + [1.25 × (0.1425 − 0.0875)]
= 0.0875 + [1.25 × 0.0550]
= 0.0875 + 0.0688
= 0.1563 = 15.63%

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3.2.1 Beta LOS 2B1g

Beta (the beta coefficient) is a measure of the movement of the price of a particular stock
compared with the movement of the market as a whole during the same period. Beta is a
measure of systematic risk, which cannot be diversified away and remains even in a fully
diversified portfolio. The beta of the overall market is 1.0. For an individual stock, beta is
interpreted as follows:
Beta > 1.0: The stock or portfolio is more volatile (riskier) than the market. More volatility
requires a higher return.
Beta < 1.0: The stock or portfolio is less volatile than the market. Less volatility requires a
lower return.
Beta = 1.0: A beta of exactly 1.0 means that the stock or portfolio has the same volatility as
the market.
Note that the beta is calculated using historical data, so a beta can change over time and may be
different depending on the historical return data used.
A security's price at any point represents the present value of the security's expected future cash
flows. Cash flows are discounted using an investor's required rate of return, which is driven in
part by a security's beta. The higher the beta, the higher the risk associated with that investment.
Higher risk will increase the investor's required return. An inverse relationship exists between
the required return (and beta) and the price of the security. The higher the required return, the
higher the discount rate, and the lower the price (or present value) of the security.
Question 1 MCQ-12661
Assume that a stock has a beta of 1.24 based on five years of monthly data. The risk-free
rate is 3 percent and the overall market return is 10 percent.
Using the CAPM, calculate the investor's required return for the stock.
a. 8.68 percent
b. 11.68 percent
c. 12.40 percent
d. 15.40 percent

A financial advisor evaluates four stocks for inclusion in an investor's portfolio. A

correlation matrix showing each stock's correlation with the other stocks is shown below:
Stock ALK BTY CMN DLE

ALK 1.00 0.40 –0.25 0.58
BTY 0.40 1.00 0.16 –0.04
CMN –0.25 0.16 1.00 0.37
DLE 0.58 –0.04 0.37 1.00
If the goal is to reduce the investor's overall portfolio risk, which two stocks should the
advisor recommend?
a. ALK and DLE
b. ALK and CMN
c. BTY and DLE
d. BTY and CMN

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2
MODULE
B.2. Long-Term Financial Part 2

Management: Part 1 Unit 2
CMA LOS Reference: Part 2—Section B.2. Long-Term Financial Management: Part 1

a. describe the term structure of interest rates, and explain why it changes over time
b. define and identify the characteristics of common stock and preferred stock
c. identify and describe the basic features of a bond such as maturity, par value, coupon
rate, provisions for redeeming, conversion provisions, covenants, options granted to
the issuer or investor, indentures, and restrictions
d. identify and evaluate debt issuance or refinancing strategies
e. value bonds, common stock, and preferred stock using discounted cash flow methods
f. demonstrate an understanding of duration as a measure of bond interest rate sensitivity
w. use the constant growth dividend discount model to value stock and demonstrate an
understanding of the two-stage dividend discount model
x. demonstrate an understanding of relative or comparable valuation methods, such as
price/earnings (P/E) ratios, market/book ratios, and price/sales ratios
1 Debt Securities
A company's capital structure consists of its mix of debt and equity financing. Debt may
include notes payable and bonds. Interest rates play a critical role in both the structure and the
valuation of all debt securities.
1.1 Term Structure of Interest Rates LOS 2B2a
The term structure of interest rates describes the relationship between interest rates on debt
securities (bonds) and the various maturities of bonds having the same risk characteristics.
Changes in the term structure of interest rates over time are caused by changes in expectations
regarding economic growth, increases (inflation) or decreases (deflation) in price levels, and
changes in interest rates.
© Becker Professional Education Corporation. All rights reserved. Module 2 2–17 B.2. Long-Term
2 B.2. Long-Term Financial Management: Part 1 PART 2 UNIT 2
A yield curve plots rates and maturities on a single curve and reflects expectations about yields, or
rates of return, at various maturities. A normal yield curve is upward sloping, showing that investors
are compensated with higher rates of return for investing their money over longer periods of time.
Yield
Maturity
2B_Normal Yield Curve

In some circumstances the yield curve can be downward-sloping, flat, or humped.
Downward-sloping yield curves, in which bonds of shorter maturity pay higher rates, are
also referred to as inverted yield curves and are considered atypical as well as indicative of a
potential recession.
LOS 2B2c 1.2 Bond Features

Bonds are a long-term means of financing by which a company or government borrows
money by selling debt securities (bonds) to investors. A bond issue represents a loan by the
bondholders (investors) to the issuing company or government. By selling the bond, the
company or government is making a promise to pay the investors a certain amount of interest
every period until the bond matures. On the maturity date the company or government
promises to pay the face amount of the bond to the investors.
1.2.1 Bond Indenture and Covenants

A bond is governed by a legal contract (bond indenture) between the bond issuer and the
bondholders. If the bond issuer does not meet the contractual obligations and does not make
the promised interest and/or principal payments, the bond issuer is said to have defaulted, and
bondholders normally have legal recourse.
Loan covenants are often incorporated into the bond indenture to protect the lender. Covenants
increase the likelihood that the bondholders will receive their scheduled interest payments and
the repayment of their principal on the maturity date. Loan covenants are either protective
covenants or positive covenants.
Protective covenants are also referred to as negative covenants or restrictive covenants.
An example of a protective covenant is a covenant stating that the bondholder will not
sell specific assets because the bondholders have a higher claim on those assets than do
shareholders.
Positive covenants specify actions that the issuing firm must take, such as maintaining
working capital at a minimum level, maintaining a specified debt to equity ratio, or
submitting financial statements at regular intervals.
2–18 Module 2 B.2.Education

© Becker Professional Long-Term FinancialAllManagement:
Corporation. rights reserved.Part 1
PART 2 UNIT
2 2 B.2. Long-Term Financial Management: Part 1
1.2.2 Basic Bond Features

The basic features of a bond include:
Par Value: The par, principal value, or face value is the amount that is paid by the issuer
to the bondholder at maturity. Bonds are generally issued in increments of $1,000. For
example, if a company wants to raise $1,500,000 from issuing bonds, the company will issue
1,500 bonds each having a par value of $1,000.
Coupon (Stated) Rate: The coupon rate determines the annual or semiannual bond
interest payment. For example, a bond that has a par value of $1,000 and a coupon rate of
3.25% will pay annual interest of $32.50 ($1,000 par value × 3.25% coupon rate). If the bond
pays interest semiannually, each coupon payment will be $16.25.
Maturity Date: The maturity date is the date on which the par value is paid back to the
bondholder (lender).
1.2.3 Bond Contingency Provisions

Many bonds include provisions for redemption prior to maturity. Embedded options refer to
various contingency provisions found in the bond indenture. These contingency provisions
provide the issuer or the bondholders the right, but not the obligation, to take some action.
Bonds with embedded options include callable bonds, puttable bonds, and convertible bonds.
Callable Bonds: A bond is callable when the issuer has the option to retire or replace the
bond before maturity at a specified price. If interest rates fall, the issuer can call the bond
and then issue new bonds at the lower interest rate. The call provision is an advantage to
the issuer and a disadvantage to the bondholder. Call features increase investor risk and
generally result in the bond trading at a lower price.
Puttable Bonds: A bond is puttable when the bondholder has the option to demand that
the issuer pay off the bond before maturity at a specified price. If interest rates rise, the
investor can exercise the put option and then buy new bonds that pay the higher interest
rate. The put provision is an advantage to the bondholder and a disadvantage to the
borrower. Put features decrease investor risk and generally result in the bond trading at a
higher price.
Conversion Provisions: A convertible bond is convertible into the common stock of the issuer
at the option of the bondholder. Key terms regarding convertible bonds include the following:
The conversion price is the amount the bondholder must pay for each share of stock to
be received upon conversion.
The conversion ratio is the number of common shares into which each bond can be
converted. The conversion ratio is equal to the par value divided by the conversion price.
Par value
Conversion ratio =
Conversion price
The conversion value is equal to the current stock price multiplied by the number of
shares to be issued if the bond is converted.
Current No. of shares issued

Conversion value = ×
stock price if bond is converted
The conversion premium is the difference between the convertible bond's current price
and the convertible bond's conversion value.
Convertible bond Convertible bond

Conversion premium = –
current price conversion value
Example 1 Bond Conversion
Facts: A convertible bond with a par value of $1,000 has a conversion price of $50 and a
current price of $1,050. The current stock price is $48 per share.
Required: Determine the conversion ratio, the conversion value, and the conversion premium.
Solution:
Conversion ratio = $1,000 par value / $50 conversion price = 20:1, or 20 common shares
per bond
Conversion value = Current stock price × Number of shares to be issued upon conversion =
$48 current stock price × 20 shares to be issued per bond = $960 conversion value
Conversion premium = $1,050 bond's current price – $960 conversion value = $90
conversion premium
LOS 2B2d 1.3 Issuance and Refinancing

The decision to issue new debt depends on a company's capital needs, the interest rate
environment, the credit ratings that the company and the debt carry, the costs associated
with issuing debt, and the company's ability to meet the regular interest and principal
payments as they come due. Debt typically offers a lower cost of capital than equity due to
the tax deductibility of interest payments on debt. However, the cost of debt increases as the
percentage of debt in the overall capital structure increases.
Refinancing involves replacing current debt with new debt that has more favorable terms
for the borrower, such as a lower interest rate or a longer term to maturity than the original
debt issuance. Refinancing also allows the borrower to potentially move from fixed-rate to
floating-rate debt, or vice versa. The decision to refinance an outstanding debt issuance requires
consideration of several factors, including:
Bond Terms: Refinancing is only permitted when the bond indenture allows for a potential
refinancing of current debt.
Refinancing Costs: The costs of refinancing (transaction fees, underwriting fees, etc.) must
be weighed against the benefits (lower interest rates, lower payments, etc.) associated with
refinancing.
Time to Maturity: It may not make sense to refinance if the debt is close to maturity.
LOS 2B2e 1.4 Bond Valuation

The value of a bond is equal to the present value of its future cash flows (which consist of interest
payments and the principal payment at maturity). The cash flows may be discounted using a single
interest rate or multiple interest rates aligned with the degree of risk for each cash flow.

PART 2 UNIT
Bonds paying a fixed coupon rate equal to the market rate for comparable bonds are issued at
par (face) value. If a bond's coupon rate at issuance is less (more) than the market rate, the bond
will be issued at a discount (premium). As market interest rates change, the market value of the
bond will also change. For fixed-rate bonds, when market interest rates rise the market value of
the bond falls, and vice versa.
Example 2 Debt Instruments
Facts: A $1,000 face value bond maturing in three years pays annual interest of 4 percent.
Required: Calculate the bond's price If the market rate at the time of issuance is 5 percent.
Solution: Because the bond pays a lower coupon rate than market rate, it will be issued at
a discount to par. The calculation for the bond's price is as follows:
Year 1 payment: 40 / 1.05 = $38.10
Year 2 payment: 40 / (1.05)2 = $36.28
Year 3 payment: (40 + 1,000) / (1.05)3 = $898.39
Total value: $38.10 + $36.28 + $898.39 = $972.77
1.5 Duration and Bond Price Sensitivity LOS 2B2f
The market value of a bond is affected by changes in current market interest rates. When market
interest rates increase (decrease), market values of bonds decrease (increase). The duration of
a bond is a measure of how sensitive the bond is to changes in market rates. Duration is also
a measure of how much the price of the bond will change when there is a 1 percent change
in the market interest rate. The price of a bond with a higher duration will be more sensitive
to changes in the market interest rate than will the price of a bond with a lower duration. The
longer the term to maturity, the higher a bond's duration.
Illustration 1 Bond Duration
Assume that a 10-year, fixed-rate bond has a duration of 3.96. If market interest rates
increase by 1.50%, then the price change will be equal to 3.96 duration × 1.50% rate
increase = 5.94%. Because interest rates and bond prices move in opposite directions, the
price of the bond will decrease by 5.94%.
Pass Key
A bond's duration is a measure of its sensitivity to interest rates. The longer the term to
maturity, the higher the duration of a bond, and the more sensitive the bond's price is to
interest rate movements.
2 Equity Securities
Equity securities such as common stock and preferred stock represent proportional ownership
in the company. Holders of stock are the owners of a corporation. If a company has issued
shares to the public, the shares are traded on a stock exchange. Common stock and preferred
stock have different features and rights that affect their risk, expected return, and valuation.
LOS 2B2b 2.1 Common Stock

Common stock is an advantageous form of financing because common stock dividend payments
are not required. Common stock is permanent capital that does not mature at some future date
and therefore does not have to be paid back. Common stock has extended voting rights, and
the issuance of additional shares to new investors may result in increased investor control and
diluted earnings per share.
Common stock typically provides its owners with the following rights:
Right to Limited Liability: Common shareholders are not liable for corporate debt.
Right to Receive Dividends: Common stockholders have the right to receive dividends
in proportion to their holdings, although common dividends are not required to be paid.
Dividend payments are approved by a company's board of directors and announced on the
declaration date.
Right to Vote: Common stockholders have the right to vote on certain company matters
such as the annual election of directors.
Liquidation Rights: Common stockholders have the right to a proportional share of the
residual value of the corporation in the event of liquidation.
Preemptive Rights: Common stockholders may have the preemptive right to a
proportionate share of any new issue of common stock before it is offered to other parties.
2.2 Preferred Stock

Preferred shares typically pay higher dividends than common shares. Preferred shares are
called preferred because preferred shareholders are entitled to dividends before common
shareholders receive any dividends. In addition, preferred shareholders have seniority
over common shareholders in the event of a liquidation. As such, preferred shares have
characteristics that more closely resemble debt.
Preferred stock typically has the following characteristics:
Preferred stock dividends are fixed and stated as a percentage of par, face, or stated value.
Dividends are not a contractual obligation and need to be declared and approved by the
board of directors.
Preferred stock dividends are either cumulative or noncumulative. Cumulative dividends
require that both the current dividend as well as any preferred dividends not paid in prior
years must be paid before any dividends can be paid on common stock.
Preferred stock is issued by class and in series. For example, the BeckCon Co. issues 6.25
percent Series B cumulative preferred stock. The 6.25 percent represents the dividend
payment (as a percentage of par value) and the series letter indicates the order in which the
shares are issued (the B series comes after the A series).
Preferred stock may have a conversion provision that can be exercised at the option of the
preferred stockholder to convert the preferred shares into either a specified number of
common shares or a different series of preferred shares.

PART 2 UNIT
Preferred stock may also come with detachable stock warrants (also called call options),
which give preferred stockholders the right to purchase common stock at a predetermined
price and date.
Preferred shares typically do not have voting rights.
Compared with debt, the advantages of issuing preferred stock include no fixed maturity date
and no contractual obligations to make dividend payments. Unlike debt, which provides the
benefit of a tax deduction for interest, dividends on preferred stock are paid from after-tax
earnings.
2.3 Stock Valuation: Absolute Value Models (Discounted Cash Flow) LOS 2B2e
Absolute value models assign an intrinsic value to an asset based on the present value of its
future cash flows. Estimates of cash flows are derived and discounted based on interest rates
applicable to the level of risk and required return associated with the asset and its projected
cash flows.
2.3.1 Annuities
An annuity is a series of equal cash flows to be received over a number of periods. The
traditional approach to asset valuation is the annuity present value formula, which divides future
cash flows by a rate of return in order to determine the value of the annuity in today's dollars.
Annuity present value = C × (1 − Present value factor) / r

1
1 −
(1 + r) t
= C×
r
Terms are defined as follows:
C = Amount of annuity (equal future cash flows)
r = Rate of return
t = Number of years
2.3.2 Perpetuities (Zero Growth Stock)

When the periodic cash flows paid by an annuity last forever, the annuity is called a perpetuity or
perpetual annuity. The traditional annuity formula for perpetual cash flow streams is simplified,
because no duration is known. When a company is expected to pay the same dividend each
period, the perpetuity formula can be used to determine the value of the company's stock. This
is the method used to value preferred stock.
Present value of a perpetuity = Stock value per share = P = D / R

P = Stock price
D = Dividend
R = Required return
Example 3 Perpetuities
Facts: Baker Corporation pays a constant annual dividend per share of $5 per year. Able
wants to invest in Baker and earn a 20 percent return.
Required: Calculate the value of Baker's stock.
Solution:
P = D—/—R
P = $5—/—20%
P = $25
Able should pay $25 for a share of Baker.
LOS 2B2w 2.4 Stock Valuation: Dividend Discount Models

The value of any investment is the present value of its future cash flows. For common stock
and preferred stock, dividends represent a series of future cash flows, and each payment is
discounted to present value. Most stock investments do not pay cash flows into perpetuity, so
assumptions are made regarding future growth. Two models, the constant growth dividend
discount model (also known as the growth model) and the two-stage dividend discount model,
are used to calculate the intrinsic value of a stock. Both models discount future cash flows to
today's dollars.
2.4.1 Constant (Gordon) Growth Dividend Discount Model (DDM)

The dividend discount model (DDM) assumes that dividend payments are the cash flows of an
equity security and that the intrinsic value of the company's stock is the present value of the
expected future dividends. If dividends are assumed to grow at a constant rate, the constant
(Gordon) growth DDM can be used to determine the value of the company's stock.
D(t + 1)
Pt =
R − G

Pt = Current price (price at period "t")
D(t+1) = Dividend one year after period "t"
R = Required return
G = Sustainable growth rate
The candidate may be given the dividend at time = t or Dt. To determine Dt + 1 , the numerator of
the formula becomes: Dt—(1 + G).

PART 2 UNIT
Determining the Required Rate of Return (R)

The capital asset pricing model (CAPM) is often used to determine the required return for
the DDM model as follows:
Where:
Rm = Market return
Example 4 Dividend Discount Model
Facts: Baker Corporation pays a current dividend per share of $5 per year and is projected
to grow at 4 percent per year. Able wants to invest in Baker and earn a 20 percent return.
Required: Calculate the value of Baker's stock today.
Solution:
Pt = D(t+1) / (R − G)
D(t+1) = $5 × 1.04
D(t+1) = $5.20
Pt = $5.20 / (0.20 − 0.04)
Pt = $5.20 / (0.16)
Pt = $32.50
The intrinsic value of Baker's stock today is $32.50.
Example 5 Dividend Discount Model
Facts: Baker Corporation pays a current dividend per share of $5 per year and is projected
to grow at 4 percent per year. Able wants to invest in Baker and earn a 20 percent return.
Required: Calculate the amount that Able will pay for Baker's stock three years from today.
Solution:
Pt = D(t+1) / (R − G)
D(t+1) = $5 × 1.04 × 1.04 × 1.04 × 1.04, or
D(t+1) = $5 × (1.04)4
D(t+1) = $5 × 1.1698586
D(t+1) = $5.85
Pt = D(t+1) / (R − G)
Pt = ($5.85) / (0.20 − 0.04)
Pt = $5.85 / (0.16)
Pt = $36.56
In order to value Baker in three years, the dividend to be paid in the fourth year is required.
Able should pay $36.56 for Baker in three years.
2.4.2 Two-Stage Dividend Discount Model

The two-stage dividend discount model assumes that there are two stages of growth: an initial
phase, in which growth is typically high but unsustainable in the long-term, and a second phase,
in which the growth rate is stable and expected to remain constant. The calculation of a stock's
value using the two-stage dividend discount model requires two growth rates (short-term and
long-term), the required rate of return, the current period dividend, and the number of years
estimated for short-term growth. The equation is shown below:
Dn 1
n D0 (1 g s )T (r gL )
Stock value = (1 r )T

(1 r )n
t 1
D0 = Current period dividend
gs = Short-term growth rate
gL = Long-term growth rate
r = Required rate of return
n = Number of years in the first stage (short-term, high-growth rate)
Dn+1 = D0 (1+ gs )n (1 + gL)
T = Payment period (i.e., one for Year 1, two for Year 2, etc.)

PART 2 UNIT
Example 6 Two-Stage Dividend Discount Model
Facts: An investor evaluates a stock that expects to grow 5 percent per year for the next
three years and then 2 percent in perpetuity after three years.
Required: With a current dividend of $2.00 per share and a required return of 4 percent,
what should the investor pay for the stock today?
Solution: The first step is to solve for the dividend amount for the numerator of the last
term in the equation.
Dn+1 = $2.00(1 + 0.05)3(1 + 0.02) = $2.36156
Then, compute the other values into the equation as follows:

Dn 1
n T
D0 (1 g s ) (r gL )
Dn 1 (1 r )T

(1 r )n
t 1
$2.36156
$2.00(1 0.05)1 $2.00(1 0.05)2 $2.00(1 0.05)3 (0.04 0.02)

1 0.04 )1
(1 (1 0.04 )2 (1 0.04 )3 (1 0.04 )3
$111.09
The stock is worth $111.09 today.
2.5 Stock Valuation: Relative Valuation Models LOS 2B2x
Relative valuation models use the value of comparable stocks to determine the value of similar
stocks. Price multiples are useful metrics in relative valuation. Price multiples represent ratios of
a stock's market price to another measure of fundamental value per share. Investors use price
multiples to determine if a stock is undervalued, fairly valued, or overvalued.
2.5.1 Price-Earnings (P/E) Ratio

The P/E ratio is the most widely used multiple when valuing equity securities. The rationale
for using this measure is that earnings are a key driver of investment value (stock price). This
multiple is widely used by the investment community and empirical research has shown that
changes in a company's P/E are tied to the long-run stock performance of that company.
Calculating the P/E Ratio
P/E ratio = P0 / E1

P0 = Stock price or value today
E1 = EPS expected in one year (next four quarters)
Note: The above formula is the "forward P/E" as the denominator is based on expected earnings
over the next year or four quarters.
Valuing Equity With the P/E Ratio

The P/E ratio, once calculated, can be multiplied by anticipated future earnings per share in
order to determine the current stock price. It requires that earnings per share be greater
than zero.
Example 7 P/E Ratio
Facts: Assume that Baker Corporation has current-year earnings per share of $1.50 and
anticipates earnings per share in the coming year of $2.
Required: If the P/E ratio is 7.5x, calculate the expected value of Baker's shares.
Solution:
(P0 ) = (P0 / E1) × E1
(P0 ) = 7.5 × $2
(P0 ) = $15
The P/E ratio of 7.5x implies that the current stock price should be 7.5x the anticipated earnings
per share of $2. An investor would expect the current stock price to therefore be $15.
Trailing vs. Forward P/E

The numerator in the P/E ratio is unambiguous, as the stock price for publicly traded
companies is readily available. This is not the case for the denominator of the ratio, as the
earnings used in the P/E ratio can either be past earnings or expected future earnings.
When past earnings are used in the P/E ratio, such as earnings for the past four quarters or
trailing 12-month EPS, the ratio calculated is the trailing P/E. When expected earnings of the
company next year is used in the denominator, the ratio is the forward P/E.
The trailing P/E is the preferred calculation method when a company's forecasted earnings
are unavailable, while the forward P/E is the preferred method when the company's
historical earnings is not representative of its future earnings. The formula for the trailing
P/E ratio is as follows:
Trailing P/E ratio = P0 / E0

E0 = EPS for the past year (past four quarters)
2.5.2 Price-to-Sales Ratio

The rationale for using the price-to-sales ratio is that sales are less subject to manipulation than
earnings or book values; sales are always positive so this multiple can be used even when EPS
is negative; and this ratio is not as volatile as the P/E ratio, which includes the effect of financial
and operating leverage. Empirical studies have shown that P/S is an appropriate measure to
value stocks that are associated with mature or cyclical companies.

PART 2 UNIT
Calculating the Price-to-Sales Ratio
Price-to-sales ratio = P0 / S1

S1 = Expected sales in one year
Valuing Equity With the Price-to-Sales Ratio

The value of equity can then be calculated as follows:
(P0 ) = (P0 / S1) × S1
2.5.3 Price-to-Book Ratio

The price-to-book (P/B) ratio is another price multiple used by analysts that focuses on the
balance sheet rather than the income statement or statement of cash flows. The rationale
for using this multiple is that a firm's book value of common equity (assets minus liabilities
and preferred stock) is more stable than earnings per share, especially when a firm's EPS is
extremely high or low for a given period. Because P/B is usually positive, this multiple can be
used even when a firm's EPS is negative or zero. Research indicates that the P/B ratio can explain
a firm's average stock returns over the long run.
Calculating the P/B Ratio
P/B ratio = P0 / B0

B0 = Book value of common equity
Valuing Equity With the P/B Ratio

The value of equity can then be calculated as follows:
(P0 ) = (P0 / B0) × B0
Example 8 Price-to-Book Ratio
Facts: An analyst assembles the following financial and market data for Bolden
Corporation's most recent year-end.
Market Data
Common stock price $18
Common shares outstanding 10,000,000
Financial Data
Total assets $250,000,000
Total liabilities 110,000,000
Preferred stock 20,000,000
Common stock 25,000,000
Additional paid-in capital 45,000,000
Retained earnings 50,000,000
Total stockholders' equity 140,000,000
Required: Using the previous data, calculate the P/B multiple.
Solution:
The P/B multiple for Bolden Corporation's current year is derived as follows:
1. Determine book value of common equity
$25,000,000 (CS) + $45,000,000 (APIC) + $50,000,000 (RE) = $120,000,000
2. Determine book of common equity per share
$120,000,000 / 10,000,000 shares = $12
3. Calculate P/B multiple
P0 / B0 = $18 / $12
= 1.5

PART 2 UNIT
Example 9 Relative Valuation Models
Facts: An investor is comparing market ratios for the XLX Company to those of its industry.
The following ratios were calculated at the end of the current fiscal year:
Ratio XLX Company Industry

P/E 16.2 14.9
P/S 18.1 19.4
P/B 19.2 17.8
Required: Discuss what each ratio indicates regarding XLX stock valuation and how the
numbers can be interpreted.
Solution:
P/E Ratio: XLX has a higher P/E ratio than its industry peer group. This measure, on its
own, would indicate that the stock price for XLX is overvalued relative to that of its peers.
Investors would expect the price of XLX stock to decline in order to align the P/E ratio
with that of its peers.
P/S Ratio: This ratio indicates that XLX stock may actually be undervalued relative to
that of its peers. However, this ratio alone does not account for cost structure, capital
structure, or tax effects that should be evaluated before determining whether a stock is
relatively overvalued or undervalued.
P/B Ratio: Relative to the value of its equity, XLS's stock price is higher than that of its
peers. The stock may not necessarily be overvalued, as a higher P/B may indicate that
the market thinks that XLX's net assets are undervalued.
A company issued 1,000 4.25 percent coupon bonds that pay interest annually, each with a
face value of $1,000 and maturing in four years. If the market rate at the time of the bond
issuance was 4.00 percent, the price of each bond on the issuance date is closest to:
a. $983.00.
b. $990.98.
c. $1,009.07.
d. $1,017.00.
Reynolds is interested in a stock that pays a current dividend of $1.15 per share and has
a growth rate of 4 percent. The risk-free rate on U.S. Treasury securities is 2 percent, the
market return is 6 percent, and the beta of the stock is 1.10.
The price that Reynolds should pay for the stock is closest to:
a. $18.69.
b. $29.90.
c. $47.92.
d. $49.83.

3
MODULE
B.2. Long-Term Financial Part 2

Management: Part 2 Unit 2
CMA LOS Reference: Part 2—Section B.2. Long-Term Financial Management: Part 2

g. explain how income taxes impact financing decisions
h. define and demonstrate an understanding of derivatives and their uses
i. identify and describe the basic features of futures and forwards
j. distinguish a long position from a short position
k. define options and distinguish between a call and a put by identifying the
characteristics of each
l. define strike price (exercise price), option premium, and intrinsic value
m. demonstrate an understanding of the interrelationship of the variables that comprise
the value of an option; e.g., relationship between exercise price and strike price, and
value of a call
n. define interest rate and foreign currency swaps
o. define and identify characteristics of other sources of long-term financing, such as
leases, convertible securities, and warrants
p. demonstrate an understanding of the relationship among inflation, interest rates, and
the prices of financial instruments
q. define the cost of capital and demonstrate an understanding of its applications in
capital structure decisions
r. determine the weighted average cost of capital and the cost of its individual components
s. calculate the marginal cost of capital
t. explain the importance of using marginal cost as opposed to historical cost
u. demonstrate an understanding of the use of the cost of capital in capital investment
decisions
v. demonstrate an understanding of how income taxes impact capital structure and
capital investment decisions
LOS 2B2q 1 Weighted Average Cost of Capital
The weighted average cost of capital (WACC) serves as a major link between the long-term
investment decisions associated with a corporation's capital structure and the wealth of a
corporation's owners. The weighted average cost of capital is the average cost of all forms
of financing used by a company. WACC is often used internally as a hurdle rate for capital
investment decisions. The theoretical optimal capital structure is the mix of financing
instruments that produces the lowest WACC.
Pass Key
The value of a firm can be computed as the present value of the cash flow it produces,
discounted by the costs of capital used to finance it. The mixture of debt and equity
financing that produces the lowest WACC maximizes the value of the firm.
LOS 2B2r 1.1 Computing the Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) is the average cost of debt and equity financing
associated with a firm's existing assets and operations.
1.1.1 Formula
The weighted average cost of capital is determined by weighting the cost of each specific type of
capital by its proportion to the firm's total capital structure.
E P D

V V

WACC R e Rp R d 1 T
V
Where:
The summed market values of the individual components of the firm's capital
V =
structure: common stock equity (E), preferred stock equity (P), and debt (D)
R = The required rate of return (also known as the "cost") of the various components
T = The corporate tax rate
The percentage equity and percentage debt in the capital structure is calculated using the
market values of the outstanding debt and equity, if market values are available.

