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2011 Edition
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CMA Ontario
February 2011
Debt Financing
For tax purposes, interest on debt is tax deductible provided it:
Equity Financing
Dividends paid on preferred and common shares are paid out of after-tax earnings. Dividend
payments may generate refunds of refundable taxes for private corporations (section (n) below).
For tax purposes, different classification criteria exist and leases are more likely to be classified
as operating leases. The tax deduction is the full amount of the lease payment.
1. Title to the assets passes to the lessee automatically at the end of the lease term, or
2. The lessee is required to purchase the asset, or
3. The lessee has the option to purchase the asset during the lease term or at expiry on
terms that a reasonable person would exercise.
Corporations − corporations resident in Canada are subject to corporate income tax and
other specified taxes (e.g. capital tax)
Forms of Business
Proprietorship − represents the business of one person
− personal income tax laws are applicable
Joint Venture − taxation of joint ventures depends on the joint venture arrangement
− if a separate company is incorporated for the joint venture, corporate tax
rules apply to the corporation
− if the joint venture is a partnership arrangement, then partnership rules
apply
Types of Income
Business income
- defined as profit from business. Profit is not defined in the act and there are a
number of specific rules about amounts to be included or excluded. ‘Commercial
principles’ are used to determine business income. GAAP/IFRSis considered to
reflect commercial principles; however, there are a number of adjustments to
income determined under GAAP/IFRS to arrive at taxable income.
Property Income
- this is passive income earned as a return on investment. It includes dividends,
interest, rent and royalties.
- this does not include the gain from the sale of the investment itself (these amounts
are considered to be capital gains).
Employment Income
- this includes all income arising from employment, including salary, wages,
gratuities, stock options and specific benefits defined by the Income Tax Act.
To determine how a specific transaction or activity will be taxed, it is necessary to relate the
transaction/activity to each of the five categories (business income, property income,
employment income, capital gains/losses and other income and deductions). If the
transaction/activity falls within one of the categories, the rules for that specific category apply
when calculating the tax consequences. Items that do not fall within these five categories are not
taxed. Examples of non-taxable items (i.e. items that do not fall within the five above
categories) include lottery winnings and inheritances.
Individuals − on or before April 30 of the next year, unless the individual or his or her
spouse carried on a business in the year, in which case the filing
deadline is June 15
Corporations − within six months after the end of the taxation year
Trusts or Estates − within 90 days after the end of the taxation year
Interest:
Interest is charged on insufficient and late instalments from the date that the instalment should
have been made to the date that final payment is due (e.g. April 30). If a taxpayer files late,
interest is calculated from the date final payment is due until the amount is paid. The interest rate
is prescribed by CCRA and is changed each quarter.
Corporations:
Instalments
- payments must be made monthly
- if tax payable for the current or preceding year is less than $1,000, instalments are not
required
Interest
- interest is calculated in the same manner as for individuals
Offense Penalty
Failure to file a return as and when required 5% of tax unpaid on the date the return was
due plus 1% per month of unpaid tax for
each month the return was late, up to 12
months
Failure to file a return as and when required 10% of tax unpaid on the date the return was
and taxpayer has been assessed a penalty for due plus 2% per month of unpaid tax for
this offense in the past three years each month the return was late up to 20
months
Failure to report income if there has been a 10% of the income the taxpayer failed to
previous failure to report income report
Offence Penalty
Failure to provide a Social Insurance Number $100 for each failure
to a person required to make an information
return
Offence Penalty
Failure to provide certain information returns $100 per partner per month to a maximum of
related to the partnership, a demand for the 24 months. This penalty is in addition to the
return has been made and a penalty for the penalty related to information returns.
same offence has been assessed within the
previous three years
Note that Canada has tax treaties with foreign countries to prevent double taxation. These tax
treaties override the Income Tax Act and therefore in situations in which there is a tax treaty the
treaty overrides the Income Tax Act.
Individuals
The definition of residency is not clearly provided in the Income Tax Act, however, past court
decisions provide common law guidance on whether or not an individual is a Canadian resident.
Note that residency does not mean citizenship. Canadian citizens can be non-residents and
individuals who are not Canadian citizens can be Canadian residents. Canada taxes individuals
based on residency, while the United States taxes individuals based on citizenship.
The CRA administrative policy is that an absence of less than two years indicates residency has
not been given up (i.e. the CRA considers the individual to be a resident of Canada); unless it is
established that all residential ties are severed. It is important to remember this is administrative
policy only and this policy is not in the Income Tax Act.
Part time residency occurs in the year an individual moves to or moves from Canada.
Note that Canada has tax treaties with foreign countries to prevent double taxation. These tax
treaties override the Income Tax Act and, therefore, in situations in which there is a tax treaty,
the above rules do not apply.
Tax Avoidance: legally reducing tax by a series of transactions or schemes, which do not
represent the true situation (not illegal, but often challenged in court by the
CRA)
Tax Planning: legally reducing tax by carrying out various transactions or activities within
current legislation
Generally, business income includes all revenue less expenses incurred to earn that revenue.
However, there are a number of restrictions on the deductibility of various expenses. When
calculating business income for tax purposes, the easiest method is to start with pre-tax
accounting income and make adjustments as required by the ITA to arrive at business income.
Business income includes income from normal commercial operating activities plus the
following:
• adventures in the nature of trade
− the courts have developed a set of factors to consider (called “badges of trade”) to
determine if an event is capital in nature or an adventure in the nature of trade. If
considered to be an adventure in the nature of trade, the resulting profit is
considered to be business income and not capital. The ‘badges of trade’ are
beyond the scope of the syllabus and will not be discussed further.
• damages for loss of property that is working capital in nature (e.g. inventory)
• purpose test
Under paragraph 18(1)(a) of the ITA for an expense or outlay to be deductible it must:
a) be made or incurred by the taxpayer for the purpose of gaining, producing or
maintaining income; and
b) be expected to generate income related to the taxpayer’s business or property
• capital nature
Expenditures for capital items are not deductible as business expenses but are subject to
capital cost allowance (tax depreciation) or cumulative eligible capital deductions. These
subjects are discussed in the Capital Cost Allowance and Cumulative Eligible Capital
section of this manual.
• reserves
− no reserves can be deducted except as permitted under subsection 20(1) of the
ITA (discussed later)
− contingent liabilities, sinking fund and warranty reserves are not deductible
• reasonableness test
− expenses are deductible only to the extent they are reasonable
− the reasonableness test applies to all deductions
Reserves, except as noted in a later section, contingent liabilities and sinking funds.
Amounts paid/payable for the discount associated with issuing bonds, except as noted on next
page
Payments on income bonds or debentures (i.e. bonds or debentures based on income or profit)
Prepaid expenses – the tax treatment of prepaid expenses is identical to GAAP/IFRS; that is,
prepaid expenses cannot be fully deducted in the year paid, but are deductible in the year to
which the expenditure relates
Interest on money borrowed for a passenger vehicle (used to earn business income) is limited to
the lesser of:
a) actual amount paid or payable
b) $300 for each 30 day period the automobile loan was outstanding (2008) [this can be
calculated as $10 per day]
Leasing costs of leasing a passenger vehicle are limited to $800 + GST + PST per month (2008)
Premiums on life insurance used as collateral – deductible only when the life insurance policy is
used as collateral for a loan
Discount on Debt (e.g. discount on bonds payable) The discount is fully deductible at the earlier
of redemption or maturity if both the following conditions are met:
1. the debt is issued at not less than 97% of face value
AND
2. the yield to maturity is not more than 4/3 of the nominal or coupon rate
Employer contributions to a Registered Pension Plan, profit sharing plan or deferred profit
sharing plan.
Representation expenses with respect to obtaining a license, permit, franchise or trademark. For
these expenses the taxpayer has the option of deducting the full expenditure or one-tenth of the
expenditure in each year over 10 years.
Depr. included in
Total Cost
total cost
Opening inventory 100 20
COG manufactured 4000 800
4100 820
Ending inventory 200 40
COGS 3900 780
Reserves, contingent liabilities and sinking funds are not deductible, except as specifically
permitted by the ITA. Reserves that are allowed and, therefore, deductible are:
• reserves for loan guarantees of a financial institution
• reserve for goods not delivered and services not rendered (in accounting terms this means
unearned revenue), except as limited by subsection 20(6) [subsection 20(6) requires that a
reserve taken for food/drink or transportation that will be provided after the end of the
year must equal the amount taken into income; in essence this means there is zero impact
on income for tax purposes]
• the reserve for goods not delivered and services not rendered includes unearned rental
income; for unearned rental income, a reasonable reserve may be taken for rent received
or receivable in advance
• reserve for deposits on returnable containers, other than bottles
• generally, warranty reserves are not deductible; however, if a warranty reserve is set up at
an amount less than or equal to the amount paid after the end of the year to an insurer to
insure the warranty liability, the warranty reserve is deductible. Basically, this means if
the warranty is insured, a reserve can be taken for the amount paid to the insurer. Since
warranties are rarely insured, this means warranty reserves are rarely deductible.
• reserve for an amount not due until a later year under an instalment sales contract
(discussed separately later in this section)
• reserve for quadrennial survey with respect to ships
A reserve deducted in one year must be brought into income the following year and a new
reserve is deducted based on the taxpayer’s circumstances at that time.
Example:
Year One:
Accounts receivable $1,280,000
Accounts receivable determined to be of doubtful collectability 143,500
Year Two:
Accounts receivable 1,431,400
Accounts receivable determined to be of doubtful collectability 164,900
Year 1:
DR bad debts expense 143,500
CR allowance for doubtful accounts 143,500
Year 2:
DR allowance for doubtful accounts 143,500
CR bad debts expense 143,500
The process of adding the Year 1 reserve back into income in Year 2 and taking a new reserve in
Year 2 in effect results in an expense on the income statement of $21,400 ($164,900 - $143,500).
The question is whether or not the $21,400 is considered a tax deductible expense. The answer
is yes, provided the allowance was determined by identifying specific accounts as being
doubtful. If the allowance was determined by applying a flat percentage to the total A/R balance
and is not determined with reference to specific accounts whatsoever, then the amount of
$21,400 would not be tax deductible and the company would have to go through the process of
identifying specific accounts, which are of doubtful collectability to determine the amount that is
tax deductible. For this reason, many companies calculate the allowance for doubtful accounts
for the GAAP/IFRS financial statements based on a review of specific accounts since it is
necessary to do this for tax purposes.
If an account is included in the allowance and it later is recovered, it is included in income in the
year recovered.
Basic Info
Year 2
Pre-tax income per financial statements $715,200
Year 1
Provision for uncollectible A/R recorded in the financial statements; 15,970
uncollectible A/R determined by reference to specific accounts
Tax Impact
The uncollectible A/R would have been included in the calculation of the $715,200. In preparing
the Year 2 financial statements the company would have posted the following entry:
These entries result in a net bad debts expense of $1,910 ($17,880 DR - $15,970 CR). Since the
allowance was calculated with reference to specific accounts, the $1,910 is deductible and it is
not necessary to adjust the GAAP/IFRS based financial statements.
Part B:
Assume that at the beginning of Year 2, one of the accounts included in the Year 1 provision was
determined to be a bad debt and not just of doubtful collectability. The account receivable
amount for this customer was $2,100.
Solution:
When this account is determined to be bad, the following entry is booked in the financial
statements:
Allowance for doubtful accounts 2,100
Accounts receivable 2,100
Since the amount was deducted in the income statement through the mechanism for recording the
allowance, there is no income statement impact.
Since the bad debt has already been recognized in income through the allowance method and
since the allowance was determined in reference to specific accounts there is no adjustment to
the financial statements for tax purposes.
A reserve taken one year is added back into income the following year and a new reserve is
calculated. In addition, the ITA (subsection 20(8)) limits the reserve to three years (i.e. can claim
a reserve in year of sale – Year 2 and Year 3 only; in Year 4 the balance is taken into income).
Land Sales
Where land is sold in the course of a business of a taxpayer (e.g. a real estate developer) and
payment will be made in instalments after the end of the tax year, the taxpayer may claim a
reserve with respect to the sale price included in income, but not yet received. The reserve is
calculated based on the profit element only, not the sale price. In addition, the CRA, when
calculating the reserve only allows the calculation to be based on the seller’s “true equity”. This
means if there is an existing mortgage on the land, this must be factored into the calculation. For
example, if the selling price of a piece of land is $100,000, the gross profit on sale is $20,000 and
the buyer pays cash of $30,000 and gives the seller a mortgage for $70,000, the reserve would be
calculated as follows:
Assuming that the seller already had an existing mortgage of $60,000 on the land and the buyer
paid cash and gave a second mortgage of $10,000, then the reserve is calculated as:
In addition, the ITA (subsection 20(8)) limits the reserve to three years (i.e. can claim a reserve
in year of sale – Year 2 and Year 3 only; in Year 4 the balance is taken into income).
For example, a capital loss of $15,000 which occurred on June 1, 2000 would be allowable at an
amount of $15,000 x 2/3 = $10,000. If this loss is carried forward to 2006 and is applied against
a gain of $40,000, the calculation would be:
Note that capital losses can only be deducted against capital gains and the carryover period for
capital losses is back three years and forward indefinitely.
Non-capital losses can be applied against any source of income and can also be applied against
taxable capital gains.
This means the maximum amount that can be deducted is $8,750, which represents a loss of
$15,000. Any loss exceeding this limit is not deductible in the current year, but can be carried
back three years and forward 10 years or 20 years (10 years for losses incurred before 2006 and
20 years for losses incurred after 2005). These losses that are carried over are known as
“restricted farm losses”. However, in the year the loss is carried over, it can only be deducted
against farming income.
The amount that can be deducted in the current year against any source of income is $8,250. The
amount that can be carried over is the remainder $22,000 – $8,250 = $13,750. However, the
$13,750, which is a ‘restricted farm loss’, in the carryover years can only be deducted against
farming income.
• non-capital losses
These losses do not expire, but can only be applied against income from the business that
generated the loss (if continued) or against income of a business that is similar to the
business that incurred the loss. In addition, in order to utilize the loss carry forward, the
business that incurred the loss cannot be terminated until the losses have been fully used.
When there is a change in control, the corporation’s tax year-end is deemed to be the date of the
change in control for tax purposes for the year of the change in control. The company can then
choose as their regular year-end any date within the next 53 weeks as the company’s year-end
date. In addition, depreciable property, eligible capital property and other capital property is
deemed to have been sold at market value, if market value is less than tax cost. This may give
rise to a terminal loss, which is included in the selling company’s income (loss), which may
result in an increased non-capital loss for the company’s final year. This loss is treated in
accordance with the change in control loss carryover provisions discussed above.
Carry Do not
forward 20 years 10 years 7 years expire 20 years 10 years 20 years 10 years
period
Income Any source of Any source of Any source of Taxable Same as non- Same as non- Against Against
against income income income capital gains capital capital farming farming
which it only losses, losses, income only income only
can be against any against any
applied source of source of
income income
Annual none none none none none none none 2,500 + 1/2 of
limit the next 12,500
(max = 2,500 +
6,250 = 8,750)
Deduct any amounts deductible for tax purposes, which are not deducted on the financial statements
Site investigation costs, which have been capitalized (s. 20(1)(ee)
Amounts paid for landscaping business premises, which have been capitalized (s. 20(1)(aa)).
Capital cost allowance (CCA) (s. 20(1)(a))
Accounting gains on sales of capital property or investments(under ITA treated as a capital. gain or loss, not
business income). This includes gains on AFS and HFT investments.
Add Net taxable capital gains = Taxable (1/2) capital gains – allowable (1/2) capital losses
Taxable Income
Note that the above chart assumes the reserve for doubtful debts (AFDA) is identical to the tax
deduction allowed (i.e. the allowance was calculated with reference to specific accounts) and,
therefore, no adjustment is needed with respect to uncollectible accounts receivable.
Under the CCA system, depreciable property is grouped into prescribed classes. A taxpayer may
have a number of identical capital items; these are grouped together into one class and are treated
as one unit for the purposes of CCA.
Candidates are advised to note that effective March 23, 2004, a new
class, class 45 described below, was created for electronic data
processing (e.g. computer hardware with its systems software).
Class 10.1 (30%) − a passenger vehicle with a cost in excess of the limit prescribed for
paragraph 13(7)(g) (i.e. $30,000 if acquired after 2000) (in 2010 the
amount remains $30,000);
Class 12 (100% − tools, instruments and kitchen utensils costing less than $500
and no (effective January 1, 2006 the threshold amount was increased to
half $500 from $200) ; linen, uniforms, dies, jigs or moulds; rental video
year cassettes; computer software (this means application software, such
rule on as Microsoft Excel and Word, systems software (e.g. operating
specific systems software) is included in either class 10 or class 45, as
items) applicable);
Class 13 SL class − leasehold interest;
Class 14 SL class − patent, franchise, concession or license for a limited period;
Class 17 (8%) − roads, parking lots, sidewalks, airplane runways, storage areas or
similar surface construction;
Class 39 (25%) − property used in manufacturing or processing acquired after 1987
and before February 26, 1992;
Class 43 (30%) − manufacturing and processing machinery and equipment acquired
after February 25, 1992;
Class 44 (25%) − patents and rights to use patented information acquired after April
26, 1993, for a limited or unlimited period. (A taxpayer can elect
not to use class 44 for patents, in which case the property will be
classified as Class 14);
Class 45 (45%) − general purpose electronic data processing equipment and systems
software for that equipment, including ancillary data processing
equipment, acquired after March 22, 2004 and before March 19,
2007 is eligible for the 45% rate.
1
Represents deduction for CCA for the year
Adjustment for
UCC after current year UCC at the
additions and additions (1/2 x Base amount CCA for the end of the
UCC at dispositions column 3 minus for CCA year (column year
the start Cost of Proceeds of (column 2 + column 4; if (column 5 7 x column 8 (column 5
Class of the additions in dispositions column 3 minus negative enter minus or an adjusted minus
Number year the year in the year column 4) 0) column 6) Rate % amount) column 9)
Common property to which the 1/2 year rule does not apply is:
• Disposition of property
− disposition can occur through selling the property, theft, destruction, confiscation,
expropriation or due to loss or abandonment without expectation of recovery
• the proceeds are less than the balance in the CCA pool
− in these situations, the balance of the pool will be positive and CCA continues to be
deducted in the normal manner, provided there are assets remaining in this class (i.e.
there are physical assets in the class); if the class balance is positive and there are no
assets remaining in the class, the balance is fully deducted, resulting in a nil balance
in the class. When the balance is fully deductible in this manner, this is known as a
terminal loss.
• the proceeds are more than the balance in the CCA pool, but less than the original cost
− in these situations, there is a negative balance in the pool; this negative balance is
taken into business income as ‘recapture’ (i.e. recapture or recovery of CCA amounts
previously deducted)
− in essence, a negative balance means the cumulative CCA that has been claimed at an
amount that is greater than the actual loss in value
• the proceeds are more than the balance in the CCA pool and more than the original cost
− in these situations the proceeds amount deducted from the CCA pool is limited to the
original cost, which still results in a negative balance in the pool; this negative
balance is taken into business income as ‘recapture’ (i.e. recapture or recovery of
CCA amounts previously deducted)
− the difference between proceeds of disposition and original cost is treated as a capital
gain and, therefore, is subject to the capital gains tax rules
capital
gain
recapture
Proceeds
recapture
Terminal loss, if
there are no
physical assets
remaining in the
class
Proceeds
The capital cost of the automobile used as a basis to calculate CCA is restricted to a
maximum of $30,000 plus GST and PST for years after 2000 (for 2010, the threshold
remains at $30,000 plus GST and PST or HST).
If a taxpayer is registered for GST/HST, the taxpayer gets an input tax credit for the
GST/HST on the automobile; therefore, for any taxpayer registered for GST/HST, the
GST/HST should not be added to the cost of the vehicle.
Each class 10.1 automobile is placed in a separate class and CCA is calculated on each car
separately. That is, class 10.1 assets are not pooled (i.e. each automobile is considered to be
its own separate class).
In addition, the rules related to recapture and terminal losses do not apply to Class 10.1
automobiles. That is, when the vehicle is sold, neither a recapture of CCA nor a terminal loss
is permitted [ITA 13(2), 20(16.1)]. Since terminal losses are denied, a special CCA
• Class 10 automobiles
If a vehicle used to earn business income costs less than $30,000 (plus GST and PST or HST)
it is included in Class 10. Automobiles in this class are subject to the normal CCA
calculations:
The CCA on leasehold improvements (Class 13) is not calculated using the declining balance
method, but is based on using a straight-line method. CCA on leasehold improvements is
calculated as follows:
the lesser of:
1. 1/5 of the capital cost of the leasehold interest
and
2. the capital cost of the leasehold interest divided by the life of the lease plus one
renewable-option period. The life of the lease is the number of full 12-month periods
from the beginning of the year in which the cost was incurred to the termination date
of the lease. The life of the lease plus one renewal option has a maximum threshold
Since leasehold improvements may occur in different years, it is necessary to calculate CCA for
each separate leasehold improvement expenditure (since Part 2 of the formula for calculating
CCA on leasehold improvements starts in the year of expenditure).
In the first year only 1/2 of the calculated CCA is allowed as a deduction.
Example:
A $25,000 leasehold improvement is made on a rented building by a tenant. The lease term is
six years, with two successive options to renew of four years and three years respectively.
In the first year only, 1/2 of the CCA is deductible, so the CCA deduction allowed in the first
year is $1,250 ($2,500 x 1/2).
Patents may be classified as either Class 14 or Class 44. A patent or a right to use patented
information for a limited or unlimited period, which is acquired after April 26, 1993, is classified
as a Class 44 asset, which has a 25% declining balance rate. However, the taxpayer can elect the
property not be included in Class 44, in which case the asset is classified as a Class 14 asset and
CCA is calculated on a straight-line basis.
There are specific rules related to representation expenses (e.g. legal fees) for patents or
franchises. Expenditures for making a representation to obtain a franchise or patent can be
treated four different ways for tax purposes.
It is important to remember that Class 14 or 44 assets must have a limited life. If the intangible
has an indefinite life, it is treated as an eligible capital expenditure.
Patent, franchise or license for a Patent (or right to use a patent) for either a Patent (or right to use a
limited period limited or unlimited period. patent) for an unlimited
period.
Note that this class applies to Note that this class applies to patents only. Eligible capital property
patents AND franchise or includes all intangible assets,
licenses. not only patents.
Note that assets in this class Note that assets in this class may have Note that assets in this class
must have a limited life either a limited life or an unlimited life must have a unlimited life
CCA = straight-line over the life CCA = 25%, 1/2 year rule applies Eligible Capital Expenditure
(i.e. term) of the = cost x 75% = base used to
patent/franchise/license calculate deduction; rate =
7%, no 1/2 year rule
This means a limited life patent can be treated as either a Class 14 or Class 44 asset and an
unlimited life patent can be treated as either a Class 44 asset or eligible capital property.
If the building is a rental building, CCA cannot be claimed if it creates a loss or increases a loss.
If more than one rental building is owned, the rental income (loss) for all buildings must be
netted together to determine the CCA deduction limitation.
If there is more than one building, which means that each building is considered a separate class,
the taxpayer can choose which building CCA is deducted against, subject to normal limitations
(maximum CCA = UCC x CCA rate).
Examples
Example 1:
Sara Mitchell owns one property and collected rents of $6,240 in 2010. Sara incurred deductible
expenses of $2,810 excluding capital cost allowance. The maximum amount of CCA Sara
would be able to claim on this building is $3,430:
The maximum CCA that is deductible is also subject to the normal CCA calculation (i.e. UCC x
CCA rate).
Example 2:
John Bertani owns a building and collected $9,360 in rent during 2010. He incurred $9,750
allowable deductible expenses. John will not be allowed to claim any capital cost allowance on
this building for 2008 as he cannot increase his rental loss by capital cost allowance:
However, John may deduct the $390 loss as deduction against his other income.
Example 3:
Wendy Lui owns two apartment buildings. A summary of her 2010 rental income is:
Building A Building B
Rent $22,100 $19,500
Deductible expenses excluding capital cost allowance 19,760 20,800
Rental income (loss) before CCA on the buildings $2,340 $(1,300)
Wendy can only claim $1,040 in capital cost allowance for the year because she must combine
her rental income on Building A with her rental loss on Building B to determine the net income
available for reduction by capital cost allowance.
Subtotal xx A
Deduct:
Proceeds of sale (less disposition expenses) from the xx x 3/4 = xx B
disposition of all eligible capital property during the year
Note that there is not a 1/2 year rule for eligible capital expenditures. For years starting after
December 21, 2000, the deduction must be prorated for short tax years based on the number of
days (e.g. first year and final year for a company usually are less than 365 days).
When eligible capital property is disposed, 3/4 of the selling price (proceeds of disposition) is
deducted from the pool’s balance. This may result in the pool having either a negative or positive
balance. The tax consequences of either of these situations are:
• if the pool is negative:
− add to business income the amount that represents recapture of eligible capital
expenditures previously deducted
− if there is still a negative amount remaining after taking into consideration the
recaptured amount, 2/3 of the excess is added to business income; this 2/3
inclusion results in the income impact being the same as if it was treated as a
capital gain [3/4 x 2/3 = 50%, which is the capital gains inclusion rate]
When a business terminates and there is a balance in the eligible capital property pool, this
balance is deducted from business income (akin to the terminal loss provisions of depreciable
capital property).
A company purchases a customer list in Year 1 for $20,000 and sells it in Year 2 for $25,000.
The tax consequences are:
Numbers check:
Total income statement impact per above:
Year 1 – Deduction $(1,050)
Year 2 – Recapture 1,050
Year 2 – Taxable portion of excess 2,500
Total $2,500
Check:
Year 1 – Deduction $(1,050)
Year 2 – Recapture $1,050
Example:
Assume the same facts in the previous example and the company elects to treat the gain portion
as a capital gain. The tax consequences are:
CCA UCC
rate balance
Class 1 – Building 4% $625,000
Class 8 – Office Furniture and Equipment 20% 155,000
Class 10 – Vehicles and
Computers Purchased Before 2005 30% 118,000
Class 13 – Leasehold Improvements S. Line 61,750
Class 43 – Manufacturing Equipment 30% 217,000
CCA UCC
rate balance
Class 8 – Office Furniture and Equipment 20% $27,000
Class 10 – Vehicles 30% 33,000
Class 12 – Tools 100% 34,000
Class 13 – Leasehold Improvements S. Line 45,000
Class 52 – Computer Hardware 100% 28,000
Class 8 – Used office furniture and equipment was sold for cash proceeds in the amount of
$35,000. The original cost of these assets was $22,000.
Class 10 – A delivery truck with an original cost of $23,000 was sold for $8,500.
1. The Company leases a building for $827,000 per year that houses a portion of its
manufacturing operations. The lease was negotiated on January 1, 2007 and has an original
term of eight years. There are two renewal options on the lease. The term for each of these
renewal options is four years. The company spent $78,000 on leasehold improvements
immediately after signing the lease. No further improvements were made until the current
year.
2. On February 24, 2010, one of the company’s cars was totally destroyed in an accident. At
the time of the accident, the fair market value of the car was $12,300. The proceeds from
the company's insurance policy amounted to $8,000. The original cost of the car was
$17,000.
3. The Class 10 vehicle purchased during the year was a delivery truck. The Class 12 tools
purchased are not subject to the half-year rule.
4. The Walters Company was organized in 2000 and has no balance in its cumulative eligible
capital account on January 1, 2010. During March, 2010, the company granted a
manufacturing license for one of its products to another Canadian company. This licensee
paid $87,000 for the licensing rights to manufacture this product.
Required:
Calculate the maximum 2010 CCA that can be taken on each class of assets, the January 1, 2010
UCC balance for each class and any other 2009 income inclusions or deductions resulting from
the information provided.
The maximum CCA would be $25,000 [(4%) ($625,000)]. The January 1, 2010 UCC of Class 1
would be $600,000 [$625,000 minus $25,000].
CCA:
Note that $22,000 is used as this is the original cost. The maximum to deduct is the original
cost. If the proceeds exceed original cost, there will be a capital gain. In this case, the capital
gain is:
Selling price $35,000
Original cost 22,000
Capital gain $13,000
Some candidates find the method below easier to remember to calculate CCA:
Opening UCC balance $155,000
Additions during fiscal year 27,000
Dispositions during fiscal year (22,000)
CCA calculations:
155,000 x 20% 31,000
CCA on the net additions/disposals (1/2 year rule):
(27,000 – 22,000) x 1/2 x 20% = 500 (31,500)
Ending UCC balance $128,500
Note 1: Note that the amount received from the insurance company on the destroyed vehicle is
treated as proceeds from a disposition. The fair market value is irrelevant.
Some candidates find the method below easier to remember to calculate CCA:
Opening UCC balance $118,000
Additions during fiscal year 33,000
Dispositions during fiscal year (16,500)
CCA calculations:
118,000 x 30% 35,400
CCA on the net additions/disposals (1/2 year rule):
(33,000 – 16,500) x 1/2 x 30% = 2,475 (37,875)
Ending UCC balance $96,625
Class 12 – Tools
The tools are eligible for a CCA rate of 100% and are not subject to the half-year rules on net
additions; therefore, the entire $34,000 can be deducted as CCA for the current year.
Recall that leasehold improvements are deducted over the term of the lease on a straight-line
basis. For the purposes of calculating the CCA deduction, the term of the lease would include the
first renewal option, beginning in the first period after the improvements were made. In the case
of the original improvements, the period to be used is 12 years. With respect to the
improvements during the current year, the write-off period will be nine years.
All the assets in Class 43 have been retired (i.e. there are no physical assets in the class) and
there is still a $29,000 UCC balance. This balance is a terminal loss that is fully deductible in
the current year.
Class 52 – Computers
The rate for Class 50 is 100% and the class is not subject to the first year rule. The required
calculations for this class are:
Opening balance 0
Additions during fiscal year $28,000
Opening balance 0
Proceeds of disposition [($87,000)(3/4)] ($65,250)
Balance ($65,250)
Addition to balance 65,250
Ending balance $0
The proceeds of $87,000 are included at 75% of the amount received. This results in a negative
balance of $65,250. The $65,250 is treated as:
− add to business income the amount that represents recapture of eligible capital
expenditures previously deducted
− if there is still a negative amount remaining after taking into consideration the
recaptured amount, 2/3 of the excess is added to business income; this 2/3
inclusion results in the income impact being the same as if it was treated as a
capital gain [3/4 x 2/3 = 50%, which is the capital gains inclusion rate]
January 1, 2009
Maximum CCA UCC
Class 1 $25,000 $600,000
Class 8 $31,500 $128,500
Class 10 $37,875 $96,625
Class 12 $34,000 Nil
Class 13 $9,000 $97,750
Class 43 Nil Nil
Class 52 $28,000 $0
Property income is passive income arising from return on invested capital. Common property
income items are:
• interest
• dividends
• rents
• royalties
It is important to note that this income is passive; that is, there is not much effort expended on
earning this income. If there is significant time and effort spent on activities to earn this income,
then the income could be considered business income.
Interest
The term interest is not defined in the income Tax Act, but has been defined by the Supreme
Court of Canada as “the return or consideration or compensation for the use of retention by one
person of a sum of money, belonging to, in a colloquial sense, or owed to, another”. There may
be instances where a sum of money could be considered interest or capital. If considered capital,
the sum is taxed according to the capital gains and losses legislation.
Due to potential disputes with respect to taxing as a capital item as opposed to a property income
item (recall capital gains are taxed at a lower rate), the government has issued various rules and
regulations governing the computation of interest income as:
• Accrual rules
Interest income reported for tax purposes for corporations, partnerships and certain trusts
must be calculated based on the accrual method (the accrual method is required by
GAAP/IFRS also).
Interest income for individuals must be accrued to the anniversary date of the contract
giving rise to the interest income, regardless of whether the interest has been received.
• Loans made at a discount and repayable at par or made at par and repayable at a premium.
The Income Tax Act requires a situation where a payment can reasonably be regarded as
having both interest and capital components, the part that can be regarded as interest is
treated as such for tax purposes.
Payments received due to the use of or production from property is treated as property income.
Dividend Income
Individuals
Dividends from corporations resident in Canada are treated as property income. The amount that
is subject to tax is dependent on whether the dividend is considered ‘eligible’ or ‘other than
eligible’.
Eligible dividends:
Generally, dividends received from public corporations are considered eligible dividends.
Dividends received from private corporations are only considered eligible if the private
corporation paid tax at the general tax rate. That is, the private corporation did not claim special
tax reductions such as the small business deduction.
For eligible dividends, the amount subject to tax is the grossed up amount, which is 145% (e.g.
the dividend plus (45% x the dividend) or alternatively, the dividend x 1.45. The taxpayer then
receives a dividend tax credit, which is 19% of the grossed up amount.
It is up to the company who is paying the dividends to determine if the dividends are considered
eligible or other than eligible.
The purpose of the dividend gross up and corresponding tax credit is integration between
corporate tax and individual tax. Integration aims to eliminate double taxation.
Example:
1
Gross up intended to result in a taxable amount that approximates the corporation’s pre-tax earnings.
2
Dividend tax credit is to compensate for the tax the corporation paid on the income earned to pay the
dividend.
Interest XX
Rent XX
Royalties XX
Grossed up dividend XX
Net property income XX
Definitions
Capital gain/loss: the gain or loss that occurs on the disposition of a capital
asset (both depreciable and non-depreciable)
Proceeds of disposition (POD): the amount received for disposing of a capital asset;
includes ‘deemed’ proceeds of disposition
Adjusted cost base (ACB): the cost of a capital asset, plus or minus specified
adjustments, if applicable.
Calculation
Calculating capital gain or loss for tax purposes:
Proceeds of disposition XX
Less:
Adjusted cost base XX
Plus: expenses of disposition XX XX
Capital gain or loss XX
Prescribed fraction 1 x 1/2
Taxable capital gain or loss XX
1
The current fraction is 1/2.
The inclusion fraction at which capital gains and losses are taxable has varied over the years and,
therefore, the taxable loss must be converted to the rate in effect in the year the capital loss is
deducted.
For example, a capital loss of $15,000 which occurred on June 1, 2000, would be allowable at an
amount of $15,000 x 2/3 = $10,000. If this loss is carried forward to 2008 and is applied against
a gain of $40,000, the calculation would be:
Note that capital losses can only be deducted against capital gains and the carryover period for
capital losses is back three years and forward indefinitely.
This is accomplished through application of a “lesser of” calculation to determine the annual
reserve.
Lesser of:
a) Proceeds not yet due as of taxation year-end x total taxable capital gain
Total proceeds
b) 20% x (4 – number of preceding taxation years ending after disposition) x total
taxable capital gain
Tax Planning
There is a capital gains deduction of $375,000 ($750,000 x 1/2), which can be applied against
taxable capital gains on qualifying shares of a small business corporation and certain farming
property. There are no other capital gains deductions.
Note 1: There is also an additional Part IV tax that is applied on certain dividends
received by a private corporation.
• Federal surtax
The federal surtax was eliminated effective January 1, 2008.
Example:
A CCPC has active business income of $140,000 and taxable income of $105,000 (after
deducting a loss carry over of $15,000 and charitable donations of $5,000). The SBD for
the 2010 year is:
• Special reductions
The ‘general rate reduction’ applies to both public companies and CCPCs and is applied
to specific types of income:
− public companies federal tax is reduced 10% in 2010, 11.5% and 13% each year
afterwards. These rate reductions are applied to income other than income from
manufacturing and processing (M&P) activities. M&P income has a separate
reduction, which is also 10%, applied to it.
− CCPCs
Any business income above the SBD threshold of $500,000 and to which no M&P
rate reduction has been applied is entitled to a federal tax rate reduction of 9%. In
addition, for a CCPC, these reductions do not apply to tax on investment income
(for a non-CCPC this reduction does apply to investment income).
