Surgent Cma p2

CMA
Review Reference Book

Part 2
Strategic Financial Management
Section 2100‐2600
2020

Table of Contents
Part 2
Strategic Financial Management

Section 2100 Financial Statement Analysis ................................................................. 1
Section 2200 Corporate Finance ............................................................................... 73
Section 2300 Decision Analysis ................................................................................ 237
Section 2400 Risk Management ............................................................................... 275
Section 2500 Investment Decisions ......................................................................... 281
Section 2600 Professional Ethics .............................................................................. 313

Surgent CMA Review
Section 2100
Basic Financial Statement Analysis (20%)

2110 Basic Financial Statement Analysis
2110.01 Financial statement analysis highlights key historical relationships and trends.
Financial statements can be prepared to show data as a comparison. Forms
of that analysis are:
a. Horizontal Analysis: Horizontal (common base year) analysis compares
similar data between periods either on an absolute or relative scale, e.g.,
cash increased $2,000,000 or 34% from last year to this year. Typically,
the earlier year is the base figure upon which change is measured.
b. Vertical Analysis: Vertical (common size) analysis compares data from
the same reporting period to a base figure; e.g. current assets are 20% of
total assets as of the reporting date. Typically, the 100% base figure is
revenue or total assets (or the equivalent). The following is an example of
a common‐size income statement.

Common‐Sized
Income Statement Income Statement
Revenue 100,000 100%
Cost of Sales 58,000 58%
Gross Profit 42,000 42%
SG&A Expenses 24,000 24%
Operating Income 18,000 18%
Interest and Taxes 8,000 8%
Net Income 10,000 10%

The balance sheet can be prepared in a similar schedule. A time‐series
analysis can identify trends in the ratios that reveal important variations.
A comparison of the common‐size percentages can also be made with
other companies within the industry.
c. Growth Analysis: Companies set growth rates and then determine if they
actually attain the growth estimate. There are different methods of
setting growth; one common growth computation is growth of earnings
per share (EPS). It is computed as follows:
© 2020 Surgent CPE, LLC 1
Section 2100 – Basic Financial Statement Analysis
EPS (end of year) – EPS (beginning of year)
EPS (beginning of year)
Other growth measures include changes in total revenues, dividends per
share, and total assets. These growth measures can then be compared to
company expectations and to other companies in the industry.
d. Ratio Analysis: Ratio analysis compares datum or data to related items,
e.g. cost of goods sold (COGS) to inventory. When comparing data that
covers a period of time to data as of a point in time (beginning or ending
inventory), more meaningful results are possible if an average (beginning
plus ending inventory divided by 2) of the point data is used.
1. User’s Objective: Users may have different needs and criteria in
analyzing financial ratios; accordingly, ratios can be characterized by
objective. There are liquidity ratios to assist short‐term creditors who
are interested in how well a firm meets its currently maturing
obligations. Activity ratios measure how effectively the assets of an
entity are employed. Profitability ratios are of particular interest to
investors (both long‐term creditors and equity investors) because
they indicate the magnitude of the return on investment. Long‐term
creditors and investors also look to leverage/coverage ratios to
measure the degree of protection afforded their investment.

2. Usefulness: By itself, any single ratio is not conclusive or even very
meaningful. Ratios become informative when compared to industry
standards (if accounting standards are uniform), prior years’
performance, budgets, or used in conjunction with other ratios.
Pitfalls in relying exclusively on ratio analyses include:

 Since the statements are historical in nature, the comparisons
reflect past, not future relationships.
 Ratios have not been standardized.
 Accounting methods, e.g., LIFO versus FIFO can produce different
data and thus ratios.

2 ©2020 Surgent CPE, LLC
2110.01 Purpose and Components of Financial Statements: A full set of financial
statements will include each of the following:
 Financial position (balance sheet) at the end of the period.
 Earnings for the period (income statement).
 Comprehensive income for the period.
 Cash flows during the period.
 Investments by and distributions to owners during the period.
Note that a statement of financial position does not purport to show the
value of a business enterprise.
a. Financial Position – Balance Sheet: The balance sheet provides
information concerning the nature of the firm’s financial resources, the
claims of creditors against those resources, and the equity of the owners
in the net resources of the firm. In order to provide useful information to
users of the financial statements, the balance sheet is normally broken
down into various classifications.
1. Current Assets: Cash and other assets that will be converted into
cash, sold, or consumed within one year or the operating cycle,
whichever is greater, are classified as current. Included are such
items as marketable securities, notes and accounts receivable and
inventories.

2. Long‐Term Investments: This category includes investments in
related companies, bonds which are not intended to be liquidated
within the operating cycle, funds accumulated to retire debt, and
the cash surrender value of life insurance.

3. Property, Plant and Equipment: Land, buildings, plant, fixtures,
furniture, leasehold improvements and the capitalized value of
certain leased assets are included along with various depreciation
contra accounts.

4. Intangible Assets: Patents, copyrights, trademarks and goodwill
are included.

5. Other Assets: This is for assets that do not fit into another
category such as deferred items and prepayments.

6. Current Liabilities: This category includes those obligations that
will be liquidated by the use of current assets or the creation of
other current liabilities within one year or the operating cycle,
whichever is greater.

7. Long‐Term Liabilities: These are liabilities that will be paid in
more than one year. Included are items such as debentures,
mortgages, and obligations under capital leases.

8. Stockholders’ Equity: This is the category that represents the
various ownership interests in the business. Common and
preferred stock, retained earnings and treasury shares are the
usual components.
b. Earnings for the Period (Income Statement): The income statement’s
function is to report the results of operations for a given period of time.
Presented in the statement are revenues and expenses from ongoing
business activities and gains and losses in the ordinary course of business.
These constitute “income from continuing operations.” A company may
also experience discontinued operations, “extraordinary” items, and the
need to report the cumulative effect of a change in accounting principle.
These are presented separately after income from continuing operations.
This is the “all‐inclusive” concept. Proponents of the “current operating
performance” concept believe that only regular earnings from normal
operations should be included in the income statement. They contend
that other types of gains and losses (i.e. extraordinary items) should be
taken directly to Retained Earnings as they do not reflect the regular
earnings capacity of a company. APB No. 9 requires application of the
“all‐inclusive” approach in practice.
c. Earnings Concept and Comprehensive Income: The concept of earnings
set forth in SFAC 5 is similar to net income for a period in present
practice; however, it excludes certain accounting adjustments of earlier
periods that are recognized in the current period – cumulative effect of a
change in accounting principles is the principal example from present
practice. Comprehensive income is a broad measure of the effects of
transactions and other events on an entity. It includes all changes in
equity (net assets) during a period from transactions and other events
and circumstances except those resulting from investments by owners
and distributions to owners. It should be noted, therefore, that earnings
and comprehensive income are not the same. Comprehensive income
includes net income plus all the other non‐owner derived changes in
equity that do not go through the income statement.
d. Cash Flows Statement: A statement of cash flows directly or indirectly
reflects an entity’s cash receipts classified by major sources and its cash
payments classified by major uses during a period, including cash flow
information about its 1) operating, 2) financing, and 3) investing
activities. The primary purpose of the statement of cash flows is to
provide information about the entity’s cash receipts and cash
disbursements during a period, i.e. the changes that occurred between
reporting periods. Through such information, investors, creditors, and
others may

 Assess the enterprise’s ability to generate positive future net cash
flows.
 Assess the enterprise’s ability to meet its obligations, its ability to pay
dividends, and its needs for external financing.
 Assess the reasons for differences between net income and
associated cash receipts and payments.
 Assess the effects on an enterprise’s financial position of both its cash
and non‐cash investing and financing transactions during the period.
e. Statement of Investments by and Distributions to Owners: This reflects
an entity’s capital transactions during a period – the extent to which and
in what ways the equity of the entity increased or decreased from
transactions with owners as owners.

2111 Common Size Financial Statements
2111.01 Common size financial statements display each item as a percentage of some
base item. Not all companies are the same size. A company has more cash,
inventory, or revenue than another company. This makes it hard to compare
the financial statements of the two companies. By using common size
financial statements, companies can compare two companies and gather
usable information.

2111.02 Common Size Balance Sheet: In a common sized balance sheet, each asset is
displayed as a percentage of total assets, each liability as a percentage of
total liabilities, and each equity item is a percentage of total equity. Example
below:

Standard Common Size
Balance Sheet Balance Sheet
Assets
Cash 5,000 50%
Inventory 3,500 35%
Accounts Receivable 1,500 15%
Total Assets 10,000 100%

Liabilities
Accounts Payable 6,000 33%
Notes Payable 9,000 67%
Total Liabilities 15,000 100%

Equity
Common Stock 20,000 40%
Retained Earnings 30,000 60%
Total Equity 50,000 100%
2111.03 Common Size Income Statement: In a common sized balance sheet profit and
loss is detailed as a percentage of total sales/revenue.
Sales 50,000 100%
Cost of Goods Sold 20,000 40%
Gross Profit 30,000 60%

Taxes 6,600 13%

Net Income 23,400 47%

2112 Common Base Year Financial Statements
2112.01 Common base year financial statements are constructed by dividing the
current year account value by the base year account value.
2112.02 Common base year balance sheet example.

Standard Common Base
Balance Sheet Year Balance Sheet
20X9 20X0
Assets
Cash 5,000 7,000 140%
Inventory 3,500 4,000 114%
Accounts Receivable 1,500 1,000 67%
Total Assets 10,000 12,000 120%

Liabilities
Accounts Payable 6,000 8,000 133%
Notes Payable 9,000 8,000 89%
Total Liabilities 15,000 16,000 107%

Equity
Common Stock 20,000 20,000 100%
Retained Earnings 30,000 32,000 107%
Total Equity 50,000 52,000 104%

2112.03 Common Size Income Statement: In a common sized balance sheet profit and
loss is detailed as a percentage of total sales/revenue.

20X9 20X0
Sales 50,000 60,000 120%
Cost of Goods Sold 20,000 45,000 225%
Gross Profit 30,000 15,000 50%

Taxes 6,600 3,150 49%

Net Income 23,400 11,850 51%

2120 Financial Ratios
2121 Liquidity
2121.01 Objectives: Short‐term liquidity ratios and other measures provide
information about how well a firm is able to meet its currently maturing
obligations.
a. Creditor and Management: This is of special interest to creditors, but
also important for management to know in order for them to be able to
avoid embarrassing last minute scrambles. Liquidity refers to the
composition of current assets and liabilities, primarily assets. A higher
proportion of cash or marketable securities is more liquid than a low
proportion.
b. Short‐term Liquidity: Operating activity and cash flow ratios are analyzed
as part of short‐term liquidity. Operating activity ratios measure how
effectively and efficiently the firm is carrying out its business – making
sales, collecting on sales, and managing inventory. Companies with slow
turning inventory and slow paying customers are less liquid. Cash flow
gives an indication of the liquidity of a company as does the speed with
which noncash current assets convert to cash.

2121.02 Definitions
a. Current Assets: Cash and other assets that will be converted into cash,
sold, or consumed within one year or the operating cycle, whichever is
longer. Items are usually listed from highly liquid to less liquid. Increasing
current assets are a use of short‐term funds for a business. Typical
categories are:
 Cash and cash equivalents
 Marketable securities (trading and available‐for‐sale‐classifications at
fair value)
 Notes and accounts receivable (at net realizable value)
 Inventories
 Prepaid expenses (at unexpired cost)
b. Current Liabilities: Current liabilities are defined as liabilities to be paid
within one year or the operating cycle, whichever is longer. Items are
usually presented in order of their liquidation dates and reported at the
amount to be paid. Increasing current liabilities are a source of short‐
term funds for a business. Typical categories are:
 accounts payable arising from the acquisition of goods and services
 other accrued liabilities, such as wages payable and interest payable
 notes payable such as but not limited to commercial paper, short
term bank credit loans, factoring
 collections of amounts in advance (unearned or deferred revenues)
 currently maturing portions of long‐term debt
c. Working Capital: Working capital is simply the difference between
Current Assets and Current Liabilities. Creditors are especially interested
in working capital as it is the source from which they will be paid.
2121.02 Ratios, Computational Issues, and Analysis
a. Current Ratio: Measures short‐term solvency − the ability to meet
current obligations. Generally higher is better, however the composition
of current assets is also important. A quick rule of thumb is that a
company should have a current ratio exceeding 2.0. However, many
successful efficient companies run well at 1.0. Too high a ratio, say 3.0,
may indicate inefficient use of capital. Creditors often look at the trend in
the Current Ratio or compare it to other companies as gauges of liquidity.
Current Assets__
Current Liabilities
Example: A company has current assets of $400,000 and current
liabilities of $500,000. The company’s current ratio would be increased
by:
1. The purchase of $100,000 of inventory on account
2. The payment of $100,000 of accounts payable
3. The collection of $100,000 of accounts receivable
4. Refinancing a $100,000 long‐term loan with short‐term debt
Answer: The present current ratio is:
400,000 = 0.8
500,000
1. 500,000 = 0.83
600,000
2. 300,000 = 0.75
400,000
3. No change; current assets increase and decrease by the same amount
4. 400,000 = 0.67
600,000

Example: The Solvent Corporation’s current ratio is 2.0 to 1 and its bond
indenture specifies the current ratio must remain above 1.5 to 1. If
current liabilities are 25 million, what is the maximum new short‐term
debt that can be taken out to finance inventory?
Answer: If Solvent’s current ratio is 2.0 and the current liabilities are $25
million, then current assets must be $50 million. The maximum increase
to both current assets and liabilities is:
50 𝑋
1.5, 𝑜𝑟 50 𝑋 1.5 25 𝑋 , 𝑜𝑟 0.5𝑋 12.5, 𝑜𝑓 𝑋 $25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑚𝑎𝑥𝑖𝑚𝑢𝑚 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒
25 𝑋
b. Acid‐Test (or Quick) Ratio: Measures short‐term liquidity, excluding
inventory (which may be obsolete, difficult to sell, or slow in converting
to cash), prepaid expense, and other non‐liquid current assets. This is a
more conservative measure of the firm’s ability to pay short‐term
obligations. It provides greater assurance to short‐term lenders about the
company’s ability to repay them. A quick ratio of 1.0 is often considered
average and adequate. A level trend of the quick ratio over time is often a
meaningful indicator of good management.

Cash + Cash Equivalents + Receivables + Marketable Securities
Current Liabilities
Example: A company has a current ratio of 2 to 1 and a quick ratio (acid
test) of 1 to 1. A transaction that would change the company’s quick
ratio, but not its current ratio is:
a. The sale of short‐term marketable securities for cash that results
in a profit
b. The sale of inventory on account at cost
c. The collection of accounts receivable
d. The payment of accounts payable
Answer: b. Inventory is the only item mentioned that is in the current
ratio, but not the quick ratio. The increase in accounts receivable would
affect the quick ratio, but the sale of inventory would not. All other items
would affect both ratios in the same way.
c. Receivables Turnover: Indicates the efficiency of receivables collection
and the quality of receivables. The higher the quality, the shorter the
time between the sale and the collection of cash. Net credit Sales
excludes cash sales and reflects all other sales during a year(period).
1. Calculation:
Net Credit Sales_______
Average Trade Receivables (Net)
If no information is available about cash sales, then total sales are
used as an estimate of credit sales. The average Trade Receivables is
usually calculated as:
(Net A/R at the beginning of the period + Net A/R at the end of the period)/2
2. Comparison Problems: Because companies do not usually report cash
versus credit sales, turnover can be difficult to pin down precisely.
Inclusion of cash sales will artificially increase the turnover figure.
Additionally, bad debt reserves should be deducted from total AR to
arrive at net AR. Receivable turnover rates will vary widely across
industries and will also be affected by credit policies, aggressiveness
of collection efforts, and economic trends. If the ending A/R balance
is used instead of the average, the ratio gives a more current
snapshot of the current situation (assuming average daily sales
remains constant over the year). This may not be a good assumption
for a seasonal business, but in that case the ratio could provide better
insight into seasonal variations.
d. Average Collection Period (or Days Sales Outstanding): The average time
in days that receivables are outstanding (date of sale to date of
collection). Because this ratio is calculated by dividing 365 days by the
receivables turnover, its interpretation is inversely related to that of the
receivables turnover ratio (discussed above)—the greater number of days
outstanding, the greater the possibility of delinquencies becoming
uncollectible. This ratio should ideally be less than the terms extended to
customers. If you offer net 30 day terms and everybody pays exactly on
time, the ratio should be 30 days.
365________
Receivables Turnover
e. Inventory Turnover: Measures how effectively the inventory portion of
working capital is being used in terms of the number of times inventory is
replaced every year. Calculations are similar to receivables insofar as
wanting to measure turnover (higher is better) and length of turnover
(shorter is better). High inventory turnover can mean high liquidity
and/or good merchandising. It could also mean frequent stockouts and
lost potential sales. Conversely, low turnover could mean obsolete
merchandise or excessive inventory accumulation.
1. Calculation:
Cost of Sales___
Average Inventory
The average inventory is usually calculated as:
(Inventory at the beginning of the period + Inventory at the end of the period)
2
2. Comparisons: To be meaningful, this ratio should be compared to the
standard for the particular industry. The inventory turnover is a
function of the technology of the industry as well as the operating
efficiency of the enterprise. For instance, it takes a certain number of
days for a farmer to raise chickens to a certain size, no matter what
else he does. Similarly, beer requires a certain amount of
fermentation time no matter what. Other factors are more
controllable.

3. Values to Use: Inventory accounts include raw materials, work‐in‐
progress, and finished goods. Analysis may be conducted on any
portion of or the total inventory, but is usually done on the total.
Inventory is valued at the lower of cost or market, not at the price for
which it will be sold. Sometimes the inventory turnover ratio is
calculated using sales instead of cost of goods sold in the numerator.
However, cost of sales is a better base for calculating turnover
because it eliminates any changes due solely to sales price changes.

Example: The following information is available for the years indicated:
20X1 20X2
Sales $1,400,000 $1,800,000
Inventory 190,000 210,000
Bad Debt Expense 12,000 10,000
Cost of Goods Sold 840,000 920,000
Calculate the inventory turnover for 20X2.
Select only the information actually needed.
920,000 920,000
= = 4.6
(190,000 + 210,000)/2 200,000
Example: Earth Corporation has budgeted sales of $144,000 and costs of
sales of $90,000 during a year. It is earning 11% currently on its
investment in certificates of deposit. If Best can increase inventory
turnover from its present level of 9 times per year to 12 times per year,
how much can it save?
Answer: $275, calculated below
If inventory turnover is currently 9 times per year, then we can use the
inventory turnover ratio formula and the information about cost of sales
to calculate average inventory:
Cost of Sales Cost of Sales = $100,000

= 9 → Average Inventory = $10,000
Average Inventory 9 9
If inventory turnover were 12 instead of 9 times per year, average
inventory would be:
Cost of Sales = $100,000
= $7,500
12 12
The average reduction in inventory would be: $10,000 ‐ $7,500 = $2,500
per year
At a rate of return of 11%, the savings would be: $2,500 × 11% = $275

f. Number of Days in Inventory (or Days Sales in Inventory): Measures the
average length of time in days that merchandise is in inventory (the
length of time necessary to sell an item of inventory). Because this ratio is
calculated by dividing 365 days by the inventory turnover, its
interpretation is inversely related to that of the inventory turnover ratio
(discussed above).
365______
Inventory Turnover
g. Accounts Payables Turnover: Measures how many times per period
accounts payable are paid. The turnover ratio is not used as frequently as
the Days Purchases in Accounts Payable, discussed below.
Cost of Goods Sold (COGS)
Average Accounts Payable
h. Days Purchases in Accounts Payable: Measures how many days’ worth of
inventory purchases are still unpaid. This gives some information about
how well a company is paying its bills to its suppliers. Previous cautions
about data quality in receivables and inventory apply here too.
365_________
Accounts Payable Turnover
In theory it would be preferable to segregate inventory purchases from
all other payables, but this information is seldom given to outsiders.
Therefore, COGS and A/P must be used as surrogates.
The two payables ratios are not used as frequently as the receivables and
inventory ratios, but they come into play when determining the
operating cycle, below.
i. Days Purchases in Accounts Payable: Measures how many days’ worth of
inventory purchases are still unpaid. This gives some information about
how well a company is paying its bills to its suppliers. Previous cautions
about data quality in receivables and inventory apply here too.
j. Operating Cycle: The operating cycle represents the average number of
days it takes to sell inventory and then collect on the sales. It is a key
measure of an enterprise’s operating efficiency and financial health. A
shorter operating cycle indicates a company is more efficient than either
it was last year or than a competitor with equivalent products and
markets. A longer cycle time indicates just the reverse. Not only are the
absolute numbers important, but the trend over time is often more
important. For instance, short‐term lenders will want to know how
quickly they can expect to be paid back.
Average Collection Period + Number of Days in Inventory
Example: Given the following information, estimate the operating cycle.
Accounts Receivable Turnover Ratio 3.65
Inventory Turnover Ratio 3.30
Answer: The answer is calculated below.
365 365
Average Collection Period = = = 100 days
AR Turnover 3.65

365 365 110.6 days
Average days in Inventory = = =
Inventory Turnover 3.30

Operating Cycle = 110 + 110.6 = 210.6 days
k. Cash Flow Cycle: A related concept is the Cash Flow Cycle (or Cash‐to‐
Cash or Cash‐on‐Cash cycle). This simply takes the Operating Cycle and
deducts the days purchases in accounts payable. This gives recognition to
the fact cash is not used to purchase inventory at the time it is acquired.
However, the longer Operating Cycle is more frequently taught and used
for analysis.
Example of Cash Flow Cycle: If the average age of inventory is 60 days,
the average age of accounts receivable is 40 days, and the average days
purchases in accounts payable is 35 days, the length of the cash flow
cycle is:
60 + 40 – 35 = 65 days
l. Cash Ratio (or Cash to Current Liabilities): Severe liquidity problems with
receivables and inventories, or pledging of those assets, may require an
even more conservative analysis of liquidity. The cash ratio includes only
cash and current assets that are readily converted to cash (i.e., cash
equivalents and marketable securities) in the numerator. Thus, it is more
conservative than either the current ratio or the acid‐test (quick) ratio for
measuring the company’s short‐term liquidity.
Cash + Cash Equivalents + Marketable Securities
Current Liabilities

m. Cash Flow Ratio: Measures the cash generated from operations
compared to the current liabilities. This ratio looks at the flow of cash
over the course of time rather than the static amount of cash on hand.
Greater operating cash flow leads to a higher likelihood that sufficient
cash will be generated to pay current obligations.
Cash Flow from Operations
Current Liabilities
n. Liquidity Index: A more comprehensive ratio for trend analysis and
comparative analysis across companies is the liquidity index. It is
measured in days and can be considered a weighted average conversion
time for current assets.
Total Dollar‐Days in Current Assets
Current Assets
Example: An example is the easiest way to understand the liquidity index.
Days to Convert
CA Component $ Amount × to Cash = Dollar‐Days
Cash 25,000 0 0
Marketable Securities 5,000 2 10,000
a
Accounts Receivable 20,000 45 900,000
Inventory 50,000 60b 3,000,000
Total Current Assets 100,000 3,910,000
a
The days to convert A/R to cash is equal to the number of days it takes
to collect A/R (i.e., the average collection period)
b
The days in the operating cycle (i.e., the number of days to convert
inventory to cash plus the number of days it takes to collect A/R)
Dollar‐Days 3,910,000
Liquidity Index = = = 39.1 days
Dollar Amount 100,000
This number is not necessarily meaningful in itself but it gains significance
when compared to other periods or other entities. A higher or increasing
liquidity index is a sign of less liquidity, while a lower or declining index
indicates greater liquidity.

2122 Leverage
2122.01 Operating leverage
a. Business risk is built partially on the degree a company uses fixed costs in
its operations. The higher the fixed costs, the greater the risk that the
breakeven point will not be reached given a drop in sales. When fixed
costs are high, a small drop in sales can result in a loss for the period.
Operating leverage relates the percentage changes in EBIT to the
percentage change in revenue. The greater the operating leverage, the
greater the change in operating income will be given a particular change
in sales. Therefore, a company with a high degree of operating leverage
would have a large change in operating income for a relatively small
change in sales.
b. The degree of operating leverage (DOL) is the percentage change in EBIT
related to a given percentage change in revenue.

% change in net operating income Contribution margin
DOL = =
% change in sales Contribution margin – Fixed costs
A DOL of 2 means that the percentage change of EBIT will be twice the
size of the percentage change in sales. If sales increase by 20%, then EBIT
will increase by 40%; however, if sales decrease by 20%, then EBIT will
decrease by 40%.
c. A firm can change the DOL by changing the proportion of fixed costs to
variable costs. The larger the proportion of fixed costs, the higher the
DOL and the higher the breakeven point. The higher the proportion of
variable costs, the lower the DOL and the lower the breakeven point.
Also, notice that after the breakeven point is reached with a high DOL,
the operating profit increases quickly; thus, the additional risk associated
with high fixed costs also contains the possibility of higher profits in the
event of a positive sales outcome. The following diagram shows how
income can increase rapidly after reaching the breakeven point if high
fixed costs and low variable costs are used in the production process.
The lower the fixed costs, the lower the DOL and breakeven point will be.
Given the same sales as in the above diagram, a lower percentage of
fixed cost will cause the breakeven point to be reached at an earlier sales
level; however, the operating profit will increase slowly in relation to
increased sales. The operating profit (loss) is the difference between the
sales and total costs.
d. Illustration: Tally Company has the following information available
regarding sales and costs from the last period:

Sales in units 10,000
Selling price per unit $10.00

Variable costs per unit $6.00
Fixed costs for period $20,000
What is the DOL?
Solution:

Contribution margin
DOL =
Contribution margin - Fixed costs

10,000 Units ($10.00 – $6.00)
= = 2
10,000 Units ($10.00 – $6.00) – $20,000
2122.02 Financial leverage
a. Financial leverage refers to the extent to which debt and preferred stock
(fixed income securities) are used in the capital structure. The larger the
percentage of debt and preferred stock that is used for financing, the
greater the risk that the company will not earn enough to cover the fixed
interest and preferred dividend payments. The more leverage, the
greater the risk, and the higher the cost of capital.
b. Degree of financial leverage (DFL) is the percentage change in earnings
available to common stockholders related to a given percentage change
in EBIT.

% change in net income EBIT
DFL = =
% change in net operating income EBIT – Interest
When there is no debt financing used, the DFL will equal 1. When debt
does exist, a change in EBIT will result in a greater proportional change in
the earnings per share.
If the DFL were 2, then a 10% increase in EBIT would result in a 20% (10%
 2) increase in earnings per share.
If the organization has preferred stock, the DFL equation is modified to:

EBIT
DFL = Preferred dividends
EBIT – Interest expense –
1 – Tax rate
c. If a firm has no debt and begins to substitute debt for equity, at first the
value of the firm will rise, reach a peak, and then begin to fall due to the
increased risk of additional debt. This peak in maximized value is the
target capital structure.
d. Illustration: Tally Company has the following information available about
sales and costs from the last period:

Interest costs for period $15,000
What is the DFL?
EBIT
Solution: DFL =
EBIT – Interest expense
10,000 Units ($10.00 – $6.00) – $20,000
=
[10,000 Units ($10.00 – $6.00) – $20,000] – $15,000
= 4
2122.03 Total leverage (degree of combined leverage)
a. If a company used both high degrees of operating and financial leverage,
only small changes in sales will result in large fluctuations in EPS. This can
be shown in equation form:

% change in net income
Degree of total leverage = = DOL  DFL
% change in sales
b. This ratio can be used to predict the effect of a change in sales on income
and ultimately the earnings available to common stockholders.
c. This ratio is determined by the relationship between operating and
financial leverage. For example, if risk is lowered by reducing the degree
of operating leverage, then the firm would be in a better position to
increase the use of debt, thus increasing the financial leverage.
d. The financial statement effects of DOL and DFL can be shown by using the
income statement format:
Percentage Resulting
Previous Increase Change
Sales $100,000 10% $110,000
DOL Variable costs 60,000 66,000
of
2 Fixed costs 20,000 20,000
DTL EBIT 20,000 20% 24,000
of
8 Fixed financing costs 15,000 15,000
DFL EBT 5,000 9,000
of
4 Taxes (40%) 2,000 3,600
Net income $ 3,000 80% $ 5,400
Please note that the results were based on the assumptions that the cost
relationships remain unchanged (fixed and variable) as well as the firm’s
capital structure, including the amount of the fixed financing payments.
As the relationships change, the DOL, DFL, and DTL would also change.
e. Illustration: Tally Company has the following information available about
sales and costs from the last period:

Interest costs for period $15,000
What is the DTL?
Solution: DTL = DOL  DFL

10,000 ($10 – $6) 10,000 ($10 – $6) – $20,000
=  10,000 ($10 – $6) – $20,000 – $15,000
10,000 ($10 – $6) – $20,000
= 2  4 = 8

2123 Activity
2123.01 Activity ratios measure how effectively the assets of an entity are employed.
Coverage of Activity Ratios is included in Section 2121.

2124 Profitability
2124.01 Profitability (asset utilization) is the measure of success in terms of income
defined in a variety of ways over a period of time. In analyzing profitability,
earnings are compared to a base such as sales, productive assets, or equity.
Increased profitability provides the potential for increased dividend
payments as well as from stock appreciation. Increased profitability also
provides greater security for debt holders.
2124.02 Gross margin
a. The gross margin ratio compares the gross margin (gross profit)
generated by the net sales revenue. In other words, what percentage of
the sales dollars were used to cover the cost of goods sold? The
remaining amount is left to cover the general and administrative
expenses as well as to provide a profit. This is also known as the gross
profit ratio.

Gross margin
Gross margin in ratio =
Net sales revenue

b. This ratio is generally more useful to management than to creditors or
investors since the data necessary to analyze why changes occurred in
the ratio are only available internally. Changes are caused by one of the
following elements or a combination of the following items.
(1) Increase/decrease in unit sales price
(2) Increase/decrease in cost per unit
c. Calculation using data from the Sample Company for 20X2:

Gross margin in ratio = Gross margin

Net sales revenue

$400,000
= = 40%
$1,000,000
2124.03 Profit margin
a. The profit margin ratio calculates the percentage of each dollar of sales
that is recognized as net income. In other words, it measures the
efficiency of earnings as compared to sales. It indicates how well
management has controlled expenses in relationship to revenues earned.
This ratio is an excellent way to compare the profits of companies of
varying sizes. This is also known as the return on sales ratio.

Net income
Profit margin ratio =
Net sales
b. In alternative definitions, the numerator for this ratio can take a variety
of forms—operating income, net income, income available to
stockholders, or income from recurring operations.
c. The use of accrual income includes estimates and items over which
management has little or no control.
d. Calculation using data from the Sample Company for 20X2:

Net income
Profit margin ratio =
Net sales

$75,000
= = 7.5%
$1,000,000

2124.04 Asset turnover
a. The asset turnover ratio indicates how many dollars of sales were
created by each dollar of total assets. It helps to determine whether the
available assets were used efficiently to create sales. One goal of
management is to generate the highest possible amount of sales per
dollar of invested capital. Note that different industries tend to have
different reasonable ranges for this ratio.

Net sales revenue
Asset turnover =
Average total assets
b. As in all turnover ratios, a high asset turnover is a desirable outcome
since it results from an effective use of available assets; however, it is not
unusual for a company that has recently expanded to see a drop in asset
turnover until the new facility is fully utilized.
c. For internal use, it is desirable to calculate this ratio comparing divisional
sales to divisional assets.
d. Comparison between firms within an industry can be difficult due to the
fact that the age of the assets used in the production of the sales may
vary. This is a limitation caused by the use of historical costs as opposed
to fair market values for the productive assets. There is also a problem
when comparing a capital‐intensive firm to a labor‐intensive firm.
e. There are also problems created due to the fact that the generally used
formula does not take into account that certain assets make no tangible
contribution to sales. It is assumed that an asset’s participation in
generating sales is related to its recorded amount. Adjustments to the
asset figure are used in attempts to compensate for this problem. For
example, long‐term investments are not involved in the production and
sale of the product and are often not included in the calculation.
f. Calculation using data from the Sample Company for 20X2:

Net sales revenue
Asset turnover =

$1,000,000
= = 0.98
$1,050,000 + $1,000,000
2

2124.015 Return on assets (ROA)
a. The return on assets ratio measures the productivity of assets in terms of
producing income. This ratio depends upon the organization’s ability to
get a high profit from each sales dollar while generating high sales per
dollar of invested capital. A consistently high ROA is an indication that
management is making effective decisions and that the organization is a
growth company.

Net income
Return on assets =
b. The DuPont equation breaks ROA down to the asset turnover and profit
margin.

Net income Net sales
Return on assets = ×
Net sales Average total assets
Through the use of the DuPont equation, ROA is broken down to the
profit margin showing the effective control of cost (Net income/Net
sales) and the asset turnover showing the efficient use of assets (Net
sales/Average total assets).
c. Since neither profit margin nor asset turnover can increase indefinitely, at
some point the only way to create further increases in earnings is to
increase the asset base by adding to production capacity.
d. Limitations specific to this ratio include the use of accrual net income
that is subject to estimates and does not reflect actual cash return. The
rate of return is also based upon historical asset costs that do not reflect
current market values.
e. The numerator can use a variety of income figures, including EBIT. The
philosophy behind the use of EBIT is that the earnings available to three
parties, stockholders, creditors, and the government (taxes) is created
through the use of the assets available to the organization. The
denominator is often restricted to only income‐producing assets by
excluding long‐term investments and intangibles.
f. Calculation using data from the Sample Company for 20X2:

Net income
Return on assets = Average total assets
$75,000
= 7.3
($1,050,000 + $1,000,000) ÷ 2
2124.06 Return on equity (ROE)
a. The return on equity ratio measures the return to common stockholders.
The ratio calculates how many dollars were earned for each dollar of
common equity. When comparing this ratio with ROA (return on assets),
the investment of the creditors is removed. This ratio is affected by the
net income available to the stockholders (Net income – Preferred
dividends), the profit margin available to the stockholders, the asset
turnover, and the extent to which assets are financed by common
stockholders. The method of financing used (debt vs. equity) has a major
effect on this ratio.

Net income – Preferred
Return on equity = dividends
Average common equity

or, using the DuPont equation:
Sales Average assets
Net income – Preferred dividends
ROE = × × Average stockholders’
Sales
Average assets equity
b. The denominator consists of the average of the total equity less
preferred shares and minority interest. One of the major problems with
this ratio is that the historical issue price is used as opposed to the
current market value.
c. The common stockholders’ leverage ratio (Average assets/Average
stockholders’ equity used above) measures the portion of assets that are
financed through common equity (also called the equity multiplier). The
larger this ratio, the greater the financial leverage will be. Various
organizations within an industry will have potentially dramatic
differences in ROE resulting from financing decisions—debt vs. equity. If
ROA is greater than the cost of borrowing, then ROE will be higher than
ROA due to the impact of financial leverage.

= Return on equity
Average common equity
$75,000 – $15,000
= 22%
($300,000 + $250,000) ÷ 2

2125 Market
2125.01 Market measures
Investors use a variety of ratios to analyze the price and yield behavior of
securities. These measures use a variety of market data as well as financial
statement information.
2125.02 Price‐earnings ratio
a. The price‐earnings ratio indicates the relationship of common stock to
net earnings. The market price is the investors’ perception of the future;
therefore, this ratio combines the performance measure of the past (EPS)
to perceptions of the future.

Price market of stock
Price‐earnings ratio =
Earnings per share
b. The earnings per share computation is subject to arbitrary assumptions
and accrual income. EPS is not the only factor affecting market prices.
c. A high P/E ratio is a possible indication of a growth company and/or of a
low‐risk organization.

Earnings per share

$17.00
= = 5.67
$3.00
2125.03 Dividend yield
a. The dividend yield ratio shows the return to the stockholder based on
the current market price of the stock.

Dividend per common share
Dividend yield =
Market price per common share
b. Dividend payments to stockholders are subject to many variables. The
relationship between dividends paid and market prices is a reciprocal
one.
c. This ratio is calculated using the current market price; however, most of
the shareholders did not purchase their shares at the current price, thus
making their personal yield different than the calculated yield.

Dividend yield = Market price per common share
$10,000 ÷ 20,000 shares
= = 2.9%
$17.00 per share
2125.04 Payout ratio to common shareholders
a. The payout ratio to common shareholders measures the portion of net
income to common shareholders that is paid out in dividends.

Payout ratio common Common dividends
=
shareholders Net income – Preferred dividends
b. Income does not necessarily measure cash available for dividend
payment. Payments are heavily influenced by management policy, the
nature of the industry, and the stage of development of the particular
firm. All of these items diminish comparability between companies.
c. Organizations that have high growth rates generally have low payout
ratios since most earnings are kept as retained earnings with the funds
being reinvested in the company instead of providing cash dividends. A
firm that has consistently paid a dividend and suddenly lowers its
dividend payout often is signaling a lack of available cash and the
existence of liquidity or solvency problems.

=

$10,000
= = 16.67%
$75,000 – $15,000
2125.05 Economic value added (EVA)
a. Economic value added (EVA) is the economic profit as opposed to the
GAAP profit. The focus of this ratio is on the earnings above the required
cost of capital for shareholders. In other words, if the required rate of
return is 12% and the company earns 16%, then value has been created
for the shareholders; therefore, it could be said that the investors value
the firm above the amount of capital that was originally invested.

b. Another way of looking at EVA is that a cost is assigned to the equity
capital in addition to the cost of debt. On the traditional income
statement, interest expense represents the cost of debt; however, there
is nothing to denote the cost of equity. Since EVA focuses on economic
profits, the opportunity cost of the equity capital must be taken into
consideration. For example, if the shareholders could earn 12% on an
investment of similar risk, then this opportunity cost of 12% must also be
accounted for. The cost of all capital employed in the first would be
considered to be the weighted‐average cost of capital (WACC). NOPAT is
the after‐tax profit of operating income and is equal to the operating
profit times (1 – Tax rate).

EVA = NOPAT – (Cost of all capital × Total assets)
c. The EVA concept is often used by firms during the decision‐making
process when determining whether a large investment in plant and
equipment would be in the best interest of the shareholder.
d. Calculation using the data from the Sample Company for the year ended
December 31, 20X2, assuming that the WACC is 10%:

EVA = NOPAT – (Cost of all capital × Total assets)
= ($175,000 × (1 – 0.40)) – (10% × $1,000,000)
= $5,000
2125.06 Price‐to‐sales (P/S)
The price‐to‐sales (P/S) ratio is a valuation ratio that compares a company’s
stock price to its revenues (an income statement item). The price‐to‐sales
ratio is a key analysis and valuation tool for investors and analysts. The ratio
shows how much investors are willing to pay per dollar of sales. Like all
ratios, the P/S ratio is most relevant when used to compare companies in the
same sector. A low ratio may indicate the stock is undervalued, while a ratio
that is significantly above the average may suggest overvaluation.
The formula for the price‐to‐sales (P/S) ratio is:

Market value per share
P/S ratio =
Sales per share

2125.07 Price‐to‐cash flow (P/CF)
The price‐to‐cash flow (P/CF) ratio is a stock valuation indicator or multiple
that measures the value of a stock’s price relative to its operating cash flow
per share. The ratio uses operating cash flow, which adds back noncash
expenses such as depreciation and amortization to net income. It is especially
useful for valuing stocks that have positive cash flow but are not profitable
because of large noncash charges.
The formula for the price‐to‐cash flow (P/CF) ratio is:

Share price
Price to cash flow =
Operating cash flow per share
2125.08 Price‐to‐book (P/B)
Companies use the price‐to‐book (P/B) ratio to compare a firm's market to
book value by dividing price per share by book value per share (BVPS). An
asset's book value is equal to its carrying value on the balance sheet, and
companies calculate it by netting the asset against its accumulated
depreciation. Book value is also the net asset value of a company calculated
as total assets minus intangible assets (patents, goodwill) and liabilities.
A lower P/B ratio could mean the stock is undervalued. However, it could
also mean something is fundamentally wrong with the company. As with
most ratios, this varies by industry. This ratio is also known as the price‐
equity ratio.
The formula for the price‐to‐book (P/B) ratio is:

Market price per share
P/B ratio =
Book value per share
2125.09 Other price multiples
A price multiple is any ratio that uses the share price of a company in
conjunction with some specific per‐share financial metric for a snapshot on
valuation. The share price is typically divided by a chosen per‐share metric to
form a ratio.
Some common price multiples are the price‐to‐earnings (P/E) ratio, forward
price‐to‐earnings (forward P/E) ratio, price‐to‐book (P/B) ratio, and price‐to‐
sales (P/S) ratio. Other ratios include price‐to‐tangible book value (P/TBV),
price‐to‐cash flow (P/CF), price‐to‐EBITDA (earnings before interest, taxes,
depreciation, and amortization) (P/EBITDA), and price‐to‐free cash flow
(P/FCF). These price multiples are easy to compute on the surface, but care
must be taken to analyze the components of the denominator to make sure
the numbers are clean, i.e., no extraordinary items, one‐offs or nonrecurring
factors that may distort a normalized financial metric.

2130 Profitability Analysis
2131 Income Measurement Analysis
2131.01 Factors Affecting Income: Various income statement items are typically used
when analyzing profitability. These financial statement values do not
necessarily represent a company’s economic performance, thus complicating
the analysis. Below are several important factors that affect the quality of
reported income statement values.
a. Accounting Estimates: Income is affected by a number of accounting
estimates, including the allowance for doubtful accounts, the salvage
values and depreciation lives of fixed assets, lower of cost or market
adjustments to inventory, and warranty or other contingent liabilities.
These accounting estimates may be influenced by managers and are also
subject to uncertain outcomes.
b. Accounting Methods: GAAP includes certain conventions, such as
historical cost and a stable monetary unit, which may distort reported
revenues and expenses. In addition, managers are allowed to adopt a
variety of different accounting methods that may reduce comparability
across companies. Examples of accounting method choices include
inventory cost flow assumptions, depreciation methods, and accounting
for long‐term contracts.
c. Disclosures and Presentation: Substantial leeway exists within GAAP for
the detail provided in financial statement disclosures. Some companies
combine items that are reported separately by others. For example, one
company might report selling costs separately from general and
administration, while another company might combine these items. Also,
some managers present earnings on temporary investments as part of
operating income, while other managers present it as nonoperating. In
addition, companies vary in the amount of detail provided in footnote
disclosures. Differing definitions and materiality judgments provide
opportunities for manages to use their discretion when preparing
financial statements.

d. Needs of Different Users: As discussed in the section on leverage,
different users have different perspectives about income. Common
shareholders are primarily interested in their return on equity, while
creditors are primarily interested in the ability of a company to pay their
obligations. Thus, shareholders might focus on the change in value of a
company’s assets, while creditors might focus more on liquidity. In
addition, some users are interested only in short‐term results, while
others have long‐term investments. These differences lead to conflicting
attitudes toward profitability measures. Nevertheless, most users are
interested in a company’s ability to generate revenues and to control
costs.
2131.02 Analysis of Revenues: The analysis of revenues often focuses on revenue
growth, or the percent change in revenues from one period to the next.
Below are several factors that should be considered in conjunction with
revenue growth.
a. Importance of Source, Stability, and Trend: Revenues are most valuable
when they are expected to continue into the future. Analysts often
monitor the stability and trend of revenues as indicators of a company’s
ability to continue generating revenues in the future. These analyses may
also highlight seasonal patterns or a company’s exposure to economic
downturns. In addition, some revenue sources are riskier than others. For
example, sometimes companies have sources of revenue that may not
continue in the future, such as revenue from products subject to patents
that will expire, or revenue from one‐time contracts. Some companies
rely heavily on one or more major customers, and the loss of a single
customer could be devastating. Companies subject to rapidly changing
technology face similar risk; products they sell today may be worthless in
the near future.
b. Relationship to Receivables and Inventory: Revenues are usually
analyzed in conjunction with receivables and inventories. Negative trends
often appear in these balance sheet accounts before they appear on the
income statement. For example, when sales volumes begin to drop some
managers engage in “channel stuffing,” in which they force their
customers (particularly in distributor relationships) to accept unneeded
shipments. This type of activity generally triggers a decline in receivables
turnover. A decline in receivables turnover might also indicate that a
company’s customers are having financial difficulties. A decline in
inventory turnover often indicates that managers anticipated higher sales
than occurred, suggesting unforeseen sales difficulties. It might also
suggest product quality or other problems. Thus, declines in receivables
and inventory turnover might indicate impending declines in revenues.
c. Accounting Methods: Alternative accounting methods are available for
some types of revenues, such as under long‐term contracts (completed
contract versus percent of completion). Obviously, managers’ choices of
accounting methods can have major effects on the analysis of revenues.
In addition, the SEC investigates instances of potential financial reporting
fraud related to revenues more often than for any other accounting area.
Sometimes managers are overly aggressive in recognizing revenues
earlier than they should (such as in the case of “channel stuffing”). Other
times managers are overly optimistic in accounting estimates.
2131.03 Analysis of Expenses
a. Major Expense Categories:
Cost of sales
Selling
Depreciation
Maintenance
Amortization
General and Administrative
Financing Expenses
Income Taxes
a. Gross Profit Margin: Cost of sales is often analyzed using the gross profit
margin, which measures the proportion of each sales dollar remaining
after covering cost of sales.
Gross Profit = Sales – Cost of Sales
Sales Sales
b. Analyzing Changes in Expenses as a Percent of Revenue: Expenses are
often analyzed as a percent of revenues. This form of analysis takes into
account the idea that expenses are expected to fluctuate at least partly
with revenues. The trend in expenses as a percent of revenues provides
information about how well managers are controlling costs. CMA
candidates should be prepared to identify possible reasons for increases
over time in an expense as a percent of revenue.
2131.04 Analyzing Income With Common‐Size Statements: Common‐size statements
— in particular, a common‐size income statement — can be used to evaluate
a company’s profitability.

2131.05 Book Value per Share: Used as a basis for evaluating changes in the net
worth of a company from year to year. Remember that book value means
historical cost, not the value of the stock nor what the shareholder would
receive in liquidation.
Net Assets Less Preferred Stock Redemption
Number of Common Shares Outstanding
2131.06 Operating Cash Flow to Income: The ratio of operating cash flow to net income is a
measure of the strength and quality of reporting earnings. In the absence of unusual
income statement items, manager manipulation, or other economic changes, this
ratio is expected to remain fairly constant over time. Thus, changes in the ratio from
year to year suggest that further analysis is called for.
Operating Cash Flow
Net Income

2132 Revenue Analysis
2132.01 The analysis of revenues often focuses on revenue growth, or the percent
change in revenues from one period to the next. Below are several factors
that should be considered in conjunction with revenue growth.
2132.02 Importance of Source, Stability, and Trend: Revenues are most valuable
when they are expected to continue into the future. Analysts often monitor
the stability and trend of revenues as indicators of a company’s ability to
continue generating revenues in the future. These analyses may also
highlight seasonal patterns or a company’s exposure to economic downturns.
In addition, some revenue sources are riskier than others. For example,
sometimes companies have sources of revenue that may not continue in the
future, such as revenue from products subject to patents that will expire, or
revenue from one‐time contracts. Some companies rely heavily on one or
more major customers, and the loss of a single customer could be
devastating. Companies subject to rapidly changing technology face similar
risk; products they sell today may be worthless in the near future.
2132.03 Relationship to Receivables and Inventory: Revenues are usually analyzed in
conjunction with receivables and inventories. Negative trends often appear
in these balance sheet accounts before they appear on the income
statement. For example, when sales volumes begin to drop some managers
engage in “channel stuffing,” in which they force their customers
(particularly in distributor relationships) to accept unneeded shipments. This
type of activity generally triggers a decline in receivables turnover. A decline
in receivables turnover might also indicate that a company’s customers are
having financial difficulties. A decline in inventory turnover often indicates
that managers anticipated higher sales than occurred, suggesting unforeseen
sales difficulties. It might also suggest product quality or other problems.
Thus, declines in receivables and inventory turnover might indicate
impending declines in revenues.
2132.04 Accounting Methods: Alternative accounting methods are available for some
types of revenues, such as under long‐term contracts (completed contract
versus percent of completion). Obviously, managers’ choices of accounting
methods can have major effects on the analysis of revenues. In addition, the
SEC investigates instances of potential financial reporting fraud related to
revenues more often than for any other accounting area. Sometimes
managers are overly aggressive in recognizing revenues earlier than they
should (such as in the case of “channel stuffing”). Other times managers are
overly optimistic in accounting estimates.

2133 Cost of Sales Analysis
2133.01 CVP analysis/margin of safety
a. In the context of capital budgeting, cost‐volume‐profit analysis (CVP) is
often used to determine the margin of safety for a project. In other
words, how much could projected sales fall and still not fall below the
breakeven point?
b. The CVP formula:
Profit = Sales – Variable costs – Fixed costs
Sales = Number of units sold times sales price per unit
Variable costs = Number of units sold times variable costs per unit
Fixed costs = Total fixed costs for anticipated range
The breakeven point is a special case of CVP analysis where the profit
equals zero. In other words, sales revenue equals total costs.
Illustration: Product A sells for $5 per unit. Variable production costs are
$3 per unit and fixed costs per period are $50,000. What will the profit be
if 100,000 units are produced and sold? What is the breakeven point?
Solution:

Profit = Sales - Variable costs - Fixed costs
= ($5  100,000) ($3  100,000) - $50,000
= $150,000

Breakeven in units: 0 = $5x - $3x - $50,000
x = 25,000 units
c. Margin of safety is the excess sales over the breakeven sales point. This
can be important when looking at projects with projected sales. The
methods used to evaluate capital budgeting decisions use projected sales
(savings). If, however, the projections are incorrect, then there could be
significant changes in the calculations of the payback period, NPV, and
IRR. When evaluating a project, the likelihood that the sales/production
projected will be achieved needs to assessed.
Illustration: Using the above illustration, calculate the margin of safety:

Margin of safety = 100,000 projected unit - 25,000 breakeven units
= 75,000 units
This could also be expressed in term of dollars. The margin of safety for
sales is $375,000 ($5 per unit  75,000 units). In this case, sales could fall
significantly (by 75%) and there would still be a profit.

2134 Expense Analysis
2134.01 Major Expense Categories
 Cost of sales
 Selling
 Depreciation
 Maintenance
 Amortization
 General and Administrative
 Financing Expenses

2134.02 Gross Profit Margin: Cost of sales is often analyzed using the gross profit
margin, which measures the proportion of each sales dollar remaining after
covering cost of sales.
Gross Profit = Sales – Cost of Sales
Sales Sales
2134.03 Analyzing Changes in Expenses as a Percent of Revenue: Expenses are often
analyzed as a percent of revenues. This form of analysis takes into account
the idea that expenses are expected to fluctuate at least partly with
revenues. The trend in expenses as a percent of revenues provides
information about how well managers are controlling costs.
CMA candidates should be prepared to identify possible reasons for
increases over time in an expense as a percent of revenue.

2135 Variation Analysis
2135.01 Common Size Analysis: Common size ratios are used to compare financial
statements of a company from year to year, or of different size companies.
By relating items on the statements to a common measure, financial
statements can be created in a standardized format that reveal trends and
insights for comparison.
a. Horizontal Common Size Analysis: One of the ways to facilitate
comparisons between companies or across years for a single company is
horizontal common size analysis. All financial statement figures are
expressed as a percentage of base year figures. Actual dollar amounts
may also be shown. Trends may be analyzed using time series analysis.
Past trends may indicate the direction of possible future trends. Analysis
may be able to determine if a change from a prior year was part of a past
trend, the start of a new trend or just normal variation in annual data.
b. Vertical Common Size Analysis: All figures are converted to percentages
of a specific figure. Income Statement figures, for example, would all be
expressed as percentage of sales and Balance Sheet figures could be a
percentage of total assets.
2135.02 Comparison With Industry: Publishers of industry information, such as Dun
and Bradstreet and Robert Morris Associates, analyze financial data from
thousands of companies which can be used for comparison. It can sometimes
be difficult to compare a firm to a specific industry, especially if the firm is in
more than one line of business. Also, the published ratios are averages for
the industry. The disadvantage is that the industry as a whole may not be
performing satisfactorily, or a large segment may be performing poorly
enough to bring the average down. Therefore, average may not be good.
Another problem using comparisons between companies is the differences in
accounting methods used by the various companies. However, one can
generally get an indication of comparative performance, especially in
conjunction with the firm’s own past performance.

2140 Special Issues
2141 Impact of Foreign Operations
International Financial Reporting Standards (IFRS)
2143.01 International Financial Reporting Standards (IFRS) are Standards,
Interpretations and the Framework adopted by the International Accounting
Standards Board (IASB). Many of the standards forming part of IFRS are
known by the older name of International Accounting Standards (IAS). IAS
were issued between 1973 and 2001 by the Board of the International
Accounting Standards Committee (IASC). In 2001 the new IASB took over the
responsibility for setting International Accounting Standards. During its first
meeting the new Board adopted existing IAS and SICs. The IASB has
continued to develop standards calling the new standards IFRS.
IFRS are considered a “principles based” set of standards in that they
establish broad rules as well as dictating specific treatments. International
Financial Reporting Standards comprise:
 International Financial Reporting Standards (IFRS) – standards issued
after 2001
 International Accounting Standards (IAS) – standards issued before
2001
 Interpretations originated from the International Financial Reporting
Interpretations Committee (IFRIC) – issued after 2001
 Standing Interpretations Committee (SIC) – issued before 2001
There is also a Framework for the Preparation and Presentation of Financial
Statements which describes the principles underlying IFRS. The U.S. will be
following the IFRS standards so that financial statements of other countries
will be comparable.
U.S. Generally Accepted Accounting Principles (GAAP) have several key
differences from International Financial Reporting Standards (IFRS, which is
used in more than 100 countries). IFRS is considered to be principles based,
whereas GAAP is considered to be rules based prescribing industry and/or
transaction guidance. Some say that this allows IFRS to better reflect the
economic view of a transaction than U.S. GAAP. As cross‐border transactions
and U.S. owned foreign subsidiaries continue to grow, convergence of U.S.
GAAP and IFRS is occurring. The goal is one set of uniform global accounting
reporting standards. Some of the differences that exist are shown below.

Comparison Chart
Item U.S. GAAP IFRS
Objectives of Financial GAAP provides separate objectives for IFRS only has one objective for
Statements business entities and non‐business all types of entities
entities
Financial Statements Balance sheet, income statement, Balance sheet, income
Required Components statement of comprehensive income, statement, changes in equity,
changes in equity, cash flow statement, cash flow statement, and
and footnotes. Separation of current and footnotes. Separation of
non‐current assets and liabilities are current and non‐current assets
recommended. and liabilities are required.
Comparative Financial Two years minimum normally must be One year minimum required.
Information presented in a format full set of financial
statements.
Intangible Assets Acquired intangible assets are recorded Intangible assets are only
Purchased at fair value. recognized if the asset has
future economic benefit and
has measured reliability.
Intangible Assets Development costs are to be expensed. Costs in the development
Developed phase may be capitalized.
Inventory Costs Last‐in, first‐out (LIFO) and first‐in, first‐ FIFO method of valuation is
out (FIFO) inventory valuations are acceptable, but LIFO is not
acceptable. allowed under IFRS.
Inventory Write Downs Once inventory is written down the write If inventory is written down,
down cannot be reversed in future the write down can be
periods. reversed in a future period if
specific criteria is met.
Fixed Assets Property, plant, and equipment are A revaluation method is
valued at cost less any accumulated allowed based on fair value of
depreciation. the asset on the date of
evaluation, less subsequent
accumulated depreciation and
impairment losses.
Extraordinary Items Extraordinary items are reported Extraordinary items are not
separately as a special item on the usually reported under IFRS.
income statement.
Tax deferrals Allows for the classification of the Only allows non‐current
deferrals as current or non‐current, treatment of deferrals.
depending on the circumstances.

International Considerations
2143.02 Accounting Methods: When analyzing the financial data of companies from
different countries, it is necessary to take into account the fact that
accounting methods may differ across countries.
2143.03 Foreign Exchange Fluctuations: Companies having transactions in other
currencies are exposed to currency exchange risk. Suppose a U.S. company
sells merchandise to a company in Spain for €1,000. Between the time the
transaction is negotiated and the time payment is received from the
customer, the exchange rate between the U.S. dollar and the euro may
become higher or lower. Some companies enter into hedging arrangements
to minimize this type of risk. In general, foreign currency exchange gains or
losses are not considered part of a company’s core earnings; they tend to
distort accounting profit. Foreign exchange fluctuations may also affect the
quantity of product demanded. The price of products sold internationally
becomes higher or lower as currencies fluctuate. Sometimes companies
experience declining (increasing) revenues because the prices of their
products become higher (lower) in other countries.

2142 Effects of Changing Prices and Inflation
2142.01 Inflation: Traditional financial statements prepared according to generally
accepted accounting principles (GAAP) are based on the historical cost
concept; this requires the asset to be recorded and carried at its past
historical acquisition price, less allowable reductions such as depreciation
and declines in value below cost.
a. Balance Sheet: During periods of inflation, historical cost accounting
understates the value of nonmonetary assets such as inventory and fixed
assets. At the same time, the purchasing power declines for monetary
assets such as cash and accounts receivable. On the other hand, it is
beneficial during times of inflation to owe monetary liabilities such as
accounts payable and long‐term debt.
b. Profitability: During periods of inflation, the costs of nonmonetary
resources that are used up during a period (such as inventory sold and
depreciation of fixed assets) are understated using historical cost.
Suppose an inventory item costing $100 was sold, but must be replaced
at a cost of $110. When historical cost ($100) is used on the income
statement, accounting income is overstated by $10 compared to
economic profit. Ratios such as return on assets (ROA) can become very
distorted. Under inflation, the numerator (income) tends to be
overstated, and the denominator (total assets) tends to be understated.
Thus, inflation causes ROA to appear artificially high. Inflation also
distorts financial statement trends. Revenues may appear to grow due
simply due to inflation.

c. Adjusting for Inflation: Price indices may be used to adjust historical cost
financial statement values for inflation. In the U.S., the Consumer Price
Index (CPI) is often used as a general price index. Indices are also
available for prices within individual industries.
Example: A company had sales of $300,000 in 20x1 and the price index for its
industry is expected to rise from 300 in 20x1 to 320 in 20x2. The level of sales
that the company must reach in 20x2 to achieve a real growth rate of 20% is:
a. $360,000
b. $320,000
c. 337,500
d. $384,000
Answer: d. If sales are $300,000 when the price index is 300, then sales must
be $320,000 ($300,000 × 300/320) to maintain the same relative position
when the price index is 320. To achieve 20% growth, multiply $320,000 by
120%. This is $384,000.
General Price‐Level Accounting
2142.02 General price‐level accounting is a process by which the effect of current
changes in the purchasing power of the monetary unit is reflected in the
financial statements. In price‐level accounting, the historical dollar basis of
items reflected in the financial statements is retained, but the units in which
the items are expressed are adjusted by means of price index numbers
applied to the original transaction basis of the item.
2142.03 The following definitions are important in understanding price‐level
accounting:
a. Monetary items: Those assets and liabilities whose amounts are fixed by
contract or otherwise in terms of numbers of dollars, regardless of
changes in specific prices or in the general level of prices
b. Nonmonetary items: Items reported in the financial statements other
than monetary assets and liabilities
c. Purchasing power gains or losses: Occur when claims to a fixed amount
of money are held during periods in which price levels change. For
example, cash held through a period of inflation results in a decline in
purchasing power and thus a purchasing power loss.

Preparing General Price‐Level Adjusted Financial Statements
2142.04 Accounting principles used in preparing price‐level adjusted financial
statements (PLAFS) are the same as those used in conventional statements.
Changes in the price level are measured in terms of a general price‐level
index. PLAFS are presented in terms of the purchasing power of the dollar at
the latest financial statement date.
2142.05 Monetary and nonmonetary items are distinguished in preparing price‐level
adjusted financial statements (PLAFS). Monetary assets and liabilities are
already stated in terms of current purchasing power and require no
adjustment. Nonmonetary items are restated at the end of the current
period based on the index in effect when the item originated. The price‐level
adjusted amount of an item is determined by applying a ratio of index
numbers to the historical cost of the item, as follows:
2142.06 Income statement items are restated to dollars of current purchasing power
at the end of the current period.
2142.07 The purchasing power gain or loss is included in current income and reported
as a separate income statement item.

Example
2142.08 Financial statements and other data for the P‐L Company are presented as
follows. The steps and computations necessary to adjust the conventional
financial statements to PLAFS are included in the following chart:

General information: Fiscal year 01/01-12/31/X2
Price indexes 01/01/X1 90
12/31/X1 98
12/31/X2 110

Unadjusted financial statements at December 31, 20X2, are as follows:

Balance Sheet Income Statement
Assets: Revenue $150,000
Currenta $100,000 Cash expenses 120,000
Fixedb 200,000 Depreciation 10,000
$300,000 Total expense 130,000
Net income $ 20,000
Liabilities:
Currenta $ 50,000
Noncurrentb 75,000
Stockholders’ equity:
Capital stock 100,000
Retained earnings 75,000
$300,000
a
assumed to be monetary in this example
b
assumed to be nonmonetary in this example

Steps Computations
(1) Treatment of monetary items No restatement
(2) Restatement of nonmonetary items
Nonmonetary items are converted by the ratio of Fixed assets:
the current index (numerator) over the index at ($200,000)  (110/90) = $244,444
the date of origination.
Capital stock:
Assume the following: ($50,000)  (110/90) = $ 61,111
– Fixed assets acquired at 01/01/X1 ($50,000)  (110/98) = 56,122
– Capital stock sold 1/2 at 01/01/X1 and 1/2 at $117,233
12/31/X1
(3) Preparation of balance sheet
Price‐level adjusted figures used with retained Assets:
earnings forced. Current $100,000
Fixed 244,444
$344,444

Liabilities:
Current $ 50,000
Noncurrent 75,000

Stockholders’ equity:
Capital stock 117,233
Retained earnings 102,211
$344,444
(4) Determine net income via change in retained
earnings
Assume the following: Retained earnings, 12/31/X2:
– No entries were made to retained earnings As determined previously $102,211
during the period.
– Retained earnings as reported in the 12/31/X1 Retained earnings, 01/01/X2:
price‐level adjusted balance sheet was $68,788. Restated: ($68,788)  (110/98) 77,211
Net income, 20X2 $ 25,000
(5) Prepare income statement, forcing price‐level
gain/loss
Revenues and expenses restated based on Revenues:
appropriate indexes. ($150,000)  (110/104) = $158,654
– Average index for year used for revenue and Expenses:
expenses other than depreciation: (98 + 110) ÷ Cash: ($120,000)  (110/104) = 126,923
2 = 104 Depreciation:
– Index for depreciation is index for related ($10,000)  (110/90) = 12,222
asset, 90. 139,145
– The purchasing power gain is “plugged” as the 19,509
difference between the $25,000 net income Purchasing power gain 5,491
from Step 4 and the $19,509 computed in Net income $ 25,000
Step 5.

2142.09 Additional considerations in preparing PLAFS
The distinction between monetary and nonmonetary items is an important
one, because monetary items are not converted and nonmonetary items are
converted. Following is a list of items that normally are considered monetary:

Assets:
Cash on hand and demand bank deposits
Time deposits
Accounts and notes receivable
Advances to employees
Inventories produced under fixed‐price contracts
Prepaid interest
Receivables under capitalized leases
Long‐term receivables
Refundable deposits
Advances to unconsolidated subsidiaries
Cash surrender value of life insurance
Liabilities:
Accounts and notes payable
Accrued expenses payable
Cash dividend payable
Refundable deposits
Accrued losses on firm purchase commitments
Bonds payable (and related discount or premium)
Convertible bonds payable
Obligations under capitalized leases
Other long‐term debt
Accrued pension costs
Some items have characteristics of both monetary and nonmonetary items
and are classified according to the purpose for which they exist, which can
usually be determined by their treatment in historical‐dollar financial
statements. For example, debentures carried at the lower of cost or market
and classified as current are dependent on the market price and are
classified as nonmonetary. On the other hand, the same debentures carried
at cost (adjusted for unamortized premium or discount) and classified as
noncurrent are dependent on the fixed cash flow of principal and interest
and thus are treated as monetary.
2142.10 The restatement of nonmonetary items requires an analysis of the account
being converted to determine the timing of the origination of the account
balance. Several observations and additional considerations are presented as
follows:
a. Items originating at several points in time require a layering of the
individual items to determine the converted balance.

b. Long‐lived assets are converted based on the index at their origin, as are
their related depreciation (amortization) expense and accumulated
depreciation (amortization).
c. Accounting principles selected to measure financial statement elements
influence the proper index to use for conversion. For example, inventory
must be analyzed based on the flow assumption used to identify indexes
or averages of indexes that will approximate price levels during the time
the inventory balances came about.
2142.11 The purchasing power gain or loss is computed independently, given
sufficient information, by the following process:
a. Convert net monetary items at the beginning of the period to the current
price level.
b. Add increases in monetary assets and decreases in monetary liabilities,
adjusted to the current price level.
c. Deduct decreases in monetary assets and increases in monetary
liabilities, adjusted to the current price level.
d. Determine net monetary items at the end of the period.
e. The difference between (d) and the total of (a), (b), and (c) is the
purchasing power gain or loss. If (d) is greater, a gain exists; if (d) is less, a
loss exists.
Example
2142.12 Rosie Company had monetary assets and monetary liabilities at the
beginning and end of 20X1 as follows:

01/01/X1 12/31/X1
Monetary assets $100,000 $135,000
Monetary liabilities (75,000) (70,000)
$ 25,000 $ 65,000
The price level index was 110 at January 1, 20X1, and 120 at December 31,
20X1. The following transactions took place during 20X1:
a. Sales affecting net monetary items of $750,000, spread evenly
throughout the year
b. Expenses affecting net monetary items, $650,000, spread evenly
throughout the year
c. Equipment acquired for $60,000 when the price index was 116

The purchasing power loss is computed as follows:

Restatement of 01/01/X1 net monetary items:
$25,000  1.09a $ 27,250
Increases in net monetary items
Sales: $750,000  1.04b 780,000
Decreases in net monetary items
Expenses: $650,000  1.04b (676,000)
Equipment: $60,000  1.03c (61,800)
69,450
Net monetary items, 12/31/X1 65,000
Purchasing power loss $ 4,450

Conversion indexes:
a
120/110 = 1.09
b
120/((120 + 110)/2) = 1.04
c
120/116 = 1.03
2142.13 Financial statements of previous periods, which are to be presented for
comparative purposes, must be restated to current dollar terms as of the
current financial statement date. This is done by the following computation
for all financial statement items:
2142.14 A major point to remember about price‐level adjusted financial statements
(PLAFS) is that the resulting financial statement amounts are not designed to
approximate current values and will do so only in unusual cases. The
amounts represent the application of GAAP, adjusted for changes in the
general purchasing power of the dollar since origination. The purchasing
power (P‐P) gain or loss represents the impact on general purchasing power
of holding a net monetary asset or liability position through a period of
inflation or deflation. The P‐P gain or loss may be generalized as follows:

Period of:
Inflation Deflation
Holding net monetary liability position P‐P gain P‐P loss
Holding net monetary asset position P‐P loss P‐P gain

2143 Impact of Changes in Accounting Treatment
2143.01 Accounting Standards Codification (ASC) Topic 250 (Accounting Changes and
Error Corrections) requires retrospective application to prior periods’
financial statements of changes in accounting principle unless it is
impracticable to determine either the period‐specific effects or the
cumulative effect of the change. If impracticable to apply, ASC Topic 250
requires that the new accounting principle be applied to the balances of
assets and liabilities as of the earliest period for which retrospective
application is practicable. Also, an adjustment must be made to the opening
balance of retained earnings rather than being reported on the income
statement.
A retrospective application as defined by ASC Topic 250 is the application of a
different accounting principle to prior accounting periods as if that principle
had always been used or as the adjustment of previously issued financial
statements to reflect a change in the reporting entity.
2143.02 Definition: A change in accounting principle results from adoption of a
generally accepted accounting principle different from the one used
previously for reporting purposes.
a. Exclusion: Neither initial adoption of an accounting principle nor
adoption of a principle for transactions or events which are clearly
different from previous transactions or events are considered changes in
accounting principle. Examples of changes in accounting principle
include:
 A change in the method of inventory pricing (e.g., a change from FIFO
to LIFO)
 A change in depreciation method (e.g., a change from straight line to
double declining balance, now accounted for as a change in
accounting estimate effected by a change in accounting principle)
 A change in the method of accounting for long‐term construction
contracts (e.g., a change from the completed‐contract method to the
percentage‐of‐completion method)
b. Change in Principle: There is a presumption that an accounting principle,
once adopted, should not be changed. That presumption can be
overcome only if the enterprise justifies the change to an alternative
accounting principle on the basis that it is preferable. The nature of and
justification for an accounting change must be disclosed in the year in
which the change is made.
2143.03 Reporting Changes in Accounting Principle: ASC Topic 250 requires a
retrospective approach to changes in accounting principles. Previously, a
cumulative effect of a change in principle was used which was included in the
year of change.
a. Retrospective Approach: Using a retrospective accounting change
approach, an entity reporting the change adjusts its financial statements
for each prior period presented to the same basis as the new accounting
principle. An adjustment is made to the carrying amounts of assets and
liabilities as of the beginning of the first year presented, plus an
adjustment to the opening balance of retained earnings.
b. Impracticability: Entities should not use retrospective application if one
of the following conditions exists.

