ICAP CA Business Finance Decisions Syllabus

What does sensitivity analysis measure in capital appraisal?

It measures how much a single input variable (e.g. selling price, volume, cost, life) can change before the NPV becomes zero - identifying the variables to which the project's viability is most sensitive.

Give the sensitivity formula for a project variable.

Sensitivity (%) = NPV / Present value of the cash flow related to that variable × 100. A smaller percentage indicates greater sensitivity (less margin for error).

What is a risk-adjusted discount rate?

A discount rate that adds a risk premium to the risk-free rate so that riskier projects are appraised using a higher required return, reducing the present value of their uncertain future cash flows.

Define capital rationing.

A situation where a company has insufficient funds to undertake all projects with a positive NPV, so it must select a subset of projects to maximise the total NPV available from limited capital.

Distinguish hard capital rationing from soft capital rationing.

Hard rationing is externally imposed - capital markets limit the funds available (e.g. lenders/investors restrict finance). Soft rationing is internally imposed by management policy (e.g. limiting capital budgets).

How are divisible projects ranked under single-period capital rationing?

By the profitability index (PI = PV of inflows ÷ initial investment, or NPV per Rs.1 invested). Projects are accepted in descending PI order until the capital is exhausted, with the marginal project part-funded.

How does the approach differ for indivisible (non-divisible) projects under capital rationing?

The profitability index ranking cannot be used directly; instead all feasible combinations of whole projects within the budget are examined and the combination giving the highest total NPV is chosen.

State the dividend growth (Gordon) model formula for the cost of equity.

Ke = [D1 / P0] + g, where D1 is next year's dividend, P0 is the current ex-div share price, and g is the constant growth rate of dividends. D1 = D0(1+g).

State the Capital Asset Pricing Model (CAPM) formula for the cost of equity.

Ke = Rf + β(Rm - Rf), where Rf is the risk-free rate, β is the equity beta, and (Rm - Rf) is the equity market risk premium.

What does beta (β) measure in the CAPM?

The systematic (market) risk of a security - its sensitivity to movements in the overall market. β = 1 means it moves with the market; β > 1 is more volatile; β < 1 is less volatile than the market.

Distinguish systematic risk from unsystematic risk.

Systematic (market) risk affects all investments and cannot be diversified away; it is rewarded with a return premium. Unsystematic (specific) risk is company-specific and can be eliminated through diversification, so it earns no premium.

How is the cost of irredeemable (perpetual) debt calculated?

Kd = I(1 - t) / P0, where I is the annual interest (coupon), t is the corporate tax rate, and P0 is the current market price of the debt (ex-interest). This gives the after-tax cost of debt.

How is the cost of redeemable debt calculated?

It is the after-tax internal rate of return (yield to maturity) that equates the current market price to the present value of future after-tax interest payments plus the redemption value, found by interpolation.

Why is the cost of debt adjusted for tax but the cost of equity is not?

Interest on debt is tax-deductible, creating a 'tax shield' that lowers its effective cost. Dividends to shareholders are an appropriation of post-tax profit and are not tax-deductible.

What is the formula for the Weighted Average Cost of Capital (WACC)?

WACC = [E/(E+D)]×Ke + [D/(E+D)]×Kd(1-t), where E and D are the market values of equity and debt, Ke is the cost of equity, and Kd(1-t) is the after-tax cost of debt.

When is it appropriate to use a company's existing WACC as the discount rate for a project?

When the project has the same business risk as the company's existing operations and undertaking it does not significantly change the company's capital (financing) structure.

What is the traditional view of capital structure?

It holds that an optimal gearing level exists where WACC is minimised (and firm value maximised). Up to that point cheaper debt lowers WACC, but beyond it rising financial risk pushes up Ke and Kd, raising WACC again.

State Modigliani and Miller's (MM) capital structure proposition in a world without taxes.

Firm value and WACC are independent of capital structure. As gearing rises, the increased cost of equity exactly offsets the benefit of cheaper debt, so WACC stays constant - there is no optimal capital structure.

How does the MM proposition change when corporate taxes are introduced?

