CMA Sri Lanka SL2 Financial Strategy & Valuation Exam cheat sheet

Strategy hierarchy: corporate strategy sets scope and portfolio; business (competitive) strategy sets how each unit wins; financial strategy sets the investment, funding and distribution policies that make both achievable.

Sustainable growth rate = retention ratio × ROE = retention × net profit margin × asset turnover × leverage. Growth above this rate must be funded by new equity, higher gearing or improved operating efficiency.

Rappaport value drivers: sales growth rate, operating profit margin, working capital investment rate, fixed capital investment rate, cash tax rate, cost of capital and the duration of competitive advantage.

Ansoff matrix in ascending risk order: market penetration, product development, market development, diversification (related, then conglomerate). Risk rises with distance from existing products and markets.

Test of any strategic plan: projected ROIC must exceed WACC over the planning horizon; value is created only when that spread is positive and sustainable, not merely when revenues grow.

Under information asymmetry financing follows the pecking order: retained earnings, then secured debt, then unsecured debt and hybrids, then new equity as the last resort.

Free cash flow to the firm = NOPAT + depreciation − capital expenditure − increase in net working capital. This is the cash flow discounted at WACC in a strategy-level valuation.

Balanced scorecard perspectives: financial, customer, internal business process, learning and growth. Financial measures are lagging indicators; the other three are leading indicators of future financial performance.

In an acquisition the premium paid above stand-alone value destroys shareholder value unless the quantified synergy (cost, revenue, financial, tax) exceeds that premium.

Shareholder value maximisation means maximising the present value of expected future cash flows discounted at the cost of capital, subject to legal and ethical constraints; it is not the same as maximising reported accounting profit.

Profit maximisation is an inadequate objective because it ignores the timing of returns, the risk attached to them and the capital invested to generate them.

Agency relationship: shareholders (principals) delegate decision-making to managers (agents). Agency costs = monitoring costs + bonding costs + residual loss.

Agency-cost control mechanisms: performance-related pay and share options, threat of takeover, audited disclosure, independent non-executive directors, debt covenants and concentrated institutional ownership.

Shareholder–bondholder conflicts: asset substitution (switching to riskier projects after debt is priced), underinvestment due to debt overhang, and dividend or asset leakage to shareholders; mitigated by protective covenants.

Mendelow stakeholder matrix maps stakeholders by power and interest; high-power/high-interest stakeholders require active engagement, low-power/low-interest require only minimal monitoring.

Public sector and not-for-profit value for money is assessed on economy (cost of inputs), efficiency (output per unit of input) and effectiveness (achievement of stated outcomes).

Triple bottom line and ESG reporting cover financial, social and environmental performance; integrated reporting links the six capitals to value creation over the short, medium and long term.

Modigliani–Miller Proposition I without tax: V(levered) = V(unlevered); capital structure is irrelevant under perfect markets, no taxes, no distress costs and equal borrowing rates for firms and individuals.

Modigliani–Miller Proposition II without tax: Ke = K0 + (D/E)(K0 − Kd); the cost of equity rises linearly with gearing because shareholders bear additional financial risk.

Modigliani–Miller with corporate tax: V(levered) = V(unlevered) + T × D; the interest tax shield adds value at the corporate tax rate, implying a 100% debt optimum, which is unrealistic.

Miller (1977) with personal taxes: gain from leverage = [1 − (1 − Tc)(1 − Te)/(1 − Td)] × D; the advantage shrinks or disappears when equity income is taxed more lightly than interest.

Static trade-off theory: the optimal capital structure is where the marginal present value of the interest tax shield equals the marginal present value of expected financial distress costs.

Pecking order theory (Myers, 1984): firms prefer internal funds, then debt, then hybrids, then new equity, because adverse selection and issue costs make equity issuance the most expensive signal.

Signalling: a debt issue signals managerial confidence in future cash flows; an equity issue is often interpreted as evidence that management believes the shares are overvalued.

Free cash flow agency theory (Jensen, 1986): debt commits managers to fixed payments, reducing discretionary cash and the scope for value-destroying investment.

Practical determinants of target gearing: business risk and cash flow volatility, asset tangibility, tax position, growth options, lender and rating-agency constraints, and covenant headroom.

WACC = (E/V) × Ke + (D/V) × Kd × (1 − Tc), where V = E + D, using market values and target weights rather than current book values.

Ke via CAPM = Rf + β(Rm − Rf); via the dividend growth model = D1/P0 + g; the bond yield plus risk premium approach is used only as a cross-check.

Kd = yield to maturity on traded debt or the marginal borrowing rate, multiplied by (1 − marginal tax rate); flotation costs raise the effective cost of new debt.

Cost of irredeemable preference shares = D/P0 with no tax adjustment, because preference dividends are paid out of after-tax profit.