 The entity cannot determine the effects of the retrospective
application.
 Retrospective application requires assumptions about management’s
intent in a prior period.
 Retrospective application requires significant estimates that the
entity cannot develop.
If any of the above conditions exists, the entity prospectively applies the
new accounting principle.
2143.04 Change in Accounting Estimate: Estimates are necessary in accounting
because financial statements must be prepared periodically before the
ultimate consequences of many transactions are known. Examples of items
for which estimates are necessary are uncollectible receivables, inventory
obsolescence, service lives and salvage values of depreciable assets,
warranty costs, recoverable mineral reserves, and periods benefited by a
deferred cost.
A change in accounting estimate is accounted for prospectively, i.e. in the
period of the change if the change affects that period only or in the period of
the change and future periods if the change also affects future periods.
Financial statements for previous periods should not be restated nor should
pro forma amounts for prior periods be reported. The effect of a change in
estimate on income before extraordinary items, net income, and related per
share amounts of the current period must be disclosed for changes which
affect several periods.
2143.05 Change in Reporting Entity: Some accounting changes are the result of
formation of a new reporting entity. (Note that purchase, creation,
disposition, or cessation of a business unit does not constitute a change in
reporting entity.) These changes are accounted for by restating the financial
statements of all prior periods presented to show how the financial
information would have appeared for the new reporting entity. The financial
statements should describe the nature of the change and the reason for it.
Examples of a change in entity include:
a. Presenting consolidated statements in place of statements for individual
companies
b. Changing the set of subsidiaries or companies included in consolidated or
combined financial statements
2143.06 Correction of an Error: A correction of an error is accounted for as a prior
period adjustment and comparative statements for prior periods are restated
to correct for the effect of the error. Any effect attributable to years prior to
the earliest year presented is shown as an adjustment of beginning retained
earnings for the earliest year. Examples of errors include:
a. A change from an accounting principle which is not generally accepted to
an accepted principle
b. Mathematical mistakes
c. Changes in estimates due to errors or inappropriate assumptions in
preparing the original estimates
d. Mistakes in application of an accounting principle
e. Incorrect classification of a cost as an expense rather than an asset or
vice versa

2144 Accounting and Economic Concepts of Value and Income
2144.01 Fair Value Accounting: Fair value is a concept used in accounting and
economics defined as a rational and unbiased estimate of the market price of
a good, service, or asset, taking into account such objective factors as:
 acquisition/production/distribution costs, replacement costs, or costs
of close substitutes
 actual utility at a given level of development of social productive
capability
 supply vs. demand and subjective factors such as
 risk characteristics
 cost of and return on capital
 individually perceived utility
2144.02 Estimate of Value: In accounting, fair value is used as an estimate of the
market value of an asset (or liability) does not have a market price because
there is no established market for the asset. Under GAAP (FAS 157), fair
value is the amount an asset could be bought or sold in a transaction
between willing parties, or transferred to an equivalent party, other than in a
liquidation sale.
2144.03 Example: An example of where fair value is an issue is where an asset is
purchased several years ago that has no active resale market. If you wanted
to put a fair value measurement on the asset it would be a subjective
estimate because of the lack of a market for such items. Another example
would be if two companies purchased similar land parcels, but one
purchased their parcel in 20x2 for $800,000 while the second company
purchased theirs for $2,000,000 in 20x7. Historical costs have been
presented in the balance sheet, but there would be no way to show the
comparable value of the assets. Fair value would allow the two assets to be
presented at their current value, $2,000,000.

2145 Earnings Quality
Fundamental Earnings‐per‐Share Concepts
2145.01 Earnings per share (EPS) is a comparison of the earnings applicable to
common stock with the number of shares of common stock of that
enterprise. The concept relates only to common stock and should be thought
of as “earnings per common share.”
2145.02 Assuming that there is no preferred stock outstanding, the fundamental EPS
computation is:

Net income
EPS =
Weighted‐average common shares outstanding
2145.03 If the enterprise has preferred stock outstanding, the fundamental EPS
computation is:

EPS =
Weighted‐average common shares outstanding
2145.04 All EPS computations involve the division of a dollar amount of earnings
(earnings applicable to common stock) by a number of common shares. The
resulting fraction or index represents the pro rata share of earnings (the
numerator) allocated to each share of common stock (the denominator).
2145.05 Conceptually, earnings per share is a very simple notion. There are, however,
securities that, because of their conversion feature (e.g., convertible
preferred, convertible debt), right to acquire common stock (e.g., stock
options, stock warrants), or capability of sharing in earnings in a manner
similar to common stock (e.g., freestanding instruments with down round
features or contingent issuance of common shares in conjunction with a
business combination), create the potential for earnings per share to be less
than if it is based solely on the number of outstanding shares of common
stock. The existence of these other potential common shares makes it
important to show their possible dilutive effect on earnings per share.
2145.06 The objective is to show (a) basic EPS—an earnings per share based only on
the actual outstanding common stock—and (b) diluted EPS—an earnings per
share after giving consideration to these potential common shares. In the
former case, the earnings per share calculation takes into consideration the
triggering of the down round feature and deducts its effect from income
available to common shareholders. In the latter case, the earnings per share
calculation takes into consideration the impact that the assumed conversion
or exercise of the securities that constitute potential common stock would
have on both the numerator earnings and the denominator shares. All
earnings‐per‐share computations are based on a weighted‐average number
of common shares outstanding or assumed to be outstanding.
2145.07 Earnings per share (EPS) must be presented on the face of the income
statement of publicly held enterprises as follows:

Type of Capital Structure EPS Presentation

SIMPLE (only common stock outstanding, BASIC EPS (based on weighted‐average number of
with no potential common stock) actual common shares outstanding)

COMPLEX (common stock outstanding DUAL EPS:
and one or more types of potential
common stock)
BASIC EPS (based on weighted‐average number of
actual common shares outstanding during the
period)
DILUTED EPS (based on weighted‐average number of
actual common shares outstanding during the
period plus the weighted‐average number of
common shares that would result from the
assumed conversion or exercise of all dilutive
potential common stock)
2145.08 Because simple capital structures include no potential common stock,
earnings per share is computed based only on the weighted‐average number
of common shares outstanding during the period. Complex capital structures,
on the other hand, include the potential for dilution, and a dual presentation
of EPS is required. Basic EPS is based on the weighted‐average number of
actual common shares outstanding during the period. Diluted EPS is based on
the weighted‐average number of actual common shares outstanding plus the
weighted‐average number of common shares that would result from the
assumed conversion or exercise of all dilutive potential common stock
2145.09 In certain circumstances, potential common stock may actually increase
rather than decrease EPS. In that case, the potential common stock is said to
be antidilutive. Since the objective of the dual presentation of EPS is to show
the potential dilution of EPS by the assumed conversion or exercise of
potential common stock, EPS calculations should include only those potential
common shares whose inclusion would decrease EPS (i.e., those that are
dilutive).
2145.10 Several definitions are important in an understanding of the dual
presentation of EPS for enterprises with a complex capital structure.
a. Dilution (dilutive): A reduction in EPS resulting from the assumption that
convertible securities were converted, that options or warrants were
exercised, or that other shares were issued on the satisfaction of certain
conditions
b. Antidilution (antidilutive): An increase in earnings‐per‐share amounts or
a decrease in loss‐per‐share amounts
c. Potential common stock (PCS): A security or other contract that may
entitle its holder to obtain common stock during the reporting period or
after the end of the reporting period
d. Weighted‐average common shares (WACS): The number of shares
determined by relating (a) the portion of time within a reporting period
that common shares have been outstanding to (b) the total time in that
period. In computing WACS, retroactive application is given to stock
splits, stock dividends, and shares of common stock issued in a business
combination accounted for as a pooling of interests (i.e., they are treated
as if they were outstanding for all of any periods presented).

e. Basic EPS: The amount of earnings for the period available to each share
of common stock outstanding during the reporting period
f. Diluted EPS: The amount of earnings for the period available to each
share of common stock outstanding during the reporting period and to
each share that would have been outstanding assuming the issuance of
common shares for all dilutive potential common shares outstanding
during the reporting period
2145.11 The most common types of potential common stock are convertible
securities, stock options and warrants, and other contingent issuances (i.e.,
arrangements whereby the enterprise is required to issue common stock on
the satisfaction of certain conditions). Each potential common stock must be
evaluated to determine if it is dilutive.
EPS Computational Guidelines
2145.12 The basic EPS and diluted EPS computations can be generalized as follows:

Net income – Dividends on preferred stock
Basic EPS =
WACS

Net income – Dividends on preferred stock + PCS adjustments
Diluted EPS =
WACS + WPCS
WACS is the weighted‐average number of actual common shares
outstanding. WPCS is the weighted‐average number of common shares that
would result from the assumed conversion or exercise of dilutive potential
common shares outstanding.
Preferred Stock Dividends
2145.13 In computing EPS, dividends on preferred stock are subtracted from net
income for all EPS computations for which the preferred stock is assumed to
be outstanding. If the preferred stock is cumulative, the amount to be
deducted is the total dividend for the period whether it is declared or not. If
the preferred stock is noncumulative, the amount to be deducted is the
amount actually declared during the current period. This adjustment
(deduction) is made to convert net income to the amount of earnings
applicable to common stock only.
2145.14 In making the EPS computations for any given period, dividends in arrears are
ignored. The preferred dividends applicable to those prior periods (i.e., the
dividends in arrears with respect to the current period) should have been
taken into consideration for the EPS computations for those prior periods.
2145.15 If there are preferred dividends and a net loss occurs, the preferred
dividends are added to the net loss for purposes of computing the loss per
share.
2145.16 Treasury stock method (for stock options and warrants): Stock options and
warrants outstanding (whether or not presently exercisable) should be
included in EPS calculations unless they are antidilutive.
2145.17 The dilutive effect of stock options and warrants is computed by the treasury
stock method. This method is based on the assumption that the options or
warrants are exercised at the beginning of the period (or date of issuance if
later) and the proceeds from the exercise used to purchase outstanding
common stock that would then become treasury stock. (Hence, the name
“treasury stock” method.) The dilutive effect is the net increase in
outstanding shares from the assumed sale of the shares (arising from the
exercise of the options or warrants) and the reacquisition of outstanding
shares with the proceeds from the exercise of the options or warrants.
2145.18 If the average market price for the period (e.g., for the year) of the
enterprise’s common stock exceeds the exercise price of the options or
warrants, the proceeds from the assumed exercise are not sufficient to buy
back as many shares as were issued on the assumed exercise of the options
or warrants. The net result is an increase in the number of shares
outstanding. Assuming a net income (as opposed to a net loss), this increase
in the number of shares outstanding would reduce EPS and, thus, the options
or warrants would be dilutive for EPS purposes.
2145.19 If the average market price of the enterprise’s common stock is less than the
exercise price of the options or warrants, the proceeds from the assumed
exercise are sufficient to buy back more shares than those issued on the
assumed exercise of the options or warrants. The net result would be a
decrease in the number of shares outstanding. Since a decrease in the
number of shares assumed outstanding (the denominator shares) would
cause EPS to increase, the options or warrants would be antidilutive. In that
case, one would not assume the exercise of the options or warrants in
calculating EPS.
2145.20 In summary, options or warrants are assumed exercised only if the average
market price of the stock exceeds the exercise price of the options or
warrants.

2145.21 Example: An enterprise has outstanding 10,000 options to acquire common
stock at $20 and the average market price of the stock for the period is $25.

1. Shares assumed issued on exercise of the options
(Proceeds = 10,000  $20 exercise price = $200,000) 10,000
2. Shares assumed reacquired with proceeds:
$200,000  $25 average market price 8,000
3. Incremental denominator shares 2,000
2145.22 Alternatively, the incremental denominator shares could be computed as
follows:

Market price - Exercise price
Incremental shares =  Number of options
Market price

$25 - $20
=  10,000
$25

= 2,000 shares
2145.23 Assuming net income of $100,000 and WACS of 50,000, basic EPS and diluted
EPS are computed as follows:

Net income $100,000
Basic EPS = = = $2.00
WACS 50,000 shares

Net income $100,000
Diluted EPS = = = $1.92
WACS + WPCS 50,000 + 2,000
Freestanding Equity‐Classified Financial Instruments (Nonconvertible Instruments) with a
Down Round Feature
2145.24 If an entity has a freestanding equity‐classified financial instrument with a
down round feature that has been triggered, the entity shall deduct the
effect of the down round feature when computing income available to
common stockholders.
a. The effect is treated as a dividend and a reduction of income available to
common stockholders in basic earnings per share.
b. The effect, determined immediately after triggering, is the difference
between the fair values of the financial instrument (without the down
round feature) using the strike price (1) before and (2) after the
reduction.
2145.25 Example (based on FASB ASC 260‐10‐55‐95 through 55‐97): Assume all are
met to classify warrants as an equity freestanding financial instrument.
Warrants, with a 10‐year life, allow the holder to buy 1,000 shares of
common stock for $20 per share. The warrants have a down round feature to
protect the holder from the firm issuing additional shares at a price below
$20 per share or issuing equity‐classified financial instruments with a strike
price below $20 per share. The strike price would be reduced to the most
recent issuance or strike price but the down round feature limits the strike
price reduction to $16 at most. Assume the entity issues common stock
shares for $12 per share. This would trigger the down round feature and the
strike price would be reduced to $16. Assume the fair value of the warrants
before the down round feature is triggered is $12,000 and that the fair value
of the warrants (using a strike price of $16) immediately after the down
round feature is $15,000. The fair value increase resulting from the triggering
of the down round feature is $3,000. The journal entry would be:

Retained Earnings 3,000
Additional Paid‐in Capital 3,000
The entity would reduce the income available to common stockholders in its
basic earnings per share (EPS) calculation by $3,000. The treasury stock
method, if the effect is dilutive, would be used to calculate diluted EPS and
the $3,000 would be added back to income available to common
stockholders during that calculation.
“If Converted” Method (for Convertible Securities)
2145.26 The “if converted” method assumes that convertible securities are converted
into common stock for purposes of computing EPS. It requires that the
numerator in the basic EPS computation be adjusted for the interest savings
(net of the related tax effect) or the dividend savings that would be
experienced if a convertible security is assumed to be converted into
common stock for purposes of the diluted EPS computation. In other words,
if one assumes that a convertible security is converted, it would be
inconsistent to assume that interest or dividends would be paid on that
security after it is assumed to be converted. Therefore, the numerator
earnings must be adjusted for the effect that the assumed conversion of the
security would have on the amount of interest or dividends.
2145.27 Example: A $200,000, 10% bond issue is convertible into 8,000 shares of
common stock. Assuming net income of $100,000, WACS of 50,000, and a tax
rate of 40%, basic EPS and diluted EPS are computed as follows:

Net income
Basic EPS = WACS

$100,000
Basic EPS = = $2.00
50,000 shares

Net income + Interest (net of tax)
Diluted EPS =
WACS + Incremental common shares from assumed conversion of bonds

$100,000 + $12,000a
Diluted EPS = = $1.93
50,000 + 8,000b

a
Interest savings, after tax ($200,000  0.10)  (1 – 0.40 tax rate) = $12,000
b
Incremental common shares resulting from assumed conversion of bonds: 8,000
Computation of Weighted Average
2145.28 Both basic EPS and diluted EPS computations are based on a weighted‐
average shares concept. Under this concept, the computation of the
denominator shares takes into consideration the portion of the period that
the common shares were outstanding or assumed to be outstanding for
purposes of EPS computations. To illustrate, assume that an enterprise had
common stock outstanding as shown:

01/01/X1—15,000 common shares outstanding
05/01/X1—9,000 common shares issued
08/01/X1—6,000 outstanding common shares reacquired as treasury stock
WACS for 20X1:
15,000 4/12 = 5,000 (a total of 15,000 shares for 4 months)
24,000  3/12 = 6,000 (a total of 24,000 shares for 3 months)
18,000 5/12 = 7,500 (a total of 18,000 shares for 5 months)
18,500
2145.29 In like manner, if a potential common stock is outstanding for only part of a
period for which EPS is computed, the computation of the number of
common shares that would result from the assumed conversion or exercise
of the potential common stock would be based on the portion of the period
that the potential common stock was actually outstanding.

2145.30 Example: A $100,000, 6% bond issue was sold on April 1, 20X1, convertible
into 10,000 shares of common stock. Assuming that net income is $200,000,
WACS is 100,000, and the effective tax rate is 40%, earnings per share is as
follows:

Net income $200,000
Basic EPS = = = $2.00
WACS 100,000 shares

Net income + Interest (net of tax) $200,000 + $2,700a
Diluted EPS = WACS + WPCS = = $1.89
100,000 + 7,500b

a
[$100,000  0.06  (1 – 0.40)]  9/12 = $2,700
b
10,000 shares  9/12 = 7,500 shares
2145.31 As the example illustrates, the computation of common shares resulting
from the assumed conversion of the bonds takes into consideration that the
bonds were not outstanding during the entire period. The incremental shares
of common stock that would result from the assumed conversion of the
bonds are weighted for the portion of the year (9/12) the bonds were
outstanding. The numerator adjustment for the interest is similarly weighted
for the portion of the year the bonds were outstanding.
Retroactive Application of Stock Splits and Stock Dividends
2145.32 Stock splits and stock dividends are treated retroactively in the computation
of EPS, both for the current period and any prior periods presented for
comparative purposes.
2145.33 Example: In 20X1, net income was $560,000 and WACS was 100,000 shares,
giving an EPS figure of $5.60. In 20X2, a 10% stock dividend is issued on
August 31 and net income for the year is $725,000. EPS for 20X2 is computed
as follows:

$725,000
EPS = = $6.59
100,000 + (0.10 × 100,000)
The 10,000 incremental shares issued as a stock dividend are treated as if
they were outstanding for the entire year, even though the stock dividend
was issued on August 31 and the resulting 10,000 shares were outstanding
for only part of the year.
2145.34 EPS computations treat stock dividends and stock splits as if they occurred at
the beginning of the earliest year presented in the current financial report.

2145.35 The EPS of $5.60 for 20X1 must be restated (in the 20X2 financial statements)
to give effect to the 10% stock dividend declared in 20X2. The comparative
years’ presentation in the 20X2 financial statements would show EPS for the
two years as follows:

20X1 20X2
Earnings per share $5.09 $6.59
2145.36 The $5.09 is determined by dividing the 20X1 net income of $560,000 by the
equivalent share that would have been outstanding if the stock dividend
were applied retroactively to the beginning of 20X1 ($560,000  110,000 =
$5.09).
2145.37 The retroactive application of a stock dividend applies to all shares issued or
assumed to be issued prior to the stock dividend or split.
2145.38 Example: Assume the following events in 20X1 related to common stock:

01/01/X1 15,000 shares outstanding
05/01/X1 9,000 shares issued for cash
06/01/X1 4,800 shares issued as a 20% stock dividend (20% of 24,000 shares)
08/01/X1 6,000 outstanding shares reacquired as treasury stock

Restatement
Shares for 20% Stock Weighted‐
Dates Outstanding Outstanding Dividend Fraction of Year Average Shares
Jan. 1-May 1 15,000 1.20 4/12 6,000
May 1-June 1 24,000 1.20 1/12 2,400
June 1-Aug. 1 28,800 2/12 4,800
Aug. 1-Dec. 31 22,800 5/12 9,500
12/12 22,700

2145.39 Note that the shares outstanding prior to June 1 are retroactively restated to
reflect the effect of the 20% stock dividend on June 1. Of course, the shares
outstanding after June 1 already reflect the effect of the 20% stock dividend.
2145.40 If a stock dividend or split occurs after the end of the year but before the
financial statements are issued, the weighted‐average number of shares
outstanding for the current year and any prior years presented in the current
period in comparative form must be restated. For example, if a 2:1 stock split
were issued on January 8, 20X2 (prior to the issuance of the 20X1 financial
statements), the weighted‐average common shares for 20X1 would be
45,400 (i.e., 22,700  2).

Inclusion of Only Dilutive Potential Common Stock
2145.41 The computation of diluted EPS includes only those potential common shares
(PCS) that are dilutive. A convenient way to determine if all potential
common shares are dilutive is to first calculate the per‐share effect of each
PCS and then include each PCS in the calculation of diluted EPS by starting
with the PCS with the lowest per‐share effect and continuing as long as the
next lowest per‐share effect is lower than the previously calculated diluted
EPS. The per‐share effect of a PCS is the ratio of (a) the change in the
numerator earnings resulting from the assumed exercise or conversion of the
PCS to (b) the change in the denominator shares resulting from the assumed
exercise or conversion of that PCS.
2145.42 Example: In 20X1, Alpha Company reported net income of $200,000 and had
20,000 shares of common stock during the entire year. Alpha also had
outstanding during all of 20X1 the following convertible securities:
a. Convertible preferred stock, 6%, $100 par, 1,000 shares, each share
convertible into 15 shares of common stock
b. Convertible bonds, 15%, $100,000 face amount, each $1,000 bond
convertible into 10 shares of common stock
Assume a tax rate of 40%.
2145.43 Basic EPS is:

Net income $200,000
BEPS = = = $10.00
WACS 20,000
2145.44 The per‐share effect of each of the convertible securities is as follows:
Convertible preferred:
Dividends $6,000 a
Per  Share Effect    $0.40
Incremental Shares 15,000 shares b

a
Dividends = $100,000 × 0.06 = $6,000
b
Incremental shares = 1,000 preferred shares × 15 common shares per preferred share
= 15,000 common shares
Convertible bonds:
Interest(net-of-tax ) $9,000 a
Per  Share Effect    $9.00
Incremental Shares 1,000 shares b

a
Interest = $100,000 × 0.15 × (1 - .40 tax rate) = $9,000
b
Incremental shares = $100,000 total face of bonds ÷ $1,000 face per bond = 100 bonds
= 100 bonds × 10 shares of common per $1,000 bond = 1,000 common
shares
2145.45 Since the convertible preferred stock has the lowest per‐share effect ($.40),
it is the most dilutive and, therefore, should be assumed to be converted
before the convertible bonds which have a higher per‐share effect ($9.00). If
only the preferred stock is assumed to be converted, the diluted EPS is:

Net income + Preferred dividends $200,000 + $6,000
Diluted EPS = = = $5.89
WACS + WPCS 20,000 + 15,000
2145.46 Note that even though the $9.00 per‐share effect of the convertible bonds is
less than basic EPS of $10.00, the convertible bonds are antidilutive because
their per‐share effect of $9.00 is greater than the $5.89 diluted EPS
computed with only the convertible preferred stock assumed to be
converted. Thus, by computing the per‐share effect of each potential
common stock and assuming their exercise or conversion in ascending order
(smallest to largest per‐share effects) and continuing until the next lowest
per‐share effect is greater than diluted EPS without including that next PCS
(or until all PCS have been included in the computation of diluted EPS if all
prove to be dilutive), one is assured that the final diluted EPS calculated is
the lowest diluted EPS (and therefore the most dilutive diluted EPS) for that
period.
Comprehensive EPS Illustration
2145.47 You are responsible for completing the income statement of the Mars
Company at year‐end 20X2. Your workpapers disclose the following opening
balances and transactions in the company’s capital stock accounts during the
year:
a. Common stock (at October 1, 20X1, stated value $10, authorized 300,000
shares; effective December 1, 20X1, stated value $5, authorized 600,000
shares):

Balance, October 1, 20X1 — issued and outstanding 60,000 shares
December 1, 20X1 — 60,000 shares issued in a 2‐for‐1 stock split
December 1, 20X1 — 280,000 shares (stated value $5) issued at $39 per share
b. Treasury stock—common:

March 1, 20X2 — purchased 40,000 shares at $38 per share
April 1, 20X2 — sold 40,000 shares at $40 per share
c. Stock purchase warrants, Series A (initially, each warrant was
exchangeable with $60 for one common share; effective December 1,
20X1, each warrant became exchangeable for two common shares at $30
per‐share):

October 1, 20X1 — 25,000 warrants issued at $6 each

d. Stock purchase warrants, Series B (each warrant is exchangeable with
$50 for one common share):

April 1, 20X2 — 20,000 warrants authorized and issued at $10 each
e. First mortgage bonds, 5½%, due 20X5 (nonconvertible; priced to yield 5%
when issued):

Balance October 1, 20X1 — authorized, issued, and outstanding—the face value of $1,400,000
f. Convertible debentures, 7%, due 20X9 (initially, each $1,000 bond was
convertible at any time until maturity into 15 common shares; effective
December 1, 20X1, the conversion rate became 30 shares for each bond):

October 1, 20X1 — authorized and issued at their face value (no premium or discount) of
$2,400,000
g. The market price for the company’s common stock was as follows:

10/01/X1 $66
04/01/X2 $40
09/30/X2 $43
Average for year ended 09/30/X2—$37.50
h. Net income for the year ended September 30, 20X2, was $540,000. The
appropriate tax rate is 40%.
i. Required:
(1) Compute WACS.
(2) Compute basic EPS.
(3) Determine the per‐share effect of each potential common stock
(PCS).
(4) Compute diluted EPS.
2145.48 Requirement 1: Compute WACS.

Shares Restatement for Fraction of Weighted Average
Dates Outstanding Outstanding 2:1 Stock Split Year Shares (WACS)

Oct. 1–Dec. 1 60,000 2.00 2/12 20,000
Dec. 1–Mar. 1 400,000 3/12 100,000
Mar. 1–Apr. 1 360,000 1/12 30,000
Apr. 1–Sept. 30 400,000 6/12 200,000
12/12 350,000
2145.49 Requirement 2: Compute basic EPS.

Net income $540,000
Basic EPS = = = $1.54
WAC 350,000 shares

2145.50 Requirement 3: Determine the per‐share effect of each potential common
stock (PCS).

Series A warrants:
Numerator effect = $0

Denominator effect:
Shares issued on exercise (25,000  2 shares per warrant) 50,000
Proceeds = 25,000  2  $30 = $1,500,000
Shares reacquired with proceeds ($1,500,000  $37.50 market price) 40,000
Incremental denominator shares 10,000

Numerator effect $0
Per‐share effect = = = $ 0.00
Incremental shares 10,000 shares
Series B warrants: Antidilutive because the average market price of $37.50 is
less than the exercise price of $50
5.5% first‐mortgage bonds: Not a potential common stock (PCS) because the
bonds are not convertible
7% convertible debentures:
Per share effect
Numerator Effect Interest(net - of - tax) $100,800 a
   $1.40
Incremental Shares Incremental Shares 72,000 shares b
a
Interest net of tax = $2,400,000 × 0.07 × (1 – 0.40) = $100,800
b
Incremental shares = $2,400,000 total face ÷ $1,000 face per bond = 2,400 bonds
2,400 bonds × 30 common shares per bond = 72,000 shares

2145.51 The per‐share effects of the relevant potential common stocks arranged in
ascending order are:

Series A stock purchase warrants $0.00
7% convertible debentures 1.40
2145.52 Since the per‐share effect of the Series A warrants is the lowest, one would
assume exercise of these warrants provided that the per‐share effect of the
warrants ($0.00) is also less than the basic EPS of $1.54. Since that is the
case, the Series A warrants are dilutive. Assuming the Series A warrants are
exercised, the diluted EPS is:

Net income + Numerator effect of warrants
Diluted EPS =
WACS + Denominator effect of warrants
$540,000 + $0.00 $540,000
= = = $1.50
350,000 + 10,000 360,000 shares
2145.53 Since the per‐share effect of the 7% convertible debentures ($1.40) is lower
than the diluted EPS, assuming exercise of the warrants only, the assumed
conversion of the debentures would reduce diluted EPS. Therefore, the
debentures are dilutive and their conversion should be assumed. In that
case, the diluted EPS is:

$540,000 + $0 + Numerator effect of warrants
Diluted EPS =
350,000 + 10,000 + Denominator effect of debentures
$540,000 + $0 + $100,800 $640 800
= = = $1.48
350,000 + 10,000 + 72,000 432,000 shares
2145.54 Thus, earnings per share would be presented for the year ended September
30, 20X2, as follows:

Basic earnings per share $1.54
Diluted earnings per share 1.48
Additional EPS Considerations
2145.55 This section contains discussion of several additional considerations with
respect to the calculation and presentation of earnings per share.
2145.56 Periods for which EPS must be presented
Earnings per share must be presented for all periods for which an income
statement or summary of earnings is presented. If diluted EPS is presented
for any period included in the current financial report, it must be presented
for all periods included in that financial report. In other words, if dual EPS is
presented for any period, it must be presented for all periods presented.
2145.57 Income captions for which EPS are presented
EPS (if applicable, both basic EPS and diluted EPS) must be presented on the
face of the income statement for each of the following income captions if
they appear on the income statement:
a. Income from continuing operations
b. Net income
2145.58 EPS must also be presented for discontinued operations, either on the face of
the income statement or in the notes to the financial statements.
2145.59 Income from continuing operations used as the “control number”
If an enterprise reports a discontinued operation, it must use income from
continuing operations as the “control number” in determining whether
potential common shares are dilutive or antidilutive.
2145.60 The importance of the control number is that the same number of potential
common shares used in computing the diluted per‐share amount for the
control number must be used in computing all other reported per‐share
amounts, even if those amounts are antidilutive to their respective basic per‐
share amounts.
2145.61 Example: Assume that an enterprise reports the following on its income
statement:

Income from continuing operations $ 100,000
Discontinued operations (250,000)
Net income $(150,000)
Assume that 10,000 shares of common stock were outstanding during the
entire year. In addition, assume that the enterprise had outstanding all year
stock options that would result in 2,000 incremental common shares if
exercised.
2145.62 The stock options are dilutive with respect to income from continuing
operations—the control number—because their assumed exercise would
reduce EPS. In this case, EPS would be presented as follows:
For income from continuing operations:

Income from continuing operations $100,000
Basic = = = $10.00
WACS 10,000

Income from continuing operations $100,000
Diluted = = = $8.33
WACS + WPCS 10,000 + 2,000
For net income or loss:

Net income ($150,000)
Basic = = = ($15.00)
WACS 10,000

Net income ($150,000)
Diluted = = = ($12.50)
WACS + WPCS 10,000 + 2,000
2145.63 Note that the stock options are dilutive with respect to income from
continuing operations; the diluted EPS of $8.33 is less than the basic EPS of
$10.00. However, the stock options are antidilutive with respect to net
income or loss; the diluted EPS of $(12.50) is greater than (rather than less
than) the basic EPS of $(15.00). A smaller loss per share is “better than” a
larger loss per share; therefore, a smaller loss per share is antidilutive.
2145.64 In this case, dual EPS (EPS and diluted EPS) would be required because
income from continuing operations is the control number and the stock
options are dilutive with respect to income from continuing operations.
Therefore, the stock options are considered to be exercised with respect to
all of the diluted earnings per share calculations (i.e., those for income from
continuing operations, discontinued operations, and net income).
2145.65 In contrast, assume that the enterprise reported the following income
statement information:

Income from continuing operations $(100,000)
Discontinued operations 250,000
Net income $ 150,000
2145.66 Since income from continuing operations is a loss amount, the assumed
exercise of the stock options would increase the denominator shares and,
therefore, reduce the loss per share. Thus, the stock options are antidilutive
with respect to income from continuing operations. Therefore, the stock
options would not be assumed to be exercised because they are antidilutive
with respect to the control number (income from continuing operations),
even though they are dilutive with respect to net income (which is a positive
amount). In this case, if this is the only year presented in the current financial
report, the earnings per share would be reported as follows:

Basic EPS:
$(100,000)
Income from continuing operations = = $(10.00)
10,000

$150,000
Net income = = $15.00
10,000

Diluted EPS:
$(100,000)
Income from continuing operations = = $(10.00)
10,000

$150,000
Net income = = $15.00
10,000
2145.67 Note that, in this case, basic EPS and diluted EPS are the same. Even though
they are the same, both must be presented because the enterprise has
potential common stock (the stock options) outstanding.
Contingent Issuance of Common Stock
2145.68 In some circumstances, an enterprise may agree to issue additional shares of
common stock if certain conditions are met. An example is in the case of a
business combination in which the acquiring company agrees to issue
additional shares of common stock (contingent shares) if certain conditions
are met. These contingent shares should be considered outstanding and
included in diluted EPS as follows:
a. If all necessary conditions have been satisfied by the end of the period,
they should be included as of the beginning of the period in which the
conditions were satisfied (or as of the date of the contingent stock
agreement, if later).
b. If all necessary conditions have not been satisfied by the end of the
period, the number of contingently issuable shares included in diluted
EPS should be based on the number of shares, if any, that would be
issuable if the end of the reporting period were the end of the
contingency period (e.g., the number of shares that would be issuable
based on current‐period earnings or period‐end market price) and if the
result would be dilutive.
2145.69 Assume that Beta Company purchased Delta Company and agreed to give
the stockholders of Delta Company 10,000 additional shares of common
stock in 20X3 if Delta’s net income in 20X2 is at least $100,000. If in 20X1
Beta’s net income is $120,000, the diluted EPS in 20X1 would include the
10,000 contingent shares in the outstanding shares computation because the
net income in 20X1 (the reporting period) equals or exceeds the earnings
level specified for the contingency period (20X2). Thus, if 20X1 were the end
of the contingency period, the contingency would be satisfied. Therefore, the
10,000 contingent shares should be included in diluted EPS in the current
reporting period (20X1).
2145.70 Nonpublic enterprises are not required to present earnings per share
information. However, if they chose to do so, they must follow FASB ASC
260‐10, which is the official pronouncement that all publicly held enterprises
must follow.
2145.71 Fixed awards and nonvested stock to be issued to employees under a stock‐
based compensation arrangement should be considered the same as options
for purposes of computing diluted EPS. Such stock‐based awards should be
considered to be outstanding as of the grant date for purposes of computing
diluted EPS, even though their exercise may be contingent on vesting.
Required Disclosures
2145.72 An enterprise should make the following disclosures for each period for
which an income statement is presented:
a. A reconciliation of the numerators and the denominators of the basic and
diluted per‐share computations for income from continuing operations
(the reconciliation should include the individual income and share
amount effects of all securities that affect earnings per share)
b. The effect that has been given to preferred dividends in arriving at
income available to common stockholders in computing basic EPS
c. Securities that could potentially dilute basic EPS in the future that were
not included in the computation of diluted EPS, because to do so would
have been antidilutive for the period or periods presented
2145.73 Nonfinancial and Qualitative Considerations: A variety of nonfinancial
considerations can affect financial statement analysis. For example, the
openness of management disclosures or the independence of a company’s
board of directors may affect perceptions of earnings quality. Some
shareholders may consider factors such as environmental management or
social responsibility when making investment decisions. Additional
qualitative factors include degree of company innovation, product
differentiation and quality, use of technology, distribution channels, and
sustainability of barriers to entry.
2145.74 Limitations of Ratio Analysis
a. Financial Statement Values: Most ratios are based on financial statement
values, which may not adequately represent economic values.
b. Lack of Comparability: Ratios are typically compared to prior year values
or to industry data. However, such comparisons are sometimes
misleading or inappropriate. For example, different accounting methods
(LIFO vs. FIFO inventory methods) may be used by the firm being
analyzed and the average industry figures. Also, a company’s year‐to‐year
comparisons may be distorted by business acquisitions or other changes.
c. Cash Flow Timing and Risk: Measures of profitability such as return on
equity suffer from deficiencies as indicators of performance. They do not
take into account the risk or timing of cash flows.
d. Magnitude of Comparison Base: In most instances, the analyst must
apply common sense when examining ratios. For instance, profit margins
for most companies are quite small and may appear to be in line with
industry averages. A difference of 2 percentage points between company
and industry profit margins may at first appear to be small; however, if
sales are $50 million, a 2 percentage‐point‐difference amounts to $1
million in net income, which may be considered significant.

Cash Flow Statement Reconciliation to Income Statement
2145.75 Cash Flows from Operating Activities: Operating activities include cash
inflows and outflows from all transactions and other events that are not
defined as investing or financing activities. Operating activities generally
involve producing and selling goods and providing services. Therefore, cash
flows from operating activities reflect the cash effects of transactions and
other events that enter into the determination of net income. It should be
noted that if a normal operating purpose of the entity is to trade
investments, plant, equipment, property, etc., then the cash in and outflows
associated with those activities are properly classified as operating, not
investing cash flows. Examples include:
a. Cash Inflows:
 Cash receipts from the sales of goods and services, including the
collection of accounts and notes arising from those sales.
 Cash receipts from the sales of goods and services, including the
collection of accounts and notes arising from those sales.
 Cash receipts from the sale of investments classified as “trading.”
 All other cash receipts that do not stem from financing or investing
activities. Some less obvious inflows are insurance settlements not
considered as investing cash flows, refunds from outside entities, and
inflows from lawsuits not otherwise capitalized.
b. Cash Outflows:
 Cash payments to acquire materials for manufacture or goods for
resale.
 Cash payments for general and administrative expenses.
 Cash payments to other suppliers and employees for other goods or
services.
 Taxes, duties and fines paid.
 Interest paid on indebtedness.
 Cash paid for investments classified as “trading.”
 All other cash payments that do not stem from transactions defined
as investing or financing activities. Some of the less obvious outflows
are charitable contributions, refunds to customers, and operating
leases.

2145.76 Reporting Cash Flows From Operating Activities
a. Direct Method: Firms are encouraged to report cash flows from
operating activities by the direct method. The following is the minimum
information to be included:
 Cash collected from customers.
 Interest and dividends received.
 Other operating cash receipts.
 Cash paid to employees and other suppliers of goods or services,
including suppliers of insurance, advertising, etc.
 Interest and taxes paid.
 Other operating cash payments.
If the direct method is used, a reconciliation of net income to net cash
flow from operating activities should be provided in a separate schedule.
This is essentially the application of the indirect method, which is
discussed below.
b. Indirect Method:
1. Net Income Adjustment: Firms that choose to report by the indirect
(reconciliation) method shall report the same amount for net cash
flow from operating activities as would be reported under the direct
method. This is accomplished by adjusting net income to net cash
flow from operations. Net income must be adjusted to eliminate:
 The effects of all deferrals of past operating cash receipts and
payments.
o Inventory
o Deferred income
o Deferred expenses
o Prepaid expenses (i.e., assets)
 The effects of all accruals of expected future operating cash
receipts and payments.
o Accounts receivable
o Notes receivable from customers arising from sale of
goods or services
o Interest receivable
o Accounts payable
o Notes payable to suppliers to acquire materials for
manufacture or goods for sale
o Interest payable
o Income taxes payable
o Excess of income of equity‐method investees over
dividends received
o Other accrued expenses
 The effects of all non‐cash operating expenses or income (e.g.,
depreciation).
o Depreciation
o Depletion
o Deferred income taxes
o Amortization of intangible assets
o Amortization of debt issuance costs
o Amortization of premiums and discounts on securities
o Provision for bad debts
o Provision for losses on long‐lived assets.

2. Reconciliation: This reconciliation may take place in the body of the
statement or in a separate schedule. If the indirect method is used,
taxes paid and interest paid should be reported in a separate
schedule. Since the effects of gains and losses from financing and
investing activities will be added or subtracted from net income to
determine operating cash flows, it may prove useful to first
determine those cash flows (investing and financing) before
determining operating cash flows.

3. Example Reconciliation:
HARRIS COMPANY
Partial Statement of Cash Flows
For the Year Ended December 31, 20x3
Cash Provided from Operating Activities (Indirect Method)
Net Income $1,140
Loss on sale of equipment 260
Depreciation Expense 50
Gain on sale of land (400)
Decrease in Accounts Receivable 140
Increase in Inventory (50)
Increase in Accounts Payable 150
Net Cash from Operating Activities $1,290

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Surgent CMA Review
Section 2200
Corporate Finance (20%)

2210 Risk and Return
2211 Calculating Return
2211.01 Interest rate risk
a. Interest rate risk is the risk of holding fixed interest‐bearing instruments
such as a bond when interest rates are changing. The price of long‐term
bonds is more sensitive to changes in interest rates than the price of
short‐term securities; thus, a rise in interest rates would cause the price
of a fixed interest‐bearing instrument to drop. Generally, the longer the
maturity value, the greater the interest rate risk.
b. Illustration: 8%, 20‐year bonds are purchased at par for $100,000 when
the market was yielding 8%. If interest rates rise to 10%, the price of the
bond will decrease so that the actual yield will equal 10% to match the
current market rate. The market value is the PV of the future cash flows,
and for a bond that matures in 20 years and pays $8,000 of interest
annually to yield 10%, the PV would be calculated as follows:

$100,000  .1486 = $14,860
+ $8,000  8.5136 = 68,109
$82,969
The potential drop in market value is the risk associated with holding a
long‐term fixed interest‐bearing instrument.
c. If a short‐term Treasury bill is held during a period of rising interest rates,
the loss in market value related to that increase in interest rates is much
less significant. For example, given the same interest rate scenario
described above, the price of a $100,000, 180 T‐bill would decline to
$99,069.
2211.02 Reinvestment risk
Reinvestment risk arises when investments must be rolled over. If rates have
declined, the interest earned will decline.

Section 2200 – Corporate Finance
2211.03 Liquidity risk (marketability risk)
a. A highly liquid asset can be sold on short notice for close to its market
value; however, an asset that changes hands infrequently often does not
have a ready market. Therefore, a price reduction is often necessary if
the asset is sold on short notice. Liquidity risk is the risk that an asset
cannot be sold for market value on short notice.
b. Securities such as U.S. Treasury bills or stock in major corporations have a
ready market and can be sold quickly for the quoted market price. Bonds
issued by an obscure firm would probably have to be sold at a discount
over market price in order to find a willing buyer on short notice. Bonds
such as these have a high level of liquidity risk.
2211.04 Market risk
Market risk is the risk associated with a security that cannot be eliminated by
diversification. This includes such items as recessions, inflation, and changing
interest rates that affect all firms. This is also known as systematic risk.
2211.05 Company risk (company‐specific risk)
Company risk is risk that is specifically associated with a particular firm due
to mix of products, new products, competition, patents, lawsuits, etc. Within
a portfolio, company risk can be eliminated by proper diversification.
Credit Risk
2211.06 Credit risk is the risk that receivables will not be collected in full on a timely
basis. Increased risk includes costs related to bad debt losses, higher
receivable balances resulting in higher carrying costs, higher customer
investigation fees, and collection costs.
2211.07 Credit risk can be evaluated by looking into the customer’s:
(1) character. Will the customer make an honest effort to pay all
obligations?
(2) capacity. Does the customer have the ability to make necessary
payments on a timely basis?
(3) capital position. Does the customer have a good financial position
such as discovered or measured through ratio analysis?
(4) collateral. Are assets pledged as security on the obligation?
(5) general conditions. What are the probable economic conditions and
how might they affect the customer’s ability to pay?

2211.08 Default risk
a. Default risk is the risk that the borrower will be unable to make interest
and/or principal payments as scheduled on the obligation. The higher the
possibility of default, the greater the return required by the lender.
b. U.S. Treasury bonds are considered to be default risk free. Securities and
bonds do have some degree of risk, and several organizations such as
Moody’s Investment Service and Standard & Poor’s Corporation rate
bonds for default risk. The lower the quality of the bonds, the greater the
interest rate the issuing firm is required to pay in order to compensate
for the risk.
2211.09 Purchasing risk
Purchasing risk (purchasing power risk) is the risk that inflation will result in
less purchasing power for a given sum of money. Assets that are expected to
rise in value during a period of inflation have a lower risk. For example, real
estate often appreciates during an inflationary period; however, cash loses
value during that same period.

2212 Types of Risk
2212.01 What is financial risk management?
a. Financial risk management is the process of dealing with uncertainties
resulting from events in the financial markets. It involves assessing the
financial risks facing an organization and developing and implementing
management strategies and policies consistent with the organization’s
internal priorities and policies.
b. A firm must decide which risks are acceptable and which are not to
optimize the amount of risk it is willing to accept, recognizing that a
passive strategy of no decision means accepting all risks by default.
c. Whatever strategies are adopted, they need to be evaluated, monitored,
and refined as market conditions change.
(1) Changes to be monitored include changes in market rates, changes in
the business environment, and changes in international or political
considerations.
(2) Effective monitoring often requires working with tactical risk takers
such as portfolio managers.

2212.02 Financial risk management is one component of the concept of enterprise
risk management of the firm, which includes items such as the following:
a. Business risk: the uncertainty associated with the ability to forecast EBIT
due to factors such as sales variability and operating leverage
b. Operations risk: the risk of loss resulting from inadequate or failed
internal processes, people, and systems, or from external events
c. Supply‐chain risk: the potential disruptions to continued manufacturing
production and thereby commercial financial exposure
d. Product liability risk: the responsibility of the firm or vendor of goods to
compensate for injury caused by defective merchandise that it has
provided for sale
e. Political and economic risk: the risk that a government buyer or a
country prevents a transaction from being completed, or fails to meets its
payment obligations; and/or the risk associated with the overall health of
the economy
2212.03 Key elements of financial risk management include the following:
a. Interest rate risk: the risk to earnings or capital arising from changes in
interest rates
b. Liquidity risk: the risk that clearing or settlement payments will not be
made when due, even though counterparties do have sufficient assets
and net worth ultimately to make them. There is an inability to convert
assets to cash in a timely fashion.
c. Foreign currency risk: the uncertainty of the value of net income that
would result from the variability of the market value of foreign‐currency‐
denominated assets and liabilities due to fluctuating exchange rates
d. Credit risk: the risk that the counterparty will not meet an obligation
when due and will never be able to meet the obligation at full value.
Bankruptcy is a primary source of such risk, and losses are associated
with loss of principal and foregone interest.
e. Default risk: the risk that the counterparty will default on clearing
obligations. This risk is often related to the liquidity risk and/or credit risk
inherent in the transaction.
f. Systemic risk: the risk that payment system failures will lead to one
market participant being unable to meet its obligation when due that will
lead to additional participants being unable to meet commitments as well
g. Counterparty risk: the inability of a counterparty to meet its
commitments
The Risk Management Process
2212.04 The risk management process includes the strategies that allow a firm to
manage its risks related to participating in financial markets.
2212.05 The firm has a choice to accept, transfer, or manage risk.
a. Management may choose to absorb the potential impact of volatility on
earnings, assuming that over time the eventual upside may outweigh the
short‐term downside.
b. A risk manager may attempt to transfer the risk along the supply chain.
This would involve shifting the risk to the end customer or to suppliers.
2212.06 The risk management process includes an understanding the requirements
for valuation of derivative securities and applicable accounting regulations
per FASB ASC 815 or IAS 39. Often a firm will attempt to manage the risk
through the use of some form of hedging program. (A hedge is a strategy to
insulate a firm from exposure to price, interest rate, or foreign exchange
fluctuations.)
2212.07 The risk management process includes both internal and external controls,
and involves:
a. identifying and prioritizing risks and understanding their relevance.
b. understanding the stakeholder’s objectives and their tolerance for risk.
c. developing and implementing appropriate strategies in the context of a
risk management policy.
2212.08 The risk management process requires understanding the
interconnectedness among and between the basic components of
economics, accounting, and control.
a. Economics requires being able to measure the risk before attempting to
manage it.
b. The control function provides the needed guidelines for the hedging
activity and any necessary oversight.

c. The accounting function requires understanding the requirements set
forth in FASB ASC 815. As per the FASB, the following points relate to
FASB ASC 815:
(1) Under FASB ASC 815, an entity that elects to apply hedge accounting
is required to establish at the inception of the hedge the method it
will use for assessing the effectiveness of the hedging derivative and
the measurement approach for determining the ineffective aspect of
the hedge. Those methods must be consistent with the entity's
approach to managing risk.
(2) For a derivative designated as hedging, the exposure to changes in
the fair value of a recognized asset or liability, or a firm commitment
(referred to as a fair value hedge), the gain or loss is recognized in
earnings in the period of change together with the offsetting loss or
gain on the hedged item attributable to the risk being hedged. The
effect of that accounting is to reflect in earnings the extent to which
the hedge is not effective in achieving offsetting changes in fair value.
(3) For a derivative designated as hedging, the exposure to variable cash
flows of a forecasted transaction (referred to as a cash flow hedge),
the effective portion of the derivative's gain or loss is initially
reported as a component of other comprehensive income (outside
earnings) and subsequently reclassified into earnings when the
forecasted transaction affects earnings. The ineffective portion of the
gain or loss is reported in earnings immediately.
(4) For a derivative designated as hedging and the foreign currency
exposure of a net investment in a foreign operation, the gain or loss is
reported in other comprehensive income (outside earnings) as part of
the cumulative translation adjustment. The accounting for a fair value
hedge described above applies to a derivative designated as a hedge
of the foreign currency exposure of an unrecognized firm
commitment or an available‐for‐sale security. Similarly, the
accounting for a cash flow hedge described above applies to a
derivative designated as a hedge of the foreign currency exposure of
a foreign‐currency‐denominated forecasted transaction.
(5) For a derivative not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change.

2212.09 Special issues facing small businesses
a. Small firms have problems with various components of the financial risk
management process that are effective for larger firms. While these
problem areas exist for large firms as well, the specific problems facing
smaller firms relate to dealing with the problems in a manner consistent
with the firm’s resource capabilities, and include the following:
(1) The fact that small firms are unable to use broader capital markets
(i.e., expand past the use of banks as a source of funds) because
investors in these markets require higher rates of return on what
would appear to be riskier investments (i.e., the investor would have
little ability to assess the creditworthiness of the firm).
(2) These firms are generally unable to diversify their operations (i.e.,
reduce business risk).
(3) Such firms usually have few suppliers and/or the clout or logistical
ability to purchase from a large number of vendors (i.e., unable to
reduce supply‐chain risk).
b. A smaller firm must understand its full economic exposure to foreign
exchange or interest rate risk and identify the degree to which there are
any natural offsetting positions in its operations to take advantage of any
benefits of diversification that exist. (Economic exposure is defined as the
degree to which a firm’s present value of expected future cash flows can
be impacted by unanticipated exchange rate fluctuations.)
c. If the firm chooses to hedge, they must be certain to use a derivative that
is specifically related to the risk in question. Risks dealing with cash flow
from operations are often best dealt with options (a derivative financial
instrument that establishes a contract between two parties concerning
the buying or selling of an asset at a reference price during a specified
time frame). More predictable asset positions often are best dealt with
forwards and futures.
d. Speculation with derivatives should never occur. It is helpful to employ
some outside entity to monitor any hedge or derivative positions that are
held.

2213 Relationship Between Risk and Return
2213.01 Mitigating financial risk from a regulatory perspective
a. In the new financial risk framework, regulators need to be more counter‐
cyclical in their approach toward devising regulatory arrangements.
Approaches being developed see regulators acting transparently to
change capital requirements for market participants when early warnings
of market “bubbles” first appear.
b. Regulators need to recognize capital as a “shock absorber” to deflate
bubbles before they burst and to allow then capital “drawdowns” during
periods of market stress, with the understanding capital will be
replenished as market conditions improve.
c. There is a strong need for increased cooperation between national
jurisdictions that would:
(1) develop an agreed‐upon risk management policy for key market‐wide
risk indicators.
(2) manage and monitor risk indicators within that policy.
(3) publicly report macro‐risk indicators.
(4) facilitate risk identification and communication with appropriate
decision makers, at both national and international levels.
Mitigating Financial Risk at the Firm Level
2213.02 There is growing consensus that the regulatory framework should apply a set
of comprehensive risk management concepts that include key concepts used
by insurance regulators and actuaries that use a “control cycle” approach:
a. Incorporating allowances (risk margin) for extreme or outlier events (i.e.,
black swan events):
(1) Traditional regulatory approaches previous to the 2008 financial crisis
did not identify or lessen critical risk concentrations (e.g., the level of
collateralized debt obligations (CDOs)).
(2) Historically, there has been inadequate capital support at both the
system and individual institution level for accepting such risks that
resulted in a significant underpricing of the risks as the 2008 financial
crisis began.

(3) There must be an ability to track risk in the unregulated financial
sector.
(4) There should be development of models that track the expected level
of loss from an expected event rather than the current “value at risk”
(VAR) approach that only measures the minimum amount of loss
from a low‐probability event.
Note: A “black swan” event has a high impact, is hard to predict, and is a
rare event that is beyond the realm of normal expectations in history,
science, finance, and technology. The result is that there is a
noncomputability of the probability of the consequential rare events
using scientific methods owing to their very nature of small probabilities.
A collateral debt obligation (CDO) is a type of structured asset‐backed
security (ABS) whose value and payments are derived from a portfolio of
fixed‐income underlying assets. The portfolio of fixed‐income assets are
rated at different levels of risk with some collateralized debt obligations
invested in subprime mortgage bonds.
b. There should be requirements for specific financial condition reporting.
c. There should be an independent sign‐off of liability and provisioning for
regulatory purposes by someone such as an actuary who is subject to
professional codes of conduct, and that individual should have the
freedom and capability to take an objective view that may differ from
management. This would be made possible by enforceable professional
codes of ethics with disciplinary standards.
The incentive structures within the industries should not distort the
proper evaluation of risk:
(1) Capital requirements should be increased for any market participant
where remuneration and incentives focus excessively on short‐term
results.
(2) Regulators should develop a deep understanding of the risk culture
within a particular enterprise that often might mitigate against timely
reporting of critical information.
(3) The concept of “risk margin” developed by actuaries to measure the
value of illiquid assets should be used.

2213.03 Improved firm risk management practices
Reporting risk measures should require applying a total balance sheet
approach, which evaluates on a consistent basis:
a. the amount of capital required to support the assets and liabilities of the
business (given all the commitments and obligations to stakeholders).
b. increasing the actual level of capital available from time to time after
excluding all interests that are not at “arm’s length.”
c. looking at what could happen in the future that requires sensitivity
testing as to the potential value of assets and/or liabilities as market
conditions change.
2213.04 The control cycle used by actuaries includes the following:
a. Modeling expected results using a set of initial assumptions
b. Doing a profit test to determine if the product provides a positive
contribution margin
c. Measurement of actual results
d. Determination in both quantitative and qualitative terms, an
understandable explanation of the differences between expected and
actual results, and determining what actions need to be taken with
respect to the product, including adjusting the reserves that might need
to be held
e. Use of the findings to strengthen the model and update the assumptions
as necessary with a feedback into the profit test (item b. above)
2213.05 Risk margin
a. The concept of risk margin is related to the insurance industry and is
generally defined as a component of insurance liabilities that is
established in addition to best estimate liabilities.
b. Risk margin reserves tend to create a cushion to cover any fluctuations or
misestimation of errors in best estimate liabilities (reserves) and to cover
risk of fluctuations under “normal situations” with required capital
serving as a buffer against more extreme black swan events.
c. The risk margin covers risks linked to the future liability cash flows over
their whole time horizon. It should be determined in a way that enables
the (re)insurance obligations to be transferred or put into run‐off.
d. The goal is to have the concept of risk margin be made applicable to
determining potential losses in the more broadly defined financial risk
areas as well as to insurance.
2213.06 Exchange rates and risk
a. Arbitrage is an action undertaken to capitalize on inefficiencies in
financial markets. It is a response to the belief in the “law of one price”
that states that a product should sell for the same price in all markets,
less the cost of transfer between markets. Arbitrage involves buying in
the low‐priced market and reselling in the high‐priced market. The
increased demand in the low‐priced market causes the price to increase
and the increased supply in the high‐priced market causes the price to
decline. Arbitrage profits are available until the two prices are equal.
b. Speculation is an attempt to use what is believed to be relevant
information to “outguess the market.” Financial transactions in foreign
exchange markets are very sensitive to market expectations regarding
exchange rates. The decision to hold securities denominated in any
particular currency is generally tied to expectations concerning the
market value of the currency. If news causes expectations concerning
currency values to change, it will affect the supply or demand for the
particular currency, and thereby exchange rates.
2213.07 Exchange rate systems and practices
a. The exchange rate is simply the price of one currency expressed in terms
of another. For example, assume that the exchange rate between the
dollar and the yen is expressed as $1 = 120 yen. This could also be
expressed as 1 yen = $0.008333 ($1/120).
b. Exchange rates are determined by the interaction of supply and demand
for the various foreign currencies in foreign exchange markets. If the
demand for a nation’s currency increases, the price of the currency will
appreciate. If a currency appreciates, it increases in value in terms of the
other currencies. In this instance, if the yen were to appreciate, it would
take fewer yen to buy a dollar. For example, as the yen appreciates, the
exchange rate might fall to $1 = 110 yen. This would make Japanese
exports more expensive for American consumers. If the supply of the
nation’s currency increases, the price of the currency will depreciate or
decline in value in terms of other currencies.

c. Exchange rate determinants include the following:
(1) Changes in consumer tastes for the products of a particular country.
If consumers wish to buy more products from a country, they will
increase the demand for that country’s currency.
(2) Relative income changes. If, for example, disposable income rises
more rapidly in Europe than in the United States, all other things
being equal, Europeans will demand more American goods. The
demand for dollars will increase and the supply of euros that will be
required to purchase the additional dollars will increase.
(3) Relative interest rates. Suppose that real interest rates rise in the
United States while they stay constant in Europe. Europeans will find
the United States a more attractive place to make financial
investments in fixed‐income securities and will increase the supply of
euros.
d. Over time flexible exchange rates will adjust and eliminate balance‐of‐
payments surpluses or deficits between two nations. Disadvantages of
flexible exchange rate systems include:
(1) a flexible exchange rate produces uncertainty in the future price of a
foreign currency and reduces the amount of trade.
(2) if a country’s currency strengthens, it will need to export fewer goods
and services to get a specific level of imports from another country.
Thus, in this instance, it would be said that the country’s terms of
trade have improved.
2213.08 Fixed exchange rate system
a. Governments determine specific boundaries within which they will allow
their currency’s exchange rate to fluctuate and commit to making
economic policy adjustments which maintain the exchange rate within
those limits. A government cannot do anything directly to stop changing
patterns of the supply and demand for its currency in international
financial markets.
b. The advantage of a fixed rate system is that multinational companies
(MNCs) would be able to engage in international trade without worrying
about exchange risk.
c. A key disadvantage of the fixed exchange rate system is that a
government, faced by economic pressures, will choose to alter the value
of its currency. While the exchange rate does not fluctuate on a regular
basis, it may be revalued or devalued by a significant amount
unexpectedly.
2213.09 Managed float system
Today most countries allow the value of their currency to float, but at times
intervene in the market when exchange rate changes are counter to national
objectives. Some nations peg their currency to the dollar and then allow their
currency to fluctuate against other currencies as the dollar fluctuates. The
key reasons for intervention are:
a. to smooth exchange rates, that is, to minimize volatility.
b. to respond to temporary disturbances that cause undesired exchange
rate movements.
2213.10 Exchange rate determinants
a. Changes in demand and/or supply of the currency: As the demand for a
currency increases, the exchange rate will also increase. As the supply of
a currency increases, the exchange rates will decrease.
b. Changes in consumer tastes: If consumers desire a foreign product, the
demand for that product and the resulting increase in demand for the
foreign currency will affect exchange rates.
c. Relative income changes: As incomes rise, the demand for imports
increases, thus having an effect on exchange rates.
d. Relative price changes: As prices decrease for a particular foreign product
relative to domestic prices, the demand for that product will increase,
thus having an effect on exchange rates.
e. Relative interest rates: As interest rates increase in a given country,
interest in investing in securities in that country rises. As investing
activities increase, the supply and demand for those currencies are
affected as well as the exchange rates.
f. Relative inflation rates: Changes in inflation can have an effect on
international trade activity. The changes in this activity will in turn
influence the supply and demand for various currencies, resulting in
changes in exchange rates.
g. Government controls: Governments can influence exchange rates by
imposing exchange and trade barriers, buying and selling securities in
foreign exchange markets, and changing interest rates in their home
country.

2213.11 Mitigating risk related to dealing with foreign currencies
a. MNCs (multinational companies) constantly face the decision as to
whether or not to hedge future payables and receivables. Often these
decisions are based on the magnitude of the potential risks and the firm’s
forecast of future foreign exchange rates.
b. Short‐term financing decisions: Firms that borrow often have access to
loans denominated in several currencies. A favorable choice would be to
borrow in the currency where market interest rates are low and the value
of the currency is expected to weaken in value over the term of the loan.
c. Short‐term investment decisions: Firms often have significant amounts
of excess cash available for short periods of time and can choose to make
their deposits in a variety of currencies. A favorable choice for the
deposit would be in a market with high interest rates where the value of
the currency is expected to strengthen during the term of the deposit.
d. Capital budgeting decisions: As an MNC assesses the viability of investing
in a foreign project, it must account for the fact that the project may
generate cash flows that periodically must be converted to another
currency. The analysis can only be completed when the estimated cash
flows are ultimately measured in the parent’s local currency.
e. Long‐term financing decisions: Corporations that issue bonds may wish
to consider denominating the bonds in a foreign currency. Their
preference would be to have the bonds denominated in a currency that
would depreciate over time against the currency they are receiving from
the sale. Exchange rate forecasts are needed to estimate the expected
cost differential from borrowing in different currencies.
f. Earnings assessment: When earnings are reported, subsidiary earnings
are consolidated and translated into the currency of the parent’s home
country.

2213.12 Forecasting techniques
The fact that firms must make decisions that can be impacted by exchange
rate movements suggests that they either explicitly or implicitly make
forecasts about exchange rate movements in the decision‐making process. If
the firm engages in explicit forecasts, the basic techniques for forecasting
include the following:
a. Technical forecasting involves the use of historical exchange rate data to
predict future values. This type of forecasting is generally limited to
forecasting the near future, which is often not effective for developing
corporate policies. This type of forecasting is generally more relevant for
speculators who are concerned with day‐to‐day exchange rate
movements.
b. Fundamental forecasting is based on the presumed relationship between
exchange rates and economic variables. This forecasting methodology is
subject to a series of limitations, including:
(1) the precise timing of the relationships predicted by the regression
model cannot be determined.
(2) some of the data for which relationships have been determined
cannot be obtained in a timely manner so that it would be usable for
current forecasts.
(3) the probability of many events that have an impact cannot be readily
quantified.
(4) regression coefficients that are obtained from the forecasting model
are often not constant over time.
c. Market‐based forecasting starts from the premise that financial markets
provide an unbiased estimate of future events, and uses either the spot
rate or the forward rate.
(1) Illustration: For example, if the current spot rate shows that the
Japanese yen is expected to appreciate against the dollar in the very
near future, this should encourage speculators to buy the yen with
U.S. dollars today in anticipation of its appreciation. These purchases
would tend to drive the yen’s value up at once and, therefore, the
current value of the yen should reflect its expected value in the very
near term.

