ICAP CFAP CFAP-4: Strategic Business Finance Syllabus

How is a real cost of capital converted to a nominal (money) rate using the Fisher equation?

(1 + nominal rate) = (1 + real rate) x (1 + inflation rate). Real cash flows must be discounted at the real rate; nominal/money cash flows at the nominal rate.

Define the discounted payback period and its main limitation.

It is the time taken for the cumulative discounted cash flows to recover the initial investment. Limitation: it ignores all cash flows after the payback point and does not directly measure overall profitability.

How are bonds (debt) valued?

The value of a bond = present value of future coupon payments + present value of redemption (par) value, discounted at the required yield (Kd). Value = Σ [Coupon/(1+r)^t] + Redemption/(1+r)^n.

What is the Yield to Maturity (YTM / gross redemption yield) of a bond?

YTM is the discount rate (IRR) that equates the bond's current market price to the present value of all its future coupon and redemption cash flows. It is the total return earned if the bond is held to maturity.

How is the cost of irredeemable (perpetual) debt calculated, with and without tax?

Pre-tax: Kd = Annual interest / Market price (ex-interest). After-tax cost of debt = [Interest(1−t)] / Market price, where t is the corporate tax rate.

What is Macaulay duration and what does it measure?

Macaulay duration is the weighted average time (in years) to receive a bond's cash flows, weights being the PV of each cash flow as a proportion of price. It measures interest-rate sensitivity — longer duration means greater price volatility for a given yield change.

State the relationship between modified duration and bond price change.

Modified duration = Macaulay duration / (1 + yield). Approximate % change in price ≈ − Modified duration x change in yield. It quantifies a bond's price sensitivity to small yield changes.

What is the value of a convertible bond at issue / on conversion?

A convertible bond's value is the higher of its straight bond value (PV of coupons + redemption) and its conversion value (conversion ratio x current share price). The conversion premium is the excess of the bond's market price over its conversion value.

What does Shareholder Value Analysis (SVA) and the concept of Value Drivers involve?

SVA measures value created for shareholders by discounting free cash flows. Rappaport's seven value drivers are: sales growth rate, operating profit margin, cash tax rate, fixed-capital investment, working-capital investment, the planning horizon, and the cost of capital.

Define Economic Value Added (EVA) and its formula.

EVA = Net Operating Profit After Tax (NOPAT) − (WACC x Capital employed). It measures economic profit (value created above the cost of capital). Positive EVA means value is being created for shareholders.

What is the residual (free cash flow) theory of dividends?

It states that a firm should fund all positive-NPV projects first and pay only the residual cash as dividends. Consequently dividends may fluctuate year to year, and dividend policy is a by-product of the investment decision.

Summarise Modigliani and Miller's dividend irrelevancy argument.

In a perfect market (no taxes, no transaction costs, rational investors), dividend policy does not affect shareholder wealth — total return depends only on investment decisions. Investors can create 'home-made dividends' by selling shares, so the timing/split of dividends vs. retentions is irrelevant.

What are the 'signalling' and 'clientele' effects in dividend policy?

Signalling: dividend changes convey management's information about future prospects (a rise signals confidence). Clientele effect: different investor groups prefer particular dividend patterns (e.g. for tax or income needs), so firms should maintain a stable, predictable policy.

State Modigliani-Miller (1958) Proposition I without taxes.

In a perfect market with no taxes, the total value of a firm is independent of its capital structure: Vg = Vu. Firm value depends only on its operating earnings and business risk, not on its debt/equity mix.

State MM Proposition II (no tax) on the cost of equity.

Ke = Keu + (Keu − Kd)(D/E). The cost of equity rises linearly with the debt-to-equity ratio to exactly offset the cheaper debt, leaving WACC constant.

How does MM's theory change when corporate taxes are introduced?

With corporate tax, Vg = Vu + (t x D), the value of the tax shield on debt. Because interest is tax-deductible, gearing increases firm value, and WACC falls as gearing rises — implying an optimal structure of (almost) 100% debt absent other costs.

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

The traditional view holds that WACC first falls as cheap debt is introduced, reaches a minimum at an optimal level of gearing where firm value is maximised, then rises as increasing financial risk pushes up both Ke and Kd.

What is trade-off theory of capital structure?

Optimal gearing balances the marginal tax-shield benefit of additional debt against the rising present value of financial-distress (bankruptcy) and agency costs. The optimum is where the marginal benefit equals the marginal cost of debt.

State pecking order theory of financing.

