FPAC Part 1 Chapter 01

FPAC Exam Prep Platform
FPAC Part 1: Chapter 1

Finance Principles and Processes
Topic 1: Objective of Financial Management………………………………………………. 1-2
Topic 2: Corporate Finance Activities……………………………………………………….. 1-4
Topic 3: Basic Corporate Financial Concepts…………………………………………….. 1-17
Topic 4: Working Capital Management …………………………………………………….1-38
Topic 5: Financial Investment Decisions …………………………………………………..1-55
©2019. Association for Financial Professionals Table of Contents 1-1

Topic 1: Objectives of Financial

Management
Maximizing Organizational Financial Strengths
In a non-profit organization, donations, endowments and other sources of funds must be efficiently
used to meet the mission. In a for-profit organization, equity, financing and other sources of funds
must be carefully used. The published mission of a corporation may be about selling the best
possible product or to be an industry leader. But the underlying reason for these missions is to
maximize the financial value of the corporation. This maximization gives the corporation ongoing
funds with which to meet the mission. Because corporations are owned by shareholders, an
increase in the financial value of the organization translates to an increase in price per share, or
increased shareholder wealth. It follows then, and is commonly agreed, that through the efficient
use of corporate resources, the objective of corporate financial management is to maximize
shareholder wealth. Let’s consider two strategies to accomplish this:
“The objective of financial management is to maximize the efficient use of the organization’s
resources to fulfill these missions.”
Present value of future cash flows
One strategy to maximize shareholder wealth is to maximize the present value of future cash flows.
All managers in an organization contribute to cash flows. The sales manager oversees maintaining
or increasing revenue, the production manager oversees controlling production costs, the human
resources manager oversees training to improve the efficiency of employees’ work. The cumulative
work of all managers to improve cash flows yields higher revenue and lower costs and, ultimately,
higher income to be returned to the shareholders or reinvested in the organization.
Return on shareholders’ investment
Another way of looking at this is to maximize and sustain a superior rate of return on the
shareholder’s investment. Corporations must continuously develop and improve the business
strategy, looking for product and production innovation, new uses of technology for all aspects of
the business, and cost reduction. This continuous improvement is aimed at using shareholder
investments as efficiently as possible to yield the highest possible return.
©2019. Association for Financial Professionals Topic 1 1-2

When superior returns are created and the present value of cash flows is maximized, profit may
be realized, and two things can happen:
• The profit can be distributed to the shareholders.

• The profit can be reinvested in the business, thereby increasing the price of the shares held by
the stockholders.
Either way, the value of the organization has increased, and the shareholder has benefited from
the growth. This is maximized shareholder value and is the primary goal of corporate financial
management.
FP&A’s Role
The FP&A professional’s role in the maximization of shareholder wealth is to help managers
collect, analyze and understand financial data in a way that allows them to make good decisions
on how to maximize the present value of cash flows and create a superior return on investment.
Among other contributions, FP&A uses profitability and performance analysis to assist with
deciding:
• How to increase or find new lines of cash flow
• How to shorten the delay in receipt of a cash flow
• How to reduce risk associated with a cash flow
• Which assets to invest in
• How to finance assets
• How to operate assets efficiently

Topic 2: Corporate Finance Activities

Corporate Finance Activities
In the course of meeting the goals of efficiently using resources and maximizing shareholder
wealth, financial managers engage in three primary types of financial activities:
• Financing. Obtaining the funds to support the organization and its endeavors.
• Investing. Using the funds obtained as efficiently as possible to produce the highest possible
returns.
• Dividend payout. Deciding what to do with of any resulting profits.
"To manage concentration accounts and to optimize cash resources, treasury professionals create
cash forecasts. These forecasts help manage activities such as scheduling cash concentration
account transfers, funding disbursement accounts and making short-term investing and borrowing
decisions."
Exhibit I.A.1-1 illustrates the flow of money to and from an organization, defining the main activities
engaging financial managers.

Exhibit I.A.1-1 – Primary Finance Activities
Financing
Financing decisions focus on how the organization is funded. Much of the money to fund an
organization comes from the profits that are earned and retained. The rest of the funding comes
from debt or equity. The decision of how to acquire funding must accommodate both long-term
and short-term funding needs. A variety of funding strategies are available; equity in the form of
stocks can be issued, bonds can be issued, loans or long-term leases can be obtained.
For any organization, a critical decision is related to the level of external financing it will use. In a
simple, sole proprietor small business, the decision may be to use as little outside capital as
possible, relying primarily on personal savings and operational cash flows for financing and
growing the business. In a similar example, a small charity may decide to provide services only to
the extent that it can raise donations.
In both of these examples, the financing decision was essentially not to use external sources of
funding for the organization. Most large organizations, however, will need to look to outside
sources (usually in the capital markets) to raise the funds necessary to start and to grow. The
financing decision for these organizations, therefore, is related to how much funding is needed,
when and in what form it should be obtained, and, ultimately, how fast the organization will grow.

Once the decision has been made to use outside funding in an organization, decisions must then
be made regarding the use of short-term versus long-term financing and, for a corporation, the use
of equity. Organizations generally want to raise funding, or capital, at the lowest cost, and there is
a capital structure mix that theoretically will minimize the overall cost of funds. Capital structure will
be discussed further later in this section.
The treasury function of an organization typically plays a significant role in short-term financing
activities.
Treasury Management and Liquidity
In the short term, treasury management is the process of managing the organization’s liquidity and
cash position to ensure the availability of adequate cash resources to sustain the organization’s
ongoing operational activities. (In the long term, treasury professionals perform critical finance
functions that ensure the availability of funds necessary to sustain the initiatives that support the
organization’s long-term financial objectives.)
The short-term treasury management objectives of managing liquidity are closely related to the
organization’s operating cycle. The operating cycle represents the flow of funds through an
organization. It is defined as the period of time beginning with the agreement to purchase raw
materials, through the production cycle and sale of products or services, to the collection of
payments from customers. This is basically the time it takes to convert the organization’s cash into
the saleable product and back into cash. Exhibit I.A.1-2 is a graphic depiction of the operating
cycle of a manufacturing organization.

The Operating Cycle
Exhibit I.A.1-2 – The Operating Cycle
Cash is required to sustain the operating cycle. Treasury professionals ensure that an
organization’s operating cycle is financed and funded adequately.
Along with ensuring adequate funding of the operating cycle, treasury management aims to use
cash as efficiently as possible and in a manner consistent with an organization’s overall strategic
plan.
To meet these goals, treasury management works to:
Treasury Professional Duties
• Maintain liquidity. Liquidity is defined as the organization’s ability to pay its bills out of cash
accounts or other assets that can quickly be turned into cash. Liquidity ensures that the
organization is able to meet current and future financial obligations in a timely and cost-
effective manner.
• Optimize cash resources. The treasury function uses policies, procedures and strategies that
minimize holdings of non-interest-earning cash balances while also providing adequate cash
to ensure liquidity. Excess cash balances are invested to generate interest income or pay down
debt and reduce interest expenses. Money market accounts are often used to maintain liquidity
while generating interest.

To optimize cash resources, treasury professionals work to speed up cash inflows, control cash
outflows and minimize the net cost of the process. To minimize the net cost of optimizing cash,
cash concentration or pooling is used.
Cash inflows rarely equal cash outflows on a particular day. Cash concentration or cash pooling is
the process of holding cash in a special bank account from which outflows are paid. When the
concentration account falls below a predetermined balance, short-term investments are liquidated
and/or funds are borrowed. When there are excess funds in the concentration account, short-term
investments are purchased, or debt is paid down.
To manage concentration accounts and to optimize cash resources, treasury professionals create
cash forecasts. These forecasts help manage activities such as scheduling cash concentration
account transfers, funding disbursement accounts and making short-term investing and borrowing
decisions. Cash forecasts require a treasury professional to take three steps:
• Estimate future cash inflows and outflows.
• Generate a pro forma cash position.
• Identify how to cover any cash deficits and use any cash surpluses.
In addition to managing liquidity, treasury professionals also:
Other Treasury Professional Duties
• Manage risk. The treasury function identifies, measures, analyzes and mitigates the
organization’s exposure to many types of risk (e.g., interest rate, foreign exchange [FX],
counterparty, operational, etc.).
• Maintain access to and minimize cost of short-term financing. Treasury establishes and
maintains reliable access to short-term borrowing facilities at the lowest possible cost. Treasury
management uses short-term borrowing facilities to finance any working capital gap that may
occur when the operating cycle produces cash outflows that precede cash inflows.
Short-Term Financing
To meet short-term financing needs—those that span less than the operating cycle or less than a
year or two—treasury management has a number of tools at their disposal.
• Credit lines/revolving credit. Organizations arrange these accounts with banks in order to
have funds available on short notice. These are often used when there is a shortage of cash
for a very short period of time such as the working capital gaps discussed earlier.
• Short-term commercial loans. Sometimes organizations issue their own short-term debt
directly to investors rather than going to a bank for the loan. In general, when a bank makes a
loan, they are actually consolidating the funds of various investors to be used for loans. In the
case of commercial loans, or commercial paper as it is sometimes called, large organizations
can bypass the bank and solicit loans directly from investors.

There are other short-term strategies for acquiring immediate funds, such as factoring accounts
receivable through a commercial lender. In this strategy, a percentage of the accounts receivable
balance is received as a cash advance from a lender, with repayment terms including the principal,
commissions and other charges.
The treasury function holds the majority of the responsibility for the short-term funding of the
organization. Professionals in charge of long-term financial management, which may be treasury
or other FP&A professionals, work to maintain access to medium- and long-term financing to
support investments in capital assets. This includes support for planned asset expansion as well
as for the firm’s existing asset base. Medium- and long-term financing provide the financial
flexibility necessary to exert strategic action when investment opportunities arise.
Medium- and Long-Term Financing
The funding needs of the organization that extend beyond the operating cycle are met with
medium- or long-term financing. This financing can take the form of equity or debt. Equity results
from the sale of shares of common or preferred stock, while debt can come in many different forms:
bank loans, long-term lease arrangements or the issuance of bonds.
Stocks and bonds are traded on structured markets called capital markets. The New York Stock
Exchange is an example of a capital market. Organizations can obtain financing by issuing stocks
or bonds that are traded on one of these markets. The purchasers of the bonds pay for the right to
receive interest on the bond and the repayment of the bond at maturity. The purchasers of the
stocks pay for the right to receive a portion of the organization’s future profits or cash flow. Stock
sold to investors is considered part of the organization’s equity.
Organizations can also obtain long-term funding through long-term debt and lease arrangements.
There are many things to consider in obtaining long-term debt, including the amount of the loan,
the interest to be paid, the term of the loan and debt covenants imposed by the lender.
Under long-term lease agreements, rather than purchasing property outright, the organization
agrees to ongoing lease payments. Leases can be used to acquire not only land and buildings but
also other depreciable assets such as equipment.
A third source of financing for an organization is the reinvestment of excess cash flows earned.
This is called retained earnings and is part of an organization’s equity. Equity therefore includes
the stocks sold to investors and earnings that have been retained in the company for future use.

In corporations, the tax implications of using debt financing versus equity financing must also be
considered. Debt is usually a less-expensive capital source due to the deductibility of interest
payments, but too much debt may increase the risk of financial distress to the firm due to the
imposition of interest and principal payments. The mixture of equity versus debt for funding an
organization is called its capital structure. Most organizations will establish a target capital structure
that provides the desired mix of different capital sources and, ideally, the minimum overall cost of
funds while preserving an acceptable degree of financial flexibility. The corporate finance function
typically provides input on the capital structure and reinvesting of cash flows. It also oversees the
activities of issuing stocks and bonds and obtaining long- and short-term debt and leases.
Application to FP&A Professionals
Responsibility for financing decisions is held by different functional groups in different

organizations, but FP&A professionals are closely involved in the process. While the treasury
personnel have primary responsibility for short-term cash needs, the FP&A professional may still
provide input into the decisions. In addition, the FP&A professional can substantially contribute to,
if not hold responsibility for, long-term financing decisions.
The FP&A professional must understand the organization’s business cycle and may work with
treasury to forecast cash needs based on operations and outstanding obligations. FP&A must be
able to identify business risks and help treasury translate the risks into financial and cash flow
risks. FP&A professionals contribute financial forecasts related to strategic plans in order to
anticipate long-term financing needs. They must be able to evaluate which financing options are
best to meet the long-term financing needs. In addition, the FP&A professionals perform scenario
analysis to improve cash and other forecasts to minimize the amount of financing needed.
It is generally agreed that financing decisions cannot make an organization successful but poor
financing decisions can undermine and seriously disrupt the success of an organization. How the
funds obtained through financing are used (invested) is more likely to determine the overall
financial success of an organization. Investing decisions are another finance activity and will be
discussed next.
Investing
Investing decisions are focused on how the assets acquired through financing decisions and
through the operations of the organization are used. Again, the focus is on maximizing the efficient
use of resources with a goal of investing in assets that generate a return exceeding the cost of the
funds invested. Investment decisions are often referred to as capital expenditures or capital
budgeting. Organizations need to make major investments in tangible items such as land, buildings
and machinery. But they also need to invest in intangible items such as research and development,
marketing and selling. At the same time, excess cash flows must earn the highest rate of return
possible. All of these decisions enter into the financial management activity of investing.