(2) The forward rate that is quoted for a specific date in the future is
commonly used as a proxy for the forecasted future spot rate on that
date. An example would be as follows: If speculators expect the spot
rate on the Japanese yen in 60 days to be $1 = 122 yen and the 60‐
day forward rate is $1 = 119 yen, they might simply buy yen 60‐days
forward at $1 = 119 yen, and then sell them when they are received
at the spot rate. If this is the common speculator strategy, then the
forward purchases of yen will cause the forward rate to increase until
the speculative demand runs its course. Thus, the forward rate
reflects the market’s expectations of the spot rate at the end of the
period. To the degree that the forward rate is shown to be an
unbiased estimate of the future spot rate, then corporations can
monitor the forward rate as they develop their exchange rate
expectations. Arbitrage activity would tend to eliminate any
differential.
Types of Exposure
2213.13 The rationale for forecasting foreign exchange rates is to help the firm make
decisions as to whether they should remain exposed to exchange rate
fluctuations or if they should attempt to hedge their foreign exchange
positions. Forecasting methodologies can be evaluated over time by
comparing the actual values of the currencies to those predicted by the
forecast over long periods of time.
2213.14 While exchange rates cannot be forecasted with perfect accuracy, a
reasonable forecast can allow a firm to estimate its exposure to exchange
rate fluctuations. To the degree that a firm discovers that it is highly exposed,
it then can begin to consider approaches to reduce the exposure.
2213.15 Transactions exposure is simply defined as the degree to which the value of
a firm’s future cash transactions can be affected by exchange rate
fluctuations. It can be measured by determining (1) the projected net
amount of inflows or outflows in a particular foreign currency and then (2)
the overall risk of exposure for each of the currencies.
a. Exposure to “net” cash flows: Forecasts of net cash flows tend to be for
relatively short periods where the anticipated cash flows can be
predicted with reasonable accuracy. Such predictions require a
reasonably sophisticated information system to track the positions in the
various currencies.

The firm needs to project a consolidated “net” position in the currency.
These positions must be converted into dollars so that the firm can
measure the exposure in each currency using a standardized measure.
Since the actual level of period cash flows and end‐of‐period exchange
rates are unknown, it would be reasonable to construct a range of
estimates for both cash flows and exchange rates.
b. The firm may not have its own method for forecasting end‐of‐period
exchange rates, but at a minimum the firm can use historical data to
measure the degree of currency variability. The standard deviation
measure is a common way to define the variability of a particular
currency. Currency variability can change over time, and use of this
method would require periodic updating of the measure.
The key is to determine how each individual currency could affect the
firm by assessing the standard deviations and correlations between the
various currencies over the period of the transaction.
2213.16 Managing transactions exposure
a. The firm should identify the net transaction exposure on a currency‐by‐
currency basis. This data would be gathered from all subsidiaries.
b. If possible, a firm may be able to modify its pricing policy. For example,
by invoicing its exports in the same currency that would be needed to pay
for imports, or in its domestic currency, the exchange rate risk could be
shifted to the foreign firm.
c. To the degree that the firm cannot match the inflows and outflows with
foreign currencies, hedging should be considered.
2213.17 Currency correlations: The correlation coefficient measures the degree to
which the two currencies move in relation to each other. Over the long run,
the correlations tend to be positive, which indicates that currencies tend to
move in the same direction against the dollar, albeit not in the same
magnitude. This information would help the firm determine the degree to
which they have transaction risk among and between various currencies to
which they might be exposed. For example, if the firm has exposure with the
Swiss franc and the Japanese yen, and those two currencies are correlated
vis‐a‐vis the dollar, then an expected inflow of Swiss francs can serve as a
partial offset against an expected outflow of Japanese yen.
2213.18 An alternative method to assess exposure would be the value‐at‐risk (VAR)
measure that would combine the methods above to predict the potential
maximum one‐day loss for a firm that is exposed to exchange rate
fluctuations. In this instance, the firm might have a policy that would trigger
hedging activities if the VAR reaches a certain magnitude.
2213.19 Economic exposure measures the degree to which a firm’s present value of
expected future cash flows can be impacted by exchange rate fluctuations.
As an example, a firm’s local sales in its home country would be expected to
decrease if its home currency appreciates because the firm will face
increased foreign competition as foreign substitute products will now be
cheaper in terms of the local currency. At the same time, cash inflows on
exports denominated in the local currency will decline due to the
appreciation of the currency since foreign importers will need more of their
currency to pay for their imports.
2213.20 We must note that if a firm’s local currency depreciates, it would be
impacted in the opposite direction from when the currency appreciates.
Local sales would be expected to increase due to reduced foreign
competition, and their exports denominated in local currency will appear
cheaper to importers, which will lead to increased foreign demand for their
products.
On the cost side with regard to cash outflows, imported supplies
denominated in the local currency will not be directly affected by exchange
rate movements. However, the cost of supplies denominated in foreign
currencies will rise because more of the depreciated currency will be needed
to acquire the foreign currency needed to make the purchase.
2213.21 Even firms that are not involved in foreign sale of goods or purchase of
foreign supplies may be subject to economic exposure due to the impact of
exchange rate movements on the price of substitute goods offered by
foreign competitors in their local markets. The degree of economic exposure
is likely to be much greater for multinational corporations (MNCs). An MNC
needs to assess the degree to which economic exposure exists and then
make a determination as to whether or not they wish to attempt to insulate
themselves against it. Economic exposure can be measured by the following:
a. Sensitivity of earnings to exchange rates: This method involves classifying
cash flows into specific income statement items and then making a
subjective prediction about the value of these items based on an
exchange rate forecast. The base forecast then can be compared with
alternative exchange rate forecasts. Comparing the resulting income
statements would allow the firm to assess the impact of exchange rate
movements on earnings and cash flows.

b. Sensitivity of cash flows to interest rates: This method involves using
regression analysis of historic cash flows and comparable exchange rates.
The following formula illustrates:
PCFt   o  a1et   t

PCFt = Percentage change of inflation‐adjusted cash flows measures in the home
country currency over period t
et = Percentage change in exchange rate of the currency over period t
μt = Random error term
α0 = y‐intercept
a1 = Slope coefficient
The regression coefficient (a1) indicates the sensitivity of PCFt to et. This
method is valid if the firm expects no major adjustments to its operating
structure.
2213.22 Translation exposure is the exposure of the MNC’s consolidated financial
statements to foreign exchange fluctuations. A subsidiary’s earnings are
translated into the reporting currency and, therefore, are subject to
exchange rate fluctuations.
There are some questions concerning the relevance of translation exposure,
with arguments in favor including the following:
a. Cash flow perspective: The key consideration is the degree to which a
subsidiary would remit earnings to the parent. If the earnings are
retained by the subsidiary and reinvested if feasible investment
opportunities exist, then the earnings would not be converted and sent
to the parent. If a portion of the earnings are remitted, or expected to be
remitted in the future, then it could be expected that future cash flows
could be adversely affected if the foreign currency is weakening.
b. Stock price perspective: Investors tend to use expected future earnings
forecasts to derive an expected value per share. If an MNC conducts a
large portion of its business in foreign countries that have changing
exchange rates that are expected to negatively affect the translation of
future earnings, then it is likely that the market stock price for the MNC
will decline.

2213.23 Determinants of translation exposure
a. Proportion of business conducted through foreign subsidiaries: The larger
the percentage of the firm’s business conducted by foreign subsidiaries,
the larger the percentage of a given financial statement item that is likely
to be susceptible to translation exposure.
b. Location of foreign subsidiaries: Since the financial statements of a
subsidiary are typically measured in the subsidiary home currency, the
correlation between that currency and the parent’s home currency will
determine the degree to which translation exposure is likely to become a
problem.
c. Accounting methods used: Many of the important rules for financial
statement consolidation for U.S.‐based firms are found in FASB ASC 830.
Under FASB ASC 830, consolidated earnings are sensitive to the
functional currency’s weighted‐average exchange rate.
2213.24 Managing translation exposure
Translation exposure exists when the future cash transactions of a firm are
impacted by exchange rate fluctuations. The problem arises when a firm
knows the amount of the foreign currency it will need to complete the
transaction but not the amount of domestic currency that will be required to
purchase it. Once the degree of transaction exposure is measured, if the firm
decides to hedge all or part of the exposure, it must then choose among the
various hedging techniques that are available.
There is one possible non‐hedging possibility that might be available to the
firm to manage the exposure. Depending on the negotiating strength of the
two parties involved in the transaction, it might be possible for the firm to
invoice the transaction in the currency that will be used to pay for the
import, effectively shifting the transaction exposure to the exporter.
Techniques to eliminate all or part of transaction exposure
a. Future hedges: A firm buys a currency futures contract that gives the firm
the right to receive a specified amount of a specified currency for a given
price on a specific date. By buying such a contract, the firm is able to lock‐
in the amount of the foreign currency needed to make the expected
payment. These contracts are designed to hedge currency needs in the
short term.
A firm could sell a futures contract if it desired to sell a specific amount of
a specified currency for a stated price on a specific date. This type of
hedge might be used to hedge future receivables denominated in a
foreign currency.
b. Forward hedge: A forward hedge is very similar to a futures hedge except
that it is designed to be used by large corporations who have relatively
large positions to hedge. These hedges are negotiated between the
corporation and a commercial bank with the contract specifying the
currency, the exchange rate, and the settlement date. These contracts
may be used to either purchase or sell foreign currency with a company
that needs foreign currency in the future. A company expecting to need
to sell currency in the future would negotiate a contract to sell the
currency forward to lock in the rate at which the currency can be sold.
c. Money market hedge: This type of hedge involves the firm taking a
position in domestic or foreign money markets to hedge a payables or
receivables position.
d. Currency option hedge: This type of hedge ideally would insulate the firm
from adverse foreign exchange movements, but also allow the firm to
benefit from favorable exchange rate movements if the currency does
not move in the expected manner during the hedging period. This could
create a situation where not hedging a position could produce a better
outcome than hedging. A currency option hedge resolves this problem by
allowing the firm to hedge the exchange risk, and at the same time
participate in any gains that might result from unexpected currency
fluctuations.
2213.25 The techniques described above could be used in the following fashions to
hedge specific transaction exposures:

Hedging
Hedging Receivables Hedging Payables
Technique
Futures Hedge A currency futures contract could A currency futures contract could be
be sold in the local currency in the purchased in the local currency in the
amount of the particular receivable. amount of the particular payable.

Forward Hedge A forward contract could be A forward contract could be
negotiated in the foreign currency negotiated in the foreign currency to
to sell the amount of the receivable. purchase the amount of the payable.

Money Market Borrow funds in the denominating Borrow funds in the local currency of
Hedge currency of the receivable, convert the payables, and invest the funds
the loan to the local currency, and until they are needed to meet the
invest it. When the receivables are payable obligation.
received, the loan is then paid off
with the cash inflows.

Currency Option A currency put option is purchased A currency call option is purchased in
Hedge in the local currency for the amount the local currency for the amount
related to the receivables. related to the payables.
2213.26 Mitigating risks related to changing interest rates
a. Interest rate risk is the risk of holding fixed interest‐bearing instruments
such as a bond when interest rates are changing. The price of long‐term
securities is more sensitive to changes in interest rates than the price of
short‐term securities. There is an inverse relationship between the
direction of the change in interest rates and the price of the fixed
interest‐bearing security.
b. Although a nonfinancial firm will usually report its bonds on issue in
financial statements at their market value at the time of issuance less
premium or discount amortization, early redemptions must be done at
the market value. These amounts may be significantly different as
interest rates will change the value of fixed‐rate debt. This risk is not
commonly considered by most nonfinancial firms.
c. This risk could be mitigated by hedging or acquiring an offsetting
exposure, which could be a derivative such as an option, a futures
contract, or a swap, or by acquiring an offsetting asset or liability.
d. The main reasons for hedging include reducing the volatility in cash flow,
avoiding financial distress, or providing predictability. Financial distress
could be as simple as a liquidity crunch with an inability to meet short‐
term demands on cash, which could ultimately result in bankruptcy. A
hedge would reduce the probability of the outcome.
e. A firm is concerned about the uncertainty of cash flows related to asset
and liability structure caused by changes in interest rates that impact the
value of the assets and liabilities.
f. A firm is concerned about the changes in market value of fixed‐rate
assets as market interest rates change.
g. There is a flow risk that relates to the sensitivity of interest rate changes
that could be hedged with fair value hedges or a risk on the ability to
make interest payments that may be covered by developing a cash flow
hedge (a hedge that is the result of the exposure to the variability of cash
flow attributable to a particular risk associated with a recognized asset or
liability (IAS 39.86)).
2213.27 An example of a cash flow hedge would be to use an interest rate swap to
convert variable‐rate interest exposure to a fixed interest rate.
a. The swap is an instrument that, in its usual form, transforms one kind of
interest stream to another, such as floating to fixed or fixed to floating.
Each swap has two counterparties and, therefore, in each swap one party
pays fixed and receives floating, while the other party receives fixed and
pays floating.
b. There are two basic forms for a swap:
(1) First, a floating‐rate borrower converts to a fixed rate. In this case, a
borrower has floating‐rate bank debt and carries out a pay‐fixed
swap, converting the debt to a fixed rate.
(2) Second, a fixed‐rate borrower converts to a floating rate. In this
case, a borrower has fixed‐rate bond debt and undertakes a receive‐
fixed swap, converting the debt to a floating rate.
c. From an accounting perspective, the changes in the fair value of the
interest rate swap would accumulate first in the statement of
comprehensive income, and a portion of the gains or losses would be
transferred from comprehensive income to the income statement
whenever interest is paid on the hedged debt.

2213.28 There is a price risk related to the sensitivity of the market value of assets
and liabilities to the level of changes in market interest rates that could be
covered by a fair value hedge.
a. A derivative would be used to hedge changes in the fair value (market
value) of a fixed‐rate bond that would occur when interest rates move up
or down. Hedging the risk associated with a bond’s price risk would be a
fair value hedge.
b. An example would be that a firm issues fixed‐rate debt and then uses a
swap for floating‐rate debt.
c. The swap would be marked to market. Any change in value of the swap
would be recognized as current earnings, and the change in the value of
the debt instrument related to change in market interest rates would be
recognized on the income statement as earnings.
2213.29 One must be aware of the differences between interest rate‐fixing products
(such as a swap) and options:
a. A swap binds its user to the rate that is set when it is transacted. An
option gives the buyer the right to walk away if it would be less expensive
to do so.
b. So, a firm taking out a pay‐fixed swap after which rates decline is left
paying the higher rates. The risk is transformed rather than transferred.
Exposure to rising rates has become an exposure to falling rates.
c. Options offer an alternative, but with a cost. The two key factors
determining the cost of the option are time (the longer an option has
until expiration, the higher the premium) and volatility (the higher the
volatility in the underlying risk being hedged, the higher the premium).
d. Both of these factors tend to deter firms from using options, and for
longer‐term risk‐transfer alternatives, interest rate swaps are usually
chosen.
Mitigating Risks Through the Use of Transfer Pricing
2213.30 Transfer pricing problems
a. Special problems arise when applying the rate of return or residual
income approaches to performance evaluations whenever segments of a
company do business with each other. One of the difficult issues has to
do with the establishment of transfer prices for intracompany sales. A
transfer price is the price charged for goods or services by one segment
of a company for those goods or services to another segment of the
company (intra‐company sale).

b. The determination of the transfer price can:
(1) include a “profit,”
(2) include only the accumulated costs to that point, or
(3) be negotiated between the two segments.
c. The problems arise when a division sells the product or service in
question to outside companies as well as the sister organization. Since
the price charged by one division becomes the cost to the second
division, the purchasing division would like the price to be low while the
selling division would like the price to be high.
2213.31 Transfer pricing approaches
a. Transfer prices can be set using:
(1) variable costs only or
(2) full absorption costs.
b. Transfer prices can equal current market prices.
c. Transfer prices can be set at a negotiated market price agreeable to both
business segments. The negotiated price could be less than, equal to, or
more than the current market price. Many times when a negotiated price
is used, the selling segment does not have an outside market for the
particular product or service.
2213.32 Transfer prices at cost
a. When transfer prices are set at cost, there will be no profits for the selling
division for the sale.
b. When cost‐based transfer prices are used, dysfunctional decisions can
result since there are no built‐in mechanisms for telling the manager
when it is in the best interest of the organization for transfers to be made
between divisions. As a result, profits for the company as a whole may be
adversely affected if the savings to one segment is less than losses to the
other.
c. Illustration: XYZ Company has two divisions, Relay and Motor. The Motor
division needs 50,000 relays a year and could purchase them from the
Relay division. The following information is available:
Relay division:
(1) Sells relays to the outside for $20 each.
(2) Has $12 of variable costs per relay.
(3) Has the capacity to produce 50,000 relays a year.
(4) Could produce relays for the Motor division for $10 of variable costs
per relay since there would be no selling or marketing expenses.
(5) There is only capacity to produce 50,000 relays a year, so production
can either be sold to the outside or internally, but not both.
Motor division:
(1) Needs 50,000 relays a year.
(2) Can purchase relays from the outside for $15 each.
(3) Adds $25 of additional variable costs to each motor.
(4) Sells the motors for $60 each.
(5) Has variable costs of $40 per relay.
Relay Motor
Total
Division Division
Sales ($20, $60) $1,000,000 $3,000,000 $4,000,000
Less Variable ($12, $40) 600,000 2,000,000 2,600,000
Contribution Margin $ 400,000 $1,000,000 $1,400,000

If the Motor division purchases the relays from the Relay division for $12
each (the Relay division’s variable costs), the contribution margins of the
divisions and the total organization will be changed to:
Relay Motor
Sale of 50,000 units Total
Division Division
Sales ($12, $60) $600,000 $3,000,000 $3,600,000
Less Variable ($12, $35) 600,000 1,750,000 2,350,000
Contribution Margin $ ‐0‐ $1,250,000 $1,250,000
Decrease in Contribution Margin $ 150,000
This situation, however, would potentially be different if the Relay
division had excess capacity, and the sales to the Motor division at $12
each would not have an adverse effect on the outside sales.
d. Another problem with the above illustration is that the only division to
show a profit is the one that makes the final sale to an outside party.
Thus, there is little incentive for the first division to control costs since all
of the costs are simply passed on to another division. Unless costs are
subject to some type of competitive pressure at transfer points, waste
and inefficiency almost invariably develop.
e. Despite the shortcoming of setting transfer prices at cost, this method is
frequently used. It is easy to understand and highly convenient to use. If,
however, transfer prices are based upon costs, standard costs should be
used. This will avoid passing on inefficiencies from one division to
another.

f. Transfer prices at cost frequently use a cost that includes at least some
level of fixed costs. However, there are numerous variations of the
definition of fixed costs:
(1) Only selling division fixed costs
(2) Only manufacturing fixed costs for the selling division
(3) Selling division’s fixed costs and corporate costs allocated to the
selling division
Obviously, there would need to be an annual allocation rate for the fixed
costs in question applied to the units transferred from one division to
another if some level of defined fixed costs were to be included in the
transfer price.
2213.33 Developing a formula for negotiated transfer prices
a. One method for developing transfer prices between divisions is to set the
transfer price equal to the variable costs of the goods being transferred
plus the contribution margin per unit that is lost to the selling division as
a result of giving up the outside sales. The transfer price computed by
this formula is a price based on competitive market conditions.
b. An important point to consider is that the price set by the transfer price
formula represents the lower limit for the transfer price. In other words,
the selling division must be at least as well off as if it only sold to outside
customers.
c. Whenever the selling division must give up outside sales in order to sell
internally, it has an opportunity cost that must be considered in setting
the transfer price. The opportunity cost is the contribution margin that
will be lost as a result of giving up outside sales. Unless the transfer price
can be set high enough to cover this opportunity cost along with the
variable costs associated with the sale, no transfers should be made.
d. Illustration: The pump division needs 20,000 special valves per year,
requiring an unusual production process. The variable costs to
manufacture the valve in the valve division would be $20 per unit. To
produce the special valve that requires a complicated production
process, the valve department would have to give up the production of
50,000 normal valves per year sold to the outside that would provide a
contribution margin of $14 per unit. What would be the lowest price that
the valve division would be willing to sell the special valve to the pump
division?

Solution: The contribution margin that would be lost would be $700,000
(50,000 valves  $14 per unit). Spreading the lost contribution margin
over the 20,000 special valves, it can be determined that the lost
contribution would be $35 per unit ($700,000 lost contribution margin 
20,000 special valves).
Using the transfer pricing formula:

Transfer price = Variable costs per unit + Lost contribution margin
= $20 + $35
= $55 per unit
The valve division would be indifferent to selling the special valve to the
pump division and selling the other normal valves to the outside if it
received a minimum of $55 per unit. Providing that the pump division
cannot purchase the special valve for less than $55 on the outside, it
should accept the $55 per unit price.
2213.34 Production for internal transfer by a division with idle capacity
a. When idle capacity exists, the selling division’s opportunity cost may be
zero. Depending upon what alternative uses this division might have for
its idle capacity it may be advantageous to sell to the purchasing division.
b. Under the idle capacity condition, as long as the selling division can
receive a price greater than its variable costs, it will be better off—at
least in the short run. As long as the purchasing division can purchase the
product for less from the sister division than the current purchase price
from the outside, it will be better off and, thus, the corporation as a
whole will benefit.
Illustration: Returning to our original illustration, the Motor division
(purchasing division) can purchase from the outside for $15. If the Relay
division (selling division) has enough idle capacity to meet the purchasing
division’s needs and there are no additional outside sales prospects at
the current $20 per unit, then the organization will benefit from the
transfer. Using the transfer price formula:

Transfer price = Variable costs per unit + Lost contribution margin per unit)

It can be determined that the minimum transfer price should be $12, the
variable costs to produce the relays, since there is no lost contribution
margin for sales that would not otherwise have occurred. The
organization as a whole will benefit if the transfer price is set anywhere
within the range of $12 and $15. If the Relay division (selling division)
refuses to sell to the Motor division (purchasing division), the company as
a whole will lose up to $3 of contribution margin on each unit. This can
be summarized as follows:

Sale of 100,000 units (50,000 to the outside Relay Motor
and 50,000 to the Motor division) Division Division Total
Original sales ($20, $60) $1,000,000 $3,000,000 $4,000,000
Additional internal sales 500,000 ‐0‐ 500,000
Total sales 1,500,000 3,000,000 4,500,000
Less outside sales variable costs ($12) (600,000) (600,000)
Less variable costs for internal sales ($10, $35) (500,000) (1,750,000) (2,250,000)
Contribution margin $ 400,000 $1,250,000 $1,650,000
Original contribution margin $1,400,000
Increase in contribution margin $ 250,000
2213.35 International issues and transfer pricing
a. Many multinational corporations (MNCs) have international sales among
the components of the organization. That means that transfer prices
must be set between divisions and/or subsidiaries that reside in different
countries. The MNCs have the same basic transfer pricing issues just
discussed; however, there is an additional issue of taxes. Not all
governments have identical tax rates; therefore, it is in the best interest
of an MNC to use transfer pricing to shift the profit to subsidiaries in
countries with lower tax rates when possible.
b. The flexibility to shift profit through the use of transfer pricing may be
limited due to the fact that some host governments restrict such
transfers when the intent is to avoid taxes. In other words,
sales/purchases between subsidiaries of a firm are expected to use the
principle of an arm’s‐length transaction when setting prices. There is still,
however, a bit of flexibility in setting transfer prices without violating
laws or regulations. Even though there is a limited range for setting
transfer prices, subsidiaries often can shift costs for technology, research
and development, etc. to subsidiaries in countries with high tax rates.

c. Currently, the U.S. tax code requires that transfer prices are “arm’s‐
length transactions.” On March 12, 2003, the Pacific Association of Tax
Administrators (PATA) reached an agreement for a final Transfer Pricing
Documentation Package. The result is the PATA members have agreed to
certain principles that allow taxpayers to prepare one set of
documentation to meet the transfer pricing documentation provisions of
each country. If a taxpayer complies with the provisions under the
agreement, the taxpayer is shielded from transfer documentation
penalties that might otherwise apply in each of the four jurisdictions
(Australia, Canada, Japan, and the United States). The IRS extended the
tax code to include transfer pricing of services as well as products in
2004.
d. Illustration: Two subsidiaries located in different countries transfer
products. Subsidiary A supplies materials to Subsidiary B. Subsidiary A has
a higher tax rate (50%) than Subsidiary B (30%). Subsidiary A is currently
charging $200,000 to Subsidiary B for a component part.

Subsidiary A Subsidiary B Total
Sales $200,000 $400,000 $600,000
COGS 100,000 200,000 300,000
Gross profit 100,000 200,000 300,000
Operating expenses 40,000 150,000 190,000
Earnings before taxes 60,000 50,000 110,000
Income tax (50%, 30%) 30,000 15,000 45,000
Net income $ 30,000 $ 35,000 $ 65,000
If the transfer price is changed to favor Subsidiary B (only charging
$150,000 for the component part), the total net income will increase due
to the fact that Subsidiary B has a lower tax rate.

Subsidiary A Subsidiary B Total
Sales $150,000 $400,000 $550,000
COGS 100,000 150,000 250,000
Gross profit 50,000 250,000 300,000
Operating expenses 40,000 150,000 190,000
Earnings before taxes 10,000 100,000 110,000
Income tax (50%, 30%) 5,000 30,000 35,000
Net income $ 5,000 $ 70,000 $ 75,000
Increase in total net income $ 10,000
2213.36 Federal Financial Institutions Examination Council (FFIEC) expectations
a. On January 6, 2010, the Federal Financial Institutions Examination
Council (FFIEC) issued an advisory dealing with the need for sound
practices for mitigating interest rate risk with recommendations that all
institutions manage their interest rate risk (IRR) exposures using
processes and systems commensurate with their earnings and capital
levels, complexity, business model, risk profile, and scope of operations.
b. This advisory held senior management responsible for ensuring that
board‐approved strategies, policies, and procedures for managing
interest rate risk are appropriately executed within the designated lines
of authority and responsibility. Management must maintain:
(1) appropriate policies, procedures, and internal controls, including
controls over risk‐taking to ensure that they stay within board‐
approved tolerances.
(2) a provision for updating IRR measurement scenarios and key
underlying assumptions that drive the institution’s IRR analysis.
(3) a sufficiently detailed reporting process to inform senior management
and the board of the level of IRR exposure. The institution’s IRR
tolerance should be communicated so the board and senior
management clearly understand the institution’s risk tolerance limits
and the capital adequacy based on those limits.
c. Institutions should engage in scenario planning and test stress scenarios
that should, at a minimum, include tests of the following:
(1) Significant changes in the level of interest rates (instantaneous rate
shocks)
(2) Substantial changes in rates over time (prolonged rate shocks)
(3) Changes in relationship between key market rates (basis risk)
(4) Changes in the shape and slope of the yield curve (yield curve risk)
d. Regulators suggest that under certain conditions, once institutions come
close to reaching a limiting positions set for IRR within their policies, that
balance sheet alterations of hedging might be an appropriate response.
However, even then, they make several suggestions related to the
conditions under which such hedging operations might be conducted,
including the following:
(1) Balance sheet alterations designed to achieve an appropriate
distribution of assets maturities or re‐pricing structures to avoid the
potential for severe maturity or duration mismatches between assets
and liabilities
(2) The level and formality of the process should be commensurate with
the activities and level of risk approved by the board and should not
be undertaken unless the board and senior management understand
the institution’s hedging strategy.
(3) Reliance on outside consultants to assist in the establishment of such
a strategy would be appropriate.
2213.37 If we compare rates of returns for various stocks over time, we would find
that some stocks rates of return would go up and down in tandem and
others may go in opposite directions (when one stock’s rate of return goes
up, the other stock’s rate of return decreases). Correlation represents the
degree to which a series of returns changes in comparison with another
series.
a. Perfect Negative Correlation: This occurs when one series of numbers
increases or decreases and the other series always does exactly the
opposite. In other words, when the rate of return on one stock goes up,
the rate of return on the second stock goes down, and vice versa. The
following graph depicts two stocks with perfect negative correlation.

b. Perfect Positive Correlation: This occurs when, in comparing rates of
returns on two stocks, one series of numbers increases or decreases
and the other series always does the same. When the rate of return
goes up on one stock it also goes up on the second stock. The
following graph depicts two stocks with perfect positive correlation.
2213.38 Relationship of Risk and Correlation: A portfolio of two stocks that have
perfect negative correlation will totally eliminate risk. If two stocks have
perfect positive correlation, risk is not reduced. In actual practice, the
correlation on most stocks is positive but not perfectly. Markets tend to
move in the same direction. The rates of return tend to change in the same
direction but not always. Since stocks do not show perfect positive
correlation, diversification can be used to reduce risk.
2213.39 Portfolio Management: Most corporate portfolio managers are averse to
risk. Because of this, investors normally diversify their investment portfolios.
Total risk in a portfolio is divided into two parts, diversifiable risk and
nondiversifiable risk. Well diversified portfolios can eliminate diversifiable
risk, so the market rewards only nondiversifiable risk. The nominal rate of
return required on an investment portfolio is equal to the risk‐free rate plus
a risk premium for expected inflation. Several models have been developed
to evaluate the required rate of return on an investment portfolio. The most
significant is the Capital Asset Pricing Model (CAPM) which quantifies the
trade‐off between risk and return.
2213.40 Capital Asset Pricing Model (CAPM): The Capital Asset Pricing Model (CAPM)
is a financial model that describes the relationship between risk and
expected return. Under CAPM, expected returns include only systematic risk,
which cannot be eliminated through diversification. CAPM is used to
evaluate the required rate of return on an investment. CAPM gives the firm’s
cost of equity capital, or the rate of return required by those investing in the
firm’s common stock. This model adds the variables of capital gains potential
and the risk that the dividend trend will continue. The CAPM expresses the
theory that the expected rate of return on a firm’s common stock should
equal the rate of return on risk‐free U.S. Treasury securities (typically T‐Bills)
plus a risk premium. The calculation of the risk premium utilizes the
security’s beta coefficient.
a. Expected Risk‐Adjusted Return: According to CAPM, the expected
rate of return on a security (or a portfolio of securities) is equal to:
Risk‐Free Return + Individual Security Risk Premium
= Risk‐Free Return + (Beta Coefficient x Market Risk Premium)
= Risk‐Free Return + [Beta Coefficient x (Market Return ‐ Risk‐Free
Return)]
This can be expressed as an equation as follows:
KC = KRF + (KM – KRF)β

Where: KC = expected rate of return on common stock
KRF = risk‐free rate of return
KM = market rate of return
β= The stock’s beta coefficient

Example: Colt Inc. plans to issue stock to finance anticipated capital
expenditures. The beta coefficient for Colt’s stock is 1.15, the risk‐free
rate of interest on a U.S. Treasury bond is 8.5% and the market return
is estimated at 12.4%. What is the required CAPM cost of capital for
this issue?
Answer: Expected Rate of Return = 8.5% + 1.15(12.4% –8.5%) =
12.99%
b. Risk‐Free Rate: The risk‐free rate is usually estimated using the rate
of return on U.S. Treasury securities (typically T‐Bills).
c. Risk Premium: A risk premium results from the amount of
nondiversifiable risk (beta coefficient) of the investment and the
market price of risk. The market price of risk is the difference
between the required rate of return on the average market and the
risk‐free rate of return.
d. Beta Coefficient: The beta coefficient for an individual security (or a
portfolio) measures the degree of risk of that particular security,
relative to the market as a whole. A beta value of zero would be that
of a risk‐free security. A beta of exactly one means that the security
moves perfectly with the market as a whole. A beta of less than one
means that the security is less risky than the market. A beta higher
than one indicates that the security is more risky than the market.
Thus, the beta coefficient under CAPM reflects the idea that higher
risk is associated with a higher return, on average.
1. Risk‐Price Relationship: Volatility is usually reflected in market
price variations. The higher the price change of a security
compared to the market as a whole the higher the beta. The
closer the price change of the security is to market, the lower the
risk.

2. Examples:
 If the market rises 5% and an individual stock rises 4%, the
beta coefficient of the security is 0.8 (.04 ÷ .05).
 Stallion Inc. has a portfolio overall risk weighted return of
13%. It is considering investing in two stocks. Stock 1 has a
return of 10% and a beta risk factor of 0.9 while stock 2
has a return of 16% and a beta factor of 1.2. Stallion
should invest only in stock 2.
.1
Stock 1 = .11 or 11.1% risk weighted value
0.9

.16
Stock 2 = .133 or 13.3% risk weighted value
1.2
If Stallion wants to raise the overall risk weighted return of the
portfolio it will only invest in stock 2. Only stock 2 has a risk
weighted return (13.3%) exceeding the present risk‐weighted
value of 13%.
e. Portfolio Betas: The portfolio beta is the weighted average beta of
the stocks in the portfolio.
1. Calculation of the Portfolio Beta:
`Portfolio Beta = (Weight of stock one × Beta1) + (Weight of stock two × Beta2) + ... + (weight of
stock N × BetaN).
All weights of stock are based on the stock’s market value as a
percentage to the total portfolio value.
2. Example: A portfolio consists of two stocks, 200 shares of Gamma
trading at $20.00 per share with a beta of 1.4 and 100 shares of
Epsilon trading at $10.00 per share with a beta of .90. What is the
portfolio beta?
Price Total % of Weighted
per Market Portfolio Stock Portfolio
Stock Shares Share Value Value Beta Beta
Gamma 200 $20 $4,000 80% 1.40 1.12
Epsilon 100 10 1,000 20% 0.90 0.18
$5,000 1.30

The weighted average Beta for the portfolio is 1.30. Notice that
the beta of the portfolio is less than the beta of the stock with the
highest individual beta. This indicates that there is some
diversification with just two stocks in the portfolio.
f. Market Return: Theoretically, the market return should be measured
using a weighted average of the return on all possible investments.
However, as a practical matter market returns are usually measured
using stock market data.
Example: Colt Inc. plans to issue stock to finance anticipated capital
expenditures. The beta coefficient for Colt’s stock is 1.15, the risk‐free
rate of interest on a U.S. Treasury bond is 8.5% and the market return
is estimated at 12.4%. What is the CAPM cost of equity capital (i.e.,
the expected risk‐adjusted return) for Colt?
Answer:
Cost of Capital = 8.5% + [1.15 × (12.4% – 8.5%)] = 8.5 + (1.15 × 3.9) = 12.99%
2213.41 Risk Tolerance: Risk tolerance refers to an investor’s financial ability and
emotional willingness to withstand declines in investment value. Following
are common attitudes toward risk and their effect on risk management.
a. Risk Averse: Risk averse investors prefer relatively low risk
investments and are willing to give up a higher return in exchange for
more predictable outcomes. When managing risk, these individuals
seek ways to avoid risk.
b. Risk Neutral: Risk neutral investors are indifferent between two
investment opportunities that have the same expected value. When
managing risk, these individuals objectively weigh the risk/return
trade‐off (i.e., costs and benefits of higher or lower risk).
2213.42 Security Market Line
a. Variables: The security market line (SML) graphically depicts the
positively correlated relationship between the required rates of
return (vertical axis) and the beta risk of stocks (horizontal axis). The
higher the beta risk the higher the required rate of return. In the
below graph, a 16% return is required for a security with a beta of
1.3; only a 12% return is required if the beta is 0.8. The steeper the
slope of the line, the greater the average investor’s risk aversion for
the security.

b. Graph of Security Market Line

Note: When beta is equal to zero, the required rate is equal to the
risk‐free rate. If the beta equals 1.0, the required rate is equal to the
required market rate of return. Those results are determined by
substituting betas of 0.0 or 1.0 in the CAPM model, yielding answers
of KRF and KM respectively.
c. Overpriced and Underpriced Stocks: A stock whose expected rate of
return differs from the required rate of return (as depicted by the
SML) is either overpriced or underpriced. An overpriced stock is one
in which the expected rate of return is less than the required rate of
return. The opposite is true for underpriced stocks. Investors will
determine this situation and then bid down (or up) the price of the
stock until the required rate and expected rate of returns are equal
(equilibrium).

2220 Long‐Term Financial Management
2221 Term Structure of Interest Rates
2221.01 Introduction to interest rates
a. Interest rate risk arises from differences between the timing of interest
rate changes and the timing of cash flows (re‐pricing risk); from the risk
that changes in interest rates will re‐price interest‐incurring liabilities
differently from re‐pricing the interest‐earning assets, thus causing an
asset‐liability mismatch (basis risk); from changing rate relationship
across the spectrum of maturities (yield curve risk); and from interest
rate‐related options embedded in a financial institution’s products
(option risk).
b. An evaluation of interest rate risk must consider the impact of complex,
illiquid hedging strategies or products, and also the potential impact on
fee income that is sensitive to changing interest rates.
c. Re‐pricing risk is the most common form of interest rate risk and some
firms make a bet on the typical upward‐sloping nature of the yield curve
and deliberately mismatch the portfolio by holding longer‐duration assets
when compared to liabilities in an attempt to enhance earnings.
d. Basis risk may be seen in the following example. A retail bank generally
funds loans from customer deposits. Thus, since loan rates tend to adjust
upward more rapidly than deposit rates, there is a tendency for interest
margins to increase spontaneously when rates are rising. However, as
rates stabilize, the improvement may disappear as deposit rates catch up,
and then interest margins would fall when rates began to decline.
e. Yield curve risk arises from variations in interest rate moves along the
yield curve, such as different changes for the 90‐day T‐bill and a 10‐year
Treasury bond. The yield curve flattens, steepens, or becomes inverted
during an interest rate cycle. These types of changes tend to accentuate
the possible impact of any asset‐liability mismatches held by the firm.
f. Option risk arises from legal rights to engage in a future transaction at a
predetermined price (puts and calls). The owner of a put option has the
right, but not the obligation, to sell a given quantity of an underlying
asset at a specified strike price during a specified period to the seller of
the put if the option is exercised. These protect against the risk of a
decline in market value of the underlying asset.
For example, a farmer is concerned that the market price of a growing
crop may decline before harvest. The farmer can buy a put option to
guarantee a minimum price. If the price declines below that price the
option is exercised and the crop sold for that minimum price. Of course, if
after harvest the price is above the floor, the farmer has no obligation to
sell the crop at the floor and will happily sell it for the higher market
price.
The owner of a call option has the right, but not the obligation, to buy a
given quantity of an underlying asset from the seller of the option during
a specified period for a specific strike price. The seller of the option is
obliged to sell the underlying asset if the option is exercised.

For example, an airline has sold a number of tickets for future flights
assuming the cost of jet fuel stays constant, but a large increase in the
cost of jet fuel would make those future flights uneconomic. The airline
can buy a call option on the price of jet fuel in the future, giving the
airline the right to buy the fuel at a maximum price. If the price of fuel
rises, the airline will exercise the option, buying the fuel at the strike
(maximum) price. If future jet fuel prices remain below the maximum
price, the airline is not obligated to buy the fuel at that strike price.
Instead, the airline will buy the fuel at the lower market price, saving the
difference in cost.
2221.02 Various interest rate formulas and their uses
Short‐term debt is that debt that will be repaid within one year. Interest
rates on short‐term bank debt are calculated in a number of ways, including
the following:
a. Basic interest is calculated on an annual basis using the stated rate of
interest.
Illustration: The customer takes out a $10,000 loan with a one‐year
maturity and a 10% interest rate. The basic interest is:

Basic interest rate = Interest  Amount borrowed
= $1,000  $10,000 = 10%
b. Interest is discounted (discounted interest) when the amount of interest
to be collected during the life of the loan is subtracted from the loan
proceeds, with the customer repaying the loan principal amount.
Illustration: The customer takes out a $10,000 loan with a one‐year
maturity and a 10% interest rate. The interest for the year is $1,000 and
the individual receives $9,000. The effective interest rate on the loan is
11.11% ($1,000  $9,000).
The add‐on interest method is one where interest is calculated on the full
amount of the original principal. The calculated interest is added to the
principal and the payment is determined by dividing the sum of principal
plus interest by the number of payments to be made. The add‐on interest
rate can be calculated as follows using the following example:

(1) Approximate add‐on annual rate = Interest paid  (Amount received  2)
= $1,000  ($10,000  2)
= $1,000  $5,000
= 20%
(2) Add‐on effective rate = (1 + i)n - 1
= (1 + .0167)12 - 1
= 1.2199 - 1
= 22%
(If the approximate annual rate is 20%, then the monthly rate is 1.67% (or
20% ÷ 12)).
Simple interest is computed on the remaining outstanding balance using
the daily periodic rate times the number of days since the prior payment.
c. Under certain situations with add‐on loans where interest is paid
according to the Rule of 78s, the monthly payment is allocated first to
the payment of interest and then to principal. If the amount of interest
due is greater than the amount of the payment, the difference would be
added on to the loan principal and is termed negative amortization. This
can commonly occur on longer‐term loans such as 15‐year mobile home
loans.
(In the Rule of 78s, 78 is equal to the sum of the digits from 1 to 12. For
an annual installment loan, 12/78ths or 15.4% of the interest due on the
loan would be charged to the first payment before anything was credited
to principal. This concept can be applied to installment loans of any
maturity by summing the digits of the number of payments. For example,
a 15‐year loan with monthly payments would sum the digits from 1 to
180.)
d. Miscellaneous considerations:
(1) Compound interest involves the paying or charging interest on
interest. The most common usage relates to the effective return on
deposits. Federal legislation in 1991 (the Truth in Savings Act) was
designed to provide consumers with information that would allow
them to be able to compare the effective yield on alternative
instruments.
Illustration: Assume that an individual deposits $10,000 in a one‐year
certificate of deposit paying 6% interest. If interest is compounded
annually, he would receive $600 in interest. If the interest were
compounded semi‐annually, there would be two payments received.
The first payment would be $300 and the second payment would also
include interest on that $300 and the consumer would receive $609.
Quarterly compounding would result in interest earnings in the
amount of $614, and daily compounding $618.
(2) 360‐day vs. a 365‐day year. Many credit card issuers compute the
daily periodic rate using a 360‐day as opposed to a 365‐day year, yet
charge interest for 365 days. This has the result of increasing the
effective annual rate on a loan. (The effective annual interest rate is
the investment’s annual rate of interest when compounding occurs
more often than once a year.)
Illustration: Assume that you have an 18% loan. With a 365‐day year,
the daily periodic rate would be 0.0493%, while with a 360‐day year
the daily periodic rate would be 0.05%.
(a) Effective interest rate using a 365‐day year with a 365‐day daily
periodic rate:

((1 + 0.000493)365 - 1) = 19.71%
(b) Effective interest rate using a 365‐day year with a 360‐day daily
periodic rate:

((1 + 0.0005) 365 - 1) = 20.02%
2221.03 Why interest rates differ
a. There is risk that the borrower will not repay the loan in a timely fashion.
The greater the likelihood that the borrower will default on the loan, the
higher the interest rates will be in order to compensate the lender for
bearing that risk.
b. Interest rates tend to be higher for longer‐term loans. Borrowers tend to
like the certainty of a known fixed expense. Lenders are concerned about
the possibility of an increase in their cost of funds over the period of the
loan and charge a premium to compensate for this risk.
c. There are fixed and variable costs associated with making loans. There
tend to be high administrative and processing costs associated with
making loans. The costs tend to be higher per dollar loaned for smaller
loans and for loans that require more frequent payments. This causes
interest rates on smaller loans to be higher than on larger loans, and
interest rates on short‐term loans to be higher than on longer‐term
loans.
2221.04 Role of interest rates
Interest rates have a significant impact on the level and composition of
investment goods purchased and the level of spending for research and
development (R&D).
a. Lower interest rates encourage an increase in business investment. This
would cause a firm to expand output and increase capital spending once
the firm no longer has idle capacity. The reverse would be true if interest
rates increase. The Federal Reserve can influence rates in an attempt to
influence the level of economic activity.

b. Interest rates are the price of money and serve to ration the supply of
available loanable funds to projects with the highest rate of return. The
rationing is not perfect, however, because firms with market power
and/or a strong financial position are able to obtain funds at lower rates,
which gives them an advantage over other firms that might have more
profitable projects but a relatively weak financial position.
Lower interest rates tend to make R&D expenditures more profitable.
Thus, lower rates would cause firms to increase such expenditures.
2221.05 Determination of interest rates
The use of credit has become ubiquitous in the American economy.
Individuals and households receive credit when they take out mortgage and
auto loans and use credit cards. Many times it is difficult to determine the
interest rate being paid on such loans. Truth‐in‐lending laws, which were
passed in 1968, were passed to provide consumers with a method for
comparing the true cost of loans.
2221.06 Methods for quoting rates of return
There are a myriad of methods for computing the rate of return on a loan.
Returns on loans such as mortgage loans and bonds that have regular
periodic payments are quoted in terms of annual percentage rates (APR).
This APR can be translated into an effective annual rate (EAR).
a. APR = Period interest rate  Number of periods per year. The period
interest can be defined as semi‐annual, quarterly, monthly, etc. For
example, if the monthly rate is 1.5%, then the APR would be 18% (1.5% 
12 months).
b. To compute the effective annual rate (EAR) we would use the following
formulas:
EAR = ((1 + Rate per period)2 – 1), where the rate per period = APR/2, or
APR = ((1 + EAR)1/n – 1)  n, where n is the number of periods

2221.07 Bond prices and yields
Since bond cash flows occur in the future, the price an investor is willing to
pay for those payments depends on the value that can be received compared
to the value of the dollars today. The nominal rate of return is a combination
of the risk‐free rate plus a premium for expected inflation. The value of a
bond can be computed as follows:
Bond value = PV of the interest payments + PV of par value
And, given a particular maturity, t, and a discount rate, r, the bond value can be defined as:
  
Bond Value  Coupon Payment  1 -

1
  
t   r   Par Value  1  r 
t

 1  r   
Illustration: Assume that there is a bond with a 6% coupon, 20‐year
remaining maturity with a $1,000 par value, paying 40 semiannual payments
of $30 each. If the market interest is equal to the coupon rate (6%), the value
of the bond can be calculated as:
 
Bond Value   $30 1 
 
1  

  3%   $1,000  1  3% 40
1  3% 40  

  
 693.44  306.56
 $1,000
The interest payments represent an annuity, and the final payment is a lump‐
sum payment. If the market interest rate were equal to the coupon rate, the
price of the bond would be equal to the par value as shown above. If,
however, the market rate was 8%, the value of the bond would decrease due
to the fact that the bondholder would still be getting only the $30
semiannual payments. Given these circumstances, the bond’s value could be
calculated as:
 
Bond Value   $30 1 
 
1  

  4%   $1,000  1  4% 40
1  4% 40  

  
 593.78  208.29
 $802.07
2221.08 Usury laws
Many states have usury laws that set a maximum rate that can be charged
for a certain type of credit. Such laws are designed to limit the cost of credit.
a. Today, many of these laws are designed to place a ceiling on the rates
charged for “payday loans” or “title loans,” where these lenders often
charge effective annual rates in excess of 400%.
b. If the state usury limits are restrictive enough, this type of lender often
simply would not offer this type of loan in a state with such limitations.
c. Since interest rates (price) no longer ration funds, less creditworthy
borrowers will be excluded from the market, and thus the credit for
lower‐income borrowers will be reduced.
2221.09 Generally lenders will charge a higher rate for long‐term financing than for
short‐term because unknown risks may arise and unknown opportunities
may be foregone. This uncertainty includes expectations as to interest rate
changes and future inflation.
2221.10 Term Structure Theories: Three principle theories exist to explain the shape
of the normal yield curve.
a. Liquidity Preference Theory: The upward‐sloping yield curve is best
explained because short‐term bonds return less interest than long‐term
bonds. The two factors supporting the liquidity preference theory are:
(1) Creditor Objective: Lenders want shorter‐term liquidity and will thus
accept less return.
(2) Debtor Objective: Borrowers prefer long‐term debt to avoid the risk
of costly refunding and will thus pay a higher rate of return than on
short‐term debt.
b. Market Segmentation Theory: Each lender and borrower has a preferred
maturity and this creates two market segments. Merchants want working
capital loans for short‐term periods while corporations building factories
and home buyers want long‐term loans. The slope of the curve depends
upon the relative demand and supply of funds in these two markets.
(1) Inflation Expectancy: This theory would add an inflation premium
equal to the average expected inflation rate from the date of issue to
the date of maturity. If future interest rates and/or inflation are
expected to be higher than at present, the yield curve will be
significantly upward sloping. If the inflation rate is expected to
decline, the yield curve would have a flat or downward slope. In
December 1998, long‐term mortgage rates were lower than short‐
term loans; many financial analysts credit this phenomenon to the
expectation theory.
(2) Recession and Interest Rates: When investors expect the economy to
slow or contract, long‐term rates drop as inflation fears fade or
deflation fears increase. By contrast short‐term interest rates are
more anchored to interest rate policies set by the Federal Reserve.
(3) Inverted Yield Curve: This is where short‐term rates are higher than
long‐term rates. Every recession since 1960 has been preceded by an
inverted yield curve.
(4) Computational Problem: The CMA exam has infrequently asked the
candidate to compute expected future interest rates. The question
often gives associated years‐to‐maturity and interest rate values from
a particular yield curve. This computation is used by investors who
are debating whether to buy a two‐year bond today or to buy a one‐
year bond today and reinvest the proceeds in another one‐year bond
at the beginning of year 2. The formula to compute expected future
interest rates is:
Expected Interest Rate in 1 + Interest rate associated with Year F)YF
= – 1
Future Year F from Base Year B (1 + Interest rate associated with Year B)YB

Where:
YF = number of years in the future that the future year is from
today
YB = number of years in the future that the base year is from
today
Example: Today, the following yields on a given security are
observed:
Yield to Maturity Interest Rate
1 year 4%
2 years 4.5%
3 years 6%

Required: Determine the market’s interest rate expectations
concerning one‐year rates on the security at the beginning of Year
2 (one year from today) and at the beginning of Year 3 (2 years
from today).
Answer: One year from today, the one‐year rate on the security is
expected to be 5.0%, computed as follows:
(1 + .045)2 – 1 = 1.191016 – 1 = 1.090649 – 1 = .090649 = 9.1%
(1 + .045)2 1.092025

2222 Types of Financial Instruments
2222.01 Bonds: A bond is a promise to pay a given amount (designated as par, face,
or maturity value) on a given date (maturity date). The bond indenture is the
contract between the issuing corporation and the bondholder. The indenture
typically provides for periodic interest payments, stated as a fixed
percentage of the face value (coupon rate). Bonds provide a creditor with
security, a priority in both earnings and liquidation and a fixed return that is
not dependent upon earnings (as opposed to common stockholders). The
interest is deductible to the corporation and therefore this source is usually
less expensive after‐tax than preferred or common stock. While this involves
no dilution of equity, it increases the debt‐to‐equity ratio, thus creating more
risk to the firm in the event of an economic downturn. Debt instruments with
a coupon rate of interest less than the current market rate will sell at a
discount.
a. Types of Bonds: There are several basic types of bonds, described as
follows:
1. Mortgage Bonds: Mortgage bonds are secured by a lien on
property. This is the usual way to secure real property collateral.
2. Debentures: Debentures are bonds with no specific collateral to
secure the debt aside from the full faith and credit of the
company issuing the debt instrument. Thus debentures may have
a higher yield than other debt instruments.
b. Special Provisions: The bond indenture can also contain the following
special provisions:
1. Call Provision: The issuer may reserve the right to call the bond
prior to the redemption date. The call price is generally above the
market price and may be exercised if interest rates decrease. A
call provision is usually considered detrimental to the investor and
thus may require a higher interest rate at issue.
2. Sinking Fund Provision: A sinking fund provision requires the
corporation to make periodic payments to a trustee and thereby
accumulate funds to retire the principle of bonds or the balloon
payment(s) when they are due. Such bonds are usually considered
safe because of the orderly retirement provisions and therefore
have lower yields.

3. Protective Covenants: The bond indenture may also contain one
or more required covenants or promises designed to protect the
creditor. These are intended to ensure that the firm will be able to
meet its obligations to the bondholders and may include:

 Payment of dividends to shareholders and salaries to
officers may be restricted
 The firm may be required to maintain a specified current
ratio or minimum level of working capital.
 Further borrowing by the firm may be restricted.
2222.02 Convertible Securities: Convertible (Bonds or Preferred Stock) securities are
exchangeable for common stock at the owner’s option on or before a stated
time in the future.
a. Creditor Advantages: This allows a creditor to receive a fixed income
today and the option to become an equity participant tomorrow. The
latter feature provides the attraction of being able to share in
possible future superior earnings. This may be a very attractive
feature to an investor. This type of debt‐equity investment is very
popular with venture capitalists.
b. Debtor Advantages: The issuer may find convertibles easier to float
and less expensive than straight debt or equity instruments. The
issuer may prefer convertibles because it involves less restrictive loan
covenants and it allows a deferral of equity participation. Because of
the conversion feature, the value of bonds with such features may be
strongly influenced by the value of the issuer’s common stock and
may sell at a lower yield than straight bonds. The conversion
premium is the difference between the issue price and the conversion
price.
2222.03 Warrants: warrant is an option to purchase a stated number of common
stock shares at a specified price by a given expiration date. It is often sold as
a detachable companion to a bond. The firm receives cash when the warrant
is exercised and the common stock is issued.
a. Advantages: Warrants make the related bond sale more attractive.
Thus, the cost of the indebtedness may be lower and/or funds may be
raised that could not otherwise. Also, warrants can be used to effect
delayed equity financing.
b. Disadvantages: Uncertainty exists as to whether or when outstanding
warrants will be exercised. If warrants are not exercised, there will be
no cash inflow from the sale of the stock. In addition, exercise of the
warrants when the common stock market price is substantially higher
than the option price can lead to a dilution of earnings per share.
Notice that in such a circumstance the issuer would be better off if
the stock had been sold directly and not available at such a “bargain”
price.
2222.04 Leases
a. Advantages and Disadvantages: The advantage to leasing is that
100% financing is possible, thus conserving cash. The risk of
obsolescence decreases, credit lines are preserved thus providing
flexibility, and there is no violation of restrictive loan covenants which
may prohibit the issuing of new debt securities. The disadvantage is
that the real cost of leasing usually exceeds that of a term loan.
b. Lease vs. Term Borrowing Decision: Take the after‐tax present value
of the expected cash outflow under both alternatives. The lease
payment and interest portion of the term loan and related
depreciation are usually net of tax. The present value factor is divided
into the face amount of the net obligation to determine the payment
amount. This calculation may become quite complicated.
2222.05 Preferred Stock: Preferred stock has features that are characteristic of both
debt and equity instruments. It is generally preferable to straight debt
because it is legally equity and has no maturity date. The dividend received
deduction makes holding preferred stock more attractive than debt
instruments to corporations.
a. Preferential Quality Specified: Preferred stock is defined in the
corporate articles or bylaws as having some preferential quality(ies)
over common shares. Usually they have superior rights upon
liquidation and/or to dividends.
b. Cumulative Preferred: Preferred stock dividends may accumulate and
must be paid current before any dividends may be paid to common
shareholders.
c. Participating Preferred: Preferred shareholders may participate with
common in additional dividends above a preset level.
d. Convertible Preferred: Preferred may also be convertible into
common shares either at the end of a given period or upon the
occurrence of some other condition.
e. Not a Legal Obligation: Preferred dividends are usually not legal
obligations until declared by the Board of Directors.
f. No Voting Rights: Unlike common shareholders, preferred
shareholders do not usually have voting rights as long as all
conditions of the issue are met.
2222.06 Common Stock: Common stock has the last priority in liquidation and
exposes investors to greater risk than debt. It is purchased for capital
appreciation and dividend objectives. Common shares may increase in value
quicker than other securities and generally have no right to dividends. But
additional common stock issuances will decrease earnings per share and
dilute existing shareholders’ voting power.
a. Different Classes of Common Stock: Companies may issue more than
one class of common stock. One class may be voting, while the other
is non‐voting.
b. Stated Capital: Stated or legal capital is that portion of corporate
capital required by state law to be retained in the business to afford
creditors a minimum degree of protection. The outstanding shares
times par or stated value constitutes the dollar amount of legal
capital. Stock dividends will increase stated capital by shares times
par value. A stock split does not affect stated capital. Dividends paid
out of legal capital are unlawful.
c. Paid‐In Surplus: Paid‐in surplus is the excess of the consideration
received by the corporation for its shares less the par or stated capital
amount.
d. Authorized Shares: Authorized shares are detailed in the articles of
incorporation. To issue a larger amount requires that the articles be
amended by the shareholders.
e. Outstanding Shares: Outstanding shares are that portion of issued
shares which have not been redeemed. This is issued shares less
those held in the treasury (see treasury shares below).
f. Stock Options: Options to purchase common shares may be sold or
granted to executives or other employees as additional
compensation. This may encourage employees to increase earnings
and align their interests with the stockholders. The option price may
be fixed or depend upon future conditions such as earning levels of
the company. There is an active put and calls market for most listed
corporations. Stock options may be a deterrent to a corporate raider.
2222.07 Treasury Shares: Treasury stock is corporate stock which has been issued
and later reacquired by the issuing firm. As long as the articles of
incorporation so provide, a corporation may repurchase or redeem its own
shares. Redeemed shares may be cancelled or held in the treasury. There is
no taxable gain or loss recognized by a corporation from transactions in its
own treasury shares. Such transactions also have no affect on stated capital.
Treasury shares do not have voting rights and cannot receive dividends.
a. Reasons for Reacquiring Stock: There are a number of reasons why a
firm reacquires its own stock, including the following:
1. Provide Cash and Tax Savings for Shareholders: By repurchasing
its stock from its shareholders, the corporation can both pay cash
and provide a tax benefit to the shareholders. The shareholders
are taxed only on the gain (amount that the transaction price
exceeds their original basis in the stock). In contrast, cash
dividends paid to shareholders are usually fully taxable.

2. Employee Stock Ownership Plans (ESOPs): Federal corporate tax
law provides for the deductibility of contributions made to
qualified ESOPs. An ESOP typically borrows funds from a bank to
purchase shares of the corporation’s stock to be held in the name
and for the benefit of the firm’s employees. These shares may be
treasury shares accumulated and held by the corporation as well
as those shares newly issued by the corporation or purchased on
the open market. The corporation makes annual tax‐deductible
contributions to the ESOP, which uses the funds to repay the bank
loan. Employees may also contribute to the ESOP. The firm
benefits by receiving the proceeds from the sale of either treasury
stock or newly‐issued shares to the ESOP.

3. Automatic Dividend Reinvestment Plans (ADRIPs): Treasury stock
may be used to provide additional shares to shareholders in

4. Stock Repurchase Programs: The corporation may choose to
purchase some of its own shares from the market, thus increasing
the proportional ownership of the remaining shareholders.
Earnings per share of outstanding stock is then increased which,
together with the stimulative buying activity, is expected to result
in a higher market value per share. Shareholders have the
potential of realizing capital gains upon eventually selling their
shares, which may be taxable at lower rates than ordinary
dividends. Such a program is especially desirable if the book value
per share exceeds the market value per share of the stock.

b. Reasons for Reacquiring Stock: There are a number of reasons why a
Disadvantages
Advantages
Increase EPS to Remaining Shareholders May create liquidity problem
Increase market price per share Increase debt to equity ratio
Obtain control Increase financial risk of takeover
Buyout of dissident stockholder Decrease a firm’s current assets
Fund pension plans
2222.08 Retained Earnings: Retained Earnings, an internal source of funds, are the
accumulated earnings of the firm which have not been distributed as
dividends.
a. Advantages: One advantage to retention is that there is no
disturbance of present ownership. Also, the price/earnings ratio of
listed corporations may mean the net appreciation in share market
value derived from the increased capital. Historically, retention of
earnings has been the major source of capital investment for large
business firms. This may be especially valuable during periods of
capital rationing.
b. Disadvantages: The amount available from this source is limited, as it
depends on the firm’s earnings and dividend policy. Financing in this
manner can reduce the amount of dividends available to
shareholders, and the dividends can become variable.
2222.09 Dividends: Dividend Policy addresses what percentage of net income to pay
out and what to retain for internal growth. According to the residual
financing theory, if a firm earns a high return on investment, it should retain
more. The higher the capitalization factor or market price‐to‐earnings ratio,
the more the increase in earnings will be multiplied to a higher stock market
price. This may exceed the return a shareholder could realize by investing the
dividend.
a. Relevant Dates
1. Declaration Date: The date the Board declares the dividend and it
becomes a corporate liability. For cumulative preferred stock, this
action may not be necessary to create a liability. The Board,
however, would be the responsible party in determining whether
to pass the dividend.

2. Ex‐Dividend Date: Because of the necessity to process buying and
selling orders, stock exchanges set a date before the holder‐of‐
record date to determine the identity of the dividend recipient.
This is usually four days, and on that date, the market price of the
stock usually falls by the dividend amount.
3. Holder‐of‐Record Date: Stock traders forward their final transfers
to the corporation or its transfer agent. The share ledger is then
brought current. The corporation then closes its share ledger and
produces a list of shareholders entitled to receive the dividend.
4. Payment Date: The date the check is mailed to the shareholder.
b. Factors Restricting Dividends: A corporation may find difficulty in
paying cash dividends if it lacks liquidity. Corporations can only legally
pay dividends up to earnings and profits (roughly retained earnings).
Loan agreements or bond indentures may further restrict or prohibit
dividends. Investment opportunities may not be available if cash
dividends are paid. The type of investor desired may affect dividend
policy such as a company owned predominantly by pensioners or
trusts which maintains a large regular dividend.
c. Non‐Cash Dividend
1. Usefulness: A non‐cash dividend is a way a corporation can
placate shareholders without using cash that may be used in the
business. This method is especially appropriate if the business can
earn a higher return on its investments than shareholders on
theirs.
2. Stock Dividend: New shares of stock are issued to existing
shareholder. The corporation must transfer the par value of the
new shares (or stated value for no‐par stock) from retained
earnings to capital stock. Net worth and ownership interest are
unchanged but future earnings per share are reduced. A stock
dividend is non‐taxable to shareholders unless they receive the
right to receive cash instead of the stock dividend.

3. Stock Split: There is no change in capital accounts because
mechanically the reduction in the legal par or stated value of the
shares outstanding is offset by an increase in the number of
shares outstanding. This may make the share trading range more
attractive and lead to a market price above the split level price. In
addition, there may be an “information value” to a stock split
because a growth in earnings is expected. A stock split is non‐
taxable to shareholders.
4. Reverse Stock Split: This is the reverse of a split. It may be used
when a company desires to increase the market value per share.
2222.10 Derivatives: The markets for derivatives began as a form of hedge against
changes in currency exchange rates. An investor with appreciated stocks
overseas may desire to ensure that the fluctuations of foreign currencies
wouldn’t dissipate the gains. So a forward instrument was created allowing
the investor (for a small fee) to freeze the value of the foreign currency.
a. Definition: A derivative is a contract whose value is tied to, or derived
from, the price of an underlying security, currency, or commodity.
They are artificial and synthetic and became popular because the
yields are higher than the prevailing market. Sophisticated investors
may engage in arbitrage (profiting from the differences in prices) and
use leverage. There is an estimated $12 trillion invested in over 2,000
different varieties of derivatives.
b. Varieties: The range is from a simple stock option to:
1. Forward Contracts: An asset is sold at a price determined today
but the seller is committed by contract to delivery at a later date.
This eliminates the purchaser’s fluctuation risk.
2. Futures: Similar to forward contracts, except futures are
standardized and traded on an organized future exchange.
Normally, futures are settled in cash rather than delivery of the
underlying commodity.
3. Swaps: This is an exchange of contracts; usually it is the
responsibility to make interest payments. An example is
exchanging a fixed rate of return obligation for an adjustable rate
obligation. Interest rate swaps enable management to hedge
interest rate risk. Because swaps do not involve an exchange of
principal, liquidity and risk management are increased.

4. Inverse Floaters: The two variable factors are opposite one
another. An example would involve mortgages with one pool
representing interest payments and another representing
principal payments.
5. Collateralized Mortgage Obligations: These are high‐quality, low‐
risk pools of mortgages. The derivatives are set up in three pools:
short‐term to 5 years; 5 to 15 years; and 30 years.

2223 Cost of Capital
2223.01 Overview
a. The sources of financing for an organization can be found on the right
side of the balance sheet—debt and equity.
b. Since accounts payable and other accrued expenses are created
spontaneously in the course of doing business and have no clear interest
expense, they do not require a special approval by management. The
financing structure items that do require the discretion of management
are short and long‐term debt as well as preferred stock and common
equity. These items are referred to as the firm’s capital structure. The
relationship between financial structure and capital structure can be
demonstrated as follows:
Financial structure = Non‐interest‐bearing liabilities + Capital structure
c. The goal of management is to minimize the firm’s cost of capital resulting
in the maximization of the common stock price. This point is referred to
as the optimal capital structure. There are two basic questions that must
be answered by management related to capital structure:
(1) What mix of short‐ and long‐term debt should be employed?
(2) What mix of debt and equity should be employed?
d. The pecking order theory indicates that the order of financing of a
company (or project) follows the path of least effort.
(1) Companies will use internal financing first.
(2) Dividend policy will be adapted to financing needs while at the same
time attempting to avoid sudden changes in dividends paid.
(3) If outside financing is required, a company will start with the cheapest
security, thus starting with debt financing, followed by hybrid
securities, and ultimately equity securities.
e. Modigliani and Miller developed the MM theorem related to the
financing of a firm, which can be summarized as follows:
(1) In a world with no taxes, no bankruptcy costs, or no agency costs, the
value of a company would be indifferent to its capital structure due to
the fact that the cost of capital would be the same for all financing
sources.
(2) In a world with taxes but no bankruptcy costs, the value of a company
would be highest with the use of 100% debt since the cost of debt
financing would be lower than the cost of equity financing due to the
interest tax shield.
(3) In a world with taxes and bankruptcy costs, the maximum value of the
firm would be the point when the marginal cost of debt based upon
the marginal tax shield would be equal to the marginal cost of
bankruptcy or financial distress costs. In other words, the optimal
capital structure would be a combination of debt and equity that
would provide the lowest overall WACC (weighted‐average cost of
capital).
f. When reviewing capital structure decisions, two basic models are
regularly used:
(1) When comparing two funding options, the EBIT‐EPS indifference
point is where the EPS will be the same no matter which financial
funding plan is employed. After the indifference point is met, EBIT in
excess of that amount will result in a higher EPS the more leverage
that is employed. An EBIT less than the indifference point will result in
a higher EPS the less leverage that is used. The tool can help
management determine whether more or less leverage should be
used based upon the likelihood of achieving a particular EBIT level.
The indifference point can be determined mathematically using the
following formula:
EPS with stock at level “a” = EPS with stock at level “b”

(EBIT – I)(1 – T) – P (EBIT – I)(1 – T) – P
=
S a Sb
Where:
I = Interest expense
T = Tax rate
P = Preferred dividends
Sa = Number of common shares using plan “a”
Sb = Number of common shares using plan “b”
(2) Firms often use ratio analysis to aid in capital structure decisions. For
example, an average company in the meat processing industry has a
debt‐to‐equity ratio of 2.17. If ABC Meat Processing Company has a
debt‐to‐equity ratio of 1.75, management may decide to use debt
financing for a proposed expansion. If, however, that same company
has a debt‐to‐equity ratio of 2.5, management may decide to use
equity financing instead. The whole idea here is for an organization to
keep their debt‐to‐equity ratio in line with the industry average.
g. Items that management may wish to consider when making capital
structure decisions would include the following:
(1) Financial flexibility: As the proportion of debt increases, the less
likely that additional debt will be available at a reasonable interest
rate; therefore, management tends to act on the conservative side
and use proportionally more debt increasingly sparingly.
(2) Tax position: Unlike dividends, interest expense provides a tax shield
for companies and will generally make debt financing less expensive
than equity financing.
(3) Interest rates: When interest rates are low, companies will look more
favorably on long‐term borrowing than when rates are high.
(4) Industry comparison: Lenders often will use industry averages as a
criterion when evaluating the creditworthiness of a firm, as will
potential investors.
(5) Internal funds: Companies will generally use internally generated
funds before seeking additional debt or issuing additional equity.
(6) Risk: The more debt a company has, the greater the financial distress
costs and the higher the risk for bankruptcy. Also, the higher the debt
level, the lower the potential credit rating. As a firm’s credit rating
drops, the cost of borrowing increases.
(7) Stock values: If a company’s stock is undervalued, management is not
likely to issue additional shares, since such an action could potentially
have a negative effect on an already low stock price. Using an
additional stock issue to raise necessary funds when a company’s
stock is overvalued stock, however, would be desirable.