Due to asymmetric information and signalling, firms prefer financing in order: (1) internal funds (retained earnings), (2) debt, (3) external equity as a last resort. The theory implies no well-defined target gearing ratio.

State the formula for the Weighted Average Cost of Capital (WACC).

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

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

When the project has the same business risk as the firm's existing operations and is financed so as to keep the firm's existing capital structure (financial risk) broadly unchanged.

State the Capital Asset Pricing Model (CAPM) equation for required return.

E(Ri) = Rf + βi [E(Rm) − Rf], where Rf is the risk-free rate, βi the asset's beta, and [E(Rm) − Rf] the equity market risk premium. It prices systematic (non-diversifiable) risk only.

What does beta measure in CAPM, and what do β = 1, β > 1 and β < 1 imply?

Beta measures an asset's systematic risk relative to the market. β = 1 moves with the market; β > 1 is more volatile/aggressive than the market; β < 1 is less volatile/defensive. Beta = Cov(Ri,Rm)/Var(Rm).

State the formulas to ungear and regear an equity beta (asset vs equity beta).

Asset (ungeared) beta: βa = βe x [E / (E + D(1−t))] (assuming βdebt = 0). To regear for a new structure: βe = βa x [1 + D(1−t)/E]. This is used to find a project-specific cost of equity.

How is a risk-adjusted (project-specific) cost of capital derived using a proxy company?

Take a proxy firm's equity beta, ungear it to an asset beta, regear it to the appraising firm's capital structure to get a new equity beta, then apply CAPM for Ke and compute a project-specific WACC.

What is the Arbitrage Pricing Theory (APT) and how does it differ from CAPM?

APT is a multi-factor model: E(Ri) = Rf + β1F1 + β2F2 + ... + βnFn, where each F is a risk factor (e.g. inflation, GDP, interest rates, industrial production) with its own beta. Unlike CAPM's single market factor, APT allows several systematic factors and makes fewer assumptions.

Compare equity and debt as sources of long-term finance on cost and risk.

Debt is cheaper (lower required return, interest is tax-deductible, ranks ahead on liquidation) but increases financial risk and fixed commitments. Equity is more expensive and not tax-deductible but carries no obligation to pay, gives no repayment date, and adds no financial risk.

List qualitative factors to consider when choosing a source of finance.

Cost and availability, impact on gearing/financial risk, dilution of control and EPS, security/covenants required, redemption/maturity and cash-flow flexibility, matching of finance to asset life, tax effects, and market conditions/timing.

What is a rights issue and the formula for the Theoretical Ex-Rights Price (TERP)?

A rights issue offers new shares to existing shareholders pro-rata at a discount. TERP = [(Existing shares x cum-rights price) + (New shares x issue price)] / Total shares after issue. Value of a right = TERP − issue price.

Distinguish hard and soft capital rationing.

Hard rationing is externally imposed — capital is genuinely limited by the capital markets (e.g. lenders/investors restrict funds). Soft rationing is self-imposed by management (e.g. budget caps, reluctance to issue shares or dilute control).

How are investments ranked under single-period capital rationing for divisible vs indivisible projects?

For divisible projects, rank by the Profitability Index (PI = PV of inflows / initial investment) and accept fractions until the budget is exhausted. For indivisible projects, examine feasible combinations of whole projects and choose the combination giving the highest total NPV within the budget.

State the Profitability Index and its decision rule.

Profitability Index (PI) = Present value of future cash flows / Initial investment (or NPV/Investment for the net version). Accept if PI > 1; under capital rationing, rank divisible projects by descending PI.

In portfolio theory, how is the expected return and risk of a two-asset portfolio calculated?

Expected return: E(Rp) = waE(Ra) + wbE(Rb). Risk (variance): σp² = wa²σa² + wb²σb² + 2wawbσaσbρab, where ρab is the correlation coefficient between the two assets' returns.

How does the correlation coefficient between two assets affect portfolio risk?

Correlation ranges from −1 to +1. The lower (more negative) the correlation, the greater the risk-reduction (diversification) benefit. At ρ = −1, risk can theoretically be eliminated; at ρ = +1 there is no diversification benefit.

Distinguish systematic and unsystematic risk and the efficient frontier.

Unsystematic (specific) risk is firm-specific and can be diversified away; systematic (market) risk cannot. The efficient frontier is the set of portfolios offering the maximum expected return for each level of risk; rational investors hold a portfolio on it.

What is a Forward Rate Agreement (FRA) and how does it hedge interest-rate risk?