For the purposes of the Entrance Examination, candidates should not memorize the
formula, but remember that generally, the amount to which the rate reduction is
applied for CCPCs is ABI above the SBD threshold ($500,000 in 2010) plus
income to which M&P has not been applied. An easy way to remember this is:
Manufacturing MC + ML
profits eligible for = TC + TL x ADJUBI
M&P
Where:
MC = Manufacturing capital, determined as the annualized cost of all depreciable
property used directly in qualified manufacturing activities. This is
calculated as:
original cost of owned annual rent for
10% x ( property
+
leased property ) x 100/85
to a maximum of TC (below)
TC = Total fixed annual capital cost related to active business income earned in
Canada. This is calculated as:
original cost of owned annual rent for
10% x ( property
+
leased property) )
Note that this formula basically defines M&P profits in terms of capital employed in M&P
and labour costs.
Understanding the M&P deduction is important because it can impact how a business is
structured. For example, assume the following two situations:
Situation 1 Situation 2
Shareholders Shareholders
Corporation A Corporation A
Activity: Profit Activity: Profit
Retail $1,000,000 Retail $1,000,000
Mftg&Processing 100,000
$1,100,000
Corporation B
Activity Profit
Mftg&Processing $100,000
Under Situation 1, the maximum profit eligible for the 10% M&P deduction is $100,000,
since manufacturing is only carried on in Corporation B. Under Situation 2, the total profit
of $1,100,000 has an arbitrary formula applied to it. Assuming that the formula results in
30% of the profits being considered M&P, the M&P profits eligible for the 10% deduction
would be:
MC + ML
= 30% x $1,100,000 = $330,000
TC + TL
As this example illustrates, tax implications can influence how a corporation is structured.
A corporation operating in only one province will pay only that province’s provincial taxes.
However, when a corporation has a permanent establishment (i.e. an office, branch, warehouse
or factory) in another province, a proportion of the corporation’s profits are taxed in that
province. If a permanent establishment in another province exists, the proportion of taxable
income attributable to that province and, therefore, subject to that province’s tax, is determined
by considering both wages paid and gross revenue earned in that province. The formula is best
illustrated using an example:
Assuming the company’s total taxable income is $1,044,000, the portion attributable to each
province and, therefore, subject to that province’s provincial tax rate and/or provincial
incentives, if any, are:
Taxable income
of $1,044,000
Ontario 12.05% x 1,044,000 = 125,802
Alberta 55.75% x 1,044,000 = 582,030
Quebec 28.10% x 1,044,000 = 293,364
Although candidates are not responsible for calculating taxable income attributable to each
province, candidates should be able to explain the consequences of having a permanent
establishment(s) in different provinces.
1. ABI that is eligible for the SBD is not eligible for the M&P deduction (i.e. cannot apply both the 17% (SBD) and the 10% (M&P deduction)
to the same income)
2. The rate reduction cannot be applied to income that has the SBD or M&P deduction applied to it.
3. This is the refundable Part I tax (6 2/3%), commonly referred to as ‘ART’, on investment income that CCPC’s pay. When dividends are paid
out to shareholders, this tax is refunded.
4. If a CCPC is part of an associated group of companies, the SBD and the rate reduction must be shared by all corporations in the group.
The rates for 2010 for non-CCPCs (e.g. public companies) are:
Non-CCPC’s
ABI from M&P ABI w/no Invest.
activities (i.e. w/ M&P income
M&P deduction) deduction
1. The rate reduction cannot be applied to income that has the M&P deduction applied to it.
2. Note that non-CCPCs can apply the rate reduction of 10% to investment income, while a CCPC cannot. This is because CCPCs enjoy
refundable tax privileges on taxes paid on investment income. This reduction applies to non-CCPCs only and is applied to investment
income, other than capital gains and dividends received from Canadian corporations. The rate reduction that applies to capital gains is ½ of
this rate, which is consistent with the tax rules for capital gains. Since dividends received from Canadian corporations are deductible when
computing Part I tax, the rate reduction is not applied to these dividends. Note that although these dividends are not subject to Part I tax, they
may be subject to Part IV tax.
As discussed earlier, the rate reduction of 10% is applied to investment income for non-CCPCs; however, it is not applied to CCPCs (since
CCPC’s receive a refundable tax on investment income that is not available to public companies.)
As mentioned above, the small business deduction is an incentive available to CCPCs only.
The small business deduction is a credit against tax otherwise payable on active business income.
Passive business income, such as interest and rents, are not eligible for the small business
deduction.
The annual limit means any active business income exceeding the threshold of $500,000 is not
eligible for the SBD.
The impact of the SBD on a CCPCs tax rate can be found by reviewing the tax rate charts in the
previous section.
It is important to note that the SBD is only applied against Canadian active business income
(ABI). Generally, this means income from Canadian operations and excludes investments and
property income. However, technically the ITA (ITA 125 (7)(a); ITA (129)(6) and IT-73R5) has
specifically defined ABI as:
Which means, any income from a specified investment, business or a personal services business,
is excluded from the definition of ABI and, therefore, the SBD cannot be applied to income from
either of these sources. These two terms have been defined in the ITA as:
Because these items (interest, dividends, rent and royalties) are classified as
specified investment business income, they are automatically disqualified from
the SBD. In addition, this income is not eligible for the 8.5% rate reduction.
There are two exceptions to the specified investment business rules, which are:
1. if a corporation has >five employees, it is not considered a specified
investment business and, therefore, its income is considered ABI and is
eligible for the SBD.
2. the business of leasing movable property (such as vehicles), but not real
property, is considered to be an active business and, therefore, income earned
in these types of businesses is eligible for the SBD.
Related Individuals:
Spouse Siblings
YOU
• Siblings of your spouse (e.g. in-laws) • Spouses of your
siblings (e.g. in-laws)
• Spouses of the siblings of your • Siblings of spouses
spouse (example 1 below) (example 2 below)
Descendents
Also for the purposes of the associated company rules, a person is deemed to be related to
her/him.
Shares of a “specified class” are excluded from the cross-ownership conditions in subsection
256(1). The term “specified class” is defined [subsection 256(1.1)] to mean a class of shares
where:
Two corporations each controlled by a single person who are related to each other and either
person holds 25% of the voting common shares of the other corporation.
Bob Bill
25%
100% 75%
Bob and Bill are brothers and Bob owns 25% of BILL Co.; therefore, BOB Co. and BILL Co.
are associated.
One corporation is controlled by a single person and the other corporation is controlled by a
group of persons. The single person is related to each person in the group and the single person
holds 25% of the voting common shares of the corporation.
Two group-controlled corporations whereby each member of one group must be related to all
members of the other group with one or more members alone or together own 25% of the
voting common shares of the corporation.
Sara, Susan and Samantha are related to Larry, Mo and Curley and Susan and Samantha own
25% of Group Co. Two, therefore, GROUP CO. ONE and GROUP CO. TWO are associated.
H W
Husband Inc. and Mgmt Co. are associated due to the following:
• H controls Husband Inc. (due to 100% common share holdings) [control test]
• H and W (a related group) control Mgmt Co.. and H is related to each member of the
related group (recall that for the purposes of the associated company rules, an individual
is deemed to be related to him/herself) [related test]
• H owns 25% of the voting common shares of Mgmt Co. [cross ownership test]
Wife Inc. and Mgmt Co. are associated in the same manner as Husband Inc. and Mgmt Co..
Under the ‘association with a third company’ rules, Husband Inc. and Wife Inc. are deemed
to be associated.
However, under the exceptions, Mgmt Co.. can elect not to be associated with Husband Inc.
and Wife Inc. for the purposes of the SBD. If Mgmt Co.. files this election, its business
limit for the purposes of the SBD is deemed to be nil.
• deemed association
There is a deemed association rule where one of the main reasons for the separate existence
of two corporations is tax considerations. However, if a taxpayer can show a valid, non-tax
reason for the separate existence of a corporation, the deemed association rule does not
apply.
The maximum credit is therefore $650 on contributions of $1,275 ($400 + $350 + $525). Any
contributions greater than $1,275 do not receive a credit and cannot be carried forward to another
year.
For a CCPC with taxable income of $500,000 or less in the preceding tax year, the following
additional incentives are available
Qualified Property
A tax credit of 10% of new capital asset purchases in the Atlantic Provinces and Gaspe is
available provided the assets are for use in manufacturing and processing, operating an oil or gas
well, extracting minerals, logging, farming or fishing.
Objective of Integration
‘Integration’ is an attempt by the tax system to recognize whether income is earned by a
shareholder through dividends or earned directly by the shareholder, the amount of tax paid on
the income should be the same. If integration did not exist, the following would occur:
Corporation:
Taxable income earned by the corporation $1,000
Income tax paid by the corporation at an assumed combined federal and
provincial rate of 38% 380
Remainder, assume it was paid out as a dividend to the shareholder $ 620
Shareholder:
Taxable income $ 620
Income tax paid by the corporation at an assumed rate of 34% 211
$ 409
Compare the total tax paid of $591 to the amount that would have been paid had the shareholder
earned the $1,000 directly, which is $340 ($1,000 × 34%). Without integration mechanisms, it is
obviously more beneficial to earn income directly as opposed to through a corporation.
• Public companies:
⎯ dividend gross up and dividend tax credit
• CCPCs:
⎯ dividend gross up and dividend tax credit
⎯ Part IV refundable tax on portfolio dividends from a connected corporation
⎯ refundable 6 2/3 tax on investment income
⎯ refundable portion of Part I tax, which is 20% of Canadian source investment
income
Corporations pay dividends out of after tax dollars. That is, the company has paid tax on the
income generated to pay the dividend. Taxing this income in the individual shareholders’ hands
again would result in double taxation. To avoid this double tax, a dividend gross up and dividend
tax credit was introduced. The gross up, which is either 44% or 25% of the dividend, is intended
to result in a taxable amount that approximates the corporation’s pre-tax earnings. The dividend
tax credit is to compensate the individual for the tax that the corporation has paid.
Corporate taxes (@ 38% for public co. and 21% for CCPC) Note 1 A 380 380 210 N/A
Cash available for dividends paid out as dividends 620 620 790 1,000
Gross Up at 44% for public and 25% for CCPC – 273 196 N/A
Dividend tax credit @ 18% for public co. and 13 1/3% for CCPC C – (161) (131) –
Summary:
Income 1,000 1,000 1,000 1,000
Taxes – corporate 380 380 210 –
– personal 211 143 204 340
Total taxes 591 523 414 340
Net cash to individual 409 477 586 660
Note 1: Tax rate of 21% for the CCPC assumes the CCPC only earns active business income
(ABI) and all of the ABI is eligible for the SBD of 17 % (38% general rate minus 17% SBD =
21%).
Note that in this example, even with the dividend tax credit, full integration is not achieved. It is
only for CCPCs and the use of three other integration tools limited to CCPCs, Part IV tax on
portfolio and connected corporation dividends, refundable tax on investment income and the
refundable portion of Part I tax, that integration is better achieved. Remember, integration refers
to ensuring the combined corporate and personal tax on income earned through a corporation is
equal to the tax that would have been paid if the income had been earned directly by the
individual taxpayer. There should be no advantage to earning business income through a
corporation as opposed to earning it directly. Although the Canadian tax system is one of the few
in the world, which attempts to achieve integration, varying tax rates at both corporate and
individual level make it difficult to achieve perfect integration.
Part IV tax
Additional Refundable portion
33 1/3 % of portfolio refundable tax of Part I tax
dividends and income
dividends received from 6 2/3% of 20% of Canadian
a connected co. investment income investment income not to
(payer co. received exceed Part I taxes
a refund)
RDTOH
1. opening balance
2. less prior year’s dividend refund
3. add: refundable Part I tax
4. add: 6 2/3% refundable tax
5. add: Part IV tax
6. closing balance
Individual dividend
Gross up
and dividend credit
mechanism
Recall that for corporations, dividends received from other corporations is completely tax-free.
When calculating the corporations’ taxable income, they are excluded. This Part IV tax exists to
prevent individuals from incorporating and placing their investments in the corporation so the
dividends are tax-free. Therefore, this tax is paid when the corporation receives the dividend and
when a dividend is paid to the shareholder, the tax that was paid is refunded.
Investment income includes all income from property, both Canadian and foreign. Income from
property includes: rents, taxable capital gains (net of capital losses) and interest. It excludes
taxable dividends because these dividends are subject to Part IV tax.
Moret Incorporated (“Moret”) had the following taxable income items, in Canadian dollars, for
the current year:
Moret paid a dividend of $60,000 to its sole shareholder, Mr. Moretson, on December 3 of the
current year. Last year, Moret paid Mr. Moretson a dividend of $15,000.
Note 1: Total dividends paid by the connected corporation were $210,000 and the total dividend
refund received by the connected corporation is $70,000.
Required:
Dividends – US connected --
companies – NO PART IV ON
THESE DIVIDENDS
33,300
× 33 1/3%
11,100 11,100
14,000 14,000
RDTOH ending balance 230,900
Revenues $3,000,000
Direct expenses (1,770,000)
Gross margin $1,230,000
Additional information:
• Capital cost allowance (i.e. depreciation for tax purposes) is $800,000 for the year.
• Management decided to write-down the value of investments in subsidiaries. There was no
actual disposition of the investments.
Required:
Compute net income for tax purposes.
Required:
Determine the impact of the disposition to Tofu Inc.
Required:
Track the Cumulative Eligible Capital Account (CEC) for the relevant years.
Required:
a. Calculate the amount of CCA that Blake may claim in relation to the leasehold for 2005.
b. Blake anticipates further improvements in 2006 in the amount of $10,000 and wishes to
know the amount of CCA, which would be deductible in 2006.
Required:
a. Calculate the maximum deduction for CEC in each of the years and the income impact of
the sale in 2005.
b. Reconsider the facts outlined above. Calculate the income impact of the sale in 2006 if
the business acquired in 2003 is sold for $300,000 including an amount of $80,000 in
respect of goodwill.
c. How would your answer change if the business acquired was purchased on March 1,
2003 instead of January 1, 2003?
During the year, Ranger Inc. decided to significantly alter its business model. As a result, the
following occurred:
1. Ranger Inc. sold its building and entered into a lease for a new office building. The
building, which originally cost $1,300,000, was sold for $1,400,000.
4. Ranger Inc. sold one of its trucks for $20,000 (original cost $25,000) and purchased a
used truck for $8,000.
Required:
Calculate the maximum CCA claim for 2005. Identify any other tax issues arising from the
above transactions.
Both buildings qualify as Class 1 properties with a maximum CCA rate of 4%. Because building
Y has an original cost greater than $50,000, it must be placed in a separate CCA Class 1. Any
additions to Class 1 less than $50,000 would be pooled with the class containing building X.
The CCA rate is 4%.
Required:
Compute the maximum capital cost allowance that can be claimed for Beta Corp. in fiscal 2006.
Required:
Calculate the capital gain or loss for 2010.
Jermat Ltd.
Income Statement
For the Year Ended December 31, 2009
Sales $3,000,000
Cost of goods sold 800,000
Gross profit 2,200,000
Salaries 350,000
Amortization 200,000
Other selling and administrative expenses 650,000
1. Salaries expense includes $50,000 for management bonuses. The bonus will be paid in
two equal instalments on January 15 and June 15, 2010.
4. The president traveled extensively during the year for sales purposes. Reimbursed
expenses amounted to $35,000 for travel, including $10,000 for meals and $10,000 for
accommodation.
5. The president paid his 16-year-old daughter $12,000 during the year for assistance in the
filing department. The full amount was deducted for accounting purposes.
6. The company issued new common shares during the year and incurred $20,000 for legal
and accounting fees. The fees were included in the amount charged to common shares.
a. A gain of $100,000 on the sale of shares of a long-term investment. Jermat paid $20,000
for the shares in 1996 and sold them for $120,000 in 2009. Jermat received a down
payment of $30,000 on the sale. The remainder of the proceeds is due in $18,000
instalments on January 31, each year, commencing January 31, 2010.
Book
Cost Proceeds
Value
Marketable securities $10,500 $7,000 $10,500
Equipment — Class 43 42,000 11,200 15,000
Patent – Class 14 45,000 70,000 3,500
Government license 8,000 35,000 700
Trucks* 19,600 1,300 4,200
*The company has decided to lease its trucks in the future and, therefore,
disposed of all its trucks, the only assets in this class.
9. The company had the following balances in its tax accounts on January 1, 2009.
Depreciable property:
10. The company made the following capital purchases during the year:
Building $315,000
Manufacturing machinery 87,000
11. During the year, the company made an improvement costing $7,000 to a leased
warehouse. The 15-year lease commenced 10 years ago and has two successive options to
renew of five years and three years, respectively.
Required:
Compute net income for tax purposes and taxable income for the year ended December 31, 2009.
JEB is 65% owned by non-Canadian residents. Its gross revenues are 83% earned in Canadian
provinces. Total salaries and wages paid in Canada are 77%.
Required:
Botsal is associated with Latsob Inc. (Latsob) for Canadian tax purposes. The two corporations
have agreed to share the small business limit equally.
Required:
Determine the amount of small business deduction that Botsal may claim for 2010.
Required:
Determine whether Coco Inc. and Bobot Inc. are associated corporations.
Required:
Peleluc had $10,000 in net capital losses carried forward from 2009 and an RDTOH balance of
$6,000 at the end of 2009. During 2009, $27,000 of dividends was paid.
Required:
Calculate the balance in the RDTOH account at the end of 2010 and the dividend refund for
2010.
1) During the fiscal period, there was active business income of $550,000. All profits are
attributed to the M&P operations of the business.
2) ABC Corporation also owns a building on the other side of town, which they rent out.
Net rent for prior periods were normally much higher; however, this year, due to the
deteriorating condition of the building, much more was invested in maintenance and
repairs. Net rental income before CCA was $23,500. The maximum CCA available for
this building for deduction is $60,000.
3) During the course of the year, ABC made a donation of $10,000 to the Children's
Hospital and Mr. ABC, on behalf of the company, donated $15,000 to the Liberal Party
of Canada.
5) In June, ABC disposed of a piece of equipment in Asset Class 12. The net book value of
this asset was $25,000; the asset was sold for proceeds of $15,000. There are four other
assets remaining in this asset class.
6) During the course of the year, ABC received dividends from non-connected Canadian
Corporations of $32,000 and interest of $5,000.
7) In August, ABC disposed of land they have owned since incorporation. The original cost
of the land was $12,000 and it sold for $150,000with associated costs of $7,500.
9) ABC reported meal and entertainment expense of $35,000 for the year.
10) The company has a maximum of $55,000 CCA available for deduction (excluding the
CCA for the building)
• The write-down of investment will be recognized as a capital loss for tax purposes only
when the investments are actually disposed.
• The above shows net income for tax purposes can be positive even though there is a loss
for accounting. If management decided not to write-down the investment, then
accounting income would be $300,000 and net income for tax would remain unchanged
at $400,000. In other words, the arbitrary accounting entries (such as depreciation and
write-down of investment) have no effect on net income for tax.
Class 4
The recapture of $5,920 in 2010 is a logical result because Tofu Inc. fully recovered the
$100,000 cost from the proceeds of disposition. Therefore, the deductions taken in 2008 and
2009 (total $5,920) were, in hindsight, excessive.
If Tofu Inc. were to purchase another building before the end of its 2010 taxation year, the
Continuing with the example above, if the proceeds of disposition were $80,000 instead of
$100,000, then the UCC balance at the end of 2010 would be $14,080 (i.e. $94,080 UCC less
$80,000 proceeds). Since no other assets remain in Class 1, Tofu Inc. would be entitled to
deduct the $14,080 as a terminal loss. The net cost to Tofu Inc. of the building of $20,000
($100,000 original cost less $80,000 proceeds from sale) is recovered in the tax system as:
$5,920 total CCA in 2008 and 2009 and $14,080 in terminal loss.
2010
Disposal Sale of customer list (75% of $40,000) (30,000)
Sale of goodwill (75% of $100,000) (75,000)
($53,106)
Business income inclusion 53,106
The sale of the customer list and goodwill results in a negative CEC pool fully taxable as
business income in 2010.
The capital gain component on the sale of property is taxed at 75% because of the rates used for
the ECE pool. However, all other capital gains are taxed at a rate of 50%. This inequitable
treatment caused CRA to put rules in place to allow taxpayers to adjust the inclusion rate on the
capital gain component to 50% for all dispositions after October 17, 2000. For the above
taxpayer, the adjusted amount of capital gain is 50% of $60,000 = $30,000 or 2/3 of $45,000.
The $30,000 is combined with the true recapture component of $8,106 to total a business income
inclusion of $38,106. This is preferable to a business income inclusion of $53,106.
For 2005 improvement (over the remaining term of the lease plus
one renewal):
$20,000/(5 - 2 + 2) x ½ year rule 2,000
$15,333
b. 2006 CCA
For 2004 improvement (over the remaining term of the lease plus
one renewal)
$80,000 / 5 -1 + 2 $13,333
For 2005 improvement (over the remaining term of the lease plus
one renewal)
$20,000/5 - 2 + 2 4,000
For 2006 improvement (over the remaining term of the lease plus
one renewal)
$10,000/5* x ½ year rule 1,000
$18,333
Breakdown of ($122,633):
Recapture of previous CEC deduction
($5,250 + $4,883) $10,133
Capital gain
($122,633 - $10,133) 112,500*
$122,633
c. The solution would not change from Parts ‘a’ and ‘b’ as the ½ year rule does not
apply to the CEC account.
UCC nil
A taxable capital gain of 1/2 ($1,400,000 - $1,300,000) = $50,000 would also arise.
UCC nil
A taxable capital gain of 1/2 ($35,000 - $22,000) = $6,500 would also arise.
½ net amount rule is calculated on net of addition and disposition.
The ½ net amount rule does not apply as the net additions are negative (i.e. dispositions
exceed additions).
The maximum CCA that could normally be claimed from rental income in fiscal 2006 is $4,800.
However, CCA cannot be claimed to create or increase a rental loss. Therefore, CCA is limited
to $3,000. The $3,000 CCA may be claimed from either the class containing building X or Y or
a combination of the two. Allocating the CCA between the two buildings should consider any
future sale prospects.
The benefit from $1,800 of CCA that could not be claimed is not lost. The UCC of the class is
only reduced by the actual CCA claimed. Therefore, the unclaimed amount of $1,800 remains in
the UCC of the class and will be considered in the calculation of maximum CCA allowable in
future years. The benefit of the unclaimed CCA is, therefore, not lost it is merely deferred.
The net taxable capital gain for 2010 is $50,000 ($75,000 - $25,000). If Magma Corporation’s
marginal tax rate is 40%, then the capital gain will attract $20,000 in taxes. Therefore, the
effective tax rate on the capital gain is 20% (i.e. 1/2 * 40% or $20,000 taxes / $100,000
economic gain).
Capital losses are only deductible against capital gains. If Magma Corporation. did not sell stock
A, then the allowable capital loss in stock B could not be used in 2010. Instead, the capital loss
could only be carried backthree 3 years or forward indefinitely and claimed against capital gains.
Adjustments:
Excluded items:
Bonuses – deductible as paid within 180 days after the end of the tax year
Breach of contract – for the purpose of earning income; damages paid as part of a normal risk of
doing business
Landscaping – already fully deducted
Theft – normal risk of doing business
Salary to child – reasonable for services rendered
Schedule 1
Cl. 1. Cl. 3. Cl. 8. Cl. 10. Cl. 13. Cl. 14. Cl. 43.
4% 5% 20% 30% S.L. S.L. 30%
Jan. 1, 2009 U.C.C. Nil $49,000 $8,400 $1,500 Nil $35,900 $35,000
Purchases $315,000 — — — $7,000 — 87,000
Disposals — — — (1,300) — (45,000) (11,200)
Dec. 31, 2009 U.C.C. $315,000 $49,000 $8,400 $200 $7,000 $(9,100) $110,800
* Lesser of:
(a) 1/5 x $7,000 = $1,400
(b) $7,000/(5 + 5) = $ 700
$700 x ½ = $ 350
Note that JEB would not be eligible for the small business deduction as they are not a CCPC.
Nor would they be eligible for the M&P profits deduction as they carry on a retailing business.
Finally, none of their income was investment income and would not be eligible for the
refundable tax system. Consequently, their full taxable income would be eligible for the general
rate reduction as it was taxed at full rate.
Taxes Payable
Federal tax (38%) $174,800
Federal abatement (10%) (46,000)
Net federal tax 128,800
1. What long-term investments should the company take on? For example, the financial
manager must decide on lines of business and the property plant and equipment
needed.
2. How will the company obtain the long-term financing for the investment? Options
include issuing more shares or borrowing money.
3. How will the day-to-day (i.e. short-term) financial activities such as collecting
receivables and paying suppliers be managed?
The financial management function normally has a senior executive, such as a VP Finance or
Chief Financial Officer (CFO). The financial management function is split between two
functions, controllership and treasury. The controllership function deals with cost accounting,
financial accounting, tax payments and sometimes management information systems. The
treasury function is responsible for managing cash, financial planning (e.g. budgeting) and
capital expenditures.
1. Capital Budgeting
Capital budgeting allows the financial manager to evaluate and manage long-term
investments.
2. Capital Structure
Capital structure refers to the mix of debt vs. equity a company uses to finance its
long-term activities.
• identifying investments and financing arrangements that favourably impact the share
price
Management compensation:
If management’s compensation (e.g. bonuses) is tied to profit and increasing share value,
management has an incentive to act in a manner beneficial to shareholders. The management
compensation could be structured in two ways so that it is tied directly to both profit
maximization and share value. First, cash bonuses can be tied to profit levels. Second, stock
options can be issued to management. Since the value of the stock option increases with the
market price of the share, management has an incentive to increase the market price of
shares.
Note to candidates: Although the CMA Competency Map states candidates are required to
calculate “…future and/or present values…” the tables provided on the Entrance Examination
are present value tables. Future value tables are not provided. Therefore, this material
recommends candidates focus their studying of the time value of money on present values.
Future values have rarely been examined on the Entrance Examination.
Calculator Use:
The CMA Canada rules related to the Entrance Examination restricts the calculators that may be
used in the Entrance Examination to the following three models (as of the date of writing,
February 2009):
Hewlett-Packard 10BII
Texas Instrument BAII-Plus (including the professional model)
Sharp EL-738C
Note that restricts means other calculators will not be allowed. It is strongly suggested candidates
become familiar with the use of one of these calculators. Becoming familiar with the present and
future value functions will save time on the examination. A convenient way of following this
advice is to complete the illustrative examples below using your chosen calculator.
Overview
The time value of money refers to the fact that a dollar today can be invested, which means it
would increase to more than a dollar later. The ‘dollar today’ is the present value and the ‘more
than a dollar later’ is the future value. Note that this reflects the opportunity cost of money
relating to investment opportunities – inflation is a separate issue. .
In other words, it answers questions like “if I need $1,000 in five years, how much do I need to
invest today, assuming an interest rate of 6%?” or “if I were to receive $1,000 in five years, how
much would the $1,000 be worth today, assuming an interest rate of 6%?”
Example
To have $5 at the end of one year, how much needs to be invested today, if the interest rate is
10%? This could also be stated as “what is the value today of $5 to be received at the end of one
year at an annual interest rate of 10%?”
Solution
1
Present value = FV x
(1 + r)
1 $5
Present value = $5 × = = 4.5455
1 + 10% 1.1
Check
Future value = PV x (1 + r)
= 4.5455 × (1 + .10)
As you can see, the present value formula for one period can be stated as:
1
Future amount ×
1+r
Example
You need $1,000 in two years and the annual interest rate is 7%. How much needs to be
invested today to ensure you have $1,000 in two years?
1 1,000
Present value = 1,000 × = = $873.4387
(1 + 7%)2 (1.07)2
Check
As you can see, the present value formula for multiple periods can be stated as:
1
investment ×
(1 + r)t
where
r = interest rate
t = time periods
A note on terminology
Discount rate:
In these examples, r is the interest rate for a given period. Unless otherwise stated the interest
period is one year. It is also called the discount rate.
Example:
An investment will pay $1,000 at the end of each year for the next five years. At an annual
interest rate of 6%, what is the present value of this future cash flow stream today?
Solution
0 1 2 3 4 5
$ 943.40 × 1/1.06
890.00 × 1/1.062
839.62 × 1/1.063
792.09 × 1/1.064
747.26 × 1/1.065
$4,212.37
An easier method to calculate the present value is to use the present value tables provided in the
examination (the formula sheet provided at the examination provides present value factors for
the present value of an amount and the present value of an annuity).
Since this question represents an annuity (annuities discussed later) the present value tables can
be used.
Calculation:
You will note small rounding errors when you use tabulated values as opposed to computer or
calculator accuracy.
• annuity due – each of the cash flows occur at the beginning of each period. A common
example is a lease payment, which is usually made at the beginning of each period.
In the previous example, $1,000 per period for five periods, paid at the end of each period,
yielded a present value of $4,212.40.
This is an ordinary annuity. However, assume the payments of $1,000 were at the beginning of
the period. What is the present value?
Solution
0 1 2 3 4 5
943.40 × 1/1.06
890.00 × 1/1.062
839.62 × 1/1.063
792.26 × 1/1.064
$4,465.28
Note that this is the same as calculating the present value for a four year annuity and adding one
payment at time zero.
Using the present value tables, the solution can be calculated as:
($1,000 × PV factor at 6%, t = 4) + 1,000
= (1,000 × 3.4651) + 1,000
= 4,465
Recall that leases normally must be paid at the beginning of the period. In the lease section of
financial reporting in this manual, converting an ordinary annuity to an annuity due is addressed.
Therefore, not only do candidates need to know this concept for finance, it is also necessary for
financial accounting, specifically, capital leases (calculating the present value of minimum lease
payments).
Perpetuities
A perpetuity is when the cash flow stream continues forever – into perpetuity. An annuity has a
limited life, while a perpetuity continues forever. Perpetuities are also known as consols.
where
C = periodic cash flow
r = periodic interest rate
A simple analogy can be made to calculating the value of an investment. Recall the formula for
calculating ROI is
income
ROI % =
investment
Assume you know the income and the ROI %. The investment can then easily be calculated as:
income
investment =
ROI %
The underlying concept is the same, except the present value is concerned with cash flows and
ROI is concerned with income, which may not be the same as cash flows due to the use of
accrual accounting.
Example:
An investment of $1,000 at 6% for one year would be worth $1,000 × (1 + .06) = $1,060 at the
end of one year. The $1,060 consists of the $1,000 principal plus $60 of interest. So, the future
value of $1,000 invested for one year at 6% is $1,060.
investment × (1 + r)
where:
r = interest rate
Example
An investment of $1,000 is made at 6% interest per year and both the interest and principal are
left to accumulate for two years.
What is the value of the investment at the end of the two years?
Interest Investment
6%
(investment × 6%)
Initial investment $1,000.00
Year 1 60.00 1,060.00
Year 2 63.60 1,123.60
If there were many periods, it would be an arduous task to calculate this manually; therefore, it
is important to remember the formula
investment × (1 + r)t
where
r = rate
t = time periods.
The expression (1 + r)t is known as the future value interest factor (FVIF).
Note: Candidates must remember the formula for future value – neither the formula nor future
value interest tables are included in the formula sheet provided on the Entrance Exam. For this
reason, future values are rarely examined on the Entrance Examination.
Principal $1,000
Interest
1,000 × 6% × 2 years 120
$1,120
Basic Data:
Solution
Note that the interest earned on the interest reinvested is $69.33, calculated as $469.33 - $400.
Example # 1
Basic Data:
How much will the total be at the end of the two years?
Solution
Time line:
0 1 year 2 years
× 1.08 108
Future value
208
× 1.08
$224.64
Amount invested each year for five years (deposited at the end of each year) $2,000
Annual interest rate 10%
Solution
0 1 2 3 4 5
× 1.10
2,200.00
× 1.102
2,420.00
× 1.103
2,662.00
× 1.104
2,928.20
$12,210.20
In this example, note that it is assumed the amounts are deposited at the end of the year. All
future value and present value questions assume end of period cash flows. Unless the question
specifically states or makes it clear the cash flows occur at the beginning of the period, assume
the cash flows occur at the end.
Note that most financial calculators are preset (default) to assume cash flows occur at the end of
the period. You need to reset to calculate present or future values for questions where the cash
flows are at the beginning of the period.
((1 + r)t - 1)
Annuity future value = C ×
r
where
C = cash flow
r = rate
t = number of periods
Example:
$2,000 per year is invested each year for 30 years at 8%. What is the future value of the
investment?
= 2,000 x ((1.08)30 - 1
.08
= 2,000 x 113.2832
= $226,566.40
1
PV = FV x
(1 + r)t
1
PV = FV x
(1 + r)t
1
1,250 = 1,350 x
(1 + r)1
= 1,350
1+r
1,250
= 1.08
r = .08 or 8%
1
PV = FV x
(1 + r)t
1
100 = 200 x
(1 + r)8
200
(1 + r)8 =
100
= 2
Candidates should have a financial calculator and learn how to use it.
Calculating t, or number of periods, is also determined by manipulating the basic present value
formula. Note that this is rarely examined on the Entrance Examination.
Example
Calculate how long it will take for the $30,000 to grow to $50,313.
1
PV = FV ×
(1 + r)t
1
30,000 = 50,313 ×
(1 + .09)t
(1.09)t = 50,313
30,000
= 1.6771
Since future value tables are not provided in the examination, it is only possible to solve using a
financial calculator.
In general, when problems like this arise, they are best solved using a spreadsheet. However,
the solution can also be found using a calculator as follows.
Example:
Although the stated rate is 10%, the effective rate in this case is 10.25%, calculated as follows:
10% compounded semi-annually means the investment pays 5% every six months. Assume $1 is
invested for one year at 10% compounded semi-annually. The interest earned is:
$1.00 × .05 = .05
$1.05 × .05 = .0525
Total interest earned .1025
The 10% is known as the stated rate and the 10.25% is known as the effective annual rate
(EAR).
Note that if the stated rate is per year and the compounding period is annually, the stated rate and
the effective rate are equal.
The easiest means of calculating the EAR is with a financial calculator. The formula is not
provided on the exam.
EAR = (1 + APR/12)12 - 1
= 1.0112 - 1
= 12.6825%
Note to candidates: On the examination please read carefully to determine if the question is
referring to EAR or APR.
Mortgage Considerations
Under the provisions of the Dominion Interest Act, revised statutes of Canada 1952, Chapter
102, Section 6, whenver any principal money or interest secured by a mortgage of real estate is,
by the same, made payable on the sinking fund plan or on any plan in which the payments of
interest and principal are blended, no interest whatsover shall be chargeable unless the mortgage
contains a statement showing the amounts of such principal and the rate of interest chargeable
thereon, calculated yearly or half yearly not in advance.
You have negotiated a mortgage in the amount of $400,000 with the stated nominal annual
interest of 6% and the mortgage document states interest will be calculated half yearly and not
in advance. You will make monthly blended payments of principal and interest and the
amortization period for the mortgage is 25 years.
Since interest cannot be computed in advance, but the lender requires monthly payments the
lender is require to, in effect, pay interest on the monthly payments made in advance of the
semi-annual compounding.
The effective semi-annual rate is 3% = 6%/2, so the monthly rate that yields 3% can be
computed as i in the following equation
(1 + i)6 -1 = 0.03. or i = (1.03)1/6 – 1 = 0.4939%. This percentage rate can be used in the normal
present value calcuations to find the loan amount needed to repay a $400,000 mortgage over 25
years (300 interest periods).
Example
Since the present value is $100 and the future value is $115.50, the rate of return is
15.50/100 = 15.50%. However, this 15.50% ignores the inflation rate of 5%.
If inflation is considered, the $115.50 received at the end of the year has a buying power that is
5% less in real terms. Therefore, the real dollar value of the investment is
115.50 = 110
1.05
This means that the real return is 10/100 = 10%.