Hamada: βL = βU[1 + (1 − T)(D/E)]. Unlever the betas of pure-play comparables, average them, then relever at the target gearing of the project or division.

Use the marginal cost of capital for the accept/reject decision; the historical average WACC reflects past financing and is irrelevant to a new project's required return.

Divisional WACC requires a pure-play proxy because a group-wide WACC misprices divisions whose business risk differs from the group average.

Gearing measures: debt/equity (book and market), debt/(debt + equity), net debt/EBITDA and interest cover = EBIT/interest. Interest cover is the covenant lenders watch most closely.

As gearing rises, both Kd and Ke rise once default risk becomes material; WACC therefore falls, flattens and then rises, producing a shallow U-shape rather than a single tax-driven optimum.

International projects: add a country risk premium to the discount rate, or adjust cash flows for expropriation and remittance restrictions and use a home-currency WACC with forward rates.

NPV = Σ Ct/(1 + r)^t − I0. Accept a project if NPV > 0; for mutually exclusive projects choose the highest NPV because it measures the absolute addition to shareholder wealth.

IRR is the discount rate at which NPV = 0. Accept if IRR > cost of capital, but non-conventional cash flows can produce multiple IRRs or none, so NPV or MIRR should prevail.

MIRR assumes cash flows are reinvested at the cost of capital, removing the IRR method's implicit and often unrealistic reinvestment assumption.

Payback is the time to recover the outlay; discounted payback uses discounted flows; ARR = average annual accounting profit / average investment. All ignore or mis-time risk and post-cut-off cash flows.

Profitability index = PV of inflows / initial outlay. Under single-period capital rationing with divisible projects, rank by PI to maximise total NPV.

Relevant cash flows are incremental and after tax: include opportunity costs and incremental overheads; exclude sunk costs and apportioned fixed overheads that do not change with the decision.

Tax: capital allowances give a tax shield; a balancing charge or balancing allowance arises on disposal; tax is normally assumed to be paid in the year after the taxable cash flow.

Working capital: an increase is a cash outflow at the start and through the project's life; it is released as an inflow at the end. Never omit this from an appraisal.

Unequal lives and replacement decisions: compare equivalent annual cost = NPV ÷ annuity factor for the relevant number of periods.

Inflation: discount nominal (money) cash flows at the money rate, or real cash flows at the real rate. Fisher: (1 + money rate) = (1 + real rate) × (1 + inflation rate).

Sensitivity analysis: margin of safety for a variable = NPV ÷ present value of that variable's cash flows; it states the percentage change that drives NPV to zero and ignores probabilities and correlations.

Scenario analysis varies sets of consistent variables (base, optimistic, pessimistic) and produces a probability-weighted NPV, capturing correlation between inputs that sensitivity analysis misses.

Simulation (Monte Carlo) assigns probability distributions to inputs, runs many iterations and produces a distribution of NPV; it is powerful but costly and exposed to model risk.

Risk-adjusted discount rate adds a project-specific premium to WACC; the certainty equivalent approach instead scales cash flows down and discounts at the risk-free rate.

Adjusted present value: APV = base-case NPV discounted at the all-equity rate + present value of financing side effects (interest tax shield, issue costs, subsidy benefits).

Decision trees model staged decisions; evaluate by rolling back from the terminal branches, weighting by probabilities and discounting at the appropriate rate.

Real options: option value = NPV with flexibility − NPV without. Options to defer, expand, contract, abandon or switch are valued with Black–Scholes or a binomial lattice.

Relevant risk is the project's contribution to the firm's systematic risk, not its stand-alone total risk; unsystematic risk is diversifiable and should not attract a premium.

Overseas projects: assess political risk (expropriation, blocked remittances), exchange controls, inflation and tax differentials and double taxation relief, then adjust cash flows or the discount rate accordingly.

FCFF = EBIT(1 − T) + depreciation − capital expenditure − increase in net working capital; discount at WACC to obtain enterprise value, then subtract net debt to obtain equity value.

FCFE = net income + depreciation − capital expenditure − ΔNWC + net borrowing; discount at Ke to obtain the value of equity directly.

Terminal value (Gordon growth) = FCF(n+1) ÷ (WACC − g). The growth rate must not exceed long-run nominal GDP growth; an exit multiple is the alternative and must be justified by peer evidence.

Enterprise value = market capitalisation + net debt + minority interest + preference shares − associates and other investments. EV/EBITDA is capital-structure and depreciation-policy neutral.

P/E valuation: value = sustainable earnings × peer P/E, adjusted for differences in growth, payout and risk. The method is sensitive to accounting policy and to cyclical earnings distortion.

Dividend valuation model: P0 = D1 ÷ (Ke − g). A minority stake in an unlisted company may require a discount for lack of marketability; a controlling stake may attract a control premium.