Because organizations have limited financial resources, it is important to assess carefully which
competing projects, initiatives or acquisitions to fund and how much to invest in each competing
option. This analysis involves estimating both the risks and returns of a given project. The outcome
of this analysis could also suggest the divesting of some asset. For example, a school district may
decide that some schools need to be closed in order to meet budget constraints. In a corporation,
it may involve the sale of a division or subsidiary or discontinuing a product line because the
company’s capital resources could be used more effectively elsewhere. An organization
accumulates assets through financing decisions and through excess cash flows from their
operations.
Treasury Professional Duties
The assets are generally invested in one of three categories:

• Working capital. Working capital is defined as the current assets used to operate the business
less the current liabilities assumed to acquire them. Working capital is made up of things like
the raw materials for production or resale and other direct production costs. Investing in
working capital is part of the ongoing cost of business.
• Operating expenditures. These expenditures are operating costs such as salaries, utilities,
etc. As with working capital, investing in operating expenditures is part of the ongoing cost of
business.
• Capital expenditures. These are expenditures for assets that will provide benefits over the
long term. The resulting assets from these expenditures are depreciated or amortized over the
life of the asset. Examples of capital expenditures are buildings, equipment, improvements to
property or buildings and the purchase of another business.
Investment Decisions and Analysis
Investment decisions between alternative capital expenditures are where the FP&A professional
contributes to the process. Investment in ongoing working capital and operating expenditures must
occur to keep the organization operating. But the investment in capital expenditures may include
many options and requires significant analysis. This is generally performed by the FP&A
professional.
The first part of the analysis requires a quantitative evaluation of the alternative projects in which
an organization might invest capital resources. Quantitative factors include costs, expected
benefits and potential cash flows.
Next an estimate of the economic returns of projects in relation to one another as well as to the
organization’s cost of capital must be completed.

Finally, the qualitative factors of projects must be evaluated. Qualitative factors include
considerations such as how a project fits into an organization’s core strategy. In a for-profit entity,
there may also be a consideration about whether it is an activity in which a company has or can
gain a competitive advantage.
Investing: Application to FP&A Professionals
Investing decisions are a key FP&A professional contribution to an organization. As noted earlier,
financing decisions tend not to drive the fundamental success of an organization but investing
decisions do. How efficiently available assets are used to produce returns determines the financial
success of the organization and to what extent the financial management goal of maximizing
shareholder wealth is met.
FP&A professionals are usually significantly involved in budgeting and forecasting. Along with
ongoing budgeting and forecasting analysis, the FP&A professional is often called to contribute
analysis on major one-time investment decisions such as purchasing another business or investing
in a new facility. To provide a complete analysis, the FP&A professional must gather all input, both
financial and non-financial, analyze costs versus benefits, consider the timing, advisability and best
options for taking on debt, research competition and market and technology trends, and consider
the quality and strength of the management team.
Dividend Payout Policy
The result of the financing and investing decisions made by an organization is the firm’s net income
(profit or loss). In theory, the organization’s maximum dividend is its net income (unless it borrows
or uses other sources of funds to pay a dividend). However, paying all of net income as a dividend
would not leave any money available to fund future growth and would create unstable dividends in
each period, which is highly undesirable.
Dividend policy is typically set based on a number of factors:
• The sustainable level of cash a company generates
• The investment needs for the foreseeable future
• Business volatility
• Financing
• Required cash surplus
Generally, dividend payout is the last use of cash after these other factors have been considered.
Payout policy also considers tax rates on ordinary income and capital gains. Therefore, funds
available to pay dividends could be either net income or net cash flow less funds that are necessary
to reinvest in the organization.

The corporate finance function assesses payout policy alternatives and advises senior
management and the board of directors. The alternatives include to retain all the net income for
future use or to distribute some or all of it to shareholders and, if so, how much to distribute and
how to distribute it.
The payout decision has three options for net income for a period:
• Issue dividends. Some portion of the profit or excess cash flow can be paid out to
shareholders as dividends. Dividends provide shareholders with a return on their investment.
• Repurchase outstanding shares. Some portion of the profit or excess cash flow can be used
to repurchase outstanding shares. This reduces the number of shares outstanding and thereby
increases the value per share. In this way, shareholders receive a return on their investment.
• Retain the earnings. If it is determined that long-term or short-term needs require it, excess
earnings can be held and reinvested in the organization. These earnings are reflected in
retained earnings and comprise part of the value of the shares held by shareholders. Therefore,
in general, the change in retained earnings (the change from the prior period to the next period)
on the balance sheet is equal to net income minus dividends.
If the assumptions are that the organization will neither borrow funds to pay the dividend nor pay
more than the amount of cash available after considering necessary investments in the
organization’s growth, then other ways to measure funds available for dividends are to use free
cash flow (FCF) or free cash flow to equity (FCFE).
Dividend Payout Policy Considerations
Dividend payout policy can be guided by shareholder or, in some cases, analyst expectations and
may also depend on an organization’s industry, stage of development, dividend payment history,
and/or covenants contained in the organization’s debt agreements.
Stable, profitable, low-growth industries typically have higher payouts than fast-growth, high-
investment, volatile companies. Therefore, industries tend to gravitate into ranges.

Cash Surplus Availability
The first step in considering how to initially develop an organization’s dividend payout policy is to
analyze whether there truly is and will continue to be excess cash to be distributed. A common
misconception is that companies that earn positive net income distribute dividends. In reality, the
decision to make a distribution is often based on available cash flow. There are four questions to
be answered in the affirmative to determine if there is a cash surplus available to distribute:
• After considering all potential investments with a positive net present value, is there still
remaining cash available? In this case, the finance professional may look out over several
years to identify potential investment opportunities. If there are positive investment
opportunities that meet the organization’s requirements, cash should be reserved to take
advantage of them. This may take the form of a forecast of capital expenditures (CAPEX) for
future years, which might be determined by looking at the current CAPEX on the balance sheet
(change between years) or statement of cash flows.
• Is the positive cash flow expected to continue? Once dividends are issued, the expectation of
continuing dividends is set. More on the messages delivered with dividends will come later in
this section.
• Are debt levels reasonable? Debt and leverage ratios are calculated and compared against
the industry and competitors’ ratios. If the organization’s ratios are high, it may be prudent to
pay down debt rather than to distribute cash. On the other hand, an organization might borrow
funds in order to keep its dividend levels stable. Lenders may object to borrowing simply to
pay dividends; in fact, they may establish covenants on debt that indicate a maximum dividend
payment. If debt is increased to pay dividends, then dividends plus the change in retained
earnings could exceed net income, which is unsustainable.
• Does the organization have a sufficient cash cushion to address any unexpected problems or
opportunities? Note that since dividends are not tax-deductible, the organization must have
enough pre-tax income to pay both the dividend and the tax on the income used to pay the
dividend.
If any of the answers to the four surplus cash questions are no or are ambiguous, the FP&A
professional might advise management to consider retaining some or all of the excess cash,
especially if the organization doesn’t already have a history of issuing regular dividends.
If the answer to all of these questions is yes, the organization may consider issuing a payout. The
payout can take the form of a dividend or of a share repurchase. The issuance of dividends has
other consequences that must be considered.

Issuing Dividends
The issuance of a dividend communicates a message to shareholders and analysts monitoring

stocks. Once a dividend is received, the expectation is that dividends will continue at similar levels.
Once a dividend level is established, reducing the dividend sends a negative message about the
organization’s financial position. Increasing a dividend level sends a positive message, but then
the increased level must be maintained over the long term in order to not send a negative message
in later periods. Because of these expectations and understandings in the market, organizations
seek to keep their dividend issuances stable and to consider their ability to continue to pay the
same dividend level over a long period.
If an organization has sufficient cash to issue a larger-than-normal payout but doesn’t want to send
the messages that a cash dividend sends, it can choose to repurchase outstanding shares or issue
a special (one-time) dividend. Repurchasing shares has tax advantages for shareholders and has
become prevalent in the United States. Currently, as many firms repurchase shares as issue
dividends for payouts in the United States.
Where an organization is in the business life cycle has an impact on the likelihood that it will be
able to answer the four cash surplus questions with a yes. A young organization will find a lot of
opportunities with a positive net present value in which to invest. Building their business and
broadening their offerings often takes additional investment in the early years of the business.
These organizations often find it beneficial to retain all of their excess cash flow to be able to take
advantage of opportunities that come along. Investors seek to earn a return based only on stock
price appreciation in this situation.
On the other hand, more mature, established organizations sometimes find it more difficult to locate
investment opportunities with positive net present values. Excess cash can begin to accumulate,
and investors will want a return on it. They can exert pressure on an organization to either invest
the funds at a good rate of return or to return it to the shareholders so they can do so themselves.
For these reasons, it is less common for young organizations to issue dividends or repurchase
shares than it is for mature organizations.

Types of Dividends
There are several types of dividends:

• Cash dividends are the most common type of dividend, paid in cash.
• Special dividends are dividends declared to be one-off payments.
• Liquidating dividends are paid as a return of the stockholders’ investment rather than from
retained earnings. It is a liquidation of the actual stock.
• Property dividends are paid in the form of property, investments, etc., and are accounted for
at the fair value of the assets given.
• Stock dividends are paid in shares of stock, reclassifying a portion of retained earnings as
paid-in capital instead of reducing total assets or shareholders’ equity.
• Stock splits are not dividends but reduce the price per share, resulting in no net change to
stockholders’ equity. A three-for-one stock split would triple each shareholder’s shares and
divide the par value by three.
There are several ways in which to issue a payout through stock repurchase:
• Repurchase shares on the open market.
• Offer to buy back a number of shares for a specific price through a tender or other offer. These
offered prices are generally higher than the current market price.
• Negotiate with a single (or several) major shareholders.
Dividend Payout Policy: Application to FP&A Professionals

The determination of a dividend payout policy by an organization takes a significant amount of
analysis. The FP&A professional contributes analysis on investment opportunities, cash surpluses,
advisable cash cushions, investor/analyst expectations, industry and competitor payout ratios and
the organization’s capital structure, among other things. As has been noted earlier, a complete
understanding of the business, its market and investor forces, and potential future investments is
necessary for the FP&A professional to contribute to the dividend payout policy discussion.

Topic 3: Basic Corporate Financial

Concepts
Time Value of Money
Most financial decisions involve a trade-off between present and future cash flows. For example,
an organization must decide whether to invest funds now to produce future, expected cash flows.
The time value of money, a fundamental finance principle, establishes the relationship between
cash flows received at different times.
Time value means that a dollar received today is worth more than a dollar received tomorrow
because today’s dollar can be invested to earn a return. Conversely, a dollar received tomorrow is
worth less than a dollar received today because the opportunity to earn interest is lost. The value
of a cash flow at a point in time depends upon an applicable interest rate and when the cash flow
is expected to occur.
Two related concepts are discussed next, future value and present value. Present value is typically
more important to FP&A professionals because they are usually responsible for quantifying what
the financial benefit is today based on cash flows to be received in the future. However, future
value is discussed first because it is the conceptual foundation of present value.
"Financial valuation methods that account for the time value of money are called discounted cash
flow (DCF) methods."
Future Value
The future value (FV) of an investment made today is the expected value of that investment at a
specified future date. Calculation of FV requires compounding, which is when any cash flows that
the investment earns along the way are re-invested and grow at the same interest rate as the
original investment.
For example, investing $100 for two years at 10 percent per year yields a $10 return at the end of
the first year. That $10 is added to the original amount of $100. In the second year, $110 is invested
at 10 percent and the investment pays $11 in interest. The $11 is added to $110, which equates
to an investment value of $121 at the end of year two. FV computations are based on compounding
the growth of an amount invested now to see what its value will be in the future.

The formula for calculating FV is as follows:
𝐅𝐅𝐅𝐅 = 𝐏𝐏𝐏𝐏(𝟏𝟏 + 𝐢𝐢)𝐧𝐧

Where:
FV = Future value
PV = Present value or value today
i = Periodic (annual) interest rate
n = Number of periods (years)
The mathematical term (1 + i)n is called the interest, compound value or FV factor. It has the
mathematics of compounding embedded in it and is an exponential function.
The value of $100 was invested at 10 percent for two periods, but the ending value is not $100 +
$10 + $10 = $120; rather, it is $121 because the interest is compounded. It is calculated as $121
= $100 (1 + 0.1)2.
Using a Worksheet to Calculate Future Value
Worksheets such as Microsoft Excel can be used to quickly perform many financial calculations.
The FP&A exam allows you to use a basic, generic worksheet for calculations, but you do need
to know the names and order of the arguments since this is not provided (e.g., rate is the first
argument in the future value formula).
When calculating future value in a worksheet, future value syntax is =FV(rate,nper,pmt,[pv],[type]).
Rate is periodic interest rate, nper is the number of periods going into the future, pmt is the periodic
payment such as for an annuity, pv is the present value of the investment, and type is when the
payment is made, either 0 (the end of the period [the default]) or 1 (the beginning of the period).
Note that the payment (pmt) and present value (pv) must be expressed as negative values and
cannot change per period.
• Future Value
A basic formula for calculating future value is Principal * (1 + Rate)Term. Exhibit I.A.1-3 shows
the inputs and calculations to calculate future value.