The Fisher Effect provides the following formula that describes the relationship between nominal
rates, real rates and inflation:
1+R = (1 + r) × (1 + h)
where
R = nominal rate
r = real rate
h = inflation rate
The above formula for the nominal rate, R, can be broken into three components:
2. compensation for the decrease in buying power of the original investment amount (due to
inflation)
3. compensation for the decrease in buying power of the income earned on the investment
(due to inflation).
Example
Solution
a)
R = (r + h) + (r × h)
= (.10 + .08) + (.10 × .08)
= .18 + .008 = .188 = 18.8%
Cost of capital is defined as the rate of return that must be earned on a project or other economic
activity to maintain the market value of the company (or its common shares). The cost of capital
is important in making capital purchase and equity decisions, such as capital budgeting,
establishing the optimum capital structure, lease vs. buy and managing working capital.
The cost of capital for organizations is a weighted average of the costs of the various components
of the capital structure of the organization. These components usually include debt, preferred
shares and common equity. The costs of these components are based upon the required yields
(i.e. market rates) in the financial markets.
kb = k (1 – T) or ( 1 – T) I
F
k = interest rate
T = corporate tax rate
I = annual interest payment on debt
F = face value of debt
kp = Dp
NPp
a. The simplest and least relevant method looks at the historic yields on the common shares
over the recent past. These yields, while readily available, are not reliable because their
use would imply the recent past is likely to be repeated. Simply stated, the past in the
financial markets is not a reliable predictor of the future.
b. A second and more reliable method is the dividend growth method based upon the
Gordon valuation approach. The yield is equal to the expected dividend yield plus the
long-run expected growth rate. The dividend yield is equal to the expected dividend (the
same value as in the Gordon valuation model) divided by the current share price. The
growth rate is the same growth estimate as is used in the Gordon valuation model.
(The Gordon Growth Model formula is on the formula sheet provided in the Entrance
Examination.)
c. A third and also reliable method uses the CAPM. In this approach, the SML is used to
compute the required yield from financial market data and the beta of the common
shares. This model uses market driven data based on the systematic risk of the
organization. (The CAPM formula is on the formula sheet provided in the Entrance
Examination.)
Formula for Cost of Common Shares (Capitalization of Dividends with Constant Growth Rate or
Gordon’s Growth Model):
ke = D1 + g
NPe
The weights of each component of capital, debt, preferred shares and common shares is applied
to the cost of each to determine the WACC:
k = B kb + P kp + E ke
V V V
5.2.1.1 Sources of financing (e.g. public vs. private, debt vs. equity, etc.)
a) Describes the purpose and features (e.g. function, cash flow, risks,
investment characteristics and provisions, etc.) of various sources of
short- and long-term financing and financial instruments (e.g. bank
loans, money market instruments, working capital, venture capital, 9
common stock, preferred stock, notes, debentures, bonds, leases,
derivative securities such as warrants and options, convertible
securities, rights offerings, etc.)
b) Compares the features and relative merits of various sources of
financing and financial instruments available to a given organization 9 9
and calculates their effective costs and market values
c) Describes shareholder and creditor rights and determines the
9 9
return/yield of various types of financial instruments
d) Explains bond ratings, describes the various types of bonds and bond
9
provisions and explains related financial risk implications
e) Describes the various classes and features of stock and explains related
9
financial risk implications
f) Explains the types of financial risk exposure (e.g. transaction,
economic, interest rate, exchange rate, etc.) and explains the use of
9
various methods of hedging to manage financial risk (e.g. forwards,
futures, options, swaps, etc.)
Note that each of the CMA Competency Map requirements listed above have been extracted
from different subtopics in the financial management section of the CMA Competency Map,
specifically, the time value of money, valuing stocks and bonds and long-term financing. The
requirements with respect to bonds have been included in one area to facilitate efficient studying.
The elements of the CMA Competency Map included in this section have been bolded under the
“Skill Level” requirements listed above.
Coupon:
the stated interest rate on the bond and is used to calculate the interest paid to the bondholder
Example:
Assume one year has expired and the market rate for bonds has increased to 12%. What is the
value (price) of the bond?
Solution:
Present value of face value at market rate
$100,000 x PVIFn = 8 i = 6
$100,000 x .627 $62,700
present value factor: .627
Note that the PVIF is foreight periods, calculated as four years x two and
the interest rate is based on the new market rate of 12%, 12% x 6/12 = 6%
How much interest rate risk a bond has depends on how sensitive its price is to interest rate
changes. This sensitivity depends on two factors:
1. The longer the time to maturity, the greater the interest rate risk.
2. The lower the coupon (or stated) rate, the greater the interest rate risk.
Time to Maturity
The reason longer term bonds have greater interest rate sensitivity is because a large portion of
the bond’s value is due to the face value amount. If the bond is long-term, a small change in
interest rates can significantly impact the value (price of the bond) because the small change
impacts many periods.
Recall that the value of a bond depends on two factors, present value of the face amount and
present value of the interest stream. If two bonds have the same maturity date and face value, but
have different coupon amounts, the a larger proportion of the total value of the bond with the
lower coupon comes from the face amount.
Example:
Bond 1 Bond 2
Note that the value of the bond with the lower coupon rate is proportionately more dependent on
the face amount (the face amount comprises 72% of the bond’s value). As a result, when market
interest rates change, the value of the bond with the lower coupon will fluctuate more than the
bond with the higher coupon.
Example:
Market price of bond $954.88
Face value $1,000
Coupon rate 8%, paid annually
Term six years
To calculate the yield manually requires trial and error (a financial calculator provides an answer
quickly and easily).
The value of the bond consists of two components, present value of an amount (i.e. present value
of the face amount) and present value of an annuity (i.e. present value of the interest payment
stream).
1,000
OR 1,000 × PVIF = ?
(1 + r)6
80 × 1 - [1/(1 + r)6]
OR 80 × PVIF = ?
r
$954.88
PV of the interest:
80 × PVIF n = 6, i = 10
80 × 4.355 = 348.40
$912.40
PV of the interest:
80 × PVIF n = 6, i = 9 = 358.88
80 × 4.486
$954.88
Features of Bonds
All long-term debt, including bonds, are promises by the issuing company to pay the principal
when due and to make interest payments when requiredIn addition to these basic elements of
debt, there are other features as well.
Note that many of the features discussed here are not only applicable to bonds, but to debt in
general. To facilitate efficient studying, the terms of debt in general are included here.
Maturity
Short-term debt has a maturity of less than one year, intermediate term debt has a maturity of
between one to three or five years and long-term debt, theoretically, has a term of more than one
year, although long-term debt could be categorized into intermediate term and long-term.
The bonds can either be registered or be in bearer form. Registered bonds are bonds
whereby an external party, called the registrar, keeps a record of the ownership of each of
the bonds. Interest is paid to the registered owner. Bearer bonds are not registered and
holding the physical bond certificate is considered evidence of ownership. The holder of the
bond certificate detaches the interest coupons that are attached to the bond and mails them
to the corporation to receive payment of the interest.
2. Security
This refers to the security attached to debt.
Collateral means there is a pledge of some type of asset for the debt. If the debt is not
repaid, the debt holder can claim the asset. In bonds, collateral is sometimes a pledge of
common stock of the company.
Mortgage loans are secured by the property being mortgaged. If a mortgage is on specific
property, it is called a chattel mortgage. A blanket mortgage pledges all the real property
owned by the company as security.
Bonds are often unsecured. A debenture is unsecured debt, usually with a maturity of 10
years or more when issued. The term ‘note’ is generally used for debt instruments that are
unsecured and have a maturity of less than 10 years when originally issued.
3. Seniority
Seniority is the position debt holders have over other creditors. In the event of default by
the company, the seniority ranking determines the amount the debt holder will recoup.
Subordinated debt is debt that has a lower seniority ranking than other debt. In the event of
default, subordinated debt holders lose preference to specified creditors, which means the
subordinated debt holders will only be paid after the specified creditors have been paid.
A special mention of the seniority ranking of taxes owing is warranted. The ranking for
taxes owing depends on the type of tax that is owing.
This means these taxes owing would be first (among all creditors).
GST/HST/PST
Since these amounts are collected by companies on behalf of Her Majesty (government),
they are like a “trust” fund and are treated in the same light as a secured creditor in a
bankruptcy situation. For these taxes, if the corporation does not pay, the CRA can seek
amounts owing from the company directors.
This means these taxes would be below source deductions but likely above all other
creditors.
This means the amounts owing would be on the same level as all other unsecured creditors.
4. Repayment
Bonds can be repaid in full at maturity or in part or full before maturity. To ensure
sufficient funds to repay the bonds, many companies use sinking funds. A sinking fund is a
fund to which the corporation makes regular payments and the fund is used to repay the
bond when it comes due. Sinking funds, are usually managed by a bond trustee.
5. Call provisions
A call provision in the terms of the bond allows the company to repurchase (“call”) part or
all of the bond at a stated price over a specified period of time.
Generally, the call price is more than the bond’s stated value (face value). The difference
between the call price and the stated value is the call premium. The call premium may be
stated as a percentage of the bond’s face value and usually declines over time.
The call provision is usually not operative during the first part of a bond’s life; normally,
the call provision starts later. For example, a bond may have a provision where it cannot be
called for 10 years. This is known as a “deferred call”. During the period it cannot be
called, it is said to be call protected.
Positive covenants
i) working capital must be maintained at a specified level
ii) audited financial statement must be provided to the creditor
iii) assets pledged as collateral or security must be kept in good condition
Bond Ratings
Bonds are rated by two leading bond rating companies, the Canadian Bond Rating Service
(CBRS) and the Dominion Bond Rating Service (DBRS). In the US, the leading bond rating
company is Standard & Poors (S&P). These bond rating services rate the credit-worthiness of the
bond; in other words, the likelihood the bondholder will get paid. This is also known as default
risk.
Bond ratings only measure default risk and do not measure interest rate risk (discussed earlier).
This means a bond can be highly rated, which means the risk of default is low, but the bond’s
prices are volatile because of the interest rate risk associated with the bond.
AAA Bonds rated AAA are of the highest credit quality, with exceptionally strong protection
for the timely repayment of principal and interest.
AA Bonds rated AA are of superior credit quality and protection of interest and principal is
considered high.
A Bonds rated A are of satisfactory credit quality. Protection of interest and principal is
still substantial but the degree of strength is less than with AA-rated entities.
When long-term rates are higher than short-term rates, the term structure is upward sloping and
when short-term rates are higher, the term structure is downward sloping.
The question is “what determines the shape of the term structure?” There are three main
components that define the term structure:
1. Real rate of interest (may be phrased as required rate of return on the Entrance Exam)
This is the rate investors require for investing their money.
2. Inflation rate
Investors demand a premium to compensate for future changes in inflation. This is
known as the inflation premium. The inflation premium is the portion of a nominal
interest rate that represents compensation for expected future inflation.
Nominal
interest
rate
Interest rate
Interest risk premium
rate
Inflation
premium
Real rate
Time to maturity
Inflation
premium
Real rate
Time to maturity
6.5
6
Bond Yields (%)
5.5
4.5
0 5 10 15 20 25 30
Years to maturity
This is called the Canada yield curve or the yield curve. The shape of the curve is a result of the
same factors as the term structure of interest rates: real interest rates, inflation rates and interest
rate risk. So, it can be concluded the shape of the yield curve for Canadian government bonds is
influenced by several factors: zero default risk (because they are considered to be default free),
high liquidity, real interest rates, inflation rates and interest rate risks. The question for investors
is the shape of the yield curve for corporate bonds and whether it is similar to the Canada yield
curve. The answer is no, because the corporate yield curve is subject to two other influences,
default risk and the liquidity of the bond. A corporate bond is not default free, which means there
is a risk the bond issuer will not pay. Investors demand a premium for bearing this risk, which is
called the default risk premium. The default risk premium is defined as the portion of a nominal
interest rate or bond yield that represents compensation for bearing the risk of default.
Note that these three theories are not mutually exclusive. There is good reason to believe that
elements of all three are present in the financial markets.
5.2.1.1 Sources of financing (e.g. public vs. private, debt vs. equity, etc.)
a) Describes the purpose and features (e.g. function, cash flow, risks,
investment characteristics and provisions, etc.) of various sources of
short- and long-term financing and financial instruments (e.g. bank
loans, money market instruments, working capital, venture capital, 9
common stock, preferred stock, notes, debentures, bonds, leases,
derivative securities such as warrants and options, convertible
securities, rights offerings, etc.)
b) Compares the features and relative merits of various sources of
financing and financial instruments available to a given organization 9 9
and calculates their effective costs and market values
c) Describes shareholder and creditor rights and determines the
9 9
return/yield of various types of financial instruments
e) Describes the various classes and features of stock and explains related
9
financial risk implications
f) Explains the types of financial risk exposure (e.g. transaction,
economic, interest rate, exchange rate, etc.) and explains the use of
9
various methods of hedging to manage financial risk (e.g. forwards,
futures, options, swaps, etc.)
Note that each of the CMA competency requirements listed above have been extracted from
different subtopics in the financial management section of the Competency Map,. The
requirements with respect to common and preferred shares have been included in one area to
facilitate efficient studying. The CMA Competency Map requirements covered in this section
are in bold font.
Common Shares
1. Zero growth
The value of a zero growth common share is simple to calculate. Since common shares do
not have a maturity date, theoretically, the dividend stream extends to infinity. This is a
perpetuity. Recall that calculating a perpetuity is:
C
Value of Perpetuity =
r
Calculating the price (value) of a zero growth common share is identical, excepting
terminology. The value (price) of a zero growth share is:
Solution:
D
P0 =
r
where
P0 = price (or value) of the share
D = dividend (which is the cash flow)
r = the investor’s required return
Solution:
1.0
P0 = = $6.25 per share
.16
2. Constant growth
If a company’s dividends grow each year, the value (price) of the common shares is like a
growing perpetuity. Calculating the value (price) of a common share in this circumstance is
through the following formula:
D1
P0 =
r–g
where
P0 = price of the share today
D1 = dividends
r = required rate of return
g = growth rate
This is known as the dividend growth model or Gordon’s growth model and is easy to use.
Example:
Next year’s dividends (i.e. dividends at time D1) on a company’s shares are $2.50, the
required rate of return is 15% and the growth rate is 5%. What is the price of a share?
2.50
P0 = = $25
.15 - .05
This formula is not provided on the formula sheet provided on the exam. However, the
formula sheet does provide the formula for calculating the cost of common shares.
This formula can be easily manipulated into the price (value) formula. This being said, note
that the terminology for calculating the price (value) of a share from an investor’s perspective
is different than the terminology from the company’s perspective. An investor is concerned
with returns (r) while a company is concerned with cost (ke). These are the same thing, just
different words.
This is the formula to calculate the value (price) of common shares. You need to remember
that NPe means Price (P0) and that ke means required rate of return (r).
3. Non-constant growth
This refers to a situation where there is zero growth at the beginning, but dividends start at a
later date and once the dividends begin, there is constant growth.
In these circumstances, it is necessary to calculate the price of the bond on the date that
dividends begin and there is constant growth and then present value to the present.
Example:
A startup company will not pay dividends for the first four years. At that time, dividends will
be paid at the end of Year 4 in the amount of $1.20 per share. The required rate of return is
16%. Once dividends begin, the dividend is expected to grow 6% per year. What is the price
of the share?
D1 1.20
P0 = = = $12 per share
r–g .16 - .06
D1
r = + g
P0
where:
D1 = dividends at time 1
P0 = price of stock at time zero
g = growth rate
Note that this formula is identical the one provided on the formula sheet, except for terminology.
The formula sheet provides the formula from the company perspective, which refers to cost,
while the price (value) of shares refers to the required rate of return (r).
Common shareholders may also have what is known as preemptive rights. A preemptive right
means if the company is selling additional shares, the current shareholders have a right to buy
them before the common shares are offered to the public.
Dividends
Dividends are paid to shareholders and represent a return on the shareholders’ capital invested in
the company. For common shares, the Board of Directors determines the dividend payment.
Common share dividends are not mandatory, but are paid at the discretion of the Board of
Directors.
1. Dividends must be declared by the Board of Directors to become a liability. That is,
unless a dividend is declared, it is not a liability. This law prevents a corporation from
going bankrupt due to non-payment of dividends. This means no accounting entry is
recorded for dividends until they are declared.
2. Dividends are not tax deductible. They are paid out of after tax profits.
Classes of Shares
Some companies have more than one class of common shares. These different classes are created
with unequal voting rights. The main purpose of creating different classes is to avoid unwanted
changes in control or to retain control within a small group. For example, Canadian Tire has two
classes of common shares, both are publicly traded, but one class is voting and one is not. Of the
voting shares, the majority (> 50%) are owned by members of the family that founded the
company.
Since majority ownership, which is > 50% of the voting shares, is required to control a company,
the non-voting shareholders could find themselves at a loss in the event of a takeover bid. To
protect these non-voting shareholders, companies may institute ‘coattail’ provisions for these
shareholders, which allow the non-voting shareholders to vote or convert their shares into voting
shares in the event of a takeover bid.
Preferred Shares
This means the dividend stream is a perpetuity, which means the value (price) of preferred shares
is calculated in the same manner as perpetuity.
Solution:
Price (Value) = $1.00 = $40
.025
Stated Value
Preferred shares have a stated value. A cash dividend, which is a set amount, can be described as
an amount per share. For example, a set dividend of $2.25 on preferred shares with a stated value
of $25 actually represents a dividend yield of 9% ($2.25/$25).
If a dividend is cumulative, it means if dividends are not declared in one year, they are carried
forward in arrears. When dividends are declared, both the past dividends (dividends in arrears)
and the current dividends are paid.
Non-cumulative dividends are not carried forward, which means if dividends are not declared in
any given year, the shareholder will not receive them.
If there are dividends in arrears, the cumulative dividends must be paid before any common
share dividends can be paid.
Preferred share dividend rates tend to be low, which raises the question, why invest in preferred
shares? When corporations invest in the shares of other corporations, the dividends received are
not taxed. This is covered in the tax section in this manual. Since this income is non-taxable,
while bond interest is taxable, there is a lower dividend rate on the preferred shares so the return
is not substantially different than investing in other instruments, such as bonds.
Impact on net income of preferred share dividends vs. bond interest for the issuer:
Bonds Preferred Shares
Earnings before interest and taxes $100,000 $100,000
Interest (assumed amount) 10,000 N/A
90,000 100,000
Taxes at 40% 36,000 40,000
54,000 60,000
Dividends (assumed amount) N/A 10,000
Net increase in equity $54,000 $50,000
Debt
Advantages Disadvantages
• interest is tax deductible • interest must be paid regardless of net
income/cash flows
• interest paid does not bear any relationship • debt may have restrictive covenants
to a company’s net earnings; therefore,
there is less focus on income ‘smoothing’
• control is not diluted by issuing debt • principal must be repaid at maturity (if
financed through share issuance, no
repayment required)
• if inflation rate is high, debt is repaid in • decreases future borrowing capacity
cheaper dollars
Equity
Advantages Disadvantages
• no repayment required • dividends are not tax deductible
• dividends are not required, excepting • dilutes control of a corporation (if voting
preferred shares that have a stated dividend rights attached to shares issued)
amount
• improves debt-to-equity ratio • as more shares are issued the market value
per share decreases
• usually more expensive to issue shares than
debt (underwriting costs, legal and
accounting fees etc.)
CCA: capital cost allowance; represents the amount of depreciation for tax purposes that can be
deducted in a year
UCC: undepreciated capital cost; represents the balance remaining after yearly CCA is deducted
for tax deductible investments
Capital cost classes: classes of assets, each of which has a prescribed CCA rate
Recapture: represents recovery of previously deducted CCA; is the amount the selling price
(“proceeds of disposal”) exceeds UCC up to the original cost:
Capital gain
Original cost
Recapture of
previously
deducted CCA
UCC
Terminal loss: represents loss due to selling price being lower than UCC – in effect, CCA was
insufficient:
Original cost
UCC
Terminal loss reduces tax liability; therefore, is an inflow. It is important to remember that
terminal losses are tax deductible only when there are no more physical assets in the class. If
there are assets remaining, then the terminal loss is not deductible and there is not an inflow.
Capital loss: arises only on non-depreciable assets, as depreciable assets are subject to the
terminal loss provisions
Salvage value: (also known as disposal value or terminal value) is the expected cash proceeds
when investment is sold, often at the end of its useful life. Salvage has two
impacts:
1. cash inflow at disposal (present value of an amount)
2. reduces the present value of the CCA tax shield
Recurring:
• incremental yearly revenue
• yearly cost savings
Cash flows may also be deferred annuities, where the first payment or receipt does not take place
until more than one period has expired. Calculation of the present value of these cash flows is
illustrated as:
Time line:
$$ $$ $$ $$ $$ $$
$$$
Calculate the
present value using
the present value of
an annuity
$$$
Calculate the
present value
using the present
value of an
amount
On the other, hand taxable cash receipts of $20,000 have an after tax value of $12,000 ($20,000
– ($20,000 X 0.4) because the company must pay tax on the $20,000.
PV of CCA = Cdt x (2 + k)
tax shield d+k 2 (1 + k)
= Cdt x (1 + .5k)
d+k (1 + k)
Where:
C = capital cost
d = CCA rate
t = tax rate
k = cost of capital or discount rate
This formula is provided on the Entrance Examination so it does not need to be memorized.
If the asset will be disposed of prior to its useful life, there will be lost CCA tax shield on the
disposal proceeds. This must be incorporated into the CCA tax shield formula:
Where:
S = salvage value
n = time period
Note that the second part of the formula is subtracting the present value of the lost tax shield on
salvage.
PV of CCA = UCC x dt
tax shield d+k
Where:
UCC = undepreciated capital cost of asset
Candidates often have difficulty understanding why it would be necessary to calculate the CCA
for an ‘asset that is not newly acquired”. Suppose a company is deciding on whether to buy a
new machine and dispose of the old machine. When the old machine is disposed of, there will
not be any future CCA tax shield on the old machine. Therefore, when deciding whether to
purchase the new machine, management of the company needs to take into consideration the
CCA tax shield on the old machine that will be foregone if the new machine is purchased. In
these instances, the formula, PV of the CCA tax shield on an asst that is not newly acquired,
would be used
Limitations:
• long-term cash flow forecasting may be difficult to obtain
• assumes cash flows occur at the end of the period
• there could be goal incongruency if management is evaluated on a different basis than
the potential investment. For example, if management is evaluated on ROI,
management may not undertake an investment because it decreases their ROI;
however, the investment may have a positive NPV, which indicates the investment
should be undertaken since it would benefit the company. To avoid this, management
should not be evaluated solely on ROI in the short-term.
Comprehensive Example
Initial cost $100,000
Life of project 6 years
Annual cash inflows $12,500
Residual (salvage) value $11,000
CCA rate 30%
Discount rate, pre-tax 20%
Working capital required $18,000
(starting at Year 1, released at end of project)
Additional cash inputs required for maintenance (tax deductible):
At end of Year 3 $2,000
At end of Year 4 $1,500
Tax rate 40%
Cash Flows:
A B AxB
Post-Tax Post-Tax Present Outflow
Pre-tax Amount Discount Rate Value Present or
Year Amount (Note 2) (Note 1) Factor Value Inflow
Non-recurring:
1 $100,000 $100,000 12% 1 $100,000.00 O
3 2,000 1,200 12% .712 854.40 O
4 1,500 900 12% .636 572.40 O
1 18,000 18,000 12% 1 18,000.00 O
6 18,000 18,000 12% .507 9,126.00 I
6 11,000 11,000 12% .507 5,577.00 I
Net outflow $104,723.80 O
Recurring:
1-6 12,500 7,500 12% 4.111 $30,832.50 I
Tax Shield:
Cdt x (1 + 0.5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= 27,040.816 – 1,592.2688
= 25,448.55 (rounded)
Note that candidates may get slightly different answers due to rounding and differences in the
number of decimal places set in your calculator. In this regard, storing intermediate calculations
in your calculator will reduce the size of rounding errors since calculators use the amounts stored
internally, which usually have more significant digits than the amounts displayed.
Calculating IRR
If annual cash flows are constant, it is relatively easy to compute the IRR.
Example:
Investment = $3,433
Annual cash flows at end of each year for five years = $1,000
3433
Present value interest factor =
1000
= 3.433
Looking up 3.433 on a present value of annuity table (n=5) shows this investment earns
14%. If the calculated present value interest factor lies between two values on the table, a
percentage return can be determined using interpolation.
If annual cash flows are not constant, the IRR is calculated by trial-and-error to find the rate of
return that equates the present value of cash outflows to the present value of cash inflows. Many
financial calculators can compute the internal rate of return.
Merits of IRR
• considers the time value of money
Limitations of IRR
• difficult to calculate
• if cash flows cycle between positive and negative, there may be multiple values of IRR
• ignores varying sizes of investments in competing projects
• the IRR is in percentages, not in absolute dollars
• cannot combine the IRR's of different projects to derive an IRR on the combination of
projects
Example:
Potential Investments
A B A÷B
Investment Annual Cash Payback
Flow
Machine A $150,000 $50,000 3.0 years
Machine B $100,000 $40,000 2.5 years
As can be seen, Machine A is the better investment, ignoring the time value of money
and considering total cash flows.
To address the risk associated with investments, companies can set guidelines for the payback
period. A high-risk project must meet a shorter payback period to be accepted and vice versa for
low risk projects.
Profitability Index
The profitability index is equal to the sum of the present value of the future cash flows divided
by the initial investment. If the PI > 1, then the project is accepted. The PI is used in situations
where we have capital rationing, i.e. we have more positive NPV projects than we have funds to
invest in. We use the profitability index to rank the projects and accept the ones with the highest
PIs until you run out of funding.
Capital Rationing
When there are several investment opportunities and limited funds, companies must select which
mix of projects to accept. This is called capital rationing.
Using the ranking, along with qualitative factors, a decision about which projects to accept can
be made.
Example:
A B B÷A
Present
Value of
Initial Net Cash Profitability
Projects Investment Inflows Index
A $500,000 $750,000 1.5
B 900,000 1,260,000 1.4
C 800,000 1,160,000 1.45
D 815,000 1,304,000 1.6
E 525,000 630,000 1.2
F 125,000 147,500 1.18
Assume projects A and B are mutually exclusive and available funds are limited to $2,640,000.
The projects are ranked using the profitability index and present values are compared.
Combination 1 including Project A Combination 2 including Project B
Project Investment Profitability PV of cash Project Investment Profitability PV of cash
Required Index inflows Required Index inflows
D $815,000 1.6 $1,304,000 D $815,000 1.6 $1,304,000
A 500,000 1.5 750,000 A excluded – A + B are mutually exclusive
C 800,000 1.45 1,160,000 C 800,000 1.45 1,160,000
B excluded – A + B are mutually exclusive B 900,000 1.40 1,260,000
E 525,000 1.2 630,000 E excluded – insufficient funds
F excluded – insufficient funds F 125,000 1.18 147,000
Note that although the profitability index for Project A is higher than Project B, ultimately
Project B is accepted because the combination of projects allowed by selecting B provides a
higher overall net present value.
Note to candidates: An extensive example has not been provided as the decision to buy vs. lease
is merely application of the capital budgeting process described in the previous section.
Disadvantages of leasing:
• often has a higher interest cost than bank debt
• may have a buyout clause requiring the lessee to buy the property at the end of the lease
(there is a risk the buyout amount may be greater than FV)
• in the long-term, often has a higher cost than buying the property
• if a building or land lease, may need lessor’s permission to make improvements
• if capital improvements are made, their benefit is lost if the lease is not renewed
• if lease is too long, lessee may experience obsolescence
Example: The Roberts Company has the option of buying some computer equipment with a
three-year life for $72,000 or leasing it at a payment of $27,000 per year over three years. If the
cost of borrowing is 10%, the tax rate is 40%,and the CCA rate for the asset is 30%. Should the
company lease or purchase? Assume obsolescence in three years in any case.
In a lease vs. buy situation, the ‘buy’ and ‘lease’ cash flows are always discounted at the
after-tax incremental borrowing rate of the organization. In this case, 10%(1-.4) = 6%.
The net advantage to leasing is positive, therefore, we should lease the asset.
Definitions
Merger or statutory amalgamation: combination of two or more companies into one
Acquisition of assets: only the assets of the corporation are acquired; debt may or
may not be assumed by the purchaser
The purchase of another organization has a set of rules that must be followed. In cases where a
certain percentage of the shares of an organization have been obtained, then the acquirer must
declare the intention to acquire and make a formal offer to all shareholders. The organization
being acquired has the right to refuse the offer and take certain actions to defend itself. The
financial markets often call these methods “poison pills”. Some acquisitions are quite friendly as
the two organizations agree in advance on the terms and conditions of the merger. Some are
unfriendly, where two organizations engage in a legal skirmish, sometimes even a full-scale legal
war, which can be acrimonious and expensive.
The impact of taxes on acquisitions depends on the financing methods used. Some acquisitions
are tax-free, while others are taxable. Acquirers need to look at the financing of the merger and
its probable tax impacts. Cash acquisitions, in particular, have significant tax implications.
Generally, the intention in acquisitions is to enhance shareholder value. Whether that is the
result or not depends a great deal on what is done after the acquisition. The primary benefits
should be operating synergies so the sum of the parts is greater than the parts individually. Thus,
earnings or profits should increase in a more than proportionate manner.
VA+B > VA + VB
This inequality will hold only if the operating cash flows of the two companies, when combined,
exceed the sum of their operating cash flows as separate companies. In other words, the merger
must bring about synergies that lead to an increase in revenue or a reduction in cost. Otherwise,
there is no economic rationale for merging.
Synergies can be generated in a number of ways. Among the more important ones are the
following.
4. To gain market power: Mergers can also consolidate market power and limit competition.
Buying a competitor is a way to do this; however, such activities may run afoul of
antitrust laws. A more subtle form of market power is possible when an
organizationengages in horizontal integration by acquiring organizations in the same
broad line of business. By increasing its market share, a company's bargaining power
with its suppliers and customers can be strengthened.
What causes the synergies or enhancements of shareholder value in acquisitions? How can
organizations be sure to achieve them? What is needed is a close look at where these synergies
can be found. Usually, they come from revenue increases, cost reductions, tax savings or lower
costs of capital. But, in addition to recognizing these potential gains, the organization must be
sure to achieve them. Achieving synergies is often not easily done.
Business valuation is a critical part of acquisitions and IPOs. What creates value? Generally the
process of valuation involves a critical look at a number of factors:
a. risk
b. growth potential
c. accuracy and reliability of past financial information
d. maintaining the benefits of the past, including customers and suppliers
e. differing perspectives of seller and buyer.
The calculations of value can be done in several different ways, while incorporating the above
factors.
a. Asset valuation methods, including net book value and net realizable value, incorporate
the valuation of the assets and liabilities. Where book values are not reliable, then the
net realizable value is used. Note that the best method for asset and liability valuation
would be market values, but these are often not available. Thus, book values become the
starting point for valuation, while realizable value is an adjustment to book values to
allow for less or more on realization in a sale. After all, what something is worth is what
someone else is willing to pay for it.
b. Earnings methods, such as the earnings multiple approach, use the expected earnings in
the next period or an average of the next several fiscal years combined with some
earnings multiple like the Price/Earnings ratio (P/E). The P/E is based upon similar
companies in the marketplace and is used as a multiplier to estimate the value. In some
of the mergers and valuations seen recently, the P/E ratio is assumed to be 50 or even 100
c. Cash flow methods, such as net present value (NPV), are typically similar to the capital
budgeting methods used in finance. Cash flows for the foreseeable future are estimated
and then a net present value is calculated for these cash flows. To simplify the approach,
sometimes an above normal growth rate is assumed forfive or 10 years and then a static
cash flow or a cash flow with a stable growth rate is assumed thereafter.
The cash flow method used most often in business valuations is the present value of free
cash flows. Free cash flows are defined as:
Earnings before taxes and interest (1 – t)
Add depreciation
Less capital spending and investments in working capital
The projected free cash flows of the organization are then discounted at the
organization’s WACC to obtain a measure of its value. As in any capital budgeting
exercise, the terminal value in the past year should reflect the present value of cash flows
beyond the initial evaluation period. Because we are interested in the target's value to the
acquiring organization, the cash flow estimates must incorporate the consequences of any
changes the acquirer expects to make to the target's current method of operation.
The annual cash flows calculated in this way ignore financing flows such as interest on
debt, debt repayment and preferred stock dividends. These free cash flows represent the
cash flows that would be available to compensate all sources of capital used to finance
the acquisition. Discounting these free cash flows at the "appropriate" weighted average
cost of capital yields the value of the assets.
The procedure outlined above establishes the maximum amount that should be paid for
the assets of the target. Subtracting from the target's estimated value those liabilities not
included in the forecast of working capital needs gives us the value of the target's equity.
Dividing this equity value by the number of the target's common shares outstanding gives
us an estimate of the maximum price per share that could be offered.
Note that business valuation is not an exact science and these methods can and, often do, lead to
different answers. It is up to the valuator to determine which method is more reliable and what
value or range of values is appropriate. In theory, the best approach is to adjust the cash flow or
income figures and then use a reliable estimate for the interest rate or P/E ratio. However, this is
easier said than done.
Sole Proprietorship
A sole proprietorship is a simple business structure where one individual controls the business
personally, without the benefit of a separate legal structure. From a legal standpoint, the business
is completely identified with the proprietor. The vast majority of operating businesses are sole
proprietorships, especially those in retail trade, agriculture and services. Most sole
proprietorships are quite small and account for a relatively low proportion of total monetary
transactions in Canada. But millions of sole proprietorships in existence testify to the advantages
offered by this form of business organization. Foremost among these advantages, especially for
new businesses, is simplicity. Other forms of business organization require elaborate forms and
fees and are governed by detailed legal strictures. Although a sole proprietorship may require
some form of provincial or municipal operating license, little else is required and the owner may
save considerable cost and paperwork.
Sole proprietorships also have other advantages. With few legal requirements, this type of
organization offers the owner a unique degree of control and flexibility. Any income generated
by the sole proprietorship has to be taken into income by the individual in the year incurred. For
tax purposes, sole proprietorship year-ends are December 31 to coincide with the taxation year of
the individual.
Counterbalancing these advantages are a number of potentially serious disadvantages. The most
significant of these is unlimited liability. Because the sole proprietor is, in effect, the business,
they are liable for all debts and other liabilities incurred by the business and risk losing even
non-business personal property. If, for example, the company defaults on a loan, the sole
A second problem for sole proprietors is the difficulty of obtaining financing. Because the ability
to borrow capital for expansion is limited by the proprietor's personal creditworthiness, profitable
expansion may have to be forgone. Sole proprietors may also have difficulty borrowing when the
business has financial problems. Another disadvantage of sole proprietorship is lack of
continuity. When the proprietor dies, so does the business, to the possible detriment of
employees and heirs.
Partnership
A partnership is defined as an association of two or more persons conducting a business.
Traditionally, all members of the partnership share equally in managing the enterprise and the
profits.
Partnerships offer a number of unique advantages. Unlike sole proprietors, partners have an
easier time obtaining financing because they may pool their resources to obtain credit; the ability
to borrow is backed up by their combined personal creditworthiness. Like sole proprietorships,
the partnership structure allows considerable management flexibility, though this depends upon
the expertise of individual partners.
Compared with corporations, partnerships experience less government control and generally
need not file any papers or formally adopt a specific organizational structure. Nevertheless, most
partnerships are based on a written agreement among the partners that spells out their relative
duties and rights. These agreements can be quite complex.
However, the partnership structure retains most of the disadvantages of the sole proprietorship.
Overall partnership liability is unlimited and includes all the personal assets of the partners. This
situation is ameliorated somewhat, though, by risk-sharing among the partners. In addition, a
different form of partnership, known as a limited partnership, can limit liability. A partnership
may include limited partners who invest money but do not participate in management. These
partners risk only the amount they invest in the organization. The law places specific restrictions
on this limited partnership structure, however, and all such partnerships must include at least one
general partner who is subject to full personal liability.
