ICMA Pakistan Strategic Financial Management Syllabus

How is selection handled for indivisible projects under capital rationing?

By examining all feasible combinations of whole projects within the budget and choosing the combination that maximizes total NPV.

What is Adjusted Present Value (APV)?

A valuation method that values a project as if all-equity financed (base-case NPV), then adds the present value of financing side effects such as the tax shield on debt and issue costs.

State the APV formula.

APV = Base-case NPV (financed wholly by equity) + PV of tax shield on debt + PV of other financing effects (e.g., issue costs, subsidized loans).

When is APV particularly useful compared with the WACC approach?

When the project's capital structure or debt level changes significantly over time, making a constant WACC inappropriate.

What is a real option in capital budgeting?

The right, but not the obligation, to take a future managerial action regarding a real (physical) investment, such as expanding, abandoning, deferring, or switching a project.

Name four common types of real options.

Option to delay/defer, option to expand (follow-on), option to abandon, and option to switch/redeploy (e.g., inputs or outputs).

Define the Weighted Average Cost of Capital (WACC).

The average rate of return a firm must earn on its investments to satisfy all providers of capital, weighting the cost of each source (equity and debt) by its proportion in the capital structure.

State the basic WACC formula.

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

Why is the cost of debt multiplied by (1 − tax rate) in WACC?

Because interest on debt is tax-deductible, providing a tax shield that reduces the effective (after-tax) cost of debt to the firm.

How is the cost of equity commonly estimated using CAPM?

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

What does the dividend growth (Gordon) model say about cost of equity?

Ke = [D1 / P0] + g, where D1 is next year's dividend, P0 is the current share price, and g is the constant dividend growth rate.

What does Modigliani and Miller's Proposition I (without taxes) state?

In a perfect market with no taxes, a firm's capital structure is irrelevant; total firm value is unaffected by the debt-equity mix, and WACC stays constant.

What does Modigliani and Miller's theory with corporate taxes conclude?

Because debt interest is tax-deductible, the value of a geared firm exceeds that of an ungeared firm by the present value of the tax shield, so value rises as gearing increases (favoring 100% debt in theory).

What is the traditional view of capital structure?

There exists an optimal capital structure where WACC is minimized and firm value is maximized; moderate gearing lowers WACC, but excessive gearing raises it due to financial risk.

What does the trade-off theory of capital structure propose?

Firms balance the tax-shield benefits of debt against the costs of financial distress and bankruptcy, arriving at an optimal level of gearing where the marginal benefit equals the marginal cost.

What does the pecking order theory state about financing preferences?

Firms prefer internal financing (retained earnings) first, then debt, and issue new equity only as a last resort, due to asymmetric information and signaling costs.

According to M&M, is dividend policy irrelevant, and why?

In a perfect market with no taxes or transaction costs, dividend policy is irrelevant because shareholders can create 'homemade dividends' by selling shares; firm value depends only on investment decisions and earning power.

What is the 'bird-in-the-hand' argument regarding dividends?

It argues that investors prefer the certainty of current dividends over uncertain future capital gains, so higher dividends raise share value (contradicting M&M irrelevance).

What is the signaling effect of dividends?

Changes in dividend policy convey information to the market about management's expectations; a dividend increase signals confidence in future earnings, while a cut signals trouble.

What is the clientele effect in dividend policy?

Different groups of investors are attracted to firms whose dividend policies match their income needs and tax positions, so firms should maintain a stable, consistent policy to retain their clientele.

What is asset-based valuation?

Valuing a business based on the value of its net assets — using net book value, net realizable value, or replacement cost of assets less liabilities.

What is a key limitation of asset-based (net asset) valuation?

It ignores intangible assets, goodwill, and the firm's earning/cash-generating potential as a going concern, so it often understates true value.

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

Equity value = Earnings (profit after tax) × an appropriate P/E ratio, typically derived from comparable listed companies in the same sector.

What is the earnings yield valuation method?

Value = Earnings / Earnings yield, where earnings yield is the reciprocal of the P/E ratio; it capitalizes earnings at a required rate of return.

How does the dividend valuation model value a share with constant growth?

P0 = D1 / (Ke − g), where D1 is next year's dividend, Ke is the cost of equity, and g is the constant growth rate of dividends.

