Chartered Institute of Management Accountants (CIMA) Strategic Level: Management Accounting (E3, F3, P3) Syllabus

Give the formula for the Weighted Average Cost of Capital (WACC) with equity and debt.

$$WACC = K_e\!\left(\frac{E}{E+D}\right) + K_d(1-t)\!\left(\frac{D}{E+D}\right)$$ where $E$ and $D$ are market values of equity and debt, weighting each source's cost by its proportion of total capital.

What does Modigliani and Miller's capital structure theory conclude (a) without tax and (b) with tax?

(a) Without tax: capital structure is irrelevant — WACC and firm value are constant regardless of gearing. (b) With tax: because debt interest is tax-deductible, value rises with gearing, so an all-debt structure theoretically minimises WACC and maximises value.

What is the 'traditional view' of capital structure regarding an optimal gearing level?

The traditional view holds that WACC first falls as cheaper debt is introduced, reaches a minimum at an optimal gearing level, then rises as financial risk (and the cost of equity and debt) increases — so there is an optimal capital structure that maximises firm value.

Define financial gearing and give a common formula.

Financial gearing measures the proportion of debt in the capital structure (financial risk). A common measure: $$\text{Gearing} = \frac{\text{Debt}}{\text{Equity}} \quad\text{or}\quad \frac{\text{Debt}}{\text{Debt}+\text{Equity}}$$ usually based on market or book values of long-term capital.

What is the interest cover ratio and what does it indicate?

$$\text{Interest cover} = \frac{\text{Profit before interest and tax (PBIT)}}{\text{Interest payable}}$$ It shows how many times operating profit covers interest charges; a low figure signals high financial risk and difficulty servicing debt.

Distinguish between equity finance and debt finance.

Equity (ordinary shares) gives ownership, voting rights, variable dividends, no repayment obligation and the highest risk/return. Debt (loans, bonds) carries fixed interest, is repayable, ranks ahead of equity on liquidation, is cheaper (tax-deductible, lower risk) but increases financial risk/gearing.

What is mezzanine finance?

Mezzanine finance is a hybrid between debt and equity — typically unsecured/subordinated debt carrying a high interest rate plus an equity 'kicker' (e.g., warrants or options). It is often used in buyouts to bridge the gap between senior debt and equity.

Define a rights issue and how the theoretical ex-rights price (TERP) is calculated.

A rights issue offers new shares to existing shareholders pro-rata, usually at a discount. The TERP is the weighted average of the old market value and the new rights money: $$\text{TERP} = \frac{(\text{No. old shares}\times\text{old price}) + (\text{No. new shares}\times\text{issue price})}{\text{Total shares after issue}}$$

What are the three main asset-based and income-based methods of business valuation?

Asset-based: net asset value (book, replacement or realisable). Income/earnings-based: P/E ratio (capitalised earnings) and dividend valuation models. Cash-flow based: discounted free cash flow (DCF/shareholder value).

How is the value of a company estimated using the P/E ratio method?

$$\text{Market value} = \text{P/E ratio} \times \text{Earnings}$$ Typically an appropriate (often comparable quoted-company) P/E ratio is applied to the target's sustainable earnings, sometimes discounted for an unquoted company's lower marketability.

State the dividend valuation model (dividend growth) for the value of a share.

$$P_0 = \frac{D_0(1+g)}{K_e - g}$$ where $D_0$ is the current dividend, $g$ is the constant dividend growth rate, and $K_e$ is the shareholders' required return (valid only when $K_e > g$).

How is a business valued using the discounted free cash flow method?

Forecast future free cash flows (to the firm or to equity), discount them at the appropriate cost of capital (WACC or $K_e$), and add the present value of a terminal value. Deduct debt (if valuing the firm) to obtain equity value.

What is the formula for the terminal value using a perpetuity growth (Gordon) approach in DCF valuation?

$$TV = \frac{CF_{n}(1+g)}{r - g}$$ where $CF_n$ is the final explicit-period cash flow, $g$ is the long-term growth rate, and $r$ is the discount rate; this terminal value is then discounted back to present value.

What is the efficient market hypothesis (EMH) and its three forms?

EMH states that share prices reflect available information. Weak form: prices reflect all past price data (technical analysis is useless). Semi-strong: prices reflect all publicly available information. Strong: prices reflect all information including private/insider information.

Distinguish between a merger, an acquisition, and a takeover.

A merger combines two firms into a new single entity, usually by mutual agreement of similar-sized firms. An acquisition is one company purchasing control of another. A takeover is an acquisition that may be agreed (friendly) or contested (hostile) by the target's board.