Other disadvantages parallel those of sole proprietorships. The death or retirement of a partner
automatically dissolves the organization, severely limiting continuity. However, partnership
agreements and partnership insurance (including a Buy-and-Sell Agreement) can significantly
reduce problems arising from the demise of one partner. Typical partnership interests cannot be
transferred without the unanimous consent of other partners, which also limits owner flexibility
and the ability to obtain new sources of capital.
Establishing a corporation is considerably more complex than setting up other forms of business
organization. A remarkable number of legal requirements cover corporate ownership; there are
filing requirements, taxes, fees and rules governing structure and ownership. Large corporations
usually also have a complex internal structure.
Although the shareholders theoretically own the corporation, individual shareholders generally
have little influence on management. Some major corporations have thousands or even millions
of shareholders. Shareholders are represented by a Board of Directors that exercise ultimate
responsibility in many matters.
The corporate structure offers a number of substantial advantages to the entrepreneur. Paramount
among these advantages is limited liability; because the corporation is recognized as an
independent legal entity, liability generally extends only to corporate resources and not to the
personal assets of the owners. A significant exception exists, however, where the owners have
undercapitalized the corporation; in this case, creditors may "pierce the corporate veil" and insist
on personal guarantees from the entrepreneur before extending the loan.
A second important advantage of corporations is their ability to raise additional money for
business expansion. A corporation may borrow money from conventional sources, depending on
its creditworthiness. It may also raise money through equity financing. In this process, the
company issues securities, known as shares of stock, for sale to the public. Purchasers become
part-owners of the corporation, with shares proportionate to their investment.
Corporations also allow relative ease and flexibility in the transference of ownership interest and
can continue to exist even after the death or departure of the original owners.
The corporate structure is not without its disadvantages, however. The complicated process of
forming a corporation may represent a considerable disadvantage, especially to a small or new
business. Ongoing compliance costs may also be considerable because certain corporate
activities, such as the issuance of new securities, are governed by a large and complex body of
regulatory law. In large corporations, the complex corporate structure also results in relative
inflexibility for management and lack of control for owners. Finally, corporations face a different
tax situation, one that, for example, requires more regular tax payments than is the case for sole
proprietors.
Income Trust
An income trust is a corporate form that holds income-producing assets. Its shares are traded
much like stocks. Income is passed on to the unit holders (investors) through regular periodic
distributions. The main advantage of an income trust is the distribution of income to investors.
Choosing a Structure
There are no hard and fast rules regarding the best form of organization for a given enterprise.
Each structure has its own unique advantages and disadvantages, all of which must be considered
in setting up a business. But size is often an important consideration. For new businesses,
especially relatively small ones, the sole proprietorship is probably preferable, so long as no
major liability is contemplated. As the enterprise grows, its owners should consider changing to a
partnership or to a corporation, since these forms of business are better suited to the new
financial needs and risks of the operation. In general, the choice of an appropriate form of
business organization would certainly be influenced by: a) expected business size/profitability;
b) tax considerations; c) potential legal liability; and d) expected need for capital and the
potential sources of capital.
Direct Investment
A direct investment is defined as an investment that is sufficiently large to affect a company's
subsequent decisions. This is sometimes a majority ownership, but sometimes it is just a
significant minority ownership. Usually this direct investment is facilitated through share
ownership.
Reasons for direct investment vary, from controlling a supplier, to capital appreciation of the
underlying shares. Owning shares, either as a majority owner or significant minority, subjects
the owner to the financial health of the company (i.e. the investee company). This means if the
company has poor financial results, dividends will be reduced or not paid at all and capital
appreciation of the shares will not occur. In the worst case scenario, common shares could
become worthless.
Outsourcing
Outsourcing is the purchase of a good or service from an external supplier. Outsourcing is an
effective and often necessary approach as few organizations can afford to develop internally all
the skills and technologies needed to get and keep a competitive advantage. Attempting to build
competencies in all areas can cause an organizationto become overextended and thus decrease
their competitiveness. When an organizationoutsources activities in which it lacks competence,
it frees up time and resources, which can be focused on those areas where it is capable of
building strong competencies leading to a competitive advantage. Companies can investigate
how effectively they are performing their internal activities by examining their profit pools
and/or conducting activity based costing and/or doing a cost benefit analyses. The results should
be compared to the cost of outsourcing the less strategically relevant activities remembering that
There are some things that must be considered carefully when outsourcing. The first
consideration is an organizationshould never outsource anything that is currently a source of
competitive advantage for them. For example, companies should exercise extreme caution when
they outsource activities that can result in a potential decrease in an organization’sability to
innovate. The second consideration is managers need to be capable of creating and managing
partnerships in a strategic manner so that the internal management can fully benefit from the
work done by their partners. Management must have the ability to oversee and govern the
partnership arrangement as well as help the organization adapt to changes that inevitably occur
when an organization’s structure and operations change.
Strategic Alliances
This type of structure entails cooperation between competitors. An alliance represents a
collaborative agreement between competitors whereby each competitor contributes a distinctive
item, such as technology, distribution ability, basic research or manufacturing capacity.
A risk with strategic alliances is too much information or transfers of skills and/or technology
may occur (i.e. more than intended in the initial agreement). This can result in loss of future
earnings, as one party may take advantage of the knowledge learned in the alliance.
Financial Markets
This is a forum whereby suppliers of funds (e.g. savers) and users (e.g. borrowers) of funds are
brought together. Suppliers provide cash to users and earn a return either through interest or
appreciation in value.
The interrelationship between the financial markets, the company and the debt holders or
shareholders can be depicted as:
The term ‘financial markets’ is broad. There are various markets that comprise the financial
markets. These are primary and secondary markets, money and capital markets and intermediary
markets. These are described below.
Secondary market: This is for previously issued securities (shares or debt). The value this market
places on securities is the perceived worth (i.e. fair value) of the company. An example of a
secondary market is the Toronto Stock Exchange.
Capital markets: This is the long-term market in which long-term debt and shares are traded.
Debt instruments in this market earn higher returns than those in money markets, but have
greater default risk. This market provides security valuations that are useful for assessing the
worth of a company.
International financial markets: This market handles international financial transactions between
Canada and other countries. These markets determine foreign exchange rates.
Derivatives markets: The derivatives securities markets have not added additional sources of
capital to the marketplace, but rather they added new risk management tools to the financial
markets, making old sources of capital less risky. Derivative securities are intended to provide
the opportunity for financial market participants to trade risk, based upon contractual
arrangements that place limits on potential losses. Options (puts and calls), futures contracts,
forward contracts and swaps all provide benefits to financial market participants, depending on
the terms and conditions of the contracts. In addition, there are more exotic derivatives that
combine the characteristics of various other derivatives to create even more specialized tools for
risk management.
An efficient market benefits the economy because in an efficient market the true worth of the
company is known at all times.
There are three types of market efficiency: weak form efficiency, semi-strong form efficiency
and strong form efficiency:
• Weak form efficiency
− All historical information is reflected in the price
− Technical analysis and fundamental (ratio) analysis will not lead to superior returns
− Most markets are at least this efficient
The efficient market theory indicates markets should be trusted since most prices represent a
consensus of the fair market value.
There is significant empirical evidence to support the idea that markets are weak-form efficient
and no useful information can be gleaned from examining past changes in stock price. Further, a
number of academic studies – known as event studies because they examine the stock market's
reaction to specific events – show the market reacts quickly to announcements of earnings or
dividend changes or unexpected mergers. In other cases, the event announcement may have a
negligible effect on the price of a stock because the market already anticipated the news from
other sources. The market's reaction to changes in an organization’sfinancing and dividend
decisions will depend, in large measure, on whether the news is truly new and how the market
interprets the data.
The idea that the market is strong-form efficient has not been warmly welcomed by investment
professionals. Why? If market prices reflect all information, both public and private, then efforts
to find inside information in order to beat the market would be a waste of time; after all, this
information is already imbedded in security prices. Proponents of strong-form market efficiency
would, therefore, contend that no one can beat the market on a consistent basis over time. Money
managers, of course, make a good living by convincing investors they can beat the market
through superior security selection.
rm = rf + risk premium
risk premium = r m - rf
Measuring Risk
Measuring risk is useful when comparing investment opportunities. Common measures used are
variance, standard deviation and the coefficient of variation (derived from variances).
The expected return on an investment is the sum of various levels of estimated return, multiplied
by the probability of each level of return. This concept is identical to the concepts covered in
Expected Values (see Management Accounting notes). In essence, the expected value is the
arithmetic mean or average of all possible outcomes.
Example:
The following estimates of annual returns from owning shares in Remmit Inc. are based on
historical returns:
Rate of Probability of
Return Occurrence
0% 10%
7.75% 20%
18% 25%
25% 35%
32% 10%
100%
expected return = (0% × .10) + (7.75% × .20) + (18% × .25) + (25% × .35) + (32% × .10)
= 18%
2
expected value of actual return - expected return
In the above calculations, the variance represents the sum of the squared deviations (between
actual and expected return) multiplied by the probability of their occurrence.
Example:
Using the data presented previously, Remmit Inc.’s variance and standard deviation are
calculated as follows:
A B A–B (A – B)2
Probability x
Actual rate of Expected rate Squared squared
return of return Deviation deviation Probability deviation
0% 18% -18% 324 .10 32.4%
7.75% 18% -10.25% 105 .20 21%
18% 18% 0 0 .25 0%
25% 18% 7% 49 .35 17.15%
32% 18% 14% 196 .10 19.6%
1.00
Variance = 90.15%
Standard deviation = 90.15 = 9.49%
Example:
An alternative investment, Noah Inc., has an expected return of 18%, but has a standard
deviation of 7.20%.
Recap:
Expected Return Standard Deviation
Remmit Inc. 18% 9.49%
Noah Inc. 18% 7.20%
Although both companies have the same expected return, Remmit is riskier, since it has a higher
standard deviation. This means the variability in returns (between expected and actual) is greater
in Remmit than Noah.
Portfolios
Portfolios refer to owning a group of investments as opposed to an individual security. The
expected return of a portfolio is calculated as the sum of the expected returns for each individual
security in the portfolio multiplied by its weight (usually determined by the amount of money
invested in each security).
Example:
Amount Expected
invested Weight return1
= 5% + 5.4% + 5%
= 15.4%
The numerical value indicates the strength of the correlation. If the correlation coefficient is near
zero, the linear relationship is not strong. If it is near +1 or –1, the linear relationship is strong.
The degree of correlation between investments is important because this determines the degree to
which diversification reduces the overall risk of the portfolio. For example, imagine two
perfectly positively correlated investments (i.e. correlation factor is +1). Owning these two
investments will not have any diversification effect because the investments move in the same
direction. Therefore, if one investment’s return drops by 10%, the second investment will do the
same, resulting in a net overall drop of 10%. On the other hand, if the two investments are
perfectly negatively correlated, they travel in opposite directions. If one of the investments drops
10%, the other investment increases 10%. The net overall result is zero percent drop.
Calculating the covariance of pairs of securities within a portfolio incorporates the correlation
between the two securities and the standard deviation of each security. Recall that the standard
deviation is derived from the variance. The formula is:
The standard deviation of the portfolio is calculated as follows. The securities in the portfolio are
securities A and B.
standard = Variance ( A + B )
deviation
= (WA2 × std devA2) + (WB2 × std devB2) + 2 WAWB × correlation × std dev × std dev
b/w A & B of A of B
Where
Note that the formula incorporates the covariance of the securities, which in turn incorporates the
correlation coefficient of the securities.
Portfolio Theory
Portfolio theory refers to the practice of assessing the risk of an individual investment in the
context of its contribution to the overall risk of a portfolio (e.g. group) of investments, rather
than assessing the investments individually based on the individual investments’ possible
deviations from expected returns. In other words, securities are evaluated relative to their impact
on overall portfolio risk, not on their individual risk characteristics.
Diversification reduces risk because of the correlation and covariance effect discussed earlier.
Studies of common shares listed on the Toronto Stock Exchange (TSX) (note that the TSX
restructured and became the TSX Venture Exchange in 2002, but is still known as the Toronto
Stock Exchange) have shown the standard deviation (a measure of risk) of a portfolio decreases
as the number of securities in the portfolio increases. Significant decreases in the standard
deviation of a portfolio were seen when the number of different securities was increased to 10.
Once past 10 securities, further decreases in the portfolio’s standard deviation were seen, but
they were small.
Unsystematic risk is diversifiable because in a portfolio the effects of unsystematic risk on one
security offsets the unsystematic risk on another security, thereby reducing the overall risk effect.
Market risk is the risk arising from general economy-wide conditions. Generally, securities have
a tendency to move together in response to general market conditions. Regardless of the number
of securities held in a portfolio, a recession has a negative impact on all securities in the
portfolio. Conversely, a booming economy has a positive impact on all securities in the portfolio.
Market risk is non-diversifiable, as it arises from overall market conditions.
1 5 10 15
Number of securities
Systematic risk of an investment is measured by the investment’s beta coefficient. The beta is a
measure of an investment’s sensitivity to market movement. It is calculated as:
investment return
market return
Return on security A
16%
return on
market
__ 10% +
__
Where:
Two securities, Security A and B, have the following standard deviations and betas.
Security A Security B
Since Security A has a higher standard deviation, it has higher total risk, although it has less
systematic risk (beta is lower than Security B).
Since total risk is the combination of systematic and unsystematic risk combined, Security A has
greater unsystematic risk. The standard deviation is higher than Security B and since the standard
deviation is a measure of total risk, A’s total risk is higher than B’s. However, A’s beta, which is
a measure of systematic risk, is lower than B’s beta, which means A has less systematic risk than
B.
Recall that since unsystematic risk can be eliminated through diversification, investors are
rewarded (i.e. earn a risk premium) only for assuming systematic (market) risk. Since B has a
higher beta, it has higher systematic risk. This means B has a higher risk premium and a greater
expected return, despite the fact it has less total risk.
Example:
Portfolio consists of two assets, Security A and a risk-free asset. The returns and betas are:
Weights
Percentage Percentage Portfolio Portfolio
of of risk-free Expected Beta
Security A asset Return
0% 100% 8% 0.0
25% 75% 11% 0.4
50% 50% 14% 0.8
75% 25% 17% 1.2
100% 0% 20% 1.6
Risk-free rate 8%
E(RA) - Rf
slope =
ȕA
Where:
E(RA) = expected return
Rf = risk-free rate
ȕA = beta of A
(.20 - .08)
slope =
1.6
= 7.5%
This 7.5% is the risk premium of Security A. This means, for every unit of systematic risk,
Security A has a risk premium of 7.5%. This is also stated as Security A has a reward-to-risk
ratio of 7.5%.
Assume an investor invests in Security A, with a risk-to-return ratio of 7.5% (calculated above)
or Security B. Assume Security B has an expected return of 16% and a beta of 1.2%. If the
investor’s portfolio consists of a risk-free asset that has a rate of 8% and Security B, the
portfolio’s return and beta at different weights for each of the assets is:
Weights
Percentage Percentage Portfolio Portfolio
of of risk-free expected beta
Security B asset return
0% 100% 8% 0.0
25% 75% 10% 0.3
50% 50% 12% 0.6
75% 25% 14% 0.9
100% 0% 16% 1.2
E(RB) - Rf = 6.67%
E(RB) = 16% ȕB
Rf = 8%
= (.16 - .08)
1.2
= 6.67%
A B
Risk-to-reward ratio 7.50% 6.67%
= 6.67%
E(RB) = 16%
Rf = 8%
Since, in equilbrium, all securities must have the same risk-to-reward ratio, if a security’s risk-to-
reward ratio falls above the line or below the line, there will be sufficient buying or selling of the
security such that the risk-to-reward eventually falls on the line.
There are two securities, Avone and Besel, with the following beta’s and expected returns:
Expected
Beta Return
Solution:
Calculation of risk-to-reward ratio:
Avone Besel
The risk-to-reward ratios indicate Besel is overpriced because the risk-to-reward ratio of Besel is
less than Avone.
This could also be stated as Avone is underpriced because its risk-to-reward ratio is higher than
Besel’s.
In an active and properly functioning market, buying and selling activity on each security would
be such that their risk-to-reward ratio would eventually equalize.
Since the beta of the market is 1 (i.e. the combined betas of all the securities trading on a market
must add up to one), this formula can be shortened to:
Expected - Risk-free
market return rate
rm
Risk
Expected return
premium
rf
Any security in the market must plot on the SML (if it doesn’t, buying and selling will occur
until it does). This means any particular security’s risk premium is the market’s risk premium.
This can be stated as:
Rj -Rf = Rm - Rf
ȕj
This formula, Rj = Rf + ȕj (Rm - Rf) is the CAPM formula (note that this formula is provided on
the formula sheet provided at the exam).
Note that the CAPM formula states the expected return of any security is a function of the risk-
free rate plus the risk premium and the risk premium impact will always vary in direct proportion
to the security’s beta.
A security has a beta of 1.3, the risk-free rate is 4%, the market risk premium is 8.6%. What is
the expected return of the security using CAPM?
Solution:
Rj = Rf + ȕj (Rm - Rf)
= 4% + 1.3(8.6) = 4% + 11.18% = 15.18%
If the beta doubled to 2.6, what would the expected return be?
Rj = Rf + ȕj (Rm - Rf)
= 4% + 2.6(8.6) = 4% + 22.36% = 26.36%
5.2.1.1 Sources of financing (e.g. public vs. private, debt vs. equity, etc.)
a) Describes the purpose and features (e.g. function, cash flow, risks,
investment characteristics and provisions, etc.) of various sources of
short- and long-term financing and financial instruments (e.g. bank
loans, money market instruments, working capital, venture capital, 9
common stock, preferred stock, notes, debentures, bonds, leases,
derivative securities such as warrants and options, convertible
securities, rights offerings, etc.)
Note to candidates: The CMA Competency Map requirements related to short-term financing
have been combined in one location to facilitate efficient studying.
Liquid assets can be readily converted into cash with a high degree of certainty about the
resulting price. With a high degree of liquidity comes a cost in terms of the yield that can be
achieved. There is a trade-off between liquidity and yields (return) – lliquidity has a cost in
terms of lower yields.
The rate of return on current assets is usually less than the return on fixed assets. Therefore,
when liquidity is improved (i.e. there are more current assets than fixed assets) the total return
earned decreases (liquidity ↑, return ↓).
Cash Management
Lower yields on liquid assets are one of the reasons why the management of cash and other
liquid assets is important. Cash provides the lowest yield of all liquid assets and should be
maintained only at levels needed to support ongoing activities. The question, of course, is what
are the cash needs of an organization? The primary needs are transaction and precautionary
needs; the former is used to meet day to day needs, while the latter is kept as a risk reduction tool
to avoid any unpleasant surprises. Modelling cash management needs is a complicated
mathematical process and, for organizations with large amounts of cash flows, a detailed model
is often advisable. For smaller organizations, however, the complexity of the process can be
considerably reduced. With good banking relationships and common sense, cash management
can be relatively easy.
Cash management refers to managing cash such that the amount of cash held is optimal. A
corporation should know its cash needs, sources of cash, amount available and the amount that
can be spent.
To determine the amount of cash to have on hand, management needs to take into consideration:
• liquidity position
• date of debt maturity
• ability to borrow
• expected cash flows
• risk preferences
• availability of a line of credit
There is a cost of holding accounts receivable, as the cash amount is not available for use in
income producing activities. To reduce accounts receivable, a company can introduce various
policies.
• credit policy
- perform credit checks on new customers
- monitor customers’ financial position and decrease credit limits accordingly
- establish early payment terms or charge interest on late payments
- sell by cash on delivery to extremely high-risk customers
• billing policy
- bill customers immediately after sale
- invoice at the date the order is placed, not the shipping date
• collection policy
- monitor the aging of accounts receivables
- use collection agencies if necessary
- have credit insurance for unusual bad debt losses
Inventory Management
Inventories are the least liquid of current assets. The speed with which they can be turned into
cash depends on the nature of the inventory and the nature of the business in which the
organization operates. Inventory must be managed to ensure inventory levels are kept to a
minimum. There is a trade-off between inventory carrying costs and the benefits of holding
inventory. High inventory levels result in high carrying costs and insufficient inventory levels
result in potential lost sales due to stock outs and production slowdowns.
Accounts Payable
Accounts payable (A/P) or trade credit are liabilities of the organization owed to others. These
accounts occur in the normal course of business and are often called spontaneous financing.
Generally, accounts payable are a prime source of funds for organizations because they allow
delays in payments for goods and services received. Often creditors will encourage the
organization to pay its accounts by offering trade discounts. These discounts can have a
significant cost based on the opportunity cost of not taking them. A standard example is 2/10,
net 30, where a cash discount of 2% is offered if payment is made in 10 days, while full payment
is required in 30 days.
Accounts payable should be managed so payments are made at the last possible moment,
resulting in improved cash flows. Common accounts payable management practices:
• stretch A/P (pay at last possible moment)
• make payments in instalments
• monitor liquidity ratios, such as current asset to current liability ratio or acid test
• coordinate payment of payables with timing of cash receipts
• take advantage of trade discounts
Trade Discounts
When trade discounts (e.g. 2/10, net 30) are offered, not taking them results in a significant cost.
There is an opportunity cost of not taking advantage of the discount.
There are two different methods of calculating the opportunity cost of not taking the trade
discount. Which one to use is dependent on whether you are asked to calculate the effective
annual rate (EAR) or the annual percentage rate (APR). (Note to candidates – on the
examination please read the question carefully to determine whether it is asking for the EAR or
the APR. If the question does not indicate which to use, assume it requires you to calculate the
EAR.)
Where:
Discount = discount offered
DD = due date
EPD = early payment date
Note to candidates: Most financial calculators calculate the APR and the EAR, so rather then
memorizing this formula, consider using a financial calculator on the exam.
Example:
Invoice = $100
terms = 2/10, n/30
discount
EAR = 1+ 1 - discount
- 1
365
1 + - 1
30 - 10
EAR = .02
(1 - .02)
.02 365
= x
(1 - .02) (30 – 10)
= .020408 x 18.25
= 37.24%
Note that either the FV or PV must be entered with a minus sign. If it is not, an “error 5”
message will appear.
Short-Term Financing
Other forms of short-term financing also exist, as well as trade credit, but these require specific
arrangements with creditors such as banks or other financing organizations. Banks provide what
are called lines of credit or revolving credit to organizations to allow them to manage their
working capital. Usually the collateral for such loans will be accounts receivable, inventories or
both. Other types of short-term financing can be obtained from money markets in the form of
commercial paper. These are short-term loans provided by lenders for terms of 90 to 360 days,
usually without specific collateral. Sometimes, however, organizations can provide collateral in
the form of accounts receivable.
Bank Loans
Short-term bank loans are repayable within one year or less and may be secured or unsecured.
Types:
• Overdraft
í An agreement with a bank to allow an account balance to become negative.
í Usually overdraft protection is limited.
í Interest charged on overdrafts is usually higher than interest on bank loans.
• Lines of credit
í An arrangement whereby the amount a customer can borrow is limited.
í The amount granted depends on the credit worthiness of the borrower.
• Revolving loan agreements
í In a revolving loan arrangement, the borrower can borrow at any time to a specified
limit.
í Usually these agreements extend beyond one year and can be regarded as
intermediate term financing.
• Transaction loans
í Represents borrowing for one specific purpose (e.g. a contractor borrowing to
construct a condominium).
í When the project is complete, the borrower repays the loan.
í These loans are made on a case by case basis and a borrower’s cash flow ability is
heavily scrutinized.
Types of Instruments
• Commercial paper
í Represents a short-term negotiable promissory note
í Normally sold in multiples of $100,000
í May be sold at a discount or on an interest bearing basis
í Usually is less expensive than borrowing from a bank
• Bankers acceptances
í Often used to finance inventory sold but in transit
í Sold in multiples of $100,000 with terms of 30 to 180 days
í Often used by Canadian importers to finance imported inventory
The cost of borrowing should be calculated using the effective annual rate (EAR). The general
formula for the EAR in the context of loans can be stated as:
365
Days outstanding
interest
EAR = 1+ Net amount of financing
- 1
Calculating the EAR of the loan is dependent on whether the total amount of the loan is received
by the borrower or the amount received is reduced by the interest. A loan may have terms
whereby the borrower does not receive the total amount of the loan, but the loan amount minus
the interest. This impacts the EAR.
Example:
Compare the before tax cost of a borrowing $50,000 for 60 days at 8%, assuming that: 1. interest
is added to the total amount owing; and 2. interest is deducted from the 50,000, so the borrower
receives less than $50,000.
Solution:
1. EAR with the borrower receiving $50,000.
Amount of interest paid = 50,000 x 8% x 60/365 = 657.53
365
60
657.53
EAR = 1+ 50,000
- 1
= 8.272%
657.53
EAR = 1+ 49,342.47
- 1
= 8.386%
First, it is necessary to calculate the interest paid on the loan and then calculate the EAR using
the formula above. The interest paid should be calculated using weighted average and then
calculate EAR using the interest paid amount.
Example
Calculate the cost of a variable rate loan at prime + 2% for 150 days. The prime rates are 6.25%
for the first 50 days, 7% for the next 72 days and 6.75% for the next 28 days.
Solution:
Calculation of interest paid:
Prime Prime + 2% Days Dollars
outstanding interest
6.25% 8.25% 50 $565.07
7.00% 9.00% 72 887.67
6.75% 8.75% 28 335.62
150 $1,788.36
Calculation of EAR:
365
150
1,788.36
EAR = 1+ 50,000
- 1
= 8.928%
Leases can be evaluated by using standard net present value (NPV) techniques. Usually the cost
of funds assumed is higher than a standard loan, but the risks of obsolescence are avoided if this
is a concern. In addition, since the organization that leases is often not able to afford to
purchase, the lease provides a slightly higher priced form of financing.
Venture Capital
Venture capital is money invested in companies that do not have access to conventional sources
of financing, such as bank loans or money markets. The funds may be lent at initial startup or
expansion. Venture capital is high risk because these companies are in startup or growth stages
and do not have a sufficient credit history to borrow from traditional sources. In Canada, venture
capital is frequently provided by the government, although there are private venture capital
companies. Due to the high risk of these companies, venture capitalists require a high rate of
return on money invested. Venture capitalists may require control of the investee or,
alternatively, include covenants in the debt agreement. Although a venture capitalist may have
control over the Board of Directors, venture capitalists normally do not participate in the direct
management of the company.
This topic has the same underlying principles as cash budgeting and budgeting, which is covered
in the budgeting section in the ‘Performance Management” section of this manual. Candidates
are advised to refer to that section. Please keep in mind this topic could be examined in either
the Performance Management or the Financial Management section of the examination, since it
is listed in both areas of the CMA Competency Map.
The critical issue in the long-term success of any organization is its ability to plan its financial
needs with a significant degree of reliability. Both long-term and short-term financial needs
require careful planning. In addition, the uses of these funds will dictate to some degree the
sources that are most suitable.
In addition to cash planning, the organization will try to plan its overall financial position by
developing pro forma financial statements. These are based on anticipated sales, cash flows,
expenses and profits. Cash planning is just one part of the financial planning process involved in
preparing pro forma financial statements.
Note that the financial statements organizations prepare today require a statement of changes in
financial position based upon sources and uses of cash. The planning of these sources and uses is
of considerable importance to avoid unpleasant surprises at the end of the fiscal year.
Pro forma financial statements are typically prepared under the assumption the company
undertook various large scale projects or proposals. Preparing these statements allows the
company to see the impact the project has on the entire financial statements.
Note to candidates: methods of hedging is covered in the Financial Reporting Section of this
manual and will not be repeated here.
If the exchange rate is treated as the price that clears the market for a given currency, then we
must ask what determines the supply and demand of the currency. The traditional approach to
determining exchange rate, an approach which uses the supply-and-demand framework, views
the exchange rate as the price that brings about equilibrium between the demand for and supply
of domestic currency in exchange for foreign currency. These "demands and supplies" reflect, in
turn, international transactions in goods, services and financial assets.
If Germany does not want all the dollars, it can sell them to another country that has an excess
demand for dollars. Such an excess demand will occur if that country imports more from Canada
than it exports; therefore, the dollars are needed to make up the difference. Germany will sell its
excess dollars at whatever price the market will bear. The world price for dollars will be
determined by the net world demand for dollars compared with the net world supply of dollars. If
Canada is faced with a trade deficit with all countries, then all countries will eventually find they
are holding more dollars than they want at the going exchange rate. For example, Germany may
try to sell its dollars to Britain, only to find Britain also has more dollars than it wants. The only
way Germany can get rid of its excess supply of dollars is to sell them at a discount. Instead of
trading them to Britain at the going rate of, say, $1.50 per pound, it must sell them at, say
$1.60/pound. In such a case, the dollar has depreciated relative to the British pound.
The exchange rate for the dollar will depreciate until supply and demand are equal. If Canada
continues to finance its trade with dollars, rather than with exports of goods and services, then it
will continue to increase the supply of dollars abroad and the dollar will continue to depreciate.
Operating Leverage
Operating leverage (“DOL” – Degree of Operating Leverage) represents the amount of fixed
operating costs included in the income statement. It is directly related to the business risks,
although it is not a measure of business risk. The degree of operating leverage measures the
sensitivity of a organization’s operating income (i.e. EBIT) to a change in sales. In other words,
it is is a measure of volatility of earnings before interest and taxes (operating income) relative to
a change in sales.
A DOL of 3.0 means that a 1% increase in sales would lead to a 3% increase in earnings before
interest and taxes.
Formula:
% change in EBIT
% change in sales
OR
x (SP – VC)
x (SP – VC) – FC
OR
DOL = Contribution Margin / Earnings before Interest and Taxes (operating income)
A company with high fixed costs has a high degree of operating leverage. High fixed costs
indicate high risk because these costs cannot be reduced in the event of a short run decline in
sales. The limitation of operating leverage is it uses accounting income and not cash flows.
Using cash flows rather than accounting income is a truer measure of operating risk.
Financial Leverage
Financial leverage is the proportion of a company’s assets that are financed with debt rather than
equity. It is directly related to financial risk and is sometimes considered a measure of financial
risk.
The degree of financial leverage (DFL) is the measure of volatility of net income relative to a
change in operating income.
A DFL of 1.5 means a 3% increase in earnings before interest and taxes would lead to a 3% x 1.5
= 4.5% increase in net income and net income before taxes.
Formula:
% change in EPS
% change in EBIT
OR
EBIT
EBIT – interest
Financial leverage is also measured by various financial ratios, such as debt-to-equity or times-
interest-earned.
The higher a company’s financial leverage, the higher the financial risk, therefore, the higher the
cost of capital.
Formula:
% change in EPS
% change in sales
OR
OR
x (SP – VC)
x (SP – VC) – FC – I
Where:
x = sales in units
SP = selling price
VC = variable cost
FC = fixed cost
I = interest
5.2.4 Describes policies that affect the capital structure and cost of capital for a
given organization (i.e. policies regarding capital financing, debt and equity
requirement and dividends)
c) Dividend policy
• Explains the concept of dividend policy 9
• Describes the factors considered in the development of a
dividend policy (e.g. legal rules, cash position, contractual
constraints, growth constraints, tax position of shareholders,
9
potential dilution of ownership, market considerations, access
to capital markets, corporate control, international factors,
etc.)
• Describes the procedures involved in dividend payments 9
• Describes the impact of cash dividends, stock splits and stock
dividends on capital structure and the position of the 9
shareholders
• Explains the reasons for low dividend payout, high dividend
9
payout and repurchase of shares
Note to candidates: The CMA Competency Map requirements related to dividend distributions
have been combined in one location to facilitate efficient studying.
• Availability of cash
The amount of cash available restricts the amount of dividends that can be paid.
• Investor expectations
Investors buy stock for two reasons – dividends and capital appreciation. Investors purchasing
a company for the dividend income stream expect a certain dividend payout amount.
• Internal requirements
A company may need financing and rather than borrowing externally, choose to finance
internally. Using retained earnings is the least costly source of financing.
Stock Splits
A share is split into two or more shares. For example, in a two for one stock split, 100 shares
become 200 shares. Stock splits often take place to reduce the market price of shares to make
them more attractive to investors. There is no impact on control because an investor's
proportionate share of holdings remains the same as before the split.
Stock Dividends
New shares are issued to shareholders as a dividend in lieu of cash. There is no impact on control
as each shareholder retains the same proportionate interest in the company.
Recall that the weighted average cost of capital (WACC) is a weight of all of the various types of
capital a company employs. Minimizing the WACC maximizes the value of the organization
since this lowers the cost of carrying the various sources of capital. The optimal capital structure
is the one that results in the lowest possible WACC.
When determining an optimal capital structure, it is important to consider the impact leverage
has on the payoffs to shareholders. Financial leverage, which is dependent on the amount of debt
a company has, can significantly impact the payoffs to shareholders, although it may or may not
affect the overall cost of capital. The impact of leverage on shareholders can be seen by
considering the impact of leverage on EPS (earnings per share) and ROE (return on equity).
Scenario A Scenario B
Debt $0 $4,000,000
Equity 8,000,000 4,000,000
$8,000,000 $8,000,000
EPS
$1,000,000 ÷ 8,000,000 $2.50
$600,000 ÷ 4,000,000 $3
The above table shows the proportion of debt-to-equity can greatly impact the payoff to
shareholders as measured by EPS and ROE.
EPS
With debt (i.e. with
(in $) financial leverage)
Advantage to debt
2 Indifference point
Disadvantage to debt
-2
Assume: Assume:
Debt = 60% Debt = 40%
Equity = 40% Equity = 60%
Therefore, the total value of an organization(total assets) does not have any relationship to the
debt vs. equity ratio. The formula for M&M’s proposition I is:
Vu = EBIT/REu = VL = EL+ DL
Where:
Vu = value of the unlevered organization
VL = value of the levered organization
EBIT = perpetual operating income
REu = equity required return for the unlevered organization
EL = market value of equity
DL = market value of debt
Note to candidates: Calculation questions with respect to M&M are not common, however,
theory questions have appeared on the examination.
k = B kb + E ke
V V
The WACC is also used as a measure of the required rate of return on the organization’s overall
assets, however, the formula changes slightly as:
RA = B kb + E ke
V V
where:
ke = cost of equity
kb = cost of debt
RA = required rate of return
B = amount of debt outstanding
E = amount of common equity outstanding
This rearranged formula is M&M’s Proposition II, which states the cost of equity depends on
three things:
• required rate of return on the company’s assets (RA)
• the cost of debt (kb)
• the company’s debt-to-equity ratio, B/E
ke
Cost
of
Capital
(%)
Slope = RA – kb
WACC = RA
kb
Note that at the y
intercept the
company has zero
debt & therefore
WACC = ke Debt-to-equity ratio
This graph shows as debt increases (i.e. leverage increases, which results in the debt-to-equity
ratio increasing), the increase results in an increase in the cost of equity. This is because in a
highly levered organization, the investors required rate of return increases because of the
increased risk associated with the higher debt (the company must be able to ensure sufficient
earnings to pay the debt). Note that in the graph, WACC is not impacted by the deb- to-equity
ratio – WACC is the same regardless of the D:E ratio. This is another way of stating M&M’s
Proposition I, which is the overall cost of capital is not impacted by its capital structure. As
shown, the fact that the cost of debt is lower than the cost of equity is exactly offset by the
increase in the cost of equity borrowing. The change in capital structure weights (E/V and B/V)
is exactly offset by the change in cost of equity (ke), so the WACC stays the same.
Example:
There are two companies, Company A and Company B who have identical assets and operations.