PART 2 UNIT
Example 1 Calculating WACC
Facts: Assume that the cost of common stock equity for XYZ Company is 8.4 percent, the
cost of preferred stock equity is 6.8 percent, and the weighted average interest rate on the
company's debt is 6.0 percent. Also, assume that the market value percentages of each
component of the capital structure are 55 percent common stock, 20 percent preferred
stock, and 25 percent debt. The corporate tax rate is 30 percent.
Required: Compute XYZ's WACC.
Solution:
1. Cost of debt (after tax):
= Interest rate × (1 − Tax rate)
= 6.0% × (1 − 30%)
= 4.2%
2. WACC = (8.4% × 55%) + (6.8% × 20%) + (4.2% × 25%) = 7.03%
If XYZ is using its WACC as the hurdle rate, then it should invest in any project that will yield
a return higher than 7.03%.
1.1.2 Individual Capital Components

Individual capital components include both long-term and short-term elements of a firm's
permanent financing mix.
Long-Term Elements: Long-term elements include long-term debt, preferred stock,
common stock, and retained earnings.
Short-Term Elements: Short-term elements may include short-term interest-bearing debt
(e.g., notes payable). Other forms of current liabilities (e.g., accounts payables and accruals)
are not included in the cost-of-capital estimate, because they generally represent interest-
free capital.
After-Tax Cash Flows: In evaluating the cost of the components of capital structure,
after-tax cash flows are the most relevant. The cost of debt is computed on an after-tax
basis because interest expense is tax deductible.
1.2 Weighted Average Cost of Debt

The relevant cost of long-term debt is the after-tax cost of raising long-term funds through
borrowing. Sources of long-term debt generally include issuance of bonds or long-term loans.
Debt costs are generally stated as the interest rate of the various debt instruments. In some
cases, debt costs are stated according to basis points above U.S. Treasury bond rates (where
1 basis point is equal to one-hundredth of 1 percent, or 0.01 percent). The weighted average
interest rate is calculated by dividing a company's total interest obligations on an annual basis
by the debt outstanding:
Effective annual interest payments

Weighted average interest rate =
Debt outstanding
1.2.1 Pretax Cost of Debt

The pretax cost of debt represents the cost of debt before considering the tax shielding effects
of the debt.
LOS 2B2g 1.2.2 After-Tax Cost of Debt

Because interest on debt is tax deductible, the tax savings reduces the actual cost of debt. The
formula for computing the after-tax cost of debt is:
After-tax cost of debt = Pretax cost of debt × (1 − Tax rate)
Example 2 After-Tax Cost of Long-Term Debt
Facts: Assume that the long-term debt component of the weighted average cost of capital
for a firm includes a pretax cost of debt of 12.5 percent and a 30 percent tax rate.
Required: Compute the after-tax cost of long-term debt.
Solution:
After-tax cost of long-term debt = Pretax cost of debt × (1 − Tax rate)
= 0.125 × (1 − 0.30)
= 0.125 × 0.7
= 0.0875 = 8.75%
Although the pretax interest rate is 12.5 percent, the after-tax interest rate, after considering
the deductibility of the interest expense, is 8.75 percent. Note that if the tax rate increased
to 40 percent, the cost of debt would decrease to 7.5 percent [12.5% × (1 − 0.40)].
Pass Key
Debt carries the lowest cost of capital because the interest is tax deductible.
The higher the tax rate, the higher the incentive exists to use debt financing.
1.3 Cost of Preferred Stock

The cost of preferred stock is the dividends paid to preferred stockholders. After-tax
considerations are irrelevant with equity securities because dividends are not tax deductible.
1.3.1 Formula
Preferred stock dividends

Cost of preferred stock =
Net proceeds of preferred stock

PART 2 UNIT
1.3.2 Preferred Stock Dividends

Preferred stock dividends can be stated as a dollar amount or a percentage. For example,
5 percent preferred stock pays an annual dividend of 5 percent of par value, if dividends are
declared by the corporation.
1.3.3 Net Proceeds of Preferred Stocks

The net proceeds from a preferred stock issuance can be calculated as the proceeds net of
flotation costs (i.e., issuance costs).
Example 3 Cost of Preferred Stock
Facts: Assume that the preferred stock component of the weighted average cost of capital
for a firm is 10 percent, $100 par value preferred stock that was issued at par value with a
flotation cost of $5 per share.
Required: Compute the cost of preferred stock.
Solution:
Preferred stock dividend = Dividend percentage times par value = 10% × $100 = $10
Cost of preferred stock = Dividends / Net proceeds
= $10 / ($100 − $5)
= $10 / $95
= 0.1053 = 10.53%
1.4 Cost of Retained Earnings

The cost of equity capital obtained through retained earnings is equal to the rate of return
required by the firm's common stockholders. A firm should earn at least as much on any earnings
retained and reinvested in the business as stockholders could have earned on alternative
investments of equivalent risk. As mentioned above, after-tax considerations are irrelevant to
equity securities because dividends are not tax deductible. Arriving at the components of the
formula for the cost of retained earnings can be difficult and potentially subjective.
1.4.1 Three Common Methods of Computing the Cost of Retained Earnings

1. Capital asset pricing model (CAPM)
2. Discounted cash flow (DCF)
3. Bond yield plus risk premium (BYRP)
1.4.2 The Capital Asset Pricing Model (CAPM)

Key Assumptions
yy The cost of retained earnings is equal to the risk-free rate plus a risk premium.
yy The market risk premium is equal to the systematic (nondiversifiable) risks associated
with the overall stock market.
yy The beta coefficient is a numerical representation of the volatility (risk) of the stock
relative to the volatility of the overall market. A beta equal to 1 means the stock is as
volatile as the market, and a beta greater (less) than 1 means the stock is more (less)
volatile than the market.
yy The risk premium is the stock's beta coefficient multiplied by the market risk premium.
yy The market risk premium is the market rate of return minus the risk-free rate.
Cost of Retained Earnings Formula (CAPM)
Cost of retained earnings = Rce = Rf + β[Rm − Rf ]

Where:
Rm = Market return
Example 4 Capital Asset Pricing Model
Facts: Assume that a firm's beta is 1.25, the risk-free rate is 8.75 percent, and the market
rate of return is 14.25 percent.
Required: Compute the cost of retained earnings using the capital asset pricing model (CAPM).
Solution: Cost of retained earnings using the capital asset pricing model (CAPM):
Cost of retained earnings = Rce = Rf + β[Rm − Rf—]
= 0.0875 + [1.25 × (0.1425 − 0.0875)]
= 0.0875 + [1.25 × 0.0550]
= 0.0875 + 0.0688
= 0.1563 = 15.63%
1.4.3 Discounted Cash Flow (DCF)

Key Assumptions
Stocks are normally in equilibrium relative to risk and return.
The estimated expected rate of return will yield an estimated required rate of return.
The expected growth rate may be based on projections of past growth rates, a retention
growth model, or analysts' forecasts.
Formula
D1
Cost of retained earnings = + g
P0
Where:
P0 = Current market value or price of the outstanding common stock
D1 = The dividend per share expected at the end of one year
g = The constant rate of growth in dividends

PART 2 UNIT
Example 5 Discounted Cash Flow
Facts: Assume that a firm is a constant growth firm that just paid an annual common stock
dividend of $2.00, has a dividend growth rate of 7.5 percent, and a current market price for
common stock of $25.25 per share.
Required: Compute the cost of retained earnings using the discounted cash flow
(DCF) method.
Solution: Compute the dividend per share expected at the end of the year as follows:
D1 = D0 × (1 + g)
D1 = $2.00 × (1 + 0.075)
D1 = $2.00 × 1.075
D1 = $2.15
Cost of retained earnings using the discounted cash flow (DCF) method:
Cost of retained earnings = (D1 / P0) + g
= ($2.15 / $25.25) + 0.075
= 0.0851 + 0.075
= 0.1601 = 16.01%
1.4.4 The Bond Yield Plus Risk Premium (BYRP)

Key Assumptions
Equity and debt security values are comparable before taxes.
Risks are associated with both the individual firm and the state of the economy. Risk
premiums depend on nondiversifiable risk.
Risk estimation can be derived by using a market analysts' survey approach or by
subtracting the yield on an average (A-rated) corporate long-term bond from an
estimate of the return on the equity market.
Formula
Cost of retained earnings = Pretax cost of long-term debt + Market risk premium
Example 6 Bond Yield Plus Risk Premium
Facts: Assume that a firm has estimated its market risk premium at 4.5 percent and has
determined that the yield to maturity on its own bonds is 11.34 percent.
Required: Compute the cost of retained earnings using the bond yield plus risk premium
(BYRP) method.
Solution: Cost of retained earnings using the bond yield plus risk premium method:
Cost of retained earnings = Firm's own bond yield + Market risk premium
= 0.1134 + 0.045
= 0.1584 = 15.84%
1.4.5 Comparison of the CAPM, DCF, and BYRP Methods

Each method is a valid method of calculating the cost of retained earnings.
The average of the three cost amounts could be used as the estimate of the cost of retained
earnings if there is sufficient consistency in the results of the three methods.
Example 7 Cost of Retained Earnings
Facts: The cost of retained earnings under:

CAPM method = 15.63%
DCF method = 16.01%
BYRP method = 15.84%
Required: Compute the average cost of retained earnings.
Solution: Average cost of retained earnings:
(CAPM + DCF + BYRP)
Average =
3
(15.63% + 16.01% + 15.84%)
=
3
= 15.83%
1.5 Optimal Capital Structure

The optimal cost of capital is the ratio of debt to equity that produces the lowest WACC.
Required rates of return demanded by debt and equity holders fluctuate as the ratio of debt to
equity changes. At some point as debt to equity increases, leverage becomes more pronounced
and debtors will demand a greater return for the high level of default risk. In addition, equity
holders also will require a greater return due to the negative effect of high leverage on their
potential future cash flows.
1.5.1 Determination of Lowest WACC

The following graph displays an example of the cost of using equity financing, the cost of using
debt financing, and the resulting WACC as debt and equity conditions change.

PART 2 UNIT
In this example, the firm achieves its lowest WACC when its debt-to-equity ratio is at 4.0.
DETERM IN ATION OF LOWE S T WA C C

Cost of Capital
18.0% Cost of Equity
WACC
16.0%
Cost of Debt
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
1.0 1.5 2.0 2.5 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 Debt-to-Equity Ratio
1.6 Application to Capital Budgeting LOS 2B2t
Generally, new projects are funded by sources of capital that maintain the optimum capital
structure (ratio of debt2B_Determination of Lowest
to equity) and meet Wacc
or exceed the hurdle rate implied by its cost. The
historic weighted average cost of capital may not be appropriate for use as a discount rate for
a new capital project unless the project carries the same risk as the corporation and results in
identical leveraging characteristics.
1.6.1 Marginal Cost of Capital LOS 2B2s

Whereas the weighted average cost of capital is based on the cost of debt and equity already
issued, the marginal cost of capital is the weighted average cost of an additional dollar raised to
finance a company's investments. The marginal cost of capital is a composite (weighted) rate of
return that is required by shareholders and debtholders to finance new investments made by
the company.
The marginal cost of capital increases as the company raises additional funds. The increase in
marginal cost of capital occurs in steps. A company investing in a new project can use retained
earnings and maintain its current capital structure. However, once capital requirements exceed
available retained earnings, the marginal cost of capital increases as the company issues new
debt and/or new equity.
1.6.2 Capital Investment Decisions LOS 2B2u

A new investment is considered feasible only if the expected rate of return is higher than the LOS 2B2v
marginal cost of new capital raised to fund the investment.
Marginal Cost of Capital, Tax Rates,

Example 8
and Investment Decisions
Facts: The management of a company is considering several projects to undertake in the

next financial year. All projects have the same risk profile. The results of the evaluation are
as follows:
Project Required Investment Expected Rate of Return

Project A $4,000,000 8.80%
Project B $2,000,000 19.40%
Project C $6,000,000 12.20%
Project D $4,000,000 10.70%
Project E $3,000,000 7.80%
Project F $5,000,000 17.50%
The following schedule shows the expected cost of debt and cost of equity for the company:
Amount of Cumulative After-Tax Cost of Debt = Amount of Cumulative Cost of

New Debt (in millions) Pretax × (1 – Income tax rate) New Equity (in millions) Equity
New debt ≤ $10 8.57% × (1 – 30%) = 6% New equity ≤ $10 12%
$10 < New debt <$20 11.43% × (1 – 30%) = 8% $10 < New equity < $20 16%
New debt ≥ $20 14.29% × (1 – 30%) = 10% New equity ≥ $20 18%
The company wants to maintain a capital structure of 50 percent debt and 50 percent equity.
Required:
1. What projects should the company invest in if the tax rate is 30 percent?
2. Will the decision be any different if the income tax rate is 20 percent?
Solution:
1. Because company management prefers projects with higher returns, the first step is
to arrange the projects in descending order based on the expected rate of return of
each investment:
Cumulative Required
Project Required Investment Investment Expected Rate of Return
Project B $2,000,000 $ 2,000,000 19.40%
Project F $5,000,000 $ 7,000,000 17.50%
Project C $6,000,000 $13,000,000 12.20%
Project D $4,000,000 $17,000,000 10.70%
Project A $4,000,000 $21,000,000 8.80%
Project E $3,000,000 $24,000,000 7.80%
(continued)

PART 2 UNIT
(continued)
The weighted average cost of capital is determined for the different levels of financing
as follows:
For the first $10,000,000 the marginal WACC = (50% × 6%) + (50% × 12%) = 9%
For the second $10,000,000 the marginal WACC = (50% × 8%) + (50% × 16%) = 12%
For all additional capital the marginal WACC = (50% × 10%) + (50% × 18%) = 14%
According to the above calculations, only projects B, F, and C are viable and will be
selected by the company's management. The cumulative amount needed to finance
these investments is $13,000,000. The first $10,000,000 cumulative increment of
investments will have a cost of capital of 9.00 percent; the next $3,000,000 will have a
cost of capital of 12.00 percent. The three selected projects each have an expected rate
of return that are higher than the marginal cost of capital. Projects D, A, and E will not
be undertaken because each of their expected rates of return is less than the marginal
cost of capital needed to finance those projects.
2. The following schedule shows the expected cost of debt and cost of equity for the
company if the income tax rate is 20 percent:
Amount of Cumulative After-Tax Cost of Debt = Amount of Cumulative Cost of

New Debt (in millions) Pretax × (1 – Tax rate) New Equity (in millions) Equity
New debt ≤ $10 8.57% × (1 – 20%) = 6.86% New equity ≤ $10 12.00%
$10 < New debt <$20 11.43% × (1 – 20%) = 9.14% $10 < New equity < $20 16.00%
New debt ≥ $20 14.29% × (1 – 20%) = 11.43% New equity ≥ $20 18.00%
The weighted average cost of capital is determined for the different levels of financing
as follows:
For the first $10,000,000
= (50% × 6.86%) + (50% × 12.00%) = 9.43%
the marginal WACC
For the second $10,000,000

= (50% × 9.14%) + (50% × 16.00%) = 12.57%
the marginal WACC
For all additional capital

= (50% × 11.43%) + (50% × 18.00%) = 14.72%
the marginal WACC
Only projects B and F are viable and will be selected by the company's management.
The cumulative amount needed to finance these two investments is $7,000,000. The
first $10,000,000 in incremental investment has a cost of capital of 9.43 percent; these
two projects each have an expected rate of return that is higher than the marginal
cost of capital. Projects C, D, A, and E will not be undertaken because the expected
rate of return for each is less than the marginal cost of capital needed to finance
those projects.
LOS 2B2h 2 Derivatives
A derivative security derives its value from the price of another asset or another liability.
Derivatives are useful for risk management because the fair values or cash flows of these
instruments can be used to hedge or offset the changes in fair values or cash flows of other
assets or liabilities that are at risk. Derivatives may also be used for speculative purposes,
with a goal of profiting from fluctuations in the value of the underlying asset or liability and/or
fluctuations in the price of the derivative itself.
2.1 Definitions and Concepts

2.1.1 Derivative Instrument
A derivative instrument is a financial instrument that derives its value from the value of some
other instrument and has all three of the following characteristics:
One or more underlyings and one or more notional amounts or payment provisions
(or both);
It requires no initial net investment or one that is smaller than would be required for other
types of similar contracts; and
Its terms require or permit a net settlement (i.e., it can be settled for cash in lieu of physical
delivery), or it can readily be settled net outside the contract (e.g., on an exchange) or
by delivery of an asset that gives substantially the same results (e.g., an asset readily
convertible to cash).
2.1.2 Underlying
An underlying is a specified price, rate, or other variable (e.g., interest rate, security or
commodity price, foreign exchange rate, index of prices or rates, etc.), including a scheduled
event (e.g., a payment under contract) that may or may not occur.
2.1.3 Notional Amount

A notional amount is a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.).
2.1.4 Value or Settlement Amount

The value or settlement amount of a derivative is the amount determined by the multiplication
(or other arithmetical interaction) of the notional amount and the underlying. For example,
shares of stock times the price per share.
2.1.5 Payment Provision

A payment provision is a specified (fixed) or determinable settlement that is to be made if the
underlying behaves in a specified way.
2.1.6 Hedging
Hedging is the use of a derivative to offset anticipated losses or to reduce earnings volatility.
When a hedge is effective, the change in the value of the derivative offsets the change in value of
a hedged item or the cash flows of the hedged item.
LOS 2B2j 2.1.7 Long Position

A long position is a commitment to purchase an asset in the future at an agreed upon price. The
holder of a long position benefits when the underlying asset's price increases above the agreed
upon purchase price.

PART 2 UNIT
2.1.8 Short Position

A short position is a commitment to sell an asset in the future at an agreed upon price. The
holder of a short position benefits when the underlying asset's price decreases below the agreed
upon sales price.
Illustration 1 Derivative Positions
An investor holds a long position in a derivative contract that locks in a price of $15 for the
purchase of an asset. If the price of the underlying asset goes up to $20, the investor can
pay $15 to the seller, take possession of the underlying asset, and then immediately sell
that asset for $20 and earn a $5 profit. Or, more commonly, the seller (who holds a short
position in the contract) will settle by paying the investor $5 rather than deliver the asset to
the investor.
If, on the other hand, the price of the asset falls below $15, the investor (long position) does
not benefit, but the seller (short position) does benefit. For example, if the price of the asset
drops to $12, the investor will be required to pay the seller the $3 difference.
2.2 Forward Commitments LOS 2B2i
Forward commitments allow the holder to lock in a price today to buy or sell an underlying asset
at some point in the future. There are three types of forward commitments: forward contracts,
futures contracts, and swaps.
2.2.1 Forward Contracts

A forward contract is a customized, negotiated agreement between two parties to exchange a
commodity, currency, or other asset at a specified price on a specified future date.
Characteristics of forward contracts include:
Contracts are customized.
There is no active secondary market.
Contracts expire and must be settled on a specified date in the future.
Contracts require either delivery of the underlying asset or cash settlement.
Forward contracts are essentially unregulated and have no credit guarantees.
2.2.2 Futures Contracts

A futures contract is a standardized agreement between two parties to exchange a commodity,
currency, or other asset at a specified price on a specified future date. Futures contracts are
traded on exchanges. Clearinghouses record all the transactions and guarantee timely payments
on the futures contracts and therefore eliminate much of the risk associated with potential
default.
The two basic types of futures contracts are commodity futures and financial futures. Examples
of commodities traded in commodity futures markets are agricultural products, metals, energy
products, and forest products. A financial futures contract is a contract to buy or sell a specific
financial instrument (such as Treasury bills, certificates of deposit, or foreign currencies) at a
specific future date and at a specified price.
Characteristics of future contracts include the following:

Contracts are standardized.
Contracts are exchange-traded with an active secondary market.
Contracts require margin deposit, mark to market, and daily settlement based on a
settlement price.
Buyers and sellers of futures contracts often settle their positions in cash on the delivery
date rather than purchase or sell the underlying asset.
Contracts have no default (counterparty) risk as they are guaranteed through the exchange
clearinghouse.
Illustration 2 Futures Contract
On January 1, Year 1, Jones Company entered into a long position on a futures contract in
which it agreed to buy €100,000 for $1.67/€ on April 1, Year 1. On April 1, Year 1, the spot
rate was $1.74/€.
Underlying: $1.67/€
Notional amount: €100,000
Initial net investment: $0 (no cost to enter into the futures contract)
Settlement amount: $1.67/€ × €100,000 = $167,000
Derivatives generally have multiple settlement options. This derivative could be settled in
the following ways:
1. Jones could pay $167,000 and receive €100,000. Jones could then realize a $7,000 gain
by selling the €100,000 at the spot rate of $1.74/€ ($174,000 – $167,000 = $7,000).
2. The other party to the futures contract could pay $7,000 to Jones. This is a net
settlement. Jones could then purchase the €100,000 for $174,000 and still show a net
outflow of $167,000 ($174,000 purchase price – $7,000 gain).
If the spot rate on April 1 had been $1.59/€, Jones would have realized loss on the contract
because Jones would have paid $167,000 for €100,000 that could have been purchased
outside the futures contract for only $159,000 (€100,000 × $1.59/€).
LOS 2B2n 2.2.3 Swaps

A swap is a customized contract in which two parties agree to exchange a series of cash flows.
Swaps can be based on interest rates, currency exchange rates, commodity prices, or equity
prices. Parties enter a swaps contract to change their cash position without having to adjust
their original holdings. A swap agreement is equivalent to a series of forward contracts.
An interest rate swap is used when one party wants to receive a variable interest rate payment
while the other party wants to limit risk by receiving a fixed-rate payment.

PART 2 UNIT
Illustration 3 Interest Rate Swap
East Company has invested in $1,000,000 of 8 percent fixed rate bonds. East expects
interest rates to increase during the next 12 months. On January 1, East Company enters
into an interest rate swap with West Company in which East Company agrees to make to
West Company a series of future payments equal to the fixed interest rate of 8 percent on
the principal amount of $1,000,000. In exchange, West Company agrees to make to East
Company a series of future payments equal to a floating interest rate of SOFR* + 1 percent
on the principal amount of $1,000,000.
Underlying: East Company—8%, and West Company—SOFR + 1%
Notional amount: $1,000,000
Initial net investment: $0 (no cost to enter into the swap contract)
Settlement amount: East Company—8% × $1,000,000 = $80,000, and West
Company—(SOFR + 1%) × $1,000,000
On the first settlement date, SOFR was 8.5 percent and the following amounts were exchanged:
$80,000
East Company West Company
$95,000 = $1,000,000 × 9.5%

the following ways:
1. East Company could pay $80,000 to West Company, and West Company could pay
$95,000 to East Company.
2. West Company could pay $15,000 ($95,000 − $80,000) to East Company. This is a net
settlement and is the most likely form of settlement in this example.
*SOFR (secured overnight funding rate) is a benchmark median of rates that market
participants pay to borrow cash on an overnight basis, using U.S. Treasuries as collateral.
Foreign currency (FX) swaps are designed to allow each party to gain exposure to a currency
other than each party's own. Payments in one currency are swapped for payments in another
currency at an agreed upon exchange rate.
Example 9 Currency Swap
Facts: In order to hedge its future raw material purchases for its operations, in Poland, a
U.S. manufacturing firm (U.S. counterparty) agrees to enter into a currency swap with a
Polish multinational firm (foreign counterparty) whereby the U.S. counterparty agrees to
provide the following quarterly notional amounts in U.S. dollars to the foreign counterparty
in exchange for the following quarterly notional amounts in Polish zlotys.
Quarter End U.S. Counterparty Receives Foreign Counterparty Receives
1 1,500,000 zloty 500,000 USD
2 900,000 zloty 300,000 USD
3 750,000 zloty 250,000 USD
4 1,800,000 zloty 600,000 USD
Assume that the exchange rates are 3.25 zloty/1.0 USD and 2.85 zloty/1.0 USD at the end of
quarter 1 and quarter 2, respectively.
Required: Calculate the U.S. manufacturing firm's foreign currency gain or loss recorded at
the end of the first and second quarters on the currency swap.
Solution: The U.S. manufacturing firm (U.S. counterparty) entered into a fixed notional
amount currency swap with a foreign counterparty when the exchange rates were 3.0
zloty/1.0 USD. Because the contractual quarterly payments made in U.S. dollars to the
Polish firm are fixed at that exchange rate throughout the swap, any movement up or
down of these two exchange rates will result in a foreign currency gain or loss.
In the first quarter, the U.S. dollar appreciates versus the Polish zloty, so the U.S.
counterparty incurs a foreign currency loss. Under the terms of the currency swap, the U.S.
counterparty pays 500,000 U.S. dollars and receives 1,500,000 zloty (based on an exchange
rate of 3.0 zloty/1.0 USD). The 1,500,000 zloty received are worth only 461,538 U.S. dollars
based on the end of quarter exchange rate of 3.25 zloty/1.0 USD:
1,500,000 / 3.25 = 461,538 USD
Paying 500,000 U.S. dollars and receiving zloty worth only 463,538 U.S. dollars represents a
loss of 38,462 U.S. dollars:
500,000 – 461,538 = 38,462 USD
In the second quarter, the U.S. dollar depreciates versus the Polish zloty. As a result of
the swap, the U.S. counterparty incurs a foreign currency gain. The U.S. counterparty pays
300,000 U.S. dollars and receives 900,000 zloty. The value in U.S. dollars of 900,000 zloty
based on the end of quarter exchange rate of 2.85 zloty/1.0 USD is 315,789 U.S. dollars.
900,000 / 2.85 = 315,789
Paying 300,000 U.S. dollars and receiving zloty worth 315,789 U.S. dollars represents a gain
of 15,789 in U.S. dollars:
315,789 – 300,000 = 15,789 USD

PART 2 UNIT
Pass Key
Derivatives are a zero-sum game. When one party wins, the other party loses. If, for
example, a derivative position moves in the favor of the option holder, the derivative
position has moved against the option writer.
2.3 Option Contracts LOS 2B2k
An option is a contract between two parties that gives one party the right, but not the obligation, LOS 2B2l
to buy or sell an underlying asset to the other party at a specified price (the strike price or
exercise price) during a specified period of time. The option buyer, or holder, must pay a
premium to the option seller, or writer, to enter into the option contract. A call option gives the
holder the right to buy from the option writer at a specified price during a specified period of
time. A put option gives the holder the right to sell to the option writer at a specified price during
a specified period of time.
Illustration 4 Put Option
On January 1, Year 1, Roberts Company purchased a put option on the stock of Buy Big Inc.
The option gave Roberts the right to sell 10,000 shares of Buy Big stock at $75/share during
the next 30 days. Roberts paid a premium of $2/share to enter into the option. Roberts
exercised the option when Buy Big stock was selling for $69/share.
Underlying: $75/share
Notional amount: 10,000 shares of Buy Big stock
Initial net investment: $2/share × 10,000 shares = $20,000
Settlement amount: $75/share × 10,000 shares = $750,000
the following ways:
1. Roberts could deliver 10,000 shares of Big Buy stock to the option writer in exchange
for $750,000. Note that these shares could either be shares already owned by Roberts,
or shares purchased by Roberts for $690,000 ($69/share market price × 10,000 shares)
and then delivered to the option writer. Either way, Roberts realizes a gain of $60,000
[($75/share exercise price – $69/share market price) × 10,000 shares]. The option writer
realizes a loss of $60,000 because the option writer must pay $75/share for stock with a
market value of $69/share.
2. The option writer could pay Roberts $60,000 to settle the contract. This is a net settlement.
Because $20,000 was paid to purchase the put option, Roberts will report a net gain of
$40,000 ($60,000 gain – $20,000 premium). If the stock price had remained above $75/
share during the 30-day period, Roberts would not have exercised the option.
LOS 2B2m 2.3.1 Option Valuation

The intrinsic value of an option is the difference between the strike price (exercise price) and the
underlying asset price. The intrinsic value can only be stated as zero or positive. Note that an
option can still have market value even if the intrinsic value is zero. An option is considered "in-
the-money" if the intrinsic value is positive, while the option is "out-of-the-money" if the current
price of the underlying asset is greater than the option's strike price.
Illustration 5 Call Options
An investor is evaluating two call options:

Option 1: Strike price of $10 and an underlying stock price of $13. The intrinsic value for
this option is equal to $3 = $13 price of underlying stock – $10 option strike price. The
option premium will be greater than $3, depending on the time remaining until expiration.
Option 2: Strike price of $10 and an underlying stock price of $8. The intrinsic value for
this option is equal to $0. Although the stock price of $8 is less than the strike price of
$10, the intrinsic value cannot be stated below zero.
The Black-Scholes model is used to determine the value of a call option or put option. Six inputs
are used in the model. Although the model calculation itself is outside of the scope of the exam,
the inputs and their effect on the value of the option are important to understand. Note that the
impact with respect to the first four inputs has opposite effects on calls and puts.
Change in Impact on the Impact on the

Inputs Input Value of Call Value of a Put
Current price of the underlying asset Increases Higher Lower
Option strike (exercise) price Increases Lower Higher
Risk-free interest rate Higher Higher Lower
Dividends Higher Lower Higher
Time to expiration Longer Higher Higher
Underlying asset volatility Higher Higher Higher
LOS 2B2o 3 Other Sources of Long-Term Financing
Entities use other sources of long-term financing, including leases, convertible securities,
and warrants.
3.1 Leases
A lease is a contractual agreement between a lessor and a lessee that provides the lessee the
right to use property owned by the lessor for a specified period of time in return for periodic
cash payments (rents) from the lessee to the lessor.

PART 2 UNIT
Under U.S. GAAP, the lessee must record (capitalize) the present value of future payments as
a right-of-use (ROU) asset and must also record a corresponding lease liability when the lease
meets at least one of the following criteria:
Ownership of the underlying asset transfers from the lessor to the lessee by the end of the
lease term.
The lessee has the written option to purchase the underlying asset; the option is one that
the lessee is "reasonably certain" to exercise.
The net present value of all lease payments plus the net present value of any guaranteed
residual value are equal to or substantially exceed the underlying asset's fair value.
The term of the lease represents the major part of the economic life remaining for the
underlying asset.
The asset is specialized such that it will not have an expected, alternative use to the lessor
when the lease term ends.
Lease requirements under IFRS differ from U.S. GAAP in a few critical areas:
Lessees do not have to record leased assets under IFRS if the value is less than $5,000,
whereas GAAP has no dollar threshold.
IFRS requires lessees to account for only finance leases and not for operating leases,
whereas GAAP has two classifications (operating and finance).
3.2 Convertible Securities

Convertible bonds can be converted by the bondholder into shares of the issuer's common stock
during some point in the bond's life. If the value of the underlying stock increases significantly,
a bondholder may convert the bond and receive shares of the underlying stock based on a
preestablished conversion ratio. Due to the potential benefit to the holder, the interest rate paid
on a convertible bond is usually lower and represents a less expensive method of financing for
the issuing company.
Convertible preferred shares provide the owner with the option of converting the preferred
shares into common shares. A preferred shareholder will benefit not only from preferential
dividend payments but also from the potential to benefit from capital appreciation in common
stock. This benefit allows the issuer to offer a lower dividend rate than similar securities without
the conversion feature.
3.3 Warrants
Warrants provide their holders the option to buy shares of stock during a future period at an
established exercise price (strike price). The issuing company receives new capital only if the
holders of the warrants exercise the warrants. Warrants can be offered either as standalone
products or as an attachment to other offerings, such as bonds.
A warrant allows the issuing company to reduce the interest rate on the bond because the
buyers of the bonds are receiving the value of the warrant in addition to the bond. Usually,
warrants included with bonds are detachable warrants. Detachable warrants allow the holder
to separate the two securities (the bond and the warrants) and choose to hold or to sell
each independently.
LOS 2B2p 4 Impact of Inflation and Interest Rates on

Financial Instruments
Changes in inflation and interest rates have a direct impact on the prices of financial instruments.
4.1 Nominal and Real Interest Rates

4.1.1 Nominal Interest Rate
The nominal interest rate is the amount of interest paid (or earned) measured in current dollars.
When the economy experiences inflation, nominal interest rates are not a good measure of how
much borrowers really pay or lenders really receive when they take out or make a loan. A more
accurate measure of the interest borrowers pay or lenders receive is the real interest rate.
4.1.2 Real Interest Rate

The real interest rate is defined as the nominal interest rate minus the inflation rate. It is a
measure of the purchasing power of interest earned or paid.
Real interest rate = Nominal interest rate – Inflation rate
Illustration 6 Real Interest Rate
If you take out a loan with a 10 percent nominal interest rate and the inflation rate is
3 percent, then your real interest rate is only 7 percent. That is, after adjusting for the fact
that the dollars with which you will repay the loan in the future are worth less than current
dollars due to inflation, you are really only paying 7 percent to borrow the money.
4.1.3 Relationship Between Nominal Interest Rates and Inflation

Nominal interest rates and inflation naturally move together. When the inflation rate increases,
so does the nominal interest rate. The relationship between nominal interest rates and inflation
may be shown by rearranging the above equation for real interest rates as follows:
Nominal interest rate = Real interest rate + Inflation rate
4.2 Impact on Financial Instruments

As interest rates rise, the prices of financial instruments fall for several reasons:
Rising interest rates increase the discount rate used to value future cash flows, which lowers
the present value of an investment.
Rising rates lead to companies and individuals borrowing less and spending less, which
slows economic activity, reduces demand, reduces sales and profits, and lowers stock prices.
Fixed-rate bonds become less attractive as rates in the marketplace increase because
increasing market rates lower the value of these bonds.
Higher interest rates allow investors to earn more on their idle cash, but cash that is already
allocated to stock and bond investments do not earn this higher interest.

PART 2 UNIT
An investor has a long put option on XYZ stock and a long call option on ABC, both expiring
in 90 days. If interest rates decrease, what will happen to the values of the put position and
the call position from the investor's perspective?
a. The values of the put and the call will both be lower.
b. The values of the put and the call will both be higher.
c. The put value will be higher while the call value will be lower.
d. The put value will be lower while the call value will be higher.
Which of the following statements comparing forward contracts to futures contracts is

most accurate?
a. Credit risk is mitigated in a forward contract due to the presence of a
clearinghouse.
b. Both parties to a forward contract and both parties to a future contract are
obligated by the terms of the contract.
c. Forward contracts require posting initial margin, whereas futures do not require
any upfront payment.
d. Forward contracts have standardized terms, whereas futures contracts have terms
negotiated for each contract.
On June 1, an investor shorted five three-month forward contracts each for 500 bushels of
wheat for $5.20 per bushel. The spot price on September 1 was $4.70 per bushel.
As a result of the transaction the investor will record a:
a. Loss of $250.
b. Gain of $250.
c. Loss of $1,250.
d. Gain of $1,250.
NOTES

4
MODULE
B.3. Raising Capital

Part 2
Unit 2
CMA LOS Reference: Part 2—Section B.3. Raising Capital

a. identify the characteristics of the different types of financial markets and exchanges
b. demonstrate an understanding of the concept of market efficiency, including the
strong form, semi-strong form, and weak form of market efficiency
c. describe the role of the credit rating agencies
d. demonstrate an understanding of the roles of investment banks, including
underwriting, advice, and trading
e. define initial public offerings (IPOs)
f. define subsequent/secondary offerings
g. describe lease financing, explain its benefits and disadvantages, and calculate the net
advantage to leasing using discounted cash flow concepts
h. define the different types of dividends, including cash dividends, stock dividends, and
stock splits
i. identify and discuss the factors that influence the dividend policy of a firm
j. demonstrate an understanding of the dividend payment process for both common and
preferred stock
k. define share repurchase and explain why a firm would repurchase its stock
l. define insider trading and explain why it is illegal
1 Financial Markets and Regulations LOS 2B3a
The term financial market refers to any marketplace in which securities and other financial
instruments are bought and sold. These markets are necessary because they facilitate the
allocation of resources, create liquidity for businesses, and provide a place of exchange for
buyers and sellers. Investors or lenders seeking to earn a return on excess funds use financial
markets to invest in or lend to businesses that need funds.
Securities traded in financial markets include equity securities, debt securities, and derivatives.
Primary markets are those markets in which securities are initially sold in transactions known
as initial public offerings (IPOs). Secondary markets are exchanges where buyers and sellers of
previously sold securities come together to buy and sell securities subsequent to the IPO.

