ICAP CFAP CFAP-4: Strategic Business Finance Flashcards

24 sample cards from the CFAP-4: Strategic Business Finance deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. 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.

2. 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).

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. 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.

17. 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.

18. 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.

19. 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.

20. 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).

21. 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.

22. 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).

23. 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.

24. 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).

What this deck covers

CFAP-4: Strategic Business Finance flashcards FAQ