Company A has no debt (i.e. is unlevered) and Company B has $1,000 of perpetual bonds on
which it pays 8% per year. The tax rate is 30%. The impact of the debt is :
Company A Company B
(no debt; (with debt;
unlevered) levered)
Therefore, the total cash flow to Company B, which is levered, is $24 more. This is because
Company B’s taxes, which are a cash outflow, are $24 less than Company A. This tax savings
($24 in this example) is known as the interest tax shield. Since the bond is perpetual, this $24
per year would be generated each year, forever and, therefore, Company B is worth more than
Company A by the value of this perpetuity. The total value of the tax shield can be calculated as:
OR
1
= yearly cash flow
Required rate of return
= $24
.08
= $300
The value of the interest tax shield can also be calculated as:
= .30 x 1,000
= $300
The fact that company B is levered (i.e. has debt) results in it being worth more than Company
A. This is M&M’s Proposition I with taxes, which states the value of a levered organization
exceeds that of an unlevered organization by the value of the present value of the interest tax
shield. Stated algebraically, this means:
VL = VU + (tax rate x debt)
where
VL = value of levered organization
VU = value of unlevered organization
Continuing the previous example, assume that Company A, the unlevered company, has a cost of
equity capital of 10%. The value of company A is calculated as follows:
(1 – tax rate)
VU = EBIT x
unlevered cost of capital
(1 – .30)
VU = 1,000 x
.10
VU = $7,000
where
VL = value of levered company
VU = value of unlevered company
The relationship between the levered company and the unlevered company can be depicted
graphically:
Vu = 7,000
1,000
Total debt
As can be seen, the value of the organization increases as total debt increases because of the
interest tax shield. This is the basis of M&M Proposition I with taxes. Note that in this case, for
each $1 increase in debt the value of the organization goes up $.30.
k = B kb + E ke
V V
where:
ke = cost of equity
kb = cost of debt
B = amount of debt outstanding
E = amount of common equity outstanding
V=B+E
K= B kb x (1 – tax rate) + E ke
V V
Ke = ȡ + (ȡ – kb) x B/E
where:
ȡ = cost of capital for an unlevered company (e.g. cost of equity for the unlevered company)
In the previous example, for Company B, the levered company, the cost of equity is calculated
as:
B Kb x (1-tax rate) + E
k = k
V V e
1000 6300
k = .08 x (1-.30) + .1022
7300 7300
= 9.6%
Therefore, without debt, the WACC is 10.22% and with debt the WACC is 9.6%.
The relationship between debt and taxes and their impact on the value of an organizationis:
Cost of Capital
ke = 10.22%
(cost of equity
for unlevered org.)
ȡ = 10%, cost
ȡ = 10% of capital for
WACC = 9.6% WACC unlevered org.
cost of debt
100%
100% debt equity
financing financing
The static theory of capital structure states that a company should borrow up to the point the tax
benefit from an extra dollar in debt is exactly equal to the cost of financial distress. This is called
the static theory because it assumes the organization’s assets and operations are fixed (i.e.
operating leverage is fixed) and it only considers possible changes in the D:WE ratio. The static
theory is, in essence, M&M with corporate taxes, plus the impact of financial distress and can be
depicted as:
Vu Vu
optimal
amount of debt Total Debt
Note that this graph is identical to the M&M graph with corporate taxes, except the impact of
financial distress costs have been added. There are several observations from this graph:
− Vu, the value of an unlevered organization, is M&M’s Proposition I without taxes,
which states the value of the organization is unaffected by capital structure. Since
this proposition ignores taxes, the present value of the interest tax shield is ignored
and, therefore, there is no advantage to debt.
− Vu, the value of the levered organization, is M&M Proposition I, with taxes (the only
difference between Vu and VL is the present value of the interest tax shield)
− The maximum value of the organization is the point at which the benefit (due to
lowered taxes since interest is deductible) from an extra dollar is debt is equal to the
cost of financial distress; the optimal amount of debt is at this point.
2. Treasury management has been added to the traditional roles of the financial manager.
Which of the following best describes the functions of treasury management?
a. Development of strategies for capital formation
b. Planning tax strategies and ensuring compliance in all jurisdictions
c. Analysis and interpretation of economic events and their impact on capital
formation
d. Cash and funds management activities
e. All of the above
3. The Chief Financial Officer (CFO) of the organization has a number of duties to fulfil
within the organization. Which of the following is not one of those duties?
a. Financial forecasting and planning
b. Investment and financing decisions for the organization
c. Decisions about suppliers and trade credit terms
d. Interaction with capital suppliers and capital markets
e. Coordination with other, non-financial parts of the organization
4. The financial management goal of the organization is defined as which of the following?
a. Maximization of profits
b. Maximization of corporate wealth
c. Maximization of shareholder wealth
d. b. or c. depending on where you live in the world
e. None of the above
6. Often there are stakeholders other than shareholders and managers that have an impact on
organizations. For example, political, social and environmental rules can have an impact
on the organization. How should financial managers react to these rules?
a. Financial managers should do the minimum to meet the requirements of the rules.
b. It is incumbent on financial managers to follow not only the letter of the law but
the spirit as well. Therefore, financial managers should go beyond the rules to be
“good corporate citizens”.
c. All investments in projects to meet these rules should be considered and evaluated
just like any other project requiring capital. Only if the NPV is positive should
the project be undertaken.
d. The first consideration should be shareholder wealth and all such decisions should
be considered in the light of this concept.
e. Either a. or b. is possible.
3. An organization has earnings of $5 per share and 1,000,000 shares outstanding. When all
earnings are paid out as dividends and shareholders require a 15% yield on their
investment, what is the value of a share?
a. $30
b. $33.33
c. $36
d. $45
e. $50
4. Assuming the same data as in question 3, if investments are available in the next period
requiring that no dividends be paid, at what point are shareholders indifferent as to
whether they receive dividends or not? Assume dividends will be resumed as before in
subsequent years.
a. The investments must yield at least the WACC.
b. The investments must have long-term growth potential.
c. The NPV of the investments must be positive at 10%.
d. The investments must yield an IRR of 15%.
e. None of the above is true.
Required:
How much must you deposit in the bank at 10% on January 1, 0, in order to achieve your goal?
2. An organization has decided to estimate its cost of equity capital from the dividend
growth model. The following data is known:
Expected dividend = $3.30
Anticipated growth rate = 6%
Required yield on the market portfolio = 12%
Risk free rate = 5.5%
Organizational beta = 1.6
Stock price as of today = $30
Rm 13%
Risk-free rate 6%
Tax rate 34%
2. The following information is known about the Teall Corporation. It had a dividend last
year of $2.25 per share. Its expected return, based on investor requirements, is 12%. The
long run growth rate is expected to be 7%. The expected market return is 10%. What
should the approximate value of its share price be in the marketplace?
a. $45
b. $32.14
c. $48.20
d. $80.33
e. $120.50
a. If you expect a rate of return of 12% on this stock, what would you expect to pay for a
share of the Renfroe Company stock today?
b. Calculate the income return and capital gain return on the stock for the first two years.
Required:
Rockyford plans to finance the new machinery partially through debt by taking out a loan of
$30,000 requiring annual payments of $8,117.11. The following is the loan amortization
schedule:
The new machinery would belong to a special class for purposes of calculating capital cost
allowance. This special class allows the fast write-off of equipment over two years on the
straight-line basis and is subject to the half rate rule, i.e. the machinery would be depreciated
25% in the first year, 50% in the second and 25% in the third.
Required:
A piece of equipment being considered would provide annual cash savings of $7,000 before
income taxes. The equipment would cost $18,000 and would be depreciated on the straight-line
basis for both book and tax purposes. It would have no salvage value at the end of five years.
The company is subject to a 40% tax rate and has a 14% weighted average cost of capital.
Required:
In 0, SWA operated 10 divisions with combined sales of just under $1 billion. Each of the 10
divisions is regarded as an investment centre. Managers of each division are responsible for
achieving a target divisional return on assets (ROA) of 30%. Divisional ROA is calculated by
dividing divisional income (i.e. income before interest, taxes, bonuses and head office
administration) by divisional assets (i.e. working capital plus net fixed assets). Divisions that
meet or exceed the target ROA are awarded a bonus. The bonus is calculated as 2% of divisional
assets for meeting the target, plus an additional 1% for each five percentage points of divisional
ROA in excess of the 30% target (e.g. 2% for ROA of 30% to 34%, 3% for ROA of 35% to 39%,
4% for ROA of 40% to 45%, etc.). Divisional managers are responsible for distributing the
bonus. Most divisional managers distribute the bonus to all divisional employees based on their
salary or wage levels.
Although divisions usually achieved the target ROA, the overall corporate profit had steadily
declined over the past few years to the point the corporate after-tax ROA for 0 was only 8%.
In early January 1, the president of SWA called a meeting of his executive committee to discuss
short and long-term corporate strategy.
President: Corporate ROA has decreased for three years in a row. When we set up the divisional
target a few years ago, I thought the overall corporate ROA would be at least 12%, as long as the
average divisional ROA exceeded 30%. Why has the corporate ROA decreased when the
average divisional ROA has been greater than 30% in each of the past three years?
Controller: My preliminary investigation reveals that some of the older divisions are achieving
ROA's of over 40% and overall interest expenses and total bonuses increased significantly during
the past three years. We should consider charging the divisions for interest and bonuses. We
cannot afford to continue paying large bonuses when overall profitability is declining.
VP Marketing: Our market share has been declining steadily. Sales have increased an average of
5% per year over the past five years, while the total appliance market expanded at a rate of about
10% per year. Divisional managers report that product quality and pricing are competitive, but
production throughput is too slow to satisfy some of their major customers, despite having plenty
of available capacity. Some large accounts have been lost because our divisions could not deliver
orders within 10 days of the order being placed.
Controller: I also looked at the possibility of automating all of the divisions' manufacturing
processes. It would cost about $30,000,000, which we'd have to raise externally and now is not
President: Well, something has to be done. We previously tried to replace old equipment with
new equipment without changing the labour-intensive operations despite the protests of
divisional managers, but we only accomplished manufacturing cost savings for a short period
and overall profit growth did not improve. I think it's time to call in a consultant to evaluate our
situation. We'll meet again next week to review the consultant's report.
Immediately after the meeting, the president contracted Lee Roberts, a management consultant,
to review SWA's situation and to provide recommendations to improve overall company
profitability. The president requested the following:
1. A calculation of the incremental bonus for the refrigerator division for each of the next three
years assuming it automates its operations and the bonus system remains unchanged (i.e.
difference in bonus using current equipment vs. using automated equipment).
2. A net present value analysis of replacing the refrigerator division's current equipment with
fully automated, computer controlled equipment.
As a first step, Lee obtained from the controller projected divisional asset data for the refrigerator
division for the next three years (see Exhibit 2).
As Lee Roberts, prepare a report to the president of S.W. Appliances Ltd. Your report should
include all the information requested by SWA's president as well as any other information or
recommendations you feel may be necessary for the future health of the company.
Exhibit 1
Feasibility Study for Automating the Refrigerator Division
Benefits of Automating
1. The average production time for a single refrigerator (i.e. throughput time) would be reduced
from 14 days to three days resulting in a $2,000,000 reduction in average inventory levels.
2. Quality and cost control would be improved resulting in a reduction of variable costs from
79% of sales to 62% of sales.
3. Complete production scheduling flexibility would result in faster delivery to
customers.
4. Better quality control and customer service would result in the expected sales growth
increasing from 8% per year to 20% per year for the next three years.
5. By automating now, the refrigerator division would be the first in its industry to do so, giving
it a competitive advantage.
Costs of Automating
1. Fixed production overhead costs (other than depreciation) would increase to $15,000,000 per
year.
2. Severance pay of $3,300,000 would have to be paid in 1, but would be amortized over three
years.
3. Capital costs and related information would be:
New equipment - capital cost $50,000,000
- disposal value at end ofthree3 years $20,000,000
Current equipment - disposal value now $3,000,000
- disposal value three years from now NIL
Capital cost allowance rate for current and new equipment 20%
Corporate effective income tax rate 40%
Current Automated
System System
Current System
1 2 3
Automated System
1 2 3
Per
unit
Material $5.60
Direct labour 4.48
Factory overheads:
Variable 1.68
Allocated fixed 1.12
Equipment depreciation .42
Selling, delivery and administration .56
The selling, delivery and administration costs are specific to the units (i.e. are directly related to
the units) and are variable.
The equipment used to produce the units is old and will have to be replaced within the next few
years. Its book value is $364,000, although it could be sold on the open market for $42,000.
A major retailer that is not a regular customer has approached TI and made a special offer to buy
920,000 units per year for at least four years. These units would be identical to the regular line,
except the packaging would bear the retailers logo and trademark. The retail chain proposes a
price of $14 per unit.
Since TI does not have the capacity to produce the additional units (the proposed special order of
920,000 units) for the large chain store, TI would have to buy new equipment to have the
capacity to accept the special order. TI is considering replacing the old equipment with new
equipment, which will triple the capacity of the old equipment. The additional capacity would
provide sufficient capacity for both the special order and for regular production.
Required:
Perform the necessary calculations to determine whether TI should accept the special order of
920,000 additional units per year.
The machine can be built by the company without affecting current production and revenue
producing activity. The machine is estimated to have a useful life of five years and will not have
any salvage value at the end of the five years.
$510,000
The special features related to this new machine means the company could accept new contracts
it would not have been able to accept with the old machine.
This machine requires only one operator and output per hour increases 25% from the current
output. Maintenance costs are also reduced significantly. However, the special features will
require extensive training for the operators. The operators will need to spend 26 weeks at the
supplier’s location to learn how to operate the equipment. While the company’s operators are
being trained, the supplier will provide an operator to run the new equipment. This operator is to
be paid the same amount as the current operators (paid by TI). The cost of travel and lodging for
the operators while they are receiving training at the supplier’s location, which is located 0
kilometres away from TI’s facilities, is C$3,000 per week.
The machine costs $1,500,000 and the supplier guarantees a salvage value of $60,000 at the end
of five years. It is available immediately.
The price of this machine is $700,000 and costs associated with this machine are the same as the
general purpose machine built by the company (same as alternative 1). However, the salvage
value of the machine is much less and is estimated to be $15,000 in five years. This machine is
available immediately.
The current machine has no salvage value and its book value is zero
The discount rate before taxes is 8%
Additional cost and revenue information for each alternative is provided in the attached exhibit.
Determine which alternative is best for the company using NPV. Ignore taxes and the CCA tax
shield in your answer.
For alternative # 1 assume the machine would be available immediately (i.e. no months will be
discounted for the time it takes to build the machine.
Operators:
- required 2 1 2
- wages and benefits $28/hour $28/hour $28/hour
- standard hours per year per 2,000 2,000 2,000
operator, no overtime
Fixed Overhead (including depr.) 25% of DL$ 25% of DL$ 25% of DL$
Required:
Machine A Machine B
Cost of machines $180,000 $220,000
Annual maintenance 14,000 12,000
Useful life of machines 8 years 11 years
CCA rate 30% 30%
Savage value at end of eight and 11 years respectively $60,000 $75,000
Yearly savings due to purchasing new machines $38,000 $56,000
Mister Donut Inc.’s minimum pre-tax desired rate of return is 20%. Mister Donut Inc. is subject
to a tax rate of 40%.
Required:
Mining and processing operations began in January 2 and have continued without interruption
since that date. During 3, the company removed 1,,000 tons of ore from the mine; this level of
production is expected to continue for the next 25 years. Overall, the company hopes to earn a
15% pre-tax profit on sales, although this has not been met in recent years. The cost of
transporting personnel and materials between Carlsbad and the closest railway link during the
summer months has become prohibitive. Furthermore, the northern isolation of Carlsbad has
resulted in a high turnover of production and administrative personnel.
During the winter, food and supplies are brought to the mine and the town of Carlsbad from the
town of Fargo on a winter road built over the frozen tundra and lakes. Fargo is LMC’s closest
link to a railway line. Once the supply trucks are emptied, processed minerals are loaded for
shipment to outside markets. The total cost of winter road transportation was $3,000,000 in 3.
This cost was split equally between LMC and the residents of Carlsbad. During the spring,
summer and fall periods, all shipments between Fargo and the mine site have to be made by float
plane and helicopter. LMC spent a total of $5,500,000 on these flights during 3. No figures were
available on summer transportation expenditures for local businesses and residents.
The high cost of transporting supplies and personnel to the mine site and getting processed
minerals to the outside market is of great concern to the management of LMC. They are
considering the option of building a railroad from Carlsbad to Fargo. Preliminary studies
indicated construction of the railroad would cost $75,000,000 and a train (engine, box cars,
caboose and a passenger car) would cost an additional $15,000,000. With the railroad, LMC
would be able to charge the residents of Carlsbad for freight and passenger fares for trips to and
from Fargo. It is estimated the revenue collected from freight and passenger fares would amount
to $570,000 per year. The operating and maintenance costs (not including interest and
depreciation) for the railroad would be $240,000 and $140,000 per year, respectively. LMC
expects the railroad and train to last 25 years with no salvage value at the end of that time.
Money to finance the purchase of the train and construction of the railroad would be borrowed at
a rate of 10% per annum (post-tax). The capital cost allowance for the railroad and train are set at
4% and 10%, respectively and LMC would depreciate the fixed assets for financial reporting
purposes using the straight-line method. Management believes the railroad would eliminate the
need for summer air freight and winter roads between Carlsbad and Fargo. Also, administrative
costs ($1,250,000 in 3) would be reduced by 25% because LMC would no longer have to pay
large isolation bonuses to key personnel. The effective corporate tax rate is 40%
Should the subsidy be granted, LMC would receive all revenue and incur all operating and
Required:
2. Which of the following statements best represents the differences among horizontal,
vertical and conglomerate acquisitions?
a. Horizontal acquisitions involve similar types of organizations, while
conglomerate acquisitions do not. Vertical acquisitions involve acquisitions of
foreign organizations in the same lines of business.
b. Vertical acquisitions involve extending the organization’s ownership to suppliers
or distributors of its products and services or to other parts of the production or
distribution process. Conglomerate acquisitions involve related businesses, while
horizontal acquisitions involve unrelated organizations.
c. Conglomerate acquisitions involve the acquisition of unrelated businesses, while
horizontal acquisitions involve acquiring organizations in the same or closely
related lines of business. Vertical acquisitions involve a combination of a
horizontal and conglomerate acquisition at the same time.
d. Conglomerate acquisitions involve the acquisition of unrelated businesses, while
horizontal acquisitions involve acquiring organizations in the same or closely
related lines of business. Vertical acquisitions involve extending the
organization’s ownership to suppliers or distributors of its products and services
or to other parts of the production or distribution process.
e. None of the above statements is a true representation.
4. A number of possible sources of gains exist in the event of synergies from acquisitions.
What are these possible sources of gains? Select the most appropriate items from the
following list.
a. Revenue enhancement
b. Cost reduction
c. Tax gains
d. Both a. and b.
e. All of a., b. and c.
Organization A Organization B
Provide an estimate of the market value of the assets of the combined organization, the estimated
value using the earnings method and the estimated value of the expected future cash flows.
Assume no synergies are available. What is the likely range of values of the combined
organization?
Sales growth is expected to be 15% and the percentage of sales method* is used to forecast
financing needs. The dividend pa out ratio is expected be the same in the next period. Tax rates
will not change and the fixed assets are being used at full capacity.
* cost of sales, current assets, fixed assets and current liabilities will grow at the same
rate as the increase in sales
Assets/Sales 1.2
Liabilities/Sales 0.6
Profit Margin 12%
Dividend Pay Out Ratio 60%
Most Recent Year’s Sales $100 million
What is the maximum sales growth that can be achieved without resorting to an increase in long-
term debt, assuming these ratios will remain constant?
Which is better from the point of view of the trade credit grantor and why?
An organization has the opportunity to issue a rights-offering to provide $30 million for some
urgently needed computer technology upgrades. The current share price is $40 and five million
shares are outstanding. If the price per share in the rights offering is $30, what is the value of a
right and the e-rights price of the shares?
2. The financial markets consist of many components, including money markets, capital
markets, primary and secondary markets, and derivative securities markets. What
differentiates the derivative securities markets from the other components of the financial
markets?
a. Derivative securities markets are where speculators take uncovered positions in
various options, futures or swaps to provide liquidity for the derivative securities
markets.
b. Derivative securities markets are where the securities are derived from various
underlying securities. Thus, they do not supply additional capital to the financial
markets, but provide risk reduction tools for financial managers.
c. Derivative securities markets provide specialized forms of capital for
organizations, which would not be available in conventional financial markets
around the world.
d. Derivative securities markets are international in scope and involve large,
international banks and other financial institutions.
e. Derivative securities markets in Canada are centred in Montreal and provide
Canadian organizations access to a number of exotic sources of additional capital
by connecting with other derivative securities markets around the world.
4. Compute the required return on the following security using the security market line
(SML). The security has a beta of 1.2. The risk free rate is 6% and the expected return
on the market portfolio is 12%. What is the estimated required return?
a. 12%
b. 14.4%
c. 13.2%
d. 20.4%
e. It cannot be computed from the information given.
5. A number of methods are used to measure the risk of a security. One of the most
common is to the look at the dispersion of its return. What measures of dispersion are
commonly used to measure portfolio risk?
a. standard deviation
b. variance
c. coefficient of variation
d. variance and covariance
e. all of the above
Compute the economic order quantity (EOQ) and the level of inventory at which an order should
take place to prevent drawing down the safety stock.
What is the net annual benefit of changing to the new credit policy?
An organization has the option of financing an expansion project with one of the following three
alternatives:
a. debt financing at 8% in the amount of $20 million
b. common share financing to net $20 per share, with the issue of 1,000,000 new
shares, to add to the 1.5 million existing shares
c. preferred share financing at 6% in the amount of $20 million.
The organization has no existing debt and expects operating earnings before taxes to be $4.3
million in the next year. Taxes are 40% on income. For each of the three alternatives, what is
the estimated EPS? Which is the best alternative? If the operating income decreased to $1.3
million, would this have any impact on the decision?
Sales $2,000,000
Variable costs 1,,000
Contribution margin 800,000
Fixed costs 350,000
Operating income 450,000
Interest expense 150,000
Net income before taxes 300,000
Income taxes 90,000
Net income $210,000
Required:
a. Calculate Wasu Company’s: (i) degree of operating leverage; (ii) degree of financial
leverage; and (iii) degree of total leverage.
b. Assume that sales for the year 7 are expected to increase by 15%
over 6. Prepare a projected statement of income for 7 and explain how the calculation in
part (a) relates to the increased numbers in your projected statement of income.
a. What would the value of the organization be if it was financed entirely with equity?
An all-equity organization is subject to a 40%- corporate tax rate. Its equity holders require a
20%- return. The organization’s initial market value is $3,500,000 and there are 175,000 shares
outstanding. The organization issues $1 million of bonds at 10% and uses the proceeds to
repurchase common stock.
Assume there is no change in the costs of financial distress for the organization. According to
MM, what is the new market value of the equity of the organization?
RR Company, an all-equity company, generates perpetual earnings before interest and taxes
(EBIT) of $2.5 million per year. RR's after-tax; all-equity discount rate is 20%. The company's
tax rate is 40%.
b. If RR adjusts its capital structure to include $600,000 of debt, what is the value of the
company?
d. What assumptions are you making when you are valuing Streiber?
The Simard Company has perpetual EBIT of $4 million per year. The after-tax, all-
equity discount rate r0 is 15%. The company's tax rate is 40%. The cost of debt capital is 10%
and Nikko has $10 million of debt in its capital structure.
A. To calculate the expected risk premium, one needs to compute the expected return on the
risky asset and the certain return on the risk free asset.
B. The risk premium is the difference between the return on a risky asset and on the market
portfolio.
C. The expected return on an asset is equal to the sum of the possible returns multiplied by
their probabilities.
2. Which of the following is NOT true about computing expected portfolio return and variance?
A. You need to calculate the weight of each asset relative to the total portfolio to compute
the portfolio return, but not compute the portfolio variance.
B. Portfolio return can be calculated with the expected return and weight of each asset.
C. You can use the portfolio return to help compute the portfolio variance.
D. The portfolio return and variance are dependent on the possible states of nature.
E. The portfolio variance is not generally a weighted average of the variances of the assets
in the portfolio.
3. If the actual return on an investment is equal to the expected return, then it is likely that:
A. When investors estimated the expected return, they incorrectly weighed all the
information that they believed would bear on the investment.
B. Interest rates changed unexpectedly after the expected return was computed.
C. Even though the expected return was incorrect, the normal return was estimated
accurately.
D. Some anticipated information about the investment was revealed after the expected return
was computed.
E. Investors used all relevant information that was available when computing the expected
return.
A. I only
B. II only
C. III only
D. II and III only
E. I, II and III
A. Unique risk
B. Market risk
C. Company specific risk
D. Diversifiable risk
E. Asset risk
7. The CAPM shows the expected return for a particular asset depends on:
I. the amount of unsystematic risk
II. the reward for accepting systematic risk
III. the pure time value of money
IV. the amount of systematic risk
A. I only
B. II on1y
C. I, III and IV only
D. II, III and IV only
E. I, II, III and IV
A. II only
B. III only
C. I, II and III only
D. I, II and IV only
E. I, II, III and IV
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
A. I only
B. II only
C. III only
D. I and III only
E. I, II and III
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
13. All else being equal, actions or events that cause a company’s returns to be more highly
correlated with the changes in the economy will (increase/decrease/not affect) the company's
systematic risk.
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
15. No matter how many risky assets a person invests in, _____________ risk can never be
eliminated.
I. unsystematic
II. market
III. systematic
IV. non-diversifiable
A. I only
B. II only
C. III only
D. IV only
E. II, III and IV only
17. What is the expected return on asset A if it has a beta of 1.3, the expected market return is
14% and the risk-free rate is 6%?
18. What is the expected market return if the expected return on asset A is 16% and the risk-free
rate is 7%? Asset A has a beta of .9.
19. Asset A has an expected return of 18% and a beta of 1.4. The expected market return is 14%.
What is the risk-free rate?
20. Asset A has an expected return of 15% and a beta of .95. The risk-free rate is 5%. What is the
market risk premium?
21. Using the information below, which security has the greatest expected return?
Standard Deviation Beta
Security X 35% 1.75
Security Y 68% 1.06
Security Z 24% 1.22
23. Prime Incorporated intends on issuing 10 15-year, $1,000 zero-coupon bonds. If each bond
has a yield of 10%, how much will Prime Incorporated receive when the bonds are issued?
Ignore issuance and flotation costs.
A. $1,.00
B. $1,827.00
C. $2,393.92
D. $8,880.00
E. $10,000.00
24. What is the yield-to-maturity on a 15-year, $1,000, zero coupon bond that currently has a
market value of $375.39?
25. When the shares in a public company lose value as a result of the company issuing additional
shares, the shareholders in the company have suffered from ________________.
A. a rights offering
B. indirect issuance costs
C. dilution
D. ex-rights
E. excessive spread
26. An arrangement between a bank and a business that allows the business to periodically
borrow up to a pre-specified limit, without specified repayment terms for the principal, is a:
29. Abril Limited, a large company, is attempting to do things: 1) raise badly needed cash, and 2)
reduce the level of its accounts receivable. Which of the following options would best meet
both of these needs simultaneously?
30. A large company with a strong credit rating needs to borrow money for the next 90-180 days.
The company would likely obtain the best interest rate by:
A. I only
B. III only
C. I and III only
D. II and III only
E. I, III and IV only
A. I only
B. IV only
C. I and IV only
D. II and III only
E. III and IV only
33. A company is preparing a short-term financial plan. Which of the following questions would
the organization most likely NOT consider when creating the plan?
34. Assuming a beginning current ratio higher than 1.0, which of the following activities will
decrease net working capital?
I. sale of inventory (at book value) on credit
II. using cash to pay off short-term note
III. selling marketable securities in order to pay dividends
A. I only
B. II only
C. I and II only
D. I, II and III
E. III only
36. ____________ falls with increases in the level of inventory, while ____________ increase
with increases in the level of inventory.
37. Tyler Limited needs to raise cash quickly. The CFO has arranged for Tyler Limited to sell
receivables with a face value of $1,000,000 to Canada Bank Group for $940,000, payable
immediately. Under the agreement, Canada Bank Group is responsible for collecting the
receivables. This is an example of:
A. assignment of receivables
B. a line-of-credit security arrangement
C. a conventional factoring arrangement
D. a maturity factoring arrangement
E. an assigned factoring arrangement
38. Your company purchased a piece of land seven years ago for $150,000 and subsequently
incurred $75,000 in improvements. The current book value of the property is $225,000.
There are three options for the future use of the land: 1) the land can be sold today for
$375,000; 2) the land can be leased to another party on a long-term basis; or 3) your
company can destroy the past improvements and build a factory on the land. In consideration
of the factory project, what amount (if any) should the land be valued at?
A. I only
B. II only
C. I, III and IV only
D. III only
E. I, II, III,
40. A machine costs $60 and requires $35 in maintenance for each year of its three-year life.
After three years, the machine will be replaced. Suppose the machine is depreciable on a
straight-line basis over its three-year life to a salvage value of $15. It will be sold for $15
after three years. Assuming a tax rate of 34% and an after-tax discount rate of 14%, what is
the NPV for the machine?
41. Your company currently sells regular furniture. The controller has asked you to analyze
introducing a new line of high -end furniture. Which of the following are relevant costs?
I. $,000 spent on research and development last year on high-end furniture.
II. Land you already own, but may be used for the project, which has a market value of
$700,000.
III. $300,000 drop in sales of regular furniture if oversized rackets are introduced.
A. I only
B. II only
C. III only
D. I and III only
E. II and III only
44. In terms of riskiness, lease cash flows are most similar to the lessee’s cash flows attributable
to _____________.
45. Which of the following is the relevant rate for evaluating a lease from the viewpoint of the
lessee?
You work for Sunny Golf Limited, a golf course that is considering leasing a fleet of golf carts to
transport golfers around the golf course. These carts qualify for a 40% CCA rate. Because of
their heavy use, they have no value after 5 years. The carts could be leased for $12,000 per year
for five years or purchased now for $48,000. Further, a 10% pre-tax cost of capital and a 40% tax
rate is applicable to all parties involved in the lease. Assume the purchase and lease payments
are made at the beginning of the year (@ T=0, T=1, etc.) and CCA tax shield is taken at the end
of each year.
46. Given the above information, should you lease or buy? For this question only, ignore the
CCA half year rule.
A. Lease, it saves you $372.
B. Buy, it saves you $15,954.
C. Buy, it saves you $8,052.
D. Buy, it saves you $372.
Lease or buy, it doesn't matter. Because of taxes, they are the same.
47. If Sunny Golf Limited decided to lease, what are the cash flows in the first year (T=0) and
the fifth year (T=4)?
First Fifth
year year
A 36,960 -5,949
B. 37,179 -5,949
C. 36,960 -4,073
D. 37,179 -4,073
E. 36,960 4,073
48. What would the lease payments have to be for both the lessee and the lessor to be indifferent
to the lease?
A. $11 B. $11,861 C. $12,800 D. $14,954 E. $17,917
49. Assuming Sunny Golf Limited pays no taxes, what are the company’s cash flows in the first
year (T=0) and fourth year (T=3)?
First Fourth year
year
A -$48,000 $0
B. $48,000 $0
C. $36,000 $0
D. $36,960 $1,992
E. -$36,960 $1,992
******************************************************************************
51. You work for a laundry delivery service that is considering leasing a fleet of trucks. These
trucks qualify for a 40% CCA rate. Because of their heavy use, they have no value after five
years. You could lease them for $5,700 per year for five years or purchase them now for
$22,500. Further, a 10% pre-tax cost of capital and a 30% tax rate is applicable to all parties
involved in the lease. Assume the first payment was made at T=0. Should you lease or buy?
52. Which of the following is NOT accurate regarding the dividend growth model approach to
estimating the cost of equity capital?
53. A company that uses its WACC as a hurdle rate without considering the risk involved in a
investments will:
I. tend to become riskier over time
II. tend to accept unprofitable projects over time
III. likely see its WACC rise over time
IV. tend to accept projects with risks lower than those of existing operations
A. I and II only
B. II and III only
C. I, II and III only
D. I, II and IV only
E. II, III and IV only
55. Which of the following are potential problems associated with the use of the dividend growth
model to compute the cost of equity?
I. the estimated cost of equity is sensitive to the estimated dividend growth rate
II. the approach does not explicitly consider risk
III. the approach requires one to assume the dividend growth rate will remain constant
A. I only
B. III only
C. II only
D. I and III only
E. I, II and III
56. Big Money Limited’s common stock is currently selling at $37.86 per share. You expect the
next dividend to be $5.30 per share. If the company has a dividend growth rate of 6%, what
is its cost of equity?
57. Treasury bills currently have a return of 8%. The market risk premium is 9%. If Company A
has a beta of 1.35, what is its cost of equity?
58. EDI Institute sold a 20-year bond issue eight years ago. It pays a 10% annual coupon and has
a $1,000 face value. If the current price per bond is $1,110.17, what is the cost of debt?
******************************************************************************
62. A company is considering a project that will generate perpetual cash flows of $30,000 per
year beginning next year. The project has the same risk as the organization’s overall
operations and must be financed externally. Equity costs 16% and debt costs 7%. The
organization’s debt/equity ratio is 1.5. What is the most the organization could pay for the
project and still earn its required return?
A. $275,027
B. $283,019
C. $302,539
D. $303,216
E. $1,250,000
65. When choosing a capital structure, the objective of the organization should be to:
A. choose the one that maximizes the current value of the stock
B. choose the one that minimizes the value of the organization
C. choose the one that maximizes the organization’s WACC
D. choose the one that results in the greatest possible interest tax shield
E. choose any capital structure since capital structure is always irrelevant
67. Which of the following statements is/are true regarding corporate borrowing?
I. increasing financial leverage increases the sensitivity of EPS and ROE to changes in
EBIT
II. the effect of financial leverage depends on the company's EBIT -- leverage is
favourable when EBIT is relatively high and leverage is unfavourable when EBIT is
relatively low
III. high leverage magnifies the returns to shareholders (as measured by ROE)
68. The required return on the assets of Kamil Limited is 10%. Debt cost is 6% before-tax for
Kamil Limited. Assuming a capital structure of 50% debt and 50% equity, what is the cost of
equity? The tax rate is 34%.
A. 10.0% B. 12.6% C. 15.1% D. 16.0% E. 18.7%
70. An unlevered organization has a net income after tax of $660,000. The unlevered cost of
capital is 15% and the corporate tax rate is 34%. What is the value of this organization?
A. $1,000,000 B. $2,266,667 C. $3,333,333 D. $4,400,000 E. $8,000,000
71. McKenzie Incorporated has expected EBIT of $3,300, debt with a face and market value of
$4,000 paying a 9% annual coupon and an unlevered cost of capital of 12%. If the tax rate is
39%, what is the value of the equity of McKenzie Incorporated?
A. $9,335 B. $14,335 C. $18,335 D. $22,245 E. $25,625
74. A manager using the EOQ model can compute ___________ to account for delivery times.
A. carrying costs
B. safety stocks
C. restocking costs
D. reorder points
E. theft losses
75. Reorder costs for at cows at Gregko Limited are $500 and carrying costs are $25. What is the
optimal reorder quantity?
A. 50
B. 100
C. 125
D. 500
E. Not enough information to calculate
76. Reorder costs for cows at Sasasha Incorporated are $900, carrying costs are $54 and unit
sales are $7,500. What is the optimal reorder quantity?
A. 125
B. 141
C. 447
D. 500
E. Not enough information to calculate
Krohl Limited maintains an average inventory of 1,000 units. The carrying cost per unit per year
is estimated to be $1. Krohl Limited places an order for 500 units the first of each month and the
order cost is $4.
78. What are the total restocking costs under the current system?
79. What is the economic order quantity (EOQ)? (round to the nearest whole number.)
A. 110 units
A. 110 units
B. 219 units
C. 312 units
D. 401 units
E. 500 units
81. What are the total carrying costs using the EOQ?
82. What are the total restocking costs using the EOQ?
******************************************************************************
83. You will take delivery of a US dollar 60 days from today but you want to lock in the price
now. _______________ is the price of this transaction today.
