CMA Final Paper 14 (SFM) common mistakes
CMA Final Paper 14 (SFM) · Understand the traps and how to avoid them.
Calculating WACC using the book value of debt and equity from the balance sheet, or using the coupon rate on existing debt as the cost of debt, instead of market values and the current yield-to-maturity (or a synthetic rating-based pre-tax cost of debt adjusted for tax).
Candidates default to numbers that are printed on the financial statements because they are easy to find, and they confuse the historical cost of already-issued debt with the marginal cost of new debt that a project must earn against. This is reinforced by textbook illustrations that use book weights.
What to do instead
Build a standard WACC working note: (1) take market capitalisation = shares outstanding × current price; (2) take market value of debt from the current YTM on traded debt or a credit-spread-based rate; (3) use target or market weights, never book weights; (4) apply the marginal tax rate to the interest rate, not to the effective historical rate. State the weights and the source of each input in one line so the marker can follow the logic.
Treating a capital investment appraisal and a financing decision as separable when they are not - for example accepting a project on an unadjusted WACC when the project's business risk or leverage differs materially from the firm's existing operations, or ignoring the interest tax shield and issue costs in an APV-style problem.
The standard NPV template is drilled in isolation, so candidates apply the corporate WACC mechanically to every project regardless of risk class, and they forget that the WACC already embeds the firm's target debt ratio. In APV questions they compute the base-case NPV and stop.
What to do instead
Before discounting, classify the project: same risk class and same financing mix → use WACC; different business risk → use a pure-play or asset-beta relevered discount rate; different or changing leverage → use APV (base-case NPV at the all-equity rate plus the present value of the tax shield less issue/flotation costs). Write one sentence justifying the chosen discount rate in the answer.
Computing a VaR figure and presenting it as if it were the maximum possible loss, without stating the confidence level, the holding period, and the fact that it is a loss threshold exceeded with a given probability; or mixing up the parametric, historical simulation, and Monte Carlo methods and their assumptions.
VaR is taught as a formula (z × σ × √t) and candidates reproduce the arithmetic without the interpretive caveats. The three methodologies look interchangeable in a formula sheet, so the assumptions (normality, linearity, stable historical distribution) are never examined.
What to do instead
Always report VaR as 'we are X% confident that losses will not exceed Y over a Z-day horizon', then add the tail caveat (expected shortfall / CVaR beyond the VaR threshold). For each method state one assumption and one limitation: parametric assumes normality and understates fat tails; historical simulation assumes the past window is representative; Monte Carlo requires a specified distribution and is computationally heavy. Show the √t scaling explicitly when converting daily to multi-day VaR.
In security valuation, applying a constant-growth Gordon model to a company with a high or unsustainable payout, or using a trailing EPS as the forward earnings base, and then failing to reconcile the resulting value with a relative valuation multiple.
The DDM formula is simple and candidates reach for it whenever a dividend is mentioned, without testing whether g < required return, whether growth is sustainable (g = retention ratio × ROE), or whether the dividend is a stable policy. Relative valuation is treated as a separate topic rather than a cross-check.
What to do instead
Run a two-stage or three-stage DDM when growth is above the sustainable rate, and explicitly test g = b × ROE against the assumed perpetual growth. Distinguish trailing from forward EPS and state which you used. Finish with a triangulation paragraph: compare the DDM value with a justified P/E or EV/EBITDA multiple and explain the gap (growth expectations, risk, or margin differences).
Reporting portfolio performance on return alone - quoting a Sharpe ratio without checking whether it is comparable (same period, same risk-free rate, annualised consistently) or omitting the Treynor ratio, Jensen's alpha, and the information ratio where the context is a diversified fund benchmarked to an index.
Sharpe is the most familiar metric, so it becomes the default. Candidates also annualise inconsistently (multiplying a monthly Sharpe by 12 instead of by √12) and compare funds measured over different windows.
What to do instead
Match the metric to the question: total-risk context → Sharpe; well-diversified fund judged against a benchmark → Treynor, Jensen's alpha, information ratio; ranking of many portfolios → M² or the Sharpe-based rank. Annualise returns arithmetically and risk by √periods, use the same risk-free rate throughout, and state the measurement window. Add a one-line interpretation of each number rather than leaving a table of ratios.
Pricing an option or a swap by plugging numbers into Black-Scholes or a swap formula without checking applicability - using Black-Scholes for an American-style option, for a dividend-paying stock without adjustment, or for a currency option without converting to the domestic risk-free rate and the forward rate.
The formula sheet supplies the equation but not the boundary conditions, so candidates treat it as universal. Dividend yield and the foreign interest rate are the two inputs most often dropped because they are not obviously a 'rate' in the question.
