CMA Intermediate Financial Management Syllabus

What is the Cost of Capital?

The minimum rate of return that a firm must earn on its investments to maintain the market value of its shares and satisfy its providers of capital; it is the required rate of return used as the discount rate for investment decisions.

What is the formula for Cost of Equity using the Dividend Growth Model (Gordon model)?

Ke = (D1 / P0) + g, where D1 = expected dividend next year, P0 = current market price per share, and g = constant growth rate of dividends.

What is the formula for Cost of Equity using the CAPM?

Ke = Rf + β(Rm − Rf), where Rf = risk-free rate, β = beta (systematic risk), and Rm = expected market return.

What is the formula for the Cost of Debt (after tax)?

Kd = I(1 − t) / Net Proceeds, where I = annual interest, t = tax rate, and the (1 − t) factor reflects the tax shield on interest.

Why is the cost of debt adjusted for tax?

Because interest on debt is a tax-deductible expense, it reduces taxable income, so the effective (after-tax) cost of debt is lower: Kd(after tax) = Kd(before tax) × (1 − t).

What is the formula for Cost of Preference Shares (irredeemable)?

Kp = Preference Dividend / Net Proceeds (or market price). For redeemable preference shares, the redemption premium/discount and time are also factored in.

What is WACC and how is it computed?

Weighted Average Cost of Capital = the weighted average of the costs of each source of capital using their proportions as weights: WACC = (We × Ke) + (Wd × Kd) + (Wp × Kp), where weights may be book-value or market-value based.

Why is cost of equity generally higher than cost of debt?

Equity holders bear greater risk (residual claim, no fixed return, paid last), so they demand a higher return; additionally debt enjoys a tax shield, further lowering its after-tax cost.

What is the marginal cost of capital?

The cost of raising an additional rupee of new capital; it is the weighted average cost of the additional/incremental funds raised by the firm.

What is meant by the 'flotation cost' in cost of capital?

The cost incurred in issuing securities (underwriting, brokerage, legal, printing fees); it reduces net proceeds and thereby raises the effective cost of the capital raised.

What is Capital Budgeting?

The process of planning, evaluating and selecting long-term investment proposals (capital expenditures) whose benefits accrue over more than one year, to maximize shareholder wealth.

What are the main capital budgeting evaluation techniques?

Traditional/non-discounting methods (Payback Period, Accounting Rate of Return) and discounted cash flow methods (Net Present Value, Internal Rate of Return, Profitability Index, Discounted Payback).

What is the Payback Period?

The length of time required to recover the initial investment from the project's net cash inflows; shorter payback is preferred. For even cash flows: Payback = Initial Investment / Annual Cash Inflow.

What are the limitations of the Payback Period method?

It ignores the time value of money, ignores cash flows occurring after the payback period, and emphasizes liquidity rather than profitability.

What is the Accounting Rate of Return (ARR)?

ARR = Average Annual Accounting Profit (after tax) / Average (or Initial) Investment × 100; it is a non-discounting method based on accounting profits rather than cash flows.

What is Net Present Value (NPV)?

NPV = Present value of cash inflows − Present value of cash outflows (initial investment), discounted at the cost of capital. Accept the project if NPV > 0.

What is the decision rule for NPV?

Accept if NPV is positive (> 0), reject if negative (< 0); for mutually exclusive projects, choose the one with the highest positive NPV.

What is the Internal Rate of Return (IRR)?

The discount rate at which the NPV of a project equals zero, i.e., the rate where PV of inflows = PV of outflows. Accept if IRR > cost of capital.

What is the formula to interpolate IRR between two rates?

IRR = LR + [NPV at LR / (NPV at LR − NPV at HR)] × (HR − LR), where LR = lower rate and HR = higher rate used in interpolation.

What is the Profitability Index (PI)?

PI = Present Value of Cash Inflows / Initial Investment (PV of outflows). Accept if PI > 1; it measures value created per unit of investment (benefit-cost ratio).

How do NPV and IRR differ when ranking mutually exclusive projects?

They can give conflicting rankings due to differences in project size, cash flow timing, and the reinvestment rate assumption. NPV assumes reinvestment at the cost of capital and is generally preferred as it directly measures wealth added.

What is the discounted payback period?

The time required to recover the initial investment from discounted (present value) cash inflows; it improves on the simple payback by incorporating the time value of money but still ignores cash flows after payback.

What is a capital rationing situation?

A situation where a firm has limited funds and cannot accept all profitable (positive-NPV) projects, so it must select the combination of projects that maximizes total NPV within the budget constraint (often ranked using the Profitability Index).

What is risk analysis in capital budgeting?

The process of identifying and measuring the variability/uncertainty of a project's future cash flows and returns, and incorporating that risk into the investment evaluation.

What is the Risk-Adjusted Discount Rate (RADR) method?

A technique that adds a risk premium to the risk-free/normal discount rate so riskier projects are discounted at a higher rate: RADR = Risk-free rate + Risk premium; higher risk means a higher discount rate and lower present value.

What is the Certainty Equivalent (CE) approach to risk?

Risky cash flows are converted into certain (risk-free) equivalents by multiplying them with certainty-equivalent coefficients (between 0 and 1), then discounted at the risk-free rate.

What is sensitivity analysis in capital budgeting?

A technique that examines how the project's NPV/return changes when one key variable (e.g., sales, cost, life) is changed at a time, identifying the variables to which the project outcome is most sensitive.

What is the standard deviation used for in capital budgeting risk analysis?

It measures the absolute dispersion/variability of expected cash flows or returns around their expected value; a higher standard deviation indicates greater risk.

What is the Coefficient of Variation and why is it used in risk analysis?

CV = Standard Deviation / Expected Value (mean). It measures relative risk per unit of return, making it useful for comparing the risk of projects with different expected values; a lower CV means lower relative risk.

What is scenario analysis (and decision-tree analysis) in capital budgeting?

Scenario analysis evaluates project NPV under different sets of assumptions (e.g., optimistic, most likely, pessimistic). Decision-tree analysis maps sequential decisions and their probabilistic outcomes to evaluate expected value across uncertain, multi-stage events.