A. the cross-rate
B. the spot exchange rate
C. the forward exchange rate
D. the London Interbank Offer Rate
E. the swap rate
A. backward trade
B. forward trade
C. futures trade
D. triangle arbitrage transaction
E. spot trade
85. According to today’s exchange rate posted on the Bank of Canada website, you can exchange
C$1 for two Euros today. Thus, the ___________ is .50 Euros.
A. backward rate
B. forward rate
C. futures rate
D. triangle rate
E. spot rate
86. According to today’s exchange rate posted on the Bank of Canada website, the spot exchange
rate is Euro 1 = C$.83. The six-month forward exchange rate is Euro 1 = C$.67. Which
statement below is true?
I. The Euro is selling at a discount relative to the Canadian dollar.
II. The Euro is selling at a premium relative to the Canadian dollar.
III. The Canadian dollar is selling at a discount relative to the Euro.
IV. The Canadian dollar is selling at a premium relative to the Euro.
A. I only
B. II and IV only
C. and III only
D. I and IV only
E. II and III only
87. According to today’s exchange rate posted on the Bank of Canada website, the spot exchange
rate is Euro 1 = C$0.81. The six-month forward exchange rate is Euro 1 = C$0.95. Which
statement below is true?
I. The Euro is selling at a discount relative to the Canadian dollar.
II. The Euro is selling at a premium relative to the Canadian dollar.
III. The Canadian dollar is selling at a discount relative to the Euro.
IV. The Canadian dollar is selling at a premium relative to the Euro.
88. The 60-day forward rate for Japanese Yen is 112.16 per C$1. The spot rate is Yen 103.9 per
C$1. In 60 days, you expect to receive Yen500,000. If you agree to a forward contract, how
many Canadian dollars will you receive in 60 days?
2. e. All of the activities noted are part of the treasury management function as
described by the Financial Executives Institute.
3. c. This is not usually the CFO’s decision, as it would be delegated to others in the
organization. Usually, purchasing will make such decisions subject to corporate
guidelines already established by the CFO.
4. d. This is the most correct response, but some will answer c. because of the
strong belief in Anglo-American markets that shareholders are the most
important. However, outside of these markets, corporate wealth for a diverse
group of stakeholders is considered most important and not just shareholder
wealth.
5. e. All three difficulties exist in the financial markets. Share values are
not easy to compute, the stakeholder group is not clear and agency issues
generally exist.
6. e. The minimum requirements will not break the law, but the appearance of
being a “good corporate citizen” is important in a political sense. It depends on
how much the management and ownership want to satisfy the political masters.
NPV rules and shareholder wealth must be subordinated to the regulations of the
jurisdiction in which the organization operates.
N = 4, I = 10, FV = $425,678
Solve for PV = $290,744
PV of inheritance = $1,000,000*PVIF10%,25
N = 25, I = 10, FV = $1,000,000
Solve for PV = $92,296
First, we calculate the present value, assuming we are dealing with a perpetuity:
2. a. The best estimate for the model requested is based on the dividend yield
+ growth rate, which in this case is:
3.3/30 + .06 = .11 + .06 = .17
Therefore, the cost of equity is 17%.
3. e. The estimate for WACC depends on the cost of equity capital; therefore, are
two possible estimates. The CAPM approach says the cost of equity = 6% + .9 *
6% = 11.4%. The dividend growth approach says the cost of equity is 2/24 + .03
= .1133 or 11.33%.
The first term is the cost of preferred times the preferred proportion. The second
term is the cost of debt after tax (.6 * .07) times the debt proportion and the third
term is the cost of equity times the equity proportion.
Kb = 10%(1-.34) = 6.6%
2. c. The dividend must be increased to the expected value from its current, past year’s
level. The calculation is: 2.25 * 1.07 = 2.4075 or approximately $2.41.
The share price, therefore, is: $2.41 / (.12 - .07) = 2.41 / .05 =$48.20
The amount required is the future value of an annuity for 20 periods at 4% to equal $100 million.
To compute this, the following is done: $100,000,000 / 29.778 (future value at 4% for 20
periods) = $3,358,184
Therefore, an amount of $3,358,184 must be invested every six months to achieve the goal.
b. You will sell the bond for $100,000 since the coupon rate = YTM.
a. D1 = $5(1.25) = $6.25
D2 = $6.25(1.20) = $7.50
D3 = $7.50(1.18) = $8.85
D4 = $8.85(1.05) = $9.2925
P0 = PV of $6.25 to be received N = 1
+ PV of $7.50 to be received N = 2
+ PV of $8.85 + 132.75 to be received N = 3
= $5.58 + 5.98 + 100.79
= $112.35
b. P1 = PV of $7.50 to be received N = 1
+ PV of $8.85 + 132.75 to be received N = 2
= $6.70 + 112.88
= $119.58
Divisional bonus % 4% 7% 9%
Proposed System -
Sales (20% increase) $120,000 $144,000 $172,800
CM =38% of sales 45,600 54,720 65,664
Fixed costs 34,600 34,600 34,600
Present value of increased after-tax cash flows before CCA and severance
Total $26,583
Regular line:
Old equip New Equip Increased
CM
Contribution margin:
Variable costs:
Material 5.60 5.60 – (5.60 x .10) 5.04
Labour 4.48 4.48 – (4.48 x 25%) 3.36
Variable overhead 1.68 VOH rate1.68/4.48 = 1.26
. 375 therefore new
VOH is 3.36 x 0.375
SD&A .56 .56
Total variable 12.32 10.22
costs
CM per unit 10.08 12.18
Special Order:
Contribution margin:
Selling price 14.00
Variable costs:
Material Calculated above 5.04
Labour Calculated above 3.36
Variable overhead Calculated above 1.26
SD&A Regular rate of .56 x 50% .28
Total variable costs 9.94
Contribution margin per unit 4.06
Volume x 920,000
Total contribution margin $3,735,200
Note that the appropriate interest rate to use is 14% and the correct period is four years.
PV of cash flows:
Increase in CM
$5,205,200 x 2.914 (PV factor, i = 14%, n = 4) $15,167,953 Inflow
Recommendation:
It is recommended that the company accept the new order and purchase the new equipment,
since the NPV is positive. However, it is important to note that TI will have excess capacity at
the end of the contract for the special order with the major retail chain.
Capacity Utilization:
Regular production (assumes no increase in sales of regular units) 700,000
Note that fixed overhead is irrelevant. The fixed overhead will be incurred regardless of the
alternative and, therefore, it is irrelevant.
Cash to purchase/build
1
(see previous page) (456,000) (1,578,000) (700,000)
Recommendation: The best alternative is alternative 1; build the machine, as it has a higher net
present value than the other two alternatives.
A B AxB
Post-Tax Pos- Tax Present Outflow
Pre-tax Discount Value Present or
Description Year Amount Amount Rate Factor Value Inflow
Tax Shield:
Cdt x (1 + 0.5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= 89,593.30 – 5,449.60
= $84,143.70
NPV:
Nonrecurring cash flows $334,476 Outflow
Recurring cash flows 177,523 Inflow
Tax shield 84,144 Inflow
Net outflow or negative NPV $72,809 Outflow
A B AxB
Post-tax
Post-Tax Discount Present
Pre-tax Outflow or
Rate Value Present
Description Year Amount Inflow
Amount (20% x 1 - Factor Value
.40))
Tax Shield:
Cdt x (1 + .5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= 48,673.465 – 6,923.711
= $41,749.75
NPV of Machine A:
Nonrecurring cash flows $155,760 Outflow
Recurring cash flows 71,539 Inflow
Tax shield 41,750 Inflow
Net outflow or negative NPV $42,471 Outflow
A B AxB
Post-Tax Post-tax Present
Pre-tax Present Outflow
Description Year Discount Value
Amount Amount Value or Inflow
Rate Factor
Tax Shield:
Cdt x (1 + .5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= 59,489.79 – 6,160.20
= $53,329.59
NPV of Machine B:
Nonrecurring cash flows $198,475 Outflow
Recurring cash flows 156,763 Inflow
Tax shield 53,330 Inflow
Net inflow (positive NPV) $11,618 Outflow
Machine A Machine B
NPV $42,471 Negative $11,618 Positive
Since machine B has a positive NPV, Mister Donut Inc. should purchase machine B.
Capital Cost:
Cost of railroad = 50 kms x $1,500,000 per km $75,000,000
Cost of train and cars 15,000,000
Railroad Train
Capital cost (C) $37,500,000 $7,500,000
Capital cost allowance rate (d) 4% 10%
Tax rate (T) 40% 40%
Cost of capital (k) 10% 10%
CdT x (2 + k)
(d + k) (2(1 + k))
The net present value of the project is positive (i.e. $1,382,843) suggesting the project is
economically feasible, but only if LMC is granted a 50% subsidy from the government. The net
present value of the project would be negative without the government subsidy (i.e. $90,000,000
- $40,860,116 - $11,045,454 = outflow of $38,094,430).
3. e. Both trade credit and bank loans are primary sources of funds for
small businesses. Commercial paper is not available and one would hope
government subsidies were not important.
The income statements and balance sheets will look as follows, in the next period.
The increase in sales is defined as g. Therefore, new sales equal 100(1 + g). The increase in
sales is 100g. Additional funds needed are equal to zero.
Therefore:
0 = 1.2(100g) – 0.6(100g) – 0.12(0.4)[100(1 + g)]
0 = 120g – 60g – 4.8 – 4.8g
55.2g = 4.8
g = 4.8/55.2 = 0.087 or 8.7%
A: (1 + 3/97)365/45 – 1 = 28%
B: (1 + 2/98)365/20 – 1 = 44.6%
The organization must issue 30,000,000/30 or one million shares. The organization is currently
worth $40 * 5 million or $200 million. The issue will raise $30 million and there will be six
million shares after the issue of the rights. Therefore the value of the shares, ex-rights, will be
230 million/6 million = 38.33 per share. The value of the right is 40 – 38.33 or $1.67 per right.
2. b. Derivative securities markets do not supply additional capital but do provide risk
management tools. Speculators do not provide liquidity on purpose, but rather
they are looking for a profit. All of the other answers are partly true but not
totally. Derivative securities markets are domestic and international and not just
international and financial institutions are not the only participants. Any answer
implying that additional capital is supplied is misleading or incorrect.
3. e. The first three statements are all true. Options are rights but not obligations and
forward and futures contracts lock in prices for future delivery. In addition, a
long position in forward or futures contracts is like a call option, the option to
buy, while a short position is like an option to purchase. However, the option
always leaves open the right to refuse to exercise, while forward and futures
contracts do not.
4. c. The formula is: risk free rate plus beta times (the return on market less the risk
free rate) = 6% + 1.2 (12% - 6%) = 6% + 7.2% = 13.2%
5. d. While all of the measures mentioned are used quite extensively in finance,
variances and co-variances are used to measure portfolio risk.
Incremental discounts:
Before: $10,000,000 x 1% x 75% $75,000
After: $12,000,000 x 2% x 70% 168,000 (93,000)
Accounts receivable -
Before: $10,000,000 / 365 x 15 days $410,959
After: $12,000,000 / 365 x 26 days 854,795
Increase in A/R $443,836
Inventory -
Before: $10,000,000 x 70% /5 $1,400,000
After: $12,000,000 x 70% / 7 1,200,000
Decrease in inventory $ 200,000
Any sales increase will cause an increase in EPS of four times the percentage sales increase.
Thus, a 10% sales increase will cause a 40% EPS increase.
Based on the information above, the debt appears to be the best alternative at an income level of
$4.3 million, although only by a slight margin. This assumes, of course, that the net income
figure is correct. When income drops, the other alternatives become quite unsuitable and
common shares are a far less risky choice.
The degree of operating leverage tells us that a 1% increase in sales will lead to a
1.7778% increase in operating income. Alternatively, a 15% increase in sales will
lead to a 15% (1.7778) = 26 2/3% increase.
The degree of total leverage tells us that a 1% change in sales will lead to a
2.6667% change in net income before taxes. In this case, sales increased 15%;
therefore, we would expect net income before taxes to increase by 15% (2.667) =
40%. (as predicted by the degree of financial leverage)
b. If the organization was all equity, it would earn: $1,500,000 x 20% = $300,000
With debt, we subtract interest of $500,000(10%)(.6) = $30,000
Income accruing to shareholders = $300,000 – 30,000 = $270,000
Check: V = D + E
1,700,000 = 500,000 + 1,200,000
RL = RU + (RU – RD)(D/E)(1-t)
= .20 + (.20 - .10)(5,000/12,000)(.6)
= .225
E = 270,000 / .225
= $1,200,000
V=E+D
E=V–D
= $3,900,000 – 1,000,000
= $2,900,000
b. VL = 7,500,000 + 600,000(.4)
= $7,740,000
c. Debt creates a tax shield for the organization. This has value and accounts for the
increase in the value of the organization.
d. No cost of financial distress. Debt is constant and the interest date on debt is constant.
VU = EBIT (1-t) / RU
= 4,000,000(.6) / .15
b. V=D+E
20 = 10 + 10
RL = RU + (RU – RD)(D/E)(1-t)
= .15 + (.15 - .10)(1)(.6)
= 18%
This statement is inaccurate since the risk premium is calculated as the difference
between the return on a risky asset and the return on a risk free asset (e.g. Canadian
government treasury bills).
2. A You need to calculate the weight of each asset relative to the total portfolio to compute
the portfolio return, but not to compute the portfolio variance
Since the portfolio’s variance is a calculation of its actual return compared to expected,
the weighting of each asset in the portfolio is taken into consideration (i.e. when
calculating expected and actual returns of the portfolio.
3. E Investors used all relevant information available when computing the expected return
If the expected return equals the actual return, investors used all information available
when computing the expected return.
Diversification reduces unsystematic risk. Market risk (also known as systematic risk)
cannot be reduced by diversifying.
5. B. Market risk
6. D A beta of one indicating an asset is totally risk free is incorrect. A beta of 1.0 means
there is perfect correlation between market risk and an individual security’s risk.
Since unsystematic risk is diversifiable risk, “III lower sales for IBM than expected”, is
correct since “I lower trade deficit than expected” and “II higher GDP than expected” are
included in market (systematic) risk.
Since virtually all companies are subject to interest rates, this factor is not diversifiable
and is included in systematic risk.
I is included because the company has increased the impact of interest rates on its return
and II because interest rates are included in market risk.
13. A Increase
The terms market risk, systematic risk and non-diversifiable risk are synonymous. This
risk cannot be eliminated.
16. E Beta
Solution:
Note that the CAPM formula is on the formula sheet provided in the examination.
r = rf + ȕ ( rm – rf)
r = 6% + 1.3(14% - 6%)
r = 16.4%
18. D 17%
Given:
r = 16% rf = 7% Beta (ȕ) = 0.9
r = r f + ȕ ( r m – rf )
r – rf = ȕ ( r m – rf )
r – rf + rf = rm
ȕ
rm = 16% - 7% + 7%
0.9
=10% + 7%
= 17%
19. D 4%
Given:
r = 18% Beta (ȕ) = 1.4 rm = 14%
r = r f + ȕ ( r m – rf )
r = rf + ȕ r m – ȕ rf
r - ȕ rm = rf – ȕ rf = rf (1 – ȕ)
= 4%
20. C 10.53%
Given:
r = 15% rf = 5% Beta (ȕ) = 0.95
15% - 5%
= + 5%
0.95
rm = 15.53%
r m – rf = 15.53% - 5%
22. A $34.86
Given:
Future value (FV) = $1,000
n =8
Present value = $664.08
(1.5058)1/8 = 1 + i
8
1+i = 1.5058
1+i = 1.052497
i = 5.25%
23. C $2,393.92
Given:
Number of bonds = 10
Face value (FV) = $1,000
Coupon = zero
n = 15
I = ytm = 10%
Solution:
FV
P0 =
(1 + i)n
1,000
=
(1.10)15
1,000
=
4.1772
= 239.392/bond
Given:
n = 15
Future value (FV) = $1,000
Coupon = zero
Present value (P0) = 375.39
Solution:
FV = P0 (1 + i)n
FV
= (1 + i)n
P0
1/n
FV
i = –1
P0
1/15
1,000
i = –1
375.39
i = (2.6639)0.0667 – 1
i = 6.75%
27. C In a factoring arrangement, the default risk on the accounts receivable transfers to the
purchaser of the receivable. When factoring receivables, the purchaser of the receivables
assumes the risk of default.
Factoring receivables meets both needs – provides cash and reduces accounts receivable.
31. C I and III only (issuing commercial paper and factoring accounts receivable)
33. B Should the company cancel and redeem its outstanding bonds
38. D Whichever amount represents the greatest opportunity cost, that is, the best alternative
use you must forgo in order to build the factory
40. E -$103.51
NPV:
41. E II and III only (land you already own, but may be used for the project, with a market
value of $700,000; and $300,000 drop in sales of regular furniture if high end furniture is
introduced.)
BUY:
Cost to purchase (48,000.00)
Tax shield gained 16,223.13 (48,000 x .40) x (.40/.40+.06) x (2+.06/2 x 1.06)
(31,776.86)
LEASE:
after tax lease payment = 12,000 x .60=7,200
NPV of lease payments (32,148.00) 7,200+7,200(PVFA 4 6%)= 7,200+7,200(3.465)
Difference:
Lease 32,148.00
Buy 31,776.86
371.34 Savings from buying
@T=0
Cost to purchase ($48,000)
Tax shield gained $3,621 CCA (40%)*1/2 year rule*.40=48,000*.40*1/2*.40=3,840
Discounted to the beginning of the year
=3,840*(PVF16%)=3,621
Tax Shield from CCA $1,251 3317 x (PVF16%) x .40=1,251(discounted to Beginning of year)
Tax Shield from Terminal Loss $1,876 4976 x (PVF16%) x .40=1,876(discounted to Beginning of year)
Total Tax Shield @ T=4 $3,127 1,251 + 1,876=3,127
48. B $11,861
NPV to Buy NPV of Lease Payments
49. C $36,000; $0
BUY:
Cost to Purchase @ T=0 (48,000)
Tax shield gained @ T=0 0
(48,000)
LEASE:
Lease Payment @ T=0 (12,000)
Difference:
Lease 48,000
Buy 12,000
36,000 Cash inflow from leasing @ T=0
Buy 48,000 0 0 0 0
Lease 12,000 12,000 12,000 12,000 12,000
Cash flow 36,000 24,000 12,000 0 -12,000
(36,000-12,000) (24,000-12,000) (12,000-12,000)
50. B $11,511
Difference:
Lease 17504.13
Buy 16,943.23
560.90 Savings from buying
52. B The results from this model are not sensitive to changes in the dividend growth rate
53. C I, II and III only (tend to become riskier over time; tend to accept unprofitable projects
over time; and likely see its WACC rise over time)
54. C A low earning division will be ignored in capital allocation even though it tends to
maintain lower levels of risk.
56. E 20%
Given:
P0 = 37.86
D1 = 5.30
g = 6%
Required: Find ke
Solution:
D
ke = +g
NPe
5.30
= + 6%
37.86
= 14% + 6%
= 20%
57. D 20.15%
Given:
rf = 8%
(rm - rf) = 9%
Beta (ȕ) = 1.35
Required: Find ke
Solution:
ke = rf + (rm - rf) ȕ
ke = 8% + 9% (1.35)
ke = 20.15%
Given:
n = 20 – 8 = 12
Face value (FV) = $1,000
Price (or present value), (P0) = 1,110.17
Coupon = 10%
90.8192
= 8.6%
59. A 8.0%
Given:
Dp = 4 NPp = 50
Solution:
Dp
Kp =
NPp
4
=
50
= 8%
Given:
Debt/total asset, D/TA = 50%
Pre-tax cost of debt, kd = 8%
Cost of equity, ke = 14%
Tax rate, t = 40%
Solution:
D E
___ ____
WACC = (kd) (1 – t) + (ke)
TA TA
61. C -$1,356
D E
WACC = Kd + Ke
V V
NPV:
Equipment (200,000)
a/f tax cash flows 198,644 40,000 x (PFVA7 9.4%)
(1,356)
Note the present value tables do not have a discount value for 9.4% but if you were to use
a factor of 9% the answer is close. (We chose to keep this solution “close” and not
perfect since many candidates will be using calculators that can perform the present and
future value functions on the Entrance Examination. Typically, these calculators provide
an answer “close” to the actual choice on the examination, but not exact.)
Given:
ke = 16%
kd = 7%
Debt/equity, D/E = 1.5% (could be stated as 1.5:1)
Annuity = $30,000
Required: Find maximum price for the project (present value or PV)
Solution:
PMT Annuity
PV = =
r WACC
D E
_______ ________
WACC = (kd) + (ke)
D+E D+E
1.5 1.0
___________ ___________
= (7%) + (16%)
1.5 + 1.0 1.5 + 1.0
PV = Annuity
= 30,000
10.60%
= $283,019
63. D The level of financial leverage that produces the highest firm value is the one most
beneficial to stockholders.
64. D I, III and IV only (The ultimate effect of leverage depends on the organization’s EBIT.
As an organization levers up, shareholders are exposed to more and more risk. The
benefits of leverage will not be as great in a organization with substantial accumulated
losses or other types of tax shields as for a organization without many tax shields.)
65. A Choose the one that maximizes the current value of the stock
67. E I, II and III (increasing financial leverage increases the sensitivity of EPS and ROE to
changes in EBIT. Increasing financial leverage increases the sensitivity of EPS and ROE
to changes in EBIT. High leverage magnifies the returns to shareholders (as measured by
ROE).)
68. D 16.0%
D E
WACC = Kd + Ke
V V
69. C $6,253
Value of unlevered organization:
VU = EBIT x (1-tax rate)/unlevered cost of capital
VU = 1,110 x (1-.34)/.14
VU = 5,232.85
Value of levered
organization:
VL = VU + (tax rate x debt)
VL = 5,232.85 + (.34 x 3,000)
VL = 6,252.85
70. D $4,400,000
4,400,000 = 660,000/.15
Value of equity:
VE = VL - debt
VE = 18,335 - 4,000
VE = 14,335
72. E I, II, III and IV (maturity risk; marketability risk; taxability; and default risk)
73. D The higher the cash balance, the higher the opportunity costs in terms of the interest
income that could be earned in the next best use
EOQ = 2SO
C
= _2 x S x 500
C
EOQ = 2SO
C
= _2 (7500) (900)
54
= 250,000 = 500
77. E $1,000
78. B $48
EOQ = 2SO
C
= _2 (500) (12 x 4)
1
= 219 = 110
2
81. C $110
= 219 x $1 = $110
2
82. A $110
Total restocking cost = S
x O
EOQ
= 110
86. D I and IV only (the Deutsche mark is selling at a discount relative to the dollar. The dollar
is selling at a premium relative to the Deutsche mark.)
87. E II and III only (The Deutsche mark is selling at a premium relative to the dollar. The
dollar is selling at a discount relative to the Deutsche mark.)
500,000
=
112.16
= $4,458
Strategic Management
ORGANIZATIONAL DESIGN...................................................................................................................415
TYPES OF ORGANIZATIONAL STRUCTURES ...............................................................................................415
CENTRALIZED VS. DECENTRALIZED STRUCTURES .....................................................................................418
SPAN OF CONTROL..................................................................................................................................418
TALL VS. FLAT STRUCTURES ....................................................................................................................418
COMPLEXITY ...........................................................................................................................................418
CORPORATE CULTURE .........................................................................................................................420
1.1.3 Explains how mission and vision statements impact corporate culture and
9
public image for a given organization
Many organizations have both a vision statement and a mission statement, while other
organizations combine the vision and mission statement into one statement.
The difference between a vision statement and a mission statement can be summarized as:
Vision Mission
Answers the question: Answers the question:
What do we want to become? What is our business?
Properly constructed vision statements not only help companies avoid aimless decision-making,
but they also help prepare an organization for the future. They guide managerial decision
making and encourage employee commitment to the organization by conveying the
organization’s identity and long-term direction.
All the above components of a mission statement are determined according to an organization’s
current business scope; whereas, the vision statement can include these things, but adds the extra
component about where the organization wants to go in the future.
Mission Statement
The Bellevue Hospital, with respect, compassion, integrity and courage, honours the
individuality and confidentiality of our patients, employees and community, and is progressive in
anticipating and providing future health care services.
Mission Statement
1. We will partner with our affiliated state organizations to attack common problems.
2. We are committed to the advancement of all areas of research and education in poultry
technology.
3. The International Poultry Exposition must continue to grow and be beneficial to both
exhibitors and attendees.
4. We must always be responsive and effective to the changing needs of our industry.
5. Our imperatives must be such that we do not duplicate the efforts of our sister organizations
6. We will strive to constantly improve the quality and safety of poultry products.
Mission Statement
John Deere has grown and prospered through a long-standing partnership with the world's most
productive farmers. Today, John Deere is a global company with several equipment operations
and complementary service businesses. These businesses are closely interrelated, providing the
company with significant growth opportunities and other synergistic benefits.
The mission of USGS is to serve the Nation by providing reliable scientific information to
• describe and understand the Earth
• minimize loss of life and property from natural disasters
• manage water, biological, energy and mineral resources; and enhance and protect our
quality of life
Note to candidates: For the purpose of the Entrance Examination, candidates should focus on
understanding the elements of a PESTE, as well as identifying which category an item may fall
under in a PESTE analysis.
Description of PESTE
The purpose of an external audit is to identify opportunities that are favourable for an
organization and threats the organization should avoid. This external audit should not list every
possible factor that could influence a business, but should identify key factors. Strategies chosen
should take advantage of opportunities and/or minimize the impact of threats.
1. Economic
Refers to general economic conditions, such as disposable income, unemployment rates,
interest rates, foreign exchange rates, tax rates, etc. Trends in various economic conditions
impact industries. For example, sales for luxury goods fluctuate with fluctuations in
disposable income.
4. Technological forces
Technological changes can significantly impact organizations. The advent of the Internet,
which brought worldwide accessibility to information, as well as potential new markets in
foreign countries, changed the way many companies sold their product. Technological
innovation has resulted in new products and services, such as Research in Motion’s
“Blackberry”, which allows remote access to e-mail.
5. Competitive forces
This refers to rival companies. Understanding who competitors are and the strength of their
products or services is a critical element to take into consideration when formulating
strategies. However, obtaining information on competitors can be difficult, particularly if
the competition is a private company. News related to public companies is often reported
in the media, but news related to private companies is not.
Strategic Management
• GDP (gross domestic product)
• Trade agreements (GAAT and NAFTA)
• Inflation and employment rates
• Income distribution
• Personal and savings rates
• Wage rates
• Real disposable income per capita
• Real discretionary income per capita
• Retail sales aggregate and consumption per capita
• Transportation costs per capita
• Inventory to sales ratio
• Orders for durable goods
• Exchange rates for US/CDN, US/EURO, US, YEN
• Business inventories, business capital investment
• Average housing prices, annual home construction starts
• Relevant commodity prices (such as oil or coffee)
• Orders for non-defence capital goods (indicator of business investment plans)
• Wholesale price index, consumer price index, commodities price index
• Consumer confidence, investor confidence, producer confidence
• Labour productivity, capital productivity, total factor productivity
S – Socio-Cultural/Demographic Factors
• Level of diversity
• Age distribution of population
• Ethnic distribution – multi-cultural and multi-ethnicity (need for a greater level of
understanding of the role of hierarchical order, group harmony, duty over rights,
formality and self control, etc.)
• Education distribution (percentage with public school, high school, undergraduate and/or
graduate degrees)
• Regional distribution of population in country
• Income distribution by percentage
• Population size, growth and density
• Annual births/deaths, fertility rates, mortality rates
• Average percentage of home ownership
• Family/household size and the number of people working in a unit
• How people live, including their attitudes, values and preferences
E – Environmental Factors
Competitive/Industry Analysis
Porter’s Five Forces Model was created by Michael Porter and is widely used in developing
strategies. This model is:
1.2.1.3 Describes and conducts profit pool analysis (i.e. identifies where the
money is being made along the industry value chain) (see also 3.2.2)
a) Disaggregates the industry value chain (i.e. documents the flow of
goods from raw material suppliers to the end consumer) into different 9 9
segments
b) Identifies segments in the industry value chain to dominate and then
9 9
formulates strategies to improve organizational profitability
The following information on the Value Chain has been extracted from CMA Canada’s
Management Accounting Guideline “Value Chain Analysis for Assessing Competitive
Advantage”. It has been reprinted with permission.
Primary activities are directly involved in transforming inputs into outputs and in delivery and
after-sales support. These are generally also the line activities of the organization. They include:
• Inbound logistics. Material handling and warehousing;
• Operations. Transforming inputs into the final product;
• Outbound logistics. Order processing and distribution;
• Marketing and sales. Communication, pricing and channel management; and
• Service. Installation, repairs and parts.
Strategic Management
organization’s staff functions and include:
• Procurement. Purchasing of raw materials, supplies and other consumable items as well as
assets;
• Technology development. Know-how, procedures and technological inputs needed in every
value chain activity;
• Human resource management. Selection, promotion and placement; appraisal; rewards;
management development; labour/employee relations; and
• Company infrastructure. General management, planning, finance, accounting, legal,
government affairs and quality management.
This example has been extracted from CMA Canada’s Management Accounting Guideline
“Value Chain Analysis for Assessing Competitive Advantage”. It has been reprinted with
permission.
Organizations use the value chain approach to identify and understand the cost of their internal
processes or activities. The principal steps of internal cost analysis are:
• identify the organization’s value-creating processes;
• determine the portion of the total cost of the product or service attributable to each value-
creating process;
• identify the cost drivers for each process;
• identify the links between processes; and
• evaluate the opportunities for achieving relative cost advantage.
Once the drivers have been identified, it is necessary to determine what influences these drivers.
Once the influences have been identified, an organization is able to take action to improve areas
requiring improvement and to eliminate actions that do not add value to end product or service.
If the nature and intensity of Porter’s five forces or the core competencies vary for various
segments of an industry, then the structural characteristics of different industry segments need to
be examined. This examination will reveal the competitive advantages or disadvantages of
different segments. An organization may use this information to decide to exit a segment, to
enter a segment, reconfigure one or more segments or embark on cost reduction or differentiation
programs.
Differences in structure and competition among segments may also mean differences in key
success factors among segments. Using the value chain approach for segmentation analysis,
Grant (1991) recommends five steps:
i) identify segmentation variables and categories;
ii) construct a segmentation matrix;
iii) analyze segment attractiveness;
iv) identify key success factors for each segment; and
v) analyze attractiveness of broad vs. narrow segment scope.
The selection of the most useful segment defining variables is rarely obvious. Industries may be
subdivided by product lines, type of customer, channels of distribution and region/geography.
The most common segmentation variables considered are type of customer and product related,
as illustrated in Exhibit 10 [reproduced on the following page].
Customer Characteristics
Geographic Small communities as markets for discount stores
Type of organization Computer needs of restaurants vs. manufacturing organizations vs. banks vs. retailers
Size of company Large hospital vs. medium vs. small
Lifestyle Jaguar buyers tend to be more adventurous, less conservative than buyers of Mercedes
Benz and BMW
Sex The Virginia Slims cigarettes for women
Age Cereals for children vs. adults
Occupation The paper copier needs of lawyers vs. bankers vs. dentists
Produce-related Approaches
User type Appliance buyer – home builder, remodeler, homeowner
Usage The heavy potato user – the fast-food outlets
Benefits sought Dessert eaters – those who are calorie-conscious vs. those who are more concerned with
convenience
Price sensitivity Price-sensitive Honda Civic buyer vs. the luxury Mercedes Benz buyer
Competitor Those computer users now committed to IBM
Application Professional users of chain saws vs. the homeowner
Brand loyalty Those committed to IBM vs. others
This example has been extracted from CMA Canada’s Management Accounting Guideline
“Value Chain Analysis for Assessing Competitive Advantage”. It has been reprinted with
permission.
The first set of variables describes segments in terms of general characteristics unrelated to the
product involved. Thus, a bakery might be concerned with geographic segments, focusing on one
or more regions or even neighbourhoods. It might also divide its market into organizational types
such as at-home customers, restaurants, dining operations in schools, hospitals and so on.
Demographics can define segments representing strategic opportunities such as single parents,
professional women and elderly people.
The second category of segment variables includes those related to the product. One most
frequently employed is usage. A bakery may employ a different strategy in serving restaurants
that are heavy users of bakery products than restaurants that use fewer bakery products.
For example, restaurants could be divided into four dimensions: type of cuisine, price range, type
of service (e.g. sit-down, buffet, cafeteria, take-out, fast food) and location.
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of product and five channels of distribution are used to construct the two dimensional
segmentation matrixes consisting of 25 potential segments. However, not every cell in the matrix
may be relevant. Empty cells may represent future opportunities for products or services.
For example, in the frozen food industry segmentation, independent grocers and caterers may be
willing to substitute fresh fruits and vegetables for frozen goods. Therefore, the threat of
substitutes within the segments and from outside sources must be carefully examined.
In addition, the interrelationship among segments must be carefully considered. For example,
caterers may purchase frozen food items from supermarkets at bargain prices. Segments may be
natural buyers, sellers or substitutes for one another.
In the automobile industry, the luxury car and sports car segments were high-priced, high-margin
products with less intense competition than other automobile segments. The introduction of
high-quality, lower priced Acura, Lexus and Infiniti autos changed the competitive structure of
these high-priced segments.
Examination of differences among segments in buyers’ purchase criteria can reveal clear
differences in key success factors.
Sharing costs across different market segments may provide a competitive advantage. For
example, Gillette broadened its shaving systems to include electric shavers through its 1970
acquisition of Braun. Lipton recently entered the bottled iced-tea market.
On the other hand, when the Toro Company broadened its distribution channels for its snow
blowers and lawnmowers to include discount chains, it almost went bankrupt. Feeling betrayed, a
number of Toro’s dealers dropped its products.
A segment justifying a unique strategy must be of worthwhile size to support a business strategy.
Furthermore, the business strategy needs to be effective with respect to the target segment in
order to be cost effective. In general, it is costly to develop a strategy for a segment. The
question usually is whether or not the effectiveness of the strategy will compensate for this added
cost.
Understanding what the primary sources of profit are is important because it identifies the areas
in which money is being made and lost. When conducting profit pool analysis in individual
organizations, management can identify and focus their resources more strategically in those
value chain activities where the greatest profits can be made. This is different than looking at
the outcomes of different decisions from a revenue point of view. Looking at profits rather than
just revenues lets an organization know how effectively it is using its resources and whether
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valuable when making investment decisions concerning the different value chain activities. It
can provide evidence for either abandoning or investing in certain parts for the value chain
(weak, unprofitable areas may be outsourced so areas where profits are being realized can be
further developed) so that overall profitability of the organization can occur. There are four steps
to follow when identifying profit pools: (Source: Hitt, M., Ireland, D. and R. Hoskisson, (2007). Strategic
Management Competitiveness and Globalization, 7th ed., p. 26)
Stakeholder Analysis
Stakeholders have been defined as “any individual or group who can affect or is affected by the
actions, decisions, policies, practices and goals of the organization”. In other words, any group
impacted by the actions of the company is stakeholders. Stakeholders have been categorized into
primary and secondary stakeholders, as listed below.
Primary stakeholders:
• owners
• customers
• employees
• suppliers
• shareholders
• Board of Directors
• creditors (e.g. financers)
Secondary stakeholders:
• governments
• competitors
• interest groups
• general community
The above lists are not exhaustive. Any group or person who is impacted by the actions of an
organization is a stakeholder.
When creating a mission or vision statement, it is critical to consider the stakeholders needs and
wants. An organization must maintain performance at a sufficient level to maintain the
participation of key stakeholders. The first step in this process is to consider the stakeholders
when creating the vision and mission statement.
Capability to deploy
the resources
identified in the first
step
Core competencies
provide competitive
advantages.
Resources
Resources represent the inputs into a company’s production (or service) processes. Resources
are either tangible or intangible. Tangible resources are items that can be seen and quantified.