4 B.3. Raising Capital PART 2 UNIT 2
1.1 Types of Financial Markets

Financial markets can be classified as either capital markets or money markets. Long-term
securities that have either no maturity or a maturity greater than one year are traded in
capital markets. These securities include stocks (equity securities) and bonds (debt securities).
Short‑term debt securities that mature in less than one year are traded in money markets.
Financial markets can be classified based on the type of securities traded as follows:
1) exchanges, 2) bond and fixed income securities markets, 3) government securities markets,
4) money markets, 5) federal fund markets, 6) over-the-counter markets, 7) foreign exchange
markets, and 8) derivatives markets.
1.1.1 Exchanges
Exchanges can be either physical or electronic.
Originally, physical exchanges, like the New York Stock Exchange, were auction markets
where sellers and buyers came together in a physical location to execute transactions.
Today, most exchanges offer their services electronically.
Electronic exchanges are often used by smaller companies and by dealers buying and selling
for their own accounts who then resell the securities to profit from the difference (the
spread) between the selling price (ask price) and the buying price (bid price).
1.1.2 Bond and Fixed Income Securities Markets

Fixed income securities markets are networks of dealers who electronically buy and sell bonds.
Fixed income securities are quoted in the market at a percentage of the security's face value. For
example, a bond with a face value of $1,000 that is quoted in the marketplace at 102 is sold for
102 percent of face ($1,020 plus accrued interest). If quoted at 97, then the bond's market price
is $970 (plus accrued interest).
1.1.3 Government Securities Markets

Government securities include short-term U. S. Treasury bills (also called T-bills), Treasury notes
(up to a 10-year maturity), and Treasury bonds (up to a 40-year maturity). These securities can
be sold directly by the government entity or in government securities markets. After government
securities are issued, they are traded on secondary markets.
Treasury bills are sold at a discount and their face value is repaid at maturity. The difference
between the discounted selling price and the face value is the interest earned by the investor.
All other government securities periodically pay a stated interest rate but are sold at a price that
effectively yields the market interest rate. The government pays back the face value when the
bond matures.
1.1.4 Money Markets

Money market transactions are generally in large denominations, making the market attractive
mostly to wealthy individuals or large companies. Generally, individual investors access the
money market by investing in pools of investment funds called money market funds. Money
market funds accumulate large volumes of low-dollar investments from less affluent investors
and generate enough funds to invest in more expensive securities. The short-term securities
traded on money markets include Treasury bills, commercial paper, bankers' acceptance,
Eurodollars, and repurchase agreements representing short-term loans to firms in need
of funds.
2–56 Module 4 B.3. Raising

© Becker Professional Education Corporation. All rights Capital
reserved.
PART 2 UNIT
4 2 B.3. Raising Capital
1.1.5 Federal Funds Market

Governmental banking authorities (the Federal Reserve in the United States, and the
central banks in other countries) require all other banks to make a minimum deposit at
the government's bank at the end of each business day. Amounts kept on reserve at the
government's bank do not earn any interest. Any bank that has more cash reserves than the
amount required to be deposited overnight can lend the excess to other banks that are unable
to meet the required reserve. In this overnight transaction, the lending bank earns a specified
interest rate, known as the overnight bank funding rate (OBFR), on the temporary funds used to
cover the reserves for the borrowing bank.
1.1.6 Over-the-Counter Market

Over-the-counter (OTC) markets bring together dealers who sell and buy securities electronically.
There is no physical location for OTC markets and the buy and sell prices for trades are not
published. These markets are similar to exchange-traded markets except for the absence of
a physical exchange to act as a facilitator or a guarantor. The absence of a physical exchange
means that there may be less transparency and liquidity in OTC markets.
1.1.7 Foreign Exchange Market

In a foreign exchange market, also called forex or an FX market, financial intermediaries use
cash to buy and sell currencies. Currencies trade in pairs (two different currencies for each
transaction) setting relative currency prices for all monetary denominations. Foreign currency
exchange rates can be quoted two ways: direct and indirect. Direct exchange rate quotation is
when one unit of foreign currency is expressed in terms of the domestic currency. The indirect
exchange rate quotation is when one unit of domestic currency is expressed in terms of a
foreign currency.
1.1.8 Derivatives Markets

Derivatives are traded on derivative markets. Derivatives are financial instruments that derive
their value from an underlying asset, called the underlying. The underlying could be stocks,
bonds, hybrid securities, commodities, or currencies. Common derivatives include futures
contracts, forward contacts, and options. Most derivatives, including forwards, swaps, and
complex options, are traded over-the-counter. Plain vanilla options and futures are traded on
specialized exchanges.
2 Market Efficiency LOS 2B3b
Market efficiency refers to how well current market prices reflect all available, relevant
information. If a market is efficient, then no single investor can make above-normal profits
because everyone trading in the market has the same information, which is reflected in the
market price of the security. As more information becomes available, the market becomes more
efficient with fewer opportunities to make above-average rates of return.
There are three market efficiency hypotheses:
1. Weak Form Efficiency: The market prices of securities reflect only historical information
regarding trends in price and volume. Analysts often use technical analysis by analyzing
historical trends to predict future market movements. In the weak-form efficient market
hypothesis, a technical analyst depending on analyzing trends in historical stock prices and
changes in trade volume cannot make abnormal or superior profits compared with other
investors because that information is already reflected in the market prices of the securities.

2. Semi-Strong Form Efficiency: The market prices reflect not only historical price and
volume trends but also other published information, including earnings announcements,
new product announcements, and economic news. Analysts use this type of information to
conduct fundamental analysis, which involves analyzing a company's core financial statements
(balance sheet, income statement, statement of cash flows), as well as the company's industry,
competition, and historical performance given the economic circumstances. As the information
becomes public information, it will immediately be reflected in the market prices of the
securities and, as a result, superior risk-adjusted returns are not achievable. New information
comes to the market independent from other information and in a random fashion.
3. Strong Form Efficiency: The strong-form market efficiency hypothesis states that market
prices reflect all possible information, including private information usually known only to
insiders (individuals with privileged information). With strong form efficiency, all information
including private information is reflected in market prices, which means that an investor
would not be able to achieve an above-average return making trades using such information.
Pass Key
Information Reflected in Market Prices

Historical Public Private
Market Efficiency Hypothesis Information Information Information
Weak Yes No No
Semi-strong Yes Yes No
Strong Yes Yes Yes
LOS 2B3l 2.1 Insider Trading

Insider trading is the buying or selling of a publicly traded stock based on material, nonpublic
information. Insiders can be a company's officers, directors, owners with a significant portion
of a class of the company's equity securities, and/or government employees with access to
confidential information. An insider could also be someone less directly tied to a company, such
as a vendor or relative of a company's officers. Insiders have the ability to obtain above-average
profits by trading the company's stock before the privileged information becomes public
because that information is not yet reflected in the stock's price.
The laws of many countries state that insider trading is illegal. Insiders violate their fiduciary
duty to shareholders when they trade for their own personal financial benefit. For markets to be
fair, information must be made public so that all investors will have an equal opportunity to earn
reasonable profits in the market.
Illustration 1 Insider Trading
A corporation's attorney worked to obtain a new patent for the corporation and filed the
documents on behalf of the company. The attorney purchased 100,000 shares before the
patent was awarded and made public. The attorney knows that when the patent is awarded,
the price of the company's stock will increase. The attorney's purchase of the 100,000 shares
of stock is illegal in many countries because the attorney used private, material information
for personal benefit before the information became public knowledge.

reserved.
PART 2 UNIT
Pass Key
Trading based on private information that makes abnormal profits for the trader is an
indicator that markets are not strong-form efficient. The private information is not reflected
in market prices.
3 Investment Banks LOS 2B3d
Investment banks are banks that specialize in facilitating investment transactions for companies
seeking to issue new shares of stock or bonds. Investment banks offer advisory services, provide
a platform for selling new securities for businesses, and act as a broker or underwriter of
the sale.
3.1 Advising
An investment bank serving as an advisor provides the following services:
Development of financial models to determine the type of securities to issue and the
issuance price of the securities.
Assist in the development and filing of registration statements such as those required by the
Securities and Exchange Commission (SEC) in the United States when issuers (publicly held
entities) issue new securities.
3.2 Underwriting
When a company seeks to raise funds through the issuance of stocks or bonds, the company
usually approaches an investment bank that sells the securities in the market to investors. This
process performed by the investment bank is called underwriting. The investment bank acts as
either a facilitator that sells to the market for a fee or purchases the issue and then sells it to
the market.
When underwriting, an investment bank may have three roles:
1. Firm Commitment: Under this arrangement, the parties agree that the bank assumes
all the risks regarding the issuance, with the investment bank purchasing and holding
("absorbing") all stocks or bonds that are not sold to the public.
2. Best Efforts: In this arrangement, the investment bank's role is to use the bank's best
efforts to market the securities to the public, but the investment bank has no commitment
to absorb the unsold securities.
3. All or None: The entire issue must be sold in order for the trade to be completed. Under
this arrangement, the investment bank bears little risk and is not responsible for purchasing
the shares if the issuance transaction is canceled.

3.3 Trading
Most investment banks have a trading department to execute stock and bond transactions
for clients.
3.4 Other Services

Many investment banks offer other services, such as wealth management, asset management,
and research. Wealth management involves the implementation of wealth creation and
preservation strategies, along with investment and asset management services. This array of
services often includes a combination of advisory services, risk mitigation through insurance,
investment brokerage, and tax planning.
Investment research includes buy-side research and sell-side research. Buy-side research is
typically focused on providing internal insights for corporations purchasing securities. Buy-side
research provides guidance on companies' financial health, industry position, and projected
performance, which assists buyers making investment decisions. Sell-side research is usually
provided by investment firms selling securities, is a means of providing buyers insights, and
potentially serves as tools of persuasion for institutions selling those securities.
LOS 2B3e 4 Initial Public Offering and Secondary Public Offering
4.1 Initial Public Offerings

Private companies are owned by private entities or individuals and are not required to comply
with the same regulations and reporting standards with which public companies must comply.
When a public company issues new securities to sell to the public, it does so in the primary
market through an investment bank. It issues shares for the first time and makes a public
offering called an initial public offering (IPO). This process is called going public.
Going public requires the company to follow certain procedures, such as filing articles of
incorporation with the SEC; waiting for permission to issue shares; announcing the sale;
distributing a prospectus to interested potential investors; and paying underwriting fees,
attorney's fees, and audit fees.
Taking a company from being privately controlled to publicly controlled results in a substantial
loss of control by the owners of the company. New owners may wish to be involved in running
the business or to be represented on the board of directors. Public companies face increased
regulatory scrutiny, significant reporting requirements, and the potential for more litigation
resulting from dissatisfied or dissenting stockholders.
LOS 2B3f 4.2 Subsequent and Secondary Offerings

A subsequent offering occurs after a company has gone public through an IPO. The subsequent
offering may consist of either newly issued shares or shares that were repurchased from
stockholders by the company (called treasury stock). Newly issued shares make the offering
dilutive, meaning existing shareholders' ownership percentages are reduced due to additional
shares being added to the total of outstanding shares.
A secondary offering occurs when a shareholder or corporation decides to sell some or all of the
interest in the company. The offering is from shareholder to shareholder. Secondary offerings
have no dilutive impact because there is no change in the total shares outstanding.

reserved.
PART 2 UNIT
5 Credit Rating Agencies LOS 2B3c
A credit rating agency is an independent company that analyzes financial and qualitative data to
assess an entity's ability to pay both the interest and principal on debt. Entities may be companies,
state or local governments, non-for-profit organizations, or sovereign nations. Debt instruments
include government bonds, corporate bonds, certificates of deposit, municipal bonds, preferred
stock, or collateralized debt obligations. At the completion of the credit rating agency's analysis,
a grade or rating is given to the entity. A higher rating signals to the market that the entity is less
risky, which allows the entity to borrow from lenders at lower rates of interest.
The major credit rating agencies are Moody's Investors Service, Standard & Poor's (S&P), and
Fitch Ratings. Each agency has a rating system that divides securities into either investment
grade (high-quality bonds) or speculative (junk bonds). The lower the rating, the higher the
interest rate the entity must pay on its debt securities. The higher the rating, the lower the
interest rate on the entity's debt and the lower the entity's cost of capital. Each ratings agency
provides both a short-term credit rating service rating and a long-term credit rating service.
Illustration 2 Rating Agencies and Symbols
Moody's Investors Service Ratings

Long-term credit rating
—Investment grade ranges from highest (Aaa) to lowest (A)
—Speculative grade ranges from higher (Baa) to Lowest (C)
Short-term credit rating
—Investment grade ranges from highest (P-1) to lowest (P-3)
—Speculative grade ranges are classified as not prime (NP)
Standard & Poor's (S&P) Ratings
—Investment grade ranges from highest (AAA) to lowest (BBB)
—Speculative grade ranges from higher (BB) to Lowest (D)
—Investment grade ranges from highest (A-1) to lowest (A-3)
—Speculative grade ranges from highest (B) to lowest (D)
Fitch Ratings
—Investment grade ranges from highest (AAA) to lowest (BBB)
—Speculative grade ranges from higher (BB) to Lowest (D)
—Investment grade ranges from highest (F1) to lowest (F3)
—Speculative grade ranges from highest (B) to lowest (D)

6 Distributions to Shareholders
A dividend is a pro rata distribution by a corporation based on the shares of a particular class of
stock and usually represents a distribution of earnings. Cash dividends are the most common
type of dividend distribution, although there are many other types (covered below). Preferred
stock usually pays a fixed dividend, expressed in dollars or as a percentage.
LOS 2B3j 6.1 The Dividend Payment Process

The dividend payment process is the same whether dividends are declared on preferred stock or
common stock. Three dates are associated with dividend payments:
Date of Declaration: the date the board of directors formally approves a dividend.
On the declaration date, a liability is created (dividends payable) and retained earnings is
reduced (debited).
Date of Record: the date the board of directors specifies as the date the names of the
shareholders to receive the dividend are determined.
Date of Payment: the date on which the dividend is actually disbursed by the corporation
or its paying agent.
6.2 Preferred Stock Dividends

Dividends must be first paid to preferred shareholders before any dividend is paid to common
shareholders. Preferred stock can be cumulative or noncumulative and participating or
nonparticipating.
6.2.1 Cumulative Preferred Stock

The cumulative feature provides that all or part of the preferred dividend not paid in any
year accumulates and must be paid in the future before dividends can be paid to common
shareholders. The accumulated amount is referred to as dividends in arrears. The amount of
dividends in arrears is not a legal liability, but it must be disclosed in total and on a per-share
basis either parenthetically on the balance sheet or in the footnotes.
6.2.2 Noncumulative Preferred Stock

With noncumulative preferred stock, dividends not paid in any year do not accumulate. The
preferred shareholders lose the right to receive dividends that are not declared.
6.2.3 Participating Preferred Stock

The participating feature provides that preferred shareholders share (participate) with common
shareholders in dividends in excess of a specific amount. The participation may be full or
partial. Fully participating means that preferred shareholders participate in excess dividends
without limit. Generally, preferred shareholders receive their preference dividend first, and
then additional dividends are shared between common and preferred shareholders. Partially
participating means preferred shareholders participate in excess dividends, but to a limited
extent (e.g., a percentage limit).
6.2.4 Non-participating Preferred Stock

When preferred stock is nonparticipating, preferred shareholders are limited to the dividends
provided by their preference. They do not share in excess dividends.

reserved.
PART 2 UNIT
Distribution of Dividends to Participating

Example 1
Preferred Stockholders
Facts: On January 1, Year 1, Samuel Co. issued 100,000 shares of $5 par common stock
and 25,000 shares of $10 par fully participating 8 percent cumulative preferred stock.
No dividends were paid in Year 1. Cash dividends of $101,000 were declared and paid
in Year 2.
Required: Determine the dividend to be paid on the preferred and common stock.
Solution:
Schedule 1: Dividends Remaining for Distribution
Cash dividends $101,000
Year 1 preferred dividends in arrears [(25,000 × $10) × 0.08] (20,000)
Preferred dividends accumulated in Year 2 (20,000)
61,000
Common stock [(100,000 × $5) × 0.08]* (40,000)
Remaining for proration between preferred and common stock $ 21,000
Schedule 2: Proration of Remaining Dividends According to Par Values

Preferred stock
250,000
× $21,000 = $7,000
750,000
Common stock
500,000
× $21,000 = $14,000
750,000
Schedule 3: Total Dividends Paid on Preferred and Common Stock

Preferred stock $7,000 + $20,000 + $20,000 = $ 47,000
Common stock $14,000 + $40,000 = 54,000
Total cash dividends distributed $101,000
*The principle applied here is that, with participating cumulative preferred stock, before
any proration of dividends may exist, the common shareholders must receive an equal
dividend as the preferred shareholders. In this case, preferred shareholders receive an
8 percent dividend first; common shareholders receive an 8 percent dividend second; and
the balance ($21,000) is shared pro rata.
6.3 Cash Dividends LOS 2B3h
Cash dividends distribute cash to shareholders and may be declared on common or preferred
stock. They are paid from retained earnings. Dividends are paid only on authorized, issued, and
outstanding shares. They are not paid (or declared) on treasury stock.

6.4 Property (In-Kind) Dividends

Property dividends distribute noncash assets (e.g., inventory, investment securities, etc.) to
shareholders. They are nonreciprocal transfers of nonmonetary assets from the company to its
shareholders. On the date of declaration, the property to be distributed should be restated to
fair value and any gain or loss should be recognized in income. The dividend liability and related
debit to retained earnings should be recorded at the fair value of the assets transferred.
6.5 Scrip Dividends

Scrip dividends are simply a special form of notes payable whereby a corporation commits
to paying a dividend at some later date. Scrip dividends may be used when there is a cash
shortage. On the date of declaration, retained earnings is debited and notes payable (instead
of dividends payable) is credited. Some scrip dividends even bear interest from the declaration
date to the date of payment (and, thus, require accrual).
6.6 Liquidating Dividends

Liquidating dividends occur when dividends to shareholders exceed retained earnings.
Dividends in excess of retained earnings would be charged (debited) first to additional paid-in
capital and then to common or preferred stock (as appropriate). Liquidating dividends reduce
total paid-in capital.
6.7 Stock Dividends

Stock dividends distribute additional shares of a company's own stock to its shareholders. The
treatment of stock dividends depends on the size (percentage) of the dividend in proportion to
the total shares outstanding before the dividend.
6.7.1 Treatment of a Small Stock Dividend (< 20–25 Percent)

When less than 20 to 25 percent of the shares previously outstanding are distributed, the
dividend is treated as a small stock dividend because the issuance is not expected to affect the
market price of the stock. The fair market value of the stock dividend at the date of declaration
is transferred from retained earnings to capital stock and additional paid-in capital. There is
no effect on total shareholders' equity, as paid-in capital is substituted for retained earnings
(i.e., retained earnings is "capitalized" and made part of paid-in capital).
Illustration 3 Small Stock Dividend
Capital Corp. has 100,000 shares of $10 par value common stock outstanding. The
company declares a stock dividend of 5,000 shares when the fair market value is $15 (on
the date of declaration). 5,000 shares / 100,000 shares = 5%, which is considered a small
stock dividend. The amount of the distribution is (5,000 × $15 FV) $75,000.
6.7.2 Treatment of a Large Stock Dividend (> 20–25 Percent)

When more than 20 to 25 percent of the previously issued shares outstanding are distributed,
the dividend is treated as a large stock dividend, as it may be expected to reduce the market
price of the stock (similar to a stock split). The par (or stated) value of the stock dividend is
normally transferred from retained earnings to capital stock to meet legal requirements. The
amount transferred is the number of shares issued multiplied by the par (or stated) value of
the stock.

reserved.
PART 2 UNIT
Illustration 4 Large Stock Dividend
LMT Corp. declares a 40 percent stock dividend on its 1,000,000 shares of outstanding $10
par common stock (5,000,000 authorized). On the date of declaration, LMT stock is selling
for $20 per share. Total stock dividend (0.40 × 1,000,000) of 400,000 shares valued at
$4,000,000 (400,000 shares @ $10 per share par) should be recorded.
6.7.3 Stock Dividends on Treasury Stock

Stock dividends are generally not distributed on treasury stock because such stock is not
considered outstanding. However, an exception is made when:
1. The company is maintaining a ratio of treasury shares to shares outstanding in order to
meet stock option or other contractual commitments or
2. State law requires that treasury stock be protected from dilution.
6.8 Stock Splits

Stock splits occur when a corporation issues additional shares of its own stock (without charge)
to current shareholders and reduces the par (or stated) value per share proportionately.
There is no change in the total book value of the shares outstanding. Thus, the memo entry to
acknowledge a stock split is merely a formality.
A stock split usually does not affect retained earnings or total shareholders' equity, as is
exhibited below:
Before the Split

Common stock (10,000 shares outstanding @ $10 par) $100,000
After the Split (× 2) (÷ 2)
Common stock (20,000 shares outstanding @ $5 par) $100,000
6.8.1 Reverse Stock Splits

A reverse stock split would involve reducing the number of shares outstanding and increasing
the par (or stated) value proportionately. One way to reduce the amount of outstanding shares
is to recall outstanding stock certificates and issue new certificates.
6.8.2 Stock Splits on Treasury Stock

Stock splits are usually not applied to treasury stock because such stock is not considered
outstanding. However, an exception is made when:
the company is maintaining a ratio of treasury shares to shares outstanding in order to
meet stock option or other contractual commitments; or
state law requires that treasury stock be protected from dilution.
6.9 Dividend Policy LOS 2B3i
A company's board sets the policy for what profits to distribute as dividends and what to retain
for the purpose of business expansion. The dividend policy that the board adopts signals to the
market its expectations of future profitability.

Dividend policies may include:

Equal Annual Payments: Regular payments made by companies that have stable earnings
and cash flows. Dividends are the same each year regardless of earnings.
Equal Annual Percentage: A fixed percentage of earnings distributed annually to
shareholders.
Irregular: The board of directors decides annually whether to distribute dividends and how
much to pay out.
No Dividends: Start-ups, high-growth companies, and firms in an expansion mode may
choose to retain earnings for growth rather than pay dividends. Compensation to investors
comes from stock price appreciation.
Residual Distribution: The board declares dividends only if earnings are more than the
amount needed for reinvestment.
6.9.1 Dividend Policy Factors

When establishing dividend policy, the board of directors considers several factors, including:
Stability of Earnings: Companies with relatively stable earnings each year may distribute a
higher percentage of those earnings compared with companies with less predictable earnings.
Financing Policy: If financing operations through borrowing is less expensive than using
internal funds (retained earnings), the board will choose to borrow funds and distribute a
higher percentage of retained earnings to shareholders.
Liquidity: Increased liquidity means that cash is available to distribute cash dividends to
shareholders.
Competitor Policies: Higher dividends paid by competitors may attract investors to the
competition.
History: Companies may prefer to be consistent with dividend payments.
Debt Level: Companies with higher levels of debt need cash to pay those debts and may
not be able to distribute cash dividends.
Access to Capital Markets: Larger companies may have better access to capital markets
to borrow funds and may be able to distribute a higher percentage of their earnings as
dividends compared with smaller companies.
Growth and Expansion: Companies may invest internally rather than pay dividend payments
if the expected return on growth opportunities is higher than the cost of retained earnings.
Legal Requirements: Some countries require that each company maintain a certain level of
retained earnings. Other countries have laws or regulations or both governing distributions.
Tax Considerations: In countries in which the corporate tax rate is high, companies have
less earnings available for distribution. Additionally, tax codes in some countries (including
the U.S.) impose taxes on dividend income to the shareholders, making the receipt of
dividends less appealing. High-income shareholders may also prefer not to receive large
dividend payments but would prefer instead to pay the capital gains tax (which is usually
lower) on stock appreciation when the shareholders sell their investments.
LOS 2B3k 6.10 Stock Repurchase (Treasury Shares)

Treasury stock is a corporation's own stock that has been issued to shareholders and subsequently
reacquired (but not retired). Treasury stockholders are not entitled to any of the rights of ownership
given to common shareholders, such as the right to vote or to receive dividends. In addition, a
portion of retained earnings equal to the cost of treasury stock may be restricted and may not be
used as a basis for the declaration or payment of dividends (depending on applicable state law).

reserved.
PART 2 UNIT
6.10.1 Reasons to Repurchase Shares

A company may repurchase its shares for treasury purposes for one or more of the following
reasons:
Increase Earnings per Share (EPS): Treasury shares are issued but not outstanding shares.
When the number of outstanding shares decreases, EPS will increase.
Employee Stock Options: Using treasury shares is often less expensive than issuing new
shares to fulfill employee stock option contracts.
Defense: Reducing the number of outstanding shares can be used to defend against
takeover attempts. If the company buys its own shares, it can prevent others from buying
the stock and obtaining control.
Create Demand: Purchasing shares in the marketplace may cause the stock price of the
remaining shares to increase and may create more demand for the stock.
Tax Incentives: Repurchasing shares may provide a tax-efficient distribution of excess cash
to shareholders. Paying a higher price to repurchase shares from shareholders, rather than
distributing dividends, may allow shareholders to pay the long-term capital gains tax rate,
which may be lower than the tax on dividends.
7 Lease Financing LOS 2B3g
Leases are used by public and private entities as a means of gaining access to assets and
reducing their exposure to the full risks of asset ownership. A lease is defined as a contractual
agreement between a lessor who conveys the right to use real or personal property (an asset)
and a lessee who agrees to pay consideration for this right over a specific period of time. In
order for a contract to be a lease or contain a lease, both of the criteria below must be met.
The contract must depend on an identifiable asset in which the lessor does not have a
substantive substitution right.
The contract must convey the right to control the use of the asset over the lease term to
the lessee. The lessee will have the right to obtain substantially all of the economic benefits
from using the asset and have the right to direct its use.
Illustration 5 Definition of a Lease
Bentley Corp. has a written agreement in place to allow Riggs Inc. to use scientific
equipment with a book value of $75,000 for the next five years. Bentley has the right to
replace the equipment with a comparable piece of equipment during the term, but Riggs
is able to use the asset as it wishes for the next five years while keeping any cash inflows
associated with outputs from the equipment.
This is an example of a lease, as there is a contract in place that defines the asset itself,
recognizes Bentley's right to substitute the asset, and provides Riggs with the economic
benefits of and direction for the use of the asset.

7.1 Advantages of Leasing (Lessee)

The advantages of using leasing arrangements include the following:
Steady Cash Outflows: By leasing, the lessee can avoid significant one-time investments in
assets. Leasing provides to the lessee the opportunity to allocate the cash payments over a
period of time.
Use Newest Technology: The lessee can use the newest and most advanced assets
without having to purchase those assets. The use of newer assets reduces repair and
maintenance costs.
Increased Investment Opportunities: Funds that would have been used for the purchase
of assets may be used for other capital investment opportunities.
Tax Benefits: Lease expenses and lease payments may be tax deductible to the lessee.
Protection Against Inflation: Lease payments are usually fixed and protect the lessee
against inflation in the later years of the lease contract.
Avoid Obsolescence Risks: The lessee does not bear the risk of declining asset value due to
obsolescence because the asset is owned by the lessor.
Flexibility: Lease terms may range from days to years. At the end of the lease term, the
lessee may have the option to buy the asset or return it to the lessor. During the term of the
lease, the lease may be cancelable if the agreement allows for that.
7.2 Disadvantages of Leasing (Lessee)

The disadvantages of using leasing arrangements including the following:
Cost: A lease can be a more costly option than an outright purchase. To determine if the
lease is more costly than the purchase, the present value of the lease payments should be
compared with the cost of purchasing the asset.
Debt: The lease contract creates a commitment to make future payments. The present
value of all lease payments is recognized as a lease liability and may reduce the company's
ability to borrow additional funds.
Ownership: The lessor may retain ownership of the asset while the lessee pays for all
maintenance expenses.
7.3 Buy or Lease Decisions

The important issue for financial decision-making is the cash flows created by a lease, as
compared with purchasing the asset.

reserved.
PART 2 UNIT
7.4 Decision-Making
Two Decisions
1. Investment Decision 2. Financing Decision
Does the asset give Is it cheaper to

operational benefits? buy or lease?
Focus on the relative

Focus on the NPV of benefits of tax-allowable
the after-tax operating depreciation from buying
cash inflows. versus the tax savings from
the lease payments.
Discount cash flows using

Discount these cash
a rate which reflects the
outflows using the after-tax
operating risk of investment
cost of debt.
(e.g., average cost of capital)
7.4.1 Investment Decision

Discount the after-tax operating cash inflows at the firm's weighted average capital (WACC).
7.4.2 Financing Decision

Discount the cash flows specific to each financing option at the after-tax cost of debt.
The preferred financing option is that with the lowest NPV.
The relevant cash flows to consider include:
Buy asset
—Purchase cost or present value of lease payments
—Tax savings from depreciation
—Scrap proceeds
Lease asset
—Lease payments
—Tax savings on lease payments

Pass Key
If the PV of the cost of the best source of financing is less than the PV of the operating cash
flows, then the project should be undertaken.
Example 2 Lease or Buy
Facts: Boulder Inc. is considering the acquisition of a new machine, either through a lease
or by purchasing the asset.
The asset will cost $200,000 on January 1, Year 1, and will have a scrap value of $25,000 at
the end of Year 2.
Operating inflows are $150,000 for two years.
The tax rate is 30 percent and the company's weighted average cost of capital is 9 percent.
The machine is fully depreciated on a straight-line basis over two years for both book and
tax purposes.
Boulder's financing options for the asset are:
using a bank loan at a 10 percent interest rate; or
leasing for $92,500 a year, with lease payments due on January 1 of each year.
Relevant PV factors include the following:
PV of ordinary annuity at 9% 1.759
PV of annuity due at 7% 1.935
PV of $1 at 7%
Year 1 0.935
Year 2 0.873
Required:
Determine the operational benefit of the project.
Determine how the project should be financed.
Determine the NPV of the investment.
(continued)

reserved.
PART 2 UNIT
(continued)
Solution:
Operational Benefit
PV of annual after-tax cash inflow = [$150,000 × (1 – 30%)] × 1.759
PV of annual after-tax cash inflow = $105,000 × 1.759 = $184,695
Financing Decision
After-tax cost of debt = 10% × (1 – 30%) = 7%
—Borrow
— and buy asset
Annual depreciation tax shield = $100,000 × 30% = $30,000
After-tax cash inflow from scrap = $25,000 × (1 – 30%) = $17,500
Year 0 Year 1 Year 2
Cost of machine $(200,000)
Depreciation tax shield $30,000 $30,000
Scrap – – 17,500
After-tax cash flow (200,000) 30,000 47,500
Discount rate 1 0.935 0.873
Present value $(200,000) $28,050 $41,468 = $(130,483)
—Lease
—
PV of annual after-tax cash outflow = [$92,500 × (1 – 30%)] × 1.935
PV of annual after-tax cash outflow = $64,750 × 1.935 = $(125,291)
Project should be financed using the lease because the NPV of the cost is lower.
Net Present Value
PV of operating inflows $184,695
PV of lease financing (125,291)
Net present value $ 59,404
If a market is inefficient, as new information is received about a security:

a. Nothing will happen.
b. The stock price will fall at first and then later rise.
c. There will be a lag in the adjustment of the stock price.
d. There will be negative demand for the stock.

All the following conditions must occur for a market to be considered perfectly efficient except:
a. Information is inexpensive or free and widely available to market participants at
approximately the same time.
b. Information is generated in a specific fashion such that announcements are
basically dependent of each other.
c. There are many rational, profit-maximizing investors who actively participate in
the market.
d. Investors react quickly and fully to the new information, causing stock prices to
adjust accordingly.
The board of directors declared dividends of $450,000 in Year 4. On December 31, Year 4,
the company had 100,000 common shares ($20 par value) and 20,000 8 percent cumulative
preferred shares ($100 par value) outstanding. Dividends were not declared for Year 3
but were declared in all previous years. How much in total dividends will be distributed to
common shareholders in Year 4?
a. $130,000
b. $320,000
c. $160,000
d. $290,000

reserved.
5
MODULE
B.4. Working Capital

Management: Part 1
Part 2
Unit 2
CMA LOS Reference: Part 2—B.4.