Exhibit I.A.1-3 – Calculating FV Using a Worksheet
• Future Value with Compounding

Exhibit I.A.1-4 shows the inputs and calculations to calculate future value with compounding
for a situation where there is monthly compounding.
Exhibit I.A.1-4 – Calculating FV Using a Worksheet (Compounded Monthly Interest Example)

Column B repeats the annual compounding from the prior exhibit for reference.
Cells C7 to C11 show how to use the future value formula to perform monthly compounding. Here,
the annual interest rate is divided by 12 (or multiplied by 1/12) to adjust to a periodic rate and the
number of periods in years is multiplied by 12 to get the correct number of monthly periods. In
other words, the same basic future value formula can be used so long as the compounding periods
and rate cover the same units of time. In this example, the periodic rate is a monthly 0.875% and
the term is 60 monthly periods.
In Cells C13 to C16, an alternative calculation method is shown, known as the future value factor.
The formula for this equation is: future value factor = (1+rate per period)^(number of periods). In
this example with monthly compounding the annual rate is divided by 12 and the number of years
is multiplied by 12. Cell C13 demonstrates the total calculation of the future value factor and the
present value amount.
In cell C15, we demonstrate just the calculation for the future value factor. Because this calculation
is a function of rate and time, it is applicable to any amount that would have the same rate, time
period and number of compounding periods. Calculating just the future value factor would be useful
in a situation where the rate, term and compounding periods are known, but the principal amount
is subject to change.
Increasing the frequency of compounding would increase your total interest earned and push the
annual yield higher. Column D shows how the other party (e.g., a bank) might allow the
compounding period to change (in this case increase from annual compounding in Column B to
monthly compounding in Column C) but then adjust the interest rate to compensate for this
difference and thus end up at the same annual yield and future value as if the annual method were
used. This is presented here to show that the effect of changing compounding periods is well
understood by all parties and attempting to use them to the advantage of one party at the expense
of the other is unlikely to be passively accepted. The other party might say something to the effect
of; yes, we can agree to more frequent compounding, but only at an annual interest rate of
10.026%, as shown in cell D11.
This annual interest rate is the calculated periodic interest rate in cell D7 multiplied by the number
of compounding periods (12). The periodic interest rate calculation in cell D7 is one plus the annual
interest rate to the power of 1/12 (or 1/4 if quarterly compounding is used) and it is then divided by
100 to result in a percentage rate that can be used in the future value formula.
Present Value
FV is an important finance tool, but the related measure present value (PV) is used more commonly
in business contexts and is a more important tool for FP&A professionals by far, because it is used
to determine whether decisions with future financial consequences should be made today.

The PV of an expected future investment or cash flow is the value of that investment or cash flow
today. PV is used when deciding whether to make an investment at the present time that will pay
cash flows in the future. For example, if an individual is considering buying a business, the buyer
will estimate the net cash flows that the business would generate in the future. Next, the buyer
would calculate the PV of those cash flows and compare them to the present cost of the investment
to determine if it is a sound investment.
FV and PV are opposite methods. FV starts in the present and moves forward in time; PV starts in
the future and moves back in time. This is called an inverse or reciprocal mathematical relationship.
FV is isolated in the equation FV = PV(1 + i)n. To find PV, isolate it by dividing both sides of the
equation by the FV factor. The resulting equation to calculate PV is:
1
PV = FV � �
(1 + i)n
For example, if a company expects to receive $121 in two years, with a discount rate of 10 percent,
the calculated present value would be $100: $121 ((1/1.1)2) = $100.
When calculating the FV of a cash flow, the process of finding the future value of a present amount
is called compounding. When calculating the PV of a future amount, the process of finding the
present value is called discounting.
Organizations often must compare the economic value of cash flows from different investment
alternatives occurring at various times in the future. The only way to do this with consistency is to
compare their values in the present. Discounting the future cash flows to their present value allows
this to be done.
PV also applies to decisions on investments in market instruments like stocks and bonds. A bond
pays interest periodically and repays principal upon maturity. These payments are stretched over
time, but what are they worth now? A stock may pay a stream of dividends over time and can be
sold for some estimated price at some future date. Again, this is a stream of payments stretched
over time, but what are these expected payments worth in the present? Considering the time value
of money can help organizations make informed investment decisions.

Using a Worksheet to Calculate Present Value
The PV function syntax is =PV(rate,nper,pmt,[FV],[type]). Rate is the discount rate to apply (e.g.,
interest rate of a loan payment or weighted average cost of capital for an organizational average
rate), nper is the number of periods back to the present, pmt is the payment per period, such as a
periodic loan repayment, FV is the future value after the last payment is made (e.g., FV of a loan
is 0), and type is when the payment is made, either 0 (the end of the period [the default]) or 1 (the
beginning of the period). Note that pmt and FV must both be expressed as negative values.
• Present Value with Simple Interest

Exhibit I.A.1-5 shows how to calculate PV and uses information from the prior example. In this
case, this is the amount of money to be received (or paid out) five years from now.
Exhibit I.A.1-5 – Calculating PV in a Worksheet
• Present Value with Compounding

Exhibit I.A.1-6 shows how to calculate PV with compounding and uses information from the
Exhibit I.A.1-4 example. Note that the annual method is shown for comparison and both the
monthly compounding (column C) and rate-adjusted monthly compounding (column D)
methods are shown. (See the prior discussion in the future value section.) Note that these
methods result in the same present value only because they start with different initial values.
(Each is the inverse of the prior examples.)

Exhibit I.A.1-6 – Calculating PV in a Worksheet with Compounding
• Present Value of an Annuity

An annuity is a payment stream that is fixed in timing and value. An ordinary annuity involves
payments at the end of each period, and an annuity due involves payments at the beginning
of each period. For example, a stream of rental lease payments that occur each year after the
asset has been used for the year is an ordinary annuity. If $1,000 is to be received each year
at the end of each of three years, for a total of $3,000 received, the present value of this
ordinary annuity is calculated as follows:
1 1
PV of an Ordinary Annuity = Payment ∗ � − �
i i(1 + i)n
1 1
PV of an Ordinary Annuity = $1,000 ∗ � − � = $2,775
0.04 0.04(1 + 0.04)3

Exhibit I.A.1-7 shows how to calculate this in a worksheet. Note that the example shows the
financial impact of changing this to an annuity due as well. This is done by changing the final
argument, type, from 0 to 1, which changes it from an ordinary annuity to an annuity due. Note
also that the payment amount is entered as a negative value in either case.
Exhibit I.A.1-7 – Calculating PV of an Ordinary Annuity or Annuity Due in a Worksheet
• Present Value of a Constantly Growing Annuity

An annuity might be projected to grow at a constant growth rate, sometimes called perpetual
growth. For example, if the perpetual growth rate (g) is 2 percent, the equation is then
calculated as follows:
Payment (1 + g)n
PV of an Ordinary Annuity with Perpetual Growth = ∗ �1 − �
i−g (1 + i)n
$1,000 (1 + 0.02)3
= ∗ �1 − � = $2,829.50
0.04 − 0.02 (1 + 0.04)3
This type of calculation might be used for a period of time, after which a termination value is
assigned to the asset or investment (i.e., assuming that the asset or investment is sold or
scrapped at that time). The termination present value is added to the ordinary annuity with the
perpetual growth value from the prior equation to arrive at the total present value. Exhibit I.A.1-
8 shows an example of calculating present value for the same constantly growing annuity but
with a termination value of $3,000 in the fourth year.

Exhibit I.A.1-8 – Calculating PV of a Constantly Growing Annuity with a Termination Value
Discounted Cash Flow and Required Rate of Return
Financial valuation methods that account for the time value of money are called discounted cash
flow (DCF) methods. DCF discounts the future value of all cash inflows and outflows of an
investment back to their present value by factoring in costs of capital—debt and equity costs. Each
firm can calculate its own discount rate or required rate of return (RRR), the minimum acceptable
rate of return on invested capital. Two valuation methods discussed next—net present value and
internal rate of return—use the DCF methods, which is why they are generally considered more
accurate and useful tools than those that fail to account for the time value of money. Cost of capital
is usually calculated as a weighted average, and weighted average cost of capital (WACC) is
discussed later in this topic.

Net Present Value (NPV)
Net present value (NPV) converts the value of future costs and revenue to their present value by
using a discount rate, which is usually the firm’s WACC. NPV is calculated by:
• Identifying cash flows for each year of the project
• Computing the present value of the cash flow for each period, using the discount rate
• Adding the present values of the cash flows for each year in the analysis
An acceptable NPV is equal to or greater than zero.
Assume that a company that stocks snack food racks in small stores and gas stations wants to
purchase a new delivery route truck. The cost of the truck is $75,000, but the net cash flow for
each year in the five-year period under study would be $18,000. A simple (undiscounted) return
on investment (ROI) would indicate that this is a positive investment:
Gain from Investment − Cost of Investment

ROI =
Cost of Investment
or
Gain from Investment
ROI = � �−1
Cost of Investment
($18,000 ∗ 5) − $75,000
ROI = = 0.20 or 20%
$75,000
However, a discounted analysis of the cash flow tells a different story. Exhibit I.A.1-9 shows an
NPV analysis of the purchase using a discount rate of 10 percent. At that discount rate, the PV for
each of the five years would be of the form:
$18,000
PV =
(1 + 0.1)n
Thus, the $18,000 cash flow would be discounted by 1.11 for the first year, 1.12 for the second
year, 1.13 for the third year, and so on. Please note that while the chart truncates the decimal to 2
places, the calculations performed include no intermediate rounding.

Exhibit I.A.1-9 – Example of NPV Method
Discount Rate = 10% Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
1. Identify cash
($75,000) $18,000 $18,000 $18,000 $18,000 $18,000
flows
2. Calculate present $18,000 ÷ 1.1 $18,000 ÷ 1.21 $18,000 ÷ 1.33 $18,000 ÷ 1.46 $18,000 ÷ 1.61
($75,000)
value = $16,364 = $14,876 = $13,524 = $12,294 = $11,177
($75,000) $68,234
3. Add values
($6,766)
As the illustration shows, once these cash flows are appropriately discounted, the proposed
investment has a negative net present value. It does not appear to be a viable investment using
this rate of return and with these anticipated cash flows.
NPV is generally the preferred criterion for evaluating potential investments because it accounts
for the time value of money and for risk and can be used to estimate the investment’s or project’s
impact on company value.
Note that in the prior example, the costs all occur in the present and therefore are not discounted.
If there were future period costs, these would be discounted to present value as well.
Using a Worksheet to Calculate Net Present Value
The syntax for NPV is =NPV(rate,Value1,[Value2],[Value3])+Initial Investment. Rate is the

discount rate or other cost of funds. The values that follow can be a series of individual items, or a
worksheet range can be input for Value1 and no other values are then needed. Note that the initial
investment must be added after the NPV calculation (assuming that it is a negative value) rather
than being included in the calculation. If period 0 is used within the NPV calculation, it will be
assumed to be period 1 and each period’s calculation will be off by one period.
Exhibit I.A.1-10 shows how the prior example can be calculated using a worksheet formula. Note
that a range is used (C2:G2) rather than entering each cell separately. Note also that there is a
different (and more precise) result because the worksheet does not round off interim calculations
as was done using the manual method.

Exhibit I.A.1-10 – Calculating NPV in a Worksheet
NPV is often used to answer various forward-looking business questions because it compares
present values of funds expected to be received in the future to funds that the organization is
considering investing. If the payment stream is an annuity, a simple PV calculation can be made
for the payment stream, and, when it is added to the initial investment (if the investment is a
negative value), it becomes an NPV calculation.
Therefore, the calculations for the PV of an ordinary annuity and annuity due, or even those for the
PV of a constantly growing annuity, which were presented earlier, can become NPV calculations
simply by netting out the initial investment. When the payment stream varies each period, the NPV
worksheet formula saves time over having to calculate each PV individually and then sum all
periods’ PVs and the initial investment.

Using Future Value to Solve for an NPV Problem
FV can also be used to solve some NPV questions, such as the necessary cash flow for a particular
future period that would make an investment worthwhile.
For example, an FP&A professional may need to know by how much a future cash flow could be
reduced until it is equal to a given investment (an NPV of $0, or the point at which the investment
would no longer be profitable). Say an initial investment is –$20.00 and has one projected cash
flow in Year 3 of $100. If the discount rate is 10 percent, by how much could this Year 3 cash flow
be reduced before NPV reaches zero? One way to answer this question is to use the future value
calculation with the initial investment and the discount rate: $20 * (1.1)3 = $26.62. If the Year 3
cash flow was this amount (and there were no other cash flows), the investment would have an
NPV of zero, meaning you would receive $26.62 in three years if you just put the $20 into an
investment fund that paid 10 percent interest for three years. So, the percent reduction of the Year
3 cash flow from $100 to $26.62 is calculated as follows:
New Value − Old Value

Percentage Change =
Old Value
or
New Value
Percentage Change = � �−1
Old Value
$26.62
Percentage Change = � � − 1 = −73.38%
$100
Arriving at an NPV of $0 is an important threshold for many business decisions, because it is

essentially a break-even point above which an endeavor starts to become worthwhile. Therefore,
organizations pay close attention to this threshold. The next calculation discussed determines the
interest rate at which an investment would have an NPV of zero.
Internal Rate of Return (IRR)
The internal rate of return (IRR) uses discounted cash flow but approaches the calculation from
another direction. It computes the discount rate at which the present value of all cash inflows
equals the present value of all cash outflows. This is equivalent to an NPV of $0.