Intangible resources cannot be seen and are generally difficult to quantify.
The first step in the resource/capability/core competence analysis is to identify the resources an
organization currently has. Examples of intangible and tangible resources are.
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• Financial
- the company’s borrowing capacity
- the company’s ability to generate internal funds
• Organizational
- the company’s formal reporting structure and formal planning, controlling and
coordinating systems
• Physical resources
- physical assets, such as the plant and equipment
• Technological Resources
- Stock of technology, such as patents, trademarks, copyrights and trade secrets
Intangible Resources:
• Human Resources
- Knowledge and talent of employees
- Trustworthy employees
- Talented managers
- Strong organizational routines and procedures
• Innovation Resources
- Scientific capabilities
- Capacity to develop innovative ideas
• Reputational Resources
- Reputation with customers
- Brand name and company image
- Perceptions of product quality, durability and reliability
- Reputation with suppliers
- For efficient, effective, supportive and mutually beneficial interactions and relationships
Capabilities
Resources by themselves do not create a competitive advantage. It is the ability to utilize the
resources to create a core competency that is critical. The foundation of capabilities is the skills,
talents and expertise of the company’s employees. These employees develop an organization’s
capabilities over time by developing, carrying and exchanging information and knowledge
Core Competencies
The resources available, which are identified in Step 1 and the capability to use those resources,
which is developed over time, lead to a company having a core competence. These core
competencies can be exploited such that they provide a competitive advantage for the company.
Core competencies can be defined as activities a company does well compared to its competitors
or activities a company undertakes that add unique value to its goods or services.
Market Segmentation
Market segmentation involves aggregating prospective buyers into groups with common needs
and required benefits that will respond similarly to some market action. Markets can be
segmented by categorizing product or buyer characteristics (see below). This enables an
organization to effectively address its potential customers and, thereby, maintain or win more
market share (and presumably more profit). Even in the not-for-profit sector, segmentation
occurs so client needs can be addressed more effectively. Market segments consist of relatively
homogeneous groups of prospective buyers in terms of their wants, consumption patterns and
behaviours. A segment is different from a sector. For example, young middle-income
homebuyers would be a sector rather than a segment because these buyers will differ in what
they want in a home. Marketers do not create the segments. Their task is to identify the
segments and decide which to target. Due to the fact the wants of segment members are similar
(but not identical), it is often a good idea to present market offerings that are somewhat flexible
rather than presenting one standard offering to all of a segment’s members. A flexible market
offering consists of the product and service elements all segment members’ value as well as
discretionary options (perhaps for an additional charge) some members’ value. For example, a
vacation package may offer hotel and meals but charge extra for alcoholic beverages.
Segments are fairly large and attract several competitors; niches are fairly small and may attract
one or two competitors. Marketers usually identify niches by dividing a segment into sub-
segments. A niche is a more narrowly defined customer group than a segment. In an attractive
niche, customers have a distinct set of needs and will pay a premium to the organization that best
satisfies their needs. Niches gain certain economies through specializations. The low cost of
Internet marketing has led to many small start-ups aimed at niches. This can work well with
products customers do not need to see and touch.
Market segments can be constructed in many ways. In Canada, four typical ways markets are
segmented are by geographic, demographic, psychographic and behavioural.
Demographics include age, gender, education, income, occupation, race, religion, nationality,
social class, family size, stage in the family life cycle and the generation group. Marketers often
use several of these when segmenting, with age and gender being particularly common. There
are various labels applied to the many different age brackets based on when people were born.
For example, there are six different age classifications that tend to exhibit similar purchasing
patterns:
1) GI generation (born 1901–1924) – shaped by hard times and the Great Depression,
financial security is one of their core values, they tend to be conservative spenders and
civic minded;
2) Silent Generation (born 1925-1946) – trusting conformists who value stability, they are
not involved in civic life and extended families;
3) Baby Boomers (born 1947-1966) – great acquisitors, they are value- and cause-driven,
despite indulgences and hedonism;
4) Generation X (born 1967-1977) – cynical and media-savvy, they are more alienated and
individualistic;
5) Generation Y or echo boomers (born 1978-1994) – edgy, focused on urban style, they are
more idealistic than Generation X; and
6) Millennials (born 1995-2002) – multicultural, they will be tech savvy, educated, grow up
in affluent society and have big spending power.
(Source: Tsui, Bonnie, (2001). “Generation Next”, Advertising Age, January 15, pp. 14-16).
Behavioural segmentation divides consumers into groups on the basis of their knowledge of,
attitude toward, use of or, response to, a product. There are several ways to divide consumer’s
behavioural responses. The marketer can segment based on the consumer’s stage of readiness.
For example, is the buyer aware, informed, interested and desirous, and intending to buy? Usage
rate can also be used to segment. A person can be labelled as being a light, medium or heavy
user. The 80/20 rule states that 80% of an organization’s sales are obtained from 20% of its
customers. User status is also important. Someone can be a non-user, ex-user, potential user,
first-time user, regular user or an occasional user. Buyers can also be segmented according to
occasions such as Valentine’s Day, Christmas and Easter as well as when they develop a need to
There is also the Conversion Model, developed to measure the strength of the consumer’s
psychological commitment to brands as well as their openness to change in order to determine
how easily a consumer can be converted to another choice. The model assesses commitment
based on factors such as consumer attitudes toward and satisfaction with current brand choices in
a category and the importance of the brand selection decision in the category. (Source: Kotler, P.
and K.Keller (2006). “Identifying market segments and targets” in Marketing Management, 12th ed., p. 257-258).
Attitude toward a product can also be used to segment. Typically, there are five attitude groups
in a market. They include characteristics such as: enthusiasm, positivity, indifference, negativity
and hostility.
In addition to looking at behavioural issues, marketers must also consider the roles assumed
during a buying decision. Generally, people play five roles in a buying decision – initiator,
influencer, decider, buyer and user. The role assumed would partly determine the way that the
marketer interacts with the potential client.
Business markets can also be segmented using some of the same variables used in consumer
segmentation, as well as some additional variables considered. Like consumer-based
organizations, businesses dealing with organizational buyers may also ask the following
questions:
What demographic variables do they wish to address and what industries do they wish to
serve? In North America, organizations are categorized by the North American Industry
Classification System (NAICS) – some organizations have more than one NAICS code
because they operate in more than one industry
What geographic areas do they wish to serve (domestic, multi-domestic, international,
global)? What size organization do they want to serve? Estimate market size to see if it is
worth pursuing.
What behavioural variables do they consider by looking at benefits sought (e.g. quality,
customer service, low price), usage rate, user status, loyalty status, purchase method
(centralized, decentralized, individual, group) and type of buy (new buy, modified rebuy,
straight rebuy).
Some experts have combined geographic, demographic and behavioural segment variables used
in segmenting organizational markets to produce a segmentation concept known as
firmographics. Firmographics incorporates organizational characteristics such as location, size
of organization, industry category, corporate activities, business and buying objectives as well as
characteristics of the corporation of the organization (e.g. income distribution of employees, age,
Strategic Management
market groups and products to be sold are segmented into groups. This isn’t an issue if an
organization has only one product, but if it has multiple products, they need to be grouped in a
way buyers can relate to by setting up product groups.
The final step would be to develop a market product grid and estimate the size of the markets.
Developing a product grid means labelling the market (horizontal rows – your potential market)
and products (vertical columns – your market offerings) and then indicating the size of the
market in each cell or estimating the market product combination. From this, a target market
should be chosen. Choosing too narrow a segment can prevent an organization from reaching its
needed sales volume and profits; however, going too broad may spread marketing efforts too
thin. In addition, if there is a lot of competition, is this expected to continue?
To select the target segment, we look at market size, expected growth, competitive position, cost
of reaching segment and compatibility with the organization’s objectives and resources.
Organizations should only address market segments that meet the following key criteria:
1) Measurable –segment characteristics like size and purchasing power are measurable
2) Substantial – segments must be profitable enough to be worth serving
3) Accessible – segments can be effectively reached and served
4) Differentiable – segments are distinguishable and respond to different marketing mix
elements and programs
5) Actionable – effective programs can be formulated for attracting and serving segments
Product positioning refers to the place an offering occupies in consumer’s minds on important
attributes relative to competitive products. In contrast product repositioning involves changing
the place an offering occupies in a consumer’s mind relative to competitive products. There are
two main approaches in positioning a product in the market:
1) Head-to-head positioning, which involves competing directly with competitors on similar
product, attributes in the same target market.
2) Differentiating positioning involves seeking a less competitive smaller market niche in
which to locate a brand. Companies also follow a differentiation strategy among brands
in their own product line to try to minimize cannibalization of a brand’s sales or shares.
From this data, a perceptual map can be made. This displays in two dimensions the location of
products or brands in the minds of consumers so a manager can take marketing actions based on
how consumers perceive competing products or brands relative to their own.
Once the organization has decided what opportunities to pursue, it must determine how many to
target at one time. Increasingly, organizations are pursuing multiple opportunities in order to
better define target groups. This has led some market researchers to propose a more need-based
market segmentation approach. Roger Best proposed a seven-step approach to more clearly
define and segment markets:
1) Needs-Based Segmentation, where customers are grouped based on similar needs and
benefits solved in response to a particular consumption problem.
2) Segment Identification, where demographics, lifestyles and usage patterns make a distinct
segment actionable.
3) Segment Attractiveness, where attractiveness criteria such as market growth, competitive
intensity and market access are considered.
4) Segment Profitability examines how much in terms of profits can be made in the
segment?
5) Segment Positioning creates a “value proposition” and product-price positioning strategy
based on the segment’s unique consumer needs and characteristics.
6) Segment “Acid Test”, where segment storyboards are used to test the attractiveness of
each segment’s positioning strategy.
7) Marketing Mix Strategy looks at expanding the segment positioning strategy by adding
the elements of the product mix (product, place, promotion and price)
(Source of above framework: adapted from Robert J. Best, Market-Based Management,
Upper Saddle River, NJ: Prentice Hall, 2000)
Overview
Corporate strategy focuses on three questions:
1. What businesses should the corporation be in? For example, PepsiCo was in three businesses:
soft drinks, snack foods (Frito-Lay) and fast foods (KFC, Taco Bell and Pizza Hut).
2. How should the head office manage its business units? (e.g. centralized vs. decentralized,
inputs vs. outputs)
3. How will governance be handled? (Corporate governance and its relationship with the Board,
shareholders and stakeholders)
It is now widely accepted in financial markets and among corporate strategists that an
organization should not diversify into unrelated businesses (in the absence of synergy).
Moreover, time has demonstrated this is not an effective way to grow a company. Some people
argue that unrelated diversification is a good way for an organization to diversify risk for their
shareholders, but it is not an organization’s responsibility to diversify risk for its shareholders;
rather an organization should focus on how it’s going to maintain and grow the business.
Types of Diversification
Organizations vary by the degree of diversification. The following classification scheme can be
used to assist in the analysis of the corporate strategy.
• Single Business - >95% of revenues are from one business unit (e.g. Coca-Cola)
• Dominant Business – between 70% to 95% of revenues are from one business unit
• Related Diversified – less than 70% of revenues are from one business unit
(e.g. PepsiCo)
• Unrelated Diversified – multiple businesses that are not related to one another
(e.g. Hanson)
In adopting a strategy of diversification, the corporate manager should examine every acquisition
or start-up with a view to achieving a sharing of activities or transfer of competencies between
the business units. For example, Gillette acquired Duracell, which was considered a related
business because Gillette could share the costs of the distribution channel between Gillette
products and the battery products. Phillip Morris entered the beer industry by acquisition and
then transferred key marketing people from the cigarette business to the beer business, as the
marketing strategies were similar.
There are two forms of related diversification, concentric and horizontal. Concentric
diversification involves adding new related products or services and horizontal diversification is
used to offer new, unrelated products or services to current customers.
Overview
While corporate managers attempt to create “corporate advantage” (among their businesses), it is
the role of business unit managers to achieve a “sustainable competitive advantage” (in each of
their businesses) by taking the core competencies created by the different functional areas in the
organization and combining them to exploit opportunities in the environment. The primary task
at the business level is to ensure competitive advantages accrue when an organization’s products
are preferred over the offerings of other organizations. Competitive advantage is normally
secured by offering a product that is preferred and/or one that is attractive because of its price.
Cost Uniqueness
(Diagram adapted from Michael Porter’s book Competitive Advantage: Creating and Sustaining Superior
Performance, 1998)
The choice of a particular business strategy is a function of the analysis of the external
environment and industry environments identified the opportunities and threats as well as the
analysis of the organization that identified the strengths and weaknesses in the value chain.
(More information on business level strategies will follow in sections 1.2.5.1 and 1.2.5.2)
Market Strategies
Another way of looking at strategies at the business level is to use the marketing strategies
framework. Market penetration, market development and product development are referred to as
intensive strategies. Basically, in order to bring an existing product to a different level of
competitive advantage, concentrated efforts must be invested.
Market Penetration
A market penetration strategy aims to increase market share for existing products or services.
Increasing the market share of a product can mean increasing the number of stores or the number
Strategic Management
more demand by current customers.
Market Development
A market development strategy seeks to develop a new geographic market for existing products
or services. An example is Beavertails, which was developed as an Ottawa-Rideau canal winter
treat. You can now buy Beavertails in other places such as La Ronde in Montreal, Mont-
Tremblant and even Florida. The same applies to McDonald’s as it has diversified in many
countries (including Russia).
Product Development
Some companies advertise their products as “new” and “improved” in order to build up the sales.
A product development strategy aims to improve sales through either improving existing
products or services or by developing a new product or service. Improving existing products or
services is usually less expensive than developing a new product. Overall, a product or service
normally has a life cycle and a mature company will try to have products at different stages of
development at any time. Reference to the application of this strategy is explained in the product
life cycle of the marketing module.
Although second movers forgo the advantages that accrue to the first mover (especially in terms
of market share), if they respond quickly to the first mover and enter the market ahead of the late
movers and laggards, there are a number of benefits. A second mover is an organization that
Outsourcing
Outsourcing is simply the purchase of a value-creating activity from an external supplier.
Outsourcing is an effective and often necessary approach as few organizations can afford to
develop internally the skills and technologies needed to get and keep a competitive advantage.
Attempting to build competencies in all areas can cause an organization to become overextended
and thus decrease their competitiveness. When an organization outsources activities in which it
lacks competence, it frees up time and resources, which can be focused on those areas where it is
capable of building strong competencies leading to a competitive advantage. Companies can
investigate how effectively they are performing internal activities by examining profit pools
and/or conducting activity based costing and/or doing a cost benefit analyses. The results should
be compared to the cost of outsourcing the less strategically relevant activities keeping in mind
that outsourcing an activity to an outside source with strong expertise in a particular area can
result in improved performance and savings for the organization and added value for the
company’s stakeholders.
There are things that must be considered carefully when outsourcing. The first consideration is
an organization should never outsource anything that is currently a source of competitive
advantage for them. For example, companies should exercise extreme caution when outsourcing
activities that could result in a potential decrease in an organization’s ability to innovate. The
second consideration is managers need to be capable of creating and managing partnerships in a
strategic manner so internal management can fully benefit from work done by their partners.
Management must be able to oversee and govern the partnership arrangement as well as help the
organization adapt to changes that inevitably occur when an organization’s structure and
operations change.
Overview
Once the business strategy has been determined, it is the role of the business managers and the
functional managers to choose which functional strategies will support the business strategy.
Functional strategies are developed and implemented in all the functional areas of a business.
They become the game plans for the business. They also detail how key activities will be
managed.
2. Growth stage
• costs are reduced due to economies of scale
• distribution channels are developed
• sales volume increases significantly
• profitability is achieved
• customers are aware of the product
• competition begins to increase with a few new players in establishing market
• prices are set to maximize market share/maximize profitability
Introduction Stage
The characteristics of this stage from a strategy perspective are:
• products are unfamiliar to consumers
• market segments not well defined
• product features not clearly specified
• competition tends to be limited
Therefore, strategies need to be focused on developing the product and getting users to try it as
well as generating exposure for the product so it becomes well known and standard.
Growth Stage
The characteristics of this stage from a strategy perspective are:
• strong increases in sales
• attractive to potential competitors
• primary key to success is to build consumer preferences for specific brands (brand loyalty)
Therefore, strategies need to be focused on efficiency in manufacturing and lower costs. During
the maturity stage, customers become more price-sensitive, so lowering costs becomes
important.
Saturation/Decline Stage
The characteristics of this stage from a strategy perspective are:
• industry sales and profits begin to fall
• strategic options become dependent on the actions of rivals
Therefore, strategies need to be focused on maintaining market share, exiting the market or
exiting specific segments. Another strategic option is to consolidate with other competitors.
This strategy focuses on reducing cost through efficiency. It is often used for products that are
standardized and can be produced in high volumes at low cost. Producing high volumes allows a
company to achieve economies of scale. Implicit in producing high volumes is that consumer
demand is also high. For this reason, the products most conducive to this type of strategy are
standardized products that can be produced at low cost and be made available to a large
consumer base. To maintain the low cost strategy, companies must continuously search for cost
reductions in all aspects of the business. This also includes the distribution network. Since this
strategy requires the product be made available to large numbers of customers, it is necessary to
have a distribution network that allows for the most extensive distribution possible.
This strategy usually requires significant market share or preferential costs for raw materials,
components, labour or some other raw material. If a company does not have either of these
advantages (market share or preferential costs for one or more of the raw materials), the strategy
could easily be imitated by competitors.
Companies attempt to maintain a low cost base by controlling production costs, increasing their
capacity utilization, controlling material supply or product distribution and minimizing other
costs including research and development and advertising.
The most important aspect of implementing a cost leadership strategy is the need to continuously
seek cost reduction opportunities across every aspect of the business, from manufacturing to
distribution, to the final sale of the product to the final consumer. Attempts to reduce costs will
spread through the whole business process from manufacturing to the final stage of selling the
product. Any process that does not minimize costs needs to be changed or it could be outsourced
to a company that can carry out the process at a lower cost.
The cost efficiencies gained throughout the process will enable a company to charge a price
lower than competition, which ultimately results in higher sales, since competitors cannot match
the low cost. If the low cost can be maintained for longer periods of time, the result is an increase
in market share. However, it should be noted that if the competitor is able to alter its operations
so it can offer customers the same low price, then the competitive advantage will no longer exist.
The differentiation strategy refers to the creation of a product or service seen by the consumer as
being unique in some way. The uniqueness of the product allows the company to charge a
premium for its product. The differentiation can take many forms, such as:
• specialty design
• brand image
• technological features
• customer service
This strategy often results in brand loyalty and brand loyalty results in lowered sensitivity to
price. This means increased costs can be passed on to the consumer. In addition, consumer
loyalty often is a barrier to entry for new competitors. Examples of companies using the
differentiation strategy are Apple and Mercedes Benz.
Guidelines for considering when divestiture may be appropriate (per Fred R. David’s “How Do
We Choose Among Alternative Growth Strategies?”):
Methods of Restructuring
An organization restructures when it changes its set of businesses or its financial structure.
When failed acquisitions are sold off, companies typically undertake a restructuring strategy.
Restructuring organizations tend to have less slack (additional uncommitted resources) and,
therefore, find it difficult to absorb as many errors, thus making an organization vulnerable. An
organization can be restructured through both growth and non-growth strategies. Although most
strategies assume a corporate strategy of growth, many organizations also pursue non-growth
strategies such as downsizing, downscoping, leveraged buyouts, divestiture and liquidation.
These strategies are commonly used when an industry is in the decline stage; however, they are
also used as a way to restructure an organization when an organization determines they do not
have the competitive capabilities required to compete successfully in a particular market (due to
Page 396, ¤CMA Ontario Please report errors or omissions to
Page 396 studymanual_errata@cmaontario.org
Strategic Management
strategies can be positive if a company uses them as a way to restructure its organization,
improve its effectiveness and prepare for the future.
Downsizing
Although downsizing was once thought to be indicative of organizational decline, the business
world now accepts downsizing as a legitimate restructuring strategy. When a company
downsizes, it reduces the number of its employees and/or the number of operating units. This
may or may not change the composition of the businesses in its portfolio. Downsizing is not a
quick fix. Research has shown that major downsizing efforts have contributed to lower returns
for North American organizations (moderate-sized layoffs may improve performance*). Many
organizations view employees as costs rather than human capital. In contrast, some investors
fear long-term strategic competitiveness may be negatively impacted when an organization loses
the knowledge and experience of long-term employees. In addition, investors may respond
negatively if they assume downsizing occurs as a consequence of other problems in a company.
These factors suggest that downsizing is more of a tactical (short-term) approach than a strategic
(long-term) approach. However, one unexpected positive result of downsizing is laid off
employees sometimes start new businesses. (*Source: Nixon, R., Hitt, M., Lee, H. and Jeong, E. (2004).
“Market reactions to corporate announcements of downsizing actions and implementation strategies”, Strategic
Management Journal, 25:1121-1129)
Downscoping
When an organization downscopes, it divests at least one business that is unrelated to its core
business. Many organizations downsize and downscope simultaneously. When downscoping, an
organization must avoid eliminating key employees from its core businesses as this may
jeopardize one or more core competencies. An organization is often able to refocus itself in a
more positive direction after a reduction in the breadth and number of businesses in its portfolio.
This can lead to increased effectiveness, as the organization is often better able to manage the
remaining businesses. Downscoping typically results in more overall positive outcomes than one
finds in leveraged buyouts.
Leveraged Buyouts
There are three types of leveraged buyouts: whole-firm buyouts, management buyouts and
employee buyouts. A leveraged buyout is a restructuring strategy that involves buying all of an
organization’s assets in order to take an organization private. A common reason for a buyout is
to protect against unpredictable financial markets. Going private allows the owners to focus on
entrepreneurial activities with the potential to initiate a rebirth of the business and stimulate
growth. It is referred to as leveraged because these transactions normally involve high levels of
debt financing. High levels of debt increase the organization’s risk exposure. To support debt
repayment, the new owners typically sell a number of assets.
Liquidation
Liquidation involves selling all company assets and terminating its existence. Some businesses
are just not worth saving. An early liquidation normally benefits the stakeholders more than if a
business waited for bankruptcy to occur since prolonging an organization’s existence only drains
assets.
Integration Strategies
Vertical integration strategies allow an organization to gain control over distributors, suppliers
and/or competitors (i.e. control over the distribution channel).
There are two types of vertical integration strategies: forward integration and backward
integration. Another integration strategy is horizontal integration, which involves obtaining
ownership or control over competitors.
• Forward Integration
This involves gaining ownership or control over distributors or retailers (i.e. control sale or
distribution to the consumer). An example would be the acquisition of an office supply store
chain by a forest products company. The forest products company not only manufactures the
paper, but also controls the sale to consumers through ownership of the chain of office supply
stores.
• Backward Integration
• Horizontal Integration
This strategy involves obtaining ownership or control over competitors. Merging, acquiring
or otherwise taking over a competitor allows for increased economies of scale and enhanced
competencies. However, it should be noted that increased economies of scale often are only
achieved when the merged businesses are in the same industry. This is because there is
greater potential for eliminating duplicate facilities when the companies operate in the same
industry. When there is a merger of two unrelated businesses, these economies of scale are
often not achieved because there is limited duplication.
Strategic Management
Choose Among Alternative Growth Strategies?”) are:
• Sales expansion
Three factors often result in companies attempting to increase sales through international
expansion:
Strategic Management
Companies competing based on price are constantly seeking opportunities to reduce costs.
Expanding to international sites may reduce costs by spreading fixed expenses over increased
sales, produce using cheaper inputs (both raw materials and labour) or by achieving vertical
integration.
• Risk-reduction motives
To smooth sales (i.e. reduce swings in sales and profits), a company may enter a foreign market
with different timing for its business cycle. Entering a foreign market decreases dependence on
existing customers and suppliers.
• Global
The parent company integrates its operations that are located in different countries.
Characteristics of multi-domestic organizations are:
- the company offers standardized products across the various countries, with the
competitive strategy being dictated by the parent company
- emphasizes economies of scale
- strategic and operating decisions are centralized at the parent company, with
interdependent strategic business units operating in each country; the parent company
integrates across the strategic business units in each country
- is less responsive to local market opportunities (due to offering standardized products
in different countries)
Political risks
• government instability in the foreign country
• conflict or war
• government regulations (and the changing of those regulations)
• conflicting and diverse legal authorities
• potential nationalization of private assets
• government corruption
• government bureaucracy
• changes in government policies
Economic risks
• fluctuations in foreign currency rates
• monetary regulations and changes in these regulations (for example, many countries have
regulations limiting the amount of capital that can be removed from the country; this means
profits earned may not be able to be repatriated back to the parent company)
In addition to the political and economic risks, it is important that companies examine the
cultural environment in the foreign country and ensure its products and marketing is appropriate
for the culture. The cultural environment includes:
• sellers must examine the ways consumers in different countries think about and use
products before planning a marketing program.
• business norms vary from country to country.
• companies that understand cultural nuances can use them to their advantage when
positioning products internationally
• Exporting
- this is the lowest cost method to establish operations in a foreign country (compared to
the other alternatives); often it involves establishing a contractual relationship with a
local distributer
- transportation costs are high
- there may be tariffs imposed by the foreign country
- control over distribution is limited
• Licensing
- cost to expand internationally is low
- the licensee has the risk (i.e. the licensee takes on the risk of the product not selling
well)
- there is no control over the manufacturing and the marketing of the product; the
licensee has this control
- returns many not be as high as direct sales, as the licensee pays licensee fees and/or
royalties
- there is a risk the licensee may use the product inappropriately or perhaps imitate the
product
• Strategic alliances
This represents an agreement between two parties, whereby each party contributes different
skills and each party takes on some of the risk. Characteristics of strategic alliances are:
- shared risks and resources
- facilitates the development of core competencies for each party
- the resources required to enter the foreign market is less than establishing a subsidiary
in the location
- there may be incompatibility, conflict or lack of trust with partner, discovered at a later
date
- some alliances may be difficult to manage
“Strategic partnering” has become more common because it has proven to be an effective way of
enhancing corporate growth. Strategic partnering can occur using many forms, such as
outsourcing, information sharing, joint marketing and joint research and development.
Strategic Management
partnerships may fail. Common problems causing a joint venture or partnership to fail are:
1. Managers who must collaborate daily in operating the venture are not involved in
forming or shaping the venture.
2. The venture may benefit the partnering companies, but may not benefit customers who
complain about poorer service or criticize the companies in other ways.
3. Both partners may not support the venture equally. If supported unequally, problems
arise.
4. The venture may begin to compete more with one of the partners than the other.
Strategic Alliances
This type of structure entails cooperation between competitors. An alliance represents a
collaborative agreement between competitors whereby each competitor contributes a distinctive
item, such as technology, distribution ability, basic research or manufacturing capacity.
A risk with strategic alliances is too much information or transfers of skills/ technology occurs
(i.e. more than intended in the initial agreement).
A good example of an effective alliance is the Star Alliance in the airline industry. The Star
Alliance had 16 airlines as of early 2004, including Air Canada, United Airlines and Lufthansa,
to name a few. In the increasingly difficult airline industry, competing as a group makes it easier
for each airline in the alliance to survive.
An acquisition results when one organization buys controlling or 100% interest, in another
organization with the intention of making the acquired organization a subsidiary business within
its portfolio. Normally, a larger organization purchases a smaller organization, but the reverse
can also occur. When this occurs, the acquired organization comes under the control of the
acquiring organization.
Another form of acquisition (called a takeover) occurs when a target organization does not
bother to solicit the acquiring organization’s bid. As many takeover attempts are not desired by
the target organization’s managers, they are referred to as hostile takeovers. Takeovers are
particularly common during economic downturns when it becomes more obvious, which
organizations are in a precarious position and are thus great targets. If both organizations are in
favour of the acquisition, it is termed a friendly merger.
There are many reasons why organizations, even ones that have been fierce rivals, may want to
merge. Mergers and acquisitions can improve corporate competitiveness because they:
• increase market power;
• yield economies of scale (two organizations are bigger than one);
• provide access to new suppliers, distributors, customers, products and creditors;
• provide new technologies;
• increase access to funds when there is a depressed stock market (therefore, it maybe
unproductive to raise money by issuing stock);
• improve capacity utilization, reduced entry barriers;
Strategic Management
• share research and development costs;
• obtain products to market more quickly;
• reduce risk if development costs are shared;
• increase diversification;
• avoid excessive competition;
• increase opportunity to learn and develop;
• reduce tax obligations, and
• take advantage of deregulation and technological change (making it easier to merge).
There are some factors that can improve the probability of having a successful merger or
acquisition:
• horizontal acquisitions tend to be more favourable because they increase market power
by exploiting synergies;
• establishing friendly relationships with the acquiring organization before finalizing the
deal;
• the more related the acquired organization is to the purchasing organization, the greater
the probability of the acquisition being successful;
• if organizations possess similar characteristics such as similar strategies and managerial
styles;
Products
Existing Products New Products
Current Markets Market Penetration Product development
New Markets Market development Diversification
Market penetration
• Increasing sales of current products in existing markets
Since this involves no change in the basic product line(s) or the market(s) served, it is the
least risky.
Selling related products may not be risky; however, introducing completely new products
may be risky as a company’s current customer base may not purchase the new product. This
means the company may need to develop an entirely new customer base, which can be
expensive and take time.
Market Development
• Selling existing products to new markets; this involves expanding the customer base
This could involve expanding to international markets to develop the customer base.
Diversification
• Developing new products and sell them in new markets.
This is the highest risk and most expensive, as it involves new products, which requires time
and effort to develop as well as developing new markets, which is expensive and can take a
long time.
The impact of business on society and vice versa is increasing. More is expected of business
than ever before. It is no longer enough for companies to just provide employment. Managers
are mandated to consider the needs of consumers, communities, minorities, environmentalists
and other groups.
Social capital is a critical asset that involves relationships inside and outside the organization that
assists the company in accomplishing its tasks and creating value for its customers and
shareholders. Having social capital means an organization has the necessary social relationships
needed to conduct business effectively.
Another key part of gaining social capital involves establishing relationships that benefit the
organization less directly, such as those formed with the external stakeholders in the community
or society at large. Exhibiting a strong sense of corporate social responsibility in this context
becomes “good will”, which can build the brand name and reputation of the company and, if well
managed, can lead to above average returns.
An example of a social cause that can build social capital is demonstrating a concern for the
environment. Environmental awareness is needed in many aspects of a business such as
purchasing, product design, manufacturing, transportation, packaging and product disposal (a
cradle to grave approach). Effectively, managing environmental affairs can create social capital
by creating positive relationships with stakeholder groups.
Candidates are advised to keep up-to-date on current innovations and best practices by reading
CMA Magazine and CMA Canada Management Accounting Guidelines, which can be found at
www.cma-canada.org. As best practices and current innovations are continually evolving, it is
up to the candidate to keep current through reading literature published by CMA Canada.
1.3.1.1 Describes the relative merits of simple, divisional and matrix designs 9 --
1.3.1.2 Describes the relative merits of centralized and decentralized designs 9 --
1.3.1.3 Describes the relative merits of a narrow and broad span of control 9 --
The structure of an organization is the formal means by which it coordinates the activities of
employees to accomplish its objectives. All organized human activity requires two forms of
structure: the division of labour into the various tasks that need to be performed and the
coordination of these tasks to produce the organization’s outputs. In an organization, different
members of the work force are assigned component tasks necessary to achieve the organization’s
mission. These component tasks are called roles. Organizational structure is the skeleton of an
organization that captures the relationships among the different roles of the organization.
Simple (Functional)
This structure is organized according to function (sales, finance etc.). This form is most
appropriate when there is a need for collaboration and expertise within a function, the
environment is stable and when there are only a few products. However, this form is slow to
respond to change and may result in less innovation.
Example of a functional structure:
Market Shipping
Develop- Sales Purchasing Manufacturing and Finance Accounting
ment Receiving
Executive Vice-President
Information Consumer
Systems Products
Group Group
Decentralization offers increased flexibility and employees develop greater decision making
skills.
Span of Control
This refers to the number of employees who report to a single supervisor. The span of control has
an influence on the height of an organization. For example, if the span of control becomes too
large, another layer may be added.
Complexity
Complexity refers to the degree of division of labour and specialization and can occur
horizontally or vertically.
Horizontal Differentiation
This is when work is divided up and allocated among people at the same level. Horizontal
differentiation usually results in departmentalization (discussed earlier). The difference between
line and staff functions is a form of horizontal differentiation, which reflects differences in
responsibilities.
Note that horizontal and vertical differentiation is closely related to span of control.
Spatial Differentiation
This occurs when work is carried out in different physical locations. It is more difficult to
coordinate the activities of groups of employees who work in different locations.
A company’s culture is made up of beliefs about how business ought to be conducted, values and
principles of management, patterns of “how things are done” and stories illustrating a company’s
values, traditions, taboos and ethical standards. Culture comes from the company founder or
early leader, influential individuals or work groups, traditions, management practices, employee
attitudes, organizational politics, policies, vision, strategies, traditions and relationships with
stakeholders. Managers generally stamp strategies with their own personal values, ambitions and
business philosophies, attitudes toward risk and ethical beliefs and values.
Culture must be examined as a part of an internal analysis since culture can contribute to or
hinder successful strategy execution. The requirements for successful strategy execution may or
may not be compatible with culture. Therefore, culture can dominate the strategic moves a
company will consider or reject. If an organization finds its proposed strategy does not fit with
its culture, the organization should adapt its culture (although this will take some time) since a
close match between culture and strategy promotes effective strategy execution.
Strategic Management
operating practices; they provide standards, values, informal rules and peer pressures that
nurture, motivate and promote positive strategy execution as well as strengthen employee
identification with the company. Positive cultures stimulate people to take on the challenge of
realizing the company’s vision, doing their jobs competently and enthusiastically, and
collaborating with others to execute the chosen strategy. Strategy supportive cultures are also
more likely to accept change, meet customer needs and develop needed capabilities.
Strong culture organizations exhibit a genuine concern for the well-being of customers,
employees and shareholders. Weak culture organizations are characterized by politicized
internal environments where issues are resolved on the basis of turf, there is hostility to change,
experimentation and efforts to alter status quo are discouraged and managers are typically more
concerned about process than about results. Along with a must-be-invented here syndrome, there
is also an aversion to look outside for superior practices.
1.3.2.2 Describes the boundary systems, such as codes of conduct, policy manuals
and procedures
a) Understands the role an organization’s boundary systems play in
9
implementing strategy and strategic control systems
b) Assesses and recommends changes to an organization’s boundary systems
9 9
with respect to implementing the chosen strategy
Boundary Systems
Boundary systems establish rules of the game and identify actions and pitfalls employees must
avoid. Boundary systems are based on the “power of negative thinking”. It works like this: if a
manager wants an employee to do something, are they better off telling them what to do or what
they should not do? With boundary systems, the answer is the latter. It is believed telling people
what to do through the establishment of policies, procedures and rulebooks discourages initiative
and creativity that can be unleashed by empowered, entrepreneurial employees. Telling people
what they should do is thought to stifle innovation and creativity.
In contrast, telling them what not to do allow innovation within clearly defined limits. Boundary
systems stated in negative terms act as the organization’s brakes, outlining the areas where
employees must not go. There is an underlying assumption people are ethical and want to do the
correct thing. It is believed pressure in the workplace to achieve results is what causes employees
to bend the rules. Entrepreneurial individuals can misinterpret the line between acceptable and
unacceptable. Normally, ethics codes are expressed in positive terms; what one should do rather
than what one should not do. Like the Ten Commandments, boundary systems are expressed as
the set of rules one should not break or boundaries one should not cross over. Many companies
find setting strict boundaries for employees is essential, since breaking certain rules can have
profoundly negative impacts. Unfortunately, boundary systems are usually not put in place until
after a public scandal.
