CMA Final Paper 14 (SFM) flashcards

35 cards. Read the term and the definition here. The deck at the top of this page is optional.

WACC formula

WACC = (E/V)·Ke + (D/V)·Kd·(1−t), where E and D are market values and V = E + D. Use target weights and marginal costs for investment appraisal.

Sustainable growth rate

g = ROE × retention ratio b, with b = 1 − dividend payout. Growth above g requires external equity or higher leverage, otherwise leverage ratios rise.

Economic profit

Economic Profit = Invested Capital × (ROIC − WACC). Positive spread means the firm creates value; growth only adds value when the spread is positive.

Pecking order theory

Firms prefer internal funds, then debt, then new equity, because asymmetric information and issue costs make equity issuance costly and often interpreted as bad news.

Value at Risk

VaR at confidence c is the loss L such that the probability of a loss exceeding L equals 1 − c over a stated horizon. It ignores losses beyond the threshold.

Expected Shortfall

ES (CVaR) is the average loss conditional on losses exceeding VaR. It is sub-additive and coherent, unlike VaR, which can violate sub-additivity.

Expected loss formula

Expected Loss = PD × LGD × EAD. Unexpected loss above the expected level drives economic capital, while regulatory capital uses risk-weighted assets.

Interest rate duration exposure

ΔP ≈ −D·P·Δy/(1+y) plus convexity term ½·C·P·(Δy)². Duration gives first-order price sensitivity; convexity corrects for larger rate moves.

FCFF formula

FCFF = EBIT(1−t) + D&A − Capex − ΔNWC. Discount at WACC to obtain enterprise value, then subtract net debt for equity value.

Gordon growth model

P0 = D1/(Ke − g). Requires g < Ke and a stable payout ratio. Terminal value = FCFF_{n+1}/(WACC − g) in a DCF.

Hamada equation

βL = βU[1 + (1−t)D/E]. Unlever comparable betas, then relever to the target capital structure before computing the cost of equity.

Residual income model

V0 = B0 + Σ (ROE − Ke)·B_{t−1}/(1+Ke)^t. Useful when free cash flow is negative or unstable, and focuses on value created above the cost of equity.

Efficient frontier

The locus of portfolios offering maximum expected return for each level of risk. The tangency portfolio with the risk-free asset maximises the Sharpe ratio.

Sharpe ratio

Sharpe = (Rp − Rf)/σp. Treynor uses beta in the denominator, while Jensen's alpha measures return above the CAPM prediction.

Portfolio variance two assets

σp² = w1²σ1² + w2²σ2² + 2w1w2ρσ1σ2. Lower correlation reduces portfolio variance; ρ = −1 can eliminate risk entirely.

Bond immunisation

Match the duration and convexity of assets and liabilities so that a parallel shift in rates leaves surplus unchanged. Requires periodic rebalancing as durations drift.

Put-call parity

For European options: C − P = S − K·e^{−rT}. Violations allow arbitrage using synthetic positions combining stock, bond, call, and put.

Black-Scholes call formula

C = S·N(d1) − K·e^{−rT}·N(d2), with d1 = [ln(S/K) + (r + σ²/2)T]/(σ√T) and d2 = d1 − σ√T.

Credit tranching

Pool securities are split into senior, mezzanine, and equity tranches. Losses absorb bottom-up, so subordination and overcollateralisation provide credit enhancement.

Covered interest parity

F/S = (1 + r_d)/(1 + r_f). The forward premium equals the interest rate differential; deviations create covered arbitrage opportunities, net of transaction costs.

Transaction exposure

Risk from known foreign-currency cash flows, such as exports or imports. Hedged with forwards, money market hedges, futures, or options.

Translation exposure

Accounting exposure from restating foreign subsidiary financial statements into the parent currency. Current-rate and temporal methods produce different gains and losses.

International Fisher effect

The interest rate differential between two countries equals the expected change in the spot exchange rate. Combined with PPP, it links inflation, rates, and currency movements.

Adjusted present value

APV = base-case NPV (all-equity discounted) + PV of financing side effects, such as tax shields, subsidised loans, and concessionary debt in foreign projects.

Country risk premium

An addition to the cost of equity for investing in a foreign market, reflecting political, currency, and sovereign default risk. Often based on sovereign bond spreads.

Multilateral netting

A centralised process that offsets intercompany payables and receivables across subsidiaries in multiple currencies, reducing gross foreign exchange exposure and transaction costs.

Synergy value

Synergy = V_AB − (V_A + V_B). Acquirer gain = synergy − premium paid. Cash consideration transfers synergy to target shareholders; stock shares it.

EPS accretion rule

In an all-stock deal, EPS accretes if the target's P/E is below the acquirer's P/E, before synergies. A higher target P/E causes dilution.

Exchange ratio

Exchange ratio = offer price per target share ÷ acquirer share price. Post-merger EPS = combined earnings ÷ combined shares outstanding.

Venture capital method

Post-money = exit value × ownership ÷ (1 + target IRR)^n. Pre-money = post-money − investment. Early-stage target IRRs typically range from 30% to 60%.

Liquidation preference

A term entitling preferred investors to recover their investment before common shareholders. Participating preference also shares remaining proceeds; non-participating converts to common.

Carried interest

The general partner's share of fund profits, typically 20%, paid after limited partners recover capital plus an 8% hurdle rate, often with a catch-up clause.

Terminal value in DCF

TV = FCFF_{n+1}/(WACC − g). Terminal growth must not exceed long-run nominal GDP growth; TV often represents 50–75% of total enterprise value.

Control premium

The excess of an acquisition price over the target's pre-announcement market price, typically 20–40%, reflecting the value of control and expected synergies.

Marketability discount

DLOM reduces the value of minority stakes in private firms for lack of liquidity, commonly 20–30%. It is applied after any control premium adjustment.