IRR uses a discount rate to calculate the project’s NPV. If the NPV is less than zero, the calculation
is repeated using a lower discount rate (which will increase NPV).
The formula is:
Cash Flown
NPV = =0
(1 + IRR)n
Using the example in a previous exhibit, after failing to find an NPV of zero at 10 percent, an analyst
might proceed to a discount rate of 8 percent:
$18,000 * 3.993 = $71,874

Or 6 percent:
$18,000 * 4.212 = $75,816
The $75,000 investment is actually equaled at a discount rate of 6.4 percent, as is calculated below
in a worksheet.
• IRR and WACC
A project is acceptable only if the IRR exceeds the organization’s target rate of return or
weighted average cost of capital (WACC), which is discussed later in this topic. At a rate greater
than WACC, the return exceeds the cost of funding that return.
• Issues with IRR

While the IRR does consider the time value of money and the cash flows over the entire life of
the project, it is more difficult to use and less flexible than NPV. If a portfolio of projects is being
evaluated, individual NPVs can be aggregated into a single number. Individual IRRs cannot be
averaged.
When a project extends over multiple periods, cash flows may vary between positive and
negative values. There will be multiple IRRs, and it may not be clear which figure managers
should use to assess the project. Unlike NPV, IRR cannot be adjusted to reflect future
uncertainty. The analysis solves for only a single rate.

Using a Worksheet to Calculate IRR
The syntax for IRR is =IRR(values,[guess]), where values is the range of values and guess is an
optional guess at what the IRR percentage should be. Note that if an investment has net costs in
the future rather than just net revenue, it may have multiple IRRs and only the first rate found will
be returned. In this case a different function such as MIRR needs to be used because it can return
multiple IRRs.
Exhibit I.A.1-11 shows an example of the basic IRR function using the same information from the
initial NPV example. If the discount rate in the worksheet were changed to 6.4 percent, the NPV
would then equal $0.
Exhibit I.A.1-11 – Calculating IRR in a Worksheet
Duration
For longer-term investments such as bonds, present value plays a part in calculating duration.
Duration gives an estimate of the volatility of an investment, since bonds with higher durations
typically have greater price volatility than bonds with lower durations, all else being equal. Duration
is a measure similar to payback period in that it is the number of years required to recover the true
cost of a bond using present value adjustments for all coupon and principal payments received in
the future. Because a bond generally pays interest periodically and may accrue additional principal
if purchased at a discount (or depreciate if bought at a premium), it can be viewed as having an
average maturity of all these cash flows that is different from its maturity.

The formula for duration is as follows:

𝐶𝐶𝑡𝑡
∑𝑛𝑛𝑡𝑡=1 (𝑡𝑡)
(1 + 𝑟𝑟)𝑡𝑡
Duration (D) =
𝐶𝐶𝑡𝑡
∑𝑛𝑛𝑡𝑡=1
(1 + 𝑟𝑟)𝑡𝑡
Where:
Ct= Cashflow in that period
r = Current Rate
t = Time Period
Remember that the cashflow for each period will be your calculated coupon payment with the
exception of the final year where the principle is returned as well.
In the next section we will look at how this formula applies to coupon and zero-coupon bonds.
Duration of a Coupon Bond
A coupon bond is a bond with periodic interest payments and principal due at maturity. Let’s look
at a situation where an investor has purchased a three-year $10,000 face value bond with a 10
percent annual coupon rate, current interest rates are at 5 percent. The formula is applied as
follows:
Face Value: $10,000
Coupon Rate: 10%
Current Rate: 5%
Calculate the annual coupon payment: $10,000 * 10% = $1,000
$1,000 $1,000 $11,000

(1) + (2) + (3)
(1.05)1 (1.05)2 (1.05)3
Duration (D) =
$1,000 $1,000 $11,000
+ +
(1.05)1 (1.05)2 (1.05)3
Duration (D) = 2.75 Years

Duration includes two factors in one number: the time to maturity and the coupon rate. The longer
the maturity, the higher the duration. All else being equal, the higher the coupon (interest payment),
the lower the duration. Because it includes both of these factors, duration helps estimate how a
bond will respond to changes in the general level of interest rates.
Duration of a Zero-Coupon Bond
A zero-coupon bond is a debt security that doesn’t pay interest (annual coupon payment) instead
it is sold or traded at a deep discount from the face value. All cashflow happens at maturity when
the bond is redeemed for its full-face value.
Some zero-coupon bonds are issued as such while others are bonds that have had their coupon
(interest payment stream) stripped from it and then the principal without interest (the zero-coupon
bond) and the interest payment stream are sold on the market as separate commodities that trade
independently. It is more common for these bonds to be created by bondholders after the coupon
bond has been created then it is for them to be issued as a zero-coupon bond.
The duration is equal to the actual maturity for these types of bonds. A three-year zero-coupon
bond has a duration of three years. We can mathematically prove this using the duration formula.
Let’s look at a situation where an investor has purchased a three-year $10,000 face value bond
and current interest rates are at 5 percent.
Face Value: $10,000

Coupon Rate: 0% (effectively, as there are no cashflows outside of maturity)
Current Rate: 5%
Years 1-2 cancel out as the coupon payment is zero, all you have is year 3 with the payment
at maturity:
$1,000
(3)
(1.05)3
Duration (D) =
$1,000
(1.05)3
Duration (D) = 3
All of the terms in the numerator and denominator cancel out except for your last time period (the
year of maturity), which is equal to duration.

Duration and Interest Rate Risk
Duration can be used to better understand interest rate risk. Interest rate risk is the risk from
changes in market value for fixed-income investments when the general level of market rates
fluctuate. Higher duration equates to higher interest rate risk.
Opportunity Cost
Investors have a number of options open to them for investing their funds. Wherever they choose
to invest, they expect to earn a return on the investment. Shareholders expect dividends or
increased value per share. Banks and investors expect interest on their loans. The decision of
where to invest requires a comparison of expected returns. If the investor is deciding between
investing in Firm A and Firm B, the PVs of the expected returns are compared to decide on the
best investment. If the investor chooses Firm A over Firm B, the return that could have been earned
at Firm B is considered an opportunity cost—it represents the lost opportunity of investing in the
alternative (in this case, Firm B).
The concept of opportunity cost, and comparing PV for that matter, is dependent on the relative
risk of the investments. In order to compare apples to apples, the relative risk must be similar. If
the risk is not similar, the degree of certainty in the expected return decreases, and thus the
expected return (and resulting opportunity cost) should be reduced.
While investors must consider opportunity cost when deciding where to invest their funds,
organizations also must consider opportunity cost when they make investment decisions. This
applies not only to investing in businesses, securities or bonds but also to decisions about investing
in new processes, new equipment or additional employees. In the earlier example, the investors
chose to invest in Firm A. The investors’ opportunity cost is the PV of the investment in Firm B. In
this case Firm A must provide a rate of return at least equal to the investor’s opportunity cost to
meet return expectations.
This brings us to the concept of cost of capital.

Cost of Capital
As discussed, investors in an organization’s long-term debt and equity expect a rate of return on
their investment. The sum of an organization’s long-term debt and equity is defined as capital. The
cost of capital refers to the overall cost of long-term debt, preferred stock and common equity.
Common equity includes money contributed by shareholders and earnings retained in the
business.
The cost of capital is derived from the rates of return that investors in a firm could earn by investing
in the debt and equity instruments of other companies of similar risk. The cost of capital to the
organization, therefore, is based on the opportunity costs investors incur by investing in the
company and is a measure of the cost a company would incur to raise funds to make investments
in assets. It follows that the organization must earn a rate of return at least equal to the cost of
capital to justify an asset investment. This reasoning explains why the company’s cost of capital is
often referred to as an opportunity cost.
A company’s overall cost of capital depends on the mix of long-term debt and equity and the costs
of each. This mix is called the capital structure of a company. The primary cost associated with
debt is its interest rate. The primary cost of equity is the return stockholders expect to earn on the
stock they own. The cost of capital can therefore be computed as a weighted average of the
effective cost of debt and equity. This is called the weighted average cost of capital.
Weighted Average Cost of Capital (WACC)
The weighted average cost of capital (WACC) describes a firm’s respective target contributions to
capital structure based on market values, using the marginal cost of each form of capital:
• Long-term debt that must be serviced
• Equity expectations that must be fulfilled (i.e., market expectations of shareholder returns)
FP&A professionals use WACC to replicate the economic forces on the organization. Market
values are used rather than book values because they represent the opportunity cost to investors.
Historical costs are not relevant. In practice, companies often use book costs as a proxy, but this
should be avoided whenever possible.
When retained earnings are used to finance a project, it is still the current market value of the
existing debt and equity that is determined (e.g., in a period of rising interest rates, the market
value of existing fixed interest debt improves from the organization’s perspective).
WACC is an amalgam value based on an assumption about the weight of each source when raising
the capital needed for an investment.

The formula for WACC is as follows:
WACC = WD rD (1 − T) + WE rE
Where:
W = the weight of each funding source.
D = the debt (specifically, the market value of the debt).
E = the equity (specifically, the market value of the equity).
T = the marginal tax rate (i.e., the market rate of the tax).
𝐫𝐫𝐃𝐃 (𝟏𝟏 − 𝐓𝐓) = the after-tax cost of debt.
𝐫𝐫𝐄𝐄 = the cost of equity (common stock and retained earnings). The cost of equity is often
calculated using the capital asset pricing model (CAPM).
Firms may compare the potential returns on a capital investment with the firm’s WACC. Projects
that fall below the WACC will be poor investments since they may impair the organization’s ability
to pay its debts and fulfill stakeholder expectations. Projects that exceed the WACC could increase
the firm’s long-term value. WACC is a fundamental performance hurdle rate assigned by investors.
FP&A professionals know that the company should not invest in assets that earn less than WACC
because it will negatively impact a portion of the firm’s stock value.
If, for example, a firm has a WACC of 10 percent, it means that the firm must earn a return of at
least 10 percent on assets to satisfy investors’ expectations. If the firm earns less than 10 percent,
even if it reports accounting profits and has a positive cash flow, then investors will be disappointed
and bid down the company’s stock price. On the other hand, investors will be pleased if the firm
earns more than 10 percent on assets and may bid up the stock price.
WACC is used to determine what the expected future cash flows from an investment are worth to
the organization. The PV of the future cash flows is often discounted at the WACC rate of return
because this is the return that investors expect and have placed on the firm. Therefore, it is
important when estimating WACC to use market rates for debt and equity, to use marginal tax
rates (because they incorporate present value), and to use an appropriate method of estimating
the cost of equity, such as CAPM. The respective weightings of debt and equity should be the
target capital structure, assuming that the actual structure will closely reflect the target capital
structure over time.
When a particular investment has a different risk profile than the organization, CAPM can be used
to create a risk-adjusted WACC tailored to that investment. Greater risk requires a greater
performance hurdle rate.

Application to FP&A Professionals
The time value of money, opportunity cost and cost of capital are fundamental concepts FP&A
professionals use while contributing to management investment decision making. To provide
information on an investment decision, the FP&A professional forecasts the expected cash flows
from the investment, calculates the PV discounted at the WACC and compares it to the proposed
investment.

Topic 4: Working Capital Management

Treasury Management
Treasury management refers to the process of overseeing an organization’s daily liquidity

management to ensure that cash resources are available to sustain daily operations. By
maintaining adequate liquidity, treasury management enables the implementation of the tactics
required to achieve the organization’s desired strategic plan and long-term financial objectives.
To meet these goals, treasury management must meet several short-term objectives:
• Maintain liquidity
In this context, liquidity refers to the ability to meet current and future financial obligations in a
timely and cost-effective manner. Financial obligations may consist of payments to vendors
and creditors; wages, salaries, and benefits accruing to employees; tax payments; and
dividends to shareholders. In general, maintaining liquidity involves simultaneously managing
the organization’s current assets and current liabilities.
• Optimize cash resources

This objective involves the use of policies, procedures and strategies to minimize non-interest-
earning cash balances while also providing adequate cash to ensure liquidity. Excess cash
balances are either invested in highly liquid securities to generate interest income or are used
to pay down debt and reduce interest expense. The optimization of cash resources also
involves speeding up cash inflows by collecting on accounts receivable when due, controlling
cash outflows by paying vendors no earlier than the due date, and minimizing the net cost of
the cash collection and payment process by using cash concentration. Cash concentration
involves holding cash in a special bank account from which outflows are paid. When the
concentration account falls below a predetermined balance, short-term investments are
liquidated and/or funds are borrowed. When there are excess funds in the concentration
account, short-term investments are purchased or debt is paid down.

• Maintain Access to Short-Term Financing

Short-term financing is used to fund operating working capital (e.g., accounts receivable and
inventory) and to provide temporary financing for capital assets. Short-term financing is
typically used for time periods of one year or shorter. The treasury department is tasked with
establishing and maintaining reliable access to short-term financing while minimizing the cost
of borrowing. Common types of short-term financing include:
• Credit lines or revolving credit agreements- Credit lines are short-term bank loans that
provide the borrower with quick access to funds. Credit lines are often used for daily cash
shortages associated with funds tied up in inventory and/or accounts receivable.
• Commercial paper- This form of short-term financing is essentially a commercial loan
whereby the borrower issues short-term debt directly to lenders (i.e., investors), thereby
circumventing the traditional bank lending channel. The appeal of commercial paper is that
the cost of this form of financing may be lower than the cost of borrowing via bank loan.
Commercial paper is generally issued by large firms with high credit ratings as commercial
paper issues are generally denominated in $50 million increments or greater.
• Factoring- With factoring, an organization sells its accounts receivable to a firm referred to
as a factor. At the inception of the factoring agreement, the organization receives a cash
payment from the factor at a discount to the face value of the accounts receivable. The
factor then collects on the full-face value of the receivables.
• Manage Short-Term Investments

Treasury management involves overseeing the investment of excess funds in a prudent
manner to ensure that funds are readily available for short-term needs. Preservation of
principal is the primary investment objective, followed by ensuring liquidity and maximizing
overall return.
In addition to meeting short-term objectives, treasury management involves overseeing critical

finance functions that ensure the availability of funds necessary to sustain the initiatives that
support the organization’s long-term financial objectives. Specific long-term objectives include:
• Maintain Access to Medium and Long-Term Financing

Medium and long-term financing is used to provide funding for periods longer than one year.
This form of financing is required to support strategic capital investments as opportunities arise
(e.g., acquisition of property, plant, and equipment). Medium and long-term financing is raised
in the form of either equity or debt. Common sources of medium and long-term debt financing
include commercial bank loans and bond issuances. Equity can be raised externally through
the issuance and sale of common or preferred equity securities and can be raised internally by
retaining earnings from previous periods.