Adherence to an ethical code requires that the CEO communicate values and ethics to all
employees through employee training programs, management involvement and strong
endorsement. Any applicants who do not exhibit compatible character traits should be screened
out during the hiring process. Guidelines to prevent unethical behaviour must be established and
unethical behaviour must be punished. Ethics should be mentioned in the mission statement and
whistle blowing (reporting incidents of dishonest or unethical behaviour without fear of reprisal)
should be an acceptable practice. Larger organizations can even create a position for an ethics
officer. Company activities must be conducted within bounds of what is considered ethical and
in the public interest and corporate social responsibility should be celebrated and practiced.
Highly ethical organizations respond positively to emerging societal priorities and expectations
and demonstrate a willingness to take required action ahead of regulatory confrontation; there
should also be a willingness to be a “good citizen” in the community.
In order to ensure fairness among stakeholders, property rights must be considered. For
example, shareholders expect some form of return on their investment (normally the strongest
property rights); employees expect respect for their worth and devoting their energies to the
organization; customers expect reliable, safe products and services; suppliers and distributors
expect an equitable relationship with an organization; and a community expects businesses to be
good citizens in their community.
A culture based on ethical principles is vital to long-term strategic success. Some topics found in
company ethics codes include issues surrounding:
• supplier and distributor relations
• fairness in marketing practices
• using inside information
• conflicts of interest
• corrupt practices
• acquiring information
• political activities
• use of company assets
• proprietary information
• pricing
Some benefits of ethical behaviour in business include the regulation of the pursuit of self-
interest, maintenance of legality, people not wasting time trying to decide what is appropriate
and upholding fair competition (based on price and quality), which yields gains for consumers
and creates a positive reputation effect; acting ethically promotes the good of society.
Many organizations have policy and procedures manuals. For example, they normally contain
job descriptions for all the positions in the organization; therefore, they are useful for orientating
and training new employees. They spell out the proper way to do things and can be useful as a
reference. Policy and procedure manuals are time consuming to create and keeping them up to
date means they must be reviewed regularly. The downside of policy and procedure manuals is
they are so seldom used and are often left on a shelf and only consulted when it is time to review
them again. However, the process of writing and reviewing can be valuable as it forces
managers to rationalize and assess how things are done in the organization.
Note to candidates: This material is identical to the Balanced Scorecard material presented in the
Performance Measurement section of this manual. The CMA Competency Map lists this topic in
both sections, which means this topic could appear in either the Performance Management or the
Performance Measurement sections of the Entrance Examination. This material is included in
both sections of this manual to emphasize this fact to candidates.
The following material has been extracted from the CMA Canada Management Accounting
Guideline ‘Applying the Balanced Scorecard”. It has been reprinted with permission.
The four categories [financial, customer, internal business processes, learning and growth] in
Kaplan and Norton’s Balanced Scorecard can be described as:
i) Financial
The first category on the Kaplan and Norton balanced scorecard is financial. Managers
devising financial measures should ask themselves, “How can we show our strategy is
succeeding financially?” At the highest level, long-term profitability and stock price
growth demonstrate financial success of the strategy. But managers should also consider
financial measures particular to their strategy. If the organization is young and on a high-
growth trajectory, sales growth by sales channel may be a critical financial measure. If the
organization operates in a mature business, cash flow may be the right measure. If it falls
in between, economic profit, a measure that charges the company for the cost of equity
capital, may be the correct measure.
It is not sufficient that an organization implement a chosen strategy, it is critical to monitor and
adapt strategies to changing environmental conditions. A strategy, which is successful today,
may not be successful tomorrow.
It is the role of both senior management and the Board of Directors to continually monitor the
success of an organization’s current strategies and adapt or, alternatively, develop new strategies.
Candidates are advised to keep up-to-date on current innovations and best practices by reading
CMA Magazine and CMA Canada Management Accounting Guidelines, which can be found at
www.cma-canada.org. As best practices and current innovations are continually evolving, it is
up to the candidate to keep current through reading literature published by CMA Canada.
Risk Management
ENTERPRISE RISK MANAGEMENT ......................................................................................................459
DRIVERS OF INCREASED RISK AWARENESS ..............................................................................................461
APPROACHES TO RISK MANAGEMENT.......................................................................................................461
THE PROCESS OF RISK MANAGEMENT .....................................................................................................462
RISK MANAGEMENT FOR SPECIFIC BUSINESS FUNCTIONS .........................................................................465
INFORMATION RISK ..................................................................................................................................465
RISK ASSESSMENT IN DUE DILIGENCE ......................................................................................................465
COMPREHENSIVE RISK MANAGEMENT ......................................................................................................466
Governance
GOVERNANCE.........................................................................................................................................467
ROLE AND RESPONSIBILITIES OF THE BOARD OF DIRECTORS .....................................................................468
COMMITTEES OF THE BOARD OF DIRECTORS ............................................................................................468
IMPROVING THE PERFORMANCE OF CORPORATE BOARDS .........................................................................471
Internal Control
Competence
Skill Level: R/U A/A
2.1.2.1 Discusses the objectives and role of internal control with respect to integrity,
ethical values and competence
• Explains how an organization’s integrity and internal controls are
9
dependent on proper segregation of duties
• Explains how internal controls, such as access controls, authority limits
and validity checks, provide reasonable assurance of the accuracy of an
organization’s accounting records and discourage fraud and 9
misappropriation of assets
• Discusses how internal controls, such as selection and training of
employees, improve the efficiency and effectiveness of an organization’s 9
operations
• Explains the role information systems play in an organization’s control
9
system
• Recognizes ethical considerations in making business decisions 9
Segregation of Duties
First, it is important to understand what segregation of duties entails. There are three general
guidelines for segregation of duties:
• separation of the custody of assets from accounting
This protects a company from defalcation. If a person has both custody of the asset and is
responsible for accounting for it, there is a risk the person may use or steal the asset for
personal gain and adjust the accounting records to cover their tracks.
Internal controls should be in place to ensure processes are doing what they are intended to do
(i.e. achieving their objectives) and doing so in an efficient manner (i.e. making good use of
available resources).
In addition, computer systems can log attempts to misappropriate a company’s assets or other
such unauthorized activity. These logs are reviewed and any necessary action can be taken.
Internal Control
Skill Level: R/U A/A
2.1.2.2 Explains the impact of the following on overall organizational control:
management’s philosophy and leadership style organizational structure,
assignment of authority and responsibility, personnel policies and
procedures, and the external environment
a) Explains how the following improve an organization’s control
environment and reduce the potential for deviant employee
behaviour: corporate code of conduct, strong ethical culture, 9
organizational structure, assignment of authority and
responsibility, and personnel policies and procedures
b) Explains how the integrity of the CEO and senior management
9
set the “tone from the top”
c) Explains how an organization’s control environment is affected
by the external environment (both domestic and international),
9 9
evaluates the effectiveness of internal controls in light of changes
in the external environment and proposes improvements
The control environment refers to the overall ‘tone’ the organization has towards internal control.
This attitude toward internal control sets the foundation for all other components of internal
control; it provides discipline and structure to the creation of internal controls. The control
environment is broken into the following factors:
• Codes of Conduct
The existence and enforcement of codes of conduct and other policies regarding
acceptable business practice, conflicts of interest or expected standards of ethical and
moral behaviour. The codes of conduct may be formal or informal.
• Unrealistic Pressures
This refers to pressure to meet unrealistic performance targets, which can be indirect
pressure or direct pressure by basing compensation on achieving the unrealistic
performance targets.
Commitment to Competence
This consists of:
• Formal or informal job descriptions that define tasks for particular jobs.
• Analysis of the knowledge and skills needed to perform jobs adequately (e.g. through
proper interviews for potential employees, adequate screening of applicants skills etc.)
Internal Control
The Board of Directors and the Audit Committee must receive sufficient information on a
timely basis to allow monitoring of management’s objectives and strategies, the
organization’s financial position and operating results, and terms of significant
agreements.
In addition, the Board needs to be apprised of sensitive information, investigations and improper
acts on a timely basis in order to address the issues.
Organizational Structure
This refers to:
• Appropriateness of the entity’s organizational structure
The structure must be able to provide the necessary information flow to manage its
activities.
Internal Control
Skill Level: R/U A/A
2.1.2.3 b) Understands the role of risk assessment in the development of internal
controls for a given organization and the processes it uses to identify 9
business risks and decide on actions that address those risks
An organization’s performance can be at risk due to internal or external factors, which can affect
the company’s stated or implied objectives. An entity’s risk assessment process should be
comprehensive and consider risks that may occur. There are two types of risks that need to be
considered, external and internal.
The risk analysis process needs to be thorough and relevant and include:
• estimating the significance of a risk
• assessing the likelihood of the risk occurring
• considering how the risk should be managed
External Risks
The organization needs to ensure there are adequate mechanisms to identify risks arising from
such external factors as:
• technological developments
• changing customer needs or expectations
• competition
• new legislation or regulation
• natural catastrophes
• economic changes
Internal Risks
The organization needs to ensure there are adequate mechanisms to identify risks arising from
such internal factors as:
• disruption in information systems
• quality of personnel hired and methods of training and motivation
• change in management responsibilities
• nature of the entity’s activities and employee accessibility to assets
• unassertive or ineffective Board or Audit Committee
• Openness and effectiveness of channels with customers, suppliers and other external
parties for communicating information on changing customer needs.
• Extent to which outside parties have been made aware of the organization’s ethical
standards.
Internal Control
Skill Level: R/U A/A
2.1.2.3 e) Explains how an organization’s control activities (e.g. IT controls,
physical controls, approvals, verifications, supervision and security of
9 9
assets) help ensure management directives are carried out (see also
2.1.2.1)
Control activities refer to policies (which establish what should be done) and procedures (the
actions of people to carry out policies) to help ensure management guidelines or rules identified
as necessary to address risks are carried out. Policies and procedures can be divided into three
categories:
• operations
• financial reporting
• compliance
Various controls may be put into place to ensure objectives are met. Internal control activities
include:
1. Preventative – used to prevent errors or inappropriate actions from occurring and function
prior to activities or transactions. Examples: Credit checks, separation of duties,
supervisory reviews, accuracy checks etc.
2. Detective – intended to detect errors or inappropriate actions after they have occurred.
Detective controls being in place in and of themselves are a type of preventative control.
Example: Bank reconciliations.
3. Corrective – correct the problems identified by detective controls. Example: An edit in
an application problem that detects errors in coding.
4. Directive – emphasize positive actions and results and specify certain activities.
Example: Management telling a foreman to hire local workers when possible.
5. Compensating – are in place because of possible shortcomings with other controls. They
are fail-safe controls and introduce redundancy. Example: Someone other than the
person responsible for disbursements doing the bank reconciliation compensates for the
detective control, the bank reconciliations and shortcomings.
Control activities are not carried out for their own sake or because they seem to be “the right and
proper” thing to do. They serve as mechanisms for and are very much a part of managing the
achievement of objectives. The following are examples of major types of control activities
designed to keep companies “on track” toward achieving their objectives:
• Information processing
Various controls should be in place to check accuracy, completeness and proper
authorization for transactions. Entry data is checked, numerical sequences of transactions
are accounted for, balances are compared and reconciled, exceptions are acted upon and
reported, if necessary, changes to existing systems and development of new ones are
controlled and access to information is appropriately authorized.
• Physical controls
Assets such as equipment, inventories, supplies, securities and cash are periodically
counted and the number compared with control records. In addition, doors should be
locked where necessary.
• Performance indicators.
Performance indicators can be used to serve both operational and financial reporting
control purposes. Relating different sets of data, along with analysis of the relationships
and investigative and corrective actions, can serve as control activities.
• Segregation of duties.
Job duties or responsibilities are divided among different people to reduce the risk of
error or fraud.
General Controls
• Data center operations
Controls include job setup and scheduling, operator actions, backup and recovery
procedures and contingency or disaster recovery planning. In sophisticated environments,
capacity planning and resource allocation and use are also included.
• System software.
Controls should cover the effective acquisition, implementation and maintenance of
system software – operating system, data base management systems, telecommunications
software, security software and utilities.
Internal Control
work. A variety of practices can be used to grant or limit access; for example, use of
passwords or user IDs.
Application Controls
Application or program controls are fully automated (i.e. performed automatically by the
computer system) and are designed to ensure the complete and accurate processing of data from
input through output. These controls vary based on the business purpose of the specific
application. These controls may also help ensure the privacy and security of data transmitted
between applications. Categories of application controls may include:
• Completeness checks – controls that ensure all records were processed from initiation to
completion.
• Validity checks – controls that ensure only valid data is input or processed.
• Identification – controls that ensure all users are uniquely and irrefutably identified.
• Authentication – controls that provide an authentication mechanism in the application
system.
• Authorization – controls that ensure only approved business users have access to the
application system.
• Problem management – controls that ensure all application problems are recorded and
managed in a timely manner.
• Change management – controls that ensure all changes on production environment are
implemented with preserved data integrity.
• Input controls – controls that ensure data integrity are fed from upstream sources into the
application system.
2. Separate Evaluations
This consists of:
• Scope and frequency of separate evaluations of the internal control system.
• Appropriateness of the evaluation process.
• Whether the methodology for evaluating a system is logical and appropriate.
• Appropriateness of the level of documentation.
3. Reporting Deficiencies
This refers to:
• Existence of mechanism for capturing and reporting identified internal control
deficiencies.
• Appropriateness of reporting protocols.
• Appropriateness of follow-up actions.
Internal Control
Skill Level: R/U A/A
2.1.2.4 Identifies the steps in the process of developing and maintaining a system of
internal controls, including the roles and responsibilities of various
stakeholders and internal audit
a) Explains why senior management owns an organization’s control system 9
b) Explains why the accounting/finance/IT staff are primarily responsible
for the development and maintenance of an organization’s internal 9
control system
c) Explains why the Board of Directors and the Audit Committee establish
guidelines and provide oversight regarding an organization’s control 9
system
d) Explains why the internal auditor tests and suggests improvements to an
organization’s control system, but should not develop or maintain the 9
system
g) Explains the effects of computer-based information systems on internal
9
control, business ethics and fraud
The following excerpt from ‘Internal Control — Integrated Framework’ published by COSO
(Committee of Sponsoring Organizations) best describes the roles and responsibilities for
internal control.
• Management
The chief executive officer is ultimately responsible and should assume "ownership' of
the system. More than any other individual, the chief executive sets the "tone at the top"
that affects integrity and ethics and other factors of a positive control environment.
• Board of Directors
Management is accountable to the Board of Directors, which provides governance,
guidance and oversight. A strong, active Board, particularly when coupled with effective
upward communications channels and capable financial, legal and internal audit
functions, is often best able to identify and correct such a problem.
• Other Personnel
Internal control is, to some degree, the responsibility of everyone in an organization and,
therefore, should be an explicit or implicit part of everyone's job description.
Internal Control
Effectiveness
Skill Level: R/U A/A
2.1.2.4 e) Explains why external auditors may attest to the effectiveness of an
9
organization’s control system
The external auditor must attest to and report on the above assessment as a part of the audit
process. For this reason, public companies, which must comply with the Sarbanes-Oxley Act,
require the external auditor attests to the effectiveness of the company’s control system.
Note to candidates: For the purposes of the Entrance Examination, candidates should understand
that SOX exists and its purpose. Candidates are advised to limit the time spent studying this
topic.
The below has been extracted from CMA Canada’s Management Accounting Guideline
“IDENTIFYING, MEASURING AND MANAGING ORGANIZATIONAL RISKS FOR
IMPROVED PERFORMANCE”. It is reprinted with permission of CMA Canada.
Under Section 302, the chief executive and financial officers of each publicly reporting company
are required to certify each periodic (i.e. quarterly and annual) report filed or submitted to the
SEC. The chief executive officer and chief financial officer must personally sign the
certification— another executive under a power of attorney cannot sign the certification. Section
302 requires the certification to cover the review of the report, its material accuracy and fair
presentation of financial information, disclosure controls and internal accounting controls.
The internal control requirements in Section 404 represent the more important aspects of the act
to a corporation and its external auditors. Management always has been responsible for preparing
periodic financial reports; external auditors reviewed those financial numbers and certified they
were fairly stated as part of their audit. Under the Sarbanes-Oxley Act, management is now
responsible for documenting and testing its internal financial controls in order to prepare a report
on their effectiveness.
Internal Control
• Determination of what controls are significant, which should include controls over
transactions (routine, non-routine, estimation and judgment), fraud, controls on what
other significant controls are dependent on the financial statement close process and the
locations or reporting entities to be included in the evaluation;
• The documentation of controls related to management’s assertion, including each of the
five COSO definitions of internal control, controls designed to detect or prevent frauds or
errors in significant accounts, transactions or disclosures, the financial statement close
process and controls over safeguarding of assets;
• Evaluation of design and most effective combination of manual and IT controls;
• Evaluation of the operating effectiveness by the testing of controls by internal audit or
third parties under the direction of management or a self-assessment process that includes
procedures to verify controls are working effectively. Inquiry alone is not adequate; and
• Determination of what control deficiencies constitute significant deficiencies or material
weaknesses (Sheridan, 2003).
A self-assessment alone is not enough without the documentation and testing to back it up. The
external auditors also review the supporting materials leading up to the internal financial controls
report to assert the report is an accurate description of the internal control environment. The
report should cover key information such as risk control description, specification of those
performing the control, types of controls, frequency, evidence and results of testing from an
efficiency point of view.
Internal Control
can be taken. If the credit granting control mentioned above is not effective, reasons could
include the control is not being followed or the limits are still too high.
• Human Error
Human error can never be eliminated. In addition, people can suffer from fatigue or
stress, which increases the risk of human error.
• Management Override
Although controls may be in place, management is often in a position to override those
controls.
• Access
Access to assets should be restricted. However, often it is not possible to limit access to
specific areas. For example, in a large manufacturing plant, it would be virtually
impossible or not cost beneficial to limit access so the employee could only access his
own work area.
Internal Control
example, an employee with ownership or financial interest in a supplier or a customer of
their employer may want the employer to purchase from or sell at favourable rates to the
company in which he/she has an interest.
• Collusion
Two employees work together to carry out an impropriety to circumvent the control
system.
Documentation procedures are important because they: (1) help ensure all other desirable
controls are established; (2) help ensure all employees understand their responsibilities and
procedures; and (3) safeguard the investment in systems design when employees turn over. This
includes preparation of procedure and policy manuals, job descriptions, etc.
Accounting records and procedures ensure: (1) prompt preparation of accurate records; and (2)
timely reporting of accounting data to users.
Independent internal verifications allow an employee to review the accuracy and propriety of
another employee’s work. These reviews should: (1) be done by an employee who is unrelated
to and independent of the employee they are reviewing; (2) be made frequently; and (3) report
errors promptly to the employee for corrective action.
Employees are sometimes unable or unwilling to act in the best interests of the organization.
Inability can be overcome through training, procedures and policies. Unwillingness is more
problematic, but can be mitigated through positive incentives such as bonuses, profit sharing,
promotions and other rewards that link desirable efforts or results with extrinsic benefits.
In some situations, managers can avoid control problems by allowing no opportunities for
improper behaviour by:
1. Replacing employees with capital investments, where possible,
2. Centralize control,
3. Share the risk with an outside body, such as an insurance company, and
4. Eliminate activities or operations entirely through sub-contracting or divestiture.
Employees may engage in a variety of behaviours for self-interest. Three methods for
employees to manipulate information include smoothing, gaming and data falsification.
Internal Control
Skill Level: R/U A/A
2.1.2.7 Describes the role of the external auditor
a) Understands the audit planning process and the expectations of the
9
external auditor
b) Understands the audit risk model (ARM) and auditor liability 9
The audit risk model or ARM, is designed to quantify the risks associated with an audit and
consists of inherent risk, control risk and detection risk. These risks are defined as:
2. Recent models of control emphasize the following as critically important for internal
control.
a. Values
b. International expansion
c. Computerization of systems
d. The Internet
6. A failure of the internal control system to attain intended results may be due to each of
the following, except for:
a. When employees fail to act in the interests of the organization
b. Competition is more severe than anticipated
c. The control system is designed inappropriately
d. The control system fails to detect a control is not working
12. The following represent sets of activities that should be separated from one another for
internal control purposes, except for:
a. Activities from costs
b. Custody of assets from recording of assets
c. Systems development from maintenance
d. Reconciliation from recording
13. Decentralization creates internal control problems because of all the following, except
for:
a. There is confusion about the objectives of the overall organization
b. Decentralized decision makers have interests that differ from the overall organization
c. The existence of more decision-makers creates coordination problems
d. Decentralized decision-makers have access to better information
17. Which employee group has tended to monitor internal control in the past but has been
19. Which of the following is not a method employees use to manipulate information?
a. Smoothing
b. Gaming
c. Decentralization
d. Data falsification
5. d Policies and procedures improve internal control rather than limit it.
6. b
9. b
11. b.
12. a
13. d Item (d) is an advantage of decentralized decision making and not an associated
internal control problem.
16. a
17. b
18. c
19. c
21. c Plans are actually operational controls and not organizational controls.
Risk Management
R/U A/A
2.2.1 Defines and distinguishes among strategic risk, operational risk, reporting
9
risk and compliance risk for a given organization
a) Defines and gives examples of the types of strategic risk (e.g.
economic, industry, social, political, organizational, strategic 9
transaction, technological)
b) Defines and gives examples of the types of operational risk (e.g.
environmental, financial, business continuity, innovation, commercial, 9
project, human resources, health and safety, property, reputation)
c) Defines and gives examples of the types of reporting risk (e.g.
information accuracy, reporting reliability, completeness of financial 9
information, efficiency of the process for internal decision making)
d) Defines and gives examples of the types of compliance risk (e.g. legal
9
and regulatory, control, professional)
2.2.2 Identifies external risks (including political, environmental and social risk)
9
for a given organization
The COSO publication entitled Enterprise Risk Management – Integrated Framework, describes
the underlying principles of risk management. However, other more detailed publications must
also be taken into consideration. These include the Sarbanes-Oxley and Canadian Securities
Administrators releases, as well as the CMA Canada released Risk Management Payoff Model.
The objectives of the CMA Risk Management Payoff Model guideline are:
• To provide a comprehensive overview of risk management and highlight the role of risk
identification and measurement within the risk management process.
• To create a broader framework for risk identification.
• To describe key elements of a measurement model for success in dealing with risks
strategically and operationally; including inputs and processes that lead to risk-related
outputs and overall organizational success (outcomes).
• To outline specific drivers related to these inputs, processes, outputs and outcomes.
Risk Management
• To demonstrate the calculation of return on investment for risk management initiatives.
The target audience of the CMA guideline includes Boards of Directors, members of audit
committees, external auditors, CEOs, CFOs, senior management teams and accounting internal
audit and finance professionals that face the challenges of risk assessment analysis and control.
SOX caused important changes in public accounting, corporate governance and internal audit.
SOX states the reporting of financial results was insufficient and required organization do more,
including having greater control over the quality of the processes and controls used to report
these results.
Complying with SOX and the Canadian equivalent regulations is expensive and time-consuming.
However, the potential benefits of the new requirements can be improved internal control
processes, better decision making, increased reliability of information for external users and
enhanced investor confidence.
The new and greater risks in the business environment coupled with the new regulatory
requirements has resulted in greater responsibility shifting to corporate Boards, audit committees
and the internal audit function.
Risk can be viewed as uncertainty, hazard or opportunity. Tradition risk management has
concentrated on the two former views, attempting to reduce the variance between anticipated
outcomes and actual results. In contrast, organization-wide risk management systems create,
protect and enhance shareholder value by managing the uncertainties that could affect the
achievement of the organization’s objectives either positively (opportunity) or negatively
(hazard).
This classification scheme should only define a risk universe and provide a sample listing of
organizational risks. Each organization should establish a working list of the risks most relevant
to its own businesses and business environments.
Determining the costs of a potential risk, if it materializes, as well as the benefits that may be
provided by an appropriate response to the risk, should be assessed. The quantification of both
costs and benefits then makes it possible to determine the payoff of a risk management initiative.
Risk Management
This model describes the key factors for corporate success in risk management. These include
the critical inputs and processes needed for success in risk management outputs, which then
reduce the cost of risk and increase revenues. Finally, the payoff of risk management is
determined by its contribution to overall organizational success or outcomes, in terms of
shareholder value. The key components to this model are inputs, processes, outputs and
outcomes.
Inputs include: the external environment, internal environment, strategy, structure, systems and
resources, risk management strategy. The organization’s ability to develop an appropriate
internal environment to respond to external forces, to anticipate risk and allocate resources in its
corporate strategy and to develop specific risk management strategies to deal with the risk
effectively is critical and is reflected in the strategic fit.
Processes include: risk management leadership, risk management structure and risk management
systems. Key risk management systems include measurement and rewards, event identification,
risk assessment, risk response, control activities and information and communication monitoring.
As risks change over time, ongoing evaluation of policies and procedures designed to manage
and control said risks is needed.
Step 6 – Monitoring
All aspects of the risk management process need to be monitored due to constant changes in
businesses and circumstances.
Generally, monitoring can be done in one of two ways: through ongoing activities or by means
of stand-alone evaluations. If the ongoing activities are extensive and effective, the need for
separate evaluation projects decreases.
Risk Management
Risk management challenges are faced by all organizations, not only at the organization level,
but also at the functional level. As a result, specific business functions will find it useful to apply
the Risk Management Payoff Model in order to identify, measure, respond to, control and
monitor risks more carefully, as well as calculate the payoffs of risk management initiatives.
Information Risk
Information risk is the heart of risk management, yet is itself a source of risk. Information
technology plays a critical role in many companies today; however, most companies do not have
a formal process in place to identify potential risks associated with IT. IT risk strategies must be
integrated with the organization’s overall business risk strategies.
It is the responsibility of senior management to clarify what data should be protected, how
sensitive this information is, how much protection is needed for different types of data and how
much risk the organization is willing to accept.
The Risk Management Payoff Model represents a useful tool that can be applied in the context of
due diligence to risks encountered both in the merger or acquisition process and in the continuing
operations of the new organization.
Governance
R/U A/A
2.3.1 Understands the role of governance for a given organization
2.3.2 Identifies the role of a given organization’s code of corporate conduct and
ethical values with respect to governance issues and the accomplishment 9
of the organization’s strategic objectives
2.3.3 Identifies and explains the role that a given organization’s management
incentives play in maintaining organizational compliance
Describes effective managerial reward and incentive systems and
explains how they can align management actions with the interests of the 9
organization’s stakeholders
In order for the Board of Directors to carry out its duties and responsibilities adequately, a
number of committees are necessary. These include:
Governance
independent/external directors. The committee chair must report to the Board regularly and
annually.
The CEO Compensation Committee – This committee determines objectives and targets to be
achieved by the CEO in order to obtain various levels of compensation. Most compensation
committees use external consultants in the determination of compensation packages and pay.
This committee often ensures succession planning for senior management and can be
responsible, if there is no executive committee, for CEO evaluation and performance review.
The Nomination Committee – Identifies and evaluates candidates for nomination to the Board.
This committee is often the point of contact for shareholders input into the nominating process.
National Policy 58-201 sets out a series of recommended corporate governance guidelines:
Board of Directors – should have a majority of independent directors and an independent chair.
If there is no independent chair, an independent director should be appointed “lead director”.
Regular meetings and a written mandate with certain specified features must also be present.
Position Descriptions – needed for Chair of the Board, Chair of each Board committee and the
CEO
Nominating Committee – should be given the authority to engage an outside advisor and be
formed of independent directors with a written charter covering certain specified features.
Regular Board Assessments – the Board, Board committees and each director should be
regularly assessed with regard to their effectiveness and contribution.
Governance concerns relate to practices of both corporate Boards and senior managers. The
question being asked is whether the decision-making process and the decisions themselves are
made in the interest of shareholders, employees and other stakeholders or whether they are
primarily in the interests of the executives. Furthermore, the concerns relate to both the reality
and perception of Board competence, diligence and ethics and include issues such as executive
compensation, Board independence, Board oversight, succession planning and adequate and
accurate transparency.
This guideline is direct at three primary issues. How Boards of Directors can:
• use a variety of performance metrics to improve both the evaluation and management of
performance of Boards of Directors and individual Board members;
• use performance metrics to improve the evaluation and governance of both corporate
performance and CEO performance; and
• use performance measurement and strategic management systems for communicating the
performance of Boards of Directors, the corporation and the CEO to external
stakeholders.
The guideline is directed at the leadership required of Boards of Directors and senior corporate
executives to improve corporate performance and the measures, systems and reporting necessary
to support good governance. Strategic management systems, like the balanced scorecard, can
help companies establish the drivers of good Board performance and how that performance
affects shareholder value.
Governance
The Roles and Responsibilities of Boards
There are standards of conduct that directors must meet in fulfilling their responsibilities to their
organizations. These are typically defined in the corporation’s bylaws, in numerous statutes and
regulations and in court precedents. Examples include: duty of care, duty of loyalty and duty of
obedience.
Boards of Directors assume a central role in governance as their primary duty is to promote the
long-term interests of the corporation. The Board has a fiduciary duty to represent the owners’
interest in protecting and creating shareholder value and monitor and evaluate whether the
company is managed well to achieve long-term success.
Corporations make important choices in Board composition (inputs) that have a significant
impact on Board performance. The Board structure and systems (processes) also significantly
affect the Board decisions and performance. The manner in which the Board prepares,
deliberates and decides on important decisions is affected by the Board’s composition and does
affect the Board’s success at fulfilling its roles and responsibilities and improving Board
performance (outputs), ultimately improving corporate performance (outcomes). Further,
continuous feedback provides the basis for improvement for the directors, the Board and the
corporation.
3) Skills and Knowledge – Board members should possess both functional knowledge in the
traditional areas of business as well as industry specific knowledge for the company.
Personal qualities such as integrity, business sense, sound judgment, communication
skills and commitment are all equally important.
4) Board Size – studies show Boards of nine to13 individuals is ideal for most companies.
Processes:
1) Systems and Structure – decisions about the Board’s structures and systems are primary
processes that will affect the Board’s performance. These include decisions about
leadership of the Board, how the agenda is set and the way the Board is organized.
2) Leadership of the Board – Board leadership must be independent and solely devoted to
providing oversight and fulfilling a fiduciary duty to the shareholders. Boards should set
the agendas to their meetings (as opposed to the CEO) and have access to all employees
at all times to answer any questions they have.
Audit Committee – responsible for four elements: internal controls and risk assessment;
internal and external auditing processes; financial reporting; and compliance with laws,
regulations and codes of ethics.
Governance
1) Monitoring and Evaluating Corporate Performance
Typically done through standard accounting information, but this has limitations of
measuring success. Performance measures must include both financial and non-financial
metrics, should be linked to strategy and include a combination of input, process, output
and outcome measures.
The Board evaluation should be focused on how it can improve the Board’s inputs and
processes so the Board’s contribution to overall corporate performance can be increased.
The four dimensions of the Board’s balanced scorecard are: the financial dimension; the
stakeholders’ dimension; the internal process dimension; and the learning and growth
dimension
3) Monitoring and Evaluating the CEO’s Performance – among the many benefits
associated with carefully planned and designed CEO performance evaluation systems are:
providing a basis for evaluating and rewarding CEO performance.
Evaluating needs and performance of the management team and succession; providing
clear indicators of current and future CEO needs for growth and learning.
The four dimensions of the CEO’s balanced scorecard are: the financial dimension; the
stakeholders’ dimension; the internal process dimension; and the learning and growth
dimension
1) Board’s roles and responsibilities include ensuring accountability, ensuring senior level
staffing and performance evaluation, and ensuring strategic oversight.
3) New rules and regulations: regulatory requirements, particularly for public companies,
powerfully drive information strategy.
Current Situation
Results of recent surveys show that although Boards are getting considerable information
concerning financial performance, operating performance, annual strategic planning and major
capital expenditures, they are getting less information about long-term strategy, data to monitor
and evaluate the strategies, and risk management. Furthermore, they are getting even less
information about the external environment, organizational performance and alternate strategies
management considered.
Ensuring Accountability
To effectively monitor accountability, which includes ensuring their corporations are providing
various stakeholders with complete and reliable information on matters that can affect them and
Governance
Financial Issues – usually managed by audit committee; includes annual audited financial
statements, quarterly financial statements, annual information form, quarterly and annual
MD&A's and earnings press releases. Also, reports from internal and external auditors on
internal controls must be given to the audit committee.
Corporate Governance Issues – typically under the governance committee. Includes any
information dealing with the evaluation of Board performance, as well as disclosure of corporate
governance guidelines. May include external reports obtained from time to time on the
company’s governance practices.
The following information should be received by either the Board or its compensation committee
members in order to properly staff and evaluate the CEO and other senior management positions:
• report on compensation policy, including performance targets and objectives
• performance report on identified targets, including surveys and interviews from various
stakeholders
• report on company performance
• benchmarking report – executive compensation package
• report on compensation – from outside consultant
• report of succession planning
• report on management development activities
The following information should be received by either the Board or its compensation committee
members in order to properly staff and evaluate the Board of Directors:
• report on Board compensation
• report on Board performance, including individual performance
• report on directors’ orientation and educational programs
• updates on trends and regulations regarding compensation issues
Directors need to understand the company’s internal and external environment to help them
assess the effectiveness of strategies. The CIMA and IFAC have proposed a strategic scorecard
to help provide a good framework that guides Boards on the type of information they should
receive, which includes information on: strategic position; strategic options; strategic
implementation; and strategic risks.
Directors must supplement information received from management by getting information from
other sources, including other stakeholders, to develop an independent opinion on major
decisions. Companies must determine their procedures for how directors will access this
information. Key issues include:
• access to management and company external stakeholders
• access to independent advisors
• access to the Board
The majority of information that a Board receives relates to topics discussed during Board and
committee meetings. If the CEO controls the agenda, then the CEO controls what the Board
hears, discusses and votes on. Therefore, directors should be given the opportunity to add topics
to the agenda on their own. Furthermore, a Board briefing should accompany the agenda and
supporting material. This document succinctly highlights the current issues facing the company.
Establish the appropriate format of information going to the Board will avoid information
overload and permit directors to focus on important relevant issues. Information should be given
both orally and through written reports. Also, information must be:
• relevant
• concise
• complete
• clear
• balanced
Although public sector and non-profit organizations often use their regular websites to include
Board-related information, many companies have developed intranets to limit access. Sensitive
information that would not be desirable to share with the public can be put on the intranet and all
Board members can have unlimited access. Using this resource, directors can locate and share
knowledge and data, collaborate and communicate in real time.
Governance
• specifying information categories
• deciding on technical aspects
• testing a prototype model with directors
• organizing a training session for directors
• evaluating the intranet
If companies are going to provide more information to their Boards, they must also evaluate
whether they have the ability to assimilate and comprehend this information. Directors who do
not have these competencies may not be able to fully participate.
Orientation programs can ensure new directors become familiar with business operations and the
industry and have a clear understanding of their role on the Board. Site visits, meetings with
chairs and top executives, formal presentations and a directors’ manual are typical elements of a
director orientation program. Directors’ manuals usually include:
• company information (code of ethics, by-laws, organizational charts, company history)
• strategic plans (mission statements, corporate goals, action plans, major programs)
• Board information (charters, members with biographies, committees, roles and
responsibilities, governance guidelines, minutes from recent meetings, committee reports,
Board and committees’ calendar)
• financial information (annual reports, proxy statements, analysts’ reports)
• industry information (articles, associations, sector analysis, competitor information)
• contact lists
Beyond orientation programs, educational programs should build and maintain director’s
competencies on a variety of topics relevant to their responsibilities. Both internal and external
program can and should be used.
Step 1 – Situation Analysis – understanding and shared vision of the Board’s information needs.
Step 2 – Strategy Formulation – details specific topics on which the Board wants information.
Step 3 – Strategy Implementation – includes evaluating operational issues and ensuring
information is provided in a useful format; may include designing an intranet.
Step 4 – Evaluation and Control – the quality of the strategy and directors’ satisfaction is
essential.
2011 Edition