Weighted‐Average Cost of Capital
2223.02 Weighted‐average cost of capital
a. The cost of capital is an important element in making investment
decisions, as projects with a higher rate of return than the firm’s cost of
capital will increase the value of the firm. The relevant cost of capital is
the firm’s long‐term cost of capital since we are evaluating long‐term
projects or investments.
b. The weighted‐average cost of capital is the weighted average of the cost
of debt and the various equity components of the firm’s capital structure.
It is preferable to use weights based on the market value of the items or
the firm’s target capital structure.
(1) The cost of debt for the issuing firm is based upon the required rate
of return for debt holders and the marginal tax rate for the issuing
company. Due to the tax shield associated with interest‐bearing debt,
the effective cost of the debt is lower than the interest rate paid due
to the reduction in the taxes paid.
Cost of debt = kd (1 – T)
Where:
kd = Cost of debt
T = Marginal tax rate
(2) Preferred stock provides the investor with a constant stream of
dividends; however, these dividends do not provide a tax shield since
they are not a deductible expense for the issuing company. The cost
of preferred stock to the issuing company can be calculated by
dividing the annual return (interest payment) by the net issuance
price for the preferred stock.

Dp
kp =
Pp
Where:
kp = Cost of preferred stock
Dp = Preferred dividend
Pp = Price of preferred stock

Generally, however, when looking at the cost of issuing new
preferred stock, the company would have to pay flotation costs to an
investment house; thus, the proceeds received by the company
would be less than the issue price. This would increase the cost of this
form of financing. Taking flotation costs into consideration, the
formula to calculate the cost of preferred stock to the issuing
company would be:

Dp
Kp =
(1 – f)Pp
Where:
kp = Cost of preferred stock
Dp = Preferred dividend
Pp = Price of preferred stock
f = Flotation costs
(3) The cost of retained earnings is the opportunity cost that
stockholders of a firm could earn elsewhere if they made investments
of comparable risk. This figure would need to be imputed.
(4) The cost of equity (ke) is more expensive than the cost of debt since
stockholders are subject to more risk than debt holders. There are a
number of ways to estimate the cost of equity, and one commonly
used method to obtain the estimate is the dividend growth model.
The formula used is:

ke = (D1  Po (1 – F)) + g
This formula assumes that the firm pays a future dividend per share
equal to D1, would issue new stock at price Po, and would pay a
flotation cost (F) that is equal to some percentage of the value of the
stock being issued. It is assumed that the firm’s dividend will grow at
a constant rate (g). The result is the cost of using internally generated
equity. If new stock is going to be issued, the cost of new equity
would be the result obtained for internally generated equity divided
(1 – Percent of flotation costs).
Illustration: The firm’s current dividend was $1.50 and is expected to
grow 6% per year. They expect to be able to sell new stock at a price
$30 per share and flotation costs are expected to be 10% of the value
of the stock issue. What is the firm’s cost of equity?

ke = (($1.50 × 1.06)  ($30 × (1 – 0.10))) + 6.0%
= ($1.59  $27.00) + 6.0%
= 5.89% + 6.0%
= 11.89%
c. Most analysts use the CAPM (capital asset pricing model) to estimate the
required return on a firm’s cost of equity. The basic equation for
estimating the required return on equity (Ri) is:

Ri = RF + βi (Rm – RF)

d. The primary conclusion of the capital‐asset pricing model (CAPM) is that
the relevant risk on any security is its contribution to the risk of a well‐
diversified portfolio. A commonly used benchmark portfolio for the
market portfolio is the S&P 500.
e. Illustration: Assume that the current T‐bill rate is 3.35% and the market
risk premium is 7% for a diversified market portfolio.

Ri = RF + β i (Rm – RF)
= 3.35% + 1.0 (7.0%)
= 10.35%
Under this scenario, investors would expect to earn 10.35% on a
diversified market portfolio. (Note: The beta coefficient for the diversified
market portfolio is 1.0.)
Given the information in the example above and assuming that the beta
coefficient for an individual security is 1.4, what return would investors
require to hold this security?
Solution: Using the formula from (c) above, that is, Ri = RF + βi (Rm – RF),
the return required by investors would be 13.15%. Again, this is the cost
of internally generated equity. The cost of issuing new stock would be the
cost of internally generated equity divided by (1 – Percentage of flotation
costs).

Ri = RF + βi (Rm – RF)
= 3.35% + 1.4 (7.0%)
= 13.15%
f. The weighted‐average cost of capital can be computed as follows:

WACC = (wtd  kd) + (wtpf  kpf) + (wte  ke)
Example: Assume that the firm can issue new debt at 5% and that the
marginal tax rate is 40%. The firm has $1,000 par preferred stock that
pays a dividend of 4%. Using the CAPM, it is estimated that investors
require a 16% return on equity investments. The firm has a target capital
structure of 30% debt, 10% preferred stock, and 60% equity. What is the
firm’s WACC?
Solution:

WACC = (.30  [.05  (1 – .40)]) + (.10  .04) + (.60  .16)
= .009 + .004 + .096
= .109 or 10.9%
2223.03 Optimal capital structure
a. Finance theory indicates that the goal for a firm should be to minimize its
weighted‐average cost of capital, and it can do so by achieving its optimal
capital structure.
b. The tax shield for debt makes debt a very attractive component of the
capital structure. However, increasing the amount of debt in the
structure beyond some point causes increasing financial distress costs
that would cause the cost of additional debt to climb. Theoretically, the
firm should continue to issue debt until the increasing financial distress
costs offset the positive value of the tax shield.
c. It is very difficult to accurately determine the optimal capital structure,
and in practice a firm attempts to find an optimal range of debt‐to‐equity
that would minimize the weighted‐average cost of capital.
d. Key elements in making capital structure decisions include the following:
(1) Sales stability: A firm whose sales are stable can take on more debt
than a firm with unstable sales.
(2) Asset structure: Firms with assets that are suitable to be pledged as
security for a loan can use debt more heavily than firms with special
purpose assets.
(3) Operating leverage: Firms with less operating leverage are better
able to employ financial leverage.
(4) Growth rate: Faster‐growing companies are more likely to rely more
heavily on debt.
(5) Profitability: Firms with high profitability are better able to support
more of their financing needs with internally generated funds.
(6) Taxes: The higher a firm’s marginal tax rate, the greater the
advantages of using debt.
(7) Management attitude: Management can exercise judgment as to the
appropriate capital structure.
e. As shown by the following graphs, the lower the firm’s weighted‐average
cost of capital (WACC), the greater the value of the firm since the WACC
is used to discount the firm’s expected cash flows. Thus, many firms are
concerned about creating a capital structure that minimizes its cost of
capital. As a firm moves from being an all‐equity firm (that is, with debt
equal to zero) to adding debt to the capital structure, the firm’s WACC
will begin to decline. This is true because debt is less risky than equity
(demanding a lower return) and debt has a “tax shield” in that the
interest cost is tax deductible. Therefore, adding debt to the capital
structure mix reduces WACC. This decline will continue until financial
markets perceive that the firm’s debt‐to‐asset (or equity) ratio has
reached a point where additional debt will increase the firm’s “financial
distress costs” (that is, the possibility of bankruptcy) and require a higher
return on the debt to compensate for the increased risk. At this point, the
firm’s WACC will begin to rise. A firm’s “optimal capital structure” is the
ratio that minimizes WACC; in the example found in Graph B it is found to
be 40%.

Graph A:

Graph B:

2224 Valuation of Financial Instruments
Valuation Fundamentals
2224.01 Fair value basics
a. As part of the FASB’s Convergence Project working with the IASB
(International Accounting Standards Board) as well as other standard‐
setting bodies to work toward compatible international reporting
requirements, the FASB issued Fair Value Measurements and Disclosures
(FASB ASC 820) to clarify the definition of fair value as well as to provide
guidelines for measuring fair value. Per this statement, fair value is
defined as “the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants
at the measurement date.”
b. Since the calculation of fair value assumes that the value determination is
for a particular asset, liability, or equity ownership, the following items
must be taken into consideration:
(1) Age and condition of the valuation object
(2) Attributes for the valuation object
(3) Ability of the valuation object to stand alone or the need to function
as part of a unit
(4) Location of the valuation object
(5) Restriction placed on the use or sale of the valuation object
c. In determining the price under a fair value assumption, the conditions
under which the hypothetical sale are assumed to occur would be orderly
and not under conditions of liquidation or distress. The seller would be
able to take advantage of normal market activities and would have the
ability to take enough time prior to the date of measurement to take
advantage of normal exposure to the market given the item being valued.

d. Under fair value assumptions, the hypothetical transaction is considered
to have occurred in either the principal market for the subject transaction
or, in the absence of such a market, in the most advantageous market for
that transaction. The principal market is considered to be where the
holder of the transaction asset or liability could locate the greatest
volume of similar transfers. The most advantageous market is considered
to be where either the sales price for an asset can be maximized or the
transfer costs for a liability can be minimized. Note that these
hypothetical transfers are considered from the perspective of the holder
of the asset or liability. Also, if there is a principal market for the subject
item, then the fair value measurement is determined using that market
even if the most advantageous market would yield a more beneficial
transfer for the holder.
e. The market participants to be considered when determining fair market
value are the actual holder of the asset or liability being valued and the
hypothetical buyer in the principal (or most advantageous) market.
Characteristics for both the buyer and seller would include:
(1) buyer and seller are not related parties (independence).
(2) both parties are knowledgeable about the item being transferred and
have access to usual and customary information.
(3) both parties have the ability to complete the transaction.
(4) both parties are willing to complete the transaction but are not being
forced to do so.
f. A fair value measurement assumes that the item being valued will be put
to the highest and best use resulting in the maximization of value that
would be physically possible, legally permissible, and financially feasible.
Note that the highest and best use is not determined from the
perspective of the current holder but by the hypothetical market
participants.
g. The fair value determination of an asset uses either an in‐use or an in‐
exchange premise. An in‐use premise assumes that the maximum value
from the purchaser’s perspective of the subject asset is when it is used in
conjunction with other assets as a group. An in‐exchange premise
assumes that the maximum value from the purchaser’s perspective of the
subject asset is when it is used alone.
h. The fair value determination of a liability assumes that the liability will
continue to exist after the transfer and maintain the same risk of
nonperformance after the transfer as before.
2224.02 Approaches to determining fair value
a. Fair value can be determined by using one of three different approaches.
The approach to be used is based upon the circumstances of the
particular asset, liability, business segment, or business entity to be
valued. The three approaches are the cost approach, the market
approach, and the income approach.
b. The cost approach to determining fair value is based upon what it would
cost to replace the subject item with an asset of like function and
capacity. This is similar to the economic substitution principle. Such items
as functional obsolescence, physical deterioration, and economic
obsolescence need to be taken into consideration. Note that book value
per GAAP using financial depreciation is not related to the fair value of an
asset.
c. The market approach to determining fair value uses market comparison
of identical or comparable assets or liabilities. A comparable is an item
that has reasonable and justifiable similarity to the subject item being
valued. This process is similar to that used by real estate agents in
determining a reasonable market price for a home.
d. The income approach to determining fair value uses the company’s
ability to create earnings or cash inflows and the risk involved in the
specific investment. Capitalization or discount rates are applied to the
benefit stream (earnings or cash inflows) in order to establish a value.
The theory behind the use of the income approach is that an investor will
require a particular investment to yield a benefit sufficient to recover the
initial cost of the investment as well as a return to offset the riskiness of
that investment. The higher the perceived risk, the higher the required
return. The income methods incorporate the use of discounted cash
flows. For example, future cash flows are estimated, and then those cash
flows are discounted to present value using a discount rate suitable to
reflect the risk of the subject investment. The income approaches require
a careful analysis of cash inflows and outflows, capital assets, capital
structure, the industry, and economic environment.
e. The method used to determine fair value should be based upon the
particular circumstance of the valuation as well as the data that are
available. In some cases, a single method will be used, and in others,
multiple methods. When multiple methods are used, the results should
be analyzed and weighted taking the range of the results into
consideration. An acceptable fair value measurement should be the point
that is most representative of the fair value given the particular
circumstances.
f. When measuring fair value over multiple periods, methods should be
used consistently; however, a change in methods is appropriate providing
the change results in an equally or more representative fair value under
the particular set of circumstances.
2224.03 Fair value hierarchy
a. FASB ASC 820 has grouped possible inputs used to determine value fair
into three groups (hierarchies) in an attempt to achieve consistency and
comparability. Note that it is the inputs that are classified as to the
preferred usage and not the methods or techniques used to determine
fair value. In determining fair value of a particular asset or liability when
inputs from two or more levels are used, then the fair value
measurement will be classified at the lowest input level that is significant
to those measurements. For example, if significant inputs from both Level
2 and Level 3 are used to determine fair value, then the fair value
measurement will be considered to be based upon Level 3.
b. Observable inputs are the most desirable ones to use when determining
fair value. Observable inputs are those that reflect the assumptions
based on market data obtained from sources independent of the
reporting entity used in pricing an asset or liability. When possible, it is
expected that more observable inputs will be used than unobservable
inputs.
c. Unobservable inputs are the least desirable ones to use when
determining fair value. Unobservable inputs are those based upon
assumptions developed using the best information available in the
circumstances reflecting the reporting entity’s own speculations used in
pricing assets or liabilities.
d. Level 1 inputs are observable and considered to be the highest level and
most desirable when determining fair value. Level 1 inputs would include
unadjusted quoted active market prices of identical assets. An active
market is where there is adequate trading to provide constant market
data.
(1) Generally accepted business valuation techniques often apply a
blockage discount to the quoted market price when valuing a large
block of stock, since it is assumed that the market price would drop if
a large block of stock was put on the market on a particular date.
FASB ASC 820 specifically disallows the use of such a blockage
discount.
(2) It is not unusual for a company to announce information that will
have a negative impact on market price at the end of the day or
shortly after the close of the market. If the quoted market price is
adjusted for the new information, then the fair value should be listed
at the lower price.
e. Level 2 inputs are considered to be the middle level when determining
fair value, and include such items as prices of assets or liabilities that can
be either directly or indirectly observed but do not include the Level 1
quoted market prices. Often market values of similar assets or liabilities
(as opposed to identical) are used to determine fair value. In such cases,
the degree of comparability must be determined, and often adjustment
must be made when determining fair value. A higher degree of
adjustment could cause the fair value measure to fall to a Level 3
category. Level 2 items would include such items as the following:
(1) Active market prices for similar assets or liabilities
(2) Available market prices for identical or similar assets or liabilities
when markets are not active
(3) Inputs such as interest rates, default rates, yield curves, and credit
risks
(4) Other market‐corroborated inputs
f. Level 3 inputs are unobservable and considered to be the lowest and
least desirable level when determining fair value.
(1) Level 3 inputs should be used to develop an exit price to represent
fair value from the perspective of the reporting entity.
(2) Level 3 inputs should reflect the reporting entity’s market
assumptions.
(3) Level 3 inputs should be based upon the best available information
that can be obtained without undue cost and effort.
2224.04 Disclosures needed when using fair value
a. Information needs to be disclosed related to fair value measurement
that:
(1) allows for enough information to be provided so that the user of that
information can do a fair assessment of the inputs used to develop
the fair value.
(2) provides enough information so that the use of significant
unobservable inputs (Level 3) can be assessed.

b. When a fair value measurement is done on a recurring basis, the
following information needs to be disclosed:
(1) The fair value measurement as of the reporting date
(2) The level within the hierarchy (Level 1 market information, Level 2
other significant observable inputs, and/or Level 3 significant
unobservable inputs) of the inputs used in the fair value
measurement
(3) Reconciliation of the beginning and ending balances when using
significant unobservable inputs (Level 3)
(4) The amount of the total gains or losses that are attributable to the
change in unrealized gains or losses still held at the date of
measurement
(5) The valuation method(s) used
(6) A discussion of any changes in valuation techniques, if any, within the
period
c. When a fair value measurement is done on a nonrecurring basis, the
following information needs to be disclosed:
(1) The fair value measurement as of the reporting date and the reason
for the measurement
(2) The level within the hierarchy (Level 1 market information, Level 2
other significant observable inputs, and/or Level 3 significant
unobservable inputs) of the inputs used in the fair value
measurement and a description of any Level 3 inputs used
(3) Reconciliation of the beginning and ending balances when using
significant unobservable inputs (Level 3)
(4) A discussion of the valuation method(s) used
2224.05 Other standards of value
a. In a valuation engagement, a standard of value is the identification of the
type of value being utilized. It is important that this standard be defined
before the engagement begins since different standards lead to
potentially different estimated values. Common standards include fair
market value, fair value, intrinsic value, replacement value, and
investment value. No matter how the standard of value is defined, the
potential exists to use any of the three generally accepted valuations
approaches (asset‐based, market, or income) in preparing the valuation.
b. Fair market value is probably the most common standard value used in
business valuation work. In the International Glossary of Business
Valuation Terms, it is defined as follows:
“The price, expressed in terms of the cash equivalent, at which property
would change hands between a hypothetical willing and able buyer and a
hypothetical willing and able seller, acting at arm’s length in an open and
unrestricted market, when neither is under compulsion to buy or sell and
when both have reasonable knowledge of the relevant facts.”
c. The differences between fair market value and fair value are quite
substantial:
(1) Fair market value implies a willing buyer and seller, whereas the
buyer and seller under fair value are not necessarily willing.
(2) Fair market value defines the seller as hypothetical, whereas there is
a specific seller when using fair value.
(3) Fair market value takes advantage of an unrestricted market, whereas
fair value uses the principal or most advantageous market.
d. Per the International Glossary of Business Valuation Terms, intrinsic value
is defined as follows:
“The value that an investor considers, on the basis of an evaluation of
available facts, to be the ‘true’ or ‘real’ value that will become the market
value when other investors reach the same conclusion.”
e. Per the International Glossary of Business Valuation Terms, replacement
cost new is defined as “the current cost of a similar new property having
the nearest equivalent utility to the property being valued.”
Reproduction cost new is defined as “the current cost of an identical new
property.”
f. Per the International Glossary of Business Valuation Terms, investment
value is defined as “the value to a particular investor based on individual
investment requirements and expectations.”
2224.06 Other valuation items
a. Valuations are often necessary for items such as a specific capital asset or
investment, a business segment, or a complete business. Accountants
have become increasingly involved in the valuation process, and the
AICPA has developed the Statement on Standards for Valuation Services
1 (SSVS 1), Valuation of a Business, Business Ownership Interest, Security,
or Intangible Asset, that became effective in 2008 to help provide
guidance to practitioners and promote consistency within the valuation
niche. Per the AICPA Professional Code of Conduct, a CPA should only
undertake a valuation engagement providing the individual (or firm):

(1) possesses a good understanding of valuation principles and theory.
(2) has the skill necessary to apply the theoretical knowledge.
(3) has the professional judgment necessary to develop a conclusion or a
calculation of value.
b. Beyond the identification of the subject of a valuation (asset, business
segment, entire business, etc.), the date of the valuation, and the
standard of value to be used, it is important to determine the premise of
value before initiating any work on the engagement. The International
Glossary of Business Valuation Terms defines the premise of value as an
assumption regarding the most likely set of transactional circumstances
that may be applicable to the subject of the valuation. For example, if an
entire business is being valued, is the entity considered to be a going
concern or in the process of liquidation?
c. There are two types of business valuation engagements outlined in SSVS
1:
(1) In a valuation engagement, the valuation analyst is free to employ the
use of any valuations approach or method that is professionally
deemed appropriate under the circumstances. The results are
expressed in terms of a conclusion of value and can either be a single
number or a range.
(2) In a calculation engagement, the valuation analyst and the client
agree upon the valuation methods and approaches to be used;
therefore, the analyst is not free to use any approach or method
available. The results are expressed in terms of a calculated valued
and can be either a single number or a range.
Valuation Assumptions
2224.07 Price, worth, and value
a. Price, worth, and value are three terms that are often used
interchangeably; however, they each have distinct meanings. It is
important to understand which of these three items is being considered
when evaluating assumptions used in valuations.
b. Price is the actual observed exchange price that is used in the
marketplace.
c. Worth relates to the advantages of ownership based upon the perceived
benefits at a particular point in time and for a particular use.
d. Value is based upon the amount that would be received in exchange for
an asset or settlement of a liability between willing parties in an arm’s‐
length transaction where both parties had acted with knowledge, with
prudence, and without compulsion.
When determining market value, assumptions are made about market
conditions, sellers, and buyers. The more assumptions made or the
greater the uncertainty related to those assumptions, the less the
confidence in the valuation results.
e. Valuation is based upon events yet to occur and is therefore dependent
upon various assumptions made during the valuation process. The use of
assumptions results in the risk that either the assumptions were incorrect
or that future events will not occur as assumed. It is crucial to carefully
examine any assumption used in the process of a valuation in order to
assess the validity of the valuation results.
2224.08 Premise of value
a. At the beginning of the valuation process, the premise of value must be
determined. Per the International Glossary of Business Valuation Terms,
the premise of value is defined as “an assumption regarding the most
likely set of transactional circumstances that may be applicable to the
subject valuation.”
b. The premise of value will be one of two situations—a going concern or
liquidation. For a going concern, the company will be expected to
continue operations into the future. This would include situations where
a company will have to reorganize due to such events as a past poor
business decision or a court judgment in order to continue. Companies
can falter, regroup, and continue. A company in liquidation will have its
assets sold or disposed of in some fashion and will ultimately discontinue
operations completely.
c. The first assumption that needs to be carefully reviewed in the process of
a valuation is the choice of the premise of value, due to the fact that
generally a going concern is worth more than an organization in
liquidation for the following reasons:
(1) When in liquidation, few if any additional receivables will be created,
and the receivables currently on the book may be difficult to collect
due to lack of staff and debtors trying to take advantage of a
liquidating firm. A going concern would continue to create and collect
receivables in the course of doing business.
(2) When in liquidation, inventories will likely have to be sold at
dramatically reduced prices if they cannot be returned, and if
returned, there is likely to be a high restocking charge. A going
concern would continue to purchase and sell inventory in the course
of doing business.
(3) When in liquidation, equipment on hand is not likely to be of the
most recent technology; therefore, any disposal price would tend to
be low. A going concern would continue to use the equipment on
hand to create products to sell.
(4) When in liquidation, leasehold improvements would be of no further
use and could not be sold. A going concern would continue to use
leasehold improvements.
(5) When in liquidation, no goodwill would exist. A going concern would
potentially continue to have goodwill associated with its good name,
reputation, and brand.
(6) When in liquidation, the costs of asset disposal and the
administration of the liquation process can be costly. A going concern
would not have any costs related to a liquidation process.
d. When the premise of value is liquidation, the valuator will assume that
historical records will provide little valuable information needed to
predict future inflows and outflows for the organization.
e. When the premise of value is a going concern, the valuator will generally
base future predictions at least in part on the firm’s historical
performance.
f. The assumption related to the premise of value must be translated into
estimates of future inflows and outflows.
2224.09 Due diligence
When evaluating assumptions used in a valuation of a particular asset,
business segment, or business, it is important to verify the assumptions
related the following items as appropriate:
a. Existence of physical assets and their value:
(1) A physical inspection should be performed.
(2) Inquiries should be made to possible liens and encumbrances.
(3) Inquiries should be made to determine that the physical assets are
suitable for their intended use.

b. Projections of future benefit streams (e.g., income or cash flow):
(1) All assumptions related to the prediction of revenue streams should
be examined for reasonableness, taking past trends, market share,
economic conditions, etc. into consideration. Sales forecasts are
affected by products produced, changes in product lines, changes in
markets, changes in promotion, changes in the competition, etc. Each
of these areas will require assumptions when predicting the future
that need to be potentially challenged for validity and evaluated for
reasonableness.
(2) The future of all product lines and/or projects should be reviewed for
the likelihood for future profitability. Profit margins are affected by
sales price of goods and services, physical capacity, human resource
capacity, union contracts, cost and availability of raw materials, etc.
Each of these areas will require assumptions when predicting the
future that need to be potentially challenged for validity and
evaluated for reasonableness.
(3) Past and future budgets should be examined for reasonableness of
cost relationships with both the revenue stream and working capital
requirements.
c. Existence of risk: All businesses operate in an environment filled with
risk. When valuing a business or business segment, it is important to
identify various risks that could have negative impacts on the subject of
the valuation such as general market risk, labor efficiency, attrition,
availability risk, supplier risk, and competitive risk. The higher the risk
level, the lower the value of the subject of the valuation.
2224.10 Assumptions using cost (asset) approaches for valuation
a. The cost basis valuation approach is used when liquidation is defined as
the premise of value or when the value for a firm is basically related to
the assets held such as a holding company.
b. Since the basic value determined using the cost approach is related to the
value of the assets including property, plant, and equipment, the use of
an appraiser is often necessary. Statement on Standards for Valuation
Services 1 (SSVS 1), Valuation of a Business, Business Ownership Interest,
Security, or Intangible Asset, issued by the AICPA, states that the
evaluation of the outside professional be based upon the following:
(1) The education, professional certification, license, or other indication
of professional competence
(2) The reputation and standing of the specialist among peers
(3) The knowledge and understanding of valuation concepts by the
specialist
(4) The experience of the specialist with like assignments
(5) The knowledge and experience of the specialist within the industry of
the subject company
2224.11 Assumptions using market approaches for valuation
a. Using the market approach, the value of an asset is based upon what
similar or comparable assets have recently sold for on the open market.
The difficulty is to find guideline companies (comparables) that are truly
comparable to the subject being valued. In the case of a business, it
would be impossible to find guideline companies reasonably similar in all
manners to the subject of the valuation.
b. There are data sources available containing information about publicly
and privately held companies that can be used to help find appropriate
guideline organizations. It is important that financials of the subject
company be free of GAAP errors and that the guideline and subject
company use similar GAAP choices such as a LIFO or FIFO inventory in
order for a valid comparison to be made.
c. Some key assumptions related to finding compatible guideline companies
would include the following:
(1) Diversification of operations: Are one or more products sold? A one‐
product firm cannot successfully be compared to those having a
variety of product lines.
(2) Markets served: Are one or more markets served? A firm serving only
a limited market cannot be effectively compared to those serving
many and varied markets.
(3) Geographic diversification: How diverse are the geographic regions
served? A firm only serving one particular metropolitan area cannot
be effectively compared to those serving all of North America or
international markets.
(4) Size of organization: A company with annual sales of $100,000
cannot be successfully compared to those with annual revenues over
$10 million.
(5) Operating leverage: A firm with a high degree of operating leverage
cannot be effectively compared to those with few fixed costs.
(6) Comparability of products (services) sold: A company producing
racing bikes cannot be reasonably compared to those manufacturing
bicycles for children.
(7) Financial leverage: A company with a high debt‐to‐equity ratio
cannot be successfully compared to those with low financial leverage.
(8) Liquidity: In order to be considered comparable, the subject company
and the guideline organizations should have similar liquidity ratios.
(9) Asset and debt management: In order to be considered comparable,
the subject company and the guideline organizations should have
similar asset and debt management ratios.
(10) Profitability: In order to be considered comparable, the subject
company and the guideline organizations should have similar
profitability ratios.
(11) Growth: In order to be considered comparable, the subject company
and the guideline organizations should have similar recent growth
patterns.
It is not unusual that, after evaluating the items listed above, few if any
guideline companies can be found.
d. One company does not make a comparable. In other words, if only one
publicly traded company can be found to have reasonable comparability
to the subject organization, then the market method cannot be use as an
appropriate valuation method. As a general rule, four to six guideline
firms need to be found in order to provide validity when using the market
valuation method.
2224.12 Assumptions related to normalization adjustments
a. Publicly traded organizations are required to follow GAAP, and there is a
great deal of oversight by various individuals or groups such as the board
of directors, the CEO, the CFO, and internal and external auditors. On the
other hand, smaller, private companies often do not follow GAAP
religiously, and it is not unusual for business owners of such firms to have
a mixing of business and personal expenses. In order to make
comparisons to guideline organizations or predict future benefit streams
to be employed when using an income approach to valuation, it is often
necessary to make normalization adjustments so that the comparisons or
predictions can be performed.
b. IRS Revenue Ruling 68‐608 provides guidance as to this normalization
process. Although this passage refers to one specific valuation method
(the treasury method), the direction as to the form that the financial
statement should take in order to perform an adequate valuation is valid
for all methods and approaches. The ruling states:
“The past earnings to which the formula is applied should fairly reflect
the probable future earnings. Ordinarily, the period should not be less
than five years, and abnormal years, whether above or below the
average, should be eliminated. If the business is a sole proprietorship or
partnership, there should be deducted from the earnings of the business
a reasonable amount for services performed by the owner or partners
engaged in the business.”
c. When doing a valuation, it may be necessary to adjust the financial
statements for the subject company when:
(1) it is necessary to compare non‐GAAP statements to guideline firms
that employ the use of GAAP.
(2) items that are not considered to be part of normal operations are
included in the financial statements of the subject company.
(3) items that are considered to be part of normal operations are not
included in the financial statement of the subject company.
(4) an unusual item not considered to be recurring is included in the
historical statements used to predict the future.
(5) discretionary items not considered to be normal business expenses
are included in the financial statements. These would include such
items as personal expenses run through the business, such as family
members on the payroll being paid above‐market wages for the work
done; personal vacations; and other items of a private as opposed to
a business nature.
d. The valuator may need to make normalization adjusts for one or more of
the following items:
(1) Nonoperating adjustments: The removal of nonoperating items
included in the historical financial statements that are not assumed to
be part of normal operations
(2) Nonrecurring adjustments: The removal of unusual, unexpected, or
infrequent items not likely to occur again from the historical financial
statements
(3) Comparability adjustments: Adjustment of the historical financial
statements to match GAAP choices of potential guideline companies.
For example, a company that used a LIFO inventory could not be
compared to one using a FIFO inventory.
(4) Discretionary adjustments: Adjustments to the historical financial
statements to include or remove items considered to be part of
normal operations. For example, it is not unusual for owners of small,
private companies to pay either excessive or below‐average salaries
to themselves. It is also common for personal expenditures to be run
through the business.
2224.13 Assumptions using income approaches for valuation
a. There are four basic assumptions that are crucial when using an income
approach to valuation:
(1) The prediction the future benefit stream used to establish value
(2) The number of periods in the projection
(3) The terminal value at the end of the projection
(4) The discount/capitalization rate used
b. When predicting a future benefit stream (income or cash flow), the
following assumptions need to be examined carefully since these future
benefit streams need to be accurately predicted in order to develop a
reasonable estimate of value.
(1) Historical growth patterns and whether they could be expected to
continue into the future
(2) Expectations as to actions expected to be taken by competitors
(3) Expectations as to future economic conditions that are likely to affect
operations
(4) The cost to innovate and remain competitive
(5) Expected capacity and the cost to enlarge capacity, if necessary,
including increases in net working capital
c. When using an income approach, a benefit stream for some number of
periods must be projected, which is then discounted to the present as
part of the value of the subject company. The further out the projections
go, the less likely it is that those projections will be accurate. Many
valuators do not like to use increasingly speculative projections going out
more than five years.
d. When using an income approach, the present value of the terminal value
at the end of the projection period used needs to be calculated. Here the
valuator must decide whether the company is expected to still be a going
concern at the end of the projection period before calculating terminal
value. If not, terminal value would be the present value of the liquidation
value of the net assets at the end of the projection period. If the
company would be expected to continue as a going concern at the end of
the projection period, then terminal value would be based upon the
projected cash flows during the first year of the terminal period, the
expected growth rate into perpetuity, and the discount rate. Obviously,
there are a number of assumptions that need to be examined closely.
e. A discount rate is the total required rate of return that an investor would
expect on an investment given the risk level inherent in that investment.
The discount rate (also known as the cost of capital) is extremely critical
in the valuation process since it is used to convert projected income
streams to present value. The higher the risk, the higher the discount
rate, and the lower the present value of the subject company. Discount
rates reflect the risk involved in a particular investment. Techniques used
to develop a discount rate include the capital asset pricing model
(CAPM), build‐up methods, and the weighted‐average cost of capital
(WACC). Again, many assumptions related to the development of
discount rates need to be examined closely.
2224.14 Assumptions using rules of thumb
a. Rules of thumb have been used for many years in relation to business
valuations. These are often based upon multiples or a percentage of
revenues, earnings, book value, some type of measurement such as
number of beds, number of rooms, number of tables, etc. These
calculations are quick and easy; however, they do not take specifics
related to a particular business into consideration since these rules of
thumb are based upon the general averages for an industry.
b. Statement on Standards for Valuation Services 1 (SSVS 1), Valuation of a
Business, Business Ownership Interest, Security, or Intangible Asset,
specifically states that a rule of thumb not be used as the method to set
value; however, it can be used as a reasonableness check for the results
achieved using other methods. The use of a rule of thumb can:
(1) show that the valuator is knowledgeable about the subject company’s
industry.
(2) support a valuation arrived at using another method with similar
results.
(3) support a valuation arrived at using another method with different
results along with arguments as to why the subject company is not
“average” within the industry.
2224.15 Evaluating use of various approaches
a. The use of an asset‐based (cost) approach for a valuation is appropriate
when the company:
(1) is in liquidation or is worth more in liquidation than as a going
concern.
(2) is particularly asset‐rich.
(3) has no income in recent years and future benefit streams cannot be
adequately predicted.
b. The use of a market‐based approach for a valuation is appropriate when
relevant guideline (comparative) data are available.
c. The use of an income‐based approach for a valuation is appropriate
when:
(1) a reliable benefit stream projection such as cash flow or income is
available.
(2) the projected future benefit stream is expected to differ significantly
from the past.
(2) a substantial amount of goodwill appears to exist.
d. It is not unusual in a litigated situation to have the choice of valuation
methods dedicated by the court.
2224.16 Financial decision models: Generally it is assumed that the company being
valued will continue to operate for the foreseeable future (i.e., is a going
concern). On the operating side of the business, the objective is to value the
earnings power and cash generation capability, while on the nonoperating
side, intangible assets (e.g., trademarks, customer brand loyalty, supplier
relationships, etc.) and nonoperating assets (e.g., financial interests in other
companies) owned by the company are valued.
Black‐Scholes
2224.17 Black‐Scholes (also called Black‐Scholes‐Merton) is a price variation model of
financial instruments that can be used to determine the price of a
European call option by incorporating five input variables: the current stock
price, the related stock option's strike price, the time to the option's
expiration, the risk‐free rate, and the volatility.
a. Assumptions: The model assumes that stock prices follow a lognormal
distribution given that asset prices cannot be negative; there are no
transaction costs or taxes; the risk‐free interest rate is constant for all
maturities; short selling of securities with use of proceeds is permitted;
and there are no riskless arbitrage opportunities.
b. Formula: The call option formula is calculated by multiplying the stock
price by the cumulative standard normal probability distribution function.
In both of the formulas below, S is the stock price, K is the strike price, r is
the risk‐free interest rate, and T is the time to maturity.
(1) The net present value of the strike price, multiplied by the cumulative
standard normal distribution, is then subtracted from the resulting
value of the previous calculation. In mathematical notation, C =
S*N(d1) ‐ Ke^(‐r*T)*N(d2).
(2) The value of a put option could also be calculated using the formula P
= Ke^(‐r*T)*N(‐d2) ‐ S*N(‐d1).
(3) The formula for d1 is (ln(S/K) + (r + (Annualized volatility)^2 / 2)*T) /
(Annualized volatility * (T^(0.5))). The formula for d2 is d1 ‐
(Annualized volatility)*(T^(0.5)).
c. The binomial model of pricing options is a variation of the Black‐Scholes
model. The binomial model incorporates the underlying security for a
period of time rather than a point in time. This is accomplished by
allowing for the specification of nodes, or points in time, during the time
span between the valuation date and the option's expiration date.
(1) The model reduces possibilities of price changes and removes the
possibility for arbitrage.
(2) With binomial option price models, the assumptions are that there
are two possible outcomes, hence the binomial part of the model.
The two outcomes are a move up or a move down.
(3) The major advantage to a binomial option pricing model is that it is
mathematically simple.
Capital Asset Pricing Model
2224.18 Capital asset pricing model (CAPM): The capital asset pricing model, also
called the security market line (SML), attempts to quantify the relationship
between investment risk and the rate of return on the investment. The
CAPM model assumes that the individual investment contains two types of
risk, and is primarily concerned with measuring the former:
1. Systematic risk: Market risks that cannot be diversified away; examples
include interest rates, recessions and wars.
2. Unsystematic risk (also known as specific risk): This risk is specific to
individual stocks and can be diversified away. In other words, it
represents the component of a stock's return that is not correlated with
general market moves.
2224.19 The return on an individual stock, or a portfolio of stocks, should equal
its cost of capital. The CAPM formula is as follows:
a. Risk‐free rate of return: A default‐free rate of return is estimated as the
rate of return on long‐term (i.e., 10 years) U.S. Treasury bonds.
b. Market risk premium: The market risk premium is the additional return
over the default‐free rate required for the average stock.
c. Rate of return estimates: The required rate of return is the default‐free
rate of return plus the beta times the market risk premium.
2224.20 Beta coefficients: CAPM assumes that the beta coefficient is the only
relevant measure of a stock’s risk. It measures a stock’s volatility (i.e., how
much a stock’s price increases or decreases compared to movement in the
stock market). If a given stock moves precisely as the overall market, it is said
to have a beta of 1.
Dividend Discount Model
2224.21 Dividend discount model (DDM): A procedure for valuing the price of a stock
by using the predicted dividends and discounting them back to the present
value. If the value obtained from the DDM is higher than what the shares are
currently trading at, then the stock is undervalued.
a. There are many variations in this procedure. The most common DDM is
the Gordon growth model (GGM), computed as follows:

Predicted dividend per share
Discount rate ‐ Dividend growth rate
b. Limitation: The model assumes a constant dividend growth rate in
perpetuity. This assumption is generally true for very mature companies,
but newer companies have fluctuating dividend growth rates in their
earlier years.

2230 Raising Capital
2231 Financial Markets and Regulation
2231.01 Financial markets, through various techniques and institutions, collect
savings and make these funds available to those who wish to borrow money.
Financial institutions have developed to collect, analyze, and disseminate
information relevant to the market, thus making the markets efficient.
a. Financial Intermediation: Specialized institutions affect the structure of
the transfer process. These institutions include banks, savings and loans,
pension funds, insurance companies, and credit unions.

b. Exhibit: The following illustration shows a simple model of the financial
intermediation process.
2231.02 Financial markets have been established to accomplish three major
functions: (1) to transfer funds from savers to users, (2) to provide a method
of liquidity for investors, and (3) to provide economic signals to financial
managers.
a. Transfer Funds From Savers to Users: As an individual, it would be very
difficult to find a buyer for a particular financial security. Financial
markets facilitate the transfer of funds from savers to users.
(1) Sale of Securities: The issuance of long‐term stocks and bonds by
corporations are facilitated through investment bankers. They advise
the company, bear some of the risk of selling the securities, and
actually sell the securities being issued.
(2) Sale of Short‐Term Debt: Dealers help with the placement of short‐
term debt securities to be issued by corporations. These dealers act in
the same fashion as investment bankers do in the issuance of long‐
term securities.
b. Provide Liquidity: Investment liquidity represents the ease of which
securities can be converted into cash without incurring losses in value.
Financial markets give investors a means of converting securities into
cash in a short period of time. Stockbrokers are used to buy and sell
previously issued securities in the financial markets. This resale market
increases the liquidity of investments.
c. Provide Economic Signals: The buying and selling of securities can
indicate the future economy. For example, if financial managers feel that
a recession is likely, they will sell their investments to increase funds
necessary to help them through the recession. They will attempt to do
this prior to the start of the recession to avoid losses from sale. The sale
of securities can then signal the possibility of changes in the economy.
2231.03 Types of Markets and Exchanges: In order to raise capital, companies often
sell new stocks and bonds in the primary securities markets. These markets
are regulated by federal and state laws to reduce the possibility of fraud and
misrepresentation. After securities have been issued they trade among
investors in the secondary market.
a. Primary Market – Initial Public Offerings (IPO):
(1) Investment Banker: Corporations generally receive assistance from
investment bankers in the initial sale of their shares.
(2) Federal and State Law: Before a company can issue securities in the
primary market it must comply with a number of federal and/or state
regulations.
(a) Federal Regulation: The Securities Act of 1933 requires
registration and public disclosure of all relevant information
pertaining to the issuance of new securities. Under this act,
companies are required to prepare (1) a registration statement
(Form S‐1) to be filed with the Securities and Exchange
Commission (SEC) and (2) a prospectus to be delivered to
investors prior to their purchase of the securities.
(b) State Registration: A sale with both the issuing corporation and
all the shareholders in one state is regulated by the security
agency of the state government. This is often referred to as a
“blue sky” offering. Unlike the disclosure emphasis of the SEC, the
state agency may look at the merits of the offering.
b. Secondary Market: The secondary market was established to facilitate
on‐going trading among investors. Companies register with an exchange
and a specialized trader‐dealer is appointed. Examples are the New York
Stock Exchange or the over‐the‐counter (OTC) market. The OTC market is
computerized and regulated by the National Association of Securities
Dealers (NASDAQ).
(1) Liquidity Objective: Secondary markets give liquidity to investments
by providing a means of buying and selling securities with other
investors. The Exchange’s trader‐dealer is charged with maintaining
an orderly and stable market in the security.
(2) Market Price: The market value placed on a share of stock reflects
the evaluation investors place on the financial decisions made by
management (investors’ expectations of the future profitability of the
firm). The prices of individual stocks are also affected by the general
price level of the securities markets. The Dow Jones Industrial average
and Standard and Poor’s 500 Index are two indicators of the behavior
in the stock market.
c. Debt and Equity Markets: Financial markets can be classified as either
debt securities or equity securities. Transactions dealing with debt, such
as bonds, are dealt with in the debt market. Those dealing with the
issuance or resale of common stock are done in the equity market. The
trading of securities are done on organized exchanges and in the over‐
the‐counter (OTC) markets.
d. Money Market: The capital market deals in securities with maturities
greater than one year. The money market is used for trading securities
with maturities of one year or less.
(1) Importance of the Money Market: The money market is important
for the transfer of short‐term funds.
(a) Raise Funds: It allows companies to sell short‐term debt to raise
funds.
(b) Invest Excess Cash: Companies are able to invest excess cash in
short‐term money market securities.
(2) Characteristics of Money Market Instruments: The money markets
trade in debt securities which have short‐term maturities, there is
minimal risk of default, and the expected rates of return are relatively
small.
(3) Types of Money Market Instruments: There are several money
market instruments including treasury bills, U.S. agency securities,
commercial paper, negotiable certificate of deposits, banker’s
acceptances, and federal funds.
(a) Treasury Bills and U.S. Treasury Securities: The market for U.S.
treasury securities is the largest part of the money market. These
securities have maturities from 13 to 52 weeks. T‐bills have
almost no default risk and excellent liquidity and therefore carry
relatively low returns. Short‐term debt securities issued by
agencies of the U.S. government (such as the Federal Home Loan
Mortgage Corporation and the Federal Land Bank) offer an
investment standing similar to T‐bills with almost as low a yield.
(i) Investment Yield: T‐bills are purchased at less than face value
(discount) by investors who receive the face value at maturity.
The annual investment yield uses 365 days in a year and is
calculated as follows:
Discount from Face (Face Value – Purchase Price) 365
or ×
Purchase Price Purchase Price Days to Maturity

Example: A $10,000 face U.S. Treasury bill trades in the market
for $9,790.25 and matures in 85 days. The annual investment
yield is calculated as follows:
$10,000 – 9,790.25 × 365 = 209.75 × 365
Yield =
9,790.25 85 9,790.25 85

= .0214244 × 4.2941176 = .09199 or 9.2% per year
(ii) Discount Yield: When dealers buy and sell T‐bills, they do so at
a discount based on a 360‐day year. The calculation of the
discount yield is similar to the calculation of the investment
yield.

Discount from Face Face Value –Purchase Price 360
Annual Discount Yield = = ×
Face Value Face Value Days to Maturity

Example: A $10,000 face U.S. Treasury bill has 85 days to
maturity. The discount yield asked by the dealer is 8.75%. What is
the purchase price asked for the security?
Answer:
= 10,000 – P 360
.0875 ×
10,000 85

10,000 – P
.0875 = × 4.2352941
10,000

.0875 10,000 – P

=
4.2352941 10,000

206.59722 = 10,000 – P

P = 10,000 – 20659722 = 9,793.40

(b) Commercial Paper: Commercial paper is short‐term promissory
notes issued by corporations and is an alternative to borrowing
from a bank.
(i) Characteristics: Commercial paper is generally issued by
finance companies (such as General Motors Acceptance
Corporation) and banks. Commercial paper is unsecured and
either placed directly with large purchasers or sold through
dealers. Maturities on commercial paper generally range from
30 to 270 days and are issued at a discount usually in
$100,000 denominations. Because of its higher risk than T‐
bills, commercial paper requires a higher rate of return. The
annual investment yield on commercial paper is calculated the
same way as for T‐bills. The secondary market for commercial
paper is fairly weak.
(ii) Calculation of Interest Cost: The exam may require the
candidate to calculate the annual interest cost of commercial
paper or to compare the cost to some other source such as a
bank loan.

Cost of commercial paper Costs incurred by using commercial paper
=
Net funds available from commercial paper
Example: Fancy Flow Inc. can issue three‐month commercial
paper with a face value of $1,000,000 for $980,000. Transaction
costs would be $1,200. The annualized percentage cost of the
financing would be:
Answer:
(20,000 + 1,200) 21,200
× 4 = × 4 = 8.65%
$1,000,000 – (20,000 + 1,200) 978,800

Example: Great Expectations, Inc. will need $4 million over the
next year to finance its short‐term cash requirements. The
company could sell $4 million of 90‐day maturity commercial
paper every three months at a rate of 7.75%. The dealer’s fee to
place the issue would be an initial annual 1/8% and will require
Great Expectations to maintain a $400,000 compensating balance.
Calculate the annual effective cost of this financing alternative for
each quarter of the year and the total annual effective cost.
Answer: Cost of commercial paper in the first quarter
Cost of issuing commercial paper:
Interest ($4,000,000 × .0775 × ¼) $77,500
Placement Fee ($4,000,000 × .00125 5,000
Total First quarter cost $82,500

Funds available for use:
Funds raised $4,000,000
Less: Compensating balance $400,000
Less: Interest and placement fees 82,500 482,500
Net funds available in first quarter $3,517,500

Cost of commercial paper in the first quarter = $82,500 = 2.345%
$3,517,500

Cost of issuing commercial paper for other quarters:
Interest ($4,000,000 × .0775 × 1/4) $77,500

Funds available for use:
Funds raised $4,000,000
Less: Compensating balance $400,000
Less: Interest and Placement fees 77,500 477,500
Net funds available per quarter $3,522,500

Cost of commercial paper for other quarters = $77,500 = 2.2%
$3,522,500

Total annual effective cost of commercial paper:
Effective cost = 1st quarter cost + 3 (cost of 2nd, 3rd, 4th qtrs.)
= .02345 + 3 (.02200)
= .02345 + .06600 = .08945 = 8.95%

(iii) Annual Investment Yield: The exam may ask the candidate to
calculate the annual yield of commercial paper based upon the
investment. The calculation is the same as for T‐bills. The formula is:
Discount from Face or Face Value – Purchase Price × 365
Purchase Price Purchase Price Days to Maturity

Example: Pete Moss, financial manager of Golden Gardens, Inc., is
planning to buy $100,000 of commercial paper from Primary
Finance Company for $96,500, a discount of $3,500. The paper
matures in 120 days. What is the annual investment yield on the
commercial paper?
Answer:
100,000 – 96,500 365 3,500 73
× = ×
9,6500 120 96,500 24

= 0.0362694 × 3.0416667 = 0.11032 = 11.03%

(c) Negotiable Certificate of Deposit: A negotiable certificate of
deposit (CD) is a claim against funds that have been deposited in a
bank. The bank issues a CD for the amount of the deposit plus
interest at a specific rate for the specified period of time. CDs are
traded among securities dealers in the secondary market and are
generally denominated at $100,000 and above.
(d) Banker’s Acceptance: A banker’s acceptance is a draft drawn on
deposits at a bank. This may be issued by an importer’s bank to
guarantee payment of a foreign exporter’s invoice for goods. An
acceptance trades in the secondary market at a discount. This is
similar to a letter of credit except letters of credit do not have a
secondary market.
2231.04 Rating Agencies:
a. Types of Agencies: A financial management accountant may consult
rating agencies to assist in making investment decisions for listed
securities. There are numerous rating services that are available to
investors or portfolio managers. These can be classified by the nature of
the agency.
(1) Brokerage Firm Analysts: Almost all the larger private brokerage
firms have their own research department. Such firms often have
specialists who focus on and follow particular industries and firms.
Free newsletters to clients is the usual way such a firm disseminates
information. Brokerage firms receive their revenue from the
commissions on their client’s trades.
(2) Private Stock Analysts: There are also a number of private firms that
are not involved in stock transactions. Firms such as Value Line or
Fitch Investor Services offer yearly services to investors for a
subscription fee. These firms’ analysis tends to be more quantitatively
oriented. Many argue that their advice is more objective because
they do not underwrite offerings or receive commissions resulting
from their recommendations.
(3) Private Bond Rating Agencies: There are a number of independent
rating agencies that focus primarily on debt instruments. Their
independence ‐ like the private stock analysts ‐ creates the likelihood
of a more objective evaluation.

b. Actual Services: Most serious portfolio managers subscribe to one or
more independent services since they may quantify the subjective
analysis inherent in the role of a risk‐return manager. The most widely
known rating agencies are probably Standard & Poor’s, Moody’s and Duff
& Phelps’. These agencies tend to rate all traded bonds using a uniform
rating system. There are also numerous rating agencies that specialize in
particular industries.
c. Variables: At base, most agencies focus on two variables: quality and
default risk.
(1) Quality: While return is important to a portfolio manager, the quality
grade is almost always inversely related to the risk. Debentures with
speculative quality must pay investors a higher return (or interest
rate) than high or medium quality issues.
(2) Default Risk: The quality‐risk rating in descending order is AAA, AA
and A, which indicates the best quality, high quality, and upper
medium grade respectively. BBB, BB, and B indicate medium grade,
speculative issues, and very speculative (with little protection against
future default). CCC, CC, and C are issues in poor standing and may be
in default. D issues are in default.
d. Portfolio Manager’s Use: A corporate treasury function will involve
investing excess working capital in marketable securities.
(1) Investment Policy: The corporate investment policy will often specify
a diversification requirement. It may also dictate a minimum
investment grade for each security on an overall average basis. For
example, a federally chartered financial institution must now limit the
quality of bonds in which they can invest to BBB or above. Similarly
corporate decision makers may put such limits on the portfolio
managers.
(2) Use and Loss Justification: Managers often follow the publications of
a number of rating agencies as resources in making portfolio
decisions. In addition, a security loss may be more easily justified if
the purchase was based upon a rating agency’s standards and advice
rather than a manager’s own personal subjective judgment. The more
support for the decision, the better.

2231.05 Foreign Security Markets: Foreign companies have long sought U.S. security
markets. U.S. companies are now considering foreign security markets as a
place to list stock and raise capital. The U.S. capital markets in 2000
represent less than 40% of the total world capitalization. This is down from
65% in 1970.
a. Variables: There are three basic variables facing an issuer of securities
contemplating an offering on any exchange. Most domestic U.S. markets
do not have much variation in these three items. There is much more
variation on foreign exchanges. The three factors are flotation costs,
necessary yields, and capitalization factor.
(1) Flotation Costs: First, is the flotation costs. On large exchanges such
as the London, Tokyo or Hong Kong market the cost efficiency is close
to the U.S.
(2) Necessary Yields: Second, is the expected return or yield investors
will demand, which includes dividends on stock or the interest paid
on notes and bonds. Unlike the Dow, where the 10 highest‐yielding
stocks pay below 4%, the highest yielding issues in Hong Kong or the
United Kingdom pay better than 5.5%. In contrast, a U.S. corporation
may find issuing U.S. dollar denominated bonds outside the country
will lower their interest cost.
(3) Capitalization Factor: Third, is the market capitalization factor. This is
the quality multiple the market places upon a company’s earnings. In
the U.S., Standard & Poor’s 500 stock’s earnings are capitalized at
about 25 times; on the Tokyo exchange the rate is nearly 40.
b. Objectives: Everything else being equal and disregarding market liquidity
or volatility, management should have two objectives in picking a
jurisdiction in which to issue new securities.
(1) Lowest Cost: First, is the lowest overall cost of capital. Because the
required dividend yield may be higher outside the U.S. this favors
enterprises listing on U.S. exchanges.
(2) Highest Capitalization: It may be in the stockholders’ best interest to
own shares on an exchange that has a higher capitalization rate; this
favors some foreign exchanges.

b. Examples:
(1) American Depository Receipts: ADRs are foreign shares which are
bundled together and traded on a U.S. stock exchange. This bundling
is done by brokerage firms or banks and is useful to foreign
companies interested in lower dividend yields and increased liquidity.
(2) Euro or Asia Bonds: These are U.S. dollar designated debentures
issued in a foreign country. The advantage is that interest rates may
be lower in foreign countries than in the U.S and the cumbersome
SEC filings may be avoided.

2232 Market Efficiency
2232.01 Two Factors
a. Efficiency: Markets are efficient when 1) prices respond quickly to new
information, 2) successive trades are made at prices close to preceding
trades, and 3) the market can absorb large amounts of securities without
changing the price significantly. The closer the market adheres to the
above three items, the more efficient the market becomes.
b. Liquidity: To be efficient, the market must be liquid (a measure of how
quickly a security can be converted into cash). Markets become liquid if
continuous trading occurs with a large number of traders. Lower costs of
buying and selling enables more people to enter the market.
2232.01 Efficient Capital Markets: In efficient capital markets, expected cash flows
and required rates of return are used to determine the intrinsic value of
securities and its ultimate price. In large open markets such as the New York
Stock Exchange, intrinsic value and market price have been determined to be
the same; this is an efficient market. The market becomes efficient because
all information available to investors is utilized in the determination of the
market value.
a. The Efficient Market Hypothesis: This hypothesis asserts that security
prices not only reflect all known information but also all that is expected.
Based on various types of information, three versions of the hypothesis
have been developed.
(1) Strong‐Form Efficiency: This hypothesis asserts that all information is
reflected in the current market price. This includes even the use of
insider information not available to outside investors. This means that
corporate officers and other insiders will not be successful in using
privately held information to make abnormally higher returns on
investments of their own. Most authorities believe this is not realistic
for most companies.
(2) Semistrong‐Form Efficiency: This form assumes the current market
price of stocks reflects only all publicly available information. This
information includes stock prices, dividends, earnings, and data
contained in the company’s financial statements released to the
public. Semistrong‐form efficiency implies that analysis of publicly
available economic and financial factors affecting the corporation will
not help an investor since the market has already used that
information in determining the stock price. Insider information is
excluded, so insiders have some advantage.
(3) Weak‐Form Efficiency: The assumption is that the market price of
securities only reflects past price movements and rates of return.
Studying stock price trends, such as in technical analysis, will not help
in determining undervalued stocks.
b. Probable Actual Market Condition: The most widely accepted
hypotheses are the weak‐form and semistrong‐form of efficiency. This
means that there must be publicly available information that if properly
researched or used by insiders, will lead to abnormal returns. Abnormal
returns exceed the return justified by the risk of the investment.

2233 Financial Institutions
2233.01 Overview
a. As discussed earlier, financial leverage is created through the use of debt.
If the firm has superior profits (excess return on total assets above the
cost of debt), the return above the cost of the debt accrues to the
shareholder. Thus assets financed through debt can provide increased
worth to the stockholder. Borrowed funds generally require a fixed
payment (interest) so debt holders cannot share in superior profits after
receiving the necessary interest payments.
b. Financial structure (use of debt and equity) is influenced by:
(1) management’s attitude toward risk.
(a) Smaller firms are not likely to want to use additional equity sold
to new shareholders as a source of financing due to the diluting
effect; however, large firms generally will not be opposed to
selling additional stock since a stock sale will have little effect on
company control.
(b) A small firm may be reluctant to use debt as a source of funds due
to the extreme risk that failure of one product or a slight down‐
turn in the economy may have on cash flow. Default is more likely
in a small firm than a large one.
(2) the industry norms.
Debt service is related to sales volume and the control of costs
leading to profitability. Growth industries tend to have high profit
margins. Mature industries tend to have stable sales and profit
margins. Lenders are concerned about a specific company’s ability to
make necessary payments. Generally, debt holders will not lend funds
to a firm that has a debt to equity ratio above the normal range for
the industry or a times interest earned ratio below the normal range
for the industry without higher interest rates to compensate for the
additional risk. Lenders are particularly interested in an organization’s
solvency ratios as compared to the industry norms when deciding
whether additional funds should be lent to the firm in question.
(3) the anticipated future growth rate.
If new financing is used to expand, it is important to estimate the
future growth of sales in order to determine whether cash flows
resulting from the new productive assets will create a cash flow large
enough to service the debt.
(4) lenders’ attitudes toward the industry and the specific firm.
Lenders’ attitudes play an important role in capital structure. As
lenders become concerned about rising debt levels, they will either
demand higher interest rates to compensate for the additional risk, or
they may refuse to lend the necessary funds. A firm’s ability to grow
may often be limited to the funds available through the use of debt.
c. Whenever additional long‐term funds are needed, management can
choose between debt and equity. Long‐term debt is likely to be used
when:
(1) sales and profits are estimated to be stable or increasing.
(2) anticipated profits are sufficient to make good use of leverage.
(3) control (through voting privileges) is important.
(4) the existing capital structure has a low use of debt.
(5) requirements or covenants of debt issues are not arduous.

2233.02 Financing approaches
a. Assets are generally divided into current and long‐term, or permanent
assets. Current assets can be further divided into:
(1) temporary current assets that would include assets that would
fluctuate with the business cycle as sales vary with the corresponding
changes in the levels of accounts receivable and inventory between
the maximum and minimum levels over the annual business cycle.
(2) permanent current assets that would include assets that are more
permanent in nature in that they are carried even at the low points of
the business cycle such as the minimum accounts receivable and
inventory levels during the lowest part of the business cycle.
b. The conservative approach to financing short‐term debt uses permanent
assets to finance all of the permanent operating assets requirements and
also some of the seasonal needs. Spontaneous credit (accounts payable)
is used to finance the remaining seasonal needs. A firm using this
approach would hold liquid assets in marketable securities during the low
points of the seasonal cycle.
c. The maturity matching approach to financing matches assets to liability
maturities. This approach minimizes default risk and is considered to be a
moderate approach to financing.
Illustration: If a new factory is financed with short‐term funds, it is
unlikely that the new facility would have been built and produced a large
enough cash flow at the end of one year in order to repay the loan at
maturity. In this scenario, if the lender refused to renew the loan, the
company would be in a difficult position. If the new facility had been
financed with long‐term debt, the cash flows provided by the new
operation would have more closely matched the repayment cash
outflows, and the need for refinancing is less likely to arise.
d. The difficulty with maturity matching is that imperfect estimates are used
in determining the lives of assets. In reality, firms tend to attempt to
develop a reasonable approximation of matching. Also, it is necessary to
have some percentage of the financing come from equity that has no
maturity.

e. The aggressive approach to financing short‐term debt would be to
finance part of the permanent current assets with spontaneous credit
such as accounts payable. The aggressive approach can be carried to a
high degree by also financing part of the fixed assets with short‐term
borrowing. Such a firm would be at risk if interest rates increase as well
as face possible difficulties with loan renewals. The degree of
aggressiveness is defined by the degree to which permanent NOWC (net
operating working capital) and fixed assets are funded by spontaneous
credit and/or short‐term debt.
2233.03 Financing sources
a. The right side of the balance sheet represents the sources of funds used
to finance a company. These sources are:
(1) short‐term debt.
(2) long‐term debt.
(3) preferred stock.
(4) common stock.
(5) retained earnings.
b. When considering each of the above types of financing, management
must consider:
(1) cost.
(2) risk.
(3) the lender’s (owner’s) point of view of the investment alternatives.
Short‐Term Debt Financing
2233.04 Types of short‐term debt:
a. Spontaneous financing created through the use of accounts payable and
accruals generated in the course of doing business
b. Unsecured bank loans
c. Commercial paper
d. Secured loans

2233.05 Spontaneous financing
a. Accounts payable and accruals provide instant financing at no cost for a
firm. For example, employees provide continual services and are paid
only at set intervals. In a sense, employees provide the equivalent of
small loans to the company.
b. Trade credit is an appealing source of financing since it is free; however,
the length of this credit is only for a very limited time.
c. On occasion, vendors will offer discounts for prompt (early) payment of
obligations. Not taking advantage of these offers is a particularly
expensive form of short‐term financing. For example, if a vendor offers
1/10, net 30, this means that a 1% discount can be taken if the invoice is
paid within 10 days as opposed to 30 days, but this is 1% discount for
only paying 20 days earlier than required. This rate can be converted to
an effective annual rate by using the following formula:

Days in year 365
= × 1% = 18.25%
Lost trade credit days by taking discount 20
Thus, if a company can borrow funds for less than 18.25% in order to take
advantage of a prompt payment discount, it is in the firm’s best interest
to do so.
2233.06 Unsecured bank loans
a. Unsecured loans are not backed by any collateral and come in a variety
of forms.
b. A line of credit is an agreement with a bank to have up to a specific
amount of funds available as a short‐term loan during a particular period.
If the line of credit is for $100,000, a firm can borrow $20,000 in January,
borrow an additional $35,000 in May, repay $40,000 in July, and borrow
$50,000 in September, etc. As long as the total amount borrowed at a
given point in time remains under $100,000 during the period of the
agreement, the firm will continue to have access to additional funds.
Interest is usually paid monthly and calculated on the average
outstanding balance during the period. This method of financing allows a
firm to smooth out its cash flow cycle as well as to have funds available
for possibly both precautionary and speculative needs.
The use of the line of credit affects both current assets and current
liabilities equally. They increase and decrease in a parallel fashion.
However, as long as the current ratio is greater than one, an increase in a
line of credit (increase to cash and an increase to current liabilities) will
decrease the current ratio.
Illustration: A firm has $100,000 of current assets, $50,000 of current
liabilities, and a current ratio of 2 to 1 ($100,000 ÷ $50,000). If $25,000 is
borrowed on the line of credit, current assets will increase to $125,000,
current liabilities to $75,000, and the current ratio will become 1.7 to 1
($125,000 ÷ $75,000).
c. A variation on the line of credit is the revolving credit agreement that is
generally used by large corporations. This is an agreement by a bank to
extend credit to a company over a specified period of time; however, if
the firm does not make use of the revolving credit, there still is an annual
commitment fee. For example, the approved revolving credit could be for
three years to allow a corporation to borrow up to $50 million. Even if
the company does not use any of the credit during the year, it will still
have to pay a significant commitment fee expressed in terms of a percent
(for example, a quarter of 1% or $125,000 annually in the above
illustration). If the corporation borrows $25 million on the revolving
credit agreement, the commitment fee would drop to a percent of the
unused portion of the agreement ($62,500 in this illustration), and the
corporation would pay interest on the outstanding borrowed balance as
well. The biggest difference between a line of credit and a revolving
credit agreement is that there is a legal obligation with a revolving credit
agreement that does not exist with a simple line of credit. This legal
obligation guarantees the company access to the funds over the life of
the agreement.
d. A letter of credit is an international financing tool that guarantees
payment to an international supplier upon the safe arrival of the goods
by issuing a loan to the purchaser. A letter of credit can be irrevocable
(not subject to cancellation if the specific conditions are met) or
revocable.
e. Commercial paper is an unsecured promissory note that is issued by
large banks and big corporations to meet short‐term cash needs. It is a
promise to repay the borrowed funds at a future given date with a
maturity of no more than 270 days. Rates for these loans are normally
lower than for bank loans. This financing option is considered to be quite
safe due to the short time frame and the strength of the borrowing
companies; however, there is no flexibility in the repayment date as
might be received with a bank loan.

2233.07 Secured loans
a. Short‐term credit is often secured by current assets such as receivables
and inventory, and is often used by seasonal businesses where cash flow
and working capital needs are not synchronized.
b. Pledging of receivables entails using the cash value of the receivable as
collateral for a loan. In this case, the borrowing company agrees to remit
the cash received from the collection of particular receivables as
repayment of the loan; however, the receivables continue to be owned
by the borrowing company, and if a particular receivable proves to be
uncollectible, the borrowing company is still liable for the repayment of
the loan. Interest rates for these loans can range from 2% to 5% over
prime, often with a fee equal to 1% to 2% of the receivable pledged.
c. Factoring involves selling accounts receivable to a factor as a form of
short‐term financing. The factor assumes the risk of collection, and the
purchaser is notified of the factoring arrangement and usually remits
payments directly to the factor. (In some instances, factoring can be done
with recourse.) Since the risk is shifted to the factor, the factor will take
over the responsibility of doing the credit check on a potential customer.
Therefore, functions performed by the factor include credit checks,
lending, and bearing of default risk. Generally, the selling firm receives
funds from the sale immediately upon shipment of goods to the
purchaser. The amount received is the full amount of the sale less a
factor fee (usually some percentage of the total sale). The fee
incorporates a reserve for sales returns and allowances, interest costs,
and profit for the factor. At the end of a specified period, the reserve
amount is paid to the seller, providing there have not been sales returns
and allowances in excess of the reserve assumed in the factoring
agreement. It is not uncommon for factoring arrangements to be
ongoing.
Illustration: A company sells $50,000 of goods with the terms net/30. The
receivable is immediately factored with a 3% factor fee, 10% interest, and
a reserve of 8%. How much does the selling firm immediately receive
from the factor?
Solution: The factor fee will be $1,500 (3% of $50,000). The reserve will
be $4,000 (8% of $50,000). The interest will be calculated on 10% of the
balance available to the seller and adjusted for a monthly period length.