• Risk Management
The treasury department is often tasked with identifying, measuring, analyzing, and mitigating
various organizational risks, including financial risks (e.g., interest rate, foreign exchange, and
commodity price risks), regulatory risks (e.g., compliance risks), and operational risks (e.g.,
supplier and fraud risks). Through various risk management strategies, the treasury
department can lower the organization’s risk profile and reduce the cost of capital.
Treasury Management and the Operating and Cash Conversion Cycles
The objectives of treasury management are directly related to the operating cycle concept. The
operating cycle is the time it takes to both convert inputs into a saleable product and to turn the
saleable product into collected cash. Exhibit I.A.1-12 provides a graphic depiction of the operating
cycle for a traditional manufacturing concern. The operating cycle begins with the agreement to
purchase raw materials from a supplier, which are then transformed into inventory (i.e., a saleable
product). The inventory is then sold on trade credit terms, which results in the creation of an
accounts receivable. After the customer remits payment, the accounts receivable is transformed
into cash. In sum, the operating cycle simply shows the way in which funds flow throughout an
organization’s operating assets (e.g., inventory and accounts receivable).
Exhibit I.A.1-12 – The Operating Cycle

Since operating assets require funding, the management of the operating cycle has a direct impact
on the organization’s liquidity requirements and financing costs. Partial funding of the operating
cycle may occur spontaneously through accounts payable, thereby providing interest-free
financing to the organization. Subtracting the accounts payable period from the operating cycle
results in the cash conversion cycle. Since the cash conversion cycle is defined as the time period
between when accounts payable are paid and when cash is collected from customers, the cash
conversion cycle represents the portion of the operating cycle that must be funded through non-
accounts payable sources of financing. All else equal, a shorter cash conversion cycle implies
increased liquidity as less external financing is required. Alternatively, a longer cash conversion
cycle implies reduced liquidity as more external financing is required. Increased external financing
results in increased interest expense and lower profitability. Subsequently, the cash conversion
cycle is a primary measure of liquidity.
To illustrate, suppose that a manufacturer’s operating cycle begins with the purchase of raw
materials inventory, where the materials supplier provides 30 days of trade credit financing. This
period of time is referred to as days payable outstanding. The manufacturer then takes 60 days
to jointly convert the raw materials to finished goods and to sell the finished product to a retailer.
This inventory conversion period is referred to as days’ inventory outstanding. When selling the
inventory, the manufacturer provides trade credit to the retailer for 20 days. This trade credit period
creates an accounts receivable and represents the time gap between when the sale occurs and
when cash is collected. Subsequently, the 20-day collection period is referred to as days’ sales
outstanding. This process is illustrated in Exhibit I.A.1-13.
In this example, the operating cycle extends for 80 days, and is calculated as the sum of days’
inventory outstanding of 60 days and days’ sales outstanding of 20 days. Accounts payable will
provide financing for the first 30 days of the operating cycle, which means that the cash conversion
cycle is 50 days. The key implication is that the remaining 50 days of the operating cycle must be
funded using non-spontaneous source of financing, such as a line of credit. As the cash conversion
cycle increases, additional funds will be required from the line of credit and interest expense will
increase. This example highlights the importance of maintaining access to short-term financing
and in minimizing borrowing costs by shortening the cash conversion cycle.

Exhibit I.A.1-13
An organization’s financial statement information is required to better understand the efficiency

with which funds are moved throughout the operating cycle on an aggregate basis throughout a
fiscal year, as opposed to a transaction-by-transaction basis. Each component of the cash
conversion cycle is composed of a ratio that relates a stock variable from the balance sheet to a
flow variable from the income statement. This process of connecting the balance sheet to the
income statement transforms the dollar-based variables to day-based measures. The equations
for each component of the cash conversion cycle appear below and Exhibit I.A.1-14 provides a
sample balance sheet, income statement, and operating cash flow statement for Firm Z.

Exhibit I.A.1-14 – Firm Z’s Financial Statements
BALANCE SHEET
(in millions USD)
ASSETS
2018 2017
Cash $460 $120
Short-Term Investments 70 70
A/R 187 180
Inventory 189 176
Total Current Assets $906 $546
Gross PP&E $3,731 $3,731
Accumulated Depreciation 1,049 862
Net PP&E $2,682 $2,869
Total Assets $3,588 $3,415
LIABILITIES AND SHAREHOLDERS' EQUITY
Accounts Payable $95 $86
Notes Payable 272 164
Total Current Liabilities $367 $250
Long-Term Debt $1,424 $1,424
Common Stock 52 52
Additional Paid-In Capital 563 563
Retained Earnings 1,182 1,125
Shareholders' Equity $1,797 $1,740
Total Liabilities and Shareholders' Equity $3,588 $3,414

INCOME STATEMENT
(in millions USD)
2018 2017
Revenue $1,950 $1,875
Cost of Goods Sold 1,209 1,125
Gross Profit $741 $750
SG&A 293 225
Depreciation 187 112
EBIT $261 $413
Interest Expense 99 97
Income Before Tax $162 $316
Income Tax Expense 49 95
Net Income $113 $221
CASH FLOW FROM OPERATIONS

(in millions USD)
2018
Net Income $113
Depreciation 187
Change in A/R (7)
Change in Inventory (13)
Change in A/P 9
Cash Flow From Operations $289

Average Inventory
Days ′ Inventory Outstanding (DIO) = ∗ 365
Cost of Goods Sold
$189 + $176
� �
2
Days ′ Inventory Outstanding (DIO) = ∗ 365 = 55.1 Days
$1,209
Average Accounts Receivable

Days ′ Sales Outstanding (DSO) = ∗ 365
Revenue
$187 + $180
� �
′ 2
Days Sales Outstanding (DSO) = ∗ 365 = 34.3 Days
$1,950
Average Accounts Payable

Days ′ Payable Outstanding (DPO) = ∗ 365
Cost of Goods Sold
$95 + $86
� �
2
Days ′ Payable Outstanding (DPO) = ∗ 365 = 27.3 Days
$1,209
To summarize, the calculations from above indicate that over the fiscal year 2018, Firm Z required
an average of:
55.1 days to produce and sell each unit of inventory
34.3 days to collect on each credit sale
27.3 days to re-pay accounts payable owed to their suppliers
After calculating the aforementioned components, the cash conversion cycle can be calculated as
the sum of DIO and DSO (i.e., the operating cycle) minus DPO, as shown below.
Cash Conversion Cycle (CCC) = DIO + DSO – DPO = 55.1 + 34.3 − 27.3 = 62.1 days

For the FP&A professional, it is important to not only calculate the cash conversion cycle, but also
to understand its effect on borrowing costs. The latter is addressed in the next section.
The Cost of Financing the Cash Conversion Cycle

This cash conversion cycle calculation in the prior section indicates that Firm Z will be required to
fund 62.1 days of its operating cycle with external sources of financing, including debt or available
cash holdings. If the cash conversion cycle is financed with debt, Firm Z will be required to pay
interest for 62.1 days of each operating cycle. If the cash conversion cycle is funded with available
cash, then an opportunity cost will be incurred because the cash could be invested, used to pay
off existing debt, or returned to shareholders in the form of dividends or equity buybacks. In the
latter case the appropriate opportunity cost will depend on the alternative use of the cash in that
each potential use has a different opportunity cost due to differences in risk.
Once the appropriate financing rate is determined, the cash conversion cycle can be used to
estimate the average financing required by this cycle. The average financing required multiplied
by the financing rate provides an estimate of the financing cost associated with moving funds
throughout operating assets and into cash via the cash conversion cycle. The steps for calculating
this estimate are shown below.
COGS Revenue
Average Financing Required = (DIO − DPO) ∗ � � + DSO ∗ � �
365 365
In this step, the difference in DIO and DPO reflects the fact that the accounts payable period offsets
part of the inventory period. These components are combined since both inventory and accounts
payable are related to COGS. Overall, the first term provides an estimate of the average net
financing required to cover average daily COGS, while the second term provides an estimate of
the average net financing required to fund average daily revenues that remain uncollected. This
model can be applied to Firm Z as shown below:
$1,209 $1,950
Average Financing Required = (55.1 − 27.3) ∗ � � + 34.3 ∗ � �
365 365
Average Financing Required = $275.3 Million

Another way to calculate the average financing required to support operations is through the
Working Capital Requirement (WCR) metric. The WCR is the dollar amount of operating assets
that must be funded with a source of financing other than accounts payable. The equation for the
WCR appears below:
WCR = (Average Accounts Receivable + Average Inventory) – Average Accounts Payable

WCR = ($183.5 + $182.5) – $90.5 = $275.5 Million
The $0.2 million difference in the calculations for the average financing required and the working
capital requirement is solely attributable to rounding.
The average financing required has two major implications for the organization. First, the average
financing required shows the net amount of funds that must be held in operating assets based on
the nature of an organization’s operations and cash conversion cycle. For example, Firm Z’s
average financing required implies that $275.3 million in operating assets must be carried on the
balance sheet, which reduces the firm’s operating cash flow. A second implication of the average
financing required is that it partially determines the organization’s borrowing cost. If Firm Z has a
borrowing cost of 4.5%, then the annual cost of financing the cash conversion cycle is calculated
by multiplying the average financing required by the borrowing cost, as shown below:
Annual Financing Cost of the CCC = Average Financing Required * Borrowing Cost
Annual Financing Cost of the CCC = $275.3 * 0.045 = $12.4 Million
This calculation suggests that the annual financing cost of the cash conversion cycle is
approximately $12.4 million. This annual financing cost erodes profitability and reduces value for
shareholders.

Managing the Cash Conversion Cycle
As shown above, the cash conversion cycle is directly related to the amount and cost of financing
required to support operations. An increase in the cash conversion cycle will result in an increase
in overall financing cost and a reduction in operating cash flow. Meanwhile, shortening the cash
conversion cycle will reduce overall financing costs and increase operating cash flow. Three
independent methods to shorten the cash conversion cycle include:
1. Reduce inventory time (DIO)
2. Reduce the average collection period (DSO) 1
3. Increase the length of the payables period (DPO)
A rearrangement of the DSO, DIO, and DPO formulas show that the balance sheet amounts for
accounts receivable, inventory, and accounts payable may be calculated as a function of the DSO
and average daily revenue, and DIO or DPO and average daily cost of goods sold.
Revenue
Average Accounts Receivable = DSO ∗ � �
365
Cost of Goods Sold

Average Inventory = DIO ∗ � �
365
Cost of Goods Sold

Average Accounts Payable = DPO ∗ � �
365
1 A decrease in the DSO will produce the largest impact on the cost of financing for a given number of days change in the cash
conversion cycle. This occurs because the DSO is linked to revenue, while DIO and DPO are linked to the COGS.

Referring back to the financial statements presented in Exhibit I.A.1-4, Firm Z has an average
accounts receivable balance of $183.5 million and a DSO of 34.3 days. Suppose that by
encouraging customers to remit payment electronically, as opposed to with check, the DSO is
reduced by 3 days to 31.3 days. All else constant, the DSO reduction will result in a lower average
accounts receivable balance, WCR and annual financing costs, as shown below.
$1,950
New Average Accounts Receivable = 31.3 ∗ � � = $167.2 Million
365
Change in Average Accounts Receivable = $167.2 − $183.5 = −$16.3 Million
WCR = ($167.2 + $182.5) − $90.5 = $259.2 Million
Change in WCR = $259.2 − $275.5 = −$16.3 Million
Change in Annual Financing Costs = −$16.3 ∗ 0.045 = −$0.7335 Million
In addition to the lower financing costs, the shorter DSO period and lower average accounts
receivable balance will also increase cash flow from operations. To see this effect, note that the
new average accounts receivables balance is $167.2 million and the accounts receivable balance
at the end of 2017 was $180 million. Based on these two values, the accounts receivable balance
at the end of 2018 would be $154.4 million, which is calculated below.
$180 + 2018 Accounts Receivable

$167.2 =
2
($167.2 ∗ 2) − $180 = 2018 Accounts Receivable
$154.4 = 2018 Accounts Receivable
The change in the accounts receivable balance between 2017 and 2018 ($154.4 million minus
$180 million) represents a $25.6 million source of cash. Exhibit I.A.1-15 includes the original
operating cash flow from operations along with the cash flow from operations after the change in
DSO. Decreasing DIO or lengthening DPO will also produce increased operating cash flow.