2—Section B.1. Strategic
Working Planning
Capital Management: Part 1

a. discuss
define working
how strategic
capitalplanning
and identify
determines
its components
the path an organization chooses for
attaining its long-term goals, vision, and mission, and distinguish between vision
b. calculate net working capital
and mission
c. explain the benefit of short-term financial forecasts in the management of working capital
b. identify the time frame appropriate for a strategic plan
d. identify and describe factors influencing the levels of cash
c. identify the external factors that should be analyzed during the strategic planning
e. identify
process and
and explain
understand
the three
how this
motives
analysis
for holding
leads tocash
recognition of organizational
opportunities, limitations, and threats
f. prepare forecasts of future cash flows
d. identify the internal factors that should be analyzed during the strategic planning
g. identify methods of speeding up cash collections
process and explain how this analysis leads to recognition of organizational strengths,
h. calculate
weaknesses,
the and
net benefit
competitive
of a lockbox
advantages
system
e. demonstrate
i. define concentration
an understanding
banking of how the mission leads to the formulation of long-
term business objectives such as business diversification, the addition or deletion of
j. demonstrate an understanding of compensating balances
product lines, or the penetration of new markets
k. identify methods of slowing down disbursements
f. explain why short-term objectives, tactics for achieving these objectives, and
l. demonstrate
operational planning
an understanding
(master budget)
of disbursement
must be congruent
float andwith
overdraft
the strategic
systemsplan and
contribute to the achievement of long-term strategic goals
m. identify and describe reasons for holding marketable securities
g. identify the characteristics of successful strategic plans
n. define the different types of marketable securities, including money market
h. instruments,
describe Porter's generic
T-bills, strategies,
treasury includingbonds,
notes, treasury cost leadership,
repurchase differentiation,
agreements, federal
and focus
agency securities, bankers' acceptances, commercial paper, negotiable CDs, Eurodollar
CDs, and other marketable securities
i. demonstrate an understanding of the following planning tools and techniques: SWOT
o. evaluate
analysis, Porter's
the trade-offs
5 forces,
among
situational
the variables
analysis,
in PEST
marketable
analysis,
security
scenario
selections,
planning,
including
competitive
safety, marketability/liquidity,
analysis, contingency
yield,
planning,
maturity,
andand
the
taxability
BCG GrowthShare Matrix
p. demonstrate an understanding of the risk and return trade-off
z. demonstrate an understanding of how risk affects a firm's approach to its current
asset financing policy (aggressive, conservative, etc.)
bb. estimate the annual cost and effective annual interest rate of not taking a cash discount
ee. explain the maturity matching or hedging approach to financing
ff. demonstrate an understanding of the factors involved in managing the costs of
working capital
gg. recommend a strategy for managing current assets that would fulfill a given objective
© Becker Professional Education Corporation. All rights reserved. Module 5 2–73 B.4. Workin
5 B.4. Working Capital Management: Part 1 PART 2 UNIT 2
1 Working Capital
Working capital policy and working capital management involve managing cash so that a
company can meet its short-term obligations, and include all aspects of the administration of
current assets (CA) and current liabilities (CL). The goal of working capital management is to
manage liquidity efficiently. The optimal mix of current assets and current liabilities depends
on the nature of the business and the industry and requires offsetting the benefit of CA and CL
against the possibility of technical insolvency.
LOS 2B4a 1.1 Definition of Net Working Capital

LOS 2B4b Net working capital is defined as the difference between current assets (CA) and current
liabilities (CL).
Net working capital = Current assets – Current liabilities
Current assets are cash and other assets that are expected to be converted into cash, sold, or
consumed within one year or within one operating cycle, whichever is longer.
Current liabilities are amounts owed by a company that will be repaid or liquidated using current
assets within one year or within one operating cycle, whichever is longer.
Current Assets Current Liabilities

Cash and cash equivalents Trade accounts payable
Marketable securities classified as trading Accrued expenses
Trade accounts receivable Notes payable (maturing < 12 months)
Receivables from officers or employees (if Unearned or deferred revenue to be earned
due in < 12 months) within one year
Notes receivable (maturing < 12 months) Callable debt agreements
Inventory Short-term loan agreements
Prepaid items (e.g., insurance, interest, rents)
2–74 Module 5 B.4. Working

© Becker Professional Education CapitalAllManagement:
PART 2 UNIT
5 2 B.4. Working Capital Management: Part 1
Example 1 Calculate Net Working Capital
Facts: The following information is from the records of XYZ Co.
XYZ Co.
Adjusted Trial Balance
As of December 31, Year 1
Account Debit Credit
Cash $ 23,300
Accounts receivable 32,500
Inventory 65,000
Office equipment 75,000
Accumulated depreciation—office equipment $ 10,000
Accounts payable 26,100
Salaries payable 3,000
Notes payable (matures in Year 2) 30,000
Common stock 80,000
Retained earnings 16,050
Sales revenue 180,000
Cost of goods sold 95,000
Salaries expense 32,350
Rent expense 14,000
Supplies expense 2,000
Utilities expense 6,000
Total $345,150 $345,150
Required: Based on the adjusted trial balance, calculate net working capital.
Solution:
Net working capital = Current assets – Current liabilities
Net working capital = ( Cash + Accounts receivable + Inventory) – (Accounts payable
+ Salaries payable + Notes payable)
Net working capital = ($23,300 + $32,500 + $65,000) – ($26,100 + $3,000 + $30,000)
Net working capital = $120,800 – $59,100 = $61,700
Pass Key
Working capital increases if either current assets increase or current liabilities decrease.
Working capital decreases if either current assets decrease or current liabilities increase.
1.2 Current Ratio

While the net amount of working capital measures the amount by which current assets exceed
current liabilities, the current ratio measures the number of times current assets exceed current
liabilities and is a way of measuring liquidity. This ratio demonstrates a firm's ability to generate
cash to meet its short-term obligations.
Current assets
Current ratio =
Current liabilities
1.2.1 Evaluating the Current Ratio

A current ratio of 1 indicates that a company has exactly enough in current assets to fully pay off
or liquidate all current liabilities. Any ratio greater than 1 implies that a company has a positive
working capital reserve. Generally, a current ratio of 1.5 or 2 indicates sufficient liquidity, but
this ratio varies by industry, company size, and the economic circumstances. A ratio over 2 may
reflect unnecessary investment in current assets or may reflect too much uninvested cash. A
ratio of less than 1 may indicate potential liquidity problems as current liabilities come due.
Properly evaluating a firm's current ratio requires comparing the ratio for other companies in
the same industry and comparing the company's own ratio over several years.
Deteriorating Current Ratio
A decline in the current ratio can be attributable to increases in current liabilities, decreases
in current assets, or a combination of both.
Improving Current Ratio
An increase or improvement in the current ratio implies an increased ability to pay off
current liabilities and may be attributable to an increase in current assets or a decrease in
current liabilities.
1.2.2 Limitations of the Current Ratio (and Other Liquidity Ratios)

Unless short-term liquidity is a relevant issue, the current ratio is not necessarily the best
measure of the health of a business.
Illustration 1 Current Ratio Limitations
A restaurant might have low CA (e.g., accounts receivable and inventory) relative to CL (e.g.,
accounts payable and payroll obligations) and therefore a current ratio less than 1 but
might otherwise be healthy in terms of increasing cash flows, growing reputation, good
location, and limited long-term debt obligations.
A bookstore might have a high CA (e.g., inventory) relative to CL (e.g., accounts payable)
and therefore a current ratio greater than 1 but might otherwise be unhealthy in terms of
diminishing cash flows, poor location, increased competition from Internet vendors, and
low inventory turnover.

PART 2 UNIT
Example 2 Current Ratio Calculation
XYZ Co.
Adjusted Trial Balance
As of December 31, Year 1
Account Debit Credit

Cash $ 23,300
Accounts receivable 32,500
Inventory 65,000
Office equipment 75,000
Accumulated depreciation—office equipment $ 10,000
Accounts payable 26,100
Salaries payable 3,000
Notes payable (matures in Year 2) 30,000
Common stock 80,000
Retained earnings 16,050
Sales revenue 180,000
Cost of goods sold 95,000
Salaries expense 32,350
Rent expense 14,000
Supplies expense 2,000
Utilities expense 6,000
Total $345,150 $345,150
Required: Calculate the current ratio.

Solution: XYZ Co.'s current ratio is calculated by adding the current assets listed on the trial
balance (cash, accounts receivable, and inventory) and then dividing total current assets by
total current liabilities (accounts payable, salaries payable, and notes payable that mature
in less than 12 months):
Current assets $23,300 + 32,500 + 65,000 $120,800
Current ratio = = = = 2.04
Current liabilities $26,100 + 3,000 + 30,000 $59,100
LOS 2B4ff 2 Financing Decisions and Working Capital

LOS 2B4gg
Companies use a mix of short-term and long-term financing to meet their capital requirements.
Short-term and long-term financing have different advantages and disadvantages, and different
effects on working capital.
2.1 Short-Term Financing

2.1.1 Characteristics
Short-term financing is generally classified as current and will mature within one year.
Rates: Rates associated with short-term financing tend to be lower than long-term rates and
presume greater liquidity on the part of the organization using short-term financing.
Effect on Working Capital: Short-term financing is classified as a current liability and
decreases working capital. The extent to which an organization uses short-term financing
is dependent on both the amount of current assets it maintains and the risk tolerance of
management. Shorter-term financing strategies require current asset levels to be sufficient
to meet short-term obligations.
2.1.2 Advantages
Increased Profitability: Rapid conversion of operating cycle components (e.g., inventory,
receivables) into cash in order to meet short-term obligations carries the potential of
increased profitability and improved liquidity.
Decreased Financing Cost: Short-term interest rates are generally lower than long-term
interest rates given the shorter duration of the financing instruments.
2.1.3 Disadvantages
Increased Interest Rate Risk: Interest rates may abruptly change, and given shorter
maturities, may require greater financing charges than anticipated on future refinancing.
Decreased Capital Availability: Lender evaluation of creditworthiness may change and
thereby make financing impossible or less favorable by virtue of increased rates and/or less
favorable terms.
2.2 Long-Term Financing

2.2.1 Characteristics
Long-term financing is generally classified as non-current and will mature after one year.
Rates: Rates associated with long-term financing tend to be higher than short-term rates
and presume less liquidity on the part of the organization using long-term financing.
Effect on Working Capital: Long-term financing is classified as non-current and is not
included in the calculation of working capital. However, dividend, interest, and principal
repayments all require cash, which can reduce working capital over time. The extent to
which an organization uses long-term financing is dependent on both the amount of current
assets it maintains and the risk tolerance of management. Long-term financing increases
financial leverage.

PART 2 UNIT
2.2.2 Advantages
Decreased Interest Rate Risk: For the borrower, long-term financing locks in an interest
rate over a long period, thereby reducing the exposure to fluctuations in rates.
Increased Capital Availability: Securing long-term debt guarantees financing over a long
period and reduces the company's exposure to any risk that refinancing might be denied or
modified with less favorable terms.
2.2.3 Disadvantages
Decreased Profitability: Higher financing costs reduce profitability.
Increased Financing Costs: Long-term debt generally carries a higher interest rate given
the longer duration of the financing instruments.
Interest Rate Risk: Lender's Perspective
For the lenders, a higher interest rate is charged for longer-term debt because the
likelihood that interest rates will change over the period of the loan increases as
the term of the loan increases. Higher financing charges compensate the lender for
increased interest rate risk. Therefore, the lenders recognize their exposure to interest
rate risk with long-term financing and charge a premium to the borrower in the form of
higher rates.
Interest Rate Risk: Borrower's Perspective
The borrowers, on the other hand, lock themselves into a long-term interest rate to
reduce their exposure to interest rate risk, and pay a premium to do so.
2.3 Working Capital Management

Managing working capital involves a trade-off between profitability and risk.
2.3.1 Conservative Approach LOS 2B4z

A conservative approach to working capital management advocates using long-term financing
to purchase non-current assets, permanent current assets, and some temporary current assets.
When current asset needs are low, a company invests excess funds in marketable securities
(i.e., "storing liquidity"). Only when current asset needs are high will a company rely on short-
term financing. The conservative approach results in a margin of safety by maintaining a higher
current ratio and higher cash reserves available in the event of a market downturn.
2.3.2 Maturity-Matching Approach (MMA) or Hedging Approach LOS 2B4ee

A company uses the maturity-matching approach (MMA) to hedge its risks by matching the
maturities of its assets and liabilities. Under the MMA, current assets mature and are liquidated
as current liabilities become due, and non-current assets are financed with long-term debt
and equity securities. To avoid liquidity risks, a company using the MMA may utilize long-term
borrowing to finance a minimal amount of current assets.
2.3.3 Aggressive Approach

When using an aggressive approach, a combination of long-term and short-term debt, or only
short-term debt, is used to finance long-term assets. Because long-term borrowing generally
charges higher rates of interest than short-term loans, the use of short-term financing can
reduce interest costs. However, the aggressive approach may subject the firm to interest rate
risk when rates are rising and the firm refinances short-term debt at higher interest rates. A
firm's inability to renew maturing short-term loans may lead to bankruptcy.
3 Cash Management
LOS 2B4c 3.1 Cash Budgets

LOS 2B4f Cash budgets are necessary for anticipating liquidity and working capital needs. Cash balances
are affected by the anticipated volume and timing of both cash collections and disbursements.
Cash budgets also assist with planning for changes in liquidity so that management may borrow
additional funds in periods of anticipated cash shortages or invest in short-term marketable
securities in times of excess cash.
Example 3 Preparation of the Cash Budget

1. XYZ had sales of $60,000 in February and $70,000 in March.
2. XYZ forecasts its future sales as follows:
Month Forecasted Sales

April $90,000
May $80,000
June $100,000
3. At the beginning of April, the cash balance was $6,000.

4. 20 percent of the monthly sales is in cash, 20 percent is collected in the next month,
and the remainder is collected in the second month following the sale.
5. Other cash income is estimated about $2,500 per month.
6. Cash purchases are estimated to be $60,000, $70,000, and $75,000 in the months of
April, May, and June, respectively.
7. Rent expense of $7,500 is paid at the beginning of each quarter.
8. Wages and salaries are expected to be $8,000 per month, all paid in cash.
9. The company distributes cash dividends of $10,000 twice a year—once in June and
once in October.
10. The company is planning to purchase a new car for $7,000 cash in May.
11. Annual interest of $4,500 on all debt is due in May.
12. Tax payment of $5,000 is due in June.
13. The minimum required cash balance at the end of each month is $5,000. If cash
falls below $5,000, the company must borrow cash from a local bank to cover the
company's needs. Excess funds will be invested at the same local bank.
Required: Prepare a cash budget for XYZ Co. for the months of April, May, and June Year 1.
(continued)

PART 2 UNIT
(continued)
Solution: The cash budget for the three months of April, May, and June is as follows:
February March April May June

Sales $60,000 $70,000
Estimated sales $90,000 $80,000 $100,000
Cash Collection
Cash sales (20% of sales) $12,000 $14,000 $18,000 $16,000 $20,000
Cash collected in the following
month (20%) $12,000 $14,000 $18,000 $16,000
Cash collected in the second month
after sale (60%) $36,000 $42,000 $54,000
Other cash income $2,500 $2,500 $2,500
Total cash collections $70,500 $78,500 $92,500
Cash Disbursements
Cash purchases $60,000 $70,000 $75,000
Rent expense $7,500
Wages and salaries $8,000 $8,000 $8,000
Cash dividend distribution $10,000
Purchase a new car $7,000
Interest payment $4,500
Tax payment $5,000
Total cash disbursements $75,500 $89,500 $98,000
Expected change in cash $(5,000) $(11,000) $(5,500)
Beginning cash balance $6,000 $5,000 $5,000
Expected ending cash balance
before borrowings $1,000 $(6,000) $ (500)
Funds to be borrowed $4,000 $11,000 $5,500
Ending cash balance $5,000 $5,000 $5,000
3.2 Motives for Holding Cash LOS 2B4e
Companies hold cash to make routine payments for business transactions, to repay loans and
other financing costs, to maintain compensating balances for banks, to prepare for future
uncertainties, and to prepare for future opportunities. Motives for holding cash include:
Transaction Motive: A company may hold cash to meet payments arising from the ordinary
course of business.
Speculative Motive: Cash may be needed to take advantage of temporary opportunities.
Precautionary Motive: It is important to have enough cash on hand to maintain a safety
cushion to meet unexpected needs.
LOS 2B4d 3.3 Factors Influencing Cash Levels

LOS 2B4j When determining a company's optimal cash levels, managers should consider the following factors:
A company will need more cash if short-term liabilities mature in the near term.
Cash balances should be higher if management has low risk tolerance. Lower cash levels
mean a higher risk of insolvency.
A company can hold less cash if cash collections are consistent, reliable, and sufficient to
cover cash disbursements.
Compensating balance requirements may stipulate minimum cash levels. Compensating
balances are amounts required by the lender to be maintained in the bank account of a
borrower. To ensure that the borrower will pay interest and repay debt as it becomes due,
banks may require borrowers of short-term, unsecured loans to maintain a compensating
balance with the bank in the borrower's checking account. The compensating balance
typically ranges from 10 percent to 20 percent of the borrowed amount.
3.4 Operating Cycle and Cash Conversion Cycle

Either speeding up cash inflows or slowing down cash outflows increases cash balances. Improved
rates of cash collection are generally achieved through faster accounts receivable collections.
Reduced cash outflows are often achieved through delayed (or deferred) disbursements. The
combination of current cash inflows and current cash outflows related to a business is called the
operating cycle. The objective of financial managers is to shorten the operating cycle.
Illustration 2 Operating Cycle
Cash
payment
for
purchases
Collection
of sales
Purchase Sale proceeds
Days in Cash conversion cycle

accounts
payable
Days in inventory Days in accounts receivables
Operating cycle
1. Operating Cycle
Days sales
Days in
Operating cycle = + in accounts
inventory
receivable

PART 2 UNIT
2. Cash Conversion Cycle
Operating Days of payables

Cash conversion cycle = –
cycle outstanding
Days sales Days of

Days in
Cash conversion cycle = + in accounts – payables
inventory
receivable outstanding
3. Elements of the Cash Conversion Cycle Formula
Average inventory
Days in inventory =
Cost of goods sold / 365
Average accounts receivable (net)

Days sales in accounts receivable =
Sales (net) / 365
Average accounts payable

Days of payables outstanding =
Cost of goods sold / 365
Example 4 Cash Conversion Cycle
Facts: ABC Computers has annual sales of $36 million. On average, the company carries
$5 million in inventory, $3 million in accounts receivable, and $3 million in accounts payable.
Required: If the annual cost of goods sold for ABC is $27 million, what is the length of the
operating cycle and cash conversion cycle for the firm?
Solution:
$5,000,000
Days in inventory = = 67.6 days
$27,000,000 / 365
$3,000,000
Days sales in accounts receivable = = 30.4 days
$36,000,000 / 365
$3,000,000
Days of payables outstanding = = 40.6 days
$27,000,000 / 365
Operating cycle = 67.6 days + 30.4 days = 98 days
Cash conversion cycle = 67.6 days + 30.4 days − 40.6 days = 57.4 days
LOS 2B4g 3.5 Methods to Accelerate Collections

The operating and cash conversion cycles can be improved by accelerating cash collections and
decreasing the days in accounts receivable.
3.5.1 Customer Screening and Credit Policy

A company can choose to extend credit to more responsible customers, who are more likely
to pay bills promptly.
3.5.2 Prompt Billing

Timely billing of charges to credit customers ultimately serves to speed collections.
LOS 2B4bb 3.5.3 Payment Discounts

Offering payment discounts may influence customers to pay faster and can result in
improved cash collections. Discounts foregone represent a higher cost to the customer than
a bank loan for similar financing.
The formula for calculating the annual cost (APR) of a quick payment discount (assuming a
360-day year) follows:
360 Discount
APR of quick payment discount = ×
Pay period − Discount period 100 − Discount %
Example 5 Payment Discounts (APR)
Facts: Terranova Company's main vendor offers a quick payment discount of 1/10, net 30
to its customers.
Required: Assuming a 360-day year, calculate the annual cost to Terranova of not taking
advantage of the discount.
Solution:
360 1% 360 1%
× = × = 18.2%
30 − 10 100% − 1% 20 99%
3.5.4 Electronic Funds Transfer

The electronic movement of funds from one institution to another is called electronic
funds transfer, or EFT. Electronic funds transfer ensures timely payment. Having funds sent
electronically to a company's bank account facilitates immediate collection rather than waiting
for checks to be deposited.
LOS 2B4h 3.5.5 Lockbox Systems

Lockbox systems expedite cash inflows by having a bank receive payments from a company's
customers directly via mailboxes to which the bank has access. Payments that arrive in these
mailboxes are deposited into the company's account immediately.

PART 2 UNIT
Although a company may earn additional interest income by using a lockbox system, the
system also involves a service fee paid to a bank. Management must calculate the cost of this
service and compare this cost to the benefit derived from expediting cash collections using the
following process:
1. Calculate the average daily collection by multiplying the average number of daily payments
by the average payment amount.
2. Calculate the increase in cash balances resulting from the use of the lockbox system by
multiplying the average daily collections from the first step by the number of days saved
using the system.
3. Calculate the benefit the company will receive each year from interest on additional cash
balances by multiplying the additional cash balance from the previous step by the annual
interest rate on cash balances.
4. Calculate the annual cash net savings by comparing the benefits with the annual fee
charged for the service by the banks.
Example 6 Lockbox System
Facts: A company collects an average of 500 payments from its customers every day. The
average amount of each payment is approximately $600. It takes five days to process the
payments internally, two more days to send the payments to the bank for deposit, and
another two days for payments to be deposited to the company's bank account and be
available for use.
A local bank offered a lockbox service to the company that will expedite collections and
reduce the time needed for payments to clear the bank by six days. This service is offered
by the bank for $30,000 per year. The bank pays the company a 2.5 percent annual interest
rate on the company's checking account.
Required: Calculate the annual benefit of using the lockbox system.
Solution:
1. Calculate the average daily collections:
Average daily collections = 500 payments × $600 average payment amount = $300,000
2. Calculate the increase in cash balance resulting from the use of the lockbox system:
Increase in cash balance = $300,000 per day × 6 days saved = $1,800,000
3. Calculate the benefit the company will receive each year from the interest on the
additional cash balance:
Total annual benefit = $1,800,000 × 2.5% = $45,000
4. Calculate the cash savings from using the lockbox system:
Cash savings = $45,000 (annual benefit) − $30,000 (annual bank charges) = $15,000
Although the lockbox system is beneficial to a company financially, a company's use of

this system could have a negative effect on customer satisfaction and could require that
management reevaluate the system. Also important is management's periodic reevaluation of
the system because the financial benefits of using the lockbox system could be diminished if the
amount of average daily collections decline, if the number of average daily customer payments
decline, if interest paid by the bank decreases, and/or the bank's annual fee increases.
LOS 2B4i 3.5.6 Concentration Banking

Concentration banking is characterized by the designation of a single bank as a central
depository. Advantages of concentration banking include:
Improved controls over inflows and outflows of cash
Reduced idle balances
Improved effectiveness for investments. All cash deposited in one central bank account can
be invested in short-term securities to improve investment returns.
LOS 2B4k 3.6 Delayed Disbursements

The cash conversion cycle can also be improved by delaying disbursements.
3.6.1 Defer Payments

Postponing payment of accounts payable provides a spontaneous source of credit to which
management can resort if the company is confronted with a short-term cash shortage.
Communications to creditors that payments will arrive later than usual serve to mitigate possible
damage to relationships with suppliers and to credit ratings.
3.6.2 Line of Credit

Establishing a line of credit with a bank serves to slow down payments. A line of credit extends
the company's trade credit by paying off the company's trade accounts with borrowed funds and
allowing the company a longer period to pay back that loan to the bank.
3.6.3 Use of Drafts

Companies can also use drafts to delay cash disbursements. Using drafts instead of checks
increases the payable float. A bank draft is a payment guaranteed by the issuing bank. It travels
through the banking system more slowly, because once it is presented by the payee, it must first
be approved before it is paid.
3.6.4 Zero-Balance Accounts

Zero-balance accounts (ZBA) involve delegating account management to the bank. A ZBA is
a checking account in which a balance of zero is maintained. All company deposits are made
to a central, interest-bearing bank account, and cash is moved into the zero-balance account
automatically, but only when necessary, to cover check payments when needed. This method of
banking maintains greater control over cash balances and disbursements. For example, zero-
balance accounts are often used for payroll payments. The account has a balance of zero during
most of the month, but funds equal to the total payroll amount are transferred to the account
when payroll is processed.
LOS 2B4l 3.7 Float and Overdraft Systems

Float occurs when there is a difference between the bank balance per the company's books
versus the cash in the company's account per the bank's records. Float can come in the form
of disbursement float or collections float. Disbursement float (positive from the depositor's
perspective) occurs when the depositor has issued checks, but those checks have not yet been
received and recorded by the bank as debits (charges) against the depositor's bank account.
Collections float (negative from the depositor's perspective) occurs when deposits have been
recorded in the depositor's books, but those deposits have not yet been recorded by the bank
and credited by the bank to the depositor's bank account.

PART 2 UNIT
3.7.1 Elements of Float

Float includes consideration of the time required for checks and deposits to travel to the bank
where the payor has the checking account, the time required for processing by the bank where
the payee deposits the check received, and the time required for check clearance by the bank
where the payor has the checking account.
3.7.2 Managing Float

If a firm can handle its receipts from customers more efficiently than the payees that receive
the firm's checks, a positive net float will result. Proper management of the float allows a firm
to maintain a negative cash balance on its books while showing a positive bank balance per the
bank's books and records. Devices and procedures to measure float include wire transfers, zero
balance accounts, controlled disbursing, centralized processing of payables, and lock boxes.
Note: The availability of float management is significantly dwindling as more and more
businesses and banks use technology (e.g., electronic funds transfer) to eliminate the time
delays needed to benefit from float.
3.7.3 Overdraft Protection

Bank overdraft refers to the withdrawal of money that is greater than the available balance in a
bank account. For a fee, most banks will provide overdraft protection, which allows a withdrawal
to occur even when there are insufficient funds in an account.
Companies can provide some protection against overdrafts by arranging overdraft loans with
the bank. These very short-term loans (generally less than one week) are usually only activated
when an overdraft occurs and may be automatically repaid with the next deposit.
4 Marketable Securities Management
Marketable securities typically provide lower returns than operating assets but higher returns
than cash deposited in savings accounts. Each type of marketable security has features relating
to safety, marketability, yield, maturity, and taxability.
4.1 Common Marketable Securities LOS 2B4n
Marketable securities are investments that can be easily traded. These types of investments can LOS 2B4o
be debt securities (bonds) or equity securities (stocks). They are called marketable securities
because of the ease of selling at a low transaction cost. LOS 2B4p
Examples of marketable securities include the following:

United States Treasury Bills (or T-Bills)
T-bills are sold at a discount and mature at par value. Maturities are 30, 60, and 90 days
and are guaranteed (backed) by the U.S. government. T-bills have the lowest default risk,
have the lowest liquidity risk, and are maturity risk-free. As such, they are among the safest
securities in the market. T-bills set the base level of interest in the U.S. economy. The
government sells these securities in auctions conducted by the Federal Reserve Bank of New
York, after which they can be traded in secondary markets.
Treasury Notes and Treasury Bonds
Treasury notes (T-notes) and Treasury bonds (T-bonds) are issued by the U.S. Treasury and
have a stated interest rate that is paid semiannually. They are traded on secondary markets and
are low risk. T-notes mature in one to 10 years and T-bonds mature in 30 years. Their effective
interest rate is higher than T-bills because they carry more risk due to their longer maturities.
Federal Agency Bonds

Federal agency bonds are issued by certain federal agencies and are traded on secondary
markets. They mature in periods from nine months to 30 years. Federal agency bonds pay
higher interest rates than Treasury issues. Federal National Mortgage Association (Fannie
Mae) mortgage-backed securities are an example of federal agency bonds.
Negotiable Certificates of Deposit (CDs)
Negotiable CDs are money market instruments with maturities of one year or less. Because
CD rates, terms, and dollar amounts may vary significantly by institution, CDs are not
exchange traded. CDs can be purchased through brokers. The guarantees of the largest
commercial banks, Federal Deposit Insurance Corporation (FDIC) regulations and insurance,
and the secondary market keep CD risk and return at low levels. However, bank failure and
default are possible, and these additional risks yield higher returns for CDs than for T-bills.
Banker's Acceptances
A banker's acceptance is a negotiable instrument that is similar to a postdated check, except
that it is guaranteed by the bank rather than by the account holder. The risks associated
with banker's acceptances are only marginally higher than those of government securities,
and yields are only slightly higher. Banker's acceptances are traded on secondary money
markets and are sold at discounted amounts.
Commercial Paper
Commercial paper is unsecured, short-term debt issued by creditworthy corporations
to finance payroll, accounts payable, inventory, and other short-term liabilities. Most
commercial paper loans are sold at a discount, mature at par value, have terms of 90 to 180
days, and are usually sold in denominations of $100,000. They are typically not traded and
are held to maturity by the investor. Their return is higher than a banker's acceptance.
Eurodollars
Eurodollars represent United States dollars that are deposited in international banks,
making them free from U.S. banking regulations. Often, Eurodollar investments are simply
time deposits. Time deposits are investments in the form of interest-bearing accounts in
which deposits are kept for a specified period of time. The investor in this type of account
earns interest. The longer the period to maturity the higher the interest rate.
Money Market Mutual Funds
Money market mutual funds are professionally managed portfolios of marketable securities.
A money market mutual fund invests only in highly liquid, short-term instruments such
as cash, cash-equivalent securities, and high credit rating debt-based securities with a
short-term maturity, such as governmental securities. Because these funds offer high
liquidity with a low level of risk, they generally have returns comparable to negotiable
CDs and commercial paper. Banks and brokerage firms maintain money market funds for
investor deposits.
Repurchase Agreements
A repurchase agreement is an arrangement in which a bank or a security dealer sells
securities and agrees to repurchase them at a specified price and time. These are usually
customized in terms of maturity based on the purchaser's needs. They have slightly higher
risk than Treasury issues.
Municipal Bonds (Local Government Bonds)
Bonds issued by a municipality (also called muni bonds) are beneficial to investors because
the return on these bonds is nontaxable in some countries, including the United States.