Because debt interest is tax-deductible, increasing gearing reduces WACC and increases firm value due to the tax shield. The optimal structure becomes as much debt (gearing) as possible (subject to ignoring distress costs).

What does pecking order theory say about how firms prefer to raise finance?

Firms prefer internal finance (retained earnings) first, then debt, and issue new equity only as a last resort - driven by asymmetric information and the desire to avoid signalling and issue costs. It implies no defined target gearing ratio.

What is the trade-off theory of capital structure?

A firm balances the tax-shield benefits of debt against the rising costs of financial distress and bankruptcy as gearing increases; the optimal structure is where the marginal benefit of debt equals the marginal cost of distress.

What is the basis of the net asset (asset-based) valuation method?

It values a business as the value of its net assets (assets minus liabilities). Assets may be measured at book value, replacement cost, or realisable (break-up) value, giving a minimum or floor value for the business.

What is the price/earnings (P/E ratio) method of valuation?

Equity value = maintainable earnings (profit after tax) × a suitable P/E ratio, usually taken from a comparable quoted company and adjusted (e.g. discounted for an unquoted firm's lower marketability).

What is the earnings yield method of valuation?

Value of equity = maintainable earnings ÷ earnings yield, where earnings yield = EPS ÷ market price (the inverse of the P/E ratio). It capitalises earnings at the required rate of return on earnings.

Explain the dividend valuation model for valuing shares.

The share price equals the present value of expected future dividends. With constant growth: P0 = D1/(Ke - g). It is most appropriate for valuing a minority (non-controlling) shareholding that receives dividends but no control.

How does discounted cash flow (DCF) valuation determine the value of a business?

By forecasting future free cash flows, discounting them to present value at an appropriate cost of capital (e.g. WACC for the whole firm), and summing them - typically including a terminal value for cash flows beyond the explicit forecast horizon.

What is 'free cash flow to the firm' used in DCF valuation?

Operating profit after tax, plus depreciation/non-cash charges, less reinvestment in working capital and capital expenditure - i.e. the cash available to all providers of finance (equity and debt) before financing flows.

How is the market value of irredeemable debt calculated for valuation purposes?

Market value = annual interest ÷ the investors' required return (yield), i.e. MV = I / Kd, treating the interest as a perpetuity.

How are convertible bonds valued?

At the higher of (a) their value as straight debt - the PV of interest plus redemption discounted at the required return - and (b) their conversion value - the number of shares received on conversion × the expected future share price discounted back.

Why are intangible assets (e.g. goodwill, brands) difficult to value, and how is goodwill often estimated?

They lack an active market and generate uncertain future benefits. Goodwill is frequently estimated as the excess of the total business value (e.g. from earnings or DCF methods) over the fair value of identifiable net assets.

What is the main rationale (motive) for most acquisitions and mergers?

To create synergy - the combined entity being worth more than the sum of the separate parts (the '2+2=5' effect) - alongside growth, market power, diversification, and access to assets or skills.

Distinguish between revenue synergy, cost synergy, and financial synergy in a merger.

Revenue synergy: higher combined sales (cross-selling, market power). Cost synergy: economies of scale and removing duplicate functions. Financial synergy: lower cost of capital, tax benefits, or greater debt capacity.

Name three takeover defence strategies a target company's directors can use.

Examples: 'poison pill' (e.g. issuing rights that make takeover costly), finding a 'white knight' (a friendlier rival bidder), revaluing assets/issuing favourable forecasts, paying special dividends, or referring the bid to regulators.

What are the three motives for holding cash according to Keynes?

The transactions motive (to meet day-to-day payments), the precautionary motive (a buffer for unexpected needs), and the speculative motive (to exploit profitable opportunities as they arise).

What does the Baumol model determine in cash management?

The optimal amount of cash to raise (by selling securities or borrowing) each time, balancing the transaction cost of replenishing cash against the interest/opportunity cost of holding it - analogous to the EOQ inventory model.

What is the purpose of the Miller-Orr model in cash management?

It sets an upper and lower control limit and a return point for a cash balance that fluctuates randomly, telling management when to buy or sell securities to keep cash within a target range.