Exhibit I.A.1-15 – Change in Cash Flow from Operations
CASH FLOW FROM OPERATIONS

(in millions USD)
2018 2018 (New)
Net Income $114 $114
Depreciation 187 187
Change in A/R (7) 25
Change in Inventory (13) (13)
Change in A/P 9 9
Cash Flow from Operations $289 $321
Overall, this example and associated calculations highlight the importance of treasury
management to the shareholder wealth maximization paradigm. By maintaining a tight grip on the
operating and cash conversion cycles, the treasury department can reduce interest expense which
increases net income and cash flow that is available to shareholders.
Despite these benefits, caution must be exercised when seeking to reduce the cash conversion
cycle as the interactions between these operating accounts and revenues must be carefully
considered. For example, suppose that trade credit terms offered to customers were shortened
from net 30 to net 25. This would decrease the cash conversion cycle by 5 days. However, the
shortened credit terms may result in lost market share if competitors offer net 30 credit terms. In
this case, the reduced financing costs may be more than offset by the lost revenue due to lower
sales. On the other hand, increased sales generated by relaxing trade credit terms from net 30 to
net 40 may not offset the additional financing costs and operating cash flow impact of the large
accounts receivable balance.

An organization must also understand the impact of reducing the cash conversion cycle through a
reduction in inventory or lengthening the payables period. Lower inventory levels increase the
probability that the organization will not be able to meet demand or suffer a production slowdown
due to a lack of raw materials. Stretching accounts payable beyond the due date may hurt
relationships with suppliers and hamper the organization’s ability to obtain trade credit in the future.
However, higher inventory levels and paying accounts payable earlier than the due date may have
no tangible benefits to offset the increased financing costs associated with a longer cash
conversion cycle. In sum, the costs, benefits, and risks associated with changes in the levels of
operating current assets and liabilities must be carefully weighed.
Current Asset Financing Strategies
The organization’s current assets may be funded with a combination of short-term and long-term
sources of financing. A first step in identifying the optimal current asset financing strategy involves
determining the mix of permanent current assets and fluctuating current assets held by the
organization. Permanent current assets represent the minimum level of current assets that are
required to support the organization’s operations. For example, some level of inventory would be
required for the vast majority of manufacturers and retailers. Once the permanent level of current
assets is established, fluctuating current assets can be calculated as the difference in the overall
current asset base and permanent current assets.
The next step in formulating the optimal current asset financing strategy is to determine the
appropriate financing mix for each component of current assets. In general, short-term sources of
financing are cheaper at inception and are more flexible than long-term sources of financing. The
lower initial cost of short-term financing is attributable to the higher maturity risk premium
associated with long-term debt. The increased flexibility of short-term financing reduces costs
associated with excessive funds borrowed. Two disadvantages of short-term financing include
interest rate risk and rollover or refinancing risk. Both are attributable to the fact that short-term
financing requires frequent renegotiation or renewal. At each renewal date, the cost of short-term
financing is marked to market based on current interest rate conditions. Further, at each renewal
date the lender can decide not to renew the short-term note. The latter is especially concerning
during tight credit markets and/or periods of increased uncertainty in the financial markets. Longer-
term sources of financing guarantees the availability of funding for longer periods of time, but the
borrower may have excessive financing during certain periods of time.
Current asset financing strategies are classified as maturity matching, conservative, and
aggressive. These strategies are shown in Exhibit I.A.1-16. The top bar in the exhibit partitions
current assets into either permanent current assets or fluctuating current assets. The bars below
show the mix of short-term and long-term financing sources associated with each current asset
financing strategy. The appropriate strategy may vary over time depending on current and
expected future interest rates and management’s risk tolerance.

Exhibit I.A.1-16 – Current Asset Financing Strategies
With a maturity matching strategy, fixed assets and all of the permanent current assets are
financed with long-term sources of financing. Meanwhile, fluctuating current assets are funding
with short-term sources of financing. The maturity matching approach provides long-term
financing for permanent funding needs and allows short-term financing to fluctuate as current asset
levels expand and contract. As fluctuating asset levels increase, the organization may draw down
on short-term sources. When fluctuating current asset levels decrease, funds are used to repay
the short-term financing sources.
A conservative current asset financing strategy uses long-term sources to fund fixed assets,
permanent current assets, and a portion of fluctuating current assets. Short-term financing is used
for any remaining fluctuating current assets. Compared to the other strategies, a conservative
strategy uses the least short-term financing. As a result, this strategy has higher financing costs
than the other approaches because the organization carries excess long-term financing and the
interest rate is typically higher for long-term sources of financing.
An aggressive financing strategy involves funding all of the fluctuating current assets and part of
the permanent current assets with short-term sources. The remaining permanent current assets
and fixed assets are financed with long-term sources. As a consequence, the aggressive financing
strategy may result in higher profits due to lower borrowing costs. The tradeoff of the aggressive
current asset financing strategy is that it also exposes the organization to increased interest rate
risk, due to the potential for increases in short-term interest rates, as well as increased rollover or
refinancing risk.
To illustrate the financial impact of the current asset financing strategy chosen, refer back to the
financial statements presented in Exhibit I.A.1-14. Firm Z has $906 million in current assets and
$2,682 million in fixed assets. Assume that Firm Z has permanent current assets of $543 million
and $363 million in fluctuating current assets (i.e., $906 - $543). Since the firm has $367 million in
short-term financing and $3,221 million in long-term financing, Firm Z uses an aggressive current

asset financing strategy. Specifically, short-term sources are used to finance $367 million of the
current assets, as comprised of the full balance of fluctuating current assets of $363 million and
$4 million in permanent current assets, and the remaining $539 million in permanent current assets
is financed with long-term sources. Suppose that the interest rate on short-term debt is 2.5%, the
cost of long-term financing is 6.5%, and there is no cost associated with accounts payable. Under
this financing strategy, the total financing cost will be:
Total Current Asset Financing Cost = (0 ∗ 95) + (0.025 ∗ 272) + (0.065 ∗ 539) = $41.8 Million
To lower current asset financing costs further, Firm Z may decide to pursue an even more
aggressive current asset financing strategy. For example, suppose that Firm Z increases short-
term debt from $272 million to $600 million. Under the new strategy, the amount of short-term
financing will total $695 million (i.e., $95 million in accounts payable and $600 million in short-term
debt). Firm Z is now financing the $363 million in fluctuating current assets and $332 million in
permanent current assets with short-term sources. The remaining $211 million in permanent
current assets will be financed with long-term sources. Using the more aggressive asset financing
strategy reduces the total financing cost to $28.7 million, as shown below:
Total Current Asset Financing Cost = (0 ∗ 95) + (0.025 ∗ 600) + (0.065 ∗ 211) = $28.7 Million
This example shows that the total current asset financing cost decreases as the organization
moves toward a more aggressive strategy.
Although a more aggressive financing strategy may be expected to lower financing costs, the
treasury department must carefully assess the increased rollover/refinancing risk and interest rate
risk that accompany the more aggressive strategy. In terms of interest rate risk, interest rate
differentials between short-term and long-term financing sources play an important role in
determining the optimal current asset financing strategy. The U.S. Treasury yield curve is normally
upward sloping with short-term rates being lower than long-term rates. However, the slope of the
yield curve changes over time and the cost advantage of shorter-term debt may be eroded by a
flattening yield curve. Exhibit I.A.1-17 compares the U.S. Treasury yield curve on July 2016, July
2017, and July 2018. In July 2016, the spread between the yield on 30-year U.S. Treasury debt
and 1-year U.S. Treasury debt was 1.76%. In July 2018, the spread had declined to 0.65%,
resulting in a significant reduction in the cost advantage of short-term debt. A continued flattening
of the yield curve will further reduce the benefit associated with an aggressive financing strategy.

Exhibit I.A.1-17 -Treasury Yield Curve

Topic 5: Financial Investment Decisions

Capital Investments
Capital investments represent one of the primary long-term financial decisions made by FP&A
professionals. Specific types of capital investments include the acquisition of fixed assets (e.g.,
property, plant, and equipment) or the expansion of existing operating capacity, among others. In
addition to ensuring that a capital investment is aligned with the strategic plan, FP&A professionals
must determine the expected impact of the capital investment on the value of the overall
organization. Since the overall goal for most organizations is value maximization, a capital
investment with a positive net present value (NPV) should be accepted. Otherwise the capital
investment should be rejected (i.e., the “Go/No-Go” decision).
The NPV principle is critical in making “Go/No-Go” decisions because it involves a direct
comparison of the capital investment’s marginal costs against its expected marginal benefits. For
example, suppose that an FP&A professional is tasked with determining the viability of a capital
investment that requires the purchase of fixed assets at an upfront cost of $2,000,000. The
investment is expected to produce additional revenues that will result in annual after-tax cash flows
of $900,000 to be received at the end of each of the next three years. For simplicity, assume that
the annual after-tax cash flows represent the additional revenues earned minus all cash expenses
associated with operating the investment. That is, the after-tax cash flows represent incremental
cash flows that are directly associated with the capital investment. 2 Another simplifying assumption
is that the market value of the capital investment’s assets will have no salvage value at the end of
the three year holding period. Assume that the appropriate required rate of return for this
investment is 10%. 3 Based on these assumptions, the expected NPV of this capital investment is
calculated as: 4
$900,000 $900,000 $900,000
NPV = −$2,000,000 + + +
1.101 1.102 1.103
NPV = −$2,000,000 + $818,181.82 + $743,801.65 + $676,183.32 = $238,166.79
2 Cash Flows associated with capital projects are deemed Incremental in that they only materialize if the project is undertaken.
3 Required rates of return are normally based on the cost of capital used to finance the project.
4 Since the cash flow stream in this example is an ordinary annuity, the NVP can also be calculated as
NPV = -$2,000,000 + ($900,000 * [ 1-1/1.10^3/0.10]) = -$2,000,000 +(900,000*2.48685) =$238,166.79

The positive estimate for the NPV suggests that the investment will increase the value of the
organization. Assuming that the organization is a publicly traded corporation, the estimated NPV
indicates that the firm and its shareholders are expected to be better off by $238,166.79 in present
value terms if the capital investment is undertaken. Specifically, the firm and its shareholders
increase their wealth by $238,166.79. Assuming that the firm is not capital constrained and can
raise the necessary funds, the $2,000,000 in fixed assets should be purchased.
The NPV principle is a central component of financial decision making because it accounts for both
the tangible and intangible, or unobserved, marginal costs of an investment. In the aforementioned
example, the tangible costs of the investment include the purchase price of $2,000,000 and the
various operating expenses incurred over the three-year holding period. Meanwhile, the intangible
costs include the opportunity cost associated with the lost return on the $2,000,000 in funds that
are required to purchase the capital investment. The NPV principle accounts for this opportunity
cost by discounting the future expected cash flows. Thus, a positive NPV implies that a capital
investment is expected to generate cash flows that exceed the upfront purchase price on a present
value basis. When this condition is met, additional firm value is created.
To further conceptualize the way in which the NPV method fully accounts for both tangible and
intangible marginal costs and benefits of an investment, consider the following simplified example
in which a capital investment that is currently priced at $1,000,000 has an expected cash flow of
$1,200,000 that will occur in one year. At a 10% discount rate, the investor can either forgo the
investment and invest their $1,000,000 at 10% and have a future investment value of $1,100,000,
calculated as $1,000,000*1.10, or the investor can purchase the capital investment and receive
$1,200,000 in one year.
The difference in expected investment value at the end of year 1 is $100,000 (i.e., $1,200,000 -
$1,100,000). The present value of $100,000 one year from now is $90,909.09, which is calculated
as $100,000/1.10. This is exactly equal to the NPV for the capital investment (i.e., NPV = -
$1,000,000 + ($1,200,000/1.10)). The process of discounting future cash flows is embedded in the
NPV methodology, which eases the process determining value creation when examining capital
investments with longer and more complex cash flow streams.
Estimating After-Tax Cash Flows: The Pro-Forma Approach
In the previous example, the expected after-tax cash flows for the capital investment were given.
However, FP&A professionals are usually required to estimate the after-tax cash flows using a pro-
forma estimation approach. A general model for the pro-forma approach is shown below in Exhibit
I.A.1-18.

Exhibit I.A.1-18 - Pro-Forma After-Tax Cash Flows
Revenues
Less: Cash Expenses
Less: Depreciation Expense
Earnings Before Interest and Taxes
Less: Taxes
Earnings After Tax
Plus: Depreciation Expense
After-Tax Cash Flow
The pro-forma approach is designed to account for the tangible benefits and costs of the capital
investment. For this reason, the values used for annual revenues should be incremental revenues
that will only be earned if the capital investment is undertaken. Cash expenses represent actual
outlays of cash that occur from operating the capital investment. Common examples of cash
expenses include cost of goods sold and selling, general, and administrative expenses.
Depreciation expense represents a systematic approach of matching the costs of acquiring a
capital investment with the revenues earned by the capital investment. However, depreciation
expense is not a true cash outflow, which is why depreciation expense is added back in the final
step of the pro-forma. Consequently, the net financial result of both subtracting and adding
depreciation expense is to lower taxable income and, hence, taxes. Taxes are accounted for by
multiplying the given tax rate by earnings before interest and taxes. In the last step of the pro-
forma depreciation expense is added to earnings after tax, which results in after-tax cash flow.