This can be summarized as follows:

Sales: $50,000
Less:
Factor fee (3% × $50,000) $1,500
Reserve (8% × $50,000) 4,000 5,500
Amount due firm 44,500
Less interest on amount for
30 days (10% × $44,500 × 30/360) 371
Amount paid to seller $44,129
After 30 days, any remaining part of the reserve (maximum of $4,000 in
this case) that was not absorbed by returns and allowances will be
remitted to the seller.
The cost of factoring needs to be compared to the costs of running a
credit department when making a decision as to which alternative to
pursue.
d. Inventory financing entails the use of inventory as security for a short‐
term loan. Such a loan can attach to all inventory held or a particular
portion of inventory identified by serial numbers or placed in a particular
location.
2233.08 Advantages of short‐term debt financing
a. A short‐term loan can generally be obtained quickly.
b. The cost of obtaining short‐term debt is generally low since the lender
tends to only do a minimal financial examination of the firm applying for
funds. Spontaneous credit has no cost.
c. There are generally no prepayment penalties.
d. Short‐term debt often provides flexibility for management as it generally
has few restrictions.
e. Since the yield curve is typically upward sloping, short‐term interest rates
are generally lower than long‐term interest rates.
f. Interest expense is tax deductible and, therefore, provides financial
leverage.
g. Accounts payable is a primary source of short‐term debt and it is
spontaneously created when inventory is purchased.
2233.09 Disadvantages of short‐term debt financing
a. Short‐term interest rates can vary widely over time, subjecting the firm to
refinancing risk.
b. An unexpected need for cash during a recession could cause cash flows to
be insufficient to meet the short‐term obligations.
c. Due to changing financial conditions, short‐term debt may not be
renewable and thus, depending upon the level of short‐term debt, may
put a firm in an illiquid position that could lead to bankruptcy.
d. On occasion, compensating balances are required when unsecured debt
is received. This increases the effective cost of that debt.
Long‐Term Debt Financing
2233.10 A term loan is a legal agreement between a borrower and lender where the
borrower promises to make interest and principal payments at specific times
to the lender for the use of borrowed funds. It is a form of funded debt (long‐
term debt).
a. Term loans have advantages over the issuance of bonds and equity.
b. Term loans can be drawn up quickly since the borrower and lender work
directly together.
(1) The terms of the loan can have more flexibility since they are not
registered with the Securities and Exchange Commissions (SEC). Also,
modifications can potentially be made during the life of the loan.
(2) Term loans have low issuance costs.
c. Generally, term loans are paid off in equal installments. This is a
protection to both the lender and the borrower that funds will be
available for repayment. When funds from the loan are used to purchase
equipment, the repayment schedule is frequently matched to the
productive life of the equipment.
d. Interest rates can be either fixed or variable.
2233.11 A bond is generally a publicly offered form of long‐term debt where the
borrower agrees to makes payments of interest and principal on specific
dates to the bondholder. Most bond issues are advertised and held by many
different investors as opposed to the one lender of a term loan. The bonds
have a coupon rate (rate of interest) that is generally fixed.
2233.12 An indenture is the legal document that contains the terms of the bond
issue. This document is approved by the SEC before the bond issue is offered
to the public. It will clearly state the provisions of the issue. Common
provisions include the following:
a. Call provision: The right of the issuer to redeem the bond issue prior to
the maturity date under certain circumstances
b. Sinking fund: Requires the issuer to retire a portion of the bond issue
each year or deposit funds into a restricted account to be accumulated
for the retirement of the bonds
c. Restrictive covenants: Conditions that must be met by the issuer during
the life of the bond issue, such as maintaining a debt ratio no higher than
a specified amount, restricting dividend payments, maintaining a
minimum current ratio, or other similar requirements
2233.13 Bond ratings are determined using a rating system such as Standard & Poor’s,
based upon the probability that the issuing corporation will go into default.
These ratings range from AAA (very strong) to D (in default). AAA and AA are
considered to be of a high investment quality, and they along with A and BBB
rated bonds are considered to be investment grade, BB and B are considered
to be substandard, and CCC to D are considered to be speculative.
2233.14 The bond rating is based upon the financial health of the issuing organization
(capital structure as well as stable profitability), bond provisions, pending
legal actions, and time to maturity. The rating is done by rating agencies
using subjective judgment. The bond rating has a direct effect on the bond’s
coupon rate, and thus the firm’s cost of capital if a firm wishes to issue new
debt. Since many bonds are purchased by institutional investors who are
generally restricted to purchasing no lower than investment‐grade bonds,
this rating is extremely important. The issue here is that there is an
additional impact in the event a firm’s rating is downgraded. Then there
would be a decrease in the market price of outstanding bonds.
2233.15 The market value of bonds is based upon the present value of discounted
future cash flows, comprised of an annuity plus a lump sum. The bond’s
market value fluctuates with changes in the market interest rates. If the
coupon rate equals the market interest rate, then the market value of the
bond will be equal to the face value (par value). If the market interest rate is
above the coupon rate, the bond will be selling at a discount to par. If the
market interest rate is lower than the coupon rate, the bond will sell at a
premium to par.
As the bond approaches maturity, its market value will approach par.
Changing interest rates will have an impact on the market value of the bond,
the impact being greater the longer the remaining maturity of the bond. The
issuing corporation, however, will be required to make the same semi‐annual
interest payment no matter what changes occur in the interest rate over the
life of the bond. When bonds are issued, the coupon rate on the bond
generally is set close to the current market rate.
Illustration: A $1,000 bond with a 7% coupon rate, maturing in 10 years, is
selling in a 6% market. What is the current market value of the bond?
Solution: The bond is valued by determining the PV of the future cash flows
(maturity value of $1,000 and semi‐annual interest payments of $35 each
($1,000 × 3.5%)). Using present value tables for 3% (due to semi‐annual
interest payments), 20 periods, the value of the bond can be calculated:

PV of maturity ($1,000 × .5537) $ 553.70
PV of interest payments ($35 × 14.8775) 520.71
Present value $1,074.41
Due to the fact that the coupon rate is higher than the current market rate,
the bond will sell at a premium.
5313.16 Advantages of long‐term debt financing
a. Ownership of the company is not shared with the debt holder.
b. No matter how profitable an organization is, the bondholder will still only
receive the same semi‐annual interest payments over the life of the
bond. Operating income in excess of the bond interest goes to the equity
holder.
c. The interest on the loan is a fixed amount that can be budgeted, or in the
case of a variable interest rate, the interest for a particular period can be
adequately estimated.
d. The interest paid on the debt is a tax‐deductible expense; the tax shield
lowers the effective after‐tax cost of the debt.
e. Raising debt capital is less complicated than issuing either preferred or
common stock.
f. Some debt issues have call provisions that supply flexibility to the issuing
firm.
2233.17 Disadvantages of long‐term debt financing
a. Long‐term debt frequently has various restrictive covenants that can
dramatically limit choices available to management. Examples include
setting dividends, obtaining additional debt, holding compensation
balances, maintaining levels of liquidity and/or solvency ratios, and
prepayment penalties.
b. If interest rates fall, a firm could be locked into a high interest rate.
c. Long‐term debt has a maturity date at which time the principal needs to
be repaid.
d. Interest payments are a fixed cost that increase the breakeven point of
the firm. Interest must be paid whether a profit is made or not. During a
downturn, making interest payments can become difficult.
e. Debt increases the financial leverage (risk) of the company, and the
higher the leverage, the less flexibility a company has for raising future
financing.
f. Long‐term debt is often obtained in larger amounts, and since predicting
actual cash needs is not an exact science, long‐term borrowing is often
out of tune with actual needs.
g. The amount of debt financing is limited, and as the percentage of debt in
the capital structure increases, so does the cost of issuing additional
debt.

2234 Initial and Secondary Public Offerings
2234.01 Initial Public Offerings (IPO)
a. Advantages: An IPO is a corporation’s first sale of securities to the public.
This public offering may have been preceded by private placement or
short‐to‐medium term bank financing. Public securities can achieve
liquidity for shareholders and can be used as “currency” for subsequent
acquisitions. Registration with the SEC is required.
b. Disadvantages: Private companies may find “going public” is a time
consuming, expensive and exposing process. Professional advisors and
investment bankers can be quite helpful in meeting the requirements.
Still, many entrepreneurs find the required efforts, public scrutiny, and
financial discipline of a public listing too demanding and opt for a private
placement.
2234.02 Private Placements: If a private placement is chosen, a firm approaches one
or a small number of investors directly such as insurance companies, venture
capitalists, and commercial banks. Common and preferred stocks are usually
sold by public offerings whereas debt instruments are more likely sold
privately.
a. Advantages of Private Placements: The primary advantages of private
placements are their flexibility and the elimination of flotation expenses
(which means low transaction costs of bringing the securities to market)
and the time‐consuming process of SEC registration. A specialized
investor or private equity fund may provide assistance to management
and have advantages in multi‐round venture financing. One variety of a
private placement is when a corporation sells shares to an Employee
Stock Ownership Plan (ESOP) owned by the employees.
b. No Underwriting Required: In a private placement, there is no
underwriting involved. Therefore, the investment banker will bring
together the buyer and seller to determine a fair price for the securities
and complete the transaction. The investment banker earns a fee for this
service. A firm will choose between private placement or public sale
depending upon which method will yield the lowest borrowing cost (after
transaction costs).
c. Firms That Choose Private Placements: Generally, there are two types of
firms that use private placements.
(1) Small Firms: The first is small, lesser known firms of comparatively
low credit quality which generally issue small dollar amounts of
securities. These firms generally find public sales more expensive than
private sales after considering flotation costs.
(2) Large, Well Known Firms: The second type of firm using private
placements are large, well known firms with a high credit rating.
These companies have large issues which allow them to take
advantage of economies of scale in flotation costs. Therefore, these
companies will substitute between the two markets, selecting the
market that provides the lowest expected borrowing cost for a
particular offering.
2234.03 Secondary and Subsequent Offerings: The secondary market for corporate
stock is the largest in dollar volume and number of trades of any security.
The function of secondary markets is to provide liquidity to individuals who
acquire securities in the primary market. The primary market would not
function well if investors believed they would not be able to resell a security
quickly at a fair price in a secondary market. Markets have a dealer(s) who
specialize in a security. Dealers are charged with maintaining an orderly and
stable market in the security.
a. Organized Exchanges: Organized markets, commonly called security
exchanges, provide a meeting place and communication facility for
members to complete transactions under specific rules and regulations.
Only members of the exchange may use the facilities and only securities
listed on the exchange may be traded. The New York Stock Exchange
(NYSE), the largest organized exchange in the United States, is an
example of an organized exchange. The American Stock Exchange is
another large exchange.
b. Over‐the‐Counter Market (OTC): Securities not sold on an organized
exchange are traded in the over‐the counter market. Dealers and brokers
are connected through an elaborate communications network. In 1971,
the National Association of Security Dealers (NASD) introduced an
automatic computer‐based quotation system which provides continuous
bid and ask prices for actively traded OTC stocks. When a quote is needed
for a customer, all current bid and ask prices are printed out with the
name of the dealer to contact. A customer will place an order with a
broker to purchase or sell a security in the OTC. The broker must then
secure the best possible price with another broker or dealer who has that
particular security for sale.
c. Repurchase of Common Shares: Corporations may repurchase their own
common stock on the secondary market. They may accomplish this
through a broker, by negotiating with a large investor such as a mutual
fund manager, or by a tender offer. This is a use of cash other than for
dividends and tends to drive the stock price up, causing a capital gain for
the stockholders.
(1) Reasons for Repurchase:
(a) Change Financial Leverage: Management may want to change the
company’s financial leverage. By issuing bonds and buying back
common stock, the company will become more leveraged,
probably in the direction of the optimal level, but will also cause
an increase in the company’s financial risk.
(b) Undervalued: The company may feel that the stock is
undervalued, making it a good investment (and at the same time
increasing the share price).
(c) Resist Takeover: Stock may be repurchased to thwart a hostile
takeover attempt. T. Boone Pickens is a well‐known corporate
raider who has attempted several well publicized takeover
attempts. However, tactics employed by the targeted companies
(for example, Phillips Petroleum), including the repurchase of
shares, thwarted Mr. Pickens’ attempts.
(d) Manipulate Market Price: Management may want to keep the
stock price above what the market alone would dictate. A
corporation with the necessary cash can place an open buy‐order
for its stock at a particular price and thus create a short‐term floor
at that price.
(e) Acquisition for Stock Dividends: The company may have a policy
to repurchase common shares on a regular basis to support either
an automatic dividend reinvestment plan with shareholders or to
accommodate a proposed stock dividend.
(2) Tender Offer: In a repurchase tender offer, the corporation attempts
to buy a specific number of shares of their own stock at a set price. A
tender offer is made when the board of directors feels that it is an
appropriate use of corporate funds that will not be needed for
current operations. A tender offer is generally made through an
investment banker.

2235 Dividend Policy and Share Repurchases
2235.01 Price‐earnings ratio
a. The price‐earnings ratio indicates the relationship of common stock to
net earnings. The market price is the investors’ perception of the future;
therefore, this ratio combines the performance measure of the past (EPS)
to perceptions of the future.

Earnings per share
b. The earnings per share computation is subject to arbitrary assumptions
and accrual income. EPS is not the only factor affecting market prices.
c. A high P/E ratio is a possible indication of a growth company and/or of a
low‐risk organization.

Earnings per share

$17.00
= = 5.67
$3.00
2235.02 Dividend yield
a. The dividend yield ratio shows the return to the stockholder based on
the current market price of the stock.

Dividend yield =
Market price per common share
b. Dividend payments to stockholders are subject to many variables. The
relationship between dividends paid and market prices is a reciprocal
one.
c. This ratio is calculated using the current market price; however, most of
the shareholders did not purchase their shares at the current price, thus
making their personal yield different than the calculated yield.

Dividend yield = Market price per common share
$10,000 ÷ 20,000 shares
= = 2.9%
$17.00 per share
2235.03 Payout ratio to common shareholders
a. The payout ratio to common shareholders measures the portion of net
income to common shareholders that is paid out in dividends.

=
b. Income does not necessarily measure cash available for dividend
payment. Payments are heavily influenced by management policy, the
nature of the industry, and the stage of development of the particular
firm. All of these items diminish comparability between companies.
c. Organizations that have high growth rates generally have low payout
ratios since most earnings are kept as retained earnings with the funds
being reinvested in the company instead of providing cash dividends. A
firm that has consistently paid a dividend and suddenly lowers its
dividend payout often is signaling a lack of available cash and the
existence of liquidity or solvency problems.

=

$10,000
= = 16.67%
$75,000 – $15,000
Share Repurchase
2235.04 Stock Repurchase Agreements: As long as the articles of incorporation so
provide, a corporation may repurchase or redeem its own shares. Redeemed
shares may be cancelled or held in the treasury. There is no taxable gain or
loss recognized by a corporation from transaction in its own treasury shares.
Such transactions also have no affect on stated capital. These shares do not
have voting rights can cannot receive dividends
a. Reasons for Reacquiring Stock: There are a number of reasons why a
(1) Provide Cash and Tax Savings to Shareholders: By repurchasing its
stock from its shareholders, the corporation can both pay cash and
provide a tax benefit to the shareholders. The shareholders are taxed
only on the gain (amount that the transaction price exceeds their
original basis in the stock). In contrast, cash dividends paid to
shareholders are usually fully taxable.
(2) Employee Stock Ownership Plans (ESOPs): Federal corporate tax law
provides for the deductibility of contributions made to qualified
ESOPs. An ESOP typically borrows funds from a bank to purchase
shares of the corporation’s stock to be held in the name and for the
benefit of the firm’s employees. These shares may be treasury shares
accumulated and held by the corporation as well as those shares
newly issued by the corporation or purchased on the open market.
The corporation makes annual tax‐deductible contributions to the
ESOP, which uses the funds to repay the bank loan. Employees may
also contribute to the ESOP. The firm benefits by receiving the
proceeds from the sale of either treasury stock or newly‐issued
shares to the ESOP.
(3) Automatic Dividend Reinvestment Plans (ADRIPs): Treasury stock
may be used to provide additional shares to shareholders in lieu of
cash dividends under an ADRIP. See the detailed discussion in the
next section of this chapter.
(4) Stock Repurchase Programs: The corporation may choose to
purchase some of its own shares from the market, thus increasing the
proportional ownership of the remaining shareholders. Earnings per
share of outstanding stock is then increased which, together with the
stimulative buying activity, is expected to result in a higher market
value per share. Shareholders have the potential of realizing capital
gains upon eventually selling their shares, which may be taxable at
lower rates than ordinary dividends. Such a program is especially
desirable if the book value per share exceeds the market value per
share of the stock.

2236 Lease Financing
2236.01 The FASB defines a lease in ASU 2016‐02 to be “a contract, or part of a
contract, that conveys the right to control the use of identified property,
plant, or equipment (an identified asset) for a period of time in exchange for
consideration.” An entity will determine whether a contract contains a lease
by assessing whether the use of an identified asset is either explicitly or
implicitly specified and whether the customer controls the use of the
identified asset.
2236.02 There are two sets of lease criteria: the first set is for both lessees and
lessors, and the second set is for lessors only.
2236.03 The first set of criteria result in a finance lease for a lessee or sales‐type
lease for the lessor if the lease meets any of the following criteria at
commencement:
a. Title (ownership) transfers to the lessee by the end of the lease term.
b. The lease contains a purchase option that the lessee is reasonably certain
to exercise.
c. The lease term is for the major part of the remaining economic life of the
underlying asset. This criterion shall not be used if the lease
commencement date is near the end of the asset’s economic life.
d. The present value of the sum of the lease payments and any lessee
guaranteed residual value not already in the lease payments equals or
exceeds substantially all of the fair value of the underlying asset.
e. The underlying asset is specialized and is not expected to have an
alternative use to the lessor at the end of the lease term.
2236.04 For most leases of property (e.g., land or building), a lessee would classify the
lease as an “operating” lease if none of the five criteria listed abpve are met
and will recognize the following:
a. At commencement, a right‐of‐use (ROU) asset and a lease liability,
initially measured at the present value of lease payments, using the
interest rate implicit in the lease if known; otherwise, the lessee uses its
incremental borrowing rate.
b. Subsequent to commencement, a single lease cost, combining the
unwinding of the discount on the lease liability (i.e., interest expense)
with the amortization of the ROU asset, on a straight‐line basis. In other
words, the lease liability is reduced by the amount of the periodic
payment less the amount of that payment attributable to interest. The
lessee then “plugs” the ROU asset amortization at whatever amount is
needed for interest plus amortization to equal the straight‐line payment
in the lease contract. Impairment, if any, is recorded.
2236.05 If any of the five criteria above are met (control is deemed to have
transferred), the lessor accounts for the lease as a sales‐type lease with or
without a selling profit and will:
a. at commencement, recognize the net investment in the lease [lease
receivable (lease payments plus guaranteed residual values) plus the
unguaranteed residual asset]; derecognize the carrying amount of the
underlying asset; and recognize sales revenue and cost of goods sold at
the beginning of the lease such that selling profit (usually when the fair
value of the asset exceeds the cost or book value of the asset) if any, is
immediately recognized. Expense initial direct costs if a selling profit
exists and defer initial direct costs by increasing the net investment in the
lease if there is zero profit.
b. subsequent to commencement, recognize interest income (interest on
the lease receivable and interest from the unguaranteed residual asset
accretion) using the effective interest method and reduce the net
investment in the lease.

2236.06 When none of the first set of criteria above are met, a lessor shall classify the
lease as an operating lease unless both of the following second set of criteria
are met to classify the lease as a direct financing lease:
a. The present value of the sum of the lease payments and any lessee or
other third party guaranteed residual value not already in the lease
payments equals or exceeds substantially all of the fair value of the
underlying asset.
b. It is probable that the lessor will collect the lease payments plus the
residual value guarantee.
2236.07 The availability of credit is sometimes a major part of the decision to
purchase or lease. If an organization wishes to maximize financial leverage
while maintaining a high level of (superficial) solvency, operating leases may
be chosen.
2236.08 Advantages of lease financing
a. It can be less expensive to lease than to borrow funds in order to
purchase necessary equipment.
b. Generally, lessors do not require down payments and thus provide 100%
financing. However, lenders commonly will not finance the entire
purchase price of an asset.
c. Any restrictions placed by lessors are normally less restrictive (or non‐
existent) than those of lenders.
d. Short lease periods allow a company to avoid the risk of obsolescence.
e. If land is leased, the lease payment is a tax‐deductible expense; however,
land that is owned is not depreciable.
f. Leasing provides for fixed‐rate financing in that the lease payment is set
for the life of the lease.
g. Commonly, it is easier to lease than to borrow.
2236.09 Disadvantages of lease financing
a. In general, all lease payments during the contracted period are required
to be paid; thus, flexibility is taken away from management in the case of
a downturn in business.
b. Although the leased equipment is not owned, frequently maintenance
costs for the asset are the responsibility of the lease holder.

c. Over the life of a lease, the payments made on the lease are greater than
if the asset were purchased for cash. The additional amounts of the basic
cost of the asset are similar to the interest payments made on borrowed
funds.
d. There is no ownership during the lease period, thus no effective equity
related to ownership.

2240 Working Capital Management
2241 Working Capital Terminology
2241.01 Compensating balances
a. A compensating balance is a cash balance required to be held in an
account by a bank in order to obtain a loan or to avoid paying directly for
certain bank services. Required balances are either a fixed minimum
amount or a minimum average balance for a given period such as a
month.
b. Compensating balances increase the cost of a loan or impart a cost to
services provided.
(1) Illustration: If a compensating balance of $10,000 is required in order
to receive free bank services, the company would not hold these
funds otherwise, and the money could be invested receiving a 5%
return; then the actual cost of those services would be $500 per year
($10,000  5%). This could be compared with the actual cost of the
services to determine if it would be less expensive to pay for the
services directly.
(2) Illustration: If a compensating balance of $10,000 is required in order
to receive a $100,000 bank loan at 10%, then the effective cost of
that loan will be increased, since only $90,000 will actually be
available for use. The stated rate of interest on a $100,000 loan at
10% would be $10,000 per year. The effective rate of interest would
then be 11.1% ($10,000  $90,000).
2241.02 Trade credit
Trade credit is a source of funds that is spontaneously created as a result of
the purchase transaction. Trade credit (accounts payable) is often the largest
short‐term debt item held by firms. If a firm purchases an average of $10,000
a day under the terms of net 30, then financing of $300,000 has been
spontaneously supplied to that firm providing the payment terms are met.

2241.03 Commercial paper
a. Commercial paper is short‐term, unsecured notes that are offered by
stable companies. These are in large amounts with short‐term maturities
generally ranging from one month to a maximum of 270 days. Access to
the market for commercial paper is limited to a small number of
companies that are exceptionally good credit risks. The interest rates on
commercial paper tend to be somewhat below the prime rate.
b. The advantages of commercial paper include:
(1) providing the firm an additional source for funds that is readily
accessible once the firm’s paper has been rated.
(2) lower rates than are available with traditional bank loans—generally
ranging from 1½ to 3½ percentage points below the prime rate.
(3) absence of costly financing arrangements and the need for potential
compensating balances.
(4) the repeated issuance of successful commercial paper improves a
borrower’s reputation in the financial markets.
c. The primary disadvantage of commercial paper is that if a firm is facing
temporary financial difficulties, it would not be able to utilize this source
of funding.
2241.04 Zero balance accounts (sweep accounts)
a. Zero balance accounts are held at zero until a claim is made against the
account. At that time, the holding bank transfers sufficient funds from an
interest‐bearing account to the zero balance account. The firm must have
at least one additional account with the bank, and there is generally a
small fee associated with transfers.
b. A zero balance account can be effectively used by an organization when
the interest earned in the interest‐bearing account is greater than the
fees associated with the transfers of funds. Operationally, it reduces the
need for the firm to monitor daily fund flows.
c. A hybrid of the zero balance account is a payroll account where funds
necessary to cover payroll are transferred automatically as the payroll
checks are being issued.

2241.05 Electronic funds transfers
a. Firms are increasingly expecting payment of large bills by use of
automatic electronic debits. Funds are automatically deducted from one
account and added to another. This is the ultimate in terms of speeding
up the collection process. Today, many electronic transfers are done on
the Internet.
b. The use of debit cards by individuals is an example of the application of
this technology for small payments made by consumers.
2241.06 Lockbox systems
a. A lockbox is a system where checks are sent to post office boxes rather
than corporate headquarters. The checks are collected several times a
day by a local bank, and the funds are immediately deposited into the
company’s local account.
b. A lockbox system can significantly reduce the time required to receive
funds and make them available for use, often by two or three days, since
multiple lockboxes can be located throughout the United States and
internationally.
c. Today, the bank generally notifies the firm with a daily record of receipts
collected via an electronic data transmission system and wires funds to
the firm’s cash concentration account.
2241.07 Official bank checks (a.k.a. depository transfer checks)
a. Depository transfer checks (DTC) are official bank checks that provide a
means of moving funds from one account to another within the banking
system. A DTC is payable to a particular account in a particular bank.
(1) The payer prepares and mails a DTC.
(2) The DTC is deposited by the payee (often through the use of a
lockbox).
(3) The DTC is sent to a concentration bank that serves as a clearing
house for funds within the banking system. Often the lockbox is
located at the concentration bank as a means of speeding up the
collection process.
(4) The concentration bank begins the clearing process by sending the
check to the central bank.
(5) Ultimately, the funds are deducted from the payer’s account when
the payer’s bank is notified of the funds transfer.

b. Float is the difference between the company’s checkbook balance and
the bank’s balance. It represents the net effect of checks in the process of
collection. Checks written by the firm create disbursement float and
reduce the book cash. Checks received and deposited by the firm create
collection float and increase the book balance. As checks are cleared, the
bank cash position is reconciled to the book cash position.

2242 Cash Management
2242.01 Reasons to hold cash
There are four primary reasons for a company to hold cash.
1. Transactions purposes: Cash is necessary for a company to conduct its
day‐to‐day business.
2. Precaution purposes: Since cash flows do not flow evenly over time and
often cash inflows are not matched with cash outflows (a business cycle
consideration), it is necessary to have enough cash on hand to
compensate for unanticipated fluctuations in cash flows.
a. Precautionary cash is often held in highly liquid marketable securities.
This provides security and additional interest income.
b. Today, most companies have a line‐of‐credit arrangement to cover
the precautionary needs.
3. Speculative purposes: Cash balances are also necessary to allow a firm to
take advantage of potential business opportunities such as bargain
purchases.
a. Near‐cash is advisable for speculative purposes so that additional
interest/dividend income can be earned.
b. Organizations often do not hold cash for speculative purposes if they
have a readily available source of funds such as a line of credit.
4. To meet compensating balance requirements: Compensating balances
are amounts required to be kept in an account by a bank and are often
mandatory in order to obtain a loan or to avoid paying fees for individual
bank services.

2242.02 The cash budget
a. The cash budget is a cash management tool that details cash inflows and
outflows over a specified period of time. It can be prepared on a yearly,
quarterly, monthly, weekly, or even daily basis. Since cash inflows and
outflows are not necessarily uniform throughout the year, the cash
budget highlights when cash shortages are likely to occur, allowing
management to plan necessary borrowing, and also highlights when cash
surpluses will be available for repayments or investments.
b. The cash budget is based upon estimates of sales, credit terms, and bad
debt levels (cash collections); estimates for purchases and payment
terms (cash payments); estimates for production and payment terms for
conversion costs (cash payments); estimates for borrowings (cash
inflows), repayments, and associated interest payments (cash outflows);
estimates for capital purchases (possible cash outflows) and disposals
(possible cash inflows); and potential dividend payments (cash outflows).
Since this budget is based upon estimates, it is necessary to update the
cash budget on a regular basis when data on actual inflows and outflows
become available.
c. The target cash balance is the desired cash balance management
believes to be necessary to safely conduct business. This amount may
vary during the year due to the cyclical nature of many industries. When
estimated cash inflows exceed estimated cash outflows for a given period
including planned capital expenditures, the excess can be used to repay
short‐term credit and/or be invested. When estimated cash outflows
exceed estimated cash inflows for a given period, investments can be
turned into cash to meet these cash needs, or short‐term borrowing can
be arranged. Many companies have line‐of‐credit arrangements to help
them smooth out cash flows throughout the year.
2242.03 Synchronizing cash flows
Synchronizing cash flows matches the cash outflows with the timing of the
receipt of cash inflows. This allows firms to keep transaction balances to a
minimum. Many companies stagger the billing of customers throughout the
month in an attempt to create fairly even daily cash inflows while planning
the timing of payments for various obligations so that due dates are during
various weeks of the month. The lower the target cash balance, the more
funds that are available for productive uses.

2242.04 Speed of cash collections and disbursements
a. From the perspective of an individual firm, collections need to be made
as quickly as possible and disbursements delayed as long as possible,
providing discounts are not lost nor unnecessary interest charges
incurred. This allows for the maximum cash balance at any given time.
b. When a check is received from a customer, it does not mean that funds
are necessarily available at the time of receipt. Due to the check clearing
process, it may be one to three days before the funds are available. The
difference between the checks that have been received and those
credited by the bank is the collection float. The goal of management is to
keep this float as low as possible.
c. Techniques such as the use of lockboxes and electronic funds transfers
allow firms to speed up the collection process.
d. The net float is the difference between the firm’s checkbook balance and
the balance of the account in the bank’s records. The difference is due to
the collection float and the disbursement float. The disbursement float is
the amount of the checks written but that have yet to clear the bank. The
disbursement float allows a firm to have lower cash balances.
e. Techniques such as the use of zero balance accounts allow a firm to not
hold funds in non‐interest‐bearing accounts to meet anticipated
disbursement needs.

2243 Marketable Securities Management
2243.01 Use of marketable securities
a. Marketable securities are generally low‐risk investments that can be
quickly turned into cash. Marketable securities include:
(1) U.S. Treasury bills.
(2) bank certificates of deposit.
(3) commercial paper.
Since most firms attempt to minimize cash balances, excess cash is often
invested in marketable securities that are purchased with maturities that
coincide with seasonal needs, maturing debt, tax payments, or other
potential needs.

b. Marketable securities have low risk and high liquidity.
(1) Since safety is an important factor, short‐term marketable securities
are generally lower yielding since safety is traded for higher yield and
minimizes default risk.
(2) Short‐term investments also minimize interest rate risk since their
market values do not show a high degree of price fluctuation related
to interest rate changes.
c. Marketable securities are held as a substitute for cash. By transferring
excess cash to interest‐bearing investments, the surplus can add value to
the firm. The funds are still readily available to meet transaction,
precautionary, and speculative needs.
d. Marketable securities are held as temporary investments to be used to
meet seasonal needs or to protect against business downturns.
e. Marketable securities are held to meet planned financial needs such as a
maturing bond issue, upcoming tax payments, or a possible expenditure
for plant or equipment.
f. Marketable securities can be used as a temporary place for funds
received but yet to be invested in long‐term investments or capital
additions.
g. With the use of lines of credit, the need for marketable securities has
diminished for companies that have access to such financing options.
By using a line of credit to meet short‐term needs for funds as opposed
to marketable securities:
(1) a firm’s current ratio could be lower without indicating a greater risk
that the obligations would not be repaid on a timely basis. There is,
however, a risk that funds available from this method of financing
might not meet all of the firm’s actual short‐term needs.
(2) if excess cash is not expected to be needed for precautionary and
speculative purposes, it might be feasible to put these additional
funds to better use, such as by investing them in higher‐yield,
medium‐term investments or to fund capital enhancements to
improve the productivity of the existing capacity.

2243.02 Cash management and the multi‐company, international firm
a. A multi‐company firm has additional cash management issues. Each
subsidiary needs to manage cash on an individual basis; however, a
centralized cash management group needs to manage the cash flows
between the parent‐subsidiary and within inter‐subsidiaries in order to
optimize cash flows. Such management can benefit subsidiaries in need
of funds by supplying the needed cash from excess funds from another
subsidiary or the parent.
b. The need to increase the speed of cash inflows is magnified in the
international setting due to increased mailing times. The use of lockboxes
around the world is one method of speeding up collection. Another
method is to have preauthorized payments where the firm can charge a
customer’s account up to a specified limit. Today, most large firms use an
electronic method such as the Internet to transfer funds.
c. International cash flows result in the need for currency conversions. By
using a tool called netting, administrative and transaction costs resulting
from currency conversions can be reduced. For example, if two
subsidiaries are located in different countries and A purchases parts from
B, transactions resulting from the sale of the parts from B to A are
“netted” for a period of time (generally a month), and one net payment
involving currency exchanges is made per period, thus reducing
conversion costs.
A more complex multilateral netting system is used when there are a
parent and several subsidiaries. The transactions among the various
entities are netted so that conversion costs are minimized.
d. The use of various cash transfers for international organizations may be
hampered by foreign government restrictions and characteristics of the
banking systems in less developed countries.

2244 Accounts Receivable Management
2244.01 Introduction to accounts receivable management
a. Firms extend credit on sales in order to increase revenues. Since the
objective of increased sales is to increase profit, a firm will theoretically
extend credit until the cost of offering additional credit equals the costs
incurred in generating those sales (incremental analysis).
b. The value of the trade accounts receivable at any given time is directly
tied to sales volume, which in turn is influenced by factors some of which
management has control of, such as product price and quality and
advertising. Another major controllable factor influencing sales is the
firm’s credit policy that consists of the following:
(1) Credit period: the length of time the customer is given to pay for the
purchases. For example, credit terms of “3/10, net 30” allows buyers
to take up to 30 days to pay without incurring interest charges.
(2) Discounts: the credit terms “3/10, net 30” allow customers to take a
3% discount if the payment is received within 10 days of the invoice.
The full amount would be due in 30 days if the discount opportunity
was not taken.
(3) Credit standards: the required financial strength of acceptable
customers. Relaxing the standards is likely to boost sales, but also to
increase bad debt losses.
(4) Collection policy: how tough or lax the firm is in terms of attempting
to collect slow‐paying accounts. Again, there is a trade‐off between
attempting to speed up the collection of an account and possibly
losing a customer.
c. The credit manager is generally responsible for administering a firm’s
credit policy. However, credit policy is generally set at an administrative
level within the firm.
d. A change in credit policy involves the interaction between several
variables. Below are some of the issues management would need to
analyze when considering a change in the credit policy.
(1) Sales: What is the projected increase in the level of gross sales that
would result from the change?
(2) Account receivable: There is generally a proportional relationship
between an increase in sales and an increase in accounts receivable.
An increase in accounts receivable would mean that additional funds
would be tied up until collection. Increasing accounts receivable
would require increasing funding (debt or equity) with a possible
increase in interest costs.
(3) Discounts and bad debt losses: What proportion of customers would
be expected to take the discount? What proportion of the additional
receivable would become bad debts?
(4) Costs of running a collection department: Would more staff (higher
costs) be needed to run collection department due to higher volume?
Would there be fixed costs associated with the expansion of the
credit collection efforts?
(5) Management would have to compare the increased revenues
expected with the increased costs to determine whether the firm
would be better off on an incremental profit basis.
e. A firm’s credit policy includes the credit standards, credit period,
available discounts, and collection procedures.
f. The quality of credit is defined as the ability to collect receivables in full
and in a timely manner.
g. A firm’s credit policy is often dictated or strongly influenced by
competitors since unless the firm’s policies are competitive, sales will
often be lost.
2244.02 Credit standards
Credit standards are the firm’s standards by which potential customers are
measured in the process of being approved for credit. The lower the
standards, the higher the sales and the higher the associated costs such as
bad debt losses that come from extending credit to less creditworthy
customers. Optimal credit standards allow for the marginal cost of extending
the additional credit to equal the margin profits produced by the increased
sales resulting from the relaxed credit standards.
2244.03 Credit period
a. The credit period is the length of time for which credit is extended. It is
the time that elapses between the sale and the expected collection of
funds. Lengthening the credit period often encourages sales, but also
increases financing needs due to the fact that additional funds will be
tied up in the additional receivables. Longer credit periods are also
associated with higher bad debt expenses.
b. If the credit period is extended, trade accounts receivable will increase
due to the increased holding time of receivables as well as increased
credit sales.

c. The cost of extending the credit period can be calculated by multiplying
the increase in accounts receivable by the marginal cost of capital.
Illustration: If a firm increases its credit period from 30 to 45 days,
average accounts receivable are predicted to increase from $400,000 to
$500,000. If the cost of capital is 10%, then the marginal cost of changing
the credit period is $10,000 ($100,000  10%).
d. In poor economic times, a firm needs to be concerned that customers will
unilaterally extend the credit period.
2244.04 Available discounts
a. Discounts are used as an incentive to get the customer to make an early
payment. This would reduce the cash outflow needed by the customer to
meet the obligation. A common discount would be stated as “2/10, net
30.” This is interpreted to mean that the customer may take a 2%
discount if the payment is received within 10 days, with the full amount
due and deemed current if received between 11 to 30 days.
b. Discounts provide:
(1) a price reduction for customers.
(2) a means to attract new customers.
(3) a way to reduce the average collection period.
c. Seasonal discounts are also offered by some organizations. By placing an
order by a specified date, customers are offered discounts even if the
merchandise is shipped months later. This is a tool designed to lock in
sales that would help to facilitate scheduling production.
2244.05 Collection procedures
Collection procedures are steps that a firm takes to collect past‐due
accounts. These steps might include a series of increasingly severe letters or
telephone calls with the account ultimately turned over to a collection
agency. Collection procedures are expensive and can often be reduced by
screening customers more carefully or by tightening credit standards. These
choices generally involve a cost/benefit issue.

2244.06 Alternative credit
The acceptance of bank credit cards and debit cards is an alternative to
providing in‐house credit to customers and can often be less expensive.
Retail organizations are often forced into accepting this form of payment due
to widespread consumer use and the acceptance by competitors.
a. Charge tickets can be deposited daily, much like a check.
b. Funds are available immediately for debit card transactions and almost
immediately for credit card transactions.
c. Banks charge fees in the range of 3% to 10% of the dollar sales volume
based upon average transaction amount and total dollar volume. The
higher the volumes and the larger the average per transaction, the lower
the fee would be.

2245 Inventory Management
2245.01 The importance of inventory
Inventories can take many forms—raw materials, work‐in‐process, finished
goods, supplies—and inventories are extremely important to many
organizations. Without the appropriate inventories, there will possibly not be
an adequate level of goods available to meet demand. Thus, it is important
that management prepare adequate sales forecasts in order to assure that
enough inventory will be available to meet the forecasted demand. Without
the necessary inventory, sales are lost. On the other hand, excessive
inventories lead to high carrying costs.
There are two major issues involved in inventory management—having the
right inventory at the right place at the right time, and not having too much
inventory, which would result in excessive carrying costs.
2245.02 Just‐in‐time
a. A just‐in‐time (JIT) production system purchases raw materials and
component parts just as they are needed in the production process, thus
reducing raw material inventory close to zero. It is part of a
manufacturing philosophy that promotes the simplest, least costly means
of production. Under ideal conditions, the company would receive raw
materials just in time to go into production, manufacture parts just in
time to be assembled into products, and complete products just in time
to be shipped to customers. JIT shifts the production philosophy from a
push approach to a pull approach.

(1) The push approach begins with the acquisition of raw materials that
are pushed into production through the various stages of production,
and finally into finished goods inventory. The goal is to have finished
goods ultimately sold to customers without deep discounting.
(2) The pull approach starts with the demand for finished goods from a
customer. The customer’s order triggers the production of the goods.
Inventories are acquired only to meet production needs.
b. Under ideal conditions, the company would attempt to create a situation
where both raw material inventory as well as finished goods inventory
would be eliminated and work‐in‐process inventory kept to a minimum.
c. Raw materials are delivered just in time to meet the production schedule,
with a guaranteed high level of product quality so that they can bypass
inspection and go directly to production. This requires long‐term
purchase agreements with suppliers and coordination between
purchasing and production. The result is a virtual elimination of raw
material inventory. The cost of carrying inventory is shifted to the
supplier.
d. The rate of production for individual departments is determined by the
needs of each succeeding department. Inventory buffers with a
predetermined size are used to signal when a department should be
working. The department works as long as the buffer is less than the
desired level. This eliminates most work‐in‐process inventory.
e. As soon as products are finished, they are immediately shipped to the
customer, thus eliminating finished goods inventory and immediately
converting the product into cash or accounts receivable. Close
supplier/customer relations can allow both supplier and customer to use
JIT systems.
f. Generally there are changes required in several areas of the
manufacturing process to make JIT successful.
(1) Activities that do not add value need to be eliminated. Activities are
identified as value‐adding activities and nonvalue‐adding activities. A
nonvalue‐adding activity is any activity that could be eliminated
without detracting in any way from customers’ satisfaction with the
final product. Moving time, inspection time, and times in queues are
all nonvalue‐adding activities and should be eliminated as much as
possible. Machining, milling, and polishing of products are all value‐
adding activities, as customer satisfaction would be reduced without
them.

(2) Supplier relationships are of key importance. It is important to select
a small number of suppliers who can guarantee both the quality and
timely delivery of raw materials. Raw materials are usually delivered
in small quantities as needed for production. Responsibility for raw
material quality is also shifted to the supplier.
(3) Manufacturing cells are developed. Traditional departments and
processes are replaced with manufacturing cells that contain families
of machines typically spread through several departments. A
component or a complete product can be produced within one cell
rather than being transferred between several departments.
(4) The workforce is highly trained and flexible. The cellular
manufacturing environment requires a labor force that is capable of
operating several different machines. The workforce must be capable
of servicing the machines and performing inspections on finished
products.
(5) Total quality control is implemented at the inventory and production
level. The streamlined flow of raw materials and components through
the production process does not allow for product defects. No defects
can be allowed in parts or raw materials received from suppliers, in
work‐in‐process, or in finished goods. Emphasis is placed on doing
things right the first time and avoiding rework or waste of any type.
Products are inspected for quality at each stage of the process. When
a defect is discovered, the production process is halted until the
problem is corrected. Responsibility for inspecting products is shifted
from inspectors to production workers. There is a commitment for
continuous improvement in all aspects of the company.
(6) Set‐up time is reduced. Set‐up time is the time required to change
equipment, move materials, and obtain forms needed to shift
production from one product to another. Meeting customer demand
on short notice without any finished goods inventory requires the
ability to shift production from one product to another with a short
set‐up time.
g. When using JIT methods, the differences between net operating income
using the absorption method or variable costing method will be reduced
since the differences relating to the costing of inventory are eliminated
with the elimination of the finished goods inventory. If inventories are
almost non‐existent, then differences in inventory valuations will be
extremely small, bringing the results of net income using absorption or
variable costing extremely close.

h. Advantages of JIT production systems:
(1) Funds are no longer tied up in inventories and can be more effectively
used elsewhere.
(2) Warehouses formerly used to store inventory can be put to more
productive use.
(3) As defects are reduced, less waste occurs, and customers’ satisfaction
is increased.
(4) As production time is decreased, a greater output potential is
created.
(5) Customers’ satisfaction is increased due to the shorter delivery time
from the point the order is received (order lead time).
i. Disadvantage of JIT production systems: Increased possibility of stockouts
if delivery of a critical part is delayed due to strikes, disasters, or other
unexpected occurrences
2245.03 Economic order quantity
a. The economic order quantity is the least amount of inventory that
should be ordered given the various costs involved. The economic order
quantity model (EOQ) provides a formula for determining the quantity of
a particular inventory item that should be ordered in order to minimize
inventory costs.
2 DS
EOQ 
Ci
b. Relevant items in determining the economic order quantity:
D = The demand per year in units
S = Setup or ordering cost per order or batch
C = The cost per unit
i = The carrying costs expressed as a percentage of inventory cost
c. Inventory decision models contain costs that move in opposite directions.
Carrying costs increase as the size of the order increases. Set‐up or
ordering costs, however, decrease as the size of the production run or
order increases. The EOQ model seeks to minimize the combined total of
these two costs, as illustrated in the following graph.

d. Assuming that there is constant demand and no change in lead time, the
reorder point is equal to the sum of expected units of demand during the
lead time plus any required safety stock. This relationship can be
illustrated as follows:

The formula for the reorder point (RP) is:

RP = DLT + SS
DLT is the average demand during the lead time period. This can be
calculated by determining the demand per day and multiplying that result
by the number of days in the lead time. SS is the safety stock required.

e. Illustration: Use the following data to compute the economic order
quantity and reorder point assuming 300 business days per year.

Demand (D) 40,000 units per year
Unit cost (C) $50
Carrying cost rate (i) 20% per year
Order cost (S) $115 per order
Lead time (LT) 3 days
Safety stock (SS) 500 units
Solution:
2 DS
EOQ 
Ci

240,000$115
$5020% 
 960 units
RP  D LT  SS
 40,000 units / 300 days x 3 days   500  900 units
2245.04 Reasons for not minimizing inventory levels
a. Larger inventory levels can guarantee the availability of inventory as
needed. When stockout costs are high, carrying a larger safety stock may
be appropriate.
b. Through use of large discounts or more favorable credit terms, customers
may be convinced to purchase larger quantities. Thus, inventory policy
needs to be coordinated with other policies such as credit policies.
c. If competition is very high, suppliers may feel the need to increase
inventory levels to insure prompt deliveries to customers.
d. Inventories can be a good hedge against inflation if the cost of replacing
inventory is increasing.
e. Safety stock is a level of inventory that is held in excess of the desired
inventory level to cover unanticipated demand. This additional inventory
provides security from stockouts and lost sales when the time to replace
inventory exceeds the anticipated period. The level of safety stock is
determined by a balancing of the cost of holding additional inventory
items and the cost, or lost revenue, associated with not having goods
available for the customer when they wish to purchase them.

2246 Types of Short‐Term Credit
2246.01 Trade credit
a. Most companies purchase on credit, making trade credit a significant part
of current liabilities. Trade credit is a spontaneous source of financing
created when goods and services are purchased on account in the normal
course of business. If a firm purchases $10,000 of goods per day on
average, at the end of 30 days, $300,000 ($10,000  30) of financing has
been created. If suppliers’ credit terms increase to 45 days, an additional
$150,000 [$10,000  (45 days ‐ 30 days)] of credit can be generated.
b. As a general rule, firms will hold cash payments until the last minute that
an obligation is due in order to increase their average cash balance. This
is the case unless the cost of making an early payment is less than the
firm’s cost of capital.
2246.02 Free trade credit
a. Firms frequently have credit terms that include offering a discount on
invoices if paid within the discount period. “2/10, net 30” provides a
discount of 2% if the invoice is paid within 10 days and full payment is
expected within 30 days if the discount is not taken.
b. Free trade credit is credit received during the discount period. In the
example mentioned above, the discount period would be the first 10
days of the net purchase period.
c. Illustration: A firm purchases $50,000 of merchandise on credit with the
terms 2/10, net 30. What amount is paid to satisfy the obligation if the
payment is made by the 10th day of the net 30 period?
Solution: $50,000 ‐ ($50,000  2%) = $49,000 with the firm gaining a
$1,000 discount
2246.03 Cost of trade credit
a. If payment is not made on trade credit within the discount period, the
discount is lost, and the full amount of the credit is paid within 30 days.
The results of this lost discount are:
(1) the savings of the discount are lost.
(2) the size of trade credit increases, thus increasing the debt load.

b. Illustration: A firm purchases $2 million of merchandise throughout the
year (assuming a 360‐day year) and is offered a 2% discount on all
invoices paid within 10 days. If all invoices are paid within the discount
period, the full amount paid will be $1,960,000 ($2 million  98%). This
results in a savings of $40,000 per year.
If all discounts are taken, payables at any given time will average $54,444
[($1,960,000  360 days)  10 days]. If the discounts are not taken and
payment is made within the 30‐day period, then average accounts
payable will increase to $163,333 [($1,960,000  360 days)  30 days].
That is an additional $108,889 of trade credit that is being used.
There is a cost to this additional credit—the lost $40,000 in discounts.
The lost discounts represent increased cost for the merchandise;
therefore, the price of the additional $108,889 of trade credit is $40,000.
The cost of this credit is computed as follows:

Lost discount $40,000
= = 36.7%
Additional credit supplied $108,889
c. If a firm can borrow funds at an interest rate lower than the cost of the
foregone discount, then the funds should be borrowed and the discounts
taken. If the firm above can borrow $108,889 at 10% for an annual
interest cost of $10,889, then $29,111 would be saved on an annual basis
($40,000 ‐ $10,889).
d. The return on taking discount can also be calculated using the following
formula:

360 Percentage of discount

Total credit period – Discount period 100% - Percentage of discount
Using the above illustration, the return can be calculated:

360 2%
 = 36.7%
30 days – 10 days 100% – 2%
e. Payment of trade credit beyond the normal credit terms will likely result
in interest charges, thus increasing the cost of credit as well as hurting
relations with the supplier. Firms that do not take advantage of discounts
are generally in a weaker financial position with poor cash flow and/or
limited access to other sources of funds.

2246.04 Trade credit and financial statements
a. Not taking discounts can have a dramatic effect on the financial
statements—affecting profitability as well as liquidity.
b. The effect on profitability can be shown in the following tables comparing
the results on income of a firm taking versus not taking trade discounts.
In this example, it is assumed that a company will have to borrow at 10%
($10,889 annual interest) in order to take advantage of the available
discounts (see above information).

Do Not Take Take
Discounts Discounts
Sales $4,000,000 $4,000,000
Purchases 1,960,000 1,960,000
Other costs 1,500,000 1,500,000
Interest 0 10,889
Discounts lost 40,000 0
Total costs 3,500,000 3,470,889
Income before tax 500,000 529,111
Tax (40%) 200,000 211,644
Net income after tax $ 300,000 $ 317,467
Since the discounts exceed the cost of the interest expense, net income is
increased by taking the discounts. In this case, income is increased by
$17,467 or approximately 6%.
c. Assuming that the firm goes to the bank to finance a note payable so that
funds are available to take advantage of the discounts, the liability/equity
sections of the balance sheet will have the following comparison when
taking versus not taking trade discounts:

Do Not Take
Take Discounts
Discounts
Accounts payable $163,333 $54,444
Note payable 108,889
Accruals 50,000 50,000
Long‐term debt 75,000 75,000
Equity 250,000 250,000
Total liabilities and equity $538,333 $538,333
Thus, the total liabilities and equity will be the same. The only difference
is that the firm will be able to choose how to finance the amount needed
to take advantage of the discount for early payment and reduce the cost
of financing—short‐term loan, long‐term loan, or equity. This example
was presented using a short‐term note. The nature of the spontaneity of
the trade credit financing often causes these cost‐saving options to be
missed.

2247 Short‐Term Credit Management
2247.01 Types of short‐term debt:
a. Spontaneous financing created through the use of accounts payable and
accruals generated in the course of doing business
b. Unsecured bank loans
c. Commercial paper
d. Secured loans
2247.02 Spontaneous financing
a. Accounts payable and accruals provide instant financing at no cost for a
firm. For example, employees provide continual services and are paid
only at set intervals. In a sense, employees provide the equivalent of
small loans to the company.
b. Trade credit is an appealing source of financing since it is free; however,
the length of this credit is only for a very limited time.
c. On occasion, vendors will offer discounts for prompt (early) payment of
obligations. Not taking advantage of these offers is a particularly
expensive form of short‐term financing. For example, if a vendor offers
1/10, net 30, this means that a 1% discount can be taken if the invoice is
paid within 10 days as opposed to 30 days, but this is 1% discount for
only paying 20 days earlier than required. This rate can be converted to
an effective annual rate by using the following formula:

Days in year 365
= × 1% = 18.25%
Lost trade credit days by taking discount 20
Thus, if a company can borrow funds for less than 18.25% in order to take
advantage of a prompt payment discount, it is in the firm’s best interest
to do so.
2247.03 Unsecured bank loans
a. Unsecured loans are not backed by any collateral and come in a variety
of forms.
b. A line of credit is an agreement with a bank to have up to a specific
amount of funds available as a short‐term loan during a particular period.
If the line of credit is for $100,000, a firm can borrow $20,000 in January,
borrow an additional $35,000 in May, repay $40,000 in July, and borrow
$50,000 in September, etc. As long as the total amount borrowed at a
given point in time remains under $100,000 during the period of the
agreement, the firm will continue to have access to additional funds.
Interest is usually paid monthly and calculated on the average
outstanding balance during the period. This method of financing allows a
firm to smooth out its cash flow cycle as well as to have funds available
for possibly both precautionary and speculative needs.
The use of the line of credit affects both current assets and current
liabilities equally. They increase and decrease in a parallel fashion.
However, as long as the current ratio is greater than one, an increase in a
line of credit (increase to cash and an increase to current liabilities) will
decrease the current ratio.
Illustration: A firm has $100,000 of current assets, $50,000 of current
liabilities, and a current ratio of 2 to 1 ($100,000 ÷ $50,000). If $25,000 is
borrowed on the line of credit, current assets will increase to $125,000,
current liabilities to $75,000, and the current ratio will become 1.7 to 1
($125,000 ÷ $75,000).
c. A variation on the line of credit is the revolving credit agreement that is
generally used by large corporations. This is an agreement by a bank to
extend credit to a company over a specified period of time; however, if
the firm does not make use of the revolving credit, there still is an annual
commitment fee. For example, the approved revolving credit could be for
three years to allow a corporation to borrow up to $50 million. Even if
the company does not use any of the credit during the year, it will still
have to pay a significant commitment fee expressed in terms of a percent
(for example, a quarter of 1% or $125,000 annually in the above
illustration). If the corporation borrows $25 million on the revolving
credit agreement, the commitment fee would drop to a percent of the
unused portion of the agreement ($62,500 in this illustration), and the
corporation would pay interest on the outstanding borrowed balance as
well. The biggest difference between a line of credit and a revolving
credit agreement is that there is a legal obligation with a revolving credit
agreement that does not exist with a simple line of credit. This legal
obligation guarantees the company access to the funds over the life of
the agreement.
d. A letter of credit is an international financing tool that guarantees
payment to an international supplier upon the safe arrival of the goods
by issuing a loan to the purchaser. A letter of credit can be irrevocable
(not subject to cancellation if the specific conditions are met) or
revocable.

e. Commercial paper is an unsecured promissory note that is issued by
large banks and big corporations to meet short‐term cash needs. It is a
promise to repay the borrowed funds at a future given date with a
maturity of no more than 270 days. Rates for these loans are normally
lower than for bank loans. This financing option is considered to be quite
safe due to the short time frame and the strength of the borrowing
companies; however, there is no flexibility in the repayment date as
might be received with a bank loan.
2247.04 Secured loans
a. Short‐term credit is often secured by current assets such as receivables
and inventory, and is often used by seasonal businesses where cash flow
and working capital needs are not synchronized.
b. Pledging of receivables entails using the cash value of the receivable as
collateral for a loan. In this case, the borrowing company agrees to remit
the cash received from the collection of particular receivables as
repayment of the loan; however, the receivables continue to be owned
by the borrowing company, and if a particular receivable proves to be
uncollectible, the borrowing company is still liable for the repayment of
the loan. Interest rates for these loans can range from 2% to 5% over
prime, often with a fee equal to 1% to 2% of the receivable pledged.
c. Factoring involves selling accounts receivable to a factor as a form of
short‐term financing. The factor assumes the risk of collection, and the
purchaser is notified of the factoring arrangement and usually remits
payments directly to the factor. (In some instances, factoring can be done
with recourse.) Since the risk is shifted to the factor, the factor will take
over the responsibility of doing the credit check on a potential customer.
Therefore, functions performed by the factor include credit checks,
lending, and bearing of default risk. Generally, the selling firm receives
funds from the sale immediately upon shipment of goods to the
purchaser. The amount received is the full amount of the sale less a
factor fee (usually some percentage of the total sale). The fee
incorporates a reserve for sales returns and allowances, interest costs,
and profit for the factor. At the end of a specified period, the reserve
amount is paid to the seller, providing there have not been sales returns
and allowances in excess of the reserve assumed in the factoring
agreement. It is not uncommon for factoring arrangements to be
ongoing.

Illustration: A company sells $50,000 of goods with the terms net/30. The
receivable is immediately factored with a 3% factor fee, 10% interest, and
a reserve of 8%. How much does the selling firm immediately receive
from the factor?
Solution: The factor fee will be $1,500 (3% of $50,000). The reserve will
be $4,000 (8% of $50,000). The interest will be calculated on 10% of the
balance available to the seller and adjusted for a monthly period length.
This can be summarized as follows:

Sales: $50,000
Less:
Factor fee (3% × $50,000) $1,500
Reserve (8% × $50,000) 4,000 5,500
Amount due firm 44,500
Less interest on amount for
30 days (10% × $44,500 × 30/360) 371
Amount paid to seller $44,129
After 30 days, any remaining part of the reserve (maximum of $4,000 in
this case) that was not absorbed by returns and allowances will be
remitted to the seller.
The cost of factoring needs to be compared to the costs of running a
credit department when making a decision as to which alternative to
pursue.
d. Inventory financing entails the use of inventory as security for a short‐
term loan. Such a loan can attach to all inventory held or a particular
portion of inventory identified by serial numbers or placed in a particular
location.
2247.05 Advantages of short‐term debt financing
a. A short‐term loan can generally be obtained quickly.
b. The cost of obtaining short‐term debt is generally low since the lender
tends to only do a minimal financial examination of the firm applying for
funds. Spontaneous credit has no cost.
c. There are generally no prepayment penalties.
d. Short‐term debt often provides flexibility for management as it generally
has few restrictions.
e. Since the yield curve is typically upward sloping, short‐term interest rates
are generally lower than long‐term interest rates.
f. Interest expense is tax deductible and, therefore, provides financial
leverage.
g. Accounts payable is a primary source of short‐term debt and it is
spontaneously created when inventory is purchased.
2247.06 Disadvantages of short‐term debt financing
a. Short‐term interest rates can vary widely over time, subjecting the firm to
refinancing risk.
b. An unexpected need for cash during a recession could cause cash flows to
be insufficient to meet the short‐term obligations.
c. Due to changing financial conditions, short‐term debt may not be
renewable and thus, depending upon the level of short‐term debt, may
put a firm in an illiquid position that could lead to bankruptcy.
d. On occasion, compensating balances are required when unsecured debt
is received. This increases the effective cost of that debt.

2250 Corporate Restructuring
2250.01 Qualified Reorganizations / Divisions: IRC 354 specifies that qualified
corporate restructuring including spin‐offs, split‐offs and split‐ups are non‐
taxable. In all three of these restructuring methods there is no change in
shareholders.
a. Spin‐off: A “spin‐off” occurs when Old corporation forms New Subsidiary
corporation and transfers to it some assets in return for shares.
Subsequently, Old distributes New stock to its shareholders; this is a
dividend distribution.
b. Split‐off: A “split‐off” involves the same steps as a spin‐off except that
the shareholders would surrender a portion of Old’s stock in exchange for
New’s stock; this is a stock redemption.
c. Split‐up: In a “split‐up”, Old forms New Subsidiary, transfers to it all its
assets in return for shares which are then totally distributed to its
shareholders; this is a complete liquidation of Old corporation.
d. Tax‐Free Requirements: To avoid tax on the restructuring, there must be
a valid business purpose for the division. In addition, a 5‐year continuity
of interest requirement ensures that the division is not a disguised sell‐
out.
2250.02 Divestiture: This is the sale of a division of a company by offering shares to
the public. The corporation may treat the gain as capital, but it increases
earnings and profits. The exam has called this procedure an “equity carve‐
out.”

2250.03 Bankruptcy
a. Introduction: The 1978 Federal Bankruptcy Code was amended by the
1994 Bankruptcy Reform Act. The objective of the original Code and
amending Act is to modernize our bankruptcy courts and procedures.
This is accomplished by adding provisions aimed at curtailing abuses and
requiring an equitable sharing of the debtor’s assets among the
legitimate creditors.
b. Bankruptcy − The Process:
(1) Various Chapters: There are two relevant chapters under the new
Act.
(a) Chapter 7: The liquidation section of the Act is discussed in detail
below. All the corporation’s assets are to be liquidated and the
proceeds distributed by the trustee to the creditors. This normally
terminates the corporate existence.
(b) Chapter 11: This permits business reorganization by restructuring
the debtor’s financing. If the financial crisis is only temporary,
Chapter 11 is designed to avoid liquidation by providing court
protection while the business continues to operate. A business in
distress usually begins by petitioning the bankruptcy court for
relief from the creditors’ foreclosure actions.
(i) Debtor in Possession: A debtor is usually allowed to keep
possession of a business.
(ii) Creditors’ Committee: The Court is required to appoint a
committee of unsecured creditors. The Committee
investigates the business’ financial position and may make
suggestions concerning the plan of reorganization. The
Creditors’ Committee may also request a trustee be appointed
to run the business. The trustee must submit financial
statements to the court.
(iii) Trustee Appointment: The Court on motion or its own
initiative may also appoint a trustee and/or examiner in cases
such as management fraud or gross mismanagement.
(iv) Plan of Reorganization: Central to the Chapter 11 proceeding
is the plan of reorganization; the debtor has an exclusive right
for 120 days to submit a plan. If the debtor does not submit a
plan during this period, any other party in interest may.
Uncontested plans are usually approved (confirmed) if they
are reasonably fair and equitable.