How is a business valued using discounted free cash flow?

By forecasting future free cash flows, discounting them at the WACC to present value, adding the present value of a terminal value, to obtain enterprise value (then deduct debt for equity value).

How is the market value of irredeemable (perpetual) debt calculated?

Market value = Annual interest payment / Required yield (Kd). For example, MV = I / Kd.

How is the market value of redeemable debt determined?

By discounting the future interest payments and the redemption value at the investors' required rate of return (the pre-tax cost of debt / yield to maturity).

Why is the valuation of intangibles (e.g., brands, goodwill) difficult?

Intangibles lack an active market and physical form; their value depends on future earning potential, making valuation subjective and often based on relief-from-royalty, excess-earnings, or capitalized-earnings methods.

Distinguish a horizontal, vertical, and conglomerate merger.

Horizontal: firms in the same industry/stage; Vertical: firms at different stages of the same supply chain (supplier or customer); Conglomerate: firms in unrelated businesses.

What is synergy in the context of business combinations?

The benefit where the combined value of two merged firms exceeds the sum of their separate values (2 + 2 = 5), arising from cost savings, revenue gains, or financial efficiencies.

What are the main methods of financing an acquisition?

Cash offer, share-for-share exchange (paper offer), debt/loan stock, or a combination (mixed offer) such as cash plus shares or a vendor placing.

State one advantage and one disadvantage of a share-for-share (paper) acquisition offer.

Advantage: no cash outflow and target shareholders retain an interest; Disadvantage: it dilutes existing ownership/control and the value depends on the acquirer's volatile share price.

What is corporate reconstruction (reorganization)?

A restructuring of a company's capital, assets, or operations — such as a financial reconstruction scheme to avoid liquidation by rearranging debt and equity claims of stakeholders.

Name three forms of corporate divestment.

Sell-off (sale of a division for cash), spin-off/demerger (distributing shares of a subsidiary to existing shareholders), and management buy-out (MBO)/buy-in.

What is a management buy-out (MBO)?

The acquisition of a business (or part of it) by its existing management team, usually financed by a mix of personal equity, venture capital, and debt (often highly leveraged).

What is foreign exchange (transaction) risk?

The risk that the value of a future cash flow denominated in a foreign currency will change due to exchange rate movements between the transaction date and the settlement date.

Distinguish transaction, translation, and economic foreign exchange risk.

Transaction risk affects specific cash flows from trade; translation risk affects the reported value of foreign assets/liabilities on consolidation; economic risk affects the firm's long-term competitive position and PV of future cash flows.

How does a forward exchange contract hedge currency risk?

By locking in a fixed exchange rate today for a currency transaction settling at a future date, eliminating uncertainty about the future spot rate.

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

Borrowing/depositing in the money markets so that a deposit in the foreign currency matures to cover the payable, effectively fixing the cost now and removing exchange rate exposure.

How can currency options hedge FX risk, and what is their advantage?

They give the right but not the obligation to exchange currency at a set rate; the advantage is downside protection while allowing the holder to benefit from favorable rate movements (for a premium cost).

What is interest rate risk?

The risk that changes in market interest rates will adversely affect a firm's borrowing costs, investment returns, or the value of interest-sensitive assets and liabilities.

What is a forward rate agreement (FRA)?

An over-the-counter contract that fixes the interest rate on a notional loan or deposit for a future period, with cash settlement of the difference between the agreed rate and the actual reference rate.

What is an interest rate cap?

An option-based instrument that sets a maximum interest rate on borrowing; if rates rise above the cap, the seller compensates the borrower, protecting against rate increases for a premium.

What is a financial derivative?

A financial instrument whose value is derived from an underlying asset, rate, or index — such as forwards, futures, options, and swaps — used for hedging or speculation.

What is 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 interest payments.

What is a currency swap?

An agreement to exchange principal and interest payments in one currency for principal and interest in another currency, used to obtain cheaper foreign financing or hedge long-term currency exposure.

How do futures contracts differ from forward contracts?

Futures are standardized, exchange-traded, and marked-to-market daily with margin requirements; forwards are customized, over-the-counter, and settled at maturity with counterparty (credit) risk.