What is the difference between horizontal, vertical, and conglomerate integration?

Horizontal: combining firms at the same stage/industry (competitors). Vertical: combining firms at different stages of the same supply chain — backward (toward suppliers) or forward (toward customers). Conglomerate: combining firms in unrelated businesses (diversification).

What is synergy in the context of mergers and acquisitions?

Synergy is the idea that the combined entity is worth more than the sum of the separate parts ($2+2=5$). Sources include revenue synergies (cross-selling), cost synergies (economies of scale), and financial synergies (lower cost of capital, tax benefits).

What are the three principal methods of paying for an acquisition?

Cash (certain value, but uses funds and may trigger tax for sellers), Shares/equity (a share-for-share exchange, no cash outflow but dilutes control), and Debt/loan stock or earn-outs (deferred or contingent consideration).

Name common corporate reorganisation/exit methods used in restructuring.

Demerger/spin-off (splitting into separate entities), Divestment/sell-off (selling a division), Management buyout (MBO — managers buy the business), Management buy-in (MBI — external managers buy in), and Liquidation. These unbundle a group to release or focus value.

What is a leveraged buyout (LBO)?

A leveraged buyout is the acquisition of a company financed predominantly by debt (high gearing), with the target's assets and cash flows used as security and to service/repay the borrowing. It magnifies returns to equity but raises financial risk.

What is Enterprise Risk Management (ERM)?

ERM is a structured, organisation-wide process for identifying, assessing, managing and monitoring all risks (strategic, operational, financial, compliance) in an integrated way aligned to objectives and risk appetite, rather than managing risks in isolated silos.

What are the four classic risk responses (the TARA / 4Ts framework)?

Transfer (e.g., insurance or hedging), Avoid (stop the activity), Reduce/mitigate (controls to lower likelihood or impact), and Accept/retain (tolerate within risk appetite). Sometimes shown as the 4Ts: Transfer, Terminate, Treat, Tolerate.

How does a risk map (heat map) position risks, and what response does each quadrant suggest?

A risk map plots likelihood (probability) against impact (consequence). High likelihood/high impact = avoid or reduce; high impact/low likelihood = transfer (insure); low impact/high likelihood = reduce/control; low impact/low likelihood = accept/retain.

Define risk appetite and risk tolerance.

Risk appetite is the amount and type of risk an organisation is willing to seek or accept in pursuit of its objectives. Risk tolerance is the acceptable level of variation or specific boundaries around individual risks/objectives within that appetite.

What are the five components of the COSO Internal Control framework?

1) Control environment, 2) Risk assessment, 3) Control activities, 4) Information and communication, and 5) Monitoring activities.

What is the difference between corporate governance and internal control?

Corporate governance is the system by which organisations are directed and controlled, defining relationships among shareholders, board and management. Internal control is the set of processes/systems implemented by management to give reasonable assurance over operations, reporting and compliance — a component of good governance.

What is the principal-agent problem (agency theory) in corporate governance?

It is the conflict where managers (agents) may act in their own interests rather than those of the shareholders (principals) who own the firm, owing to separation of ownership and control. Governance mechanisms, incentives and monitoring aim to align their interests and reduce agency costs.

What are key requirements of the UK Corporate Governance Code regarding the board?

Separation of the roles of Chairman and CEO, a balance of executive and independent non-executive directors, board committees (audit, remuneration, nomination), regular board evaluation, and 'comply or explain' disclosure. It promotes accountability, independence and effective risk/control oversight.

What is the difference between transaction, translation, and economic foreign exchange risk?

Transaction risk: gains/losses on individual foreign-currency cash transactions before settlement. Translation risk: accounting gains/losses when consolidating foreign assets/liabilities into the reporting currency. Economic risk: the long-term effect of exchange-rate changes on the firm's overall competitiveness and value.

What is interest rate parity and how does it determine forward exchange rates?

Interest rate parity states the forward rate differs from the spot rate by the interest-rate differential between two currencies, so that no risk-free arbitrage exists. The currency with the higher interest rate trades at a forward discount: $$F_0 = S_0 \times \frac{1+i_c}{1+i_b}$$ where $i_c$ and $i_b$ are the counter- and base-currency interest rates.

Compare the main internal and external hedging techniques for foreign currency transaction risk.

Internal: matching receipts/payments, netting, leading and lagging, invoicing in home currency. External: forward contracts (fix a rate now), money market hedges (borrow/deposit in the foreign currency), currency futures, currency options (right not obligation), and currency swaps for longer-term exposures.