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Financial Management, Strategic Management, Risk Management and Governance, 2011 edition
CMA Entrance Examination Study Manual with Problems and Solutions

CMA Entrance
Examination Study
Manual with Problems
and Solutions
Financial Management, Strategic Management,

Risk Management and Governance
2011 Edition
CMA Fin & Tax BlueCover 2011 V1.indd 1 3/30/11 10:27 AM

Copyright
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errors or omissions you discover to studymanual_errata@cmaontario.org
CMA Ontario
February 2011
CMA Study Manual_3 Tax Fin_l V1.indd 1 3/30/11 4:19 AM

Entrance Examination Study Manual
Financial Management - Tax

Table of Contents

TAX CONSEQUENCES OF VARIOUS FINANCING METHODS................................................................ 1
TAX PRINCIPLES AND CONCEPTS .......................................................................................................... 3

ENTITIES SUBJECT TO TAX .......................................................................................................................... 3
FORMS OF BUSINESS .................................................................................................................................. 3
TYPES OF INCOME ...................................................................................................................................... 4
TAX FILING AND PAYMENT OBLIGATIONS ...................................................................................................... 5
RESIDENCY ................................................................................................................................................. 9
INDIVIDUALS ................................................................................................................................................ 9
CORPORATIONS ........................................................................................................................................ 11
TAX PLANNING ......................................................................................................................................... 12
ACCOUNTING NET INCOME VS. BUSINESS INCOME FOR TAX PURPOSES ...................................................... 13
BUSINESS INCOME VS. CAPITAL GAINS ...................................................................................................... 13
PROPERTY INCOME VS. BUSINESS INCOME ................................................................................................ 14
CALCULATING BUSINESS INCOME ............................................................................................................... 14
GENERAL RULES LIMITING DEDUCTIONS WHEN CALCULATING BUSINESS INCOME ........................................ 15
COMMON PROHIBITED DEDUCTIONS .......................................................................................................... 16
COMMON ALLOWABLE DEDUCTIONS ........................................................................................................... 17
INVENTORY ............................................................................................................................................... 18
RESERVES, EXCLUDING ALLOWANCE FOR DOUBTFUL ACCOUNTS ............................................................... 19
RESERVES FOR DOUBTFUL DEBTS (ALLOWANCE FOR DOUBTFUL ACCOUNTS) AND BAD DEBTS ................... 20
RESERVES FOR INSTALMENT SALES .......................................................................................................... 22
RESERVES FOR TAX PURPOSES VS. RESERVES PER GAAP/IFRSGAAP/IFRS/IFRS ......................................... 23
PUTTING IT ALL TOGETHER ....................................................................................................................... 27
CAPITAL COST ALLOWANCE AND CUMULATIVE ELIGIBLE CAPITAL ............................................. 29
ACCOUNTING AMORTIZATION VS. CCA ....................................................................................................... 29
THE CAPITAL COST ALLOWANCE (CCA) SYSTEM ........................................................................................ 29
CALCULATING CCA .................................................................................................................................... 32
CCA RULES .............................................................................................................................................. 33
DISPOSITIONS OF DEPRECIABLE PROPERTY – RECAPTURE AND TERMINAL LOSSES .................................... 34
AUTOS AND CCA ....................................................................................................................................... 35
COMPUTER EQUIPMENT AND SYSTEMS SOFTWARE .................................................................................... 36
STRAIGHT-LINE CCA CLASSES: LEASEHOLD IMPROVEMENTS AND