An FRA is an over-the-counter agreement fixing an interest rate on a notional principal for a future period. The buyer (borrower) is compensated if rates rise above the agreed rate and pays if they fall, locking in the borrowing cost regardless of actual rates.

How does an interest-rate swap work as a hedging instrument?

Two parties exchange interest obligations on a notional principal — typically one pays fixed and receives floating, the other vice versa. It lets a borrower convert floating-rate debt to fixed (or vice versa), manage interest-rate risk, and exploit comparative advantage in different markets.

Compare interest-rate caps, floors and collars.

A cap (option) sets a maximum interest rate for a borrower (pays out if rates rise above the strike). A floor sets a minimum rate, benefiting a lender/depositor. A collar combines buying a cap and selling a floor (or vice versa) to fix rates within a band at reduced premium cost.

State interest rate parity and how it determines the forward exchange rate.

Forward rate = Spot rate x [(1 + interest rate of counter/quote currency) / (1 + interest rate of base currency)]. The currency with the higher interest rate trades at a forward discount, eliminating risk-free arbitrage.

State purchasing power parity (PPP) and what it predicts about exchange rates.

Expected future spot rate = Current spot x [(1 + inflation rate of country B) / (1 + inflation rate of country A)]. The currency of the higher-inflation country is expected to depreciate, so price levels equalise across countries.

What is a money-market hedge for a foreign-currency payable?

To hedge a future foreign-currency payment: borrow domestic currency now, convert at spot into the foreign currency, and deposit it so it grows to the payable amount by the due date — fixing the cost today and removing exchange-rate risk.

How does a currency forward contract differ from a currency futures contract?

A forward is an OTC, tailor-made contract (any amount/date, settled at maturity, counterparty risk). A future is exchange-traded, standardised in size and date, marked-to-market daily through margin, and easily closed out before maturity.

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

Transaction exposure: gains/losses on settling foreign-currency receivables/payables. Translation (accounting) exposure: effect of restating foreign subsidiaries' assets/liabilities into the home currency. Economic exposure: long-term effect of exchange-rate movements on the firm's competitive position and future cash flows.

How can currency options be used to hedge FX risk, and what is their key advantage?

A currency option gives the right (not the obligation) to buy (call) or sell (put) currency at a set strike price. The holder exercises only if favourable, capping downside while keeping upside — the key advantage over forwards/futures — at the cost of an upfront premium.

What is the difference between a forward contract and a futures contract for commodities?

A commodity forward is an OTC, customised, single-settlement agreement with counterparty risk. A commodity future is exchange-traded, standardised, marked-to-market daily via margin accounts, highly liquid, and usually closed out before physical delivery.

How does a producer/consumer use commodity futures to hedge price risk?

A producer (who will sell) takes a short futures position to lock in a selling price; a consumer (who will buy) takes a long futures position to lock in a purchase price. Gains/losses on the futures offset adverse movements in the physical (spot) price.

What does the hedge ratio (delta) represent in option/futures hedging?

The hedge ratio is the number of hedging instruments (e.g. futures/options) needed per unit of underlying exposure. For options it equals delta — the sensitivity of the option price to a change in the underlying — and indicates how many options replicate the exposure.

What are the components and purpose of managing liquidity risk?

Liquidity risk is the risk of being unable to meet obligations as they fall due. Management involves maintaining adequate cash/near-cash and committed facilities, forecasting cash flows, matching asset and liability maturities, and monitoring liquidity ratios (current and quick ratios).

What is the difference between funding liquidity risk and market (asset) liquidity risk?

Funding liquidity risk is the inability to obtain cash to meet obligations when due. Market (asset) liquidity risk is the inability to sell or convert an asset quickly without a significant price discount due to thin or disrupted markets.

What are the '5 Cs of credit' used to assess credit risk of a borrower/customer?

Character (willingness to pay/repayment history), Capacity (ability to generate cash to repay), Capital (financial strength/net worth), Collateral (security available), and Conditions (economic/industry environment and loan purpose).

What does expected credit loss (ECL) comprise, and how is it estimated?

Expected Credit Loss = Probability of Default (PD) x Loss Given Default (LGD) x Exposure at Default (EAD). It estimates the average loss a lender expects, with LGD = 1 − recovery rate, and underpins IFRS 9 impairment provisioning.

List the main techniques for managing and mitigating credit risk.

Credit assessment/scoring and setting credit limits, requiring collateral or guarantees, credit insurance and letters of credit, factoring/invoice discounting, diversification of the receivables/loan book, netting agreements, and use of credit derivatives (e.g. credit default swaps).