 Secured Creditors: Secured creditors cannot lose their
senior position, but may not usually repossess or
otherwise execute on their collateral during the
bankruptcy period.
 Unsecured Creditors: Unsecured general creditors are
forced to accept the “Cram Down” plan as long as they will
eventually receive as much as they would had the business
been liquidated. This is usually a percentage of their
claims.
 Discharge: After all parties have input, the Judge approves
(confirms) the Chapter 11 reorganization plan. A
reorganized debtor will be discharged from all debts
except as otherwise provided in the plan and applicable
law.
 Fast Track: The 1994 Act initiated a “fast track” procedure
for small business bankruptcy under Chapter 11. The judge
may order that a creditor’s committee not be appointed.
The debtor must have less than $2 million of liabilities.
This is raised to $4 million for secured debt on real
property.
(2) Legal Procedure: Chapter 7 bankruptcy begins when a petition is filed
in federal bankruptcy court detailing the creditors and amounts
owed.
(a) Initiation: The filing of the bankruptcy petition may be initiated
either voluntarily by the debtor or involuntarily by a creditor or
group of creditors.
(i) Voluntary: There are no restrictions on a debtor filing a
voluntary petition; there is not even a requirement that the
business be insolvent.
(ii) Involuntary: If the debtor has 12 or more creditors, at least 3
must sign the involuntary petition. The provable claims must
aggregate $10,000 after deducting lien and collateral value.
The debtor has the right to controvert the validity of the
petition.
(iii) Current Debts Unpaid Requirement: The 1984 Law eliminates
the necessity of proving an act of bankruptcy. The petition
must now only allege the debtor cannot meet his debts as
they mature.
(b) Order of Relief and “Stay”: Upon filing, the court issues an “order
of relief” which automatically “stays” all legal actions and
collection efforts by creditors on account of pre‐petition debts.
IRS collections are included. The automatic stay even delays the
execution of judgment liens. Secured creditors may not repossess
their collateral or hold foreclosure sales.
(c) Relief from the Stay: A secured creditor may bring a motion for
relief from the automatic stay for good cause. This may be
granted if the creditor can show that without relief they lack
adequate protection for their collateral, the debtor has no equity
in the property (debt exceeds fair market value), and the property
is unnecessary for effective reorganization.
(d) Debtor’s Responsibilities: If filed by the debtor, the debtor must
prepare a Statement of Affairs listing assets and liabilities and
individual creditors and amounts owed. The Court then gives
creditors notice so they may file a proof of claim. The first
meeting of creditors must be called within a reasonable time.
c. Trustee Duties and Powers: A trustee is always appointed by the court in
Chapter 7 proceedings. In a Chapter 11 liquidation proceeding the court
is required to appoint a committee of unsecured creditors. The
committee may request a trustee be appointed. The trustee represents
the interests of the unsecured creditors; the secured creditors can take
care of their own interest.
(1) Duties: The trustee is charged with conducting the administration of
the estate. This includes engaging professionals, and investigating the
debtor’s financial affairs. The trustee may operate the debtor’s
business. The trustee is charged with the duty of collecting the
bankrupt’s assets which may involve liquidating the bankrupt estate’s
assets into cash and make cash distributions to creditors.
(2) Preferential Transfers and Fraudulent Conveyances: In the
liquidation process the trustee’s primary duty is to the unsecured
creditors. Any creditor receiving a preference does so at the expense
of the unsecured creditors. The bankrupt estate may be increased if
the trustee can set aside transfers and conveyances made on the eve
of bankruptcy.
(a) Property Transfers: The trustee may reclaim assets or cash given
to third parties if such transfer was preferential. This includes
payment for less than full consideration, payment of a debt within
90 days prior to the petition or pre‐payment of an obligation due
in the future. The debt the payment reduced must be antecedent
(pre‐existing) and not a contemporaneous exchange for new
value. Payment within the ordinary industry term (usually 45
days) of incurring a normal business debt is the safe harbor and
not subject to attack. If the challenge is successful, the asset must
be returned to the estate and the transferee becomes a mere
unsecured creditor.
(b) Security Interests: The trustee may also attempt to void a
collateral financing statement (UCC 1) given within 90 days of the
petition to a third party on account of an antecedent debt. This
applies if the creditor would receive more than he would
otherwise receive as an unsecured creditor. Financing statements
exchanged for new collateral are not voidable. If successful, the
security interest is voided and the collateral becomes available for
liquidation to the general creditors. An example would be a
debtor on the eve of bankruptcy giving a financing statement
(UCC 1) for a machine to a creditor who did not sell or finance
that particular collateral.
(c) Time Period: The general time period of attack is 90 days from the
petition date. This is extended to one year if the transferee was an
“insider”, a related party or the transfer was a “fraudulent
transfer”. This is an asset transfer which was made for less than
the reasonable equivalent value or was made with the intent to
hinder, delay or defraud any creditor. A fraudulent transfer would
include the sale for $500 of a machine that is worth $2,000.
d. Claim Administration
(1) Creditor’s Claims: A creditor must file a formal claim against the
bankrupt estate within 90 days of the first meeting of creditors.
Because only authorized claims share in the asset distribution, the
trustee examines all proof of claims. All contingent or unliquidated
claims must be reduced to a dollar figure. Unless a party in interest
objects, claims are generally allowed by the court.
(2) Set‐off Rights: The new Act restricts the right of creditors to improve
their position in the estate by “setting‐off” against amounts they are
owed by the bankrupt claim due to him.
(a) Time Period: A “set‐off” right is not allowed if the amount the
creditor owed the bankrupt was incurred within 90 days of the
petition date.
(b) Example: An example would be a debtor who owed a consultant
$300 for services provided in January. If in March the consultant
purchased a $300 computer from the debtor and in April the
debtor corporation took bankruptcy, the consultant would have
to pay the full $300 to the bankruptcy trustee. Because the
computer purchase was incurred within 90 days of the petition
date, it may not be “set‐off” against the earlier receivable due for
the consulting.
(3) Shareholder Personal Liability: Corporate law specifies that a
shareholder is not liable for the acts or debts of a corporation. A
shareholder’s liability is limited to the original investment in the
shares. The general rule is therefore that a corporate bankruptcy
does not affect a shareholder. Because of abuses, there have
gradually developed exceptions where liability for corporate debts
may become the personal liability of the stockholders.
(a) Subscription Agreement: Corporate law states that a shareholder
is liable to pay the consideration specified in the subscription
agreement. A corporate bankruptcy trustee could enforce this
right.
(b) Watered Stock: Undercapitalizing the corporation at formation
may lead to stockholder liability. Under the old model Act, the
original purchaser of “watered stock” was liable for a deficiency.
The liability amount was the difference between the fair market
value of the consideration given and the shares’ par or stated
value. This restriction did not apply to treasury shares. This
liability was eliminated under the Revised Act, but the majority of
states still retain this provision to protect other shareholders and
creditors from a bargain sale of shares to an insider or related
party.
(c) Capital Impairment: Dividends which “impair capital” by leaving
creditors unpaid may expose shareholders receiving the dividends
(and the directors who authorized the distribution) to deficiency
liability. Corporate law applies an “insolvency in the equity sense”
test (liabilities exceed assets) and allows unrealized appreciation
to be included in the determination of whether capital is impaired
because of the distribution. Original undercapitalization is not
usually in and of itself grounds for shareholder liability.
(d) Equitable Liability: The corporate veil can also be pierced through
an equity action to avoid unjust enrichment. If successful, the
shareholder may be treated as a general partner for liability
purposes. This may apply in the following situations:

(i) Concurrent Affiliates: Concurrent corporate affiliates may be
liable, such as a parent‐subsidiary or brother‐sister where
there is a high degree of integration and deceptive cross‐
financing. This may apply if the entities were intended to
operate as one or there was a commingling and confusion of
records, assets, and personnel.
(ii) Subsequent Affiliates: Subsequent affiliate liability may apply
if the new entity was a result of a de facto merger or
consolidation, or is virtually the same as, and a mere
continuation of, the bankrupt corporation. If the new entity
takes benefits derived from the old corporation, it should also
take the responsibility for its liabilities.
(iii) “Mere Sham”: “Mere sham” is where the shareholder treats
the corporate shell as his or her “alter ego” or uses it to
perpetuate a fraud. Failure to treat the corporation as a
separate business entity and/or a total disregard for corporate
formalities are the usual facts and circumstances that exist
when a court invokes this form of equitable relief. Often this
includes commingling personal and corporate funds and bank
accounts and failing to keep books and records. Material
advances and loans to shareholders without proper
documentation and authorization by the board may also
support the conclusion that the corporation is a “mere sham”.
e. Dischargeability and Surviving Claims: Certain debts survive bankruptcy
against the directors, officers, and/or stockholders. Occasionally, the
involved staff may also be liable.
(1) Fraud: Debts procured from a creditor where funds were extended in
reliance on materially false financial statements may be personally
assessed against the involved shareholders, directors, and statement
preparers. This may include management accountants and financial
managers.
(2) Taxes: Employment trust fund taxes withheld from employees but
not paid over to the government may be personally assessed. Persons
liable include any responsible party who had the discretion to allocate
the funds of the business.
(3) Lack of Records: The petition may be rejected if the directors or
management fail to keep or preserve financial records. Personal
liability for involved staff usually follows.
(4) Asset Irregularities: An unexplained loss of assets or a transfer of
assets within one year with the intention to defraud or hinder a
creditor may expose the involved staff.
f. Order of Distribution: As of the date of the petition filing, the trustee
acquires the status of a perfected lien creditor. All of the bankrupt’s
assets are to be applied for the benefit of the unsecured creditors. Class
members share pro rata in an amount that their claim bears to the total
class claims.
(1) 10 Day Reclamation Rights: Aggrieved sellers or buyers are
authorized by UCC 2.502 to reclaim goods sold to or purchased from
the insolvent entity within ten days of the bankruptcy petition. The
aggrieved party must tender any remaining payment due to the
trustee with a written demand for reclamation. The 1994 Bankruptcy
Act allows the seller ten additional days to request a reconveyance to
the goods if the original deadline occurs after the bankruptcy petition
was filed.
(2) Materialman or Workman Liens: A priority is given to liens which add
value to collateral, if they comply with certain filing and notice
requirements.
(3) Perfected Secured Creditors: Perfection of a security interest in
collateral can be by filing, possession, or mere attachment. If the
value of the collateral is less than the debt, the creditor is treated as
unsecured (or general) for the deficiency. Remember the trustee’s
voiding power may convert a perfected creditor to an unsecured
status.
(4) Administrative Expenses: Compensation and reimbursements
including the costs to operate the estate. This would include post‐
petition costs of managing a business. The Bankruptcy Judge must
approve the amounts of all compensation paid to professionals such
as trustee fees, accountants, and attorneys. Any related costs are also
to be paid in this category.
(5) Wages to $4,000: Wages, salaries, vacation and sick pay of up to
$4,000 per employee if earned within 90 days of the petition date.
(6) Employee Benefit Plans: Claims of employee benefit plans for
contributions accruing within 180 days of the petition date.
(7) Certain Deposits: Lease deposits of up to $1,800 or deposits made
with the debtor for consumer goods purchases which were not
provided. Examples include layaway plans, refunds of security
deposits, etc.
(8) Taxes: This category includes the employment trust fund taxes.
(9) Unsecured Creditors: Allowed unsecured or general claims. This
usually includes all creditors without the foresight to perfect their
security interest.
(10) Fines, Penalties, and Punitive Damages: Allowed fines, penalties,
and punitive damages.
(11) Shareholders: The distribution to shareholders is given the lowest
priority. Such would only occur if all the above categories receive
100% of their claims.
(a) Preferred: The claims of the preferred shareholders must usually
be satisfied in full before the common shareholders receive
anything. This may include accumulated, but unpaid preferred
dividends.
(b) Common: Common shareholders have the lowest priority.
2250.04 Dissolution: Dissolution is the legal termination of the corporate entity under
state law.
a. Voluntary: Corporate law allows voluntary dissolutions when the
corporate charter is surrendered.
(1) Resolution and Shareholder Approval: The Board of Directors must
pass a resolution recommending dissolution and notify each
shareholder. This requires a shareholder meeting and an affirmative
majority shareholders’ vote.
(2) Articles of Dissolution: Articles of dissolution are then submitted to
the secretary of state’s office. A dissolved corporation continues in
existence but may not carry on any business except for winding up
and liquidating its business and affairs.
(3) Creditors’ Claims: The dissolved corporation may dispose of any
claims against it by actually notifying its known creditors that they
have 120 days to put in a claim. For unknown claims, the notice must
be published in a newspaper of general circulation in the county
where the corporation’s principal office is or was last located. Claims
tendered within the time period may be enforced against the
shareholders to the extent they have received corporate assets.
b. Involuntary: Corporate law provides for involuntary dissolution.
(1) Non‐Compliance: The state attorney general may move to dissolve
the corporation because of non‐filing of the annual report or
nonpayment of the corporate license fees.
(2) Shareholder Suit: A shareholder may file a court petition to dissolve
the corporation if the board is deadlocked and irreparable injury is
threatened.

(3) Shareholder Suit: Other Grounds: Other grounds for dissolution are
that the directors are involved in illegal or fraudulent activities or that
there is a clear waste of assets occurring. A creditor who has reduced
a claim to judgment which has been returned unsatisfied may also
move to dissolve the corporation.

2251 Mergers and Acquisitions
2251.01 A statutory merger is of the form “A + B = A” in which one enterprise (A)
acquires another enterprise (B) with the latter (B) ceasing to exist after the
combination.
2251.02 A statutory consolidation is of the form “A + B = C” in which a new enterprise
(C) is created to acquire the net assets of other enterprises (A and B).
Enterprises A and B cease to exist after the combination.
2251.03 An acquisition is of the form “A + B = A + B” in which one enterprise (A)
acquires a majority share of the stock of another enterprise (B), but both
entities continue their legal existence after the combination in a parent‐
subsidiary relationship.
2251.04 The statutory merger and statutory consolidation forms of business
combinations may be categorized as fusions. In both forms, the acquired
enterprise ceases to exist as a legal entity; thus, it is fused into the surviving
enterprise.
2251.05 The acquisition form of business combination may be described as an
affiliation, since the combining enterprises continue to exist as affiliated
entities.
2251.06 In the remaining discussion, business combinations are identified as being
either a fusion or an affiliation.
Methods of Accounting
2251.07 Combinations after December 2010 (i.e., the effective date for FASB ASC 805‐
10‐05) must be accounted for under the acquisition method.
2251.08 The acquisition of all or part of a financial institution that meets the
definition of a business combination also should be accounted for by the
acquisition method.
Acquisition Method
2251.09 Under the acquisition method, a business combination is deemed to be the
acquisition of one entity by another. Accordingly, the accounting for the
combination follows the historical cost principle related to acquisitions. The
accounting basis is the fair value of the consideration given or the fair value
of the consideration (net assets) received, whichever is more clearly
determinable. The acquirer is the entity that obtains control of one or more
businesses in the business combination. The acquisition date is the date that
the acquirer achieves control.
If the acquiring corporation gains control with smaller noncontrolling
purchases eventually culminating in a purchase that achieves control, the
assets and liabilities acquired in the series of purchases must all be marked to
fair value as of the date control is achieved. Gains and losses from revaluing
these former purchases must be included in current financial statements.
2251.10 The acquiring corporation must recognize the assets acquired, the liabilities
assumed, and any noncontrolling interest in the acquiree at the acquisition
date, measured at their fair values as of that date. The acquirer must then
recognize goodwill as of the acquisition date equal to the excess of the
consideration transferred plus the fair value of any noncontrolling interest in
the acquiree over the fair values of all identifiable net assets acquired (all
assets other than goodwill). The tax basis of an asset or liability should not be
a factor in determining its fair value. However, a deferred tax asset or liability
should be recognized for any difference between the fair value and the tax
basis of an asset or liability if the difference represents a temporary
difference.
a. Contingent assets and liabilities should be included when a contractual
contingency exists or a noncontractual contingency is more likely than
not to give rise to an asset or a liability.
b. In‐process research and development results are classified as intangible
assets with indefinite lives until the research and development phase is
complete or the project is abandoned. These assets are originally
recorded at fair value and will be subject to impairment tests.
c. Acquisition costs must be recognized separately from the acquisition.
Restructuring costs are also recognized separately from the business
combination. These costs must be recognized in the acquirer’s
postcombination financial statements in accordance with generally
accepted accounting principles—usually expensed.
d. For provisional amounts, an acquirer must:
(1) recognize adjustments to those provisional amounts identified during
the measurement period in the reporting period in which the
adjustment amounts are determined.
(2) record, in the same period’s financial statements, the effect on
earnings of changes in depreciation, amortization, or other income
effects resulting from the change to the provisional amounts. This
effect is required to be calculated as if the accounting had been
completed at the acquisition date.
(3) present separately on the face of the income statement, or disclose in
the notes, the portion of the amount recorded in current‐period
earnings by line item that would have been recorded in previous
reporting periods if the adjustment to the provisional amounts had
been recognized as of the acquisition date.
2251.11 In an acquisition‐method business combination, the consideration given
(paid) by the acquiring corporation may be assets, debt (payable by acquirer
to acquired), stock, or combinations thereof. Any stock issued is recorded at
fair value. Any difference between par (stated) value and fair value (FV) is
recognized as additional paid‐in capital.
2251.12 When a private company is required to recognize or otherwise consider the
fair value of intangible assets, the private company may make an accounting
policy to apply the accounting alternative. This election may be applied for
any one of the following transactions:
a. Applying the acquisition method
b. Assessing the nature of the difference between the carrying amount of
an investment and the amount of underlying equity in net assets of an
investee when applying the equity method
c. Adopting fresh‐start reporting
2251.13 Upon election of the accounting alternative, the private company shall apply
all of the related recognition requirements and shall be applied to all future
transactions.
2251.14 A private company that elects the accounting alternative must adopt the
alternative for amortizing amortization. If the alternative was not adopted
previously, it should be adopted on a prospective basis as of the adoption of
the accounting alternative.

2251.15 An acquirer shall not recognize separately from goodwill the following
intangible assets:
a. Customer‐related intangible assets unless they are capable of being sold
or licensed independently
b. Noncompetition agreements
2251.16 Customer‐related intangible assets that meet the criterion for recognition
include but are not limited to the following:
a. Mortgage servicing rights
b. Commodity supply contracts
c. Customer information

Recognition of Goodwill
2251.17 If the fair value of the consideration plus the fair value of a noncontrolling
interest in the acquiree exceeds the fair value of the identifiable net assets
acquired, this “excess” should be recognized as goodwill. The acquisition
entry in that situation may be summarized as follows:

Fusion:
Individual Identifiable Assets Acquired (at FV) XXX
Goodwill (excess of cost over FV of identifiable XXX
net assets acquired)
Individual Liabilities Assumed (at FV) XXX
Common Stock (par value of stock issued) XXX
Additional Paid‐in Capital XXX
Noncontrolling Interest in Acquiree XXX
Affiliation:
Investment in Subsidiary (cost of acquired XXX
enterprise)
Common Stock (par value of stock issued) XXX
Additional Paid‐in Capital XXX
In the case of an affiliation, goodwill and the fair value of the individual
identifiable net assets acquired would surface on the consolidated
worksheet.
2251.18 Two examples of the acquisition entries to be recorded when the cost of the
acquired enterprise exceeds the fair value of the identifiable net assets
acquired are presented immediately following. Example 1 represents a
situation in which the acquiring enterprise acquires 100% of the stock of the
acquired enterprise. Example 2 relates to the acquiring enterprise’s
acquisition of less than 100% of the acquired enterprise’s stock.

Example #1
2251.19 Acquisition of 100% of acquired company’s stock. The balance sheet of S
Company (the acquired company) immediately before the combination
appears as follows:

S Company
Balance Sheet ‐ Prior to Combination
Current assets $ 15 Liabilities $ 10
Plant assets 95 Common stock, par $1 20
Retained earnings 80
$110 $110
2251.20 P Company issues 10 shares of $1 par stock for 100% of the common stock of
S Company. The fair value of the P Company stock issued is $200. Fair values
of S Company’s net identifiable assets are the same as their book values,
except for plant assets, which have a fair value of $100. The $200 fair value
of P Company’s stock issued exceeds P’s equity (100%) in the book value (BV)
of the net assets of S, allocated as follows:

Cost of investment (FV of P stock issued) $200
Less 100% of BV of identifiable net assets of S 100
Differential (excess of cost over book value of identifiable net assets) 100
Adjustments for P’s share of differences between FV and BV of
identifiable assets and liabilities of S:
Plant assets ($100 – $95) (5)
Adjusted differential (excess of cost over FV of identifiable net $ 95
assets)—goodwill
2251.21 The entries to record the acquisition are presented for both a fusion and an
affiliation:

Fusion:
Current Assets 15
Plant Assets 100
Goodwill 95
Liabilities 10
Common Stock 10
Capital in Excess of Par 190

Affiliation:
Investment in Subsidiary 200
Common Stock 10

Example #2
2251.22 Acquisition of less than 100% of stock. Assume the same facts as presented
in Example 1, except that P acquires only 80% of the stock of S for 8 shares of
P. Thus, the $160 fair value of P Company’s stock issued exceeds P’s equity
(80%) in the net assets of S. This excess of cost over book value (goodwill) is
computed as follows:

Value of controlling interest (FV of P stock issued) $160
Value of noncontrolling interest 40
Total acquisition‐date fair value of S Company 200
Identifiable net assets 105
Goodwill $ 95
2251.23 The acquisition entry is:

Fusion: No fusion since less than 100% of S stock acquired.
Affiliation:
Common Stock 8
The $5 increment in plant assets and the $95 of goodwill would surface on the consolidated
worksheet and would be included in the consolidated financial statements.
Bargain Purchase Gain
2251.24 If the values assigned to the identifiable net assets exceed the cost of the
acquired company, such “excess” must be recognized as a gain in earnings of
the acquisition date. Thus, the fair values of the “eligible” assets would be
recognized on the acquisition date.
2251.25 The following example (Example 3) demonstrates the entries involved if the
values assigned to the identifiable net assets exceed the cost of the acquired
company. In Example 3, the “excess” (the credit differential) is less than the
assigned amount of the “eligible” assets. In that case, the “excess” is
recognized as an ordinary gain.

Example #3
2251.26 Excess of book value over cost. Assume the same facts as presented in
Example 1 (P acquired 100% of S), except that the fair value of the P stock
issued is $80 instead of $200. Thus, the fair value of P’s stock ($80) is less
than P’s equity ($100) in the net assets of S. This difference is determined
and allocated as follows:

Cost of investment (FV of P stock issued) $ 80
Less 100% of BV of net assets of S 100
Differential (excess of book value over cost) (20)
100% of excess of FV of plant assets over BV ($100 – $95) (5)
Gain (excess of fair value of identifiable net assets over cost) $(25)
2251.27 The acquisition entries are:

Fusion:
Current Assets 15
Plant Assets 100
Liabilities 10
Common Stock 10
Gain on Acquisition 25

Affiliation:
Common Stock 10
2251.28 The steps involved in determining and allocating any difference between cost
and the acquiring company’s (P’s) equity in the net assets of the acquired
company (S) are as follows:
a. Step 1: Subtract P’s equity in the book value of S from the cost of the
investment.
b. Step 2: Adjust the differential computed in Step 1 for P’s share of any
difference between the fair value and book value of the identifiable net
assets of S. (This differential will be amortized on the consolidated
worksheet in an affiliation.)
c. Step 3: Allocate the adjusted differential from Step 2. If positive, allocate
to goodwill. If negative, recognize an ordinary gain.
2251.29 Fusion: The acquiring company records on its books the individual assets and
liabilities of the acquired company at their fair value. Any goodwill resulting
from the combination is also recorded on the books at that time.
2251.30 Affiliation: The acquiring company debits the investment in the subsidiary
account for the fair value of the consideration given. The individual assets
and liabilities of the acquired company are not recorded on the books of the
acquiring company. The individual assets and liabilities, the parent’s share of
any differences between their fair values and book values, and any goodwill
arising from the business combination surface only at the time consolidated
workpapers are prepared by the parent (acquiring) company.
2251.31 Acquisition: The acquiring company’s share of the net income of the
acquired company should be included with that of the acquiring company
only after the date of the business combination.
2251.32 In the case of consolidated financial statements, the consolidated net income
in the period of a purchase business combination should include the parent’s
net income for the entire year and the parent’s share of the subsidiary’s net
income after the combination. The consolidated net income also should
reflect the effect of any differential amortization (e.g., amortization of any
differential associated with plant assets whose fair values at the date of the
combination exceeded their book values) and the elimination of any
intercompany transactions.
2251.33 The FASB requires a great deal of specific disclosure, including management’s
description of the economic factors that validate the recorded goodwill,
other unrecognized intangibles, and synergies expected from the
combination.

2252 Other Forms of Restructuring
2252.01 Tender Offers: A tender offer is an acquirer’s offer to the shareholders of the
target corporation to buy their shares of stock for a given consideration,
usually cash. The objective in a corporate takeover is to acquire enough of
the target’s outstanding common voting shares to gain effective control. The
tender price is usually higher than the current market but less than the
perceived potential market value after the merger or the value of the net
assets in liquidation. The target shareholders thus benefit. A tender offer
does not require the approval of the target company’s board of directors.
a. Friendly: A friendly tender offer is where the target’s Board and/or
management agrees to be acquired because the terms offered are
financially acceptable and in the best interest of the shareholders and
management. Usually, the target’s management recommends that the
shareholders accept the tender offer.
b. Unfriendly: An unfriendly tender offer is where the target’s Board and/or
management disapproves of the terms of the tender offer. The
recommendation to the shareholders is negative; this may be because
the tender price is inadequate or because of the adverse effects upon the
corporation and/or its employees.
c. Tender Offer Deterrents:
(1) The Williams Act: The Williams Act of 1968 was passed to protect the
interests of shareholders in a hostile merger. The SEC must be
informed of the proxy fight or tender offer at least 10 days in
advance. Tender offers must be preregistered with the SEC, and the
offeror must accept all shares tendered during the offer period
(minimum 20 days). In addition, anyone that acquires 5% of the target
must register with the SEC.
(2) Fair Price: Fair price provisions in a corporate charter are designed to
deter raiders. The usual stipulation is that all stockholders are to
receive the same price. This is designed to prohibit two‐tiered bid
takeovers where the share price to obtain control of the target is
more than what is necessary to purchase the remaining shares. Such
provisions may substantially raise the tender offer cost to the
acquirer.
(3) Staggered Seats: Staggered election of directors also restricts the
effectiveness of tender offers. Such a provision divides the
corporation’s board of directors into classes so that only a portion of
the board seats is elected in any year. Because removal of directors
who are not up for election is prohibited (except for good cause), a
raider could only gain control of the Board over a period longer than a
year.
(4) Other Deterrents: A number of states have enacted other “poison
pill” legislation which is designed to restrict hostile takeover
attempts. In some states, a takeover attempt triggers the right of
current shareholders to buy additional stock at discount prices.
(a) Freeze‐out: A freeze‐out law prohibits a raider from selling parts
of an acquired company for a given time period.
(b) Control Share Acquisition: Close to half the states have “control
share acquisition” laws which are designed to convert tender
offers into proxy contests. This is accomplished by denying voting
rights to raiders holding more than 20% of the shares unless
approved by a majority of the other shareholders.
(c) Profit Disgorge: A few states have enacted requirements that
those raiders who declare an intent to buy more than a 20% stake
in a corporation must disgorge profits (return them to the
corporation) on recently purchased shares sold within 18 months
after the announcement. This provision discourages bidders who
hope to make a quick profit by putting a company’s stock into
play.
(5) Golden Parachutes: Golden Parachutes are employment contract
provisions that guarantee key executives substantial remuneration
should they lose their jobs as a result of a takeover. Because the new
company generally pays the benefits, such provisions deter takeovers
by making acquisitions more costly. They may be desirable because
they allow management to concentrate on issues more important to
the corporation without concerns about their personal future
financial security.
d. Leveraged Buyouts: A leveraged buyout (LBO) involves the purchase of a
target with borrowed capital. Sales of a corporate division to
management is often accomplished through this manner. Outsiders may
also attempt to use this method.
(1) Attractive Targets: Acquirers look for targets with low debt levels so
that after the purchase, the corporation can take on additional debt.
Another attractive characteristic is where a portion of the target can
be quickly sold to pay for the bridge borrowing incurred in the
acquisition.
(2) Advantages and Disadvantages: The advantage to an LBO is that such
an acquisition takes less cash than the traditional purchase. The
disadvantage is that any bridge borrowing is more expensive than
normal because of the high risk.
e. Greenmail: A target corporation offers to purchase its stock from a
corporate raider for a premium price in order to end a takeover attempt.
The raider must usually agree to refrain from similar takeover attempts
against the target for some specified time period. While management
may be able to regain control through this technique, it may deplete the
assets of the corporation. Such a move usually forces management to
concentrate on short‐term results and such distractions may adversely
affect long‐run performance. Since 1988, corporate raiders are subject to
a 50% federal excise tax on greenmail gains earned on shares held for
less than two years.
f. Appraisal or Dissenter Rights: Shareholders dissenting from significant
and fundamental changes such as a proposed merger have appraisal
rights to receive the fair value of their shares in cash in most states. This
rule protects minority shareholders from being forced to follow the
majority rule.

(1) Procedure: Prior to the vote, the dissenter shareholders must give
written notice of their objections to the change and intent to demand
the appraisal rights if the proposed action is effectuated. The
dissenter must also deposit his/her share certificates demanding the
corporation purchase the shares.
(2) Fair Value: The corporation has 60 days to pay the dissenter its
estimate of the fair value of the shares plus any accrued dividends
and/or interest. The payment must be accompanied by the corporate
explanation of the calculation used to arrive at value and the most
recent set of financial statements.
(3) Value Contest: The shareholder then has 30 days to contest the
corporation’s determination of fair value. If the demand for payment
remains unsettled for 60 days, the corporation shall petition the
appropriate court requesting a judicial determination of the fair value
of the shares.
(4) Minority Shareholders: The appraisal procedure is the only relief
available to a minority shareholder. Such a shareholder may not
challenge the corporate action creating the entitlement unless the act
was unlawful or fraudulent.
2252.02 Valuing Businesses: Valuations may be desirable to support the fairness of a
transaction, when the corporation is the target of a tender offer or to help
shareholders make informed analyses, decisions and settlements. There are
three traditional methods used to evaluate and quantify the acquisition value
of an on‐going entity.
a. Asset Method: The asset valuation method emphasizes the balance
sheet.
(1) Valuation: Each asset item or group (including goodwill) the
corporation owns is valued at current fair market value. Fair market
value is the price which a willing seller and a willing buyer would
arrive at when neither party is under a compulsion to deal and both
have reasonable knowledge of relevant facts and market conditions.
This is an arm’s length transactional valuation and has the advantage
of having less judgment associated with future conditions. Appraisals
are usually necessary.
(2) Qualitative Factors: Characteristics such a growth of sales, position of
the firm in the industry, responsiveness of management, debt level,
reputation for quality, etc., must also be considered.
(3) Price: The price to be paid would be based upon the excess of the
asset values over liabilities associated with the assets or otherwise
assumed by the buyer.
b. Earnings Multiple Method: The earnings capitalization method
emphasizes the income statement and the target’s earning capacity.
(1) Approaches: There are three approaches used: future earnings are
capitalized in perpetuity; earnings are discounted for a finite number
of years; or a simple multiple is used to forecast annual earnings.
(2) Capitalization: The capitalization multiple is derived by dividing the
stock price of comparable companies by their earnings. Since stock
prices reflect expectations of future performance, the capitalization
multiple provides a means of relating value and future expectations
to the historical earnings. The forecast necessarily involves
assumptions; the chances of changing trends and conditions may
create uncertainty and perhaps a risk factor for the probability that it
will all come true.
(3) Price: The price to be paid is based on some multiple of this expected
future earnings stream.
c. Cash Flow Method: The discounted cash flow method uses the present
value of the projected future cash flows for a reasonable period of time
at a market‐derived discount rate.
(1) Discount Rate: The discount rate would usually be the combined
corporate required cost of equity capital. It is necessary to prepare
cash flow projections based on the most reasonable expectations of
the company’s future performance.
(2) Assumptions and Terminal Value: Projections necessarily involve
assumptions; the chances of changing trends and conditions may
create uncertainty especially in the later years. A “risk” factor may be
desirable. It is also necessary to estimate the terminal value of the
acquired company at the end of the projection period.
(3) Price: The price to be paid is based on the discounted future cash
flows plus the terminal value of the asset discounted to present
value.
d. Multiples: Business valuation multiples can be used to value the
business. Multiples such as Price/Earnings (P/E), Price/Revenue (price
divided by annual net sales), or Price/seller’s discretionary earnings (SDE).
Seller’s discretionary earnings is net income before owner’s
compensation, other discretionary income or expenses (nonoperating or
nonrecurring), depreciation, interest, and taxes. The value determined by
this technique covers intangible assets, furniture, fixtures, and
equipment. It does not include cash, receivables, inventory, real estate,
or liabilities, so these items (at their fair market values) must be
added/subtracted to determine the value of the business. To determine
the total value of the business, the average revenue or SDE is multiplied
by the valuation multiple, and then the value of the cash, receivables,
inventory, real estate, and liabilities are added/subtracted appropriately.
2252.03 Reasons for Business Combinations
a. Synergies: The positive benefits from business acquisitions are called
synergies. This is essentially that the new combined entity will have more
value than the sum of the old entities. It should be noted that synergies
may be hard to quantitatively measure since they are in the future and
may have a high qualitative content. There are five basic synergies.
(1) Greater Revenues: Marketing power gains may result from
advertising efforts, stronger distribution networks and a more
balanced product mix. Strategic gains may result from cross‐
technologies. Market or monopoly power may allow product tying
and price increases.
(2) Cost Reductions: Economies of scale drive many horizontal mergers
in that duplicate operating functions can be eliminated. In addition,
overhead may be spread over more units.
(3) Quality Increases: An integrated vertical distribution chain may be
able to increase quality. Processes are more easy to change if a part
of the enterprise.
(4) Tax Advantages: Net operating losses may be more fully used.
Surplus funds in one corporation can be used to purchase the stock of
another. This saves the tax the shareholder would have paid had they
received a dividend and invested it in the same stock. In addition, a
corporation is allowed at least a 50% dividend received deduction not
directly available to individual shareholders.
(5) Capitalization Advantages: Three capitalization advantages are
possible. First, if the price‐to‐earnings ratio of the acquirer exceeds
that of the target, there may be an immediate market gain. Second is
that the cost of issuing financial securities is subject to economies of
scale. Underwriter and placement fees of larger offerings may cost
less as a percentage of the net issue proceeds. Third is that the
interest cost of debt instruments often fall for larger organizations.
b. Structural Integration: Due to a more relaxed federal anti‐trust policy
and the availability of debt to finance mergers and acquisitions, the
number of combinations increased radically in the 1980s and 90s.
Traditional economic analysis recognizes three types of mergers.

(1) Conglomerate Expansion: A firm purchases or merges with a firm
that has no significant overlap in products within its current
marketing mix.
(a) Advantages: This diversification may provide cyclical stability in
sales and earnings. Such investment opportunities in diversified
ventures may be less expensive than starting a new business. In
addition, a conglomerate merger may provide immediate
availability of productive facilities, skilled management and
established vendor sources and distribution channels. Greater
financial strength and easier acquisition of capital for expansion
may follow.
(b) Disadvantages: At present, there is a growing view that de‐
diversification may increase productivity as management
concentrates their attention on their core area of expertise.
(2) Horizontal Expansion: A firm merges with a competitor that produces
or sells comparable products.
(a) Advantages: This may provide operating synergy through
economies of scale and the fuller use of excess production and
distribution capacity. In addition, it may allow increased market
share and thus more control over pricing decisions.
(b) Anti‐Trust Consideration: Because the usual effect of horizontal
expansion is to restrict competition, there may also be anti‐trust
implications.
(2) Vertical Expansion: A firm expands its influence within its own
industry. This may involve a purchase of an upstream supplier or a
downstream distribution outlet.
(a) Upstream Advantages: Vertical integration can provide for more
certainty and reliability in the input decisions and lessen chances
of supply disruptions.
(b) Downstream Advantages: Quality standards may more easily be
controlled and imposed upon a distributor if it is a part of the
company.
(c) Competitive Advantages: Such expansion may also create a
potential barrier to the entry of competitors into the industry.
Vertical expansion usually produces a more efficient operation.
c. Requirements: Mergers require the creation of a formal plan of merger.
The plan must be approved by the board of directors and stockholders of
both corporations. Mergers cannot prejudice the rights of creditors.
Creditors of either entity may sue the succeeding entity.

2260 International Finance
2261 Fixed, Flexible, and Floating Exchange Rates
2261.01 Currency Exchange: Exchange rates finance import and export trade. Over
$150 billion is exchanged daily through the internationally based currency
markets. A speculator buys or sells short a foreign currency; this risk may be
undertaken to settle a foreign transaction or for a profit motive. An
arbitrageur buys and sells a foreign currency at the same time in different
markets and profits by the margin between the two transactions.
2261.02 Definition: The market exchange rate is the price of one country’s currency
in terms of another country’s currency. A U.S. consumer uses dollars to
purchase yen to pay for Japanese Toyota automobiles and Toshiba TVs.
a. Spot Transactions: A spot transaction provides purchasers with currency
immediately (although it takes two business days for the transaction to
be completed).
Example: The exchange rate of U.S. dollars to Hong Kong dollars is
roughly 1 to 8; thus the Hong Kong dollar to U.S. dollar exchange rate
is 8 to 1. The price of an American $3,000 computer is thus $24,000 in
Hong Kong dollars. Similarly the price of a Hong Kong $3,200 suit is
thus $400 in U.S. dollars.
b. Forward Transactions: A forward (or future) transaction allows a firm to
hedge against a future currency change which may occur before the
future settlement date. Currency options give the holder the right to buy
or sell a currency for a specified price at a specified future date. The
payment in foreign currency due at the settlement date is satisfied at a
definite exchange rate today. If the forward rate exceeds the spot rate,
the currency is selling at a premium and should appreciate. Conversely if
the spot rate exceeds the future rate the currency should depreciate.
Example: The exchange rate of U.S. dollars to Hong Kong dollars is
roughly 1 to 8; thus the Hong Kong dollar to U.S. dollar exchange rate
is 8 to 1. The price of an American $3,000 computer is thus $24,000 in
Hong Kong dollars. Similarly the price of a Hong Kong $3,200 suit is
thus $400 in U.S. dollars.
c. Financial Accounting: For financial statement reporting purposes, all
monetary assets held in foreign currencies must be translated into U.S.
dollars at the current exchange rate.
2261.03 Exchange Rates: The Bretton Wood agreement pegged most major
currencies to the U.S. dollar, which in turn was set to a gold standard. This
proved to be inadequate. In the early 1970s, the U.S. halted gold
convertibility ending fixed exchange rates. U.S. currency remained the
world’s standard without rare metal backing.
a. Floating Rates: Now the actual exchange rates are determined by private
currency traders’ supply and demand. Currencies float in the
international market and fluctuate daily. The exchange rate is flexible.
Governments and Central banks may intervene in this managed “dirty”
float to maintain a country’s currency stability and prevent drastic
changes in short periods of time.
b. Fixed Rates: A minority of governments attempt to peg their currency to
an official dollar or Euro convertibility rate. These attempts have
generally proven to be unstable and black markets develop. China, Brazil,
Russia, and Hong Kong all have currencies pegged to the U.S. dollar.
Typically such countries have a currency stabilization board and dollar‐to‐
dollar reserves to the U.S. dollar. Many countries devalued their
currencies at century‐end; these four countries held to fixed exchange
rate and experienced a larger stock market and property value fall. This is
an interesting test case to see if a pegged system can avoid devaluation.
On July 31, 2005 China cut its currency link to the U.S. dollar;
subsequently, the Yuan’s value has risen.
c. Complications: The accumulation of U.S. dollars outside the country have
increased substantially in the last five years. Eurodollars and Asiadollars
have complicated the effectiveness of government intervention.
2261.04 Exchange Rate Determinants: Various factors affect a flexible exchange rate
system.
a. Short‐Run Factors: Short‐run exchange rates are determined by political
events, trade or capital flow changes. Capital is now very mobile. Also
important are intangible factors such as neighboring countries’ economic
situations and interest rates change. Higher interest rates will stimulate
demand for a currency and tend to push up exchange rates. Conversely,
lower interest rates reduce a currency’s exchange rate and thus stimulate
exports.
b. Intermediate Factors: Intermediate rates are affected by the balance of
payment figures, relative price changes, wars, monetary reserves and the
seasonal flow of funds. A positive balance of trade will stimulate demand
for a nation’s currency so foreigners have currency to buy its goods; this
will tend to cause a currency to appreciate. The exchange rates of Japan
and China increased in the last decade.
c. Long‐Run Factors: The determinants of long‐run exchange rates are more
complicated and subjective. Long‐run factors include a country’s
geographical resources and talent base, expected economic and political
stability, expected national income/productivity changes, rate of inflation
and perceived safety of investment.
d. Purchasing Power Parity: The theory of purchasing power parity suggests
that exchange rates will convert inflation differences into the pricing of
goods. The exchange rates should move in an equal but opposite
direction to the difference in inflation rates between two countries.
Example: If annual inflation is 6% in the U.S. and 4% in Japan, the Yen
will appreciate 2% against the Dollar.
Example: If U.S. inflation is expected to be 5% per annum while the
German Mark is expected to depreciate against the U.S. Dollar by
10%, a German firm importing from the U.S. can expect its Mark costs
for the imports to increase by about 15%.
2261.04 Currency Valuation
a. Overvaluation: An overvalued (or strong) currency produces trade
deficits and job losses. Profits that might have been made by American
producers go overseas.
b. Devaluation: Devaluation of the U.S. currency means the exchange rate
falls so the dollar buys less of the foreign currency. This should improve a
country’s balance of trade because foreign goods become more
expensive in the domestic market. Conversely, domestic goods become
less expensive in foreign markets, which stimulates exports. Increased
exports may lead to a drop in domestic unemployment. Domestic
inflation may increase because the cost of imports will increase.
Devaluation would also reduce the relative price foreign capitalists must
pay to purchase U.S. dollar denominated investments.
c. Exchange Rate Change: If rates change, there is a consequence to
businesses. For instance, assume that one U.S. dollar was equivalent to 4
foreign currency units and then falls in value to one U.S. dollar to 3.5
foreign currency units. Now it only takes 3.5 F.C.U.s to get one dollar of
U.S. goods. So the price of U.S. goods goes down in the foreign currency
and the price of the other country’s goods goes up in U.S. dollars.
Businesses expecting such an exchange rate change would want to pre‐
pay foreign suppliers because they will pay less dollars today to settle the
account payable due tomorrow.

d. Current Situation: In 2000 the dollar soared to a five‐year high against
the Yen, Mark, and Swiss Franc because of the continuing strength of the
U.S. economy. Since then the dollar has dropped. Economists argue that
the U.S. dollar must continue to fall against foreign currencies (especially
the Yen and Yuan) until the U.S. makes substantial improvement in
balancing the trade deficits and increases its low savings rate. Most
important is that the Yuan must rise at least 40%.
e. Consequences: The increase in import prices could lead to domestic
inflation. The concern is that many southeast Asia countries that depend
on the dollar as their currency anchor will shift to a standard of value
they perceive as having less risk of future depreciation, such as the Euro
or Yen. This would require raising U.S. interest rates to attract continual
foreign purchases of U.S. securities which fund the fiscal and trade
deficits.
2261.04 Balance of Payments: The balance of payments includes all international
payments made to and from foreign countries.
a. Current Account: The current account is the net amount of a nation’s
imports and exports of physical products (trade balance and non‐goods
services such as accounting and education). Exports draw foreign
currencies to a nation while imports deplete a nation’s currency. For
2012, the U.S. current account (merchandise trade) deficit was over $800
billion; this was the worst trade year ever and shows no sign of
improvement. Unless the Yuan rises, the trade deficit is expected to climb
even further.
b. Capital Account Balance: The capital account balance is the net of a
nation’s international movement of financial capital. The capital account
also includes the net surplus or deficit for tourist’s spending and loans. It
is the difference between investments abroad and foreigners’
investments in the nation. A deficit in the current trade account is
financed by a surplus in the capital accounts. Investments abroad deplete
a nation’s currency while an increase in foreign investment in assets such
as real estate, stocks and bonds has a positive effect.
c. Official Reserves: The official reserves in the financing account is the
equalizer in a nation’s balance of payments. This account is used to settle
net differences between the current account and the capital accounts.
The official reserves are held by the central banks in the form of foreign
currencies. A net credit in the reserve account implies a surplus in its
current and capital accounts which is balanced by a net increase in the
nation’s currency. A net deficit in the reserve account implies that a
nation has a deficit in its current and capital account transactions which is
balanced by selling a nation’s currency.
d. Long‐term Results: If a nation has a long‐term positive balance of
payments in another country’s currency, it will accumulate foreign
currency. This may be used to buy the other country’s goods, debt
instruments, securities or real estate. Almost all the 2012 sale of $400
billion in U.S. treasuries were purchased by the central banks of Japan,
China, and the Gulf States who are awash in U.S. dollars. Foreigners have
also recently substantially increased their purchases of U.S. real estate
and U.S. companies.

2262 Managing Transaction Exposure
2262.01 Cost‐Based Price: Where the “selling” division is a cost center (i.e., does not
have a profit motive), it is appropriate to base the transfer price on some
form of cost. The cost could be variable or full cost. However, whatever cost
is selected, it must be at standard to avoid the potential for cost overruns to
be passed on to the “buying” divisions. If the selling division is a profit center,
the transfer price can be modified by an appropriate markup.
2262.02 Market‐Based Price: Where both segments are profit or investment centers,
a market‐based price is typically used.
a. Perfectly Competitive Product: Where the selling division would be able
to sell all it made of the product to external customers (i.e., it is a
perfectly competitive product), the transfer price must be the market
price.
b. Adjustments to Market Price: Where the market is not perfectly
competitive, the market price may be modified by negotiation to allow
for cost savings related to decreased selling and administrative costs
because this is a transaction internal to the firm. If there is no outside
market for exactly that product, a “market” price would be negotiated.
2262.03 Maximum and Minimum Transfer Price: There is typically a price range
within which managers of the buying and selling units can agree. The buying
division will not pay more than the market price it would have to pay to buy
outside the company. Thus, the maximum price is the outside market price.
In ordinary circumstances, the selling division would not sell at less than its
incremental cost. Thus, the minimum price is equal to the seller’s variable
cost plus opportunity cost. The seller’s opportunity cost depends on whether
the selling division can use its capacity for other profitable business.

a. Full Capacity: If the selling division is operating at full capacity, it would
have to reject outside sales in order to sell to the buying division. The lost
revenue from those sales is the opportunity cost of selling inside the
company. It would not be willing to forgo the contribution margin of
those sales. Therefore the transfer price needs to include the lost
contribution margin—i.e., the transfer price should not be less than the
net revenue that would be received from an outside customer.
b. Excess Capacity: If the selling division is operating at less than full
capacity, it may be able to sell to the buying division without losing
outside sales. In that case the opportunity cost would be zero, and the
transfer price could be as low as the selling division’s variable costs.
2262.04 Tax Considerations: When determining the appropriate transfer price to use,
taxes must be considered. The objective is to keep taxes between the two
entities to a minimum. In international transfers, you would want to have the
highest sales value in the country with the lowest tax rate. Therefore, if you
were transferring goods from a country with a relatively low tax rate in
comparison to the U.S., you would want the transfer price as high as possible
so that the majority of taxes are paid in the country with the lower tax rates.
2262.05 Political Risk Considerations: Political risk represents the potential that a
foreign government will expropriate your business without paying any
compensation or allowing profits to be taken out of the country. To reduce
this risk large multinational firms use joint ventures with local partners, but
they maintain the knowledge of the firm so that if the business was taken by
the foreign government, there would be little value left.

2263 Financing International Trade
2263.01 G‐8 Group: The G‐8 members ‐ Britain, Canada, France, Germany, Italy,
Japan, Russia, and U.S. finance ministers and central bankers coordinate
global economic policies and plot free enterprise strategy. The G‐8 effectively
acts as a steering committee for the world economy and promotes stable
growth with low inflation. Under their direction is the World Bank and the
International Monetary Fund.
2263.02 Basic Objectives: The World Bank and its sister organization, the
International Monetary Fund (IMF), were founded in 1944 and have 188
member countries. Their basic historical objectives are to provide planning
assistance, exchange rate stability, and short‐term loans to member nations
experiencing temporary balance of payment difficulties. Over 180 non‐
communist countries are members of the two organizations.
a. World Bank: The World Bank has been the largest source of aid to the
Third World. For the 2013 fiscal year, the Bank made new loans and
grants of $53 billion. Russia displaced China as the biggest borrower. The
International Finance Corporation’s (IFC) is an affiliate of the World Bank
and has the primary function of investing in private enterprises in less
developed countries (LDCs). The World Bank and IFC are expected to play
a big role in financing the re‐industrialization of Russia, Eastern Europe
and Iraq.
b. International Monetary Fund: The International Monetary Fund (IMF)
has a $380 billion capital base derived from membership subscriptions. In
the last four years, massive grants and loans were made to African and
South American countries experiencing severe deflation and loan
repayment defaults. The IMF conditioned these grants and loans on
changes in the governments’ involvement in the free market. Overall, the
IMF wants more open markets for imports from the industrialized
countries and a transparent financial reporting system.
(1) Special Drawing Rights (SDRs): The IMF now has its own currency.
SDRs are based on the value of a weighted basket of four major
currencies (the U.S. dollar, Euro, Japanese yen, and British pound).
SDRs were first introduced by the IMF to supplement existing
reserves and create another country‐to‐country medium of transfer
for non‐liquid members. SDRs are not used as internal circulating
currency. Many third‐world countries would like the IMF to increase
SDRs because it is a non‐banking way to sustain and increase debt.
(2) Outreach: The Soviet Union and most of the other Soviet republics
have been granted full IMF membership status thus allowing
economic advice, technical assistance, and loans. This has allowed
billions of dollars of loans to ease the economic transition from
communism to capitalism. In the 2012 meeting, the G‐8 endorsed an
African “New Partnership” plan to spur foreign investments in Africa.
Up to $6 billion per year is pledged as aid to countries that enact
major economic and social reforms.
c. Potential Problems: The European Union, some African, Latin American
and former Soviet Union debtor nations are close to default. These
countries may not be able to repay their creditor nations and banks.
Defaulting countries may be cut off from world credit. Their economies
and foreign trade would contract. The IMF’s job is to ensure such a
disaster does not occur. The IMF has accomplished this by selectively
buying private banking debt and encouraging the rescheduling of debts.

d. Current Situation: In 2010, central bankers were happy that the U.S. lead
the world’s economic recovery and expansion by way of a “strong dollar.”
This makes foreign seller’s goods less expensive to American consumers.
Still the U.S.’s massive current account deficits mean the central banks of
China, Japan, and Saudi Arabia have been financing the U.S. consumer. It
is not clear that this can continue indefinitely.

Surgent CMA Review
Section 2300
Decision Analysis (25%)
2310 Cost/Volume/Profit Analysis
2311 Breakeven Analysis
2311.01 Single Product: At the breakeven point, total revenue equals total expenses;
therefore, net income equals zero.
a. Basic C‐V‐P Equations
Sales – Variable Costs – Fixed Costs = Net Income
Contribution Margin – Fixed Costs = Net Income
b. Breakeven Point (BEP)
(1) BEP in Units = Fixed Costs/Contribution Margin ($)
(2) BEP in Revenue Dollars = Fixed Costs/Contribution Margin Ratio (%)
Example
Fixed Costs $15,000
Unit Selling Price $4.00
Unit Variable Costs $2.50
Unit Contribution Margin ($4 – $2.50) $1.50
Contribution Margin Ration ($1.50/4) 37.5%

$15,000
BEP (units) = = 10,000 units
$1.50

$15,000
BEP ($s) = = $40,000 (or 10,000 units × $4.00 per unit)
37.5%

Section 2300 –Decision Analysis
2311.02 Targeted Income for a Single Product: In addition to calculating a breakeven
point, C‐V‐P analysis may be used to calculate the number of units or total
revenues needed to achieve a targeted level of income.
a. Target Pretax Income:
(Fixed Costs + Target Pretax Income)/Contribution Margin

Example: Same facts as in the previous example, with a desired before‐
tax net income of $10,000.
$15,000 + $10,000
BEP (units) = = 16,667 units
$1.50

$15,000 + $10,000
BEP ($s) = = $66,667 (or 16,667 units × $4.00 per unit)
37.5%
b. Target After‐Tax Income: Because income taxes reduce income, they
increase the volume of sales needed to achieve a targeted level of after‐
tax income. The after‐tax income (i.e., net income) must first be
converted into a pretax figure. That is accomplished by dividing target net
income by the complement of the tax rate and is reflected in the
following formula:
Target Net Income
Fixed Costs +
(1 – Tax Rate)
Contribution Margin
Example: Same facts as previous example, with a desired after‐tax net
income of $8,000 and a tax rate of 40%.
BEP (Units) $8,000
$15,000 +
60% = 18,889 Units
$1.50

BEP ($s)
$15,000 + $13,333
= $75,555
37.5%

2311.03 Graphic Approach
a. Cost‐Volume‐Profit Graph: This graph illustrates the interrelationships of
total revenue and total costs with the breakeven point and net profit and
loss.
b. Profit‐Volume Graph: This graph illustrates the interrelationships of
profit, volume, and breakeven point. In this graph, the breakeven point is
the point at which the profit line crosses the volume axis. The profit line
originates at the fixed cost point below $0. Thus, at zero volume, the
profit line indicates a loss equal to the amount of the fixed costs. The
slope of the profit line indicates the contribution margin per unit.

2312 Profit Performance and Alternative Operating Levels
2312.01 Using C‐V‐P Analysis for Decision Making: C‐V‐P analysis can help managers
estimate the effects of alternative decisions or events on a company’s
profits. Here are some examples:
a. Indifference Point: At an indifference point, a decision maker should be
indifferent between two mutually exclusive alternatives. The indifference
point in terms of total cost may be calculated as:
FC + VC of Alternative A = FC + VC of Alternative B
b. Evaluate Change in Assumptions: C‐V‐P analysis is very useful for
determining the impact of proposed changes in costs, volume, or selling
price on profitability.
Example: Using the same facts as in the single product example presented
above, assume supply of a certain raw material is becoming scarce.
Management expects an increase in the price of this product to increase
variable cost per unit by 10%. Calculate the effect on breakeven.
New variable cost ‐ $2.50 x 1.1 = $2.75
New contribution margin ‐‐ $4.00 ‐ $2.65 = $1.25
New contribution margin ratio ‐‐ $1.25/$4.00 = 31.25%
$15,000
BEP (units) = = 12,000 units (2,000 additional units)
1.25

$15,000
BEP ($s) = = $48,000 ($8,000 additional dollars)
31.25%
2312.02 Assumptions Underlying C‐V‐P Analysis
a. Linear Costs: All costs are linear and can be divided into fixed and
variable components.
b. Predictable Cost Behavior: Fixed costs remain constant, while variable
costs change proportionally to changes in volume.
c. Linear Revenues: Sales price per unit does not change with changes in
volume.
d. Constant Sales Mix: Sales mix remains constant.
e. Constant or Zero Inventory Levels: Inventories are kept constant or at
zero.
f. Relevant Range: There is a relevant range of output for all assumptions.
2312.03 Advantages of C‐V‐P Analysis
a. Clear Relationship: Under this analysis, the interplay among sales
revenue, variable, and fixed costs is clearly seen for a relevant range of
both units and time.
b. Sensitivity Analysis: This is an excellent and simple tool for modeling
different results under varying circumstances. (What happens if variable
unit costs change? Fixed costs change? Selling price changes? Product
mix changes? etc.)
2312.08 Limitations of C‐V‐P Analysis
a. Short‐Term Tool Only: Since all costs become variable in the long run, C‐
V‐P analysis is valid only for short‐term decisions.
b. Underlying Assumptions: These are fragile and extremely sensitive to
slight changes. The results of the analysis are only as good as the extent
to which the underlying assumptions are, indeed, true.
c. Factors Ignored: Profit is a function of price, quantity, variable costs,
fixed costs, and other factors. However, these other factors (e.g.,
inflation rates, resource accessibility, level of competition, government
regulation, and the economy in general) are ignored in C‐V‐P analysis.
However, these issues can significantly affect a company’s profits.
d. Rough Guide: Given the fragility of the assumptions, the short‐term
period of relevancy, and the disregard for other factors, C‐V‐P analysis
should be regarded as only a rough guide to potential results. It is not an
accurate predictor.
2313 Analysis of Multiple Products
2313.01 No Unique Breakeven Point: To perform C‐V‐P calculations when more than
one product is sold, it is necessary to assume a constant sales mix.
Otherwise, there is no single point at which breakeven will occur. Assuming
that different products have different contribution margin ratios, the sales
mix determines the overall contribution margin ratio, which in turn
determines the number of units and level of revenues needed to breakeven.
Given a different sales mix having a different contribution margin ratio, a
different number of units and level of revenue will be needed to breakeven.
2313.02 Weighted‐Average Contribution Margin Approach: One way to incorporate
the effects of a sales mix in the C‐V‐P analysis is to use a weighted average
contribution margin, given the expected sales mix.

Example: The Benson Co. manufactures two models of hair dryers, A and B.
Budgeted sales data for the coming year is as follows:
Model A Model B
Units Sales Mix 30,000 50,000
Unit Selling Price $50 $20
Contribution Margin $20 $10
Unit Contribution Ratio 40% 50%

Required:
1. Compute the total number of units to be sold at the breakeven point.
2. Compute the number of units of each model to be sold at breakeven.
3. Compute the total sales dollars at breakeven.
4. Compute the sales dollars for each model at breakeven.
5. If sales revenue were to total $3,000,000 during the coming year,
how much net income would be earned? Assume that the actual sales
mix, fixed costs, and unit contribution margins were the same as
budgeted and that the firm has an effective federal income tax rate of
35%.
Solution:
1. C Total number of units sold at breakeven:
Total budgeted sales in units: 30,000 + 50,000 = 80,000
% of total sales in units for each model:
A: 30,000/80,000 = .375
B: 50,000/80,000 = .625
Weighted‐average contribution margin in dollars (unit CM x sales mix
percent)
($20 × .375) + ($10 × .625) = $7.50 + 6.25 = $13.75
Total number of units sold at breakeven:
$880,000/$13.75 = 64,000 units
2. Number of units of each model sold at breakeven:
A: (64,000 × .375) = 24,000
B: (64,000 × .625) = 40,000
3. Total sales dollars at breakeven:
Total budgeted sales dollars: [(30,000 × $50) +($50,000 × $20)]
$1,500,000 + $1,000,000 = $2,500,000
% of budgeted sales dollars for each model:
A: $1,500,000/$2,500,000 = .60
B: $1,000,000/$2,500,000 = .40
Weighted‐average CM percent (budgeted sales percent × contribution margin
ratios)
(.60 × .40) + (.40 × .50) = .24 + .20 = .44
Total sales dollars at breakeven:
$880,000/.44 = $2,000,000
4. C Total number of units sold at breakeven:
A: ($2,000,000 × .60) = $1,200,000
B: ($2,000,000 × .40) = $800,000

5. Net income resulting from sales revenue of $3,000,000:
Contribution margin:
$3,000,000 × .44 (weighted‐average CM %) = $1,320,000
Income before tax:
$1,320,000 – $880,000 (fixed costs) = $440,000
Net income:
$440,000 less taxes at 35% = $286,000
2313.03 Contribution Margin per Composite Unit: A second way to incorporate the
effects of a sales mix in the C‐V‐P analysis is to use a composite unit, given
the expected sales mix. A composite unit is the ratio in which the products
are expected to sell; e.g. for every unit of A, 2 of B and 3 of C are sold. In this
situation, the composite unit contribution margin would consist of CM of A x
1, CM of B x 2, and CM of C x 3.
Example: Refer to the preceding information for the Benson Co.
Required: If the composite unit approach were taken to the above example,
calculate the breakeven in units and in revenue dollars.
Solution: Breakeven in units:
Determine CM per composite unit. Ratio of sales is 3 of A to 5 of B.
(3 × $20) + ($5 × $10) = $110
$880,000/$110 = 8,000 composite units
Sales in units needed of each product to breakeven:
A. 8,000 × 3 = 24,000 units
B. 8,000 × 5 = 40,000 units
Breakeven in dollars:
Determine CM percentage per composite unit.
Composite Unit CM/Composite Unit Selling Price [(3 × $50) + (5 × $20)]
$110/$250 = 44%
$880,000/44% = $2,000,000
Sales in dollars needed for each product to breakeven:
Sales mix dollars ratio: A. $150/$250 60%
B. $100/$250 40%
Use these percentages to determine product sales at breakeven.
A. $2,000,000 × 60% $1,200,000
B. $2,000,000 × 40% $ 800,000

2320 Marginal Analysis
2320.01 Marginal analysis involves the identification and calculation of incremental
revenues and costs (i.e., relevant cash flows) for decision alternatives.
2320.02 Short‐Term Decisions: In marginal analysis, decisions are made under a given
set of conditions, including existing plant capacity, equipment, and operating
conditions. These are essentially short‐term decisions, although they may
have long run implications such as relationships with suppliers or customers.
2320.03 Long‐Term Profitability: An innate danger in short‐term decision making is
that the process does not take into account costs throughout the value chain
of a product. A product or service must be able to recover its full costs in the
long run for profitable operations. If a company relies almost exclusively on
short‐term decision scenarios, there is a very real danger of under‐costing
products to the extent that the economic health of the firm is compromised.
Short‐term decision making needs to be approached within the context of
the overall strategic planning goals and objectives of the firm.
2320.03 Long‐Term Profitability: An innate danger in short‐term decision making is
that the process does not take into account costs throughout the value chain
of a product. A product or service must be able to recover its full costs in the
long run for profitable operations. If a company relies almost exclusively on
short‐term decision scenarios, there is a very real danger of under‐costing
products to the extent that the economic health of the firm is compromised.
Short‐term decision making needs to be approached within the context of
the overall strategic planning goals and objectives of the firm.

2321 Sunk costs, Opportunity Costs, and Other Related Concepts
2321.01 Economic Revenues and Costs v. Accounting Revenues and Costs: Economic
revenues and costs are the cash flows that will be gained or foregone when
one alternative is chosen over another, while accounting revenues and costs
are usually measured using Generally Accepted Accounting Principles
(GAAP). GAAP revenues and costs are often irrelevant or mismeasured for
decision making. For example, GAAP is based on historical costs that might
not provide a reasonable estimate of future alternative costs. In addition,
accounting costs are a mixture of fixed and variable costs, and fixed costs are
irrelevant for many types of decisions. At the same time, accounting does not
recognize opportunity costs, which are relevant for making decisions.
2321.02 Relevant Revenues and Costs: For revenues or costs to be relevant for
making a decision, they must occur in the future and be different among the
alternative choices. Variable costs are often viewed as relevant while fixed
costs are viewed as irrelevant. However, fixed costs may be relevant if they
differ across the alternatives (e.g., if additional machinery needs to be
purchased or leased to fill a special order).
a. Relevant Costs: Relevant costs include the following:
(1) Incremental/Marginal/Differential Costs: This term means the same
thing as relevant costs.
(2) Avoidable Costs: Costs that may be avoided under an alternative are
relevant. For example, a company may be able to avoid variable
production costs and some or all fixed production costs by
outsourcing its product manufacturing.
(3) Opportunity Costs: When only one alternative can be selected, other
alternatives are precluded. Opportunity costs are the amount of
profit that could have been earned on the best alternative which was
not selected. An example would be any contribution margin forfeited
related to the next best alternative use of manufacturing capacity.
Opportunity costs are not transactional and are, therefore, not
recorded in the financial accounting records. They are, however,
relevant to the decision.
b. Irrelevant Costs: Costs that are the same, or present, regardless of which
alternative is selected are not relevant to a decision. An example would
be routine fixed costs that have to be covered regardless of whether an
item is to be purchased from a supplier or manufactured in‐house.
Irrelevant costs include the following:
(1) Sunk Costs: Costs that have already been incurred are past costs that
cannot be changed. These costs have no effect on the current
decision and should not be considered. An excellent example is joint
processing costs in a “sell‐now‐or‐process‐further” decision.
(2) Historical Costs: These may be a basis to help predict future costs,
but historical costs themselves are irrelevant. For example, the cost
most often incorrectly included when making an equipment‐
replacement decision is the purchase price of old equipment. This is
irrelevant to the decision.

c. Income Taxes: Income taxes are often relevant to a decision because
they are likely to differ across alternatives. However, income taxes do not
always need to be explicitly measured. For example, suppose managers
estimate that taking a special order will increase the company’s pretax
income. As long as income taxes are less than 100% of the incremental
income, then the after‐tax effect on income will also be positive. In this
situation, the managers do not need to explicitly estimate the income tax
effect to make a decision. However, incremental income taxes may need
to be estimated in cases where different amounts of historical costs are
tax deductible or where different income tax rates (e.g., capital gains
versus ordinary income rates) apply to different decision alternatives.
2321.02 Cost Behavior and Relevance: The relevance of costs for a decision depends
on cost behavior and traceability, which in turn depends on the cost object.
a. Cost Object: A cost object is the thing for which costs are measured.
When accounting for inventory, the cost object is usually the individual
unit. However, many other cost objects may be relevant, depending on
the decision being made. Suppose managers are deciding whether to
build a new manufacturing facility. In this case, the cost object is the new
facility. Costs such as the plant manager’s salary would be fixed (i.e.,
irrelevant) if the cost object were the production of individual units.
However, the plant manager’s salary would be variable (i.e., relevant)
when the cost object is a new manufacturing facility.
b. Traceability: Some costs may be traced directly to a cost object, while
other costs are indirect and must be allocated to a cost object. In general,
direct costs are likely to be relevant, whereas indirect costs are likely to
be irrelevant for decision making. However, the facts of the individual
decision must be analyzed to make a final determination of relevant
costs.
2321.03 Quantitative Factors: Quantitative factors are relevant information that can
be measured in numerical terms. There are two general types of quantitative
factors:
a. Financial: Factors that are measured in dollars (e.g., cost of direct labor)
or ratios of dollars (e.g., return on investment).
b. Nonfinancial: Factors that cannot be measured in dollars (e.g., reduction
in new‐product development time).
2321.04 Qualitative Factors: These factors are difficult or impossible to measure
quantitatively, but still need to be considered because they will flow from the
decision. Examples include the reaction of regular customers if they learn
about a low special order price, the change in employee morale from an
outsourcing decision, and the effects on remaining product sales if one
product is dropped.

2322 Marginal Costs and Marginal Revenue
2322.01 Profit maximizing rule (MR = MC)
Marginal cost represents the change in total cost associated with producing
one additional unit. Marginal revenue represents the change in total
revenue derived from selling one more unit. If the marginal revenue from
selling one more unit is greater than the marginal cost of producing the unit,
it makes sense to produce and sell the unit as doing so will increase the
firm’s profit.
If marginal revenue is greater than marginal costs, then producing more will
increase profits. However, if marginal revenue is less than marginal cost,
then producing more will lower profit. Thus, profit is at a maximum when
marginal revenue equals marginal cost: MR = MC.

2323 Special Orders and Pricing
2323.01 This situation involves a one‐time special order from a customer, in which
the proposed selling price is less than the normal selling price. There are both
qualitative and quantitative issues to consider.
a. Qualitative Factors
(1) Regular Customers: The impact on other customers and on regular
marketing channels must be examined. Will regular customers
demand the same price‐break or go elsewhere to purchase if they
learn of the deal? Also, is this really a one‐time deal, or will the new
customer become a regular customer and expect the same price in
the future?
(2) Legal Considerations: Note that the Robinson‐Patman Act prohibits
price differentiation among customers unless they can be justified by
significant differences in costs.
(3) Different Markets: Will the special order allow the company to enter
a new market?
b. Quantitative Factors
(1) Production Capacity: This is the key factor. If the firm has idle
production capacity, any revenue in excess of the incremental costs
of producing the product will contribute to increasing net income or
decreasing a net loss. If the firm does not have idle production
capacity (or not enough idle capacity to make the entire order), the
incremental revenue must exceed both the incremental costs and the
contribution margin of other sales forfeited if this order is accepted.
(2) Minimum Acceptable Offer: This is the sum of incremental costs plus
any opportunity costs from contribution margin forfeited.
(3) Relevant Costs: All variable costs that would be incurred are relevant.
Committed fixed costs are sunk costs and are not economically
relevant. Additional fixed costs that would be incurred only if the
order were accepted are relevant.
Example: Award Plus manufactures medals for winners of athletic
events. The company has a maximum manufacturing capacity per
month of 10,000 medals, and is currently operating at 75% of that
capacity. Each medal normally sells for $175. Current unit product
costs are as follows:
Variable Costs
Manufacturing
Labor $50
Material 35
Marketing 25
Total Variable Costs $110

Fixed Costs
Manufacturing $37
Marketing 23
Total fixed costs 60
Total unit costs $170
Award Plus has received a special one‐time order for 2,500 medals at
$100 per medal. No variable marketing costs would be incurred for
this order. Determine the minimum acceptable price for a special
order and whether the proposal should be accepted.

Solution: The minimum acceptable price is the sum of the
incremental relevant costs.
1. Determine Status of Manufacturing Capacity. Maximum is 10,000
medals. Current operations are at 75% level (7,500 medals).
Therefore the capacity to manufacture the 2,500 special order is
available without disturbing normal production. No opportunity
cost exists.
2. Minimum acceptable special order selling price is sum of relevant
costs (labor and material costs, $50 + $35 = $85). Fixed costs are
not relevant because they exist in both alternatives and no
additional ones are identified.
3. Provided there are no negative qualitative issues, the order
should be accepted because the $100 incremental revenue
offered exceeds the incremental costs.
2324 Make vs. Buy
2324.01 These decisions can involve the following scenarios: manufacturing a part in‐
house or purchasing from a supplier, or providing in‐house services or
contracting with a provider (e.g., human resources or customer service).
a. Qualitative Factors: There are both advantages and disadvantages to
producing a good or service internally that cannot necessarily be
quantified. Below are several examples
(1) Advantages:
(a) Reduced Supplier Dependence: Producing a good or service
internally reduces the firm’s dependence on outside suppliers.
(b) Quality Control: Quality control may be easier to maintain in‐
house.
(c) Employee Morale: The increasing use of outsourcing can cause
problems with morale for employees who are concerned about
their own long‐term job stability. Producing goods and services
internally avoids this type of employee morale problem.