The pro-forma approach can be applied to the original capital investment example presented in
this chapter after making the following additional assumptions:
• The fixed assets are expected to generate revenues of $1,250,000 for each year of the three-
year holding period.
• Cash expenses will equal 20% of revenues, which is $250,000 ($1,250,000*0.20).
• The fixed asset purchase price of $2,000,000 will be depreciated straight line to $0 over the
three-year holding period, which results in annual depreciation expense of $666,666.67
($2,000,000/3).
• The firm’s tax rate will remain at 30% over the three-year holding period.
With these assumptions, the after-tax cash flows can be estimated using the template provided
earlier, as shown below.
Exhibit I.A.1-19
Year 1 Year 2 Year 3
Revenues $1,250,000.00 $1,250,000.00 $1,250,000.00
Less: Cash Expenses ($250,000.00) ($250,000.00) ($250,000.00)
Less: Depreciation Expense ($666,666.67) ($666,666.67) ($666,666.67)
EBIT $333,333.33 $333,333.33 $333,333.33
Less: Taxes ($99,999.99) ($99,999.99) ($99,999.99)
Earnings After Tax $233,333.33 $233,333.33 $233,333.33
Plus: Depreciation Expense $666,666.67 $666,666.67 $666,666.67
After-Tax Cash Flow $900,000.00 $900,000.00 $900,000.00

The values in the exhibit illustrate the journey from revenues to after-tax cash flow. To operate the
fixed asset, cash expenses of $250,000 are expected to be incurred and the firm will have the
ability to deduct $666,666.67 in depreciation expense from taxable earnings. The net result is
operating profit or EBIT of $333,333.33. 5 After accounting for taxes and adding back for
depreciation expense, the annual projected after –tax cash flow is $900,000. At first glance the
treatment of depreciation expense in the pro forma may seem redundant, but further consideration
shows the value imparted by depreciation (i.e., the depreciation tax shield). The depreciation tax
shield represents the tax savings associated with deducting depreciation expense from taxable
earnings and is calculated as depreciation expense of $666,666.67 multiplied by the tax rate of
30%, which is $200,000. 6 That is, the depreciation expense write-off lowers taxes by $200,000.
The pro-forma results in the estimates of annual after-tax cash flow of $900,000, which provide the
basis for the NPV calculation shown earlier and re-presented here for convenience.
$900,000 $900,000 $900,000

NPV = −$2,000,000 + + + = $238,166.79
1.101 1.102 1.103
Re-Evaluating Key Assumptions
FP&A personnel must carefully consider the assumptions used to estimate a capital investment’s
after-tax cash flows and NPV. As with any model, the pro-forma approach and NPV methodology
are only as accurate as the assumed values used as model inputs. The two primary categories of
assumptions that should be carefully reviewed include:
Variables used to project after-tax cash flows
Projecting a capital investment’s after-tax cash flows may include estimating revenues, cash
expenses, working capital effects, and asset salvage value, among others. Over-or under-
estimates for these variables will lead to inaccurate forecasts of after-tax cash flow thereby biasing
the estimate of NPV.
5 Note that interest expense is not accounted for in the pro forma because it is a financing cash flow, not an operating cash flow.
6 Another way to calculate the depreciation tax shield is to re-calculate after-tax cash flow after substituting $0 for the current
depreciation expense. The difference in the after-tax cash flows that account for depreciation expense and after ignoring depreciation
expense will equal the depreciation tax shield.

The proper risk-adjusted discount rate
Given the uncertainty in the variables used to project after-tax cash flows and the difficulty in
determining the proper risk-adjusted discount rate, it is critical to use sensitivity analysis and
scenario analysis to re-evaluate the baseline estimate of the NPV. The sections below provide
descriptive illustrations.
Sensitivity Analysis
Sensitivity analysis applied to NPV allows FP&A professionals to quantify the effects of
uncertainties of a single input variable on the NPV estimate. Simply put, sensitivity analysis allows
the user to change the value for a given input variable and then re-calculate the NPV. By examining
a wide range of values for the input variable of interest, sensitivity analysis provides increased
information regarding potential risks associated with a capital investment.
The benefit of sensitivity analysis can be illustrated by re-evaluating the previous example. The
first input variable of interest is the cash expense ratio, which was assumed to be 20% of revenues.
Suppose that new information indicates that the cash expense ratio may be as low as 15% of
revenues or as high as 25% of revenues. The sensitivity of the NPV of the capital investment to
the cash expense ratio can be performed simply by re-calculating the after-tax cash flows and NPV
at each potential value for the cash expense ratio. The values for each are shown in the exhibit
below. 7
7 For brevity, the repetitive NPV calculations are shown in this footnote:
NPV Cash Expense of 15% = - $ 2,000,000 + $943,750 / 1.10^1 + $943,750 / 1.10^2 + $943,750 / 1.10^3 = $ 349,966.57
NPV Cash Expense of 25% = - $ 2,000,000 + $856,250 / 1.10^1 + $856,250 / 1.10^2 + $856,250 / 1.10^ 3 = $ 129,367.02

Exhibit I.A.1-20
Year 1 Year 2 Year 3
Revenues $1,250,000.00 $1,250,000.00 $1,250,000.00
Less: Cash Expenses ($187,500.00) ($250,000.00) ($312,500.00)
Less: Depreciation Expense ($666,666.67) ($666,666.67) ($666,666.67)
EBIT $395,833.33 $333,333.33 $270,833.33
Less: Taxes ($118,750.00) ($99,999.99) ($81,250.00)
Earnings After Tax $77,083.33 $233,333.33 $189,583.33
Plus: Depreciation Expense $666,666.67 $666,666.67 $666,666.67
After-Tax Cash Flow $943,750.01 $900,000.00 $856,250.00
NPV $349,966.57 $238,166.79 $129.367.02
Unsurprisingly, the after-tax cash flows decrease as the cash expense ratio increases. The annual
projected after-tax cash flow reaches a peak of $349,966.57 and a low of $129,367.02 at cash
expense ratios of 15% and 25%, respectively. Put another way, this potential increase in the cash
expense ratio is projected to cut after-tax cash flow by more than half. Despite the decreasing
trend in the after-tax cash flows, the each NPV estimate still exceeds $0, which suggests that the
capital investment is acceptable even if the cash expense ratio reaches 25% of revenues.
Next the sensitivity of the capital investment’s NPV to variation in the required rate of return is
examined. To illustrate, assume that interest rates are expected to increase over the three-year
operating period. Specifically, rates may increase by up to 200 basis points (i.e. 2%). This potential
increase means that the required rate of return used to calculate the present value of the capital
investment’s after-tax cash flows may increase to 12%.

To conduct the sensitivity analysis of the NPV to an increase in required rate of return, the NPV
would simply be re-calculated using the original after-tax cash flows and the revised required rate
of return. The NPV of the capital investment at a 10.5% required rate of return is $218,611.12, as
shown below.
$900,000 $900,000 $900,000

NPVr=10.5% = −$2,000,000 + + + = $218,611.12
1.1051 1.1052 1.1053
For ease of presentation, the NPV estimates using the other potential required rates of return are
summarized in the exhibit below. The results in the table clearly indicate that as the required rate
of return increases, the value created by the capital investment decreases, as expected due to the
principle of time value of money. More importantly, this example illustrates that as the uncertainty
related to the required rate of return increases, the potential value of the investment decreases.
Specifically, a 200 basis point increase in the required rate of return erodes $76,528.65 of the
value created by the capital investment (i.e., $238,166.79 - $161,648.14). Although the capital
investment is still acceptable at a 12% required return, the lower NPV decreases the attractiveness
of the capital investment relative to alternative investments available to the firm.
Exhibit I.A.1-21
Required Rate of Return (%) NPV ($)
10.0 238,166.79
10.5 218,611.12
11.0 199,343.24
11.5 180,375.45
12.0 161,648.14
An alternative method for examining the sensitivity of the NPV to changes in the required return is
through the NPV profile method. An NPV profile is a graph that displays a capital investment’s
NPV as a function of the required return. For purposes of developing an NPV profile, the relevant
range for the required return is generally 0% to 25%. The primary benefit of the NPV profile is that
it displays all potential NPV estimates for a given set of cash flows, which provides a better
visualization of the effect of uncertainty in the required rate of return on NPV. The NPV profile for
this capital investment appears in the exhibit below.

Exhibit I.A.1-22
Since the NPV profile plots the NPV on the y-axis and the required return on the x-axis, the
downward sloping curve indicates that the NPV of the capital investment decreases as the required
return increases. This inverse relation parallels the findings in the previous exhibit; however, the
NPV profile provides additional information. Namely, the NPV profile shows how high the required
return must be before the NPV reaches $0. Note that this required return is equivalent to an
investment’s IRR. For the given capital investment, the required return that forces the NPV to equal
$0 is 16.65%. Assuming that the required return will not exceed 16.65% over the three-year holding
period, the FP&A professional would feel confident that variation in the required return will not
cause a change in the “go/no-go” recommendation for this capital investment.

Scenario Analysis
Scenario analysis enables the FP&A professional to evaluate the effect of changes in two or more
input variables on the output variable. By allowing for the values of multiple inputs to vary, scenario
analysis provides a more robust framework than sensitivity analysis for evaluating the effect of
uncertainty on NPV. One of the primary uses of scenario analysis for NPV evaluation is to examine
the worst-case scenario, wherein the most adverse values for the input variables are plugged into
the model. If the worst-case scenario results in a positive NPV, then the FP&A professional will
feel even more confident in deciding to accept the capital investment. More commonly, however,
the worst-case scenario will result in a negative estimate for NPV. The potential for value
destruction must be carefully weighed when making the “go/no-go” decision.
Scenario analysis is illustrated by continuing with the previous capital investment example. The
following three scenarios are assumed:
• Worst-case: Cash expense ratio of 40% and a required return of 12%
• Base-case: Cash expense ratio of 20% and a required return of 10%
• Best-case: Cash expense ratio of 15% and a required return of 8%
For each scenario, the after-tax cash flows are re-calculated using the pro-forma approach. Next,
the NPV of each after-tax cash flow scenario is calculated using the associated required return.
The estimates for the after-tax cash flows and NPV s appear in the exhibit below.
Exhibit I.A.1-23
Worst-Case Base-Case Best-Case

Scenario Scenario Scenario
Year 1-3 After-Tax Cash Flow $725,000.00 $900,000.00 $943,750.01
Required Return 12% 10% 8%
NPV -$258,672.33 $238,166.79 $432,135.31

The exhibit shows that the worst-case scenario for the capital investment’s after-tax cash flows is
$725,000, which occurs at the cash expense ratio of 40%. Meanwhile, the base-case and best-
case scenario values for after-tax cash flow are $900,000 and $943,750, as calculated earlier.
Each scenario NPV is calculated using the scenario-based after-tax cash flows and required return.
The calculation for the worst-case NPV appears below.
$725,000 $725,000 $725,000

NPVWorst−Case = −$2,000,000 + + + = $258,672.33
1.121 1.122 1.123
The NPV scenarios indicate that the capital investment is expected to increase value under both
the base-case and best-case scenarios. However, the worst-case scenario suggests that the
capital investment could lower firm value by $258,672. For this degree of value destruction to
occur, the 40% case expense ratio and the 12% required return must occur jointly. The negative
NPV for the worst-case scenario suggests that caution should be used before undertaking the
capital investment.
A more nuanced version of scenario analysis would examine the various levels of the cash
expense ratio between the bounds of 15% to 40% and the required return of 8% and 15%. This
approach can easily be developed in a worksheet application.
Lease-Versus-Buy Analysis
As an alternative to directly purchasing fixed assets, a lease can be used to acquire a fixed asset.
A lease is a contractual agreement between a lessor (i.e., the owner of the fixed assets) and a
lessee (i.e., the user of the fixed assets) that stipulates the lessee’s right to use the fixed asset
over a defined period of time as well as the specified lease payments made by the lessee. Fixed
assets that are commonly leased include real estate and equipment used for construction projects.
Two primary types of leases are operating leases and financial leases. Operating leases are
typically for shorter periods (e.g. 3-5 years for equipment and up to 20 years for real estate), may
include an option for the lessee to cancel the agreement, and require the lessor to pay for
insurance, taxes and maintenance expenses. In contrast, financial leases, are longer term in
nature, do not include a cancellation option for the lessee, and require the lessee to cover
insurance, taxes and maintenance 8.
8
The primary purpose of the leasing aspects covered in this section is to provide a framework for evaluating
the viability of leasing using the NPV Principle. For this reason, the accounting treatment for leases is not
covered.