What to do instead
Before computing, write the applicability checklist: European exercise, known constant volatility, no dividends (or use the dividend-adjusted form with S·e^(−qT)), and for FX options use the Garman-Kohlhagen form with r_domestic and r_foreign. If the option is American and the early-exercise premium matters, use a binomial tree. For swaps, value as the difference between the fixed and floating legs discounted on the relevant curve, and state the day-count and reset conventions.
Confusing transaction exposure with translation exposure and operating (economic) exposure, and then hedging the wrong one - for example recommending a forward contract for a long-term competitive exposure that is better addressed by operational hedging (matching currency of costs and revenues, shifting production, or currency of invoicing).
All three are 'FX risk', and the labels are learned as definitions rather than as triggers for different tools. Candidates also default to derivatives because they are the most visible hedging instrument.
What to do instead
Classify first: transaction exposure = known contractual cash flows → forwards, futures, money-market hedge, options; translation exposure = accounting consolidation of foreign subsidiaries → balance-sheet hedging, matching assets and liabilities, or a net-investment hedge; operating exposure = long-run effect on competitiveness → operational and strategic responses. Then state the hedge ratio and the residual risk retained. Show the forward rate via covered interest parity when a money-market hedge is used.
In international capital budgeting, discounting foreign-currency cash flows at the domestic cost of capital, or converting at the spot rate instead of the forward rate implied by purchasing power parity / interest rate parity, so the NPV is internally inconsistent.
Candidates mix the two correct methods: (a) convert at forward/PPP rates and discount at the domestic rate, or (b) discount at the foreign rate and convert at spot. Half-applying one method to the other produces a plausible but wrong number.
What to do instead
Pick one method and label it. Method A: forecast FCFF in the foreign currency, discount at the foreign-currency cost of capital, convert the present value at today's spot rate. Method B: convert each year's foreign cash flow to domestic currency at the PPP-implied forward rate, then discount at the domestic rate. Both must give the same answer; if they do not, find the arithmetic slip. Separately assess political/country risk and state whether it is in the cash flows or the discount rate, not both.
In M&A, adding the standalone values of acquirer and target to get the merged value without computing synergy, or computing synergy as a round-number percentage of revenue rather than from specific cost and revenue line items; and then failing to split the synergy between the two sets of shareholders via the premium paid.
The value-creation formula (synergy − premium) has three components and candidates collapse it to two. Synergy is asserted rather than built, and the premium is treated as a cost of the deal rather than as a transfer to target shareholders.
What to do instead
Build the synergy line by line: cost synergies (headcount, procurement, duplicate functions) with phasing and one-off integration costs; revenue synergies only where there is a defensible mechanism. Compute gain to target shareholders = premium paid; gain to acquirer shareholders = synergy − premium. Then check the financing: cash, debt, or share exchange, and recompute post-deal EPS and ownership dilution for a share exchange using the exchange ratio.
Valuing a startup with a single DCF or a revenue multiple, without reflecting the staged nature of the investment - ignoring the pre-money/post-money mechanics, the option-like value of staging, and the liquidation preference and dilution from future rounds that determine the founder's and the VC's actual returns.
Candidates apply mature-company valuation tools to a company with negative cash flows and no history, and they treat the term sheet as boilerplate rather than as a set of cash-flow claims. The venture capital method and the option-pricing view of staging are less familiar than the DCF.
What to do instead
Use the venture capital method: exit value = terminal metric × exit multiple; discount back at the target IRR (typically 30–60% for early stage); then adjust for the expected future dilution to get the post-money and pre-money. Explicitly model the liquidation preference and participation to allocate exit proceeds between preference and ordinary shares. Where staging is material, note the real-option value of the next round and the milestone that triggers it. State clearly that the discount rate is a target return, not a CAPM cost of capital.
Producing a valuation with no reconciliation between methods - a DCF, a comparable-companies multiple, and a precedent-transaction multiple presented side by side with no explanation of why they differ, and no sensitivity analysis on the value drivers.
Each technique is practised separately, so the final answer becomes three disconnected numbers. Candidates also omit sensitivity tables because they take time, even though the marker is looking for evidence that the candidate knows which assumptions dominate.
What to do instead
Close every valuation with a football-field summary: a range per method, the chosen point estimate, and a paragraph explaining the gaps (control premium in precedent transactions, growth and margin assumptions in the DCF, comparability limits in trading multiples). Add at least a two-way sensitivity table on the two most value-sensitive inputs (e.g., WACC and terminal growth, or exit multiple and margin) and identify the break-even assumption at which the recommendation flips.