(2) Disadvantages:
(a) Suppliers: Making a component may reduce the firm’s
dependence on a supplier to the point of losing the relationship
altogether. If demand increases and the firm needs to buy some
components, it may not be able to because the supplier is full
with other work.
(b) Expertise and Other Resources: If production of the good or
service requires special knowledge, skills, or equipment that the
company does not have, then it may not be possible to produce
internally in the short‐term.
b. Quantitative Factors: Dollar cost, of course, is the key factor. The
question is which costs?
(1) Relevant Costs: The variable costs that would be incurred if the
component were made are relevant to the decision. However, fixed
costs are relevant only if they represent additional costs that arise
from one of the alternatives. In other words, the regular committed
fixed costs that are present and must be covered regardless of which
decision is selected are not relevant. Also, eliminate from any
decision all allocated common costs, as these will continue regardless
of which alternative is selected. The maximum price to be paid to a
supplier for the component should be the sum of the marginal costs
to manufacture the part, plus any opportunity cost.
(2) Opportunity Costs: The key to whether opportunity costs are relevant
is utilization of facilities. If there are alternative profitable uses for the
manufacturing capacity that would be needed to make the
component, then the opportunity cost to be included in the analysis is
the contribution margin forfeited of that other use. If there is no
alternative use (i.e. the firm has idle or excess capacity equal to the
needs to manufacture the part), then the opportunity cost is zero.

Example: The Jones Company currently manufactures all component
parts used in the manufacture of various hand tools. A steel handle is
used in three different tools. The budget for these handles is 20,000
units with the following unit cost:
Direct material $0.60
Direct labor 0.40
Variable overhead 0.10
Fixed overhead 0.20
Total unit cost $1.30
Steel Co has offered to supply 20,000 units of the handle to Jones
Company for $1.25 each, delivered. If Jones currently has idle
capacity that cannot be used, accepting the offer will:
Answer: increase the handle unit cost by $0.15. Use the incremental
cost approach to solve this problem.
Cost per unit to purchase handle $1.25
Direct material cost per unit $0.60
Direct labor cost per unit 0.40
Variable overhead cost per unit 0.10
Opportunity Cost relating to alternative use of
0
manufacturing capacity
Unit cost to make handle (and maximum purchase price)
1.10
Increase in unit cost to purchase
$0.15
Note that the fixed cost allocation of $.20 per unit is not relevant,
since it relates to committed fixed costs that are present and must be
covered regardless of whether the part is made or purchased.
Example: Assume now that Jones Co. can use all available excess
manufacturing capacity to manufacture a product that it could sell for $4.
The variable costs to manufacture, market, and distribute this product total
$3.30. How does this situation impact the above decision?
Answer: The opportunity cost of the contribution margin of the new product
($0.70) is relevant and must be added to the cost to manufacture the handle,
to arrive at a total incremental cost of $1.80. The decision would now be to
purchase the handle because its purchase price is $0.55 less than the cost to
make it.

2325 Sell or Process Further
2325.02 Objective: These situations occur when determining whether joint products
should be sold at the split‐off point, or whether they should be further
processed at additional (separable) costs and sold at a later stage. Note that
the joint processing costs are sunk costs. They will be allocated for financial
accounting purposes, but for decision analysis these costs are irrelevant.
2325.03 Rule: The decision rule is simple in theory: If the incremental revenue
exceeds the incremental cost of the additional processing, then process.
Example: A soap manufacturer has six main product lines which are
produced from common inputs. Joint product costs up to the split‐off point
constitute the bulk of the production costs for all six products lines. These
joint product costs are allocated to the six product lines on the basis of
relative market value.
The company also has a waste product that was discarded until the research
department discovered that the waste could be sold as a fertilizer ingredient
after some further processing. The further processing would cost $175,000
per year and the waste could be sold for $300,000 per year. The accounting
department included the waste as a new product with an allocation of
$150,000 in joint product costs.
Sales value of the waste product after further processing $300,000
Less costs assigned to the waste product 325,000
Net Loss $(25,000)
Management decided not to process the waste product. Was this the correct
decision?
Answer: No, this was not the correct decision. The analysis presented to
management should not have included any joint processing costs. Joint costs
are past, sunk, irrelevant. The analysis should have been:
Sales value of the waste product after further processing $300,000
Additional processing costs 175,000
Contribution margin $125,000
This shows the actual benefit from processing the waste product.

2326 Add or Drop a Segment
2326.01 A business segment can be a product, product line, department, division, etc.
Key issues in determining whether a segment should be added or eliminated
focus on how revenue and cost items would change.
a. Qualitative Factors: These include positive or negative reputation effects
when a company disposes of a segment. They may also include cross‐
product customer relationships.
b. Quantitative Factors: A segment is contributing to the overall
profitability of the organization as a whole so long as the segment
contribution margin is at least equal to the segment’s avoidable direct
fixed costs. Segment costs are divided into direct variable, direct fixed,
and allocated common costs. Direct variable costs will disappear with the
segment. Direct fixed costs may not. Each fixed cost needs to be analyzed
to determine the extent to which it is avoidable.
(1) Avoidable Fixed Costs: These will be eliminated when the segment is
dropped.
(2) Unavoidable Fixed Costs: These are items such as depreciation or
salaries of key people who will be retained by the company and
assigned to other segments upon the elimination of the segment
under examination. Those costs will continue as direct costs of
segments to which the related costs objects (equipment, personnel,
etc.) are transferred.
(3) Allocated Common Costs: These also will continue, even if the
segment is eliminated, and will be distributed among remaining
segments. They must not be used to determine the segment’s
profitability. In fact, allocated common costs are often the reason the
segment is being considered for elimination, even though it is making
a contribution to the firm. Sometimes a product is making a
contribution even without a positive segment margin, because it is a
loss leader bringing other sales to the firm.

Example: A store with four departments is considering closing one of
its departments based on the following departmental income
statement:
Sample Company
Income Statement
(000 omitted)
Departments
Total A B C D
Sales $130 $40 $40 $30 $20
Variable Costs 86 21 21 26 15
Segment Contribution Margin 44 19 16 4 5
Fixed Costs:
Direct Costs 19 7 7 2 3*
Segment Margin 25 12 9 2 2
Allocated Common Costs** 12 4 4 1 3
Departmental Net Income (Loss) $13 $8 $5 $1 $(1)

* $1,000 depreciation, $2,000 salaries
** Allocated based on space occupied
Would closing Department D improve overall company profitability?
(Assume that the equipment is retained but that personnel are laid
off.)

Answer: The analysis depends upon which costs can be avoided in the
future. Variable costs will disappear along with sales revenue and
contribution margin. The initial assumption is that direct fixed costs
will disappear as well, since they are directly traceable to the
department. However this is too simplistic, each cost must be
analyzed. This is a situation where sunk costs are relevant in the
sense that they cannot be avoided by a future decision. The
depreciation expense for store fixtures will not disappear. The cost
for salaries of employees who will be laid off will disappear. Allocated
common costs will not disappear. The analysis below shows the
potential impact of eliminating Department D.
Total D Eliminated New Total
Sales $130 $20 $20 $110
Variable Costs 86 15 15 71
Segment Contribution Margin 44 5 5 39
Fixed Costs
Direct Costs 19 3 2 17
Allocated** 12 3 0 12
Total Fixed Costs 31 6 2 29
Net Income (Loss) $13 $(1) $3 $10
Closing the department would actually decrease net income. Note
that if the original Income Statement had been on a segment basis
without allocating the common fixed costs, the question of closing
the department would not have arisen. The segment contribution
margin for Department D is $5,000. Its unavoidable direct fixed costs
are $1,000. By applying the decision rule (segment contribution
margin at least equal to or greater than avoidable fixed costs), it is
obvious that the department should remain in business.

2327 Capacity Considerations
2325.01 Introduce New Product or Change Output Levels: Addition of a new product
or changes to output levels of existing products require consideration of how
changes in the sales mix will affect the company both qualitatively and
quantitatively.
a. Qualitative Factors: A variety of qualitative factors may affect this type of
decision. For example, addition of a new product could increase or
decrease company reputation, depending on the success and features of
the new product. If productive capacity is limited, then changes to output
levels could create or alleviate product shortages, which would have
further effects on customer satisfaction.
b. Quantitative Factors: The quantitative analysis for this type of decision
involves estimating the profit of effects, incorporating the expected
changes in sales mix and volumes. The difference in profit includes
changes in the contribution margin, as well as changes in total fixed costs
(if any). If production capacity is limited so that increasing the output of
one product reduces the output of another product, then the opportunity
cost of foregone sales must also be considered. The computations are
similar to those shown for a special order, below.

2330 Pricing
2331 Pricing Methodologies
2331.01 Pricing Decisions: Companies’ product pricing decisions are influenced by a
number of factors.
a. Demand for the Product/Service: Customer willingness and ability to buy
a given amount of goods or services at a given price. In general,
customers demand lower quantities at higher prices. Some companies,
such as Wal‐Mart, adopt a strategy of setting low prices, relying on high
volumes to earn profits. Other companies sell differentiated products for
which customers are willing to pay higher prices. Shifts in demand can
also occur over time. For example, availability of a product substitute can
reduce the price customers are willing to pay for a product. Also, product
demand may shift downward or upward for a particular product because
of changes in economic conditions.

(1) Demand Curve: A demand schedule shows the quantity consumers
will purchase at various prices. The law of demand states that as unit
price falls, consumers will purchase more quantity. As unit price
increases, quantity demanded will decrease.
(2) Change in Quantity Demanded: A change in quantity demanded
results from a change in price, with all other factors remaining the
same. This is a movement along the demand curve from one price‐
quantity combination to another.
(3) Change in Demand: A change in demand is caused by changes in
consumers’ tastes, prices of complementary or substitute items,
money income, expectations as to price or income changes, the range
of available products, and the number of buyers. An increase in
demand can be caused by an increase in income or the elimination of
a substitute good. A decrease in demand can result from a decrease
in income or an increase in substitute goods.
(4) Elasticity of Demand: Elasticity of Demand measures the
responsiveness of quantity to a change in the product’s price.
(a) Characteristics: For most goods, the basic determinant of the
demand elasticity is the number of substitutes available. The
more close substitutes a good has, the greater its elasticity of
demand. Also, elasticity is greater over a longer period of time or
when a larger portion of the consumer’s income is required to
purchase the commodity. The ultimate question is the effect of
the change on total revenue. Demand is said to be elastic if total
revenue increases from a decrease in price (i.e., the percentage
change in quantity is greater than the percentage change in
price). Demand is said to be inelastic if total revenue decreases
from a decrease in price (i.e., the percentage change in quantity is
less than the percentage change in price).
(b) In Practice: In practice, the degree of elasticity is often difficult to
measure, and the decision‐maker has only a general idea of the
relative elasticity and the slope of the demand curve. However,
large retail companies such as Wal‐Mart may be able to estimate
price elasticity from transaction data.

b. Supply Availability: Producers are willing to sell a given amount of goods
or services at a given price. In general, they are willing to sell higher
quantities at higher prices. Sometimes goods or services are scarce,
causing the supply curve to cross the demand curve at a higher price.
Increased competition has the opposite effect; as new competitors enter
a market or as existing competitors increase the quantity available for
sale, the supply curve shifts to the right and crosses the demand curve at
a lower price. In addition, competitors may choose aggressive pricing
policies to help them establish a market position, thus driving the market
price downward.
(1) Supply Curve: The supply schedule shows the various quantities
producers will bring to market at various prices. The law of supply
states that sellers will offer more quantity at a higher price and less
quantity at a lower price.
(2) Change in Quantity Supplied: A change in quantity supplied is due to
a change in price, with other factors remaining the same.
(3) Change in Supply: A change in supply results from a change in one of
the following: prices of inputs, technology, prices of other goods, the
number of suppliers, and suppliers’ expectations. A decrease in the
cost of the necessary inputs or a technological improvement are
examples of changes that will increase the quantity offered by a
supplier at all price levels. If there was no quantity change, the price
would be reduced. A decrease in the number of suppliers or increase
in input prices will decrease the supply.
c. Time Horizon: Pricing decisions may be short‐term or long‐term.
Managers are willing to sell goods or services in the short‐term as long as
the selling price exceeds marginal costs. For example, they may be willing
to accept a special order at a price that is lower than the usual price
charged for a good or service. However, the selling price must be high
enough for revenues to exceed both fixed and variable costs for
companies to stay in business over the long term.

2332 Target Costing
2332.01 Target pricing and costing is the practice of establishing the market price for
a product and then determining whether the product can be produced at a
sufficiently low cost (the target cost) to ensure a desired rate of return. The
product is produced only if the targeted rate of return is achievable. Target
pricing and costing is a strategic management tool related to product pricing.
The focus of target costing is to focus product design and production on
customer needs, while at the same time achieving desired long‐term
profitability goals. An understanding of the degree to which costs are built
into the product at the design stage is critical to cost control in target costing.
2332.02 Steps in Target Pricing and Costing: Target pricing and costing involves the
following steps:
a. Determine Target Price: The process begins with estimation of a market
price for the planned design of a product.
b. Calculate Target Cost: The target cost is the difference between the price
a customer is willing to pay for a product (i.e., the target price) and the
profit the company has determined it must earn from that sale. Because
the target cost is calculated before production begins, costs include all
resources used to produce the item, including design‐stage costs.
Example: If the target price for a product is $100 and the company
requires a 30% rate of return on cost, what is the target cost?
Answer: Convert the required rate of return to an algebraic equation,
and then solve for the target cost:
$100 – Cost = 30% × Cost
$100 = 1.30 × Cost
Target Cost = $100/1.30 = $76.92
Example: If the target price for a product is $100 and the company
requires a 30% profit margin, what is the target cost?
Answer: Calculate the required profit margin, and then solve for the
target cost:
Required profit margin = $100 × 30% = $30
Target Cost = $100 – $30 = $70
c. Compare Estimated Cost to Target Cost: The estimated cost to produce
the product is then compared to the target cost. If the estimated cost is
less than or equal to the target cost, then the product will be produced. If
the estimated cost is higher than the target cost, then the company must
either drop the product or seek ways to reduce costs.
d. Eliminate Non‐Value‐Added Costs: One method to achieve the target
cost is to identify and eliminate non‐value added costs—i.e., costs
incurred that do not add value to the customer. Value chain analysis is
often used to identify non‐value‐added costs.
e. Other Cost Reductions: A variety of other methods may be used to
achieve the target cost, including product redesign, improved production
efficiency, outsourcing, and supplier price negotiations.

2333 Elasticity of Demand
2333.01 Price elasticity of demand
a. The price elasticity of demand is a measure of the responsiveness of
consumers to a change in a product’s price.
b. The law of demand states that there is an inverse relationship between
the price and quantity demanded of a product. However, it does not
provide the information about the relationship between the two
variables.
c. The formula for measuring the price elasticity of demand is:
%Q d
Ed 
%P
  the change in the particular variable

d. The law of demand states that price and quantity move in opposite
directions. In other words, as price increases, quantity demanded falls. By
convention, economists use the absolute value of the measure rather
than using the minus sign when stating price elasticity of demand.

e. A problem arises depending upon which value is used as the base value
when performing the calculation. The following situation could arise. If
the base price is $10 and the price increases to $12, the price has
increased by 20%. If the base were $12 and the price fell to $10, then the
percentage change would be 16.67%. To solve this problem, the formula
is modified to use a mid‐point and is calculated as follows:
Q0  Q1   Q0  Q1   2
Ed 
P0  P1   P0  P1   2

QO = Original quantity
Q1 = New quantity
Po = Original price
P1 = New price
f. Summary of price elasticity of demand (Ed):

Condition
Elastic Ed > 1
Inelastic Ed < 1
Unit elastic Ed = 1
Perfectly elastic Ed = ∞
Perfectly inelastic Ed = 0
2333.02 Determinants of elasticity of demand
a. The larger the number of substitutes generally available for the product,
the greater its price elasticity of demand.
Narrowness of definition of the product has a significant impact on the
number of substitutes that are available. For example, the demand for
Fords would be more elastic than the demand for automobiles. There are
other brands that are readily substitutable for Fords, but there are few, if
any, good substitutes for automobiles for most types of individual
transportation.
b. All other things being equal, the higher the price of the good relative to
the consumer’s income, the more elastic the demand for the product.
Everything else being equal, the demand for a new automobile would be
more responsive to a price change than the demand for clothing.

c. Generally speaking, the more the consumer considers the good to be a
“luxury” rather than a “necessity,” the greater the price elasticity of
demand. Everything else being equal, the demand for entertainment
would be more responsive to price changes than the demand for food.
d. Generally, the longer consumers have to respond to a price change, the
more elastic the demand would be. A classic example relates to the
demand for gasoline. When gasoline prices rise, in the short run
consumers have little opportunity to respond; however, if prices remain
high, over the long run they can replace their automobiles and trucks
with more fuel‐efficient vehicles.
2333.03 Price elasticity and total revenue (the total revenue rule)
Firms are interested in being able to estimate their revenue from sales. The
concept of elasticity provides one method to facilitate making such
measurement. In the simplest case, revenue is defined as the price of the
product times the quantity sold.
a. If demand is elastic at the current price, then reducing the price will
increase the total revenue and vice versa.
b. If demand is inelastic at the current price, then increasing the price will
increase total revenue and vice versa.
c. If demand is unitarily elastic, then changing the price will have no impact
on total revenue.
This set of relationships is known as the “total revenue rule” and allows a
firm to determine the general impact that a price change would have on the
firm’s revenue if the product’s elasticity of demand can be estimated.
2333.04 Other measures of elasticity
a. There are other measures of elasticity that could help a firm estimate the
demand for their product as other demand determinants change. These
measures are used to define various relationships among and between
products.
b. Income elasticity of demand measures the responsiveness of consumer
demand for a product relative to a change in income.
c. The formula for calculating income elasticity of demand is:

Percentage change in demand for the good
Ey =
Percentage change in income
d. When Ey > 0, then the product is a normal good. If Ey is < 0, then the
product is an inferior good.

e. Summary of income elasticity of demand (Ey):

Condition
Normal good Ey > 0
Inferior good Ey < 0
f. Cross‐elasticity of demand measures responsiveness of consumer
demand for a product relative to the change in the price of another
product. If consumers buy less of the original product, then the goods are
complements.
g. The formula for calculating cross‐elasticity of demand is:

Percentage change in the demand for one good
EPy =
Percentage change in the price of another good
h. If EPy > 0, then the goods are substitutes. If EPy < 0, then the goods are
complements. A summary of elasticity:

Condition
Complements Epy < 0
Substitutes Epy > 0
Unrelated Epy = 0
2333.05 Other supply and demand topics
a. Complementary goods are goods and services that are used in
conjunction with each other. When the price of one good falls and the
quantity demanded of that good rises, the demand for the other good
rises. The cross‐elasticity of demand of complementary goods is negative
since as the price of product A declines, the more of product B will be
purchased at any price. For example, if the price of hot dogs falls,
consumers will purchase more hot dogs, and they will also purchase
more hot dog buns, a complementary good.
b. Inferior goods are goods or services whose demand decreases as a
consumer’s income increases, assuming prices remain constant. The
“inferiority” being described has nothing to do with the actual quality of
the item but with the consumer’s ability to purchase needed items. For
example, when consumers have limited incomes, canned vegetables will
often be purchased rather than fresh vegetables; however, as incomes
rise, less canned vegetables will be purchased as the consumer
substitutes fresh vegetables for the “inferior product” that was
purchased only because of the consumer’s limited income. Inferior goods
have a negative income elasticity of demand.
c. Normal goods are good or services whose demand increases as
consumer’s income increases, assuming prices remain constant. Normal
goods have a positive income elasticity of demand.

d. Substitute goods are goods and services that can be used in place of each
other in at least some of their uses. When the price of one good falls, the
quantity demanded of that good increases and the demand for the other
good without a price decrease falls. If goods are perfect substitutes, the
consumer is indifferent as to which product to purchase and will
purchase the one with the lower price. If goods are imperfect substitutes,
the purchase decision would be based on the price change of one good
relative to trade‐offs being made such as differences in quality between
the two goods. For example, a consumer may believe a Ford truck is of
better quality that a Toyota truck, but at some difference in price, some
consumers would substitute the Toyota truck. A substitute good is the
opposite of a complementary good.
e. Law of diminishing marginal utility is a proposition that describes how an
individual’s satisfaction (or marginal utility) derived from the
consumption of each additional unit of the good or service declines as
consumption of that good or service increases. For example, a guest may
desire a piece of pie at the end of dinner on Thursday evening and
derives a level of “satisfaction” from consuming it. The host offers the
guest a second piece of pie and the “satisfaction” the guest receives from
consuming that piece of pie is less than that received from consuming the
first.

2334 Product Life‐Cycle Considerations
2334.01 Product life‐cycle costing is a strategic planning technique that incorporates
all of the expected revenues and costs over a product’s life cycle. Products
may originally sell at a loss, but are expected to generate sufficient profits
over time.
2334.02 Upstream and Downstream Costs: In addition to production costs, all
upstream (research, design, and development) and downstream (marketing,
distribution, and customer support) costs are considered.
2334.03 2. Stages of Product Life Cycle: A product’s life cycle is the time period
between the initial design and development of a product and the product’s
ultimate termination. A successful product experiences the following general
stages.
a. Development Stage: This stage is characterized by research and
development and investments in plant and equipment, etc. Revenues
may be zero or small during the development stage, resulting in losses.

b. Growth Stage: During this stage, revenue increases rapidly as volume
increases. Manufacturing efficiencies can lead to improved contribution
margin. Cash inflows are typically significant, but may be offset
somewhat by expenditures required to increase production capacity and
increased investment in inventory and accounts receivable.
c. Maturity Stage: Profits are at an optimum level during this stage.
However, higher promotional costs may be incurred to counter increased
competition, which may lead to decreased profit margins.
d. Decline Stage: Both sales volume and profits decline during this last
stage, due to greater price competition and availability of substitute
products. Unit costs tend to increase. However, significant cash inflows
can result from the liquidation of inventories and other assets related to
the product.
2334.02 Almost all products have life‐cycle stages and marketing strategies vary
depending upon the particular stage. Because of this, companies must
continually find and develop new product ideas.
a. New Product Development: Authorities identify the below steps
although some of the functions may be combined.
(1) Idea Generation: This can come from internal sources and formal
research such as surveys and focus groups. Customer feedback and
suggestions for improvements may be a good source of ideas.
Tracking competitive new products may lead to the idea of
introducing a similar item. A written plan for each new product
should be prepared.
(2) Idea Screening: Not all new ideas are good and not all good ideas are
economically viable. The company will typically have a pre‐
established set of new product criteria that must be met.
(3) Product Concept Development: The ideas that meet the company’s
threshold criteria must then be analyzed in detail. This focuses on the
detailed economics of the proposal and how the idea will be stated in
meaningful consumer product images.
(4) Concept Testing: This is empirically verifying the conclusions reached
to date. A test of the target consumers is undertaken to ensure that
strong consumer demand exists.
(5) Marketing Strategy Development: This is a formal written statement
that describes the product’s planned pricing, distribution, and
marketing budget for the first year.
(6) Business Analysis: This is an accounting‐related review of the sales,
cost, and profit projection of the proposed new product to determine
if they meet the company’s threshold financial measures.
(7) Product Test Marketing: If the product passes the company’s
business analysis, the stage of test marketing begins. This varies
depending upon management’s faith in the strategy and steps
discussed above.
b. Simulation: Many companies combine and expedite a number of the
above steps by using cross‐functional teams to examine many aspects of
the product at the same time. While reducing the time to get a new
product ready to market there may be trade‐offs in terms of
thoroughness. Rushing a product to market should not adversely affect
quality.
c. Commercialization: This is incurring the high costs to introduce the new
product into the markets. Variables include introduction timing and
where to launch the new product.
d. Product Life‐Cycle: Authorities identify five stages marketed by different
problems and opportunities. This can be applied to a product class
(automobiles), a product form (station wagon), or a brand (Volvo).
(1) Product Development: This is discussed above. Revenue is zero and
development costs are being incurred.
(2) Introduction: Sales begin slowly, promotion spending is relatively
high, and cash flow may remain negative.
(3) Growth: There is rapid market acceptance, sales climb but marketing
costs stay high. Still profits grow and cash flow turns positive.
Competition is beginning to enter the market.
(4) Maturity: Competition drives down prices and companies may stay in
the maturity stage for years. The emphasis changes from attracting
new customers to increasing service to our existing customers.
Companies modify their marketing mix and product lines to meet and
beat competitors. Profits are good but towards the end may begin
declining.
(5) Decline: Profits drop and management must decide whether to
continue carrying a weak product which may adversely affect
customer’s perception of all the products. Competitors may leave the
market and the company may decide to stay but only serve the hard
core customers and reduce marketing costs.

2335 Market Structure Considerations
2335.01 Perfect competition
a. The market structure of perfect competition is characterized by a large
number of sellers producing a standardized product with easy entry and
exit into and out of the industry. The seller has no ability to influence the
product price.
b. There are a number of assumptions involving perfect competition:
(1) There are many small independently acting buyers and sellers who
produce a standardized or homogeneous product, none of whom can
influence price.
(2) Each firm produces such a small portion of total output that they
have no influence over price. The firm is a price taker, that is, the firm
must accept the market price.
(3) There is free entry into and exit from the industry. There are no
significant legal, technological, or financial barriers to entry.
Information is free and readily available.
(4) Firms face a perfectly elastic demand curve at the market price that is
determined where consumer demand equals industry supply.
(5) For the perfectly competitive firm, Price = Average revenue =
Marginal revenue.
(6) If the firm is making an economic profit, there is an incentive for new
firms to enter the market. The entry of new firms will increase supply
and shift the industry supply curve to the right, reducing the
equilibrium price. Entry will continue until there is no economic
profit, that is, the firm is earning only a normal profit.
c. The market equilibrium occurs where price equals marginal cost at the
minimum point on the average cost curve. This means that in
equilibrium, a firm is operating at its most efficient level of output. The
following graph represents the equilibrium position in a perfectly
competitive industry. Marginal revenue equals marginal cost as minimum
average cost. At this point, the firm is making only a normal profit.

PO = Price
Q0 = Quantity demanded
D0 = Demand
MR0 = Marginal revenue
MC = Marginal cost
ATC = Average total cost
2335.02 Monopolistic competition
a. The market structure for monopolistic competition is characterized by
having many small firms that produce differentiated products. The firm
has some degree of control over product price.
b. There are a number of assumptions for monopolistic competition:
(1) There are a relatively large number of independent and small buyers
and sellers.
(2) There is free entry into and exit from the industry.
(3) Firms are producing a differentiated product. The differences may be
found in product attributes such as materials, design and
workmanship, varying degrees of customer service, convenient
location, packaging, and brand image.
c. In monopolistic competition:
(1) the firm faces a downward‐sloping demand curve and marginal
revenue is less than price. Firms can make an economic profit in the
short run.
(2) there tends to be significant use of advertising as a form of non‐price
competition. The goal of advertising is to shift the firms demand
curve to the right and to make demand less elastic; that is, to make
consumers less responsive to price changes.

(3) product differentiation leads to firms competing on quality, price, and
marketing.
(4) the existence of economic profit provides an incentive for firms to
enter the industry, shifting the industry supply curve to the right.
Entry will continue until economic profit disappears.
d. Firms in markets that are imperfectly competitive face a downward‐
sloping demand curve, which implies that marginal revenue is less than
price. In the graph below, the firm would maximize price at the point
where marginal revenue equals marginal cost. At the profit maximizing
level of output (Qo), the firm would change price (Po) and make an
economic profit as shown in the area Po ABP.

P = Price
Q = Quantity demanded
D = Demand
MC = Marginal cost
MR = Marginal revenue
ATC = Average total cost
2335.03 Oligopoly
a. Oligopoly is a market structure characterized by a few firms that sell
either a standardized or differentiated product and where entry into the
industry is difficult.
b. There are a number of assumptions for an oligopoly:
(1) There are a small number of relatively large firms.
(2) Firms may produce either a standardized or differentiated product.
(3) Firms in the industry are interdependent.
(4) Firms tend to engage in non‐price competition.
c. In oligopolies:
(1) firms face a downward‐sloping demand curve and have some degree
of control over price.
(2) there generally are barriers to the entry for new firms into the
industry, including economies of scale (that is, the firm must be large
to be efficient), ownership of raw materials, patents, and brand
image.
(3) firms can benefit from collusion. A cartel is one form of collusion
where producers create formal agreements specifying how much
each member will produce and charge. OPEC is an example of a
cartel. Such collusion is illegal in the United States.
d. A kinked demand curve is one type of demand curve that a firm
operating in an oligopoly might face. One strategic assumption is that
competitors will follow a price reduction but will not follow a price
increase. Under these circumstances prices would tend to remain
relatively stable.
(1) A firm will not gain market share by lowering prices and thus revenue
would fall.
(2) A firm would lose market share if it raises prices, and thus revenue
would fall if the firm were operating on the elastic portion of its
demand curve.
(3) If competitors fail to understand this logic, there is a strong possibility
of a price war as firms engage in successive rounds of price cutting in
an attempt to maintain market share.

e. If a firm in an oligopoly faces a kinked demand curve, demand is relatively
more elastic in response to a price increase and more inelastic if the firm
reduces price. The theory indicates that in the range of costs between
points A and B on the graph, the firm would not change price or output
even though marginal costs increased.

P = Price
q = Quantity
MR = Marginal revenue
d = Demand
MC = Marginal cost
f. Since firms in an oligopoly prefer to engage in non‐price competition,
advertising wars often occur. Product improvements and successful
advertising campaigns cannot be easily replicated by the competition.
Since many oligopolies have sufficient resources to finance advertising,
an increase in advertising expenditures on the part of one firm may force
competitors to respond or lose market share. This would be one example
of a barrier to entry for competitors.
This often is akin to the inverse of a price war in that, in the end,
advertising is self‐canceling, and firms have increased cost without
increasing revenue.
Price leadership is another form of competition in oligopoly. It often
results in an implicit agreement that coordinates prices without having
the firms engage in illegal collusion. Basic tactics of leadership include the
following:
(1) Infrequent price changes. The firm does not respond immediately to
day‐to‐day fluctuations in demand. Price tends to change only when
costs have increased significantly (an industry‐wide wage increase or
increases in energy costs).
(2) Potential impending price changes are usually “announced” by the
price leader.
(3) The goal is not to maximize short‐term profit but rather to discourage
the entry of new firms into the industry and protect long‐term
profitability. The price leader often has a cost advantage over other
firms in the industry and can still be profitable at a price level that
smaller, higher‐cost firms could not.
2335.04 Monopoly
a. In a monopoly, there is a single seller of a product for which there are no
close substitutes. The firm has considerable control over price and is a
price maker.
b. A monopolist:
(1) has strong barriers to entry that keep competitors out of the industry.
These barriers might include economies of scale, legal barriers such as
patents and licenses, advertising or competitive pricing strategies,
and control of existing resources.
(2) faces a downward‐sloping demand curve with marginal revenue less
than price.
(3) may have its monopoly position derived from government action. In
this instance, the firm may go to great limits to maintain that
monopoly by engaging in rent‐seeking activities such as lobbying
legislators.
(4) will tend to set price in the elastic range of their demand curve.
(5) tends to have less incentive to innovate and improve efficiency than
firms in monopolistically competitive or oligopolistic industries.
A public utility is a common example of a regulated monopoly.
c. Natural monopolies arise when economies of scale extend beyond the
market’s size and total costs are minimized by having only one firm in the
industry. Conditions often exist for local public utilities where
competition is impractical.
(1) Often the government regulates the industry with a key form of
regulation being the setting of prices that can be charged.
(2) In some instances in the United States, natural monopolies have been
moved to private ownership. For example, the U.S. Postal Service has
been privatized.
(3) Some regulation (for example, early regulation of the airline industry)
was designed to prevent creation of a natural monopoly.
2335.05 Consumer surplus and producer surplus: The demand curve and supply
curve show what consumers and producers are willing and able to buy or
offer for sale at various alternative prices at a given moment in time. The
interaction of buyers and sellers in the marketplace determines an
equilibrium price. If a consumer is able to buy the product at the equilibrium
price, and that price is below what the consumer would be willing to pay for
the product, a “consumer surplus” exists. The same would be true for
producers who are able to sell their product above the price they would have
been willing to use. This difference is known as a “producer surplus.” The
graph below demonstrates the degree of consumer and producer surplus at
a market equilibrium.

p = Price
q = Quantity
D = Demand
S = Supply
2335.06 Price discrimination
a. A firm can increase profits if different prices can be charged to different
buyers. This would be price discrimination. Price discrimination is the
practice of selling a product or service at different prices to different
consumers when those price differences are not justified by cost
differences.

b. Price discrimination is possible when:
(1) the firm is able to have some degree of control over output and price.
(2) buyers can be segregated into distinct classes that have different
abilities (or willingness) to pay for the product or service often based
upon different elasticities of demand. Prices are often varied for
different age groups. For example, admission to entertainment
facilities often varies with age, with children and senior citizens
receiving discounts.
(3) purchasers from the lower‐priced market would not have the ability
to resell to purchasers from the higher‐priced market. Examples
would be airline tickets and legal or medical services. Price
discrimination is widely used in the airline industry. For example, the
business traveler often has an inelastic demand when the need for
traveling arises. The vacationer, however, has a more elastic demand
and is willing to buy advance purchase tickets to obtain lower fares.
c. The logic of price discrimination is to attempt to segment the market,
change the price consumers would be willing to pay, and recapture a
portion of the consumer surplus.

Surgent CMA Review
Section 2400
Risk Management (10%)

2410 Enterprise Risk
2411 Types of Risk
2411.01 Risk assessment is a step in the risk management process that determines
the amount of risk related to a threat (or hazard). To calculate the amount of
risk there must be an estimate of the potential loss and the probability the
loss will occur. The risk may be related to financial decisions, or it could be
environmental or a health risk issue. The risk will be accepted as long as the
benefits derived are greater than the cost.
2411.02 Types of Risk
a. Operational Risk: Operational risk is defined as “The risk of loss resulting
from inadequate or failed internal processes, people and systems or from
external events.” Operational risk deals with the overall risk of operating
a business and would include fraud risks, legal risks, and physical and
environmental risks. Operational failures can lead to other risks, such as
risk of damage to the reputation of the firm and customer satisfaction.
b. Hazard Risk: Hazard risk (liability torts, property damage, natural
disaster) may be considered a part of operational risk and may involve
environmental and health issues. An example of hazard risk is the
uncertainty assumed by a pharmaceutical company in going to market
with a new drug. Although the drug has gone through rigorous testing,
there is still a risk that there will be reportable cases of bad side effects,
or even death, from the use of the drug. Hazard risk can also be a factor
in manufacturing since equipment could fail and cause bodily harm to the
operator.
c. Financial Risk: Financial risk is the risk involved with financing an asset
(pricing risk, asset risk, currency risk, liquidity risk). This risk exists
because there is a probability that the actual return received from the
asset will be less than the expected return. High risk investments have
the potential for greater returns, but there is greater potential for loss of
the investment (loss of capital). If an investment is held in another
currency, you also have the risk that there will be exchange value
Section 2400 – Risk Management
changes that could affect the value of the investment at the point of
liquidating the investment). The asset may have a limited sale market
which increases the risk of the investment (liquidity risk).
d. Strategic Risk: Strategic risk (competition, capital availability) is the risk
associated with the future business plans and strategies for the business.
This risk arises because of the current or future impact on earnings that
arise from improper decisions or implementation. This can include adding
new products or entering a new line of business, expanding through
merger or acquisition, or expansion through the purchase of additional
plant and equipment. The expansion of the firm will expose the company
to increased risk since it is possible the firm will not receive a large
enough return on investment to recoup their costs and provide an
appropriate return. Strategic plans should document that the risks have
been examined and how the firm plans to mitigate the risks.

2412 Risk Identification and Assessment
2412.01 The risk management process includes the strategies that allow a firm to
manage its risks related to participating in financial markets.
2412.02 The firm has a choice to accept, transfer, or manage risk.
a. Management may choose to absorb the potential impact of volatility on
earnings, assuming that over time the eventual upside may outweigh the
short‐term downside.
b. A risk manager may attempt to transfer the risk along the supply chain.
This would involve shifting the risk to the end customer or to suppliers.
2412.03 The risk management process includes an understanding the requirements
for valuation of derivative securities and applicable accounting regulations
per FASB ASC 815 or IAS 39. Often a firm will attempt to manage the risk
through the use of some form of hedging program. (A hedge is a strategy to
insulate a firm from exposure to price, interest rate, or foreign exchange
fluctuations.)
2412.04 The risk management process includes both internal and external controls,
and involves:
a. identifying and prioritizing risks and understanding their relevance.
b. understanding the stakeholder’s objectives and their tolerance for risk.
c. developing and implementing appropriate strategies in the context of a
risk management policy.

2412.05 The risk management process requires understanding the
interconnectedness among and between the basic components of
economics, accounting, and control.
a. Economics requires being able to measure the risk before attempting to
manage it.
b. The control function provides the needed guidelines for the hedging
activity and any necessary oversight.
c. The accounting function requires understanding the requirements set
forth in FASB ASC 815. As per the FASB, the following points relate to
FASB ASC 815:
(1) Under FASB ASC 815, an entity that elects to apply hedge accounting
is required to establish at the inception of the hedge the method it
will use for assessing the effectiveness of the hedging derivative and
the measurement approach for determining the ineffective aspect of
the hedge. Those methods must be consistent with the entity's
approach to managing risk.
(2) For a derivative designated as hedging, the exposure to changes in
the fair value of a recognized asset or liability, or a firm commitment
(referred to as a fair value hedge), the gain or loss is recognized in
earnings in the period of change together with the offsetting loss or
gain on the hedged item attributable to the risk being hedged. The
effect of that accounting is to reflect in earnings the extent to which
the hedge is not effective in achieving offsetting changes in fair value.
(3) For a derivative designated as hedging, the exposure to variable cash
flows of a forecasted transaction (referred to as a cash flow hedge),
the effective portion of the derivative's gain or loss is initially
reported as a component of other comprehensive income (outside
earnings) and subsequently reclassified into earnings when the
forecasted transaction affects earnings. The ineffective portion of the
gain or loss is reported in earnings immediately.

(4) For a derivative designated as hedging and the foreign currency
exposure of a net investment in a foreign operation, the gain or loss is
reported in other comprehensive income (outside earnings) as part of
the cumulative translation adjustment. The accounting for a fair value
hedge described above applies to a derivative designated as a hedge
of the foreign currency exposure of an unrecognized firm
commitment or an available‐for‐sale security. Similarly, the
accounting for a cash flow hedge described above applies to a
derivative designated as a hedge of the foreign currency exposure of
a foreign‐currency‐denominated forecasted transaction.
(5) For a derivative not designated as a hedging instrument, the gain or
loss is recognized in earnings in the period of change.
2412.06 Special issues facing small businesses
a. Small firms have problems with various components of the financial risk
management process that are effective for larger firms. While these
problem areas exist for large firms as well, the specific problems facing
smaller firms relate to dealing with the problems in a manner consistent
with the firm’s resource capabilities, and include the following:
(1) The fact that small firms are unable to use broader capital markets
(i.e., expand past the use of banks as a source of funds) because
investors in these markets require higher rates of return on what
would appear to be riskier investments (i.e., the investor would have
little ability to assess the creditworthiness of the firm).
(2) These firms are generally unable to diversify their operations (i.e.,
reduce business risk).
(3) Such firms usually have few suppliers and/or the clout or logistical
ability to purchase from a large number of vendors (i.e., unable to
reduce supply‐chain risk).
b. A smaller firm must understand its full economic exposure to foreign
exchange or interest rate risk and identify the degree to which there are
any natural offsetting positions in its operations to take advantage of any
benefits of diversification that exist. (Economic exposure is defined as the
degree to which a firm’s present value of expected future cash flows can
be impacted by unanticipated exchange rate fluctuations.)


c. If the firm chooses to hedge, they must be certain to use a derivative that
is specifically related to the risk in question. Risks dealing with cash flow
from operations are often best dealt with options (a derivative financial
instrument that establishes a contract between two parties concerning
the buying or selling of an asset at a reference price during a specified
time frame). More predictable asset positions often are best dealt with
forwards and futures.
d. Speculation with derivatives should never occur. It is helpful to employ
some outside entity to monitor any hedge or derivative positions that are
held.

2413 Risk Mitigation Strategies
2413.01 The first step in mitigating risk is to determine what individual items of risk
exists. Once this has been completed, a management activity should be
associated with each risk. This can be entered into a table format (see below)
for documentation. A poorly designed scope for a project may have several
risk factors to document (cost estimates are not sound, cannot get complete
requirements, etc.).
Risk Factor to Investigate Management Activity Required
Cost estimates not sound Determine proper scope of the project, who is
affected, what information is required, define business
requirements.

2414 Managing Risk
2414.01 Enterprise Risk Management: Enterprise risk management (ERM) includes
the methods and processes used by the organization to manage risks and
take advantage of opportunities related to and furthering the objectives of
the firm. This typically involves the determination of events or circumstances
that is relevant to the organization’s objectives, risks and opportunities,
determining their likelihood of occurrence and impact on the firm,
determining a strategy in response, and monitor the progress (through the
internal control system).
a. ERM Framework: The ERM framework is a system that identifies,
analyzes, responds to, and monitors risks and opportunities, both internal
and external, for the entity. Management selects a strategy for specific
risks that may include avoidance (exit the activity), reduction (take an
action that should reduce risk), share or insure (shares the risk with
another entity), or accept (take no action because the benefits exceed
the costs).
b. Steps in an ERM Program: The risk management process may include 1)
an understanding of the internal environment of the firm, 2) an
identification of the risks (material threats) to the firm, 3) assessing the
risk by analyzing and quantifying (if possible) using probability
distributions, 4) determine strategies for controlling risks, and 5) monitor
the effectiveness of the risk strategies used.
(1) Environment
(2) Risks and Threats Identification
(3) Assessing Risk
(4) Strategy for Risk Control
(5) Monitor Effectiveness

Surgent CMA Review
Section 2500
Investment Decisions (10%)

2510 Capital Budgeting Process
2511 Stages of Capital Budgeting
2511.01 Capital budgeting fundamentals
a. Capital budgeting is the analysis of investment decisions that have a
useful life longer than one year. Management uses capital budgeting to
allocate resources to investment opportunities in an attempt to obtain
the maximum value for the firm. Investment decisions are project
oriented. Poor capital budgeting decisions can often be difficult to
reverse. Questions such as the following are addressed:
(1) Should machinery be replaced by more expensive but more efficient
models?
(2) Should a new product or market be added?
(3) Should existing debt be extinguished or refinanced?
(4) How can a constrained resource best be used?
b. The relevant data in capital budgeting is cash‐flow oriented. Regardless
of the approach used, the following items are essential:
(1) Initial investment
(2) Future net cash inflows or net savings in cash outflows
c. Data for capital budgeting is relevant only if it affects the cash flows.
Some data accumulated for financial reporting is either not useful or
must be adjusted to be useful for capital budgeting purposes. Financial
accounting is primarily concerned with computing periodic earnings using
the accrual basis of accounting for the firm or a reportable segment of
the firm. Accrual accounting is not relevant in capital budgeting. The
decision is project oriented, and relevant data includes the expected cash
flows associated with that project. Items such as the depreciation
expense are sunk costs as they relate to capital decisions, and only
become relevant as they relate to tax consequences.
Section 2500 – Investment Decisions
d. Because capital budgeting is long‐term oriented, the time value of
money is very important. Some approaches to capital budgeting account
for the time value of money and some do not. Those that account for it
are considered preferable because of the difference between a $1
investment today and a $1 return sometime in the future. Inflation that
persists and the opportunity cost of having money sit idle make present
and future earnings unequal. Present‐value techniques are useful in
adjusting dollar amounts received or paid at different points in time to a
common point in time.
e. The statistical term expected value describes the numerical average of a
probability distribution. It can be used to estimate future cash receipts
from a capital budgeting project. This method is employed to estimate
the weighted‐average amount of future cash receipts by (a) estimating
the various amounts of cash receipts from the project each year under
different assumptions or operating conditions, (b) assigning probabilities
to the various amounts estimated for each year, and (c) determining the
mean value of the estimated receipts for each year.
f. Cost of capital refers to an overall cost of obtaining investment funds.
While different techniques may be used in computing cost of capital, it is
generally agreed that a cost factor should be assigned to both debt and
all stockholders’ equity (including retained earnings). Some authorities
suggest using a weighted‐average cost of capital for capital budgeting
purposes. Cost of capital is the desired or target rate of return used in the
net present value method of discounted cash flow computations. It is also
the minimum acceptable (cutoff) rate used in choosing among projects
employing the time‐adjusted rate of return method, described below.
g. There are several techniques for capital budgeting. These approaches are
often used, first to screen project possibilities, and second to rank
existing choices. Those commonly used techniques include the following:
(1) Payback method
(2) Discounted payback
(3) Accounting rate of return
(4) Net present value
(5) Internal rate of return
(6) Profitability index
(7) CVP analysis/margin of safety

2511.02 Time value of money
a. Cash received at different points in time is not comparable because of
the time value of money. Money held today has a greater value than
money that will be received tomorrow. The time value of money is
determined by the price of the money (interest) and the length of the
time period. Present value or future value computations are made to
adjust for time and interest so that all cash flows are set at a common
point in time. There are two basic questions involving the time value of
money computations. First, what is the future value (value at some
specified point in the future) of a sum of money to be received today?
Second, what is the present value (value today) of a sum of money
received in the future? These questions can be answered for a single,
lump‐sum cash flow or a series of cash flows. A series of equal cash flows
is called an annuity.
b. Future value of a $1 sum. A sum of money (P) invested today at a given
interest rate (i) will increase in value over time (n). The future value (F) of
that sum can be computed as:
F = P(1 + i)n
Factors have been computed for various combinations of i and n where
the interest factor is specified as fin = (1 + i)n and are contained in future
value tables. A portion of a future value table is shown below.

Period 8% 10% 12%
1 1.0800 1.1000 1.1200
2 1.1664 1.2100 1.2544
3 1.2597 1.3310 1.4049
4 1.3605 1.4641 1.5735
5 1.4693 1.6105 1.7623
When using the factors from the table, the equation F = P(fin) is used.
Illustration: How much will $10,000 be worth in four years if the interest
rate is 10%?

Formula solution: F = P (1 + i)n
= $10,000 (1 + .10)4
= $14,641
Table solution: F = P(fin) when i = 10% and n = 4
= $10,000 (1.4641)
= $14,641

c. Present value of a $1 sum: The method for computing the present value
or discounted value of a $1 sum is just the opposite of future value. The
question is, what amount (P) must be invested today at a given interest
rate (i) to be worth a specified amount (F) in a given number of years (n)?
The present value equation can be solved for P to obtain the following:
 1 
P  F 
 1  i n 
 
…where the PV factor for a sum received in the future is specified as:
1
Pin 
1  i n
The present value tables contain various combinations of i and n. Note
that Pin is the reciprocal of fin. A portion of the PV tables is shown below.

Period 8% 10% 12%
1 0.9259 0.9091 0.8929
2 0.8573 0.8264 0.7972
3 0.7938 0.7513 0.7118
4 0.7350 0.6830 0.6355
5 0.6806 0.6209 0.5674
Illustration: An investment will pay $15,000 in four years. What is the
present value of the payout if the interest rate is 10%? In other words,
what amount of money would have to be invested today to pay $15,000
in four years?
Formula solution:
 1 
PF x  
 1  i n 
 
 1 
 $15, 000 x  
 1.104 
 $15, 000 x (0.6830)
 $10, 245
Table solution:
P = F(Pin) where i = 10% and n = 4
= $15,000(0.6830)
= $10,245

d. Annuity: An ordinary annuity (annuity in arrears) is a series of equal cash
flows received at the end of equal intervals of time. An annuity due
(annuity in advance) is a series of equal cash flows received at the
beginning of equal intervals of time. The difference between these two
cash flows is that no interest is computed on the last payment of an
annuity in arrears. When dealing with future value/present value tables,
care must be taken that the correct annuity table is used.
An example of an annuity in arrears (regular, ordinary, or deferred
annuity) with three annual payments of $1,000 each would be:

Time Period Payment
0 0
1 $1,000
2 $1,000
3 $1,000
An example of an annuity due (annuity in advance) with three annual
payments of $1,000 each would be:

Time Period Payment
0 $1,000
1 $1,000
2 $1,000
3 0
e. Future value of an ordinary annuity: The future value of an ordinary
annuity represents equal annual payments received at the end of the
period that are accumulated and earn interest. In other words, what will
be the value of a series of payments that are compounded at a given rate
of interest at a point in the future? There will be no interest earned until
the first payment is made, and no interest will be earned on the last
payment. (FVA = future value of an annuity, PMT = the payment)
 1  i n  1 
FVA  PMT  
 i 
 
As with future value and present value of a $1 sum, there are tables
available to speed the calculation of the future value of an annuity. A
portion is shown below:

Period 8% 10% 12%
1 1.0000 1.0000 1.0000
2 2.0800 2.1000 2.1200
3 3.2464 3.3100 3.3744
4 4.5061 4.6410 4.7793
5 5.8666 6.1051 6.3528

Illustration: What is the future value of a three‐year, ordinary $1,000
annuity when money is worth 10%?
Formula solution:

 1  i n  1 
FVA  PMT  
 i 
 
 1  .10 3  1 
 $1, 000  
 .10 
 
 $1, 000(3.3100)
 $3, 310
Table solution:
FVA = PMT(FVIFAin) where i = 10% and n = 3
= $1,000(3.3100)
= $3,310
The future value of an annuity due has a similar formula to the one
above. Remember, an annuity due has the cash flow occurring at the
beginning of the period.
 1  i n  1 
FVAdue  PMT  1  i 
 i 
 
There are also annuities due tables available in order to make
calculations easy.
f. Present value of an annuity: The present value of an annuity is the value
today of a future series of payments discounted at a particular interest
rate. The present value of an annuity can be computed by restating each
of the annuity amounts to the present time period using the present
value of an annuity formula or the factor from a table of present values
of an annuity of $1. Remember to be careful to determine whether an
annuity in arrears (ordinary annuity) or an annuity in advance (annuity
due) is appropriate.
The formula for the present value of an ordinary annuity is:
 1  1  i  n 
PVAn  PMT  
 i 
 

There are tables available to speed the calculation of the present value of
an annuity. A portion for an annuity due is shown below:

Period 8% 10% 12%
1 0.9259 0.9091 0.8929
2 1.7833 1.7355 1.6901
3 2.5771 2.4869 2.4018
4 3.3121 3.1699 3.0373
5 3.9927 3.7908 3.6048
Illustration: What is the present value of a $1,000 annuity received at the
end of the year for three years when interest is 10% and payments are
made at the end of the period?

Formula solution: PVAn = $1,000 ( 1 - (1 + i)‐n )
i
= $1,000 ( 1 - (1 + .10)‐3 )
.10
= $1,000 (2.4869)
= $2,489
Table solution: PVAn = PMT (PVIFAin) where i = 10% and n = 3

= $1,000 (2.4869)
= $2,489
The present value of an annuity due has a similar formula to the one
above. Remember, an annuity due has the cash flow occurring at the
beginning of the period.
 1  1  i  n 
PVAdue  $1,000 1  i 
 i 
 
There are also annuities due tables available in order to make
calculations easy.
g. Compound interest: When dealing with capital budgeting problems,
assume that interest is compounded annually. However, it is not unusual
to have interest stated at an annual rate but paid semi‐annually (bonds),
quarterly, or even monthly. In these cases, the interest rate and number
of periods must be adjusted when making the calculation by using the
following steps:
(1) Adjust the interest rate according to the compounding period. For
example, 16% interest compounded semi‐annually is 8% each period.
(2) Adjust n from the number of years to the number of compounding
periods. For example, five years compounded semi‐annually is 10
periods.

5335.05 Accounting rate of return (simple rate of return)
a. The accounting rate of return does not consider the time value of
money. The annual net cash inflow is adjusted for depreciation to arrive
at annual accounting income and divided by the investment. It focuses on
the average income generated by a project in relation to the investment.
Unlike other methods, it focuses on income and not cash flows.

Net cash inflow - Depreciation
Accounting rate of return =
Investment
b. The average annual profits (or increased income) is the numerator. This
method does not differentiate between projects that have high early cash
inflows and projects that have high late cash inflows. Thus, the time value
of money is not taken into account.
c. There is not unanimous agreement as to how the investment should be
defined. Some alternatives include (a) initial cost, (b) average book value,
or (c) annual book value. Either (a) or (b) is preferable to (c). The use of
annual book value results in an increasing rate of return over the life of
the investment, providing the accounting income was relatively stable
over the life of the project, since the book value would decrease as
accumulated depreciation increases.
d. When using this method as a screening tool, the accounting rate of
return must be equal to or greater than the company’s hurdle rate for
the project to be acceptable.
e. This method is popular due to consistency with financial reporting
techniques commonly used to evaluate company and divisional
performance; however, it does bring all of the accrual income problems
into the formula. It is also simple and easy to understand.
f. Illustration: Accounting rate of return method (simple rate of return)
Problem: Compute the accounting rate of return for an investment
opportunity that costs $100,000 and provides equal net cash inflows of
$20,000 per year for 10 years. Straight‐line depreciation is used in
calculating net income; therefore, annual depreciation will be $10,000
($100,000 ÷ 10 years). The average investment will be the initial
investment divided by 2, or $50,000.
Solution:

Net cash inflow - Depreciation
Accounting rate of return =
Investment

$20,000 - $10,000
=
$50,000

= 20%
2511.06 Net present value
a. The net present value method adjusts for the time value of money. It
seeks to determine whether the present value of the estimated net
future cash inflows at a desired (or required) rate of return will be greater
or less than the cost of the proposed investment. Using this method,
initial investment, net cash inflows (or cash savings), and the discount
rate are givens. The present value (PV) of the net cash inflows is
calculated and compared to the initial investment. An investment
proposal is desirable if its net present value (NPV) is positive. In other
words, the present value of the future cash inflows is greater than the
cost of the investment.
b. When several investment proposals with reasonably similar investment
sizes are being considered, they can be ranked by net present values. The
proposal with the highest NPV should be chosen. An implicit assumption
of this method is that all net cash inflows can be reinvested at the
discount rate used in computing NPV. If the proposals have unequal
investments, they should be ranked according to their profitability index.
The profitability index is computed by dividing the present value of the
cash flows by the initial investment.
The net present value method can also be used when examining cost‐
saving projects. For example, when considering projects that would
replace equipment with newer, more efficient models, the costs with the
lowest NPV would be the most desirable alternative.
c. Illustration: Net present value
Problem: An investment costing $20,000 will reduce production costs by
$5,000 per year. The useful life will be eight years, and there will be a
zero salvage value. The desired minimum rate of return of 12% is used for
capital budgeting purposes. Should this investment be considered?
Solution: The NPV is calculated by determining the PV of the $5,000
annual cash savings for eight periods using a 12% rate. The present value
factor for eight periods at 12% is 4.968.

Net present value:
Cash flows ($5,000  4.968) $ 24,840
Initial investment (20,000)
Net present value $ 4,840
Since the NPV is positive, this is a desirable investment at a 12% return.

d. The NPV method can easily be applied if the annual cash flows are not
equal.
Illustration: An investment alternative costs $10,000 and results in cash
flows of $5,000, $4,000, and $3,000, respectively, for three years. The
desired minimum rate of return is 14%. In this case, the PV of cash flows
for each year is calculated, summed, and compared to the cost of the
investment. If the NPV is negative, the investment is rejected.
Solution: The NPV is calculated by determining the PV of the cash flows
for each year using a 14% discount rate.
Net present value:

Cash flows
Year 1: $5,000  .877 $ 4,385.00
Year 2: $4,000  .769 3,076.00
Year 3: $3,000  .675 2,025.00
Total PV of cash flows 9,486.00
Initial investment (10,000.00)
Net present value $ (514.00)
Since the NPV is negative, this is not a desirable investment at a 14%
return.
e. The discount rate (or hurdle rate) is the required internal rate of return
for projects considered by a company or investor. This rate is often based
upon a company’s weighted‐average cost of capital, incorporating a risk
premium related to the riskiness of the project in question. In other
words, this rate must reward the investor for the risk that is being
assumed when undertaking the investment.
2511.07 Profitability index (excess present value index)
a. The profitability index takes both the size of the original investment and
the value of the discounted cash flows into account. This is calculated by
dividing the present values of the cash flows after the initial investment
by that investment.

Present value of cash flows not including the initial investment
= Profitability index
Initial investment
This allows for the comparison of various projects with differing initial
investment amounts. Note that any project with a positive NPV will, by
definition, have a profitability index greater than 1. The present value of
cash flows not including the initial investment equals the NPV of that
project plus the initial investment.

b. The profitability index is often used to compare two or more mutually
exclusive projects. Potential projects might be mutually exclusive in that
they represent viable options to accomplish the same task. Other
constraints might include a limited capital budget or lack of adequate
resources to accomplish multiple projects. The alternative project with
the highest profitability index is the most desirable.
c. Example: Assume that the information is available on two mutually
exclusive projects:

Project 1 Project 2
Initial investment $50,000 $75,000
NPV $20,250 $25,000
Calculate the profitability index:

Project 1: $20,250 + $50,000
= 1.41
$50,000

Project 2: $25,000 + $75,000
= 1.33
$75,000
Assuming that funds are available, the most desirable project based upon
the profitability index would be Project 1. Note that the profitability index
uses the PV of the cash flows and not the NPV; therefore, the initial
investment amount must be added back to the NPV.
d. The profitability index is also known as the benefit‐cost ratio.
e. An alternative formula used to calculate the profitability index is:

Net present value of the project
+ 1 = Profitability index
Initial investment
Using this alternative formula and the above data for Project 1, the
profitability index would be calculated as:

$20,250
+ 1 = 0.41 + 1 = 1.41
$50,000
f. The project profitability index is an additional variation of the
profitability index. When an organization with limited funds is considering
projects that require different initial investments, the NPV of one project
cannot be directly compared to the NPV of another potential project. If
the NPV of each project is divided by the required investment of that
project, the project profitabilities can then be compared. The project with
the highest project profitability index would be the most desirable
project.

Project profitability index Net present value of the project
= Investment required

g. Example: Look at the following information regarding two possible
investment opportunities.

Project 1 Project 2
NPV of proposed project (a) $8,000 $4,500
Investment required (b) $10,000 $5,000
Project profitability index (a ÷ b) 0.80 0.90
Since the project profitability is higher for Project 2 than Project 1,
Project 2 is the more desirable choice.
h. An additional variation of the profitability index is used when there is a
constrained resource that can be used to produce incremental profits in
multiple segments. Here the profitability index formula is:

Incremental profit from the segment
Profitability index =
Constrained resource required by the segment
If machine hours were the constraint (bottleneck) and multiple segments
of the organization could use the limited machine hours to produce
incremental profits, then by determining the profitability of one unit of
the constraint, management can determine the most profitable way to
use the constraint.
This formula is really the basis for the formula shown in section (a) to be
used for projects of a more long‐term nature. For that formula, the
incremental profits from the segment are defined as the positive net
present values of the cash flows after the initial investment, and the
amount of the constrained resource is defined as the investment required
by the project.
i. Example: The following information is available regarding incremental
profits that could be produced by two different segments using a
constrained resource (machine hours).
Product 1 Product 2
Incremental profit possible $250,000 $400,000
Amount of machine hours necessary to produce
the incremental profit 100 hours 200 hours
Segment 2 may appear to be more attractive since an additional
$400,000 of profit is possible; however, more machine hours (constraint)
are necessary for each dollar of profit; therefore, the constraint of
machine hours can be best be utilized in producing Product 1 than
Product 2.

2511.08 CVP analysis/margin of safety
a. In the context of capital budgeting, cost‐volume‐profit analysis (CVP) is
often used to determine the margin of safety for a project. In other
words, how much could projected sales fall and still not fall below the
breakeven point?
b. The CVP formula:
Profit = Sales – Variable costs – Fixed costs
Sales = Number of units sold times sales price per unit
Variable costs = Number of units sold times variable costs per unit
Fixed costs = Total fixed costs for anticipated range
The breakeven point is a special case of CVP analysis where the profit
equals zero. In other words, sales revenue equals total costs.
Illustration: Product A sells for $5 per unit. Variable production costs are
$3 per unit and fixed costs per period are $50,000. What will the profit be
if 100,000 units are produced and sold? What is the breakeven point?
Solution:

Profit = Sales - Variable costs - Fixed costs
= ($5  100,000) ($3  100,000) - $50,000
= $150,000

Breakeven in units: 0 = $5x - $3x - $50,000
x = 25,000 units
c. Margin of safety is the excess sales over the breakeven sales point. This
can be important when looking at projects with projected sales. The
methods used to evaluate capital budgeting decisions use projected sales
(savings). If, however, the projections are incorrect, then there could be
significant changes in the calculations of the payback period, NPV, and
IRR. When evaluating a project, the likelihood that the sales/production
projected will be achieved needs to assessed.
Illustration: Using the above illustration, calculate the margin of safety:

Margin of safety = 100,000 projected unit - 25,000 breakeven units
= 75,000 units
This could also be expressed in term of dollars. The margin of safety for
sales is $375,000 ($5 per unit  75,000 units). In this case, sales could fall
significantly (by 75%) and there would still be a profit.

2512 Incremental Cash Flows
2512.01 Internal rate of return (time‐adjusted rate of return)—equal annual cash
flows
a. The internal rate of return (IRR) is the rate of discount (interest) that
equates the present value of the net cash flows including the initial cash
outlay to zero. This method can be used when the cost of the investment
and annual cash flows are known, and the calculated rate of return is
then compared to the firm’s desired rate of return (hurdle rate). If the
return is less than the desired rate of return, the project should be
rejected. This method is also known as the time‐adjusted rate of return.

Investment required
= Factor of the internal rate of return
Net annual cash inflow
b. After the factor of the internal rate of return is calculated, the present
value tables of an annuity are used in order to determine the rate of
return that equates the present value of the cash inflows and outflows to
zero. Since the discount factors frequently do not coincide with the
annuity table, extrapolation is often necessary.
c. The IRR can be interpreted as the highest rate of interest an investor
could pay for borrowed funds to finance the investment being considered
and be no worse off than if the investment were not undertaken. In other
words, the investment equals the present value of the payoff.
d. When more than one project is being considered, they are ranked
according to their projected rate of return. Those with the highest rate of
return are the most desirable. An implicit assumption of this method is
that all net cash inflows from the project under consideration can be
reinvested at the computed rate of return, and the method is, therefore,
a less reliable method than the NPV method for ranking investments. This
method is a good tool for making an accept/reject decision for potential
projects that have met the initial requirements for consideration. Using
this method, all projects that have a return greater than the company’s
hurdle rate should be given further consideration.
e. The NPV and IRR methods will potentially rank projects differently if the
initial investment differs and/or the timing of the cash flows differs
between the projects. The NPV method is the better method since the
reinvestment assumption is the cost of capital as opposed to the IRR
assumption of reinvestment at the computed rate of return on the cash
flows for the particular project.
f. The payback reciprocal can be used to approximate a project’s internal
rate of return if the cash flow pattern is relatively stable.

g. Illustration: Internal rate of return
Problem: The company is considering the acquisition of a new machine
that costs $20,000. It will provide a savings of $5,000 per year over its
useful life of eight years. The salvage value is expected to be zero. What
is the internal rate of return, and should the machine be acquired?
Solution: The cash flows are charted as follows:

Initial cash outflow $20,000
Cash inflows
Year 1 $5,000
Year 2 $5,000
Year 3 $5,000
Year 4 $5,000
Year 5 $5,000
Year 6 $5,000
Year 7 $5,000
Year 8 $5,000
When the cash flows are an annuity, the present value factor can be
determined by dividing the initial investment by the annuity:

Investment required
= Factor of the internal rate of return
Net annual cash inflow

$20,000
=
$5,000

= 4.0000 present value factor
The internal rate of return (time‐adjusted rate of return) can be obtained
from the present value table for an annuity in arrears (since it is assumed
that the cash flows occur at the end of the period) by finding the rate for
the number of periods (in this case, eight) that has a factor closest to
4.000. In this case, the rate is approximately 18.5%. This project would be
desirable if the minimum acceptable rate of return (hurdle rate) is less
than 18.5%.

Period 17% 18% 19% 20% 21%
8 4.207 4.078 3.954 3.837 3.726

Discounted Cash Flow Methods
2512.02 These methods involve some means of comparing the net cost of the
investment project with the present value of the future cash flows expected
to be generated by the project. They are the theoretically correct methods of
capital budgeting, because they take into account the time value of money.
They also focus on the cash flows involved, not on accrual accounting
returns.
2512.03 Discount Rate: All present value methods require the discounting of future
cash flows at some desired rate of return. Discount rate, hurdle rate,
required rate of return, and cost of capital are all terms for the interest rate
used to adjust future cash flows to the present.
a. Hurdle Rate: The hurdle rate minimum is sometimes established for all
capital projects, sometimes based on the average return on projects. This
is not theoretically correct, because this rate could be above or below
what the investors could earn elsewhere for similar risk.
b. Short‐Term Borrowing Rate: The discount rate may be based on the cost
of borrowing current funds, which is actually irrelevant to the rate that
should be earned on projects.
c. Weighted Average Cost of Capital: The discount rate may be based on
the company’s weighted average cost of capital (see Chapter 2). This rate
is appropriate only if the risk level of the project is equal to the weighted
average risk level of the firm.
d. Risk‐Adjusted Rate: Different discount rates may be established for
different categories of projects to adjust for different levels of risk. Higher
risk translates into a higher discount rate.
e. Real and Nominal Rates: An inflation adjustment is also possible. In
practice, the “real rate of interest” is the pure rate of interest plus a risk
factor. The “nominal rate of interest” is the real rate plus an inflation
factor if prices are expected to increase.
2512.04 Assumptions
a. Timing: Cash flows occur at the beginning or end of a period as specified,
not continuously during the period as in real life. In most CMA questions,
cash flows are assumed to occur at the end of the period.
b. Certainty: Cash flows are known with certainty – both the amounts and
the timing.

c. Reinvestment: In the net present value method, it is assumed that cash
flows from the project can be reinvested at the discount (hurdle) rate.
This is a conservative approach. In the internal rate of return method, it is
assumed that cash inflows can be reinvested at the actual interest rate
generated by the project. Since this is often a higher rate than the hurdle
rate, this is an optimistic (and aggressive) approach to capital budgeting
decision analysis.
d. Stability: It is assumed that the interest rate used is stable for the entire
life of the project.
2512.05 Cash Flows: The after‐tax cash flows must be used. Note that this is different
from the income from operations. Some of the following additional
considerations may be appropriate depending on the fact pattern of the
question.
a. Working Capital Adjustments
(1) Beginning Increase: If working capital increases at the beginning of a
project, it is assumed that some cash has been used to acquire
additional inventories, receivables, etc. This is treated as a cash
outflow at the inception of the project. There is no tax adjustment for
this, because acquisition of such items is not a taxable event. At the
end of the project, a decrease in working capital is assumed as the
additional working capital is liquidated. This liquidation is assumed to
result in a gain, and is reduced by the tax on that gain. The resulting
net‐of‐tax figure is treated as an additional cash flow in the final year
of the project.
(2) Beginning Decrease: In some instances, working capital may decrease
at the beginning of the project. In this situation, the liquidation (net
of corresponding tax) is treated as a cash flow at the inception of the
project, and the corresponding increase in working capital (with no
tax effect) is a cash outflow in the final year.
b. Depreciation Issues: When the after‐tax cash flows from operations have
been given in a fact pattern, the depreciation for financial statement
purposes has already been factored in and no additional computations
need to be made. However, when different depreciation methods are
used for financial accounting purposes as opposed to tax purposes, the
cash from operations must be adjusted for the taxes on the difference
effect between the two depreciation amounts.