The NPV principle can be used to determine whether a fixed asset should be acquired via lease
or direct purchase. The first step in this process involves estimating the incremental after-tax cash
flows associated with both acquisition types. Next, the NPV of these incremental after-tax cash
flows should be calculated to determine the acquisition option that provides the maximum increase
in firm value. Since the lease-versus-buy decision is essentially a financing choice, the firm’s after-
tax borrowing cost is the appropriate required return to use to calculate the present value of the
incremental after-tax cash flows.
To illustrate, suppose that an FP&A professional is tasked with determining the best way to acquire
a new piece of equipment that will lower the production costs by $120,000 per year over the next
two years. The equipment can be purchased for $180,000 and would be depreciated using the
straight-line method to $0 over the two-year holding period. Alternatively, the equipment can be
leased from the manufacturer for an annual lease payment of $100,000. The organization has a
tax rate of 30% and a before-tax borrowing cost of 8%.
The pro-forma after-tax cash flows from purchasing the equipment are shown in the following
exhibit.
Exhibit I.A.1-24
Purchasing: Incremental Cash Flows
Year 1 Year 2
Cost Savings $120,000 $120,000
Less: Depreciation Expense -$90,000 -$90,000
Taxable Income $30,000 $30,000
Less: Taxes -$9,000 -$9,000
Net Income $21,000 $21,000
Plus: Depreciation Expense $90,000 $90,000
After-Tax Cash Flow $111,000 $111,000

The exhibit indicates that the equipment’s cost savings are treated as a cash inflow. The
depreciation expense of $90,000 is calculated with the straight-line approach over the two-year
holding period with a salvage value of $0, calculated as $180,000/2. Taxes of $9,000 are
calculated as taxable income of $30,000 multiplied by the tax rate of 30%. Overall, the purchase
of the equipment is expected to result in annual after-tax cash flow of $111,000 over the two-year
operating period. The analysis shows that a key benefit of purchasing the equipment is the
depreciation tax shield, which lowers the tax liability by $27,000. The depreciation tax shield is
calculated as depreciation expense of $90,000 multiplied by the tax rate of 30%. For further proof
of the value created by the depreciation tax shield, the after-tax cash flows can be re-calculated
after substituting a value of $0 for depreciation expense. By doing so, the tax liability increases to
$36,000 (i.e., $120,000*0.3) and after-tax cash flow drops to $84,000. Note that this is a $27,000
increase in taxes and, hence, a $27,000 decrease in after-tax cash flows.
The after-tax cash flows from the exhibit are then used to calculate the expected NPV using the
after-tax borrowing rate of 5.60% (0.08*1-0.30)) as the required rate of return, as shown below:
$111,000 $111,000
NPVBuy = −$180,000 + +
1.0561 1.0562
NPVBuy = −$180,000 + $105,113.64 + $99,539.43 = $24,653.07
From this analysis, the FP&A professional would conclude that buying the equipment is expected
to add value.
Due to the presence of a leasing option a major question remains as to whether the organization
would be better off by leasing the equipment instead of purchasing it. The following exhibit shows
the after-tax cash flows associated with leasing the equipment.

Exhibit I.A.1-25
Leasing: Incremental Cash Flows
Year 1 Year 2
Cost Savings $120,000 $120,000
Less: Lease Expense -$100,000 -$100,000
Taxable Income $20,000 $20,000
Less: Taxes -$6,000 -$6,000
Net Income/After-Tax Cash Flow $14,000 $14,000
As with the purchasing option, the equipment’s cost savings are treated as a cash inflow. There is
no expense for depreciation since the lessee does not own the equipment. However, the lease
expense is tax deductible. Since there is no depreciation expense, net income and after-tax cash
flow are identical. The NPV of the leasing option appears below:
$14,000 $14,000
NPVLease = $0 + +
1.0561 1.0562
NPVLease = $0 + $13,257.58 + $12,554.52 = $25,812.10
The NPV analysis highlights one of the primary benefits of leasing the equipment: The lack of an
upfront purchase price, which is a large negative cash flow under the purchase scenario. From the
NPV leasing calculation, the FP&A professional would conclude that leasing the equipment is
expected to increase value.
Furthermore, leasing is preferred to purchasing the equipment. A simple comparison of the NPVs
indicates that the leasing option creates more value than with the purchasing option. The difference
in the leasing NPV and the purchasing NPV is commonly referred to as the Net Advantage to
Leasing (NAL). If the NAL is positive, then leasing is preferred to purchasing. If the NAL is negative,
then purchasing is preferred to leasing. For this example, the NAL is $1,159.04, as shown below:
NAL = NPVLease − NPVBuy = $25,812.10 − $24,653.07 = $1,159.04

A shortcut approach for determining the NAL is to calculate the NPV of the difference in the
incremental cash flows across both the lease and purchase options. A comparison of the
purchasing and leasing after-tax cash flow pro formas, indicates that the incremental cash flows
include the lease payment, the depreciation tax shield, and the upfront purchase price. By leasing
the equipment, the lessor incurs the after-tax least payment and loses the depreciation tax shield
but saves the upfront cash outflow associated with the purchase price.
The shortcut approach is illustrated with the previous example. The incremental cash outflows from
the lessor’s perspective include the after-tax lease payment of $70,000, calculated as $100,000*(1-
0.30) and the depreciation tax shield of $27,000, calculated as ($90,000*0.30). The sum of the
after-tax lease payment and the depreciation tax shield represents the after-tax cash outflow, which
occurs at the end of each of the next two years. Meanwhile, the lessor’s incremental cash inflow
is $180,000, which is the upfront savings of avoiding purchasing the equipment. The shortcut
approach results in the same NAL as before, as shown below: 9
$97,000 $97,000
NAL = $180,000 − − = $1,159.03
1.0561 1.0562
9 The difference in NAL of $0.01 is due to rounding.

Mergers and Acquisitions
The purchase of a firm or a subsidiary by another firm often occurs through corporate transactions
referred to as mergers and acquisitions (M&A activity). With an acquisition, a firm purchases
another firm’s stock and/or assets. Meanwhile, in a merger a target firm is absorbed by a bidding
firm or a new firm is formed from the combination of the two. 10Three specific types of merger
transactions are described below:
• Horizontal merger
Horizontal merger is the combination of two firms in the same line of business into one
entity. An example of a horizontal merger would be a merger between two regional
commercial banks with similar operating and loan portfolio structures.
• Vertical merger
Vertical merger is the combination of two firms in different stages of the production chain
into one entity. These mergers can be either backward or forward along the production
chain. For example, a cell phone manufacturer purchasing the battery manufacturer used
in its phone units is an example of a backward vertical merger. Meanwhile a compounding
pharmaceutical firm purchasing a retail pharmaceutical chain is an example of a forward
vertical merger.
• Conglomerate merger
Conglomerate merger is the combination of two firms in unrelated lines of business. For
example, a large internet retailer purchasing a large grocery chain would be an example of
a conglomerate merger.
M&A activity requires significant financial resources, which necessitates application of the NPV
principle before committing to a given course of action. M&A activity should only occur if the bidding
firm’s offer is in-line with its current strategic focus and goals and if its value is expected to increase
due to the M&A activity.
The first step in evaluating the viability of potential M&A activity is to estimate the potential gains
from the transaction. The primary types of gains from M&A activity include increased revenues and
decreased costs. Increased revenues may be realized through a larger customer base, improved
marketing and distribution channels, and strategic benefits through both increased pricing power
and flexibility options. M&A activity may result in cost reductions through increased economies of
scale, vertical integration that improves the coordination in operating activities, and tax gains (e.g.,
net operating losses carried by the acquired firm and/or unused debt capacity).
10 Technically, the latter is referred to as a consolidation. However, the financial press frequently uses the term merger for both
types of corporate transactions.

In sum, the incremental value of M&A activity is equal to the difference in the value of the combined
firm, using the revised values for revenues and costs, and the summed values of the firms as
separate entities. A positive incremental value is often referred to as synergy.
To apply the NPV principle to M&A activity, the cost of the transaction must be weighed against
the sum of the incremental value and the market value of the acquired firm. The NPV of an
acquisition can be calculated as:
NPVAcquisition = −Cost of Acquisition + Incremental Value + Value of Acquired Firm
Since M&A activity often involves publicly traded firms, share prices are often used to estimate the
components of the NPV model. The following example applies this approach.
Suppose that Firm Y is considering acquiring Firm Z. For ease of illustration, assume that both
firms are financed entirely by equity. The pre-acquisition information for the firms appears below:
Exhibit I.A.1-26
Firm Y Firm Z
Current Market Price/Share $40 $15
Number of Shares
100 20
Outstanding
The board of directors for Firm Z has stated that they will agree to the sale of their firm at a cash
price of $350. Firm Y’s analysts estimate that the incremental value created from the acquisition is
$30. Given these assumptions, the NPV of the acquisition is negative, which implies that this
acquisition would reduce firm value for Firm Y’s shareholders. The calculation appears below.
NPVAcquistion = −$350 + $30 + ($15 ∗ 20) = −$20
In short, the synergistic benefits of the acquisition do not justify the $50 value premium (i.e., $350
- $300) requested by Firm Z’s board. Since the total additional benefit of the acquisition is $330
($30 + $300), the maximum acquisition price is $330.

Divestitures
Divestitures represent the sale of certain assets, business divisions, or operating segments to
another entity (i.e. an outsider). Divestitures are inextricably tied to M&A activity; one firm’s
acquisition is another firm’s divestiture. Management may opt for a divestiture due to a lack of
profitability, scale, or strategic fit. Also, divestitures may be used to raise cash when financing is
scarce. Common types of divestitures include equity carve-outs, spin-offs, and split-ups.
Regardless of the type of divestiture, these transactions represent a decision by the firm to
abandon the asset(s) thus affecting the value of the selling firm.
As with other financial decisions, the viability of a divestiture depends on the selling firm’s estimate
of the future after-tax cash flows that will be earned by the assets in question if they remain in the
firm’s asset portfolio versus the price that a potential buyer is willing to pay for the assets.
Essentially the FP&A professional must decide if the assets in question have greater value if they
are separated from the firm than they currently have as part of the firm’s asset portfolio. If the price
exceeds the present value of the expected after-tax cash flows, then the selling firm would be
inclined to agree to the divestiture. This discussion is simply another application of the NPV
principle.
To illustrate, suppose that management of Firm H is considering divesting a portion of the firm’s
asset base that is expected to produce annual after-tax cash flows of $1,500,000, $1,200,000, and
$900,000 over the next three years. 11 Further, Firm J has offered to buy the divested assets for an
upfront payment of $3,200,000. From Firm H’s perspective, the upfront payment represents a cash
inflow and the future cash flows that are expected to be earned by the assets represent cash
outflows (i.e., the tradeoff of divesting the assets). At a required rate of return of 10%, the NPV of
the divestiture to Firm H’s shareholders would be calculated as follows.
$1,500,000 $1,200,000 $900,000

NPVDivestiture = $3,200,000 − − − = $168,444.78
1.101 1.102 1.103
The NPV of the divestiture is $168,444.78, which indicates that management should proceed with
the divestiture. Note that the calculation also indirectly provides the minimum price at which Firm
H would be willing to divest the assets. At any sales price above $3,031,555.22, the divestiture
results in an increase in firm value. However, a sale price below $3,031,555.22 would lower firm
value.
11 In the aforementioned example it is assumed that all marginal costs of the assets are accounted for in the projected after-tax cash
flows.

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FPAC Exam Prep Platform

FPAC Part 1: Chapter 1

Topic 1: Objective of Financial Management………………………………………………. 1-2

Topic 2: Corporate Finance Activities……………………………………………………….. 1-4

Topic 3: Basic Corporate Financial Concepts…………………………………………….. 1-17

Topic 4: Working Capital Management …………………………………………………….1-38

Topic 5: Financial Investment Decisions …………………………………………………..1-55

©2019. Association for Financial Professionals Table of Contents 1-1

Topic 1: Objectives of Financial

Present value of future cash flows

Return on shareholders’ investment

©2019. Association for Financial Professionals Topic 1 1-2

• The profit can be distributed to the shareholders.

©2019. Association for Financial Professionals Topic 1 1-3

Topic 2: Corporate Finance Activities

©2019. Association for Financial Professionals Topic 2 1-4

Exhibit I.A.1-1 – Primary Finance Activities

©2019. Association for Financial Professionals Topic 2 1-5

Treasury Management and Liquidity

©2019. Association for Financial Professionals Topic 2 1-6

The Operating Cycle

Exhibit I.A.1-2 – The Operating Cycle

Treasury Professional Duties

©2019. Association for Financial Professionals Topic 2 1-7

Other Treasury Professional Duties

©2019. Association for Financial Professionals Topic 2 1-8

Medium- and Long-Term Financing

©2019. Association for Financial Professionals Topic 2 1-9

Application to FP&A Professionals

Responsibility for financing decisions is held by different functional groups in different

©2019. Association for Financial Professionals Topic 2 1-10

Treasury Professional Duties

The assets are generally invested in one of three categories:

Investment Decisions and Analysis

©2019. Association for Financial Professionals Topic 2 1-11

Investing: Application to FP&A Professionals

Dividend Payout Policy

©2019. Association for Financial Professionals Topic 2 1-12

Dividend Payout Policy Considerations

©2019. Association for Financial Professionals Topic 2 1-13

Cash Surplus Availability

©2019. Association for Financial Professionals Topic 2 1-14

The issuance of a dividend communicates a message to shareholders and analysts monitoring

©2019. Association for Financial Professionals Topic 2 1-15

There are several types of dividends:

Dividend Payout Policy: Application to FP&A Professionals

©2019. Association for Financial Professionals Topic 2 1-16

Topic 3: Basic Corporate Financial

©2019. Association for Financial Professionals Topic 3 1-17

The formula for calculating FV is as follows:

𝐅𝐅𝐅𝐅 = 𝐏𝐏𝐏𝐏(𝟏𝟏 + 𝐢𝐢)𝐧𝐧

Using a Worksheet to Calculate Future Value

©2019. Association for Financial Professionals Topic 3 1-18

Exhibit I.A.1-3 – Calculating FV Using a Worksheet

• Future Value with Compounding

Exhibit I.A.1-4 – Calculating FV Using a Worksheet (Compounded Monthly Interest Example)

©2019. Association for Financial Professionals Topic 3 1-19

©2019. Association for Financial Professionals Topic 3 1-20