PART 2 UNIT
4.2 Factors Influencing the Level of Marketable Securities LOS 2B4m
Companies often hold marketable securities because they can be converted to cash on short
notice. Because marketable securities yield higher returns than cash, many firms will hold
marketable securities in lieu of large cash balances.
Liquidity Motives
When cash outflows exceed inflows, companies can liquidate marketable securities to
increase cash balances.
Precautionary Motives
Marketable securities may be held as a precaution against possible shortages of bank credit
in times of cash need.
4.3 Strategies for Holding Marketable Securities

If interest rates for marketable securities are low and if the time required to liquidate these
securities is substantial, then cash holdings (cash in bank accounts) are preferable to marketable
securities. If interest rates for marketable securities are relatively high and if the time required
to liquidate these securities is minimal, then holding marketable securities is preferable to cash
holdings (cash in bank accounts).
Zolta Co. grants cash discounts to its customers to accelerate cash collections. The credit
terms are 2/10, n/45. Beta Co., one of the customers of Zolta, is reluctant to pay within the
cash discount period and claims that the cash discount is too low and not feasible. Beta
has no cash available to make a payment. Beta's incremental borrowing rate is 12 percent.
What should Beta's financial manager advise? Assume a 360-day year.
a. Not to pay within the discount period; the discount rate is low compared with the
incremental borrowing rate.
b. Borrow enough funds at 12 percent to pay Zolta within the discount period.
c. Postpone the payment of the liabilities to Zolta until cash becomes available
to pay.
d. Borrow funds at a cost of debt higher than the cash discount.
A retailer buys products for resale. A unit of product is sold at cost plus a percentage
markup. Which of the following statements is correct regarding the effect of selling on
credit that unit of product?
a. Working capital will increase.
b. Working capital will decrease.
c. Working capital will not be affected.
d. Working capital is not affected unless the sale was made for cash.
A company has a current ratio of 2 before settling current liabilities by paying cash. What is
the effect on the current ratio when the current liability is paid?
a. No effect
b. Current ratio increases
c. Current ratio decreases
d. Current ratio cannot be determined from the given information

6
MODULE
B.4. Working Capital

Management: Part 2
Part 2
Unit 2
CMA LOS Reference: Part 2—Section B.4. Working Capital Management: Part 2

q. identify the factors influencing the level of receivables
r. demonstrate an understanding of the impact of changes in credit terms or collection
policies on accounts receivable, working capital, and sales volume
s. define default risk
t. identify and explain the factors involved in determining an optimal credit policy
u. define lead time and safety stock; identify reasons for carrying inventory and the
factors influencing its level
v. identify and calculate the costs related to inventory, including carrying costs, ordering
costs, and shortage (stockout) costs
w. explain how a just-in-time (JIT) inventory management system helps manage inventory
x. identify the interaction between high inventory turnover and high gross margin
(calculation not required)
y. demonstrate an understanding of economic order quantity (EOQ) and how a change in
one variable would affect the EOQ (calculation not required)
aa. identify and describe the different types of short-term credit, including trade credit,
short-term bank loans, commercial paper, lines of credit, and bankers' acceptances
cc. calculate the effective annual interest rate of a bank loan with a compensating balance
requirement and/or a commitment fee
dd. demonstrate an understanding of factoring accounts receivable and calculate the cost
of factoring
gg. recommend a strategy for managing current assets that would fulfill a given objective
1 Accounts Receivable Management
Accounts receivable management includes achieving a balance between converting accounts

receivable into cash quickly to meet short-term obligations and extending enough credit to
capture additional sales without increasing bad debt expense.
LOS 2B4q 1.1 Factors That Influence the Level of Receivables

The factors that influence the level of receivables are:
Total Sales: Higher sales generally mean higher receivables.
Level of Credit Sales: Receivables are higher for companies that primarily sell on credit
rather than cash.
Credit Policies: Companies with less stringent credit policies, including lower credit
standards and longer payment periods, generally have higher receivables, but may also
have higher write-offs.
LOS 2B4r 1.2 Credit Policy

LOS 2B4s Credit policy is one of the major determinants of demand for a firm's products or services,
along with price, product quality, and advertising. The credit policy of a company is typically
LOS 2B4t established by a committee of senior company executives. Credit policy variables include:
Credit Period: Credit period is the length of time buyers are given to pay for their
purchases. A commonly used credit period is 30 days. If the credit period is too long, the
company may experience cash shortages. A credit period that is too short may damage
relationships with customers and negatively affect future sales.
Credit Standards: Credit standards refer to the required financial strength of credit customers.
Extending credit to only financially strong customers minimizes uncollectible receivables, but
also limits potential sales. Extending credit to a broader base of customers increases sales, but
adds risk in that a greater percentage of receivables are likely to be written off.
Collection Policy: Collection policy is measured by its stringency or laxity in collecting
delinquent accounts. This is also a balancing act between wanting to collect cash owed
quickly versus maintaining positive relationships with customers.
Discounts: Discounts include the discount percentage and period. Offering discounts to
customers who pay early may result in faster receivables collection, depending on the terms
of the discount and the customer's own cash needs and capacity to pay early.
Pass Key
Stricter credit terms (i.e., shorter credit periods and higher credit standards) generally lead
to lower sales volume, lower accounts receivable, and lower working capital, but also lower
levels of uncollectible accounts. More generous credit terms (i.e., longer credit periods and
lower credit standards) generally lead to higher sales volume, higher accounts receivable,
and higher working capital, but may also lead to higher levels of uncollectible accounts.

PART 2 UNIT
1.3 Factoring LOS 2B4dd
Factoring accounts receivable entails turning over the collection of accounts receivable to a
third-party factor in exchange for a discounted short-term loan. Cash is collected from the factor
immediately rather than from the customer according to the credit terms.
Example 1 Factoring
Facts: Radon Technologies enters into an agreement with a firm that will factor the company's
accounts receivable. The factor agrees to buy the company's receivables, which average
$50,000 a month, and have an average collection period of 30 days. The factor will advance up
to 80 percent of the face value of receivables at an annual rate of 12 percent and charge a fee
of 2 percent on all receivables purchased. The controller of the company estimates that the
company would save $10,000 in collection expenses over the year. Fees and interest are not
deducted in advance. Assuming a 360-day year, what is the annual cost of financing?
Required: Assuming a 360-day year, compute the annual cost of financing.
Solution:
× (Days in year /
AR × Fee days in period) Subtotals
AR submitted $50,000 2% 360 / 30 $ 12,000
Amount withheld (20%) (10,000)
Amount subject to interest 40,000 12% / 12 360 / 30 4,800
Cost to company 16,800
Less expense saved (due to
(10,000)
outsource of collections)
Net cost $ 6,800
Net cost / average amount advanced = $6,800 / $40,000 = 17% (APR)
2 Inventory Management LOS 2B4u
LOS 2B4v
Inventory management balances the cash requirements of the firm with the product delivery
requirements of its customers. This means having adequate product in the right place at the
right time to meet consumer demand without incurring excessive or unnecessary inventory
carrying costs.
2.1 Factors Influencing Inventory Levels

Accurate sales forecasts enable management to optimize inventory levels. Lack of inventory can
result in lost sales, and excessive inventory can result in burdensome carrying costs, including:
Storage costs
Insurance costs
Opportunity costs of inventory investment
Lost inventory due to obsolescence or spoilage
Pass Key
The lower the carrying costs of inventory, the more inventory companies are willing to carry.
2.2 Optimal Levels of Inventory

Numerous factors affect the optimal level of inventory, including the usage rate of inventory per
period of time, cost per unit of inventory, cost of placing orders for inventory, and the time required
to receive inventory. Concepts related to the determination of the optimal level of inventory include:
Safety stock
Reorder point
Economic order quantity
2.3 Safety Stock

Many companies maintain safety stock to ensure that manufacturing or customer supply
requirements are met. The determination of safety stock depends on the following factors:
Reliability of sales forecasts
Possibility of customer dissatisfaction resulting from back orders
Stockout costs (the cost of running out of inventory), including loss of income, the cost of
restoring goodwill with customers, and the cost of expedited shipping to meet customer demand
Lead time (the time that elapses from the placement to the receipt of an order)
Seasonal demands on inventory
2.4 Reorder Point

The reorder point is the inventory level at which a company should order or manufacture
additional inventory to meet demand and to avert incurring stockout costs. The reorder point
can be calculated using the following formula:
Reorder point = Safety stock + (Lead time × Sales during lead time)
Example 2 Safety Stock and Reorder Point
Facts: Worldwide Widgets sells 8,000 widgets per year, manufactures widgets in groups of
1,500, and requires five weeks of lead time for widget production. Worldwide also maintains an
absolute minimum safety stock of 1,200 widgets.
Required: Assuming a 50-week year and constant demand, compute Worldwide's reorder point
for widgets.
Solution: Worldwide sells an average of 160 widgets per week (8,000 widgets per year / 50 weeks).
Reorder point = Safety stock + (Lead time × Sales during lead time)
Reorder point = 1,200 widgets + (5 weeks × 160 widgets per week) = 2,000 widgets
Worldwide will manufacture additional widgets when its inventory of widgets falls to 2,000 units.

PART 2 UNIT
2.5 Economic Order Quantity LOS 2B4y

When managing inventory, there is a trade-off between carrying costs (the costs of holding
inventory) and ordering costs (the costs of ordering additional inventory). For example, if
the order quantity is small then carrying costs are low, but inventory must be ordered more
frequently to meet demand, which increases ordering costs.
Ordering costs typically represent the costs of labor associated with order placement. The costs
are driven by order frequency (rather than quantity per order) and they include the costs of
entering the purchase order, processing the receipt of the inventory, inspecting the inventory to
ensure that the goods received (typically a sample) are acceptable, and processing of the vendor
invoice and consequent payment.
The economic order quantity (EOQ) inventory model attempts to minimize total ordering and
carrying costs. The model can be applied to the management of any exchangeable good.
Illustration 1 Variables Affecting Economic Order Quantity
Order Cost: Assuming all other things are equal, as cost per order goes up, the
purchasing manager is willing to purchase more units in one order.
Annual Demand: As annual demand for an item increases, assuming all other variables
are constant, the EOQ will also increase.
Carrying Cost per Unit: When carrying cost per unit goes up, the purchasing manager
will not be interested to have too much inventory sitting around in a warehouse. This
results in a lower EOQ.
2.5.1 Assumptions
EOQ assumes that demand is known and is constant throughout the year, so EOQ does not
consider stockout costs, nor does it account for costs of safety stock. EOQ also assumes that
carrying costs per unit and ordering costs per unit are fixed.
2.5.2 The EOQ Equation and Equation Components
2SO
E =
C
Order size (EOQ)

S = Annual Sales (in units)
O = Cost per Purchase Order
C = Annual Carrying cost per unit
Note the annual carrying cost may also be stated as a percentage of the unit's cost.
Example 3 EOQ
Facts: Maximus Company incurs carrying costs of $50 a month and each order costs the
firm $5,625.
Required: Calculate Maximus' economic order quantity if Maximus goes through 100 units of
inventory monthly.
Solution:
2SO
E=
C
2 × 100 × $5 ,625
E=
$50
E = 150 units
When Maximus orders inventory, it should order 150 units to minimize total ordering costs and
carrying costs.
Note: Although the formula calls for annual sales and carrying costs, using monthly sales in the
numerator and monthly carrying costs in the denominator will produce the same result.
LOS 2B4w 2.6 Other Inventory Management Issues

2.6.1 Just-in-Time Inventory Models
The just-in-time (JIT) inventory model was developed to reduce the lag time between inventory
arrival and inventory use. JIT ties delivery of components to the speed of the assembly line.
JIT reduces the need of manufacturers to carry large inventories, but requires a considerable
degree of coordination between manufacturer and supplier. The benefits of JIT implementation
include tying production scheduling with demand, more efficient flow of goods between
warehouses and production, reduced setup time, and greater employee efficiencies.
2.6.2 Kanban Inventory Control

Kanban inventory control techniques give visual signals that a component required in
production must be replenished. This technique prevents oversupply or interruption of the
entire manufacturing process as the result of lacking a component.
2.6.3 Computerized Inventory Control

Computerized inventory control operates by establishing real-time communication links
between the cashier and the stock room. Every purchase is recognized instantaneously by the
inventory database, as is every product return. Computers are programmed to alert inventory
managers as to reorder requirements. In some cases, company databases interface directly with
supplier software to allow for instantaneous reorders, thereby removing the human element.
LOS 2B4x 2.7 Relationship Between Inventory Turnover and Gross Margin
The relationship between turnover and gross margin is important. An entity with high gross
margin and/or high inventory turnover will be more profitable. If gross margin declines,
inventory turnover will need to increase in order to maintain profitability. Conversely, if
inventory turnover declines, gross margin will need to increase to maintain profits.

PART 2 UNIT
3 Short-Term Credit LOS 2B4aa
Entities unable to satisfy current asset acquisitions with cash on hand often finance them with
short-term credit instruments (loans).
3.1 Short-Term Financial Instruments LOS 2B4cc
A variety of short-term financial instruments, each with their own risk characteristics, are
available to financial managers for various short-term financing needs.
3.1.1 Trade Credit

Trade credit (accounts payable) generally provides the largest source of short-term credit for
small firms. Trade credit represents the purchases of goods and services as part of usual and
customary business transactions that are generally paid 30 to 60 days after acquisition of the
goods and services unless an early payment discount is offered.
3.1.2 Short-Term Bank Loans

Short-term bank loans are notes payable to financial institutions that are due in 12 months or
less from the time of issuance.
Compensating balance requirements related to bank loans increase the effective annual interest
rate on such borrowings, which can be calculated using the following formula:
Annual interest expense

Effective annual interest rate =
Amount available for use
Example 4 Compensating Balance and Effective Interest Rates
Facts: A company borrows $1,000,000 for one year from a local bank at an annual interest rate
of 10 percent. The bank requires a 15 percent compensating balance as a security amount.
Required: Calculate the effective interest rate on the funds borrowed.
Solution:
Effective annual Annual interest expense

interest rate Amount available for use
$1,000,000
10%
funds borrowed

$1,000,000 Compensating
$1, 000, 000
funds borrowed balance of 15%
$100,000
11.76%
$850,000
The compensating balance requirements cause the effective interest rate paid on the
borrowed funds to increase from 10 percent to 11.76 percent because the company is
unable to use the full amount of the $1,000,000 funds borrowed.
3.1.3 Line of Credit

A line of credit is an arrangement with a financial institution that establishes a maximum loan
amount that can be borrowed. The borrower can access and pay back funds at any time as long
as the credit limit is not exceeded.
3.1.4 Commercial Paper

Commercial paper is unsecured, short-term debt issued by creditworthy corporations to finance
payroll, accounts payable, inventory, and other short-term liabilities. Most commercial paper
loans are sold at a discount, mature at par value, and have terms of no more than 270 days.
Commercial paper is issued in denominations of $100,000 or more.
3.1.5 Banker's Acceptances

A banker's acceptance is a negotiable instrument that is similar to a postdated check, except that
it is guaranteed by the bank rather than the account holder. Banker's acceptances can be used
as a bank-backed payment for large transactions. After issuance, banker's acceptances can be
traded at a discount in the money market.
LOS 2B4gg 4 Current Asset Levels
Determining the appropriate level of current assets and the best method to finance those assets
is a matter of management's judgment and risk appetite. If management is risk-aggressive,
the company may employ short-term financing sources to fund acquisitions of long-term
assets. Risk-averse managers, however, may prefer the use of current liabilities to acquire
current assets.
Example 5 Working Capital Management
Facts: A new financial manager is hired at Home Office Furnishings Inc., a small
manufacturer of metal office furniture, and is asked to develop a sound working capital
policy while maintaining a debt-to-equity ratio of 1.
Three potential policies are identified:
1. An aggressive policy, which calls for a minimum amount of current assets (30 percent
of sales);
2. A conservative policy, which calls for a substantial amount of current assets (70 percent
of sales); and
3. A moderate policy, which falls between the aggressive and conservative policies and
calls for a moderate amount of current assets (50 percent of sales).
(continued)

PART 2 UNIT
(continued)
The financial manager forecasts a balance sheet for each scenario based on $4 million of
estimated sales, as follows (in thousands):
Home Office Furnishings Inc.
December 31, Year 1
Balance Sheet
Aggressive Moderate Conservative
(Current assets (Current assets (Current assets
= 30% of sales) = 50% of sales) = 70% of sales)
Current assets $1,200 $2,000 $2,800
Net fixed assets 600 600 600
Total assets 1,800 2,600 3,400
Short-term debt (8.00%) $ 900 $ 650 $ 0
Long-term debt (10.00%) 0 650 1,700
Common equity 900 1,300 1,700
Total liabilities and equity $1,800 $2,600 $3,400
Variable costs will account for 60 percent of forecasted sales, regardless of the policy
adopted. Fixed costs will increase as more current assets are held due to increased inventory
storage fees and higher insurance premiums. Annual fixed costs would be $1,000,000
under an aggressive policy, $1,050,000 under a moderate policy, and $1,100,000 under a
conservative policy. The tax rate is 40 percent.
Required:
1. Draft a report that shows the return on equity under each of the working policies
described above.
2. Describe how a firm that is willing to take relatively high risks in the hope of earning high
returns would make such a decision using the scenario above.
Solution:
1. The expected return on equity under each of the working capital policies described is
calculated as follows:
Aggressive Moderate Conservative
Sales (given) $4,000 $4,000 $4,000
Variable cost (60% of sales) (2,400) (2,400) (2,400)
Fixed cost (given) (1,000) (1,050) (1,100)
EBIT $600 $550 $500
Interest on short-term debt (8%) (72) (52) -
Interest on long-term debt (10%) – (65) (170)
EBT $ 528 $ 433 $ 330
Taxes (40%) (211) (173) (132)
NI $ 317 $ 260 $ 198
ROE 35% 20% 12%
2. With an aggressive working capital policy, a firm would hold minimal safety stock and have
a restrictive credit policy to minimize costs. This results in low levels of current assets. To
achieve a debt-to-equity ratio of 1:1, the company borrowed $900,000 in short-term debt.
This strategy resulted in a current ratio of 1.33 ($1,200 ÷ $900), indicating the liquidity risk the
company is taking. Return on equity (ROE) is the highest in this aggressive case (35 percent).
A company produces widgets. Management estimates the annual demand to be

approximately 120,000 units. The ordering cost is $250 per order and the carrying cost
is $2.40 per unit per year. Each month consists of approximately four weeks, and the
company receives the goods a week after the goods are ordered. The company has a policy
of retaining 400 units as safety stock. At what point should the company reorder new units?
a. 10,000 units
b. 2,900 units
c. 2,500 units
d. 400 units
A company produces spools of nylon thread. Management estimates the annual demand
to be approximately 120,000 units. The ordering cost is $250 per order and the carrying
cost is $2.40 per unit per year. What is the optimal number of units per order?
a. 5,000 units
b. 3,356 units
c. 1,444 units
d. 48 units
Zelfo Co. spends an average of $35,000 annually to collect its receivables. Management
can factor the company's receivables and eliminate the collection costs. The accountant
accumulated the following information:
yyAverage accounts receivable balance per month is $400,000 with an expected collection
period of 30 days.
yyA factor charges a 1 percent fee on all receivables factored each month.
yyThe factor advances 75 percent of the accounts receivable factored each month and
charges annual interest of 8 percent.
What is the net annual cost of factoring the receivables?
a. $24,000
b. $37,000
c. $48,000
d. $72,000

PART 2 UNIT
Malki Co. is currently evaluating two suppliers. The payment terms offered by each supplier
are as follows:
Supplier Terms
Supplier A 1/10, net 30
Supplier B 2/20, net 80
Other than this difference in payment terms, both suppliers provide identical products,
quality, and service. Which of the following statements is correct?
a. Supplier B offers a 2 percent discount for early payments and Supplier A offers
only a 1 percent discount for early payment; therefore, Supplier B's products are
more costly.
b. Supplier B is a better choice because the annual savings resulting from paying
Supplier B during the discount period are higher than the annual savings resulting
from paying Supplier A.
c. Malki cannot use the presented information for any decision.
d. Both suppliers are offering identical products; therefore, Malki is indifferent when
dealing with either supplier.
NOTES

7
MODULE
B.5. Corporate
Restructuring
Part 2
Unit 2
CMA LOS Reference: Part 2—Section B.5. Corporate Restructuring

a. demonstrate an understanding of the following:
i. mergers and acquisitions, including horizontal, vertical, and conglomerate
ii. leveraged buyouts
b. identify defenses against takeovers [e.g., golden parachute, leveraged recapitalization,
poison pill (shareholders' rights plan), staggered board of directors, fair price, voting
rights plan, white knight]
c. identify and describe divestiture concepts such as spin-offs, split-ups, equity carve-
outs, and tracking stock
d. evaluate key factors in a company's financial situation and determine if a restructuring
would be beneficial to the shareholders
e. identify possible synergies in targeted mergers and acquisitions
f. value a business, a business segment, and a business combination using discounted
cash flow method
g. evaluate a proposed business combination and make a recommendation based on
both quantitative and qualitative considerations
1 Business Combinations LOS 2B5a
In business combinations, two or more companies combine to create a new, larger company
that potentially expands its production capabilities, workforce, market share, and/or access to
new markets. Companies combine because they think they can be more valuable as one entity,
reduce duplicative functions (e.g., accounting and other administrative departments) and/or
combine advanced technological capabilities.
An entity can expand its operations by entering into a business combination. The four primary
types of combinations include horizontal, vertical, circular, and diagonal combinations.
Transactions include mergers, acquisitions, consolidations, tender offers, purchases of assets,
and management acquisitions.

7 B.5. Corporate Restructuring PART 2 UNIT 2
1.1 Types of Business Combinations

1.1.1 Horizontal Combination
A horizontal combination occurs when companies in the same industry that produce the
same goods or provide the same services join together under single management/leadership.
Both horizontal and vertical combinations (described next) offer benefits, such as reduced
competition, economies of scale leading to reduced costs, expertise at various levels of
production, minimized overproduction, and maximized profits.
Illustration 1 Horizontal Combination
Heinz and Kraft Foods, both in the business of selling processed food to consumers, merged
into one company—the Kraft Heinz Company—in 2015. The expectation at the time of the
merger was that the new company would become one of the largest food and beverage
companies in both the United States and the world. The new company projected annual
revenues of approximately $28 billion, along with an expected $1.5 billion in cost savings.
1.1.2 Vertical Combination

A vertical combination involves the combination of companies at different stages of the
production process. The companies can be from the same industry or multiple industries. A
vertical combination can assure the supply of raw materials (backward integration) or provide a
stable market for products sold (forward integration).
Illustration 2 Vertical Combination
In 1996, Time Warner Inc. merged with Turner Broadcasting to create a massive, worldwide
entertainment conglomerate. This merger provided Time Warner access to many of the
basic cable television channels (and historical films) that were owned previously by Turner.
Federal Trade Commission concerns about the merger's effect on competition in the cable
industry kept the deal in limbo for months.
1.1.3 Circular Combination (Conglomerate Combination)

A circular combination occurs when different business units with relatively remote connections come
together under single management. The relationship could come from using similar distribution or
advertising channels, or requiring similar production processes. Having one management group
over the combined units reduces overall administrative and other operational costs.
Illustration 3 Circular Combination
Pharma Inc. is a leading company in the U.S. pharmaceuticals industry. In order to expand
its business within its current consumer market and to take advantage of potential cost
reductions, it acquires Letson Watson—a company specializing in building residential real
estate for adult communities 55 and older.
2–104 Module 7 B.5. Corporate

© Becker Professional Education Corporation. Restructuring
All rights reserved.
PART 2 UNIT
7 2 B.5. Corporate Restructuring
1.1.4 Diagonal Combination

A diagonal combination occurs when a company that engages in an activity integrates with
another company that provides ancillary support for that primary activity. The purpose is to
ensure that the ancillary support is delivered in a timely and effective manner, which is crucial to
the mission of the primary activity and business.
Illustration 4 Diagonal Combination
Landbright Farms breeds organic livestock and sells the meat to high-end grocery
stores. Fresh Meats Inc. transports Landbright's products to market in refrigerated
trucks. If Landbright were to merge with Fresh Meats, this would be an example of a
diagonal combination.
1.2 Transactions
A company acquiring another company has several options to complete the transaction:
completing a merger with the target company, purchasing the assets of the target company,
or purchasing enough of the target company's voting shares to exercise control. Local laws,
including antitrust laws, govern each of these transactions. Attempts to monopolize a market
are illegal in many countries. Complying with laws in multiple countries complicates business
combinations.
1.2.1 Merger
In a merger, two (or more) entities combine to form a single new corporation, with the stocks
of all merging companies surrendered and replaced with new stock in the name of the new
company. Mergers often involve the combination of like-sized companies. The boards of
directors of both companies initiate and approve the plan, and notice is given to all shareholders
of the companies to attend a meeting and approve the plan. Most countries require a
supermajority vote (over two-thirds of the votes) in favor of the merger to be able to complete it.
Illustration 5 Merger
A merger generally results in a new company that is the combination of two or more
companies. The Dow Chemical Company and E.I. du Pont de Nemours & Company
("DuPont") was successfully completed on Sept. 1, 2017, when shares of DowDuPont began
trading on the New York Stock Exchange. Upon completion of the merger, DowDuPont
became the second largest chemical company in the world.

1.2.2 Acquisition
In an acquisition, the acquirer purchases majority ownership of the acquired company. The
acquisition of one company by another involves no new company. Only the acquirer remains
after the acquisition. The acquired firm, which is generally smaller than the acquiring firm, may
retain its legal structure and name, or it may be subsumed by the acquirer and cease to exist.
Illustration 6 Acquisition
In 2017, Amazon and Whole Foods Market Inc. entered into an agreement under which
Amazon acquired Whole Foods Market for $42 per share in an all-cash transaction valued
at approximately $13.7 billion, which included Whole Foods Market's net debt.
1.2.3 Tender Offer

In a tender offer, a company makes an offer directly to shareholders to buy the outstanding
shares of another company at a specified price. The offer may be in the form of cash or
securities of the acquiring corporation (stocks, warrants, debt issuances). Shareholders of the
target company have the option of accepting or rejecting the offer.
Illustration 7 Tender Offer
Biltmore Inc. offers $13 per share to buy the stock directly from the shareholders of
Alexander Co. (the target company). Alexander stock is currently selling at $11 per share,
making the Biltmore offer very attractive to the target's shareholders. Assuming that the
majority of shareholders agree to the terms, Biltmore will provide $13 per share. This is an
example of a tender offer.
1.2.4 Purchase of Assets

A purchase of assets transaction occurs when a portion (or all) of the selling company's assets
are purchased by the acquiring company, which may result in the dissolution of the selling
company. As with a tender offer, shareholder approval must be obtained. Unlike a merger, the
buyer need not assume all liabilities of the selling company. Liabilities not assumed by the buyer
continue to be the responsibility of the selling company.
Illustration 8 Purchase of Assets
Lox Industries enters into an asset purchase agreement with Bright Star Inc. to purchase
approximately 80 percent of the latter's buildings and equipment. As part of the
agreement, Lox agrees to assume the liabilities associated with mortgages outstanding on
the buildings and capital leases on the equipment purchased.

PART 2 UNIT
1.2.5 Management Acquisition/Leveraged Buyout

In a management acquisition, a company's executives purchase a controlling interest in that
company. After the purchase, the company is privately held.
Many management acquisitions are financed with large amounts of debt and referred to as
leveraged buyouts (LBOs). Some leveraged buyouts are financed with the issuance of junk bonds.
These buyouts are very risky for the lender and require the payment of high interest rates.
Illustration 9 Management Acquisition
The chief executive officer of a publicly traded corporation purchases all of the
corporation's voting shares of stock. By the officer's action, the company is now a private
company acquired by management.
1.3 Resulting Synergies of Business Combinations LOS 2B5e
Companies enter into business combinations with the premise that such combinations will
result in synergies. Synergies are realized when the value of the merged company exceeds
the combined value of the separate companies before the combination. Synergies can be
categorized into three common types: revenue, cost, and financial.
1.3.1 Revenue Synergies

Revenue synergies occur when the combined company is able to generate revenues that exceed
the sum of the revenues of the separate companies.
Revenues can be increased by entering a market's geographic areas where only one of the
companies operated before the combination.
Revenues can be increased by better utilizing existing distribution channels of both
companies and by encouraging the sales force to sell more complementary products.
Revenues can be increased by capitalizing on each company's area of expertise. A company
with excellent products can increase its sales when merging with a company with excellent
distribution channels and sales force.
1.3.2 Cost Synergies
Cost synergies occur when the combined company is able to reduce costs more than the two
companies are able to individually.
The average cost of production may be reduced due to economies of scale resulting from
the combination. Economies of scale occur more often in horizontal mergers.
Information technology costs may be reduced or leveraged by pooling the IT resources of
both companies.
Warehousing costs can be reduced through sharing storage space.
Redundant activities may be eliminated.
Supply chain relationships may be better utilized.
The results of research and development efforts conducted by one company may be used
to improve efficiencies of the other company.
A larger company can negotiate better prices and better payment terms with vendors.
The new company can reduce staffing needs through the elimination of duplicate positions.

1.3.3 Financial Synergies

Combining companies may result in financial advantages that the smaller, individual companies
could not achieve.
The costs of borrowing may be reduced if the combined companies can borrow funds at
lower interest rates.
The cost of capital may be reduced for the combined company if the larger company is
perceived to be less risky than the smaller, individual companies.
Tax benefits may be achieved when a company with strong earnings merges with a
company with accumulated operating losses.
Larger companies may have better investment opportunities. Excess funds from the
combined liquidity of the new company may be used to purchase higher-return investment
opportunities.
Reduced portfolio risk may be achieved by merging with a company in a different industry.
This diversification can help stabilize earnings of the combined company.
LOS 2B5b 2 Takeover Defenses
Takeover is the term used to describe one company (or a group of owners) assuming control of
another company. The term may be used to describe any merger or consolidation, but a hostile
takeover is a takeover that is not negotiated or approved by the directors of the target company.
A hostile takeover occurs when a buyer attempts to control another entity (the target) without
the consent of the target's board of directors (or management). During a hostile takeover
attempt, the buyer may approach shareholders and initiate a tender offer or may ask to control
the shareholders' proxies in a proxy fight (a proxy is the authority to represent shareholders in
voting). Several methods can be used as defenses against hostile takeovers.
2.1 Issuing Restricted or Differential Voting Rights

A hostile takeover can be prevented by selling shares with fewer voting rights to outside
shareholders while management owns shares with higher voting rights. This combination makes
it difficult for a buyer to buy enough shares to take control of the company. Another defense is
to require a shareholder owning a significant number of shares to obtain board permission to
vote once a specified ownership threshold occurs.
2.2 Stock Repurchase

Stock repurchases are an effective defense against takeover attempts. When a target company
purchases its own shares from its shareholders, the target company reduces the available
shares that a hostile buyer may purchase. This may result in an increase in the market price per
share due to the reduction of the number of shares on the market, which increases the cost of
the takeover target and reduces potential gains from the acquisition.

PART 2 UNIT
2.3 Poison Pill

There are several types of poison pill strategies, including the flip-in poison pill, the flip-over
poison pill, and the voting rights plan. These strategies allow the shareholders of the target
company to receive rights to purchase additional shares of either the target corporation or the
buying corporation at a reduced price when a takeover attempt is announced. The shareholders
of the target company can exercise the rights when the buying corporation acquires a certain
percentage of the target company. Exercising these rights dilutes either the buyer's ownership
of the target company or dilutes the ownership of the buyer's shareholders. This dilution may
deter the takeover.
A flip-in poison pill strategy involves allowing the shareholders of the target company to
purchase additional target company shares at a discounted price. This right to purchase
additional target company shares at a discounted price is usually triggered as soon as the
buyer purchases a specified percentage of the target company's stock.
A flip-over poison pill gives shareholders of the target company the right to purchase shares
of the buying company at a deep discount. This right may make the target company less
attractive if the buyer perceives that execution of the flip-over poison pill will dilute the
current shareholders' ownership of the buying company after the acquisition takes place.
However, the target company's shareholders have this exercise right only if the bylaws of
the buying company provide this right to the target company's shareholders.
A voting rights plan is implemented when a company issues preferred stock with superior
voting rights to common shareholders, preventing the acquirer of a substantial quantity of
the target firm's voting common stock from controlling the company. For example, acquiring
all of the common stock of a company may give the holder only 20 percent of the voting
rights if the rest of the voting rights are held by preferred shareholders.
2.4 Staggered Board of Directors

In a staggered board strategy, only a few members of the board of directors of the target
company are elected each year. This strategy makes it difficult for the buyer to control the target
company as the buyer must wait several years before having the ability to appoint a majority
representation to the target company's board. This requirement to wait several years may make
the target company less attractive to a potential buyer.
2.5 Shark Repellent

The target company persuades its shareholders to amend the charter or bylaws to include
some provisions that make the takeover unattractive to the buyer (the shark). An example of a
shark repellent strategy is to include provisions in the charter that require a supermajority of
shareholders' votes to approve a takeover.
2.6 Golden Parachutes

Golden parachutes are additional, substantial compensation that the target company's executive
officers will receive in the event of a successful takeover. These large compensation payments
to executive officers reduce the available assets of the target company and may force the buyer
to reduce the offering price for the target company's shares. A lower offering price generally
is less attractive to shareholders and may blunt the buyer's proposed acquisition of the
target company.

