Ch10. Financial Management Review — Key Formulas for CPA, CFA & Finance Exams

Series Summary

Ch1   Time Value of Money   — PV, FV, annuities
Ch2   Capital Budgeting     — NPV, IRR, PI, Payback Period
Ch3   Risk and Return       — Portfolio theory, CAPM, Beta
Ch4   Capital Structure     — MM Theorem, WACC, Leverage
Ch5   Dividend Policy       — MM dividend irrelevance, payout ratio, buybacks
Ch6   Bond Pricing          — Rate-price relationship, YTM, Duration
Ch7   Stock Valuation       — DDM, P/E, P/B, EV/EBITDA
Ch8   Derivatives           — Futures, options, swaps, hedging
Ch9   Working Capital       — CCC, EOQ, 5 Cs of credit
Ch10  Comprehensive Review  — Formula memorization

Complete Formula Reference

Time Value of Money

FV = PV × (1 + r)^n
PV = FV / (1 + r)^n

Annuity PV         = C × [1 − (1 + r)^(−n)] / r
Perpetuity PV      = C / r
Growing Perpetuity = C / (r − g)

Capital Budgeting

NPV = Σ CF_t / (1 + r)^t − Initial Investment
PI  = PV(CF) / Initial Investment
IRR: The rate r at which NPV = 0

CAPM

E(R_i) = R_f + β_i × [E(R_m) − R_f]

WACC

WACC = R_E × (E/V) + R_D × (1 − T_c) × (D/V)

MM Theorem

No taxes:    V_L = V_U
With taxes:  V_L = V_U + T_c × D

Dividend Valuation

P_0 = D_1 / (r_E − g)    [Gordon Growth Model]

Bonds

Bond Price = Σ C / (1 + r)^t + FV / (1 + r)^n
ΔP/P ≈ −D* × Δr           [Modified Duration]

Working Capital

CCC = DIO + DSO − DPO
EOQ = √(2DO/H)

Capital Budgeting Methods Compared

Method	Strengths	Weaknesses
NPV	Directly measures value creation; theoretically superior	Requires estimating cost of capital
IRR	Intuitive as a rate of return	Multiple IRRs possible; conflicts with NPV on mutually exclusive projects
PI	Useful for ranking under capital constraints	Ignores absolute scale
Payback Period	Simple; emphasizes liquidity	Ignores time value; ignores cash flows after payback

MM Theorem Summary

Assumption	Conclusion
Perfect market (no taxes)	V_L = V_U (capital structure irrelevant)
With corporate taxes	V_L = V_U + T_c × D (debt is beneficial)
Taxes + bankruptcy costs	Optimal capital structure exists (Trade-Off Theory)

Risk Summary

Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk:   Measured by Beta (β); cannot be diversified away
Unsystematic Risk: Can be eliminated through diversification

CAPM: Only systematic risk is priced
→ Unsystematic risk earns no extra return (because it can be diversified away)

Exam Relevance by Credential

CPA Exam (Business Environment & Concepts / Financial Accounting)

High-Weight Topics:
① Capital Budgeting (NPV, IRR)        — ~30%
② Capital Structure (MM, WACC)        — ~25%
③ Risk and Return (CAPM, Beta)        — ~20%
④ Bond & Stock Valuation              — ~15%
⑤ Working Capital & Dividends         — ~10%

CFA Level 1 (Corporate Finance / Portfolio Management)

Additional Topics:
- Capital Market Line (CML) vs Security Market Line (SML)
- Efficient Market Hypothesis (EMH)
- Corporate Governance
- Options pricing (Black-Scholes overview)
- M&A and corporate restructuring

Common Exam Traps

1. Beta > 1 means the stock outperforms the market? (FALSE)
   → Higher beta simply means higher required return. Actual returns vary.

2. Bond price and YTM move in the same direction? (FALSE)
   → They move inversely (rates ↑ → price ↓).

3. If NPV > 0, IRR always exceeds the cost of capital? (TRUE — for a single project)
   → On mutually exclusive projects, NPV and IRR rankings can diverge.

4. In a perfect market, a stock buyback = cash dividend in terms of shareholder wealth? (TRUE)
   → MM dividend irrelevance theorem.

5. Greater diversification always lowers beta? (FALSE)
   → Beta measures systematic risk. Diversification eliminates unsystematic risk, not beta.

Comprehensive Practice Quiz

Q. Risk-free rate = 3%, market risk premium = 7%, β = 1.2. Use CAPM to find the required return; then use DDM to price the stock with D₁ = $0.60 and g = 3%.

CAPM: E(R) = 3% + 1.2 × 7% = 3% + 8.4% = 11.4% DDM: P₀ = $0.60 / (0.114 − 0.03) =$ 0.60 / 0.084 ≈ $7.14

Q. NPV and IRR give conflicting rankings on mutually exclusive projects. Which rule should you follow and why?

Follow NPV. NPV directly measures the dollar increase in shareholder wealth. IRR is a percentage return that ignores the scale of investment. To maximize shareholder value, always choose the project with the highest positive NPV.