Define the cash operating cycle (working capital cycle).

The time between paying for raw materials/inventory and receiving cash from customers: Inventory days + Receivables days - Payables days. A longer cycle requires more working capital financing.

What is factoring of receivables?

A service where a company sells/assigns its trade receivables to a factor who provides finance (an advance, often 80%), and may also handle sales-ledger administration and offer credit protection (non-recourse factoring).

State the Economic Order Quantity (EOQ) formula for inventory management.

EOQ = √(2 × Co × D ÷ Ch), where Co is the cost per order, D is annual demand, and Ch is the holding cost per unit per year. It minimises total ordering plus holding costs.

What is the aim of a Just-In-Time (JIT) inventory system?

To minimise inventory holding by receiving goods only as they are needed in production, reducing holding costs and waste - relying on close supplier relationships and reliable, frequent deliveries.

Contrast aggressive, conservative, and moderate working capital financing policies.

Aggressive: finance more of even permanent current assets with short-term funds (lower cost, higher risk). Conservative: finance most current assets with long-term funds (higher cost, lower risk). Moderate (matching): match the maturity of funding to the life of the asset.

What are the two main types of foreign exchange exposure besides translation exposure?

Transaction exposure (the risk that exchange rates change between agreeing a foreign-currency transaction and settling it) and economic exposure (the effect of long-term exchange-rate movements on the present value of future cash flows and competitiveness).

Explain a forward exchange contract as a hedge.

A binding contract to buy or sell a fixed amount of currency at an agreed rate on (or by) a set future date. It eliminates transaction risk by fixing the exchange rate today, removing uncertainty about the future spot rate.

How does a money market hedge work for a future foreign-currency payment?

Borrow domestic currency now, convert it at the spot rate to the foreign currency, and deposit it to earn interest so it grows to the amount payable by the due date - locking in the cost and avoiding future spot-rate movements.

What is purchasing power parity (PPP) and what does it predict about exchange rates?

PPP states that exchange rates adjust to reflect inflation differentials between countries. The currency of the country with higher inflation is expected to depreciate. Future spot = Spot × [(1 + inflation_foreign)/(1 + inflation_home)].

What is interest rate parity (IRP)?

The forward exchange rate differs from the spot rate to reflect the interest-rate differential between two currencies. Forward rate = Spot × [(1 + interest_foreign)/(1 + interest_home)], preventing risk-free arbitrage.

What is the main source of interest rate risk for a company?

The risk that changes in market interest rates adversely affect the company - e.g. rising rates increasing the cost of floating-rate borrowing, or falling rates reducing returns on deposits, plus the effect of rate changes on the value of fixed-rate instruments.

What is a forward rate agreement (FRA)?

An over-the-counter agreement fixing the interest rate on a notional loan or deposit for a future period. The parties settle the difference between the agreed rate and the actual reference rate, hedging interest-rate movements without exchanging principal.

Define an interest rate swap.

An agreement between two parties to exchange interest payment streams on a notional principal - typically swapping fixed-rate for floating-rate payments - to manage interest-rate risk or exploit differences in borrowing costs (comparative advantage).

What is the key difference between a forward/futures contract and an option as a hedging instrument?

A forward or future is a binding obligation to transact at the agreed price, removing both downside risk and upside benefit. An option gives the right but not the obligation to transact, protecting against adverse moves while keeping favourable ones, in exchange for a premium.

Distinguish a call option from a put option.

A call option gives the holder the right to buy the underlying asset at the exercise (strike) price. A put option gives the holder the right to sell the underlying asset at the exercise price - both before/on expiry for a premium.

What is the difference between exchange-traded futures and over-the-counter forwards?

Futures are standardised, exchange-traded contracts with daily margining and a clearing house (low counterparty risk, less flexible). Forwards are customised OTC contracts negotiated between two parties (flexible amount/date but higher counterparty/default risk).

What is the basic principle of hedging financial risk with derivatives?

To take a position in a derivative whose value moves in the opposite direction to the exposure, so that a loss on the underlying position is offset by a gain on the derivative (and vice versa), reducing overall volatility.