2.7 Greenmail
Similar to the term blackmail, greenmailing refers to when an acquirer buys enough stock to
threaten a target with a hostile acquisition and then resells it to the target at a substantial
premium to prevent the takeover.
2.8 Standstill Agreements

A standstill agreement usually accompanies the greenmail strategy. With the execution of a
standstill agreement, the buyer agrees not to buy any additional shares of the target company
within a specified period.
2.9 Crown Jewels

To make the target company less attractive to the buyer, the target company sells its valuable
assets (the crown jewels) to a company other than the one attempting the takeover. With the
crown jewels no longer owned by the target company, the target company generally is no longer
attractive to the buyer and the buyer often forgoes its attempt to buy the target company. In a
crown jewels/lockup provision, the target company may buy back the crown jewels (assets) from
the third party (which could be a white knight) at a predetermined price.
2.10 Leveraged Recapitalization

In a leveraged recapitalization, management of the target company restructures its own
debt-to-equity ratio by borrowing a large amount of funds and paying a cash dividend to its
shareholders. Increasing the debt and reducing the equity through the payment of dividends
makes the target company less attractive and may deter the buyer from pursuing the
takeover. Rather than paying dividends, the target company may choose to borrow the funds
to repurchase its own stock. This course of action has the same effect of increasing debt and
reducing equity.
2.11 White Knight

A white knight is a desirable buyer that the management of the target company wants to be
acquired by (rather than the hostile buyer). In this strategy, the management of the target
company asks the management of the white knight to issue a competing tender offer to buy the
shares of the target company. The management of the target company hopes that the white
knight's competing tender offer will outbid or ward off the hostile buyer's offer.
2.12 Pac-Man Defense

In a Pac-Man defense, the target company issues a tender offer to the buyer's shareholders to
purchase the shares of the buyer at a premium.
2.13 Fair Price Provision

A provision in the bylaws of the target company may state that any buying company is required
to pay noncontrolling interest shareholders of the target company a fair price for their shares.
The fair price may be linked to the historical earnings of the target company and/or may require
the buyer to wait for a certain period of time before the acquisition is completed. In addition, the
fair price provision may require that the acquiring company pay all target company shareholders
the same amount per share.

PART 2 UNIT
3 Divestitures LOS 2B5c
A divestiture involves the partial or full disposal of a component or business unit of a

company. Divestiture transactions include sell-offs, spin-offs, equity carve-outs, split-ups, and
tracking stock.
3.1 Sell-off
A sell-off is an outright sale of a subsidiary because, for example, the subsidiary's core
competencies do not align with the overall company's or because there is a lack of synergy
between the company and its subsidiary. Legal action stemming from anticompetitive or
antitrust practices may also require a sell-off.
Illustration 10 Sell-off
Management and shareholders of BeckCo Industries think that its ownership of Blended
Ltd. is causing the overall entity to be undervalued from a market perspective. As a result,
the company sells the assets and liabilities of Blended to another entity in the hopes that
investors will react favorably to the sale, which will lead to an increase in the stock price.
3.2 Spin-off
A spin-off creates a new, independent company by separating a subsidiary business from a parent
company. A spin-off can be completed by distributing stock in the new entity as a stock dividend
to existing shareholders or by offering shareholders stock in the new company in exchange for
their stock in the parent company. Spin-offs typically occur when a unit is less profitable and/or
unrelated to the core parent business. The assumption is that the operations of the unit after a
spin-off are expected to have more value than they did as part of the larger operation.
Shares are distributed to shareholders in the same proportion as their previous ownership in
the original corporation. For example, a shareholder owning 10 percent of the shares of the
original company will receive 10 percent of the shares of the new company.
Illustration 11 Spin-off
In 1994, Eli Lilly and Company (a large, U.S.-based global pharmaceutical company) shifted
its focus purely to pharmaceuticals and other similar businesses. As a result, Lilly spun off
its medical devices division, which went public later that year under the name Guidant.
Guidant focused on cardiovascular medical products, such as artificial pacemakers, stents,
and cardioverter-defibrillators.

3.3 Split-up
In a split-up, the parent company is broken into two or more entirely new entities. Unlike sell-offs
and spin-offs, in which the parent company survives, the parent company does not survive a split-up.
Illustration 12 Split-up
In 2018, United Technologies was split into three new companies: United Technologies, Otis
Elevator Company, and Carrier. United Technologies remains the name of one of the new
companies, but it is an entirely new company.
3.4 Equity Carve-out

An equity carve-out occurs when a subsidiary is made public through an initial public offering
(IPO), thereby creating a new publicly listed company. Unlike a spin-off, in which no cash comes
to the parent company, the sale of shares in the new company generates cash for the parent
as well as providing the parent with a controlling interest in the subsidiary. The hope is this
strategy will unlock the independent value of the subsidiary previously contained within the
merged entity.
Illustration 13 Equity Carve-out
Teco Industries is a multinational company with several divisions specializing in unique

product lines. Fearing that Teco is not focusing enough on its core business, management
would like to divest one of the company's units. Management is interested in both a cash
infusion from the divestiture and maintaining some degree of control. The equity carve‑out
is the most likely choice because it would provide cash while allowing management to
retain a controlling interest.
3.5 Tracking Stock

Tracking stock is used by companies to issue separately traded equity securities for separate
portions of the business. Tracking stock shareholders receive dividends based on the performance
of the tracked business. Changes in the price of tracking stock may not align with changes in the
price of the issuer's other stock. Tracking stock is an opportunity for investors to invest in a division
they prefer and is also beneficial to the corporation, which can raise additional capital by issuing
new tracking stock representing ownership equity in a specific division.
Illustration 14 Tracking Stock
Sony Corp. resolved at a meeting of its board of directors in May 2001 to issue shares of
subsidiary tracking stock, the economic value of which was intended to be linked with
the economic value of Sony Communication Network Corp., a wholly owned Japanese
subsidiary engaged in the provision of Internet-related services.

PART 2 UNIT
4 Business Valuation LOS 2B5f
After the buyer identifies the target that it wishes to acquire, the value of the target must be
estimated using a discounted cash flow method.
4.1 Discounted Free Cash Flow

The value of the target can be determined by discounting the entity's free cash flows (FCF) to
their present value. The following steps are used in this process:
1. Determine the free cash flows (FCFs).
2. Determine the required rate of return using the capital asset pricing model (CAPM).
3. Calculate the present value of the future FCFs using the discount rate from CAPM by using
the Gordon growth model.
4.1.1 Free Cash Flow

FCF is calculated as follows:
Free cash flow (FCF) = [EBIT × (1 – Tax rate)]

+ Noncash expenses (such as amortization
or depreciation expense)
– Increases in working capital
– Capital expenditures
Where:
EBIT = Earnings Before Interest and Taxes
Note: If the exam does not give a tax rate, then free cash flow
can be calculated on a pretax basis.
Note that the starting point for FCF is after-tax earnings before deducting interest paid by the
target company. Interest expense is not included in order to ascertain the value of the company
as if there were no debt to service. If the target company had no debt, the value of the target
equals the value of the assets, which equals the preset value of all after-tax future cash flows
without the effect of interest expense. If the buyer assumes the liabilities of the target, the
market value of the liabilities will reduce the cash or stock consideration the buyer will pay in
order to purchase the target.

4.1.2 Required Rate of Return (Capital Asset Pricing Model)

When calculating the present value of future cash flows, the buyer must determine the
discount rate to be used. This discount rate can be calculated using the capital asset pricing
model (CAPM).
The Capital Asset Pricing Model (CAPM)

Where:
Rm = Market return
4.1.3 Gordon Growth Model

The Gordon growth model can be used to calculate the present value of the target company's
free cash flows.
The Gordon growth model (using free cash flows)

The present value of cash flows (constantly growing) = FCF1 ÷ (R – G)
Where: FCF1 = The expected future free cash flows for the next year
R = The required rate of return (CAPM)
G = The expected, constant growth rate
If the target company is expected to generate varying after-tax cash flows for several years
followed by after-tax cash flows that grow at a constant growth rate into the future, the acquirer
can use the two-stage Gordon growth model (GGM). In the GGM, cash flows in the early years
are discounted at the required rate of return and the long-term cash flows projected into
perpetuity are discounted based on a constant growth rate. Adding the present value of the
cash flows in the early years with the present value of the cash flows into perpetuity results in an
estimate of the maximum price the buyer is willing to pay.

PART 2 UNIT
Example 1 Valuation of a Business
Big Company has identified Small Company as a target for acquisition and wants to
determine the maximum price Big Company should pay for the purchase using the
following data (in thousands of dollars) regarding the free cash flows of Small Company for
the next four years. Small Company's annual tax rate is 40 percent.
Year 1 Year 2 Year 3 Year 4
EBIT $115 $292 $277 $283
EBIT × (1 – 40%) 69 175 166 170
+ Noncash expense (depreciation) 15 18 20 22
− Increase in working capital (10) (15) (8) (4)
− Capital expenditures (50) (85) (82) (86)
Free cash flow (FCF) $ 24 $93 $96 $102
The management of Big Company expects that beginning in Year 5, Small Company's
free cash flow will continue to grow indefinitely at a rate of 5 percent. Big Company has a
required rate of return of 14 percent.
Required:
1. Calculate the estimated value of Small Company assuming that it has no debt.
2. What is the maximum price Big Company will pay if the liabilities of Small Company
are $500,000?
Solution:
1. This analysis is a two-step model using the Gordon growth model. The first four years
have a specified free cash flow, while in Year 5 and beyond, FCF will continue to grow
indefinitely at a constant rate of 5 percent.
The first step is to calculate the present value of the FCF identified for the first four
years:
PV of FCF for Years 1–4 = [$24 ÷ 1.14] + [$93 ÷ (1.142)] + [$96 ÷ (1.143)] + [$102 ÷ (1.144)]
= $21 + $72 + $65 + $60 = $218
The second step is to use the Gordon growth model to calculate the present value of
the FCF expected after Year 4:
FCF expected in Year 5 = FCF of Year 4 × 1.05 = $102 × 1.05 = $107.1
The end of Year 4 present value of all post-Year 4 FCF = FCF at end of Year 5 ÷
(Required rate of return − Growth rate) = $107.1 ÷ (0.14 − 0.05) = $1,190
Present value of all cash flows into perpetuity starting in Year 5 = $1,190 ÷ (1.144) = $705
The third step is to calculate the FCF for all years, which is the value of Small Company,
assuming that it has no debt:
FCF = Present value of the FCF for each of the first four years + Present value of all
post-Year 4 FCF = $218 + $705 = $923.
2. The maximum price Big Company will pay if it assumes that the liabilities of Small
Company are $923 – $500 = $423 (in hundreds of thousands).

LOS 2B5g 5 Evaluation of Proposed Business Combinations
While some analysts focus solely on quantitative factors when evaluating business combinations,
qualitative factors must also be considered in evaluations to gain a complete picture of what is
best for the company.
5.1 Quantitative Considerations

Some of the quantitative factors that should be considered when evaluating proposed business
combinations include:
Consolidated Earnings per Share (EPS): Earnings per share of the pre-combined entities
should be evaluated and then compared with projected post-consolidated EPS. If the
projected EPS of the combined entities is lower than either the acquirer or acquiree's
pre-combination figures, then both companies may pause and consider whether the
combination is beneficial. Although a temporarily low EPS may eventually lead to a higher
EPS, that may not always be the case.
In calculating the EPS, the ratio of exchange must be factored. This formula is:
Ratio of exchange = Offer price per share ÷ Market price of the acquiring entity
This ratio is then multiplied by the number of the acquiree's shares being acquired, resulting
in the number of the acquirer's shares to issue.
Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA): A non-GAAP
measure, EBITDA is important because it evaluates cash flows generated by the company
without interest paid to finance the assets generating returns; taxes paid, which can be
manipulated through targeted tax planning; and the noncash charges of depreciation and
amortization. Analyzing both companies' pre-and post-merger EBITDA can lead to more
successful business combinations because it removes some of the income statement line
items that are not a result of current performance.
Post Balance Sheet Debt and Net Assets: The acquiring company should consider the
debt load it is assuming when purchasing another company because it will be responsible
for paying off that debt. The company being acquired must consider any debt it will take
on if the acquirer decides to assume post-acquisition debt. Evaluating net assets as a
percentage of total assets can help in this determination.
Multiples: Multiples are used in valuations for deciding whether a company is a good
acquisition target. These include multiples of revenue, assets, EBITDA, and other figures
(e.g., Price of the company = 1.5 × EBITDA). These numbers will change after the acquisition
and should be evaluated prior to the combination. Lower consolidated numbers may be
acceptable if they are expected to improve in the long run.

PART 2 UNIT
Example 2 Calculating Consolidated EPS
Facts: Big Company is planning to purchase Small Company's outstanding common stock
for $120 per share in a stock-for-stock acquisition. The current market price per share of
the target company is $70, and the market price of the common stock of Big Company is
$80. Small Company's total number of shares issued and outstanding is 25,000 shares.
Before the acquisition, the companies reported the following:
Big Company Small Company

1. Earnings $600,000 $120,000
2. Number of common shares 150,000 25,000
3. EPS (1. ÷ 2.) $4.00 $4.80
4. Market price per share $80 $70
Required:
1. Calculate the number of shares Big Company must issue to purchase all of the shares
of Small Company.
2. Calculate earnings per share of Big Company after the acquisition, if earnings for both
companies are expected to remain the same.
Solution:
1. Big Company must issue 37,500 new shares in exchange for all of the common shares
of Small Company.
The ratio of exchange = Offer price per share ÷ Market price of Big Company's stock =
$120 ÷ $80 = 1.5 times the number of shares of Small Company
Total number of Big Company shares to be issued in exchange =
Ratio of exchange × Number of Small Company shares outstanding
1.5 × 25,000 = 37,500 shares.
2. If earnings continue to be the same for both companies, the results of the companies
after the acquisition will be as follows:
1. Earnings $ 720,000
2. Number of common shares (150,000 + 37,500) ÷ 187,500
3. EPS (1. ÷ 2.) $ 3.84
Shareholders of Big Company will suffer a decline in EPS from $4.00 originally to $3.84.
5.2 Qualitative Considerations

Nonquantitative factors must also be considered when analyzing a potential business
combination, including:
Control: Acquisitions of company stock without a controlling interest post-merger may not
hold the same value as a controlling interest. This is because the majority shareholders can
make decisions regarding dividends or company operations without the consent of minority
shareholders. This makes noncontrolling shares less valuable, because the shares are
subject to decisions of shareholders with more influence.

Restrictions on Stock Transfers: Preemptive rights of other shareholders to buy or sell

prior to any transfers may be required before any other stock is transferred. If numerous
contractual hurdles must be overcome before a controlling transaction is finalized, the
acquisition may be less appealing.
Regulatory Factors: Industry regulations, antitrust laws, and other restrictions in the
country of operation may apply and should be evaluated prior to combination. Severe
restrictions after the merger may affect the value of the combined entities.
State of Assets Being Acquired: The health of assets being acquired must be determined,
especially if vital equipment is near the end of its useful life and in need of replacement.
Excess cash needed to replace obsolete assets should be factored in the evaluation period.
Employees: In many cases, executive exit packages may be triggered or negotiated in the
event of an acquisition. These compensation arrangements can place an undue hardship on
the consolidated firm.
Marketplace Reaction: Competitors may take action during an acquisition, perceiving the
event as an opportunity to launch new products or services while the merger is taking place.
Others may see it as a time to exit a market if a monopolistic environment appears to be the
outcome of the combination.
Outlook: If a post-combination company appears to gain only quick synergies as a result
of basic consolidation efforts, such as eliminating duplicated administration, then the gains
may be short-lived. The increase in long-term potential success of the combined entities
should be evaluated.
LOS 2B5d 6 Financial and Operating Restructuring
In corporate restructuring, management of an entity may consider modifying its capital

structure or its operations significantly. Generally, this happens when the corporation is facing
significant financial or operational problems. Restructuring is considered important to eliminate
financial problems and to enhance performance. Usually, an entity that is facing financial and
performance problems may consider its debt financing, its operations, and, in some cases,
selling a portion or all of the company to interested investors.
6.1 Financial Restructuring

A financial restructuring could include changes to the composition of an organization's debt
load, equity, or contractual agreements that significantly impact solvency.
6.1.1 Debt Modifications

A common form of debt modification is renegotiating the terms of existing debt so the debtor
can continue to pay both interest and principal. Changes may include a lower interest rate,
longer maturity date, reduced debt covenant requirements, or changes in the default triggers.
Other alternatives to debt term revisions include:
Debt Repurchases: This typically involves shareholders purchasing the company's existing
debt in full at a discount, and then canceling that debt by issuing equity in exchange. The
payments that were being made to pay off debt can then be used to pay for operating costs
or other expenses.
Debt Exchanges: Exchanging debt essentially replaces old debt with a completely new debt
issue. This may be a good option when amendments to existing debt are not adequate or a
mutual agreement cannot be reached. The new issue may benefit the borrower by reducing
the principal, extending the maturity date, changing pieces of the debt covenant (such as
ratio requirements), or lowering interest rates.

PART 2 UNIT
Equity Swaps: In a debt-for-equity swap, debtholders are requested to convert their debt
to equity, which effectively deleverages the company. This also frees up cash that was being
used for debt payments.
Access to Short-Term Capital: Companies may opt for short-term loans or rely more
heavily on lines of credit for liquidity in times of a cash crunch. This is an alternative to
taking out long-term debt or significantly altering a company's capital structure.
Sale-Leasebacks: A sale-leaseback involves a company selling assets to get cash from the
buyer, and then the buyer leasing those assets back to the seller. This provides liquidity,
giving the seller access to cash as well as use of the assets over the lease term.
6.1.2 Equity Modifications

Similar to debt modification, the structure of equity may be revised to make it easier for a
company to meet its obligations and remain solvent. This includes:
Issuance of Equity to Reduce Outstanding Debt: The company issues equity shares
and, once proceeds from the new shares are received, those funds are used to pay down
existing debt.
Stock Buybacks: The company repurchases outstanding shares to reduce future dividend
payments or to take a company from being publicly traded to privately held. Private
companies may have more flexibility to make changes to their capital structure, not
requiring the same level of approval as public companies.
Stock Class Modifications: Companies may choose to change the rights of preferred
shareholders or introduce new classes of stock in an attempt to retain funds that would
otherwise be paid out. This can include changes in dividend accumulation rights (e.g.,
cumulative rights, which accrue when not paid, versus noncumulative, which do not accrue)
or changing voting rights.
6.1.3 Court and Bankruptcy Restructuring

When companies are insolvent, another path to restructuring is through bankruptcy court.
Bankruptcy is a form of court-approved reorganization that allows the filing company to
continue to operate, while agreeing to pay back its creditors in part or in full. This can be
accomplished by revising agreements with creditors, extending the maturity for debt repayment,
and settling various other matters under modified terms.
6.1.4 Other Forms of Financial Restructuring

Companies may look for less traditional solutions when making restructuring decisions,
including ways to improve their credit ratings to obtain capital at more desirable rates. In some
instances, it may make sense for a company to sequester certain assets and liabilities into a
separate company; creating separate legal entities with a more attractive credit profile could be
used to obtain debt or equity.
Another form of financial restructuring that is less severe is renegotiating contracts with various
business partners, such as vendors, landlords, distributors, and other companies vital to an
organization's function. This includes the following:
Modifying Terms With Partners or Joint Ventures: This may involve redefining profit-
sharing agreements, seeking a larger share (possibly through accepting more liability or
more ownership of activity in the partnership).
Negotiating Better Discounts or Payment Periods With Suppliers: If a vendor normally
has a 2/10 net 30 policy (2 percent discount if paid within the first 10 days, with full balance
due in 30 days), a firm could request the discount period be increased to 2/15 net 30, giving
it five more days to hold onto cash and still take advantage of the discount.

Accelerating Collections: By working with customers to accelerate revenue collections or

by tightening credit standards in order to cut down on potential bad debts, a company may
be able to improve liquidity. However, tightening credit standards could reduce revenues if
important customers are no longer eligible for credit.
Renegotiating Lease Terms: Seeking a lower interest rate or lower monthly payment in
exchange for a longer lease term may be an option to improve access to capital.
6.2 Operational Restructuring

In operational restructuring a company can choose to reorganize the way it operates. The firm
may add lines of business or products, expand into new geographic markets, divest business
units, or make significant changes in its workforce and technology.
It may accomplish this through the following means:
Downsizing Production: Companies facing waning demand or a weakening economy
may be forced to cut production and downsize operations. This benefits the company by
reducing costs.
Downsizing the Workforce: Often a common method of cutting costs, downsizing the
workforce can be a quick way to short-term financial savings, but has a potentially negative
impact on long-term growth.
Shifting Talent Sourcing: Companies may decide to access a different pool of employees
by moving headquarters to a location with a lower cost of living or sourcing foreign labor to
obtain lower costs for specific functions in the organization (e.g., customer service).
Expanding Products and Services: By increasing the scope of products and services
offered, a company may be able to increase revenue or at least maintain its current
market share.
Illustration 15 Restructuring
General Auto Co. has historically been the best seller of sport utility vehicles and passenger
vans in the United States. General was concerned about other auto manufacturers entering
the market with newer, more fuel-efficient technology, and decided that it would initially
lower prices to attract buyers while it worked on competing technology to implement in
new vehicles. The lower prices led to less revenue, straining the company financially, so
General decided to expand its business by opening a consumer and business financing
unit. Instead of consumers financing through a dealer or a bank, they would finance the
purchase through General Auto. This new service allowed General to make up lost revenue
with interest charged over the life of the customers' loans.
Entering New Geographic Markets: Some companies are concentrated in specific regions
in the world and could expand their market reach by entering new geographic markets.
Along with the basic, logistical setup in a new country, companies must also consider
cultural differences when marketing, building, and delivering products in a new location.
Selling Assets: Additional funds to support operations can be obtained by selling assets
that are idle due to a decline in demand, a cut in production, or a decision to exit a
product class.
Automating Functions: Adding new technology is often a way to lower costs in the long run
and increase efficiency.

PART 2 UNIT
Illustration 16 Restructuring Through Automation
Poultry Plus Inc. has a labor-intensive meat processing facility that requires employees
on the manufacturing line to work in close proximity to other employees. Due to a
recent public health crisis, employees now must work farther apart, which slows the
deboning process, significantly decreasing profits and pushing the company to the brink
of bankruptcy.
Poultry Plus decides to simultaneously downsize its operations and replace human labor
with automated technology. It invests in modern robotic deboning equipment, which
doubles the carcass production line's capacity and reduces the number of employees
needed by half, restoring sustainability through the crisis and beyond.
Zeno Co. is planning to expand its operations through the acquisition of Alpha Co. The
management of Zeno has the following information about the financial performance
of Alpha:
Average net income per year for the last five years = $120,000
Expected after-tax cash flows from operations for each of the coming five years, the
estimated life of Alpha, are:
Year 1 $150,000
Year 2 $170,000
Year 3 $180,000
Year 4 $190,000
Year 5 $150,000
If Zeno has a weighted average cost of capital of 12 percent, what is the expected value of
Alpha using the discounted cash flow model?
a. $432,573
b. $603,434
c. $1,144,151
d. $1,250,000

At the beginning of this year, Zeno Co. is planning to expand its operations through the
acquisition of Alpha Co. Management of Zeno has received the following information
regarding the financial performance of Alpha:
Alpha's average net income per year for the last five years = $120,000
The estimated amount of after-tax cash flows from operations for the current year is
$150,000, and this amount is expected to grow at a rate of 3 percent into perpetuity.
If Zeno has a weighted average cost of capital of 12 percent, what is the expected value of
Alpha Co. if Zeno Co. uses the discounted cash flow model?
a. $1,250,000
b. $1,333,333
c. $1,666,667
d. $5,000,000

8
MODULE
B.6. International
Finance
Part 2
Unit 2
CMA LOS Reference: Part 2—Section B.6. International Finance

a. demonstrate an understanding of foreign currencies and how foreign currency affects
the prices of goods and servicesb. identify the variables that affect exchange rates
b. identify the variables that affect exchange rates
c. calculate whether a currency has depreciated or appreciated against another currency
over time, and evaluate the impact of the change
d. demonstrate how currency futures, currency swaps, and currency options can be used
to manage exchange rate risk
e. calculate the net profit/loss of cross-border transactions, and evaluate the impact of
this net profit/loss
f. recommend methods of managing exchange rate risk and calculate the net profit/loss
of your strategy
g. identify and explain the benefits of international diversification
h. identify and explain common trade financing methods, including cross-border
factoring, letters of credit, bankers' acceptances, forfaiting, and countertrade
1 International Diversification LOS 2B6g
A multinational corporation (MNC) is a large corporation with economic activities in several

countries. Activities of multinational corporations can be important for both the home country
and for the host country or countries. Home countries are those in which the corporate,
administrative, and/or head offices that lead global operations are based. Host countries are
extensions of the home country. They represent countries in which additional functions or lines
of business operate.
MNCs typically must pay income and other applicable taxes in each country in which they
operate. Home countries often impose additional taxes on foreign-derived income, but in most
cases a credit based on the amount of foreign taxes paid can be used to offset this additional
tax. Multinational corporations benefit the host country through job opportunities, which reduce
unemployment, and may also bring new knowledge and technology to the host country.

8 B.6. International Finance PART 2 UNIT 2
1.1 Foreign Direct Investment

Foreign direct investment (FDI) is the primary manner by which multinational corporations
create activities in foreign countries. A foreign direct investment occurs when a firm or individual
residing in one country invests in business interests located in another country. Generally, FDI
takes place when an investor either establishes foreign business operations or acquires foreign
business assets in a foreign company.
Illustration 1 Foreign Direct Investment
A company with excess funds opens a factory in a foreign country to produce one of the
company's main products. The company invests $10 million for the design and construction
of the facilities and for installing and testing the needed equipment to begin production in
that country.
1.2 Benefits to the Host Country

A host country receiving foreign investments may experience one or more of the following benefits:
Increased Employment and Economic Growth: A major reason countries seek to attract
foreign investment is to reduce unemployment. Employed individuals generate income, pay
taxes, have increased purchasing power, and provide more revenue for the host country.
All these things lead to consumer spending, borrowing, economic expansion, and growth.
Development of Human Capital: When a multinational corporation operates in a host
country, local job seekers and employees gain access to new opportunities with the home
corporation as well as access to platforms for training and improving skills. Development of
the human capital in a country has a multiplier effect. Those who are well trained can train
others, which will improve the overall level of education in a host country.
Enhanced Efficiency and Effectiveness of the Industry: The benefits of FDI include
transfers of general or technical knowledge, advanced technologies in production and
distribution, industrial improvements, work experience for the labor force, and the
establishment of business and trade networks.
Increased Exports: If the production in the host country is meant to be a point of export,
the host country's balance of trade (exports versus imports) may improve. Countries
generally prefer to export more than import goods because it signals economic strength
and less reliance on foreign support.
Improved Stability of Exchange Rates: When goods manufactured in a host country are
exported to other countries, the host country's foreign currency reserves improve, and
exchange rates are more stable.
Improved Physical and Financial Infrastructure of a Country: The host country's
government will collect more taxes as a result of the increased economic activity of the
MNC and the income generated by individual workers. Taxes are then reinvested in the
development of the host country.
Improved Inflows of Financial Capital: Host countries that do not have access to
international financial markets can receive funds through foreign direct investments.
2–124 Module 8 B.6.All

© Becker Professional Education Corporation. International Finance
rights reserved.
PART 2 UNIT
8 2 B.6. International Finance
1.3 Benefits to the Multinational Corporation

An MNC seeks to invest in operations outside its home country for several reasons. Benefits to
the MNC include the following:
Access to New Markets: The MNC's sales and profits may increase because new markets
mean more customers for its products or services. In addition, manufacturing goods and
selling them in the host country may allow the MNC to avoid host-country trade barriers and
trade restrictions that the MNC would confront if it were to export goods from the home
country to the host country.
Reduced Portfolio Risk: Investing in foreign affiliated companies or in branches in other
countries may allow an MNC to diversify and better manage its total risk.
Improved Return on Investment: When an MNC operates in an emerging market, the
MNC may be able to operate as a monopoly until competition enters the market. Operating
as a monopoly boosts the overall return on the MNC's investment.
Access to Factors of Production: In many cases an MNC may be able to access labor and
materials at rates that are lower than those available in the home country. This helps the
MNC to lower costs and increase profits. Additionally, certain raw materials may only be
available in other countries, requiring MNCs to globally diversify to access and secure the
supply chain.
Implementation of a Natural Hedge: When an MNC operates in different countries using
different currencies, exchange rate risk may be mitigated by using the local currency both
to buy materials and labor (payables denominated in the local currency) and to sell on
credit using the local currency (receivables denominated in the local currency). Frequently,
these payables and receivables are matched in terms of maturity (that is, receivables are
collected as payables are due), and this matching eliminates exchange rate risks. In addition,
producing and selling in the same country allows a multinational corporation to avoid
import and export fluctuations that result from changes in exchange rates.
Access to Lower Interest Rates: An MNC may decide to operate in other countries where
debt financing is available at a lower cost.
1.4 Risks to the Multinational Corporation

When investing in companies or operations located in other countries, an MNC faces several
risks, including the following:
Risk of Political Instability: Investing in other countries may result in significant risks
because of events such as civil unrest, expropriation of assets by the foreign government,
and wars.
Risk of Changing Tax and Regulatory Environments: The applicable regulations and tax
codes in place at the inception of the investment may change and negatively impact the
MNC's profits.
Risk of Cultural Unfamiliarity: Demand for the MNC's products may be lower than
expected because of negative customer attitudes toward the MNC or its home country.
There is also the risk that the MNC misjudges local consumer preferences, producing
products or services unappealing to the host country's consumers.
Risk of Inflation: High inflation rates will drive down the value of the investment.
Risk of Exchange Rate Fluctuation: The value of an investment or operations in a host
country can be diminished by unfavorable exchange rates.

LOS 2B6a 2 Currency Exchange Rates
Exchange rates express the price of one currency in terms of another; that is, the rate at which
two currencies will be exchanged at equal value. The exchange rate may be expressed as using
either the direct or indirect method. The direct method is the domestic price of one unit of another
currency and the indirect method is the foreign price of one unit of the domestic currency.
Illustration 2 Exchange Rate Calculations
If a U.S. company can exchange $1.00 for 0.77 British pounds (£), then the direct exchange
rate is $1.30/£1.00 and the indirect exchange rate is £0.77/$1.00.
2.1 The Currency Market

The currency market is where currencies are exchanged. Demand for a currency is driven by
demand for the products and services of the country that issued the currency. The quantity of
currency demanded is determined by its price relative to other currencies.
2.2 Floating Exchange Rates

Floating exchange rates are established by supply and demand in currency markets. Supply and
demand for a country's currency are derived from transactions involving goods and services
from that country.
Illustration 3 Floating Exchange Rate
If the United States imports goods from Mexico, demand for the Mexican peso increases
because U.S. importers require pesos to pay for the imports from Mexico to the U.S. The
following graph shows how the equilibrium exchange rate in dollars per peso is set based
on the demand and supply for pesos.
Currency Market
Supply of pesos
Y2
Exchange rate
($ per peso)
Pe
Y1
Demand of pesos
Qe Quantity of peso
When the value of the peso is low relative to the U.S. dollar, U.S. citizens are willing to buy
more Mexican goods and services because Mexican goods are cheaper for U.S. consumers.
2B_Currency Market
When the value of the peso is high, however, Mexicans are willing to use their strong
currency to buy more U.S. goods and services.

rights reserved.
PART 2 UNIT
2.3 Fixed Exchange Rates

Fixed exchange rates are set by government or central bank policy. These rates must be
defended in currency markets through the purchase or sale of the domestic currency.
If the market exchange rate falls below the fixed rate, the government purchases the home
currency on the currency market, increasing demand for the home currency and increasing
the exchange rate. Such government purchases require reserves of foreign currencies to
facilitate the purchases. When reserves run low, the fixed rate cannot be maintained.
If the market exchange rate rises above the fixed rate, the government sells the home
currency in the market, increasing the supply of the home currency and reducing the
exchange rate.
2.4 Managed Float

Managed float is the current method of determining international exchange rates. In a managed
float system, exchange rates are primarily determined by supply and demand in currency
markets. In periods of extreme fluctuation, governments and central banks will intervene in an
attempt to maintain stability.
3 Currency Exchange Rate Risk

Within domestic environments, a single currency defines the value of assets, liabilities, and
operating transactions. In international settings, the values of assets, liabilities, and operating
transactions are established not only in terms of the single currency, but also in relation to other
currencies. Exchange rate (FX) risk exists because the relationship between domestic and foreign
currencies may be subject to volatility.
3.1 Factors Influencing Exchange Rates LOS 2B6b
Circumstances that give rise to changes in exchange rates are generally divided between
trade-related factors (including differences in inflation, income, and government regulation) and
financial factors (including differences in interest rates and restrictions on capital movements
between companies).
3.1.1 Trade Factor (Relative Inflation Rates)

When domestic inflation exceeds foreign inflation, holders of domestic currency are motivated
to purchase foreign currency to maintain the purchasing power of their money. The increase
in demand for foreign currency forces the value of the foreign currency to rise in relation to
the domestic currency, thereby changing the rate of exchange between the domestic and
foreign currency.
Illustration 4 Relative Inflation Rates
Assume that the U.S. dollar is relatively stable while the Mexican peso is suffering from
sudden inflationary pressures. As the Mexican peso buys less in the domestic Mexican
economy, Mexicans and their banking institutions seek the safe haven of the U.S. dollar
to maintain the purchasing power of their liquid resources. The demand for U.S. dollars
created by Mexicans buying them with Mexican pesos makes the U.S. dollar more valuable
in terms of the peso and drives up the exchange rate. The U.S. dollar commands more
pesos in an exchange of currency.