Example: Assume an increase in cash from operations of $20,000.
Straight‐line depreciation of $10,000 has been taken for financial
statement purposes, but $6,000 MACRS depreciation was deducted for
tax purposes. The tax rate is 40%. Since the taxable income under MACRS
would be $4,000 higher (the difference between the two depreciation
amounts), an additional $1,600 of taxes ($4,000 x 40%) must be
subtracted from the $20,000 cash flows to arrive at cash flows of
$18,400. The adjustment would obviously be an addition to the cash from
operations if the MACRS depreciation exceeded the financial statement
depreciation.
c. Salvage Values
(1) Fully Depreciated Asset: The salvage value of a fully depreciated old
asset being disposed of at the inception of a new project is treated as
a cash inflow at the inception of the new project, net of related tax.
This amount is a reduction of the cost of the new asset in the
determination of the net incremental cost of the new project.
(2) Non‐fully Depreciated Asset: Where the old asset has not been fully
depreciated, the gain or loss on disposal must be computed and the
related cash inflow (if a gain) or outflow (if a loss) – adjusted for taxes
paid or tax benefit received – must be considered in determination of
the net cost of the new investment.
(3) New Asset Treatment: The salvage value of a new asset is treated as
an additional cash flow in the final year of its life. This figure must also
be adjusted for transfer costs and any taxes. Some capital budgeting
problems present a comparison between two different options. This
is usually retaining and continuing to use an old piece of equipment
as opposed to discarding the old and buying a new asset. If there are
salvage values for both assets in the final year of the life of the new
asset, the difference between these two values (adjusted for tax
purposes) is treated as an additional cash flow in the final year of the
project.

2513 Income Tax Considerations
2513.11 The implications of tax on capital budgeting decisions
a. Many items in capital budgeting have related tax effects. Items that do
not affect cash flows such as depreciation are not relevant in basic PV
calculations. They must, however, be taken into consideration when
income taxes are relevant or the present value of the cash flows related
to taxes is relevant. Items that do not affect cash flows except as they
relate to the payment of income taxes include depreciation and gains and
losses on asset dispositions.
b. The implications of income tax on capital budgeting include the following:
(1) Cash flows in the form of revenue are taxable. Revenues must be
computed net of tax. This can have a dramatic effect on the NPV of a
project.
(2) Cash outflows in the form of expenses are deductible in computing
taxes payable. These cash outflows must be computed net of tax.
(3) Depreciation is not a cash flow, but it affects the amount of taxes
payable. The reduction in taxes payable due to depreciation is a cash
inflow item that must be included in the analysis.
(4) Gain or loss on the disposition of an existing facility (piece of
equipment) is a taxable gain or a deductible loss for computing
income tax.
(5) Salvage value at book value results in no gain (loss) and has no tax
consequences.
c. The generally accepted approach is to compute all items net of tax and
apply one of the capital budgeting approaches described previously. The
marginal tax rate is most often used.

Illustration: ABC Company is considering the replacement of the current
machine with a new one. The old machine has a book value of $0 and a
salvage value of $8,000. The new machine would cost $30,000 and will
result in an annual savings of $10,000 per year because of improved
operating efficiency. It has a useful life of six years and an expected
salvage value of $6,000. Straight‐line depreciation is used, and the
company has a marginal tax rate of 40%. The desired minimum rate of
return is 20%. (Note, when evaluating a project that would increase sales
or reduce costs, the marginal tax rate should be used.)
Solution:
(1) After‐tax cash flow from selling the old machine:

Sales price $ 8,000
Book value 0
Gain 8,000
Taxes (40%) 3,200
Net cash inflow $ 4,800
(2) Net cash outflow to purchase the new machine:

Cost of new machine $30,000
Cash available from sale of old machine after tax 4,800
Net initial investment $25,200
(3) Annual cash inflows or cash savings:

Depreciatio Cost - Salvage value $30,000 - $6,000
= = = $4,000/year
n Life 6 years

Operating savings $10,000
Less: Depreciation 4,000
Taxable savings 6,000
Taxes (40%) 2,400
Net savings $ 3,600
Total annual cash flows:

Net savings $3,600
Add back depreciation 4,000
Annual cash flow $7,600
(4) The salvage value of the new machinery has no tax consequences in
Year 6 since the salvage value will equal book value. The cash flows
for the six years will look like:

Period Cash Flow
0 ($25,200)
1 7,600
2 7,600
3 7,600
4 7,600
5 7,600
6 7,600 + 6,000

The calculation of net present value at 20% for six years:

Cash savings
Annual: $7,600  3.326 = $25,278
Salvage, Year 6: 6,000  0.335 = 2,010
Present value of cash flows 27,288
Less: Initial investment 25,200
Net present value $ 2,088
Since the NPV is positive, replacing the old machine would be a
desirable investment.

2514 Evaluating Uncertainty
2514.01 A real options approach improves organization value by encouraging
managers to take advantage of flexibility and strategic interactions when
making capital budgeting decisions. Strategic investments are viewed as a
series of options instead of as single “go‐no go” decisions. There are four
important real options available in capital investment decisions which allow
managers to add value by increasing returns or decreasing losses.
a. Wait and Learn Before Investing: Many projects require a decision to be
made today so that the project can be started immediately. However,
some projects can allow the decision maker to wait and learn before
investing. This is best when there is high uncertainty and immediate cash
flows from the project are low. Postponing or losing these cash flows will
not be significant, and the decision to invest can still be made at a later
date when cash flows are more certain. A wait and learn before investing
opportunity is a type of call option because the holder has the right to
make an additional investment in the future.
b. Follow‐on Investment Opportunities: When taking on an investment,
there can be additional value to the project because of opportunities to
extend or expand investments in the future.
(1) Flexibility: For example, a company may build a production facility
that can easily be expanded if product demand exceeds the original
capacity. In this case, the company can exercise an option to expand
its production facility. Even when a project shows an initial negative
NPV value, the project may be acceptable if follow‐on investments
may add cash flows beyond the original investment’s cash flows.

(2) Hewlett Packard Example: For instance, when Hewlett Packard
entered the market for peripheral computer equipment such as
printers, its future opportunity was to extend into the personal
computer market. Knowing that they could enter the PC market in the
future and have larger cash flows associated with computer sales
allowed Hewlett Packard’s managers to manufacture peripheral
equipment whether or not they met their required rate of return on
the initial projects. A follow‐on investment opportunity is a type of
call option because the holder has the right to make an additional
investment in the future.
c. Abandon a Project: An option to abandon a project if it is unsuccessful
provides some insurance against failure. The value of this option is the
amount received from the sale of the assets used on the project, or the
value received from shifting the assets to another more valuable project.
When making the decision to acquire equipment and machinery for a
project, you may have the choice between equipment which would be
worthless if the project fails or is abandoned, or equipment which could
be sold or shifted to other uses if the project is abandoned. Include this
abandonment option as part of your discounted cash flow analysis. An
abandonment opportunity is a type of put option because the holder has
the right to dispose of the investment in the future.
d. Vary Output or Production Methods: Existing facilities can be switched
to different products or processing methods. In some cases, the cost may
be relatively low to switch an existing facility to produce a new product
or products of different grades, or to modify the quality of inputs used in
production. To increase the value of this type of option, production
facilities can be designed with future flexibility in mind.
2514.02 Real Option Value: Traditional capital budgeting techniques such as NPV
analysis do not accurately measure the economic value of real options, and
they divert management attention away from the series of decisions that
could be made in the future to maximize value. Real option values
incorporate the following variables and factors:
a. Managerial flexibility—actions that can increase value over time
b. Market leadership position—creates more real options and provides the
financial and other resources needed to exploit options
c. Technical feasibility
d. Financial resources for project funding

e. Degree of uncertainty—probabilities associated with different outcomes
f. Expected cash flows from different decisions options and outcomes
g. Discount rate applied to expected cash flows
2514.03 Real option values are typically analyzed using a decision tree, with
probabilities and cash flows assigned to the different outcomes. The
expected cash flows are then discounted and valued using an option pricing
model, such as the Black‐Scholes model. By using risk‐adjusting probabilities,
a risk‐free rate can be used to discount the expected cash flows. The values
generated from the model depend heavily on both the cash flows and the
probabilities that are assigned to different outcomes. However, unlike NPV
and similar methods, the value of a real option increases with the degree of
uncertainty.
Ranking Investment Projects
2514.04 Capital Rationing: Capital rationing occurs when an organization has a
limited number of dollars available for capital expenditures, and managers
must choose among acceptable strategic investment opportunities.
Potentially acceptable projects are those meeting the organization’s
investment criteria, such as a positive NPV, a sufficiently short payback
period, positive qualitative factors, etc.
2514.05 Mutually Exclusive (Independent) Projects: Mutually exclusive projects have
cash flows that are independent of other projects. When projects are
mutually exclusive, there is no interdependence among project cash flows;
the cash flow of one project is not affected by whether or not an investment
is made in another potential project.
2514.06 Profitability Index: A profitability index can be used to rank‐order the
investment projects if there is capital rationing and the projects are mutually
exclusive. It is difficult to determine the relative merits of projects when
working from their absolute dollar figures. Therefore, the profitability index
relates each project’s total present value of cash inflows to its initial net
investment cost:
Net Present Value of Cash Inflows
Profitability Index =
Initial Investment Cost
If the hurdle discount rate is exactly met and the NPV of the project is zero,
then the profitability index will be exactly 1. Projects having a positive NPV
will have profitability index greater than 1. Projects having the highest
profitability index will be chosen for investment.
2514.07 Internal Capital Markets: Another method for allocating a limited capital
budget among competing projects is to rely on an organization’s internal
capital market — i.e., competition for limited funds among managers within
an organization. An advantage of internal capital markets is that capital can
be moved within an organization to more profitable projects without
incurring the cost of raising capital externally. A disadvantage is that capital
may be allocated inefficiently; strong projects might subsidize weak projects,
reducing overall value.
2514.08 Linear Programming: Another alternative to the use of a profitability index is
to allocate limited capital resources using linear programming techniques.
Linear programming can be used to maximize a linear objective function (in
this case, the sum of discounted or undiscounted expected future cash
flows), given one or more constraints (in this case, financing and the
minimum amount that may be invested in individual projects). Linear
programming can take into account dependencies among the cash flows of
multiple projects.

2520 Capital Investment Analysis Methods
2521 Net Present Value
2521.01 Net Present Value Method (NPV): The net present value (NPV) method
evaluates the net difference between the total discounted cash inflows and
outflows. If the NPV is positive, more cash came in than went out. On a
simple problem with cash inflows that are the same amount each year, the
annuity discount factor can be used. Otherwise, each year’s individual cash
flow must be discounted separately.
a. Salvage Values
(1) Step One – Compute After‐tax Cash Flows: If the figure has not been
given, compute the after‐tax cash flows for each period in the life of
the new project.
(2) Step Two – Compute Total Present Value: Compute the total present
value of the cash flows at the hurdle rate.
(3) Step Three – Determine Net Cost of New Asset: Determine the net
cost of the new asset and any other outflows.
(4) Step Four – Subtract for Net Present Value: Subtract the net cost of
the new asset from the total present value of the cash flows.

b. Significance of Results:
(1) Step One – Compute After‐tax Cash Flows: If the figure has not been
given, compute the after‐tax cash flows for each period in the life of
the new project.
(2) Net Present Value is Positive: Here, the total present value of the
cash flows exceeds the net cost of the new asset. This means that the
project generates a return higher than the hurdle rate used to
discount the flows. This makes the project even more acceptable.
Note that the internal rate of return method (the next method
discussed) can be used to find out the actual rate being earned.
(3) Net Present Value is Negative: The total present value of the cash
flows is less than the net cost of the new asset. This means that the
project does not generate a return that is at least equal to the hurdle
rate desired, and is, therefore, not acceptable.

2522 Internal Rate of Return
2522.01 Internal rate of return (time‐adjusted rate of return)—unequal annual cash
flows
a. The internal rate of return (IRR) is not easily applied when the cash flows
are not equal annuity payments. A trial‐and‐error method must be used
to obtain the rate of return when hand‐calculated; however, computer
software is available to compute the IRR that frequently uses an iterative
trial‐and‐error method. Required inputs to such a program are cash flows
(both inflows and outflows) by period and a seed internal rate of return.
The computer program uses the seed (rough approximation) IRR on the
initial calculation and refines the rate on subsequent calculations until it
has a rate that produces a net present value of zero (or very close to
zero).

b. Illustration: An investment opportunity costs $10,000 and returns
$5,000, $4,000, and $3,000, respectively, the first three years. What is
the internal rate of return (IRR)?
(1) First attempt: Using an interest rate of 10%, the net present value is
$105, computed as follows:

Cash flows:
$5,000  .9091 $ 4,545.50
4,000  .8264 3,305.60
3,000  .7513 2,253.90
Present value cash inflows 10,105.00
Cash investment (10,000.00)
Net present value $ 105.00
Since this is a positive amount, a higher interest rate is selected.
(2) Second attempt: Using an interest rate of 11%, the net present value
is ($55.50), computed as follows:

Cash flows:
$5,000  .9009 $4,504.50
4,000  .8116 3,246.40
3,000  .7312 2,193.60
Present value cash inflows 9,944.50
Cash investment (10,000.00)
Net present value ($ 55.50)
Since the NPV is a negative amount, the interest rate is somewhat
less than 11%. By extrapolation, a rate of approximately 10.7% is
obtained. If the desired minimum rate of return is greater than 10.7%,
the project should be rejected.

2523 Payback
2523.01 Payback method
a. The payback period method does not adjust for the time value of money.
It computes the length of time required to recover the initial cash
investment with net cash flows. When the annual cash flows are equal,
the payback period is computed by dividing the initial investment by the
annual cash flow.

Initial investment
Payback period =
Annual cash flow
If the annual cash flows are not equal, they are accumulated until the
cumulative amount equals the initial investment. The payback period is
the length of time required to accumulate cash that equals the amount of
the initial investment.

b. When several investment alternatives are being considered, they can be
ranked according to the payback period. The investment alternatives with
the shortest period are considered most desirable. This method is simple
to compute and easy to understand and explain. Early paybacks provide
managers with the flexibility to reinvest funds at an earlier date;
therefore, managers who are uneasy about predicting cash flows into the
distant future will often choose projects with early paybacks. Managers
who expect to be transferred in the near future may also seek projects
that will provide quick results.
c. The chief limitation is that the payback method emphasizes liquidity and
disregards profitability. This method is most appropriate when precise
estimates of profitability are not crucial. Its use often occurs when a firm
has a weak cash and/or credit position, or if there is considerable risk
involved in the proposed project. The time value of money is not
considered. For example, two projects each requiring an initial
investment of $1 million and yielding cash inflows of $250,000 a year
would be considered to be identically attractive even if the first project
has cash inflows for 5 years and the second project for 10 years.
d. The payback method can be a good screening tool but as a general rule
should not be used as the primary investment evaluation tool.
e. Illustration: Payback method
Problem: Compute the payback period for an investment opportunity
that costs $20,000 and provides equal annual cash flows of $4,000 per
year for eight years.

Solution: $20,000
= 5 years
$4,000
Notice how the payback method does not even consider the cash flows
between the end of the payback period and the end of the investment’s
useful life—in this case, between years 5 through 8.
2523.02 Discounted payback
a. The discounted payback is the length of time required to recover the
initial cash investment using a sum of the discounted future cash flows.
Since the discounted annual cash flows will not be equal, they are
accumulated until the cumulative sum equals the initial investment. The
discounted payback period is the length of time required to accumulate
the amount of the initial investment using the discounted cash flows.

b. As with the payback method, the investment alternative with the
shortest payback period is considered the most desirable. This method is
simple to compute, easy to understand and explain, and also takes the
time value of money into consideration, albeit in a very limited manner.
The chief limitation is that the discounted payback method also
emphasizes liquidity and disregards profitability.
c. Illustration: Discounted payback method
Problem: Compute the discounted payback period for an investment
opportunity that costs $10,000 and provides equal annual cash flows of
$5,000 per year for three years given an expected 10% return.
First, the cash flows need to be discounted.
Cash flows:

Initial Annual Discounted
Investment Cash Flows Value
$10,000.00 $10,000.00
$5,000  .9091 4,545.50
5,000  .8264 4,132.00
5,000  .7513 3,756.50

Solution: $10,000 - [$4,545.50 (Year 1) + $4,132.00 (Year 2) + $1,322.50
(Year 3)] = 0
Since the discounted cash flows for Year 3 equal $3,756.50 and only
$1,322.50 is needed in Year 3 to complete the payback, it can be
extrapolated that approximately 2.4 years will be needed to pay back the
initial investment in discounted terms. Note that using the traditional
payback method, the payback period would be only 2 years. When using
the discounted payback method, the payback period increases.

2524 Comparison of Investment Analysis Methods
Non‐Discounted Cash Flow Methods
2524.01 Since they ignore the time‐value of money, the non‐discounted cash flow
methods are not considered to be theoretically correct. However, in practice,
they are often used because they are relatively easy to understand by non‐
accounting personnel and simple to calculate. In addition, these methods
help managers focus on a potentially important aspect of risk under rapidly
changing conditions – the time to recover the initial investment.
2524.02 Payback Method
a. Objective: This method measures the length of time required to receive
the same amount of cash as the initial investment. It answers the
question, “When am I going to get my money back?”
b. Advantages: This method can be useful in situations where liquidity is
important. Projects with shorter payback periods are generally preferred
over those with longer periods, because assumptions underlying present‐
value models may not be valid for a long period of time. Also, since it is a
cash‐flows method, it is not affected by accrual accounting procedures,
and it is useful when precisely correct figures are not vital and as a
preliminary screening tool.
c. Disadvantages: In addition to the non‐recognition of the time value of
money, a significant disadvantage is that the method ignores total
profitability and all cash flows after the payback period. It would be
possible to have a situation where a machine with a shorter payback
period also had a shorter useful life compared with another project,
thereby reducing the potential for cash flows and profits beyond the
narrow focus of the payback period.
d. Calculation: Where the periodic cash flows are uniform, the payback
method is calculated by dividing the initial investment by the annual cash
inflow to get the number of years to payback. If the cash inflows are not
even, the calculation may have to be done on a year by year basis. If so,
apply each year’s cash flow to the balance of the initial investment to
determine the number of years.

Example: A corporation is contemplating the purchase of some
specialized machinery. The machinery will cost $250,000 and will be
depreciated over its five year life by using the straight line method.
Annual inflows of $300,000 and cash operating expenses of $220,000 are
anticipated as a result of this new machinery. The corporation is subject
to a 40 percent income tax rate. The payback period on this investment
(rounded to the nearest tenth) is:
Answer: 3.7 years.
Annual inflows $300,000
Cash operating expenses ‐220,000
Depreciation (5 yr SL) ‐50,000
Operating income 30,000
Tax expense (.40) ‐12,000
Net income 18,000
Depreciation (non‐cash) +50,000
After tax cash flow $68,000

Initial Investment = 250,000 = 3.676 = 3.7 years

After tax cash flow 68,000

The reciprocal of the payback calculation can be used to approximate the IRR.
2524.03 Discounted Payback: Under the discounted payback method, the payback
period is calculated using discounted rather than undiscounted cash flows.
Thus, this method incorporates the time value of money in evaluating
potential strategic investments.

2524.04 Accrual Accounting Rate of Return
a. Method: This method divides the incremental income attributed to the
project by either the initial investment or the average investment. As can
be seen, it is simply the return on investment ratio (ROI). The incremental
income is book income on the accrual basis, not cash flows.
b. Limitations: Accrual basis income includes or excludes items based on
GAAP for external reporting, which may not be valid for internal decision
making. Furthermore, it uses an average annual incremental figure rather
than the explicit cash flows determined in both the discounted and
payback methods. Note also that it, like the payback method, ignores the
time value of money. However, it does take into account profitability, is
easy to understand, and is useful in a situation where a divisional
manager is evaluated on a comparable basis (i.e., use of ROI measures).

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Surgent CMA Review
Section 2600
Professional Ethics (15%)
2610 Business Ethics
2611 Moral Philosophies and Values
2611.01 Kohlberg’s Theory of Ethics Development: Professor Larry Kohlberg from
Harvard has identified six progressive stages of moral and ethical
development. Each stage is characterized by the motivating factors which
prompt an individual to make the right decision when confronted with an
ethical dilemma. The higher the factor level the more ethical the individual.
a. Punishment: Fear of authorities’ ability to inflict punishment as a
consequence of unethical or illegal behavior is the most basic driver.
Punishment may be imposed within an organization or externally from
legal or regulatory controls. An example is the Foreign Corrupt Practices
Act which restricts bribes to foreign officials and governments.
b. Law and Order Adherence: Certain laws, rules, bylaws and obligations
are necessary to assure business organizational and society social
cohesion. Adherence to the letter and spirit of the law means “doing
what’s required.” This behavior is rule based and facilitated by an
understanding of why and how codes of ethics have developed.
c. Self‐Gratification: Benefits for oneself may be a motivating factor.
Enlightened self‐interest is behind the Golden Rule, “Do unto others as
you would have them do unto you.”
d. Role Expectation: Approval from others is a stimulant to act according to
particular standards that are generally accepted and expected.
“Professionalism” and acting “in a professional manner” are associated
with integrity, peer approval and adherence to a set of expectations.

Section 2600 – Professional Ethics
e. Concern for Social Welfare: Individuals recognize that they have a “social
responsibility” to act ethically and justly because this promotes the
welfare of society as a whole. It is the right thing to do. Media coverage
has recently promoted awareness of unethical behavior to be avoided.
This individual social responsibility is imputed to businesses.
f. Concern for Moral Principle: Knowledge of underlying moral concepts
and religious ethics is the basis for this personal conscience. Individuals in
this category are motivated to do what is right simply for the sake of
doing what is right. This stage is often called “moral imperative” similar
to the Ten Commandments. Such individuals are operating on Professor
Kohlberg’s highest ethical level.

2612 Ethical Decision Making
2612.01 Howard L. Siers, founding Chairperson of the official IMA Ethics Committee,
identified four steps in the process of development, approval,
communication, and administration of a corporate code of conduct. The
Sarbanes‐Oxley Act of 2002 requires internal controls including a “disclosure
controls and procedures” system that must be regularly reviewed; this is very
similar to a Code of Ethics. The following are steps as they relate to a
Company as a whole or as they relate to a particular function such as human
resources, purchasing or financial statement preparation.
2612.02 Development of Code:
a. Top Management Involvement: The single most important influence on a
firm’s ethics is top management. The “tone‐at‐the‐top” must create a
positive, proactive environment. The code should be organized around
the corporate purpose and mission statement. The mission statement
creates a goal sense and communicates why trying hard in the
corporation is important. Important themes include a true commitment
to quality, candor and customer service.
b. Committee Vehicle and Documentation Details: It may be useful to form
an ethics committee/board from a cross‐section of employees. An
understandable written document must be created. This will promote
precedential value. Employee involvement in the development process
contributes to acceptance and implementation of the code. This is
especially important at the middle management level where the code of
ethics must be aligned with existing policies, procedures, and practices.

c. Different Approaches: The code can either set forth aspirational
guideline “do’s” or detailed “don’ts.” “Don’ts” cover situations that may
harm the strategic reputation of the firm. Critics of the latter approach
contend that it is impossible to identify all of the “don’ts,” and a list of
prohibitions may result in a voluminous code. Whichever approach is
chosen, the code must be integrated into the decision‐making process.
The code should emphasize relatively clear bright‐line cases, both for
ease of understanding and to combat cynicism. If every situation is
presented as ambiguous, many employees will retreat to an uneasy
moral relativism and dismiss the whole project.
d. Unethical Behavior Drivers: It is useful to begin by studying the pressures
and incentives that can drive unethical conduct in the entity. A
compliance risk assessment of high sensitivity and/or vulnerable subjects
may be useful. This may isolate and identify the topics to be included.
e. Comprehensive Coverage: The 1992 COSO Internal Control − Integrated
Framework report suggests a comprehensive approach to the scope of
the document. To be included are such topics as conflicts of interest,
illegal or other improper payments, improper financial statement
manipulation, equal and fair employment practices, proper use of
company assets and resources, anti‐trust competitive guidelines, insider
trading and confidentiality of proprietary information. Other matters
particular to the entity in question should also be included.
f. Ethics Officer: There should be a formal Ethics Officer with ultimate
authority. It may also be useful to create an ethics council/board
consisting of employees from all levels of the organization. These
representatives may serve as a liaison between peers and the ethics
office. Experience shows that employees are more likely to discuss an
ethical dilemma with a peer than with a supervisor.
2612.03 Approval of Code: For the “tone‐at‐the‐top” to pervade the ethics initiative,
it is important for the code to be endorsed by executives and middle
management.
a. Broad Participation: The more the employees at all levels have
participated in the development of the code, the more the code will be
accepted and followed. Those who are to be subject to the code’s
jurisdiction must accept that authority. This is the best weapon to
combat apathy and/or cynicism.
b. Review Process: A broadly based document review process may facilitate
involvement. Input from a broad spectrum of constituents will generate
support for the code. The board of directors, the audit committee and
senior operating management should all approve the code.
2612.04 Communication of the Code: The corporation must implement the code. The
message communicating corporate ethics should go to all employees.
Implementation and communication activities range from distributing the
code to all new employees to introducing a formal education program for
existing employees.
a. Methods: It is possible to teach a process of identifying and considering
the right/best solution to ethical dilemmas. Companies have used in‐
house activities, external activities, employee indoctrination programs,
counseling efforts and evaluation tools to disseminate the details of the
code’s message. Dialogue should be encouraged whenever ambiguous
situations arise.
b. Reinforcements: Not only must the details of the code be known, but the
monitoring activities and sanctions in case of violations must be
understood. Highly visible support by word and deed at all levels of
management sensitizes employees and reinforces a sense of importance.
An ethics column in the company newsletter may increase the awareness
of employees. Seminars and workshops with case studies may also be
useful tools in this process. Employees should sign‐off acknowledging
receipt of the written code.
c. Third Parties: It may also be desirable to communicate information about
the firm’s ethics programs to strategic partners such as some important
customers and suppliers. These groups may be directly affected by some
of the provisions and there may be a goodwill value to such
communication.
2612.05 Administering the Corporate Ethics Program: Determining how monitoring
should be accomplished and developing a reporting system are both
necessary. Exception reporting of failure to comply is the usual monitoring
method.
a. Ethics Officer: The administration falls on the corporate ethics officer.
See www.eoa.org. The Sarbanes‐Oxley Act requires that as of April 1,
2003 all complaints by employees regarding accounting matters must be
made to the audit committee if the corporation is publicly traded.
b. Advisory Services: Advisory services in the form of an ethical advisor or
ombudsman should be available to assist in identifying ethical dilemmas
and facilitating the resolution of serious dilemmas. The business should
establish an “open door” policy by streamlining grievance channels;
employees should receive a speedy and sympathetic hearing of concerns.

c. Reporting: Employees need to believe that management will address
their grievances and rectify any abuses in a fair and equitable manner.
There should be zero tolerance for retaliation of anyone who reports a
real or perceived unethical act.
d. Performance Appraisals: Every employee must understand that ethical
behavior is an individual responsibility. Integrity and ethical conduct
should be discussed as a part of the employee’s annual performance
appraisals. Employees should sign‐off to acknowledge that they have
read the code of conduct every year.
e. Sanctions: Many enterprises find this the most difficult administration
responsibility. Identified employee infractions must be subject to
disciplinary and appropriate sanctions. Due process procedures must be
in effect if employees are to feel they have been treated fairly. Sanctions
usually begin with requiring attendance at an ethics workshop. Private
warnings and letters of censure, to temporary suspension, to permanent
termination are all possible.
f. System Improvement: Effectiveness of the code improves with feedback.
When serious ethical misconduct arises and is identified, the problem
may be an individual’s behavior or it may be because of a system
deficiency. If the former, disciplinary procedures may be necessary. If the
latter and the problem is that the system does not address the ethical
dilemma or has an inadequate procedure, improvement should be
initiated. Improvement in policies and procedures will hopefully reform
corporate self‐governance and prevent similar occurrences in the future.
A code of ethics audit measures the effectiveness of an enterprise’s
current program and may suggest useful improvements.

2620 Ethical Considerations for Management Accounting
and Financial Management Professionals
2621 IMA’s Statement of Ethical Professional Practice
2624.01 The ICMA lists four general ethical standards which must be followed by
CMAs. These are itemized in SMA 1C (July 1, 2017). Candidates should
commit the SMA 1C CCIC standards to memory because the ethics questions
may focus on the IMA’s official wording. Failure to comply with the following
CCIC standards may result in discipline. Your answer analysis should apply
the four standards to the particular fact pattern posed in a question.
2624.02 There is obviously considerable overlap between these four categories of
ethical standards. Many ethical dilemma exam questions would cover all four
standards (and the resolution of the ethical dilemma if appropriate under the
facts). Most ethical dilemmas violate more than one standard. The overall
objective of the Standards is to establish a theoretical ethical structure
against which individual behavior can be measured. We have listed the four
IMA standards below followed by editorial comments where useful.
a. Competence: Practitioners of management accounting and financial
management have a responsibility to:
‐ Maintain an appropriate level of professional competence by
continually developing their knowledge and skills.
‐ Perform their professional duties in accordance with relevant laws,
regulations, and technical standards.
‐ Provide decision support information and recommendations that are
accurate, clear, concise, and timely.
‐ Recognize and communicate professional limitations or other
constraints that would preclude responsible judgment or successful
performance of an activity.
(1) Basic Standard: Competency is the most basic standard. The CMA
examination measures the competence necessary to receive the
credential, but this is only a one‐time threshold evaluation. The
ICMA’s on‐going CPE requirements are designed to keep the
member’s knowledge and proficiency current. The theoretical
knowledge (of laws, regulations and technical standards) must be
translated into high on‐the‐job performance and discriminating
judgments.
(2) Violations: Frequently the exam poses facts where financial
statements or performance reports are being manipulated by using
incorrect accounting principles. Discrimination on the basis of sex,
age, race, religion, national origin or physical handicap violates the
standard.
(3) Factors: High‐quality work is the most important factor in achieving
and maintaining credibility. This is especially true in preparing written
reports. Oral presentations are also important and may involve
developing presentation skills. There is a duty to make a reasonable
investigation of relevant facts. In addition, these activities require
effective interpersonal and communication skills to master the
interaction with others in the organization.

b. Confidentiality: Practitioners of management accounting and financial
‐ Keep information confidential except when disclosure is authorized or
legally required.
‐ Inform all relevant parties regarding appropriate use of confidential
information. Monitor subordinates’ activities to ensure compliance.
‐ Refrain from using confidential information for unethical or illegal
advantage.
(1) Importance: Confidentiality is important because it promotes full,
honest and candid disclosures and open communications within an
organization; breach of the confidentiality standard has a chilling
effect on frank communications and disclosures. The confidentiality
restraint applies to all proprietary information that is derived from
the work activities including unauthorized use of computer data and
software.
(2) Scope: Not only should the CMA not use confidential information
acquired in the course of their work themselves, but they should not
pass such information on to third parties for their use. This would
include internal strategies, research and development projects, new
products or sales, customer lists, forecasts and projections. Tipping
off a third party security trader about financial information known
only to insiders is an example of a breach of the confidentiality
standard (and probably illegal under the Insider Trading Sanctions
Act).
(3) Subordinate: The confidentiality duty extends to the requirement
that CMAs supervise subordinates in such a manner so that they also
observe the confidentiality standard.
(4) Not a Legal Privilege: This standard is not a valid defense for failure
to comply with a subpoena, subpoena duces tecum or production
request issued by a controlling court. Such information may usually
be obtained by third parties where relevant to matters raised in
litigation.

c. Integrity: Practitioners of management accounting and financial
‐ Mitigate actual conflicts of interest. Regularly communicate with
business associates to avoid apparent conflicts of interest. Advise all
parties of any potential conflicts.
‐ Refrain from engaging in any conduct that would prejudice carrying
out duties ethically.
‐ Abstain from engaging in or supporting any activity that might
discredit the profession.
‐ Contribute to a positive ethical culture and place integrity of the
profession above personal interests.
(1) Benchmark: Integrity is the benchmark against which all decisions
must ultimately be tested. It involves exercising a high degree of
professionalism in all one’s activities. CMAs have obligations to their
employer, their profession, the public and themselves. Our
profession’s ultimate objective must be to serve the public interest.
CMAs must refrain from engaging in any activity that would prejudice
their ability to carry out their duties ethically. This includes an
obligation to supervise subordinates so that they also operate with
integrity.
(2) Fiduciary Duty: CMAs must not (directly or indirectly) undermine the
corporate objectives because it would constitute a breach of their
fiduciary duty. If there are conflicting stakeholder interests and a
fiduciary duty is involved, the interest of the stakeholder to whom the
fiduciary interest is owed has priority. Usually this means the
employer’s interest outweighs the interests of third parties. This
fiduciary duty extends beyond the termination of employment.
(3) Conflict of Interest: Conflict of interest situations must be recognized
and avoided. Most ethical dilemmas arise because what is right for
one stakeholder is wrong for another. A CMA must serve only one
principal. Positions where the CMA stands to benefit directly are
always suspect. Examples include where a supplier is owned by the
CMA or his relatives, a CMA is trading in the securities of his employer
or a CMA receives a gratuity from a supplier. Similarly, offering a
gratuity to a customer or government representative may violate the
Anti‐Kickback or Foreign Corrupt Practices Acts.

(4) Test: The best way to evaluate a perceived conflict is through an
independent examination of the situation conducted by a person
preferably outside your framework. The question is, without your
self‐interest in mind, would your action or non‐action be appropriate?
(5) Disclosure: Anything that may hinder a CMA’s judgment should be
disclosed in writing. A CMA should refrain from the decision process
involving a transaction in which he or she is “interested.” Both
favorable and unfavorable information should be disclosed to all
parties whose interests are at stake. Reports addressing a position
should explain arguments both pro and con as well as the possible
courses of action.
(6) Enterprise Resources: Company guidelines on the proper use of an
enterprise’s resources (time, material, and equipment) must be
complied with. Any acts that would discredit the CMA credential or
management accounting must be avoided. This would include sexual
harassment.
(7) Trust Fund Tax Responsibility: If a CMA has discretionary control over
allocation of cash there may be personal liability for unpaid
employment trust fund taxes withheld from employee’s wages. Some
retirement plan funding is similarly protected under ERISA and
criminal penalties may be imposed.
d. Credibility: Practitioners of management accounting and financial
‐ Communicate information fairly and objectively.
‐ Provide all relevant information that could reasonably be expected to
influence an intended user’s understanding of the reports, analyses,
or recommendations.
‐ Report any delays or deficiencies in information, timeliness,
processing, or internal controls in conformance with organization
policy and/or applicable law.
‐ Communicate professional limitations or other constraints that would
preclude responsible judgment or successful performance of an
activity.
(1) Neutrality: Objectivity means a CMA must operate and make
judgments in a neutral capacity. Communication must not be done in
a biased or untruthful manner. It is important to be fair and impartial
and state both the good and the bad aspects of any situation.

(2) Materiality: All relevant, material information must be disclosed.
Materiality depends upon whether the information would have
influenced an intended user’s understanding and decision; this is a
lower threshold than whether the information would have been
outcome determinant.
(3) Fraudulent Reporting: Fraudulent reporting violates both the
credibility and integrity standards. This includes earnings
management. Credibility is often associated with competence.
Competent professionals are objective in their attitudes. Fair and
impartial decisions are objectively based upon the merits.
(4) Assistance and Disclosure: An enterprise should have procedures in
effect to assist employees in avoiding activities or personal interests
that could adversely influence their objectivity in performing their
corporate responsibilities. CMAs have a responsibility to
communicate information fairly and objectively. Information that
would mislead a user should be corrected. Disclose, disclose, disclose
is the best rule.

2623 Fraud Triangle
2623.01 Fraud triangle is a model for explaining the reasons that result in someone
committing fraud. The three most common reasons are:
a. Pressure or Incentive: This refers to the need that someone attempts to
satisfy by committing fraud. Examples of the needs may include:
(1) Financial need arising because the individual is facing problems such
as gambling, addiction, or personal financial strain.
(2) The need to meet high performance standards at work, or to cover up
poor performance
b. Opportunity: This is the ability to commit fraud without being detected.
The opportunity to commit fraud exists when workers have access to
assets or information in a manner that allows them both to commit and
conceal fraud. Opportunity is created by factors such as weak internal
controls, poor management, lack of board oversight, or the use of one’s
authority to override controls.

c. Rationalization: This is the ability for a person to justify a fraud in a way
that is acceptable by his or her morals. Examples include justifying theft
in the context of saving a family member by paying medical bills, labeling
the theft as “borrowing” and intending to pay the stolen money back
later, or justifying fraud by believing that the organization is not paying a
fair enough salary. Rationalization may be reduced through:
(1) Implementing competitive work and pay practices
(2) Management practices that provide a model “tone at the top”

2624 Evaluation and Resolution of Ethical Issues
2624.01 The CMA exam questions may pose factual situations where it is clear that
there is an illegal and/or unethical act or practice being promulgated which
has come to the CMA’s attention. It is often far easier to spot an ethical
dilemma than to resolve it through a theoretical framework. Besides not
aiding and abetting the act or practice, it is not usually sufficient to do
nothing and say nothing. This is a matter of professional judgment. The IMA’s
counseling service may be of use. The IMA has also developed a list of the
factors to be considered in such a situation and the procedures to be
followed. PROORO is the memory acronym. The IMA’s official position is:
The CMA exam questions may pose factual situations where it is clear
that there is an illegal and/or unethical act or practice being promulgated
which has come to the CMA’s attention. It is often far easier to spot an
ethical dilemma than to resolve it through a theoretical framework.
Besides not aiding and abetting the act or practice, it is not usually
sufficient to do nothing and say nothing. This is a matter of professional
judgment. The IMA’s counseling service may be of use. The IMA has also
developed a list of the factors to be considered in such a situation and
the procedures to be followed. PROORO is the memory acronym. The
IMA’s official position is:
 Discuss such problems with the immediate superior except when it
appears that the superior is involved. In that case the problem should
be presented initially to the next higher managerial level. If a
satisfactory resolution cannot be achieved, submit the issues to the
next higher managerial level.
 If the immediate superior is the chief executive officer or equivalent,
the acceptable reviewing authority may be a group such as the audit
committee, executive committee, board of directors, board of
trustees, or owners. Contact with levels above the immediate
superior should be initiated only with the superior’s knowledge,
assuming he/she is not involved.
 Communication of such problems to authorities or individuals not
employed or engaged by the organization is not usually considered
appropriate unless there is a clear violation of law.
 Clarify relevant concepts by confidential discussion with an impartial
advisor to obtain a better understanding of possible courses of action.
 Consult your own attorney as to legal obligations and rights
concerning the ethical conflict.
a. Policy of the Entity: Ethical issues should be resolved according to the
policies of the entity, if such exist. If not, the matter should first be
discussed with the CMA’s superior.
b. Report One Step Above Participants: If the superior is involved, the CMA
must go to the management personnel one step above. The superior
should be told in advance, unless it would be futile. This may lead to the
ABC group: audit committee, board of directors, or chief executive
officer.
c. Objective Advisor: It may be prudent under some circumstances to seek
counsel with a qualified objective advisor; this may be the IMA
counseling service discussed above. In theory, a person not involved in
the dispute may be more objective than the participants.
d. Own Attorney: An attorney normally has a confidentiality advantage; the
attorney‐client privilege may shield the internal investigation. The CMA
should consider whether it is advisable to create a contemporaneous
record of dissent to be held by the attorney to prove non‐concurrence.
e. Resignation and Informative Memorandum: If not resolvable and the
matter has substantial significance, the CMA may be forced to resign.
This resignation will often be accompanied by an informative
memorandum submitted to the appropriate internal authority.

f. Outside Communications Questions: Communication to outside parties
or the legal authorities is not usually permissible unless there is an
affirmative legal duty. The reason is that this might violate the
confidentiality standard. There may be exceptions for violations of law;
typically this characterization is where the public interest is high and the
employer’s legitimate interest is low.
(1) Legal Process: This “whistleblowing” prohibition is subordinate to an
enforceable subpoena or subpoena duces tecum. Workpapers and
records in the possession of the CMA may be obtained by third
parties or the government where they appear to be relevant to issues
raised in litigation.
(2) Whistleblowing: The 1997 changes to the IMA’s Code of Ethics would
authorize disclosure to third parties “depending on the nature of the
ethical conflict.” This provides the CMA support for disclosure
(“whistleblowing”) under extreme circumstances. Examples might
include a company dumping toxic waste or management affirmatively
requiring employees to commit crimes.
(3) Balancing Test: The interest of the employer in confidentiality must
be balanced against the probable harm to be suffered by third
parties. Some states have whistleblower statutes that authorize good
faith disclosures for certain important wrong doings and make
retaliation illegal.
(4) Related Possible Litigation: Unethical employers may attack the
messenger if the message has merit. Since whistleblowing may draw
a lawsuit for defamation, interference, invasion of privacy etc.,
disclosure to third parties should not be done without the prior
advice of counsel.
g. Retaliatory Discharge: Failure to participate in fraud may lead to
discharge. At‐will employees (such as most internal CMAs) may be fired
at any time for any reason unless that reason contravenes a clearly
articulated statement of public policy. See Rocky Mountain Hospital v.
Mariani, 916 P.2d 519 (Colo. 1996) which involved management’s
termination of an internal accountant for refusing to falsify accounting
information to increase the attractiveness of a proposed merger.
Management’s action was held to violate the important public policy of
accurate financial reporting.
h. Anonymous Helpline: IMA offers an anonymous helpline that the
member may call to request how key elements of the IMA Statement of
Ethical Professional Practice could be applied to their ethical issue at
issue.

Enforcement Procedures
2624.02 Condition of IMA Membership: Compliance with IMA’s ethical standards are
a condition of membership and are now incorporated into the Institute’s
Bylaws. Monitoring and enforcement procedures are under the jurisdiction
of the Institute’s Ethics Committee.
2624.03 Definitive Boundaries: There must be enforceable boundaries to the system
if there is to be an effective firm‐wide code of ethics. This implies that there
must be negative results which result from bright‐line violations; public
discipline is the usual method of reinforcement.
2624.04 Disciplinary Procedures: Enforcement procedures include a variety of
disciplinary actions.
a. Range: Letters of censure, letters of reprimand, to suspension of any
member whose conduct is found (after formal due process procedures)
not to be in compliance with the IMA standards. The maximum discipline
authorized is the expulsion of members who have been convicted of a
felony.
b. IMA Counseling Service: The IMA provides a confidential ethics
counseling service of experienced professionals for members who wish to
discuss any ethical dilemma.
c. Final Decision: However, the final resolution of any ethical conflict is the
personal responsibility of the individual CMA.
American Account Association’s Framework ‐ ISAD
2624.05 In 1990, the American Accounting Association (AAA) published Ethics in the
Accounting Curriculum: Cases & Readings. That publication includes a
methodology or framework to be used to analyze a particular ethical
dilemma. Our editors have reduced their decision model to four ISAD steps:
issue, stakeholders, alternatives, and decision.
2624.06 Issue Recognition: Begin the analysis by asking what is known or should be
known about the dilemma. A true analysis of the facts will usually lead to a
recognition of the ethical issues in controversy. The candidate should identify
the CCIC (Competence, Credibility, Integrity, and Confidentiality) elements
discussed below in detail as they apply to the facts of the question.

2624.07 Stakeholders Identification: This identification step is important to ensure
that the interests of all the effected parties’ are considered.
a. Direct Effect: Who will be directly affected by the outcome? The
traditional view is that a company’s primary responsibility is its fiduciary
duty to the shareholders.
b. Indirect Effect: The progressive view would include within the
stakeholder group major customers, employees, directors, major
suppliers, and the community where the business is located. Many would
argue a healthy nationalism is also to be considered a stakeholder. There
may also be other third parties who may be substantially affected by the
decision.
c. Input Opportunity: Should they receive notice and be given an
opportunity to be heard? Are there other public interest considerations
which should be explored?
2624.08 Alternatives and Consequence Analysis: Is a clear, compelling decision
possible? What feasible alternative conclusions are there to the ethical
dilemma?
a. Consequences: What will be the short and long term positive and
negative consequences of each alternative?
b. Constraints: Are there practical constraints that limit the alternatives?
c. Weight: How should we weigh the alternatives and the interests of the
different stakeholders? Quantification may be helpful to create a
common yardstick for comparison.
d. Compromises: Are any compromises possible that will reasonably satisfy
all the stakeholders?
2624.09 Decision and Disclosures: The best course of action could be to do nothing.
a. Professional Judgment: The ultimate decision is usually a matter of
professional judgment that involves a balancing of competing interests.
b. Disclosure: What disclosures should be made to the stakeholders, if any?
Is there an affirmative duty to inform? In writing? How extensive should
the disclosure be?
c. Other Influences: Are there confidentiality and/or legal influences
impacting the desirability of communications to third parties?

2630 Ethical Considerations for the Organization
2631 Organizational Factors and Ethical Culture
2631.01 Tone‐at‐the‐Top: The Treadway Commission and COSO Report noted that
“the tone‐at‐the‐top” is a vital ingredient to maintaining an ethical
environment in a business. Water seldom runs uphill; neither does an ethics
program. This includes three A, B, C groups: Audit Committee, Board of
Directors and the Chief Executive Officer. The examples set by the behavior
of senior corporate management is critical to maintaining a successful code
of conduct. Policy is implicit in behavior.
2631.02 Enhancing Factors: A corporate code of ethics is enhanced when
accompanied by the establishment of a corporate ethics committee/ethics
review board and an ombudsman function. An ethics officer is appointed.
Many authorities believe that the corporate audit committee should be the
oversight body.
2631.03 Harmonization Factor: The ethics initiative may serve as a company rallying
force for all individuals and teams within a business. Corporations that are
merging and acquiring new entities will find the common bond helpful when
organizations with different cultures merge.
2631.04 Ethics Reporting: Sarbanes‐Oxley requires corporations to disclose whether
they have adopted a code of ethics for their senior officers. Management
should report annually to the Board of Directors concerning their
stewardship of the ethics policy.
a. Reasons and Purpose: A mission statement is the most public and
concise part of a business strategic plan. A written document ensures
unanimity of purpose within the organization and sets a general tone or
climate for individuals to identify with. In a dynamically changing
environment, this shared identity provides stability and goal congruence.
Allocating organizational resources has a rational basis if it is related to
the mission statement.

2632 IMA’s Statement on Management Accounting, “Values and Ethics: From
Inception to Practice”
2632.01 Purpose:
a. Identify the gaps between the ethical behavior expected from employees
and their behavior.
b. Address these gaps through various plans
c. Have the desired ethical behaviors permeate every aspect of the
organization’s operations
d. Develop indicators to ensure there is not degradation in ethical behavior,
depleting the value of human capital with its negative impact on the
organization
2632.02 Defining and Developing the Organization’s Behavioral Values : Conduct a
cultural assessment answering such questions as:
a. What values does the organization believe in?
b. What principles drive this organization’s decision making?
c. By what ethical standards does this organization live?
d. What principles/beliefs do managers and leaders demonstrate?
Input from this activity gives insight to the reality within the organization.
The same approach should be taken with organizational leadership to create
a series of “should” answers to get insight into what the business leaders’
perception of what the culture should be.
Leaders will take the information from the above and define a set of ethical
principles that will become the foundation of the ethical framework for
ethical management and leadership.
2632.03 Leadership by example: Everyone in the organization is responsible for
ethical behavior especially leadership. Leadership does this by:
a. Setting a good example
b. Keeping promises and commitments
c. Supporting others in adhering to ethics standards.

2632.04 Ethics and Internal Control: Process management and process thinking are
an essential aspect of determining risk and internal controls. The following
three tools can be used to combine aspects of process development, risk
assessment, and internal controls.
a. Business Process Reengineering (BPR)
b. Quality Management
c. Continual Process Improvement (CPI)
2632.05 Converting Intent to Reality:
a. The Right People: During the interview process, include questions to
ascertain the candidate’s alignment with the organization’s code of
ethical behavior. Some of those questions could include:
(1) Interview questions that encourage candidates to define how they
would respond to specific circumstances.
(2) Asking candidates what their own personal code of ethics (or values)
might be
(3) Asking candidates to comment about what workplace behaviors
would be unethical
(4) Creating a multiple choice test where candidates state their level of
agreement or disagreement with various ethical statements
(5) Team based interviews where one interviewer poses an ethical
question, other members offer alternatives, and the candidate is
asked to add his or her personal view.
b. Employee Training: Ethics training for employees should focus on
covering ethical concepts, the organization’s code, and compliance. To
achieve this, training include:
(1) General employee behavior and personal conduct
(2) How ethics are built into work management methods
(3) How ethics affects specific jobs, processes, activities, and
relationships
(4) How the organization monitors compliance with the code
(5) What routes are open to employees who have compliance issues
(personal guidance, advice, and “whistleblowing” frameworks)
(6) What action is taken when a compliant or issue is identified
(7) The actions and penalties once noncompliance is proven
2632.06 Measuring and Improving Ethical Compliance
a. Human Performance Feedback Loop: Performance review and
development systems must be fully aligned with the requirements for
ethical conduct. Competencies, job descriptions, and objectives will
include ethical expectations, and the employee review systems must
assess employees against the same criteria
b. Survey tools: Ongoing surveys assist in assessing ethical performance,
especially in areas such as management and leadership. Surveys are
created using the organization’s code of ethics and asks employees to
rate how well the organization is following the code of ethics contents.

2633 Ethical Leadership
2633.01 Corporate Mission Statement: A corporation’s purpose, values, and guiding
philosophies are often referred to as its vision or culture. Corporate vision or
culture is defined by a mission statement of the enterprise which guides the
long‐run collective conduct of employees. The mission statement answers
the question “Who are we and what business are we in?” This shared vision
should be supported by specific objectives and implemented by medium‐
term strategies.

a. Reasons and Purpose: A mission statement is the most public and
concise part of a business strategic plan. A written document ensures
unanimity of purpose within the organization and sets a general tone or
climate for individuals to identify with. In a dynamically changing
environment, this shared identity provides stability and goal congruence.
Allocating organizational resources has a rational basis if it is related to
the mission statement.
b. Components: Business organization behaviorists have identified nine key
ingredients to a corporate mission statement.
(1) Customers: Who are the corporation’s customers?
(2) Products/Services: What are the corporation’s major products or
services? Is horizontal integration or diversification necessary or
desirable?
(3) Location: Where does the corporation operate and compete? Is it
appealing to a local or global market?
(4) Technology: What is the corporation’s basic technology and/or core
competency?
(5) Economic Objectives: What is the corporation’s commitment to
economic goals? These objectives can be return on investment or
growth orientated such as revenues, assets, sales, market share gains,
new accounts, geographic coverage, product service quality, etc.
(6) Philosophy: What are the basic beliefs, values, aspirations and
philosophical priorities of the corporation?
(7) Strengths/Opportunities: What are the corporation’s major
strengths, weaknesses, opportunities and threats? These SWOT
factors will determine the enterprise’s competitive advantages.
(8) Public Image Concerns: What are the corporation’s social
responsibilities and what public image is desired? A well‐regarded
corporate citizen image is the objective.
(9) Employee Concerns: What is the corporation’s attitude towards its
employees? This may include opportunities for growth, advancement,
increased salaries, challenges, etc.

c. Mission Statement/Code of Ethics Relationship: A mission statement
defines the company’s culture including establishing the core values and
long‐term objectives. Objective attainment requires a strategic policy. A
code of conduct or code of ethics specifies the implementation details
controlling day‐to‐day business dealings.
(1) Higher Level Objective: The code of conduct has been described as
the “conscience of an organization.” It should rise above the required
legal minimum behavior.
(2) Participatory Empowerment: As many employees as possible (or
their representatives) should be involved in the development of both
the vision statement and code of conduct.

2634 Legal Compliance
Sarbanes‐Oxley
2634.01 In General: The Sarbanes‐Oxley Act has changed many of the traditional roles
and functions in the A, B, C groups (audit committee, board of directors, and
chief executive officer) in publicly‐traded companies. The A, B, C groups are
foremost in importance in creating the corporate code of ethics and in
determining the effectiveness of the system in operation. Under the new
law, all three group members have different independent roles and provide
an integrated system of checks and balances. There are also internal and
external reporting requirements placed on all three groups.
2634.02 Board of Directors: Of most import is that the Board of Directors is elected
by the shareholders. As such they are to be considered the most public, non‐
management oriented influence.
a. Voting System: Corporate directors are elected either through straight
voting or cumulative voting. Cumulative voting allows minority
shareholders a better chance at getting board of director representation.
This system of democratic shareholder governance is especially
important where the corporate share ownership is not widely disbursed
and thus management proxies facilitate the appointment of family or
“internal” people to the board.

b. Independence: The objective is that the board of directors be
independent in both fact and appearance and thus are in a position to
exercise significant oversight authority over senior management. The
Board Chair should not also be the CEO. The dual role is incompatible.
Some advocate term and age limits for Board members to ensure
refreshing objective judgment.
(1) No Material Relationship: In 2004 a company’s board would need a
majority of independent directors with no direct or indirect material
relationship with the company to comprise over half of its board.
Independence is clearly enhanced if the Board Chair is an outsider.
(2) Independence Requirement: Complete independence is required for
members of the audit, compensation, and nominating committees. A
director who was employed by the company in the last 3 years or
receives over $100,000 a year is not independent. Insiders are thus
limited so the director’s loyalty is more towards the shareholders and
less towards management retention.
c. Objective: Larger public corporations ideally have a board with a diverse
set of competencies; insiders and family members generally do not bring
this to the table. The director’s fiduciary duty is owed to the stockholders
and third parties, not top management.
d. Other Restrictions: Sarbanes‐Oxley has significant other restrictions on
directors.
(1) Loans: There is a ban on direct or indirect corporate loans to directors
and officers after July 30, 2002. [§402(a)]
(2) Black‐out Trading: Shareholders must be given at least 30 days
advance notice of an impending “black‐out” period in trading
corporate securities. Senior management and board members may
not trade in corporation shares during “blackout” time periods if
common rank and file employees are so restricted directly or through
retirement and pension programs. [§306]
(3) Restatement Disgorgement: The law provides that all director and
officer incentive bonuses and stock trading profits must be disgorged
under certain circumstances. This applies if there is a subsequent
restatement of financial statements due to a material error or
irregularity arising from the period in which betterment was realized.
[§305] The SEC may “freeze” extraordinary payments from the
company to persons during an investigation. [§1103]
(4) Non‐dischargeable: Director’s and Officer’s debts and judgments for
violation of the Act are not dischargeable in bankruptcy. [§803]
2634.03 Audit Committee: Historically this was the corporate organization that
represented the board of directors in its dealings with the outside auditor.
a. Selection: The audit committee historically recommended to the board
the selection or retention of the outside auditor and approved the level
of auditor compensation. The board in turn normally passed on this
recommendation to the shareholders at the annual meeting in the form
of a resolution for their approval. As of April 2, 2003, the SEC requires
that the audit committee, and not top management, be responsible for
hiring, firing, and setting fees for all work of the outside auditor.
b. Independence Factors: This audit committee must have a minimum of 3
members. The independence concern is on two levels.
(1) Management: The audit committee members must sit on the
corporate board and should be independent of the corporate
management. On April 1, 2003, the SEC adopted a rule which
effective in 2004 requires that the entire audit committee must be
outsiders (not otherwise involved in the corporation, or family
members). The stock exchanges are required to enforce this rule.
(2) No Other Compensation: No audit committee member may receive
any consulting, advisory, or other fee from the company (or any
affiliated entity) except for the normal compensation for board
service [§301]. This is intended to avoid the tainted incidents of large
“consulting contract” fees which may impair the independence of the
audit committee member.
(3) Control Auditor: Second, the audit committee is charged with the
responsibility to determine if the outside auditor is independent. This
requires the committee to analyze the extent and details of the non‐
attestation work performed by the auditor. If the company is publicly
traded, the Sarbanes‐Oxley Act requires the proxy statement and
annual report must segregate the amount the company paid for audit
related activities, tax preparation and consulting, and all other fees
including consulting. The audit committee is charged with the
responsibility to make this allocation [§202].
(4) Tax Services: All tax services by the outside auditor must be pre‐
approved by the audit committee [§201].
(5) Employee Complaints: The audit committee must establish
procedures for receiving and handling complaints by company
employees regarding accounting and financial related matters. This
must include confidential anonymous submissions of complaints.
Retaliation against whistle‐blowers is illegal. A written report must be
completed for each complaint describing the substance, status, and
any conclusions or recommendations. [§806].
c. Financial Expertise: At least one member of the audit committee must be
a “financial expert.” While there remains debate on how this
requirement is to be interpreted, the objective is that the auditing
committee includes people with significant auditing experience [§407].
d. Reporting: The question is what does the audit committee do with an
unresolved complaint involving an accounting or finance related matter?
There are two duties of communication.
(1) Disclosure Committee: The audit committee must report to the full
Board of Directors. Presumably this would be referred to the
Disclosure Committee.
(2) Audit Committee: The outside auditor may contractually require the
audit committee to report to them any fraud. This is now a required
audit procedure under SAS 99. A CPA on the audit committee has a
duty of disclosure to an external auditor that overrides the duty of
confidentiality to the employer. (AICPA Rule 102)
2634.04 Certification Required
a. Concern: Historically, responsibility for breakdowns in internal
governance and financial reporting irregularities was too easy to avoid.
The Sarbanes‐Oxley Act is designed to ensure that no longer may CEOs
and CFOs raise their hands and say “I/we didn’t know and relied upon the
accountants and lawyers.” This concern is reinforced and made necessary
by the Supreme Court’s holding in Central Bank of Denver v. First
Interstate Bank, 511 U.S. 164 (1994) which eliminated private actions
against secondary actors like outside accountants and lawyers for aiding
and abetting management fraud unless they are deemed to be primary
wrongdoers – this is a tough standard for an injured party to prove.
b. Focus: Sarbanes‐Oxley focuses on two procedural requirements.
(1) “Disclosure Controls and Procedures”: This first requirement
emphasizes that the corporation must have an effective internal
control structure which guarantees irregularities and fraud will be
reported to top management. While the focus is more on financial
problems than human resource ethical problems, it seems the same
internal reporting system would be used.

(2) “Disclosure Committee”: The SEC suggests that the corporation
establish a disclosure committee to coordinate the internal process.
The disclosure committee might consist of the corporate CFO, general
counsel, the risk management officer, and investor‐relations officer.
They should review the information coming up the corporate chain
through the disclosure control system. In many ways this committee
operates like an audit committee except the reporting is to top
management rather than the board or outside auditor. The corporate
ethics officer seems like a logical participant in this committee. The
disclosure committee must report to the SEC if management will not.
c. CEO and CFO Required Reporting: The above control system is designed
so that top management can no longer avoid personal responsibility for
financial statement restatements. Under the new law the responsibility is
squarely fixed upon the CEO and CFO [§302]. Effective August 29, 2002 all
10‐K and 10‐Q must include a certification under penalty of perjury that:
(1) Fairly Represent: The information contained in the periodic financial
statement and related disclosures fairly represents the corporate
financial position. This includes an absence of material misstatements
or omissions.
(2) GAAP Followed: The accounting procedures and principles used in
compiling and presenting the financial reports are generally accepted.
If GAAP is not followed the departure must be disclosed.
d. Officers Code of Ethics: Companies must disclose whether they have or
have not adopted a code of ethics for their senior executive and financial
officers. [§406] It seems highly unlikely any company would publicly state
that they do not have such a Code.
e. Regular Reviews: The company must assume responsibility for
maintaining and regularly reviewing internal controls covering the
financial reporting process. The CFO has the responsibility to provide the
necessary corporate internal control documentation. This is part and
parcel of the annual §302 internal certification.

(1) Annual Assessment: Management must also annually assess their
responsibility for establishing and maintaining the corporate internal
controls [§404]. The internal control structure must include the
financial reporting process and the code of ethics for senior
executives and financial staff. Most ethics experts believe that it
would be impossible (or at least very impractical) to have a code of
ethics only for senior executives and finance officers and not the
other departments of a corporation such as sales, human resources,
purchasing, etc. Thus Sarbanes‐Oxley virtually guarantees that all
public corporations will have a code of ethics which is thorough and
integrated into the corporate internal control structure.
(2) Outside Auditor’s Attestation: The question then becomes how can
the outside stakeholders be sure management is meeting their new
code of ethics requirements. The outside auditor must attest to, and
report on, the veracity of this management ethics system assertion
and any changes made to increase effectiveness of the code of ethics.
The auditor’s procedures and scope of the testing used to verify the
assertion must be disclosed. Boiled down to the essence this
assessment is a code of ethics audit. This opinion may be presented
separately or in the basic audit report. [§404]

2635 Responsibility for Ethical Conduct
2635.01 Treadway Commission: The Committee of Sponsoring Organizations − COSO
− (IMA, AAA, AICPA, IIA and FEI) sponsored the 1987 Na onal (Treadway)
Commission on Fraudulent Financial Reporting. The report states that “A
written code of corporate conduct strengthens the corporate ethical climate
by signaling to all employees standards for conducting the company’s
affairs.”
2635.02 COSO 1992 Report: In September, 1992, COSO released its first report called
Internal Control − Integrated Framework in response to the Treadway
Commission’s recommendations. Howard L. Siers, the accounting
profession’s ethical intellect, served as the ethical advisor to COSO. This
report concludes that the critical foundation of a company’s internal control
structure is “integrity, ethical values, moral guidance, and competence.”
Ethical values provide the foundation for behavior standards within an
organization.
2635.03 COSO 1999 Report: A 1999 following report of over 200 corporate financial
frauds indicated that 83% of financial frauds involved top management (the
A, B, C group ‐ audit committee, board of directors, and chief executive
officer). In addition, in almost every instance, the corporation did not have a
code of conduct or management was able to effectively override it.
2635.04 Three Objectives: The three objectives of a Code should be:
a. Symbolic Function: To serve as a symbolic function by conveying what
the organization stands for (and/or is opposed to).
b. Understandability: To reduce the standards to a brief, generalized set of
written requirements that can be clearly understood. This will define the
limits of acceptable behavior in the areas it addresses. This also will
provide a yardstick to evaluate performance.
c. Organizational Utility: Ethics are most effective when they are an
ongoing, integral part of a corporation’s culture. It should also facilitate
dedication to common ethical standards.

2636 Sustainability and Social Responsibility
2636.01 A better‐informed, more inquisitive public is increasingly expecting
businesses to do more than maximize profits to their shareholders, provide
employment for workers and provide their customers with quality service
and products. Similarly, labor must do more than maximize workers’ wages.
2636.02 Responsibility: Businesses are now seen as having responsibilities for the
effect their actions have on society as a whole. In addition, there should be a
concern for the quality of life in the local community where they operate.
a. Outreach Efforts: This may include philanthropy, community activities
and service involvement, recycling efforts, human resource activities,
environmental respect, affirmative actions, etc.
b. Stakes: Each publicized instance of corporate hypocrisy and extreme
selfishness reinforces the notion that “everyone does it,” “it’s only wrong
if you get caught,” and “good guys finish last.” The danger is that this
becomes the role model for our children and business administration
students. Business leaders must come forward and publicly rebut this
impression. Walk the talk.

2636.03 Benefits: Employee volunteer charity and community programs build
company‐wide morale and loyalty. Fulfilling corporate social responsibilities
may add luster to the corporate image. This will also improve employee
recruiting efforts.
a. Employee Retention: There is a positive reciprocal relationship between
job satisfaction and ethical conduct. Good ethics promote a positive “us
feeling” to employees thereby increasing motivation to do superior work.
b. Offensive Self‐interest: “Green consumers” may reward exemplary
companies by voting with their purchasing dollars. Good business ethics
can provide a comparative marketing advantage. The reverse is also
possible; some groups may demand that a business operate with a social
conscience or lose their patronage.
c. Defensive Self‐interest: On a more basic self‐interest level, a private,
responsible ethics program avoids and minimizes the legal system and
government involvement in corporate governance. Commercial freedom
has as a correlate commercial responsibility.
2636.04 Social Audit: A social audit measures involvement of a business in these
efforts.
2636.05 Labor Responsibility: Organized labor and unions have similar
responsibilities to their community. Beyond promoting philanthropy and
community involvement, the popular view in the new century is that labor
should cooperate with management to allow the enterprise to be
competitive in the world market place. This may include the responsibility to
engage in meaningful collective bargaining and negotiate reasonable
solutions to labor disputes. Unions may also have a social responsibility to
participate with business in developing a transition program for displaced
employees.
2636.06 Externalities: This is an attempt to quantify the negative environmental
effect some businesses create for the community. Improper toxic waste
disposal, uncontrolled air pollution from pulp mills, and adverse health
effects of cigarette manufacturers are examples of instances where the
corporation does not bear the full expense associated with producing the
revenue. Could we quantify this with an accounting entry of a debit to
externality expense and a credit to what? ‐‐ debt owed to community‐
environment?


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CMA

Cost of Sales Cost of Sales = $100,000

Computation of Weighted Average

  the change in the particular variable

Initial Investment = 250,000 = 3.676 = 3.7 years

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