EVA = NOPAT − (WACC × invested capital) = (ROIC − WACC) × invested capital. MVA = market value − book capital employed = present value of all future expected EVA.

Value-based management links strategy to the value drivers: push ROIC above WACC, grow only where the spread remains positive, and reduce the cost of capital; TSR = (share price change + dividends) ÷ opening price aligns incentives.

Maximum price payable for a target = stand-alone value + present value of synergy. Any premium above stand-alone value transfers synergy to the target's shareholders.

Rights issue: TERP = (N × cum-rights price + issue price) ÷ (N + 1); value of a right = TERP − issue price. A shareholder who does not take up or sell the rights suffers dilution in wealth.

Equity methods: IPO, rights issue, placing, offer for sale, vendor placing. They differ in cost, speed, dilution and the extent of the prospectus and marketing requirements; IPO underpricing is common.

Debt sources: bank term loans, syndicated loans, public and private bond placements, and mezzanine finance. Covenants restrict dividends, further borrowing, asset disposals and changes of control.

Convertible bond value = the higher of straight bond value and conversion value, plus a time premium. Conversion value = share price × conversion ratio; conversion premium = (price − conversion value) ÷ conversion value.

Warrants are attached options to subscribe for new shares at a fixed exercise price; exercise dilutes existing holders and the dilution must be reflected when valuing the warrant.

Lease versus buy: discount the after-tax lease payments and the capital allowance tax shield forgone under buying; leasing is preferred when its NPV is positive relative to borrowing to buy.

Under IFRS 16 a lessee recognises a right-of-use asset and a lease liability at the present value of lease payments; the expense is then split between depreciation and interest.

Sale and leaseback releases capital tied up in property while retaining use; compare the implicit financing cost of the lease with the firm's marginal borrowing rate.

Islamic finance structures: murabaha (cost-plus sale), ijarah (lease), musharaka (partnership) and mudaraba (profit-sharing); they prohibit interest and excessive uncertainty and are asset-backed.

Cash conversion cycle = inventory days + receivable days − payable days. Shortening the cycle releases cash and reduces dependence on overdraft and short-term borrowing.

Inventory days = inventory ÷ cost of sales × 365; receivable days = trade receivables ÷ revenue × 365; payable days = trade payables ÷ cost of sales × 365.

EOQ = √(2DCo/Ch), where D is annual demand, Co the cost per order and Ch the holding cost per unit per year. Reorder level = maximum usage × maximum lead time.

Credit policy is judged by comparing the incremental contribution from extra sales with the extra investment in receivables, the financing cost of that investment and any increase in bad debts.

Cost of refusing a settlement discount = (D ÷ (100 − D)) × (365 ÷ (payment period − discount period)). Compare this annualised rate with the overdraft rate before deciding.

Overtrading symptoms: rapid sales growth, rising receivables and inventory, lengthening payable periods and falling liquidity ratios - the firm is profitable but cash-short.

Treasury centralisation through netting, pooling, cash concentration and in-house banking reduces external borrowing, transaction costs and idle balances across subsidiaries.

Short-term finance menu: overdraft, revolving credit, commercial paper, banker's acceptances, factoring, invoice discounting and trade credit, each differing in cost, flexibility, security and disclosure.

Liquidity monitoring: current ratio = current assets ÷ current liabilities; quick ratio excludes inventory; the defensive interval measures the number of days of cash operating expenses covered by liquid assets.

A forward is OTC, customised, costs nothing upfront, settles at maturity and carries counterparty credit risk; a futures contract is standardised, exchange-traded, margined and marked to market daily, and exposes the hedger to basis risk.

Interest rate parity: F ÷ S = (1 + i(quote)) ÷ (1 + i(base)). Covered interest arbitrage enforces this relationship, so the forward rate reflects the interest differential, not a forecast.

Purchasing power parity: expected spot change ≈ inflation differential. Relative PPP holds better over long horizons and is used for long-term exchange rate forecasting.

Money market hedge: borrow or invest in the foreign currency now and convert at the spot rate, locking in a domestic-currency value without using a forward contract.

FX options: the buyer pays a premium and retains upside potential; a collar (buy a cap, sell a floor) reduces or eliminates the premium cost but caps the gain.

Interest rate swap: exchange fixed and floating interest payments on a notional principal. Comparative advantage can generate a quality spread differential that is shared between the counterparties.

Caps, floors and collars hedge borrowing costs: a cap sets a maximum rate for a premium, a floor sets a minimum, and a collar combines the two to reduce or eliminate the net premium.

VaR is the maximum expected loss over a stated horizon at a stated confidence level. Its limits: it says nothing about losses beyond the threshold, assumes stable correlations and relies on the chosen distribution.

Internal hedging: matching receipts and payments by currency, multilateral netting, leading and lagging payments, invoicing in the home currency and contractual price adjustment clauses.