3.1.2 Trade Factor (Relative Income Levels)

As income increases in one country relative to another, exchange rates change as a result of
increased demand for foreign currencies in the country in which income is increasing.
Illustration 5 Relative Income Levels
The income level in the United States increases significantly in the second quarter.
Americans flock to Mexico City on vacation to buy piñatas. The increased supply of
American dollars seeking to buy pesos to purchase Mexican goods causes the value of the
American dollar to fall in relation to a stated number of pesos. The exchange rate is thus
affected by relative income levels and the associated demand for foreign currency created
by higher domestic income.
3.1.3 Trade Factor (Government Controls)

Various trade and exchange barriers that artificially suppress the natural forces of supply and
demand affect exchange rates.
Illustration 6 Government Controls
A tariff on imported piñatas would have the effect of discouraging the purchase of imports,
thereby reducing demand for the peso and maintaining the exchange rate.
3.1.4 Financial Factors (Relative Interest Rates and Capital Flows)

Interest rates create demand for currencies by motivating either domestic or foreign
investments. The forces of supply and demand create changes in the exchange rate as investors
seek fixed returns. The effect of interest rates is directly affected by the volume of capital that is
allowed to flow between countries.
Illustration 7 Relative Interest Rates and Capital Flows
Assume that returns on institutional investments in Mexico skyrocket in the third quarter
while returns on comparable institutional investments remain significantly lower in the
United States. U.S. investors find the opportunity to earn high returns with similar risks
in Mexican financial institutions irresistible. The demand for pesos increases as American
investment increases. The exchange rate changes as the peso commands more U.S dollars.

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Summary Chart: Circumstances That Impact Exchange Rates
Trade-Related Factors
Relative inflation rates Demand/
Demand for
Relative income levels supply of
goods
Government controls currency
(Trade restrictions)
Exchange rate
Financial Factors Demand/

Demand for
Relative interest rates supply of
securities
Capital flow currency
3.2 Risk Exposure Categories LOS 2B6e
3.2.1 Transaction Exposure

Exchange rate risk is defined, in part, by transaction exposure. Transaction exposure is defined
as the potential that an organization could suffer economic loss or experience economic
gain upon settlement of individual transactions as a result of changes in the exchange rates.
Transaction exposure is generally measured in relation to currency variability or currency
correlation. Measurement of transaction exposure is generally done in two steps:
1. Project foreign currency inflows and foreign currency outflows.
2. Estimate the variability (risk) associated with the foreign currency.
Illustration 8 Transaction Exposure
Seattle Import/Export, a U.S. import/export company, imports commodities from Canada

that it pays for in Canadian dollars and exports commodities to Canada for which it receives
Canadian dollars. If Seattle Import/Export anticipated that it would export C$10,000,000
to Canada over the next year while importing C$8,000,000 over the same period, the net
exposure in Canadian dollars is a C$2,000,000 inflow (receivable).
If the current exchange rate is $0.75/C$1, the net exposure in U.S. dollars is $1,500,000
(C$2,000,000 × 0.75). If the rate is anticipated to fluctuate five cents, between $0.70
and $0.80, the total U.S. dollar fluctuation exposure would be expected to be between
$1,400,000 and $1,600,000.
3.2.2 Economic Exposure LOS 2B6c

In addition to transaction exposure, exchange rate risk is defined, in part, by economic exposure.
Economic exposure is defined as the potential that the present value of an organization's cash
flows could increase or decrease as a result of changes in the exchange rates.
Economic exposure is generally defined through local currency appreciation or depreciation and
is measured in relation to organization earnings and cash flows.

Loss: need more

FC
domestic currency to
Importing goods appreciates
Resulting buy FCU to settle debt
from other countries
payables in
(denominated in Foreign
FCU Gain: need less
Currency Units [FCU]) FC
domestic currency to
depreciates
buy FCU to settle debt
Gain: FCU received

FC
buy more domestic
Exporting goods appreciates
Resulting currency units
to other countries
receivables
(denominated in Foreign
in FCU Loss: FCU received
Currency Units [FCU]) FC
buy fewer domestic
depreciates
currency units
Currency Appreciation and Depreciation

Currency appreciation (depreciation) refers to the strengthening (weakening) of a currency
in relation to other currencies. The rate of a currency appreciation or depreciation is
calculated as follows:
Appreciation or depreciation rate =

End-of-period exchange rate – Beginning-of-period exchange rate
Beginning-of-period exchange rate
Illustration 9 Currency Appreciation
If the direct exchange rate for the British pound has increased from $1.30/£1.00 to
$1.39/£1.00, the pound has appreciated relative to the dollar (i.e., the pound is relatively
more expensive and costs more dollars to purchase). In this case, the appreciation of the
pound in terms of dollars is equal to:
1.39 – 1.30
Appreciation rate = = 0.0692 = 6.92%
1.30
Effect of Currency Appreciation

As a domestic currency appreciates in value or becomes stronger, it becomes more
expensive in terms of a foreign currency. As a currency appreciates, the volume of
outflows tends to decline as domestic exports become more expensive. However, the
volume of inflows tends to increase as foreign imports become less expensive.
Effect of Currency Depreciation
As a domestic currency depreciates in value or becomes weaker, it becomes less
expensive in terms of a foreign currency. As a currency depreciates, the volume of
outflows tends to rise as domestic exports become less expensive. However, the
volume of inflows tends to decline as foreign imports become more expensive.

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The economic exposure created by domestic currency appreciation or depreciation with

respect to a foreign currency depends on the net inflow or outflow of foreign currency.
Net FX Outflows Net FX Inflows

Domestic Currency (Net exports) (Net imports)
Appreciates Decrease Increase
Depreciates Increase Decrease
Pass Key
To help remember appreciation versus depreciation, think in terms of weight lifting. Assume
that yesterday's exchange rate was $1 USD to 2 pesos and that today's exchange rate is $1
USD to 3 pesos. This means that yesterday it took $1 to "lift" 2 pesos and today $1 can now lift
3 pesos. So, the dollar has gotten stronger (appreciated). Similarly, yesterday, 2 pesos could lift
$1, but today it takes 3 pesos to lift $1. So, the peso has gotten weaker (depreciated).
Example 1 Calculating Currency Appreciation/Depreciation
Facts: Following are the indirect exchange rates of the U.S. dollar (USD) relative to the euro
(EUR) at the beginning and end of the accounting period:
January 1: 1 USD = 0.891 EUR
December 31: 1 USD = 0.902 EUR
Required:
1. Determine whether the U.S. dollar appreciated or depreciated relative to the euro
during the period.
2. Calculate the respective appreciation and depreciation rates for the USD and the EUR
over the period.
Solution:
1. The dollar has appreciated (strengthened) relative to the euro because at the end of
the year, 1 USD can purchase more euros compared with the beginning of the year.
Conversely, the euro has depreciated (weakened) over the year relative to the USD.
At the end of the year, more euros are needed to purchase 1 USD compared with the
beginning of the year.
2. The appreciation rate of the USD = 0.902 − 0.891 / 0.891 = 1.23%
To calculate the depreciation rate of the euros, first determine the value of the euro
in dollars:
January 1, Year 1: 1 euro = 1 / 0.891 USD = $1.122
December 31, Year 1: 1 euro = 1 / 0.902 USD = $1.109
The depreciation rate of the euro = 1.109 − 1.122 / 1.122 = (1.16%)
Note that the 1.16% depreciation rate of the euro is different from the 1.23% appreciation
rate of the USD. The rates will always be different; this is just a function of the math.

3.2.3 Translation Exposure

In addition to the transaction and economic exposures, exchange rate risk is defined in part by
translation exposure. Translation exposure is the risk that assets, liabilities, equity, or income
of a consolidated organization that includes foreign subsidiaries will change as a result of
changes in exchange rates. Translation exposure is generally defined by the degree of foreign
involvement, the location of foreign subsidiaries, and the accounting methods used and
measured in relation to the effect on the organization's earnings or comprehensive income.
Degree of Foreign Involvement: Translation exposure increases as the proportion of
foreign involvement by subsidiaries increases.
Illustration 10 Translation Risk
Domestic International Inc. has no foreign subsidiaries but is deeply involved in exporting
to neighboring countries. Global International Inc. has 12 foreign subsidiaries, which
combined make up 65 percent of consolidated revenues. Domestic International has less
translation exposure than Global International because it has no foreign subsidiaries.
Domestic's international business exposes the company to exchange rate risks, however, in
terms of both transaction and economic exposure.
Because of Global International's extensive foreign operations, the parent company
has significant exposure to foreign currency translation exposure, and depending on
the entity's export/import activity, Global International may also be exposed to foreign
exchange transaction and economic risks.
Locations of Foreign Investments: Measurements of financial results of foreign

investments frequently occur in the foreign currency in which the investee company
operates. The exposure of the parent company to translation risk is affected by the stability
of the foreign currency in comparison to the parent's domestic currency. The more stable
the exchange rate, the lower the translation risk. The more volatile the exchange rate, the
higher the translation risk.
LOS 2B6d 4 Mitigating and Controlling Transaction Exposure

LOS 2B6f
Businesses have various methods of managing the transaction exposure associated with
exchange rate risks. Financial instruments and hedging can be used to mitigate the effect of
exchange rate fluctuations on individual transactions.
4.1 Measuring Specific Net Transaction Exposure

Net transaction exposure is the amount of gain or loss that might result from either a favorable
or an unfavorable settlement of a transaction.
4.1.1 Selective Hedging

Hedging is a financial risk management technique in which an organization, seeking to mitigate
the risk of fluctuations in value, acquires a financial instrument that behaves in the opposite
manner from the hedged item. In effect, hedging is a process of reducing the uncertainty of
the future value of a transaction or position (e.g., asset, liability, income) by actively engaging in
various derivative investments.

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Illustration 11 Hedging
Worldwide Sweet Peaches buys shipping crates for its product from Mexico. The company
incurs liabilities denominated in pesos that it satisfies in pesos bought with U.S. dollars at the
time of transaction settlement. The company incurs a significant liability in pesos at a spot
rate of $0.10. Worldwide management expects that the peso will strengthen to $0.20 by the
time the bill is due and thereby double its cost. To mitigate this perceived transaction risk, the
company decides to hedge its position by locking in the current peso spot rate of $0.10.
4.1.2 Identifying Net Transaction Exposure

Consolidated entities consider their net transaction exposure prior to considering hedge
strategies. Net transaction exposure is the effect of transaction exposure on the entity taken
as a whole rather than on individual subsidiaries. Although exchange rate fluctuations might
adversely affect one subsidiary, they might favorably affect another. The net transaction
exposure is the aggregate exposure associated with a particular foreign currency for a particular
time and is computed as follows:
1. Accumulate the inflows and outflows of foreign currencies by subsidiary.
2. Consolidate the effects on the subsidiary by currency type.
3. Compute the net effect in total.
4.1.3 Adjusting Invoice Policies
International companies may hedge transactions without complex instruments by timing the
payment for imports with the collection from exports.
4.2 Mitigating Transaction Exposure: Futures Hedge

A futures hedge entitles its holder to either purchase or sell a particular number of currency
units of an identified currency for a negotiated price on a stated date. Futures hedges are
denominated in standard amounts and tend to be used for smaller transactions.
4.2.1 Accounts Payable Application

Accounts payable denominated in a foreign currency represents a potential transaction
exposure to exchange rate risk in the event that the domestic currency weakens in relation
to the foreign currency. Should the domestic currency weaken relative to the foreign
currency, more domestic currency will be required to purchase the foreign currency, thereby
increasing the company's cost of settling the liability. If management does not hedge this
liability exposure, the company could incur a foreign exchange transaction loss.
A futures hedge contract to buy the foreign currency at a specific price at the time the
account payable is due will mitigate the risk of a weakening domestic currency.
Illustration 12 Futures Contract
Worldwide Sweet Peaches buys crates from Mexico. On the date that Worldwide Sweet
Peaches buys crates and incurs a significant liability in pesos, the spot rate is $0.10.
Because the company fears that the peso will strengthen to $0.20 by the time the bill is
due in 30 days, the company enters into a futures contract that will allow it to purchase the
pesos needed to pay the liability for $0.10 per peso in 30 days.

4.2.2 Accounts Receivable Application

Accounts receivable denominated in a foreign currency represents a potential transaction
exposure to exchange rate risk in the event that the domestic currency strengthens in
relation to the foreign currency. Should the domestic currency strengthen, less domestic
currency (than originally anticipated from the sale that created the receivable) can be
purchased with the foreign currency received. An exchange loss will result.
A futures hedge contract to sell the foreign currency received in satisfaction of the
receivable at a specific price at the time the accounts receivable is due will mitigate the risk
of a strengthening domestic currency.
Illustration 13 Futures Hedge Contract
Running Apparel International, a U.S.-based retailer, has international retail operations in

several countries, including significant business in Japan. Company management expects
that the Japanese retail operations will generate and liquidate a significant amount of its
accounts receivables in 30 days. Although the current $/¥ spot rate is $1/¥98.02, company
management expects the $/¥ spot rate to be $1/¥102.09 in 30 days. To mitigate this
expected foreign exchange loss caused by the appreciation of the U.S. dollar (relative
to the Japanese yen), the company enters into a futures contract to sell yen at the
current spot rate ($1/¥98.02) in 30 days, thereby locking in the current value of these
foreign receivables.
4.3 Mitigating Transaction Exposure: Forward Hedge

A forward hedge is similar to a futures hedge in that it entitles its holder to either purchase or
sell currency units of an identified currency for a negotiated price at a future point. Although
futures hedges tend to be used for smaller transactions, forward hedges are contracts between
businesses and commercial banks that are normally used for larger transactions.
4.3.1 Accounts Payable Application

Accounts payable denominated in a foreign currency represent a potential transaction
exposure to exchange rate risk in the event that the foreign currency strengthens.
A forward hedge contract to buy the foreign currency at a specific price at the time accounts
payable are due for an entire subsidiary will mitigate the risk of a weakening domestic currency.
4.3.2 Accounts Receivable Application

Accounts receivable denominated in a foreign currency represent a potential transaction
exposure to exchange rate risk in the event that the domestic currency strengthens.
A forward hedge contract to sell the foreign currency received in satisfaction of the
receivables at a specific price at the time the accounts receivable are due or on the monthly
cycle of a particular subsidiary will mitigate the risk of a strengthening domestic currency.
4.4 Mitigating Transaction Exposure: Money Market Hedge

A money market hedge uses international money markets to plan to meet future currency
requirements. A money market hedge uses domestic currency to purchase a foreign currency
at current spot rates and invest them in securities timed to mature at the same time as
related payables.

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4.4.1 Money Market Hedge: Payables (Excess Cash)

Firms with excess cash use money market hedges to lock in the exchange rate associated with
the foreign currency needed to satisfy payables when they come due. Money market hedges for
payables satisfaction include the following steps:
1. Determine the amount of the payable.
2. Determine the amount of interest that can be earned prior to settling the payable.
3. Discount the amount of the payable to the net investment required.
4. Purchase the amount of foreign currency equal to the net investment required and deposit
the proceeds in the appropriate money market vehicle.
Illustration 14 Money Market Hedge: Payables (Excess Cash)
Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount of
1,000,000 pesos in 90 days. The current exchange rate is $0.08 per peso and Mexican
interest rates are 16 percent. Duffy has $100,000 in excess cash and elects to use a money
market hedge to mitigate transaction exposure to exchange rate risk. Duffy performs the
following steps:
1. Determine the required investment in pesos at Mexican interest rates:
1,000,000 / 1.04 = 961,538.
Note: A 16 percent annual interest rate for 90 days is equal to approximately 4 percent.
2. Purchase 961,538 pesos with $76,923 (961,538 pesos × 0.08).
3. Invest pesos at Mexican interest rates and satisfy payables upon maturity
of the investment.
Duffy has secured the satisfaction of its current $80,000 payable for $76,923.
4.4.2 Money Market Hedge: Payables (Borrowed Funds)

Firms that do not have excess cash follow the same basic procedure for a money market hedge
on payables, except that they first borrow funds domestically and invest them internationally to
satisfy the payable denominated in a foreign currency.
Illustration 15 Money Market Hedge: Payables (Borrowed Funds)
Duffy's Discount Piñatas has a payable due to its Mexican suppliers in the amount
of 1,000,000 pesos in 90 days. The current exchange rate is $0.08 per peso, Mexican
interest rates are 16 percent, and U.S. interest rates are 6 percent. Duffy computes that
it must borrow $76,923 to use a money market hedge to mitigate transaction exposure
to exchange rate risk consistent with the first money market hedge example, but has no
excess cash. Duffy borrows the needed amount for 90 days in the United States.
Duffy has secured the satisfaction of its current $80,000 payable for $78,077
(76,923 × 1.015 or 6% for 90 days).

4.4.3 Money Market Hedge: Receivables

A money market hedge used for receivables denominated in foreign currencies effectively
involves factoring receivables with foreign bank loans. Foreign currency amounts are borrowed
in discounted amounts that are repaid in the ultimate maturity value of the receivable
denominated in the foreign currency. Borrowed foreign currency amounts are converted into
the domestic currency.
Illustration 16 Money Market Hedge: Receivables
Duffy's Discount Piñatas has a receivable from a Mexican customer in the amount of
1,000,000 pesos due in 90 days. The current exchange rate is $0.08 per peso and Mexican
interest rates are 16 percent. Duffy needs available cash and cannot wait to receive $80,000
in 90 days. Because Duffy needs the money now, the company elects to use a money
market hedge technique to expedite collection and mitigate any transaction exposure to
exchange rate risk.
Duffy computes that it can borrow 961,538 pesos and convert them to $76,923 consistent
with the first money market hedge example. Duffy borrows the pesos from Mexican
financial institutions.
Duffy will be able to meet whatever its current cash requirements are in the United
States with the $76,923, and when the 90-day discounted note for 961,538 pesos
matures for 1,000,000 pesos, Duffy will satisfy it with the collections from the foreign
accounts receivable.
4.5 Mitigating Transaction Exposure: Currency Option Hedges

Currency option hedges use the same principles as forward hedge contracts and money market
hedge transactions. However, instead of requiring a commitment to a transaction, the currency
option hedge gives the business the option of executing the option contract or purely settling its
originally negotiated transaction without the benefit of the hedge, depending on which result is
most favorable.
4.5.1 Currency Option Hedges: Payables

A call option (an option to buy) is the currency option hedge used to mitigate the transaction
exposure associated with exchange rate risk for payables.
Similar to a futures contract or forward contract, the business plans to buy a foreign
currency at a low rate in anticipation of the foreign currency strengthening in comparison to
the domestic currency in order to ensure that it can settle its liability at the predicted value.
The business has the option (not the obligation) to purchase the security at the option
(strike or exercise) price. The business evaluates the relationship between the option price
and the exchange rate at the settlement date. Generally, if the option price is less than
the exchange rate at the time of settlement, the business will exercise its option. If the
option price is more than the exchange rate at the time of settlement, the business will
allow the option to expire. Although option premiums are used to compute any net savings
associated with option transactions, they are a sunk cost and are irrelevant to the decision
to exercise the options.

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Example 2 Currency Option Hedge: Payables
Facts: Gearty International owes its Mexican supplier 1,000,000 pesos due in 30 days.
Although the peso is currently exchanged for the U.S. dollar at $0.08, the company is fearful
that the Mexican peso will strengthen in comparison to the dollar before the settlement
to as much as $0.10. Gearty International pays a $0.005 option premium to secure a call
option to buy 1,000,000 pesos in 30 days for $0.08/peso.
Required: Compute Gearty's net savings, assuming that Gearty is correct in its assessment
of international exchange rates and the exchange rate at the time of the settlement (the
spot rate) increases as predicted.
Solution:
Spot Rate at Option Total Settlement Cost
Settlement Price Premium Option for 1,000,000 Pesos
$0.10 – – – $100,000
– $0.08 $0.005 $0.085 (85,000)
Net savings $ 15,000
Gearty's consideration for the option, the $0.005 option premium, is $5,000 and is
paid regardless of whether the option is exercised. The gross savings of $20,000
[(0.10 − 0.08) × 1,000,000 pesos] is reduced by the $5,000 option premium to reflect a
$15,000 net savings. Because the option premium is a sunk cost, it does not affect the
company's decision to exercise the call option.
Facts: Same as above
Required: Calculate Gearty's loss, assuming that Gearty is incorrect in its assessment of
international exchange rates, the exchange rates stay constant at $0.08, and the company
allows its option to expire.
Solution:

$0.08 – – – $80,000
– $0.08 $0.005 $0.085 (85,000)
Loss $ (5,000)
Exercising the option is actually equal to simply settling the transaction at the spot
rate. Gearty will likely buy pesos at the spot rate regardless of the loss associated with
the premium.
4.5.2 Currency Option Hedges: Receivables

A put option (an option to sell) is the currency option hedge used to mitigate the transaction
exposure associated with exchange rate risk for receivables.
Similar to a futures contract or forward contract, the business plans to sell a foreign
currency at a higher rate, in anticipation of the foreign currency weakening in comparison to
the domestic currency, to ensure that it can capitalize on receivable collections at a stable or
predicted value.

The business has the option (not the obligation) to sell the collected amount of the foreign
currency from the receivable at the option (strike or exercise) price. The business evaluates
the relationship between the option price and the exchange rate at the settlement date.
Generally, if the option price is more than the exchange rate at the time of settlement, the
business will exercise its put option. If the put option price is less than the exchange rate at
the time of settlement, the business will allow the put option to expire. Although premiums
are used to compute any net preserved value associated with option transactions, they are a
sunk cost and irrelevant to the decision to exercise the options.
Example 3 Currency Options Hedge: Receivables
Facts: Gearty International is owed 1,000,000 pesos due in 30 days from its Mexican
customer. Although the peso is currently exchanged for the U.S. dollar at $0.08, the
company is fearful that the Mexican peso will weaken in comparison to the dollar before
the settlement to as little as $0.06. Gearty International pays a $0.005 put premium to
secure a put option to sell 1,000,000 pesos in 30 days for $0.08.
Required: Compute the net preserved value assuming that Gearty is correct in its
assessment of international exchange rates and the exchange rate at the time of the
settlement (the spot rate) decreases.
Solution:

$0.06 – – – $(60,000)
– $0.08 $0.005 $0.075 75,000
Net preserved value $ 15,000
Gearty's consideration for the put option, the $0.005 put premium, is $5,000 and is paid
regardless of whether the put option is exercised. The gross value "preserved" of $20,000
[(0.08 − 0.06) × 1,000,000 pesos] is reduced by the $5,000 put premium paid to reflect a
net $15,000 preserved receivable value. Because the put premium is a sunk cost, it is not
included in the decision to exercise the option.
Facts: Same as above
Required: Calculate Gearty's loss, assuming that Gearty is incorrect in its assessment of
international exchange rates, the exchange rates stay constant at $0.08, and Gearty allows
the put option to expire.
Solution:

$0.08 – – – $(80,000)
– $0.08 $0.005 $0.075 75,000
Loss $ (5,000)
Exercising the put option would actually be equal to simply settling the transaction at the
spot rate when the receivables are received. Gearty will likely sell pesos at the spot rate
regardless of the loss associated with the premium.

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4.6 Mitigating Transaction Exposure: Long-Term Transactions

The following hedge transactions are used to mitigate exchange rate risk presented by
transaction exposure.
4.6.1 Long-Term Forward Contracts

Mechanically, long-term forward contracts deal with the same issues as any other forward
contracts. Long-term forward contracts are set up to stabilize transaction exposure over long
periods. Long-term purchase contracts may be hedged with long-term forward contracts.
4.6.2 Currency Swaps

Transaction exposure associated with exchange rate risk for longer-term multiple transactions
can be mitigated with currency swaps. Currency swaps are really a series of long-term forward
contracts. A forward contract covers one transaction. A currency swap covers a series of
transactions.
Two Firms
Two firms with coincidental needs for international currencies may agree to swap currencies
collected in a future period at a specified exchange rate. The two entities essentially swap
their currencies in an exchange negotiation completed years in advance of their receipt of
the currencies.
Financial Intermediaries
Typically, financial intermediaries are contacted to broker or to match firms with currency needs.
Parallel Loan
Two firms may mitigate their transaction exposure to long-term exchange rate loss by
exchanging or swapping their domestic currencies for a foreign currency and simultaneously
agreeing to re-exchange or repurchase their domestic currency at a later date.
Example 4 Currency Swap
Facts: In order to hedge its future raw material purchases for its operations, in Poland, a
U.S. manufacturing firm (U.S. counterparty) agrees to enter into a currency swap with a
Polish multinational firm (foreign counterparty) whereby the U.S. counterparty agrees to
provide the following quarterly notional amounts in U.S. dollars to the foreign counterparty
in exchange for the following quarterly notional amounts in Polish zlotys.
Quarter End U.S. Counterparty Receives Foreign Counterparty Receives
1 1,500,000 zloty 500,000 USD
2 900,000 zloty 300,000 USD
3 750,000 zloty 250,000 USD
4 1,800,000 zloty 600,000 USD
Assume that the exchange rates are 3.25 zloty/1.0 USD and 2.85 zloty/1.0 USD at the end of
quarter 1 and quarter 2, respectively.
Required: Calculate the U.S. manufacturing firm's foreign currency gain or loss recorded at
the end of the first and second quarters on the currency swap.
(continued)

(continued)
Solution: The U.S. manufacturing firm (U.S. counterparty) entered into a fixed notional
amount currency swap with a foreign counterparty when the exchange rates were 3.0
zloty/1.0 USD. Because the contractual quarterly payments made in U.S. dollars to the
Polish firm are fixed at that exchange rate throughout the swap, any movement up or
down of these two exchange rates will result in a foreign currency gain or loss.
In the first quarter, the U.S. dollar appreciates versus the Polish zloty, so the U.S.
counterparty incurs a foreign currency loss. Under the terms of the currency swap, the U.S.
counterparty pays 500,000 U.S. dollars and receives 1,500,000 zloty (based on an exchange
rate of 3.0 zloty/1.0 USD). The 1,500,000 zloty received are worth only 461,538 U.S. dollars
based on the end of quarter exchange rate of 3.25 zloty/1.0 USD:
1,500,000 / 3.25 = 461,538 USD
Paying 500,000 U.S. dollars and receiving zloty worth only 463,538 U.S. dollars represents a
loss of 38,462 U.S. dollars:
500,000 – 461,538 = 38,462 USD
In the second quarter, the U.S. dollar depreciates versus the Polish zloty. As a result of
the swap, the U.S. counterparty incurs a foreign currency gain. The U.S. counterparty pays
300,000 U.S. dollars and receives 900,000 zloty. The value in U.S. dollars of 900,000 zloty
based on the end of quarter exchange rate of 2.85 zloty/1.0 USD is 315,789 U.S. dollars.
900,000 / 2.85 = 315,789
Paying 300,000 U.S. dollars and receiving zloty worth 315,789 U.S. dollars represents a gain
of 15,789 in U.S. dollars:
315,789 – 300,000 = 15,789 USD
4.7 Mitigating Transaction Exposure: Alternative Hedging Techniques

The following hedge transactions are used to mitigate exchange rate risk presented by
transaction exposure.
4.7.1 Leading and Lagging

Leading and lagging represent transactions between subsidiaries or a subsidiary and a parent.
The entity that is owed may bill in advance if the exchange rate warrants (leading) or possibly
wait until the exchange rate is favorable before settling (lagging).
4.7.2 Cross-Hedging
The technique known as cross-hedging involves hedging one instrument's risk with a different
instrument by taking a position in a related derivatives contract. This is often done when there is
no derivatives contract for the instrument being hedged, or when a suitable derivatives contract
exists but the market is highly illiquid.
4.7.3 Currency Diversification

The simplest hedge for long-term transactions is to diversify foreign currency holdings over time.
A substantial decline in the value of one currency would not affect the overall dollar value of the
firm if the currency represented only one of many foreign currencies.

rights reserved.
PART 2 UNIT
5 Mitigating and Controlling Economic Exposure LOS 2B6f
Businesses have various methods of managing the economic and translation exposure
associated with exchange rate risks. Generally, the use of organization-wide solutions related to
the entity itself and related reporting requirements are included in the approach.
5.1 Assessing Economic Exposure

Economic exposure is defined by the degree to which cash flows of the business can be affected
by fluctuations in exchange rates. The extent to which revenues and expenses are denominated
in different currencies could seriously affect the profitability of an organization and represents
economic exposure.
Illustration 17 Economic Exposure
Pete's Primo Piñatas manufactures piñatas in Mexico. The company's expenses paid to
local suppliers are denominated in the peso. The company exports nearly 80 percent of
its product to the United States and receives revenues denominated in U.S. dollars from
upscale Mexican theme-party planners. If the peso were to strengthen in relation to the
dollar, then import revenues could be significantly less than domestic expenses. Pete's
Primo Piñatas would suffer economic losses as a result of its economic exposure to
exchange rate risk.
5.2 Techniques for Economic Exposure Mitigation

Economic exposures typically relate to organization-wide issues and can usually only be
mitigated with organization-wide approaches that involve restructuring and adjustments to the
business plan.
5.2.1 Restructuring
Economic exposure to currency fluctuations can be mitigated by restructuring the sources of
income and expense to the consolidated entity.
Decreases in Sales
A company fearful of a depreciating foreign currency used by a foreign subsidiary may elect
to reduce foreign sales to preserve cash flows.
Increases in Expenses
A company anticipating a depreciating foreign currency may elect to increase reliance
on those suppliers to take advantage of paying for raw materials or supplies with
cheaper currency.
5.2.2 Characteristics of Restructuring and Economic Exposure

Restructuring tends to be more difficult than ordinary hedges. Economic exposures to exchange
rate fluctuations are viewed as more difficult to manage than transaction exposures.

LOS 2B6h 6 Trade Finance Methods
A variety of techniques are used to finance international trade by protecting sellers

(exporters) from default by international buyers (importers) including cross-border factoring,
letters of credit, banker's acceptances, forfaiting (for medium-term capital goods financing)
and countertrade.
6.1 Cross-Border Factoring

Cross-border factoring is a practical response to potential default risk. Exporters may elect
to factor or sell receivables to a third party, without recourse, to ensure cash collections and
expedite cash flows. The risk of default is assumed by the factor, which mitigates the risk
associated with the creditworthiness of the importers.
Cross-border factoring involves an international network of factors who assess the
creditworthiness of importers. The factor engaged by the exporter contacts another factor
in the importer's country to both assess the buyer's creditworthiness and to handle the
cash collections. The factor in the importer's country assists with both risk assessment
and administration.
Commercial banks, commercial finance companies, and other specialty finance houses provide
cross-border factoring services.
6.2 Letters of Credit

Letters of credit protect cash flows by guaranteeing the seller's (exporter's) cash collections.
Letter of credit arrangements involve two banks: a bank engaged by the debtor/buyer (importer)
called the issuing bank and a bank representing creditor/seller (exporter) called the advising
bank. An irrevocable letter of credit obligates the issuing bank to honor all funds drawn on it
upon presentation of documentation that conforms to the terms of the letter of credit. The
issuing bank substitutes its credit for that of the importer's, and thus guarantees payment to the
exporter. The issuing bank then seeks reimbursement from the importer of amounts drawn plus
fees for providing the letter of credit guarantee.
6.3 Banker's Acceptances

A banker's acceptance is a negotiable instrument that is similar to a postdated check, except
that it is guaranteed by the bank rather than the account holder. Banker's acceptances can be
used as a bank-backed payment for large transactions, including cross-border transactions. The
banker's acceptance may be either collected at the specified time or sold in the money market at
a discount.
6.4 Forfaiting
Forfaiting represents a credit facility for importers of higher-priced capital goods that may be
financed over several years. Forfaiting transactions share the characteristics of factoring and use
the transaction mechanics of letters of credit.
Importers that purchase capital goods from exporters (generally in excess of $500,000) may do
so by issuing a promissory note payable over a three- to five-year period. The exporter's default
risk increases as the payment terms are extended. Forfaiting mitigates the extra risk from the
extended payment terms.

rights reserved.
PART 2 UNIT
The seller (exporter) sells the promissory note to a forfaiting bank (essentially a factor) for
discounted proceeds and thereby assures both cash collection and cash flows to the exporter.
The forfaiting bank, in turn, seeks collection from the importer through a prearranged,
collateralized agreement that uses bank guarantees or letters of credit issued by the importer's
bank to ensure collection of the purchased promissory note by the forfaiting bank.
6.5 Countertrade
A countertrade refers to the mutual exchange of goods in bartering arrangements
or the purchase of goods through clearing houses with either partial or full
compensation arrangements.
Bartering involves the exchange of goods without monetary compensation. Agricultural
products from Canada (such as wheat) might be exchanged for seafood harvested in Peru in a
bartering transaction.
Compensation arrangements represent the guaranteed purchase of goods paid for with
currency. In full compensation transactions, agricultural products from Canada might be
purchased by a Peruvian company with the full understanding that the Canadian company will
purchase either an equal (full compensation) or different (partial compensation) amount of
seafood products from a Peruvian company.
Big Company, located solely in the United States, purchased items from a supplier located
in the United Kingdom for £100,000 in early December Year 1. Big reported a payable
for that purchase on the date of purchase for $130,336. On December 31, the end of the
accounting period, the payable was not yet settled. The exchange rate was 1 USD = £0.75
on December 31, Year 1, and was 1 USD = £0.73 on the date the payable was settled in
February Year 2. What is the amount of gain (loss) that Big needs to report on its income
statement for December Year 1 as a result of foreign exchange rate fluctuation? Round to
the nearest dollar.
a. $2,997 loss
b. $2,997 gain
c. $6,650 gain
d. $6,650 loss

A company located in the United Kingdom purchased materials from an Italian company
for €200,000 when the exchange rate was €1.00/£0.90. Before year-end, the British
company settled its liabilities when the exchange rate was €1.00/£0.93. What is the effect
on the British company's operating income as a result of this transaction? Assume that the
exchange rate at the end of the accounting period was €1.00/£0.95.
a. Loss of £6,000.
b. Gain of £6,000.
c. Loss of £10,000.
d. No gain or loss is reported because the settlement of the liability took place in the
same accounting period.
Romeo Co. is an Italian company that owes its Mexican supplier 1,000,000 pesos. The
amount is due in two months. The current exchange rate is 1 Mexican peso = €0.040.
Romeo Co. holds a call option to buy 1,000,000 Mexican pesos at an exercise price of
€0.041 per peso. The premium paid for the option is €0.002 per peso. Upon maturity, the
exchange rate was 1 Mexican peso = €0.045. What is the amount of gain or loss that the
Italian company will record for the year as a result of this transaction?
a. Loss of €5,000.
b. Loss of €1,000.
c. Loss of €3,000.
d. Gain of €3,000.

rights reserved.
Class Question Explanations Part 2
UNIT 2
Unit 2, Module 1
1. MCQ-12661
Choice "b" is correct. The capital asset pricing model (CAPM) is used to determine a required
rate of return for any risky asset. To accept a given amount of systematic risk for an individual
security, the investor requires a return equal to the risk-free rate added to the asset's risk
premium, which is β(Rm – Rf).
The required return is equal to 11.68 percent, calculated as follows:
R = Rf + β(Rm – Rf)
R = 0.03 + 1.24 (0.10 – 0.03) = 0.1168 = 11.68%
Choice "a" is incorrect. This answer choice does not include the risk-free rate of 3 percent added
to the risk premium of 8.68 percent.
Choice "c" is incorrect. The risk-free rate of 3 percent is omitted (twice) from the CAPM
calculation.
Choice "d" is incorrect. The risk-free rate of 3 percent is not subtracted from the market risk
premium component of the CAPM calculation.
2. MCQ-12662
Choice "b" is correct. The correlation coefficient measures the statistical relationship between
two variables. The correlation coefficient between two securities' historical returns can be used
to identify securities ideal for effectively diversifying a portfolio. Negative correlations reduce
overall portfolio risk without compromising expected portfolio return; finding two stocks with a
negative correlation to one another is critical.
Based on the data provided in the correlation matrix, the largest negative correlation is –0.25
between ALK and CMN. By adding these two stocks to a portfolio, the unsystematic risk and,
thus, the overall risk of the portfolio will decline.
Choice "a" is incorrect. ALK and DLE have a correlation of 0.58, which will not reduce
unsystematic risk and, thus, overall portfolio risk as much as combining ALK and CMN, because
ALK and DLE are highly correlated whereas ALK and CMN are negatively correlated.
Choice "c" is incorrect. While BTY and DLE have a negative correlation of –0.04, this combination
will not be as beneficial to reduce unsystematic risk as combining ALK and CMN which have a
negative correlation of –0.25.
Choice "d" is incorrect. BTY and CMN have a positive correlation of 0.16, which is not as
beneficial to reducing portfolio risk as adding ALK and CMN which have a negative correlation
of –0.25.
© Becker Professional Education Corporation. All rights reserved. CQ–11

Part 2 Class Question Explanations
Unit 2, Module 2
1. MCQ-12663
Choice "c" is correct. The value of a bond is equal to the present value of its future interest and
principal payments. Because the bond's coupon rate is greater than the market rate at the time
of issuance, the bond will be issued at a premium (above $1,000 per bond).
The calculation is performed quickly on a financial calculator, but the manual calculation of the
bond price is shown below:
Year 1 payment: $42.50 / 1.04 = $40.865
Year 2 payment: $42.50 / (1.04)2 = $39.294
Year 3 payment: $42.50 / (1.04)3 = $37.782
Year 4 payment: ($42.50 + $1,000) / (1.04)4 = $891.133
Total value: $40.865 + $39.294 + $37.782 + $891.133 = $1,009.07.
Note that $42.50 is the yearly interest payment: 4.25% stated rate × $1,000 face (par) value of
the bond.
Choice "a" is incorrect. An issuance price below par means that the bond would have been
issued at a discount. A bond is sold at a discount if the market rate is higher than the stated rate.
In this case the market rate of 4.00 percent is less than the 4.25 percent stated rate. So, the bond
is selling at a price greater than par value.
Choice "b" is incorrect. An issuance price below par means that the bond would have been
issued at a discount. A bond is sold at a discount if the market rate is higher than the stated rate.
In this case the market rate of 4.00 percent is less than the 4.25 percent stated rate. So, the bond
is selling at a price greater than par value.
Choice "d" is incorrect. This answer choice incorrectly adds $4.25 each year for four years to the
face value of $1,000. To determine the current value (price) of the bond, take the present value
of all cash flow amounts using the 4.00 percent market rate.
CQ–12 © Becker Professional Education Corporation. All rights reserved.

2. MCQ-12664
Choice "d" is correct. The intrinsic value of a stock is the price an investor should pay to purchase
a share of stock. The inputs to the calculation include the current dividend, the growth rate, and
the required return.
D0 (1 +g)
Pt =
r–g
The required return is calculated using the capital asset pricing model (CAPM), shown below:
r = rf + β(rm – rf)
For this stock, Reynolds' required return is equal to 6.4%:
r = 0.02 + 1.10(0.06 – 0.02) = 0.064 = 6.4%
Based on the intrinsic value equation above, the price that Reynolds should pay for the stock is
$49.83 per share:
$1.15 (1 + 0.04)
Pt = = $49.83.
0.064 – 0.04
Choice "a" is incorrect. $18.69 is the value if the growth rate is omitted from the denominator of
the calculation.
Choice "b" is incorrect. $29.90 is the value if the required return is omitted from the
denominator of the calculation.
Choice "c" is incorrect. $47.92 is the value if the dividend in the numerator is not multiplied by
1 + g.

Unit 2, Module 3
1. MCQ-12665
Choice "c" is correct.
Impact on the Impact on the

Inputs Change in Input Value of Call Value of a Put
Risk-free interest rate Higher Higher Lower
The risk-free interest rate is one of the inputs into the Black-Scholes option valuation model. As
interest rates in the marketplace change, the values of both calls and puts change. If the risk-
free interest rate increases, the value of a call option increases, and the value of a put option
decreases. Conversely, if the risk-free interest rate decrease, the value of a call option decreases
and the value of a put option increases.
A lower risk-free interest rate results in lower earnings on cash holdings, which means having
more cash on hand is not necessarily beneficial. The alternative to buying a put option is to short
sell the underlying stock. Short selling provides immediate cash up front, which in a low interest
rate environment is not as beneficial. Having the right to sell at a point in the future therefore
provides more value than holding cash now, which is why the put increases in value. Call options
represent the call option holder's right to buy the underlying asset at the specified strike price.
The alternative to buying a call option is to buy the stock outright. Lower interest rates are not
beneficial for call option holders because waiting to buy (versus buying right away) means more
cash is on hand—cash that is earning a lower interest rate.
Choice "a" is incorrect. The value of the put will be higher, not lower, with decreases in
interest rates.
Choice "b" is incorrect. The value of the call will be lower, not higher, with decreases in
interest rates.
Choice "d" is incorrect. When interest rates increase (not decrease), the value of the put is lower,
and the value of the call is higher.

2. MCQ-12666
Choice "b" is correct. Forward commitments allow the holder to lock in a price today to buy
or sell the underlying asset at some point in the future. There are three types of forward
commitments: forwards, futures, and swaps. A forward contract is a customized agreement
between two parties in which the buyer will purchase an underlying asset from the seller later
at a fixed price specified in the contract when the contract is signed. A futures contract is an
agreement to buy or sell a predetermined quantity of a specified asset on a future date for a
specified price. Forward contracts are not bought and sold on organized exchanges; futures
contracts are bought and sold on organized exchanges.
Both parties to a forward contract and to a futures contract are obligated by the terms of the
contract. Unlike with options where the long position has the right, but not the obligation, to act,
forwards and futures are commitments in which both sides are obligated to act.
Choice "a" is incorrect. Credit risk is mitigated in a futures contract (not forward contract) due to
the presence of a clearinghouse.
Choice "c" is incorrect. Futures (not forwards) require posting initial margin, which serves
as collateral for the transaction. Forwards do not have a collateral requirement unless that
requirement is negotiated and becomes part of the contract.
Choice "d" is incorrect. Futures contracts have standardized terms; forward contracts have
negotiated terms for each contract.
3. MCQ-12667
Choice "d" is correct. An investor takes a long position in a forward contract when the investor
expects the price of the underlying asset to increase. Generally, a long position means that
the investor is required to purchase the underlying asset at some future, specified date for
a specified price. An investor takes a short position in a forward contract when the investor
expects the price of the underlying asset to decrease.
Generally, a short position means that the investor is required to sell the underlying asset at
some future, specified date for a specified price.
The investor here has a short position and will record a gain (or a loss) if the price of the
underlying asset, the wheat, decreases (or increases). In this fact pattern the investor is required
to sell the wheat, the underlying asset, for $5.20 per bushel. The investor will collect $5.20 per
bushel from the other party to the forward contract. On September 1, the investor could buy
that wheat at $4.70 per bushel, deliver that wheat to the other party (the buyer) to the forward
contract, and collect from that buyer $5.20. As such, the investor has a $0.50 profit per bushel:
$5.20 per bushel that the investor will collect from the other party to the forward contract minus
$4.70 per bushel, which the investor will have to pay to acquire the wheat for delivery to the
other party to the forward contract.
The total value of the forward contract is $1,250: $0.50 profit per bushel × 5 contracts × 500
bushels per contract = $1,250.
Choice "a" is incorrect. There would be a loss if, for this investor, the contract were a long (rather
than a short) position. Furthermore, because there are five contracts, the loss on the long
position is –$1,250: 5 contracts x $250 loss per contract.
Choice "b" is incorrect. The gain per contract is $250, but there are five contracts.
Choice "c" is incorrect. There would be a loss if, for this investor, the contract were a long (rather
than a short) position.

Unit 2, Module 4
1. MCQ-12668
Choice "c" is correct. Market efficiency refers to how well current market prices reflect all
available and relevant information. If a market is efficient, then no single investor can make
abnormal profits based on information the investor has because everybody trading in the
market has that information, and all of that information is already reflected in the market price.
If the stock market is inefficient, information will take time to affect the market prices
of securities.
Choice "a" is incorrect. Availability of information usually affects market price either immediately
if the market is efficient or with some delay when the market is inefficient.
Choice "b" is incorrect. Given the information in the question, the trajectory of the stock price
cannot be predicted.
Choice "d" is incorrect. Given the information in the question, changes in the direction of
demand for the stock cannot be determined.
2. MCQ-12669
Choice "b" is correct. The term market efficiency refers to how well current market prices reflect
all available and relevant information. In an efficient market, information is available at low costs
to all market participants who are rational and react quickly to new information.
The efficient market theory does not discuss the manner or the fashion in which the information
is generated.
Choice "a" is correct. In efficient markets, information is inexpensive or free, and is widely
available.
Choice "c" is incorrect. In efficient markets, there are rational participants in the market.
Choice "d" is incorrect. In efficient markets, market participants react quickly and fully to new
information.

3. MCQ-12670
Choice "a" is correct. Dividends are first paid to preferred shareholders and then to common
shareholders. When preferred shares are cumulative, all preferred share dividends in arrears
(prior year dividends not yet paid) are paid to preferred shareholders, followed by the current
year preferred share dividends. Only after the preferred shareholders received dividends in
arrears and current dividends would the common shareholders receive dividend payments.
Dividends to common shareholders in Year 4 are $130,000, calculated as follows:
Preferred shareholders' dividends in arrears for Year 3 = $100 par value per share × 20,000
shares × 8% stated rate = $160,000
Preferred shareholders' dividends for Year 4 = $100 par value per share × 20,000 shares × 8%
stated rate = $160,000
Total allocated to preferred shareholders = $160,000 for Year 3 + $160,000 for Year 4 = $320,000
dividend allocated to preferred shareholders.
The remainder allocated to common shareholders = $450,000 total dividend declared – $320,000
portion of total dividend declared to be paid to preferred shareholders = $130,000 dividend to
be paid to common shareholders.
Choice "b" is incorrect. $320,000 are the dividends allocated to preferred shareholders, not
common shareholders.
Choice "c" is incorrect. $160,000 is the annual dividend payment to preferred shareholders per
the contract.
Choice "d" is incorrect. If the preferred stock were noncumulative (only current year dividends
paid) then $290,000 would be allocated to common shareholders.

Unit 2, Module 5
1. MCQ-12679
Choice "b" is correct. Offering payment discounts can result in improved cash collections
because discounts forgone generally represent a higher cost than the cost of a short-term bank
loan. The formula for calculating the annual cost (APR) of a quick payment discount is as follows:
360 Discount
APR of quick payment discount = ×
Pay period – Discount period 100 – Discount %
360 2%
The annualized rate in this question = × = 21%
45 – 10 98%
This annualized rate is higher than the annual borrowing cost (12 percent); Beta should borrow
funds from the bank to take advantage of the cash discount. The 21 percent annualized cost of
not taking the discount is greater than the 12 percent annual cost of borrowing from the bank.
Choice "a" is incorrect. It is wrong to compare the discount rate with the annual borrowing
rate. The correct comparison is annualized rate with respect to the discount versus the annual
borrowing rate.
Choice "c" is incorrect. Postponing the payment of liabilities is not a good option. In this case,
Beta should not extend payment beyond the allowable 45 days. Doing so reflects negatively on
the relationship with Beta's suppliers.
Choice "d" is incorrect. Funds should be borrowed if they can be borrowed at a cost that is
lower than the annualized cash discount savings. Although a 12 percent borrowing rate is
higher than the 2 percent cash discount, the appropriate comparison is the 12 percent annual
borrowing rate versus the 21 percent APR of the quick payment discount (annualized cash
discount savings).
2. MCQ-12680
Choice "a" is correct. Working capital is defined as the difference between current assets (CA)
and current liabilities (CL). On the one hand, when a sale occurs, inventory will be removed from
inventory at cost. On the other hand, either cash or a receivable will be recognized at the selling
price. If the selling price is greater than the cost of the inventory sold, then the cash or receivable
increase will be greater than the inventory decrease and working capital will increase in an
amount equal to the amount of the selling price in excess of the cost of the inventory sold.
In this question, the selling price is higher than cost; so, the increase in accounts receivable
exceeds the decrease in inventory by the markup amount, and there is an increase in
working capital.
Choices "b" and "c" are incorrect. When selling price exceeds cost, working capital will increase
as a result of a sale.
Choice "d" is incorrect. Working capital will be affected if a sale takes place at a profit even if the
sale was on credit.

3. MCQ-12681
Choice "b" is correct. The current ratio (CA divided by CL) measures the number of times current
assets exceed current liabilities and is a way of measuring short-term solvency. This ratio
demonstrates a firm's ability to generate cash to meet its short-term obligations.
Using cash to pay a current liability is an equal deduction from current assets in the numerator
and current liabilities in the denominator. Because the current ratio was greater than 1 before
current assets were used to settle the current liability, the ratio will increase after current assets
are used to settle the current liability.
Exam-taking suggestion: For any question asking for a number result but not providing any
numbers, use your own numbers to make the question less abstract and more concrete. For
example, in this question, you could assume that (i) current assets are $20; (ii) current liabilities
are $10 (so that the current ratio before settlement of the liability is 2); and (iii) the cash paid
to settle the current liability is $2. After settlement, current assets are now $18, and current
liabilities are now $8; so, the current ratio is now $18 / $8 = 2.25, which is greater than 2.
Only if the current ratio were 1 prior to the use of current assets to settle the current liability will
the current ratio continue to be 1 after the use of current assets to settle the current liability.
Choice "a" is incorrect. The current ratio is not affected by using current assets to settle a current
liability only when the current ratio was initially equal to 1. Example: Assume current assets and
current liabilities are each $30 (so that the current ratio is 1: $30 current assets / $30 current
liabilities). Further assume that $4 of current assets are used so settle current liabilities. After
settlement, current assets and current liabilities are each $26, and the current ratio is still 1: $26
current assets / $26 current liabilities.
Choice "c" is incorrect. Because the current ratio was greater than 1 before the settlement of
the current liability, the ratio will not decrease when settlement takes place; rather, the ratio will
increase when settlement takes place.
Choice "d" is incorrect. The information provided is sufficient to determine the current ratio
effect resulting from settlement of a current liability.
Unit 2, Module 6
1. MCQ-12682
Choice "b" is correct. The reorder point is the level of inventory that is in stock when the
company issues an order for additional quantities of inventory. This level is equal to the
sum of the need for inventory during the lead time plus the safety stock, as is shown in the
following formula:
Reorder point = Units consumed during lead time + Safety stock
The annual demand is 120,000 units, which is 10,000 units per month. Assuming that a month
comprises approximately four weeks, then the weekly demand is estimated to be 2,500 units.
Because the company receives the goods one week after the goods are ordered, sells 2,500
units of inventory each week, and always wants to have at least 400 units of inventory on hand,
the company needs to reorder when there are 2,900 units remaining on hand: 2,500 units that
will be sold from the time the replacement inventory is ordered until the time the replacement
inventory will arrive + 400 units of safety stock.
Choice "a" is incorrect. 10,000 units represents the monthly quantity demanded.
Choice "c" is incorrect. The weekly demand is 2,500 units. This number is not the reorder point.
Choice "d" is incorrect. The safety stock is 400 units. This number does not represent the
reorder point.

2. MCQ-12683
Choice "a" is correct. The economic order quantity (EOQ) inventory model attempts to minimize
ordering and carrying costs. The use of the model helps management determine the optimal
quantity to be ordered in an attempt to minimize the sum of order costs and carrying costs.
2 Annual demand Order cost 2 120, 000 units $250

The EOQ 5, 000 units
Carrying cost per unit $2.40 per unit
Choice "b" is incorrect. Omitting 2 from the numerator incorrectly results in 3,536 units.
Choice "c" is incorrect. Using the monthly demand of 10,000 units rather than the annual
demand of 120,000 units in the numerator results in 1,444 units.
Choice "d" is incorrect. Incorrectly transposing the carrying cost and the order cost results in
48 units.
3. MCQ-12684
Choice "b" is correct. Factoring accounts receivable entails turning over the collection of
accounts receivable to a third-party factor in exchange for a discounted short-term loan.
According to the credit terms, cash is collected from the factor immediately rather than later
from the customer. The cost of this service includes the fees and the interest charged by the
factor. By factoring receivables, a company can save all relevant collection costs but will incur
loan borrowing costs.
The net cost of this service is $37,000, calculated as follows:
Factoring fees = $400,000 × 1% × 12 months = $48,000
Interest = $400,000 × 75% × 8% = $24,000
Total cost of buying this service = $48,000 + $24,000 = $72,000
Savings because of eliminating collection service = $35,000
Net cost of the factoring service = $72,000 – $35,000 = $37,000.
Choice "a" is incorrect. $24,000 represents the annual interest charged on cash advances when
the company factors the receivables, but the question asks for the net annual cost of using a
factor in lieu of incurring collection costs of $35,000.
Choice "c" is incorrect. $48,000 represents the annual factoring fee only, rather than adding that
amount to the interest charged and then subtracting the eliminated collection services fees to
arrive at the net cost of factoring.
Choice "d" is incorrect. The total cost of the factoring service is $72,000, but the question asks for
the net annual cost, which requires the subtraction of the $35,000 in collection service costs that
were eliminated.

4. MCQ-12685
Choice "b" is correct. Offering a cash discount for prompt payment is a tool used by sales
managers to accelerate cash collections. To determine the cost to the customer of the
customer's not taking the discount (savings from paying within the window), the customer's
management must always annualize the rate using the following formula:
Discount % / (100% – Discount %) × 360 / (Pay period – Discount period)
The annualized rate for Supplier A is 18.18% = [(1% / 99%) × (360 / 20)]. That is, Supplier A is
offering an 18.18% APR discount if Malki pays within the first 10 days. In order to compare
Supplier B's annualized rate to Supplier A's, the time periods must be identical. To make the
comparison, use Supplier A's time periods but with Supplier B's discount rate. The annualized
rate for Supplier B is 36.73% = [(2% / 98%) × (360 / 20)]. So, Malki benefits more by selecting
Supplier B to realize a greater annualized rate savings.
Choice "a" is incorrect. If, for example, Malki purchases on credit from Supplier A a $100 item
and pays within 10 days, Malki will pay only $99. If, however, Malki purchases on credit from
Supplier B a $100 item and pays within the same 10 days, Malki will pay only $98. So, Malki
should buy from Supplier B rather than from Supplier A and pay less.
Choice "c" is incorrect. The information presented is useful for decision making.
Choice "d" is incorrect. The comparison between the two suppliers is based on cash payment
terms that are different for each supplier. Because the cash payment terms are different, Malki
is not indifferent with respect to both suppliers.
Unit 2, Module 7
1. MCQ-12686
Choice "b" is correct. To determine the value of a target company, the buyer must calculate
the present value of the future after-tax cash flows. If the expected after-tax cash flows are
specified for the initial period and if a constant growth rate is specified for later years, the use
of the Gordon growth model would be a two-stage calculation. However, in this question the
operations terminate after five years, so use of the Gordon growth model is neither necessary
nor appropriate.
The value of Alpha Co. is estimated at $603,434, calculated as follows:
[$150,000 ÷ (1.12)1] + [$170,000 ÷ (1.12)2] + [$180,000 ÷ (1.12)3] + [$190,000 ÷ (1.12)4] +
[$150,000 ÷ (1.12)5] = $603,434
Choice "a" is incorrect. The $432,573 is the present value of the average net income. When
calculating the value of a company, use after-tax cash flows from operations, not accounting
net income.
Choice "c" is incorrect. The $1,144,151, is the present value of the sum of the average net income
and the annual, after-tax cash flows. When calculating the value of a company, use only after-tax
cash flows, not accounting income.
Choice "d" is incorrect. The $1,250,000 is the beginning of the Year 5 present value of $150,000 if
$150,000 did not grow into perpetuity: $150,000 ÷ 0.12. However, the $150,000 is not estimated
to continue into perpetuity but is a single-year amount.

2. MCQ-12687
Choice "c" is correct. To determine the value of a target company, the buyer must calculate
the present value of the future after-tax cash flows. If a constant growth rate is expected for
future years, then the buyer can use the Gordon growth model to determine the value of the
target company.
The value of Alpha Co. is $1,666,667, calculated as follows:
Value = End-of-year after-tax cash flow divided by the difference between the required rate of
return and the constant growth rate.
$150,000
Value = = $1,666,667
12% − 3%
Choice "a" is incorrect. The $1,250,000 is the value if no growth in cash flows is expected.
Choice "b" is incorrect. The $1,333,333 is the value based on the annual net income of $120,000
rather than the after-tax cash flows.
Choice "d" is incorrect. The $5,000,000 is the value if the rate of return is 3% with no
expected growth.

Unit 2, Module 8
1. MCQ-12689
Choice "a" is correct. When importing items from a foreign supplier in a transaction
denominated in a foreign currency, a gain will result when the foreign currency depreciates
relative to the domestic currency. A loss will result when the foreign currency appreciates
relative to the domestic currency.
In early December, the date of the transaction, each USD could purchase £0.767
(£100,000/$130,336). On December 31, Year 1, the USD could purchase only £0.75. This smaller
number is an indicator of a weaker USD. On December 31, the payable liability is now $133,333:
£100,000 ÷ £0.75/$1.00. Because the payable amount recorded in early December was only
$130,336 and because the December 31 payable amount is $133,333, the company must
increase (credit) the payable in the amount of $2,997: $133,333 December 31 payable amount –
$130,336 early December recorded payable amount. This $2,997 is a loss (debit) to be recorded
as a reduction to operating income.
Choice "b" is incorrect. Because the USD is weaker on December 31, Year 1, the result is a loss,
not a gain. In early December, the date of the transaction, each USD could purchase £0.767
(£100,000/$130,336). On December 31, Year 1, the USD could purchase only £0.75. This smaller
number is an indicator of a weaker USD. On December 31 the payable liability is now $133,333:
£100,000 ÷ £0.75/$1.00. Because the payable amount recorded in early December was only
$130,336 and because the December 31 payable amount is $133,333, the company must
increase (credit) the payable in the amount of $2,997: $133,333 December 31 payable amount –
$130,336 early December recorded payable amount. This $2,997 is a loss (debit), not a gain, to
be recorded as a reduction to operating income.
Choice "c" is incorrect. The USD is weaker at the end of the accounting period and results in
a loss due to the increase in the value of the payables. The $6,650 results from the difference
in exchange rates from the date of the transaction in early December, Year 1, up to the date
of settlement in February Year 2. Specifically, while the payable amount recorded in early
December was $130,336, the amount of cash (U.S. dollars) the company will expend on the
February Year 2 settlement date will be $136,986: £100,000 ÷ £0.73/$1.00 Hence, the cumulative
(early December Year 1 through February Year 2) loss, not gain, is $6,650: $136,986 amount
of cash (U.S. dollars) the company will expend on the February Year 2 settlement date minus
the $130,336 payable amount recorded in early December Year 1. Also, note that the foreign
exchange rate fluctuation gain or loss to be reported in the income statement for December
Year 1 is calculated based on the change in the exchange rate through December 31, Year 1, not
through the settlement date in the subsequent year.
Choice "d" is incorrect. The $6,650 results from the difference in exchange rates from the date
of the transaction in early December Year 1 up to the date of settlement in February Year 2.
Specifically, while the payable amount recorded in early December was $130,336, the amount
of cash (U.S. dollars) the company will expend on the February Year 2 settlement date will be
$136,986: £100,000 ÷ £0.73/$1.00. Hence, the cumulative (early December Year 1 through
February Year 2) loss is $6,650: $136,986 amount of cash (U.S. dollars) the company will expend
on the February Year 2 settlement date minus the $130,336 payable amount recorded in
early December Year 1. Also, note that the foreign exchange rate fluctuation gain or loss to
be reported in the income statement for December Year 1 is calculated based on the change
in exchange rate up through December 31, Year 1, not through the settlement date in the
subsequent year.

2. MCQ-12690
Choice "a" is correct. When importing items from a foreign supplier in a transaction
denominated in a foreign currency, a company will recognize a gain when the foreign currency
depreciates relative to the domestic currency. A loss will result when the foreign currency
appreciates relative to the domestic currency.
The euro appreciated by £0.03 against the pound. As such, using euros of €200,000 became
more expensive. The increase in cost is £0.03/1.00€ × €200,000 = £6,000 (loss).
Choice "b" is incorrect. The euro appreciates in value relative to the British pound. This
appreciation results in a loss to the British company because it now needs more British pounds
to purchase the required euros to settle (pay) the payable.
Choice "c" is incorrect. Even though the liability is settled before year-end, the British company
computes its foreign exchange rate fluctuation gain or loss by comparing the exchange rate
when the transaction took place (the payable was generated) with the exchange rate when the
payable is settled in euros.
Choice "d" is incorrect. Foreign exchange rate fluctuation gains and losses from foreign currency
transactions are determined when a liability is settled (paid), regardless of whether settlement
happens during the same year or in a later year.
3. MCQ-12691
Choice "c" is correct. A call option (an option to buy) is the currency option hedge used to
mitigate the transaction exposure associated with exchange rate risk for payables. The option is
in the money when the exercise price is lower than the market price on the date of exercise.
It is better for Romeo Co. to exercise the option to buy the pesos at €0.041 per peso rather than
purchasing pesos at the market price of €0.045. The total cost is therefore €0.041 + €0.002 =
€0.043 per peso. That is €0.003 higher than the spot rate when the transaction originated. This is
a loss of €0.003 × 1,000,000 pesos = €3,000.
Choice "a" is incorrect. The loss would be €5,000 if Romeo did not exercise the option and paid
the current exchange rate for the peso, but because the exercise price is less than the current
rate, Romeo would exercise the option instead.
Choice "b" is incorrect. The loss is €1,000 only if buying the option did not cost a premium.
Choice "d" is incorrect. Because the cost to buy 1 peso increased, the result is a loss.

2B. Corporate Finance: Part 2 Unit 2

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PART 2

1 B.1. Risk and Return 3

2 B.2. Long-Term Financial Management: Part 1 17

3 B.2. Long-Term Financial Management: Part 2 33

4 B.3. Raising Capital 55

5 B.4. Working Capital Management: Part 1 73

6 B.4. Working Capital Management: Part 2 91

7 B.5. Corporate Restructuring 103

8 B.6. International Finance 123

2–2 © Becker Professional Education Corporation. All rights reserved.

B.1. Risk and Return

CMA LOS Reference: Part 2—Section B.1. Risk and Return

The candidate should be able to:

1 Rates of Return LOS 2B1a

1.1 Annual Return

Ending value – Beginning value + Income

© Becker Professional Education Corporation. All rights reserved. Module 1 2–3

Ending value – Beginning value

Ending value – Beginning value + Income

Example 1 Calculating Return

500 shares × €0.50 dividend per share

€1,700 – €1,000 + €250

Total return = 70% capital return + 25% income return = 95%

2–4 Module 1 © Becker Professional Education Corporation. AllB.1. Risk

1.2 Holding Period Return

Example 2 Annualizing Rates of Return

1.3 Geometric Return

Geometric: average = n (1  r1 )(1  r2 ) ... (1  rn )  1

[(1 + r1)(1 + r2) … (1 + rn)]1/n − 1

© Becker Professional Education Corporation. All rights reserved. Module 1 2–5

Example 3 Arithmetic and Geometric Average Returns

The geometric return is calculated as follows:

1.4 Stated Interest Rate

2–6 Module 1 © Becker Professional Education Corporation. AllB.1. Risk

Example 4 Stated Interest Rate

1.5 Effective Interest Rate

Example 5 Effective Interest Rate

1.6 Annual Percentage Rate

© Becker Professional Education Corporation. All rights reserved. Module 1 2–7

Example 6 Annual Percentage Rate

1.7 Effective Annual Percentage Rate

Effective annual interest rate = [1 + (i / p)] p – 1

Example 7 Effective Annual Percentage Rate

2–8 Module 1 © Becker Professional Education Corporation. AllB.1. Risk

2 Investment Risk LOS 2B1b

2.1 Market/Systematic/Nondiversifiable Risk

Illustration 1 Market Risk

2.2 Unsystematic/Firm-Specific/Diversifiable Risk

It is important to be able to classify risk into two broad categories:

© Becker Professional Education Corporation. All rights reserved. Module 1 2–9

2.3 Credit Risk

2.4 Foreign Exchange Risk

2.4.1 Transaction Exposure

Illustration 2 Transaction Exposure

Seattle Import/Export, a U.S. import/export company, imports commodities from Canada

2.4.2 Economic Exposure

2–10 Module 1 © Becker Professional Education Corporation. AllB.1. Risk

yy Effect of Currency Depreciation

2.4.3 Translation Exposure

Geometric: average = n (1 r1 )(1 r2 ) ... (1 rn ) 1

Determining the Required Rate of Return (R)

Valuing Equity With the P/E Ratio

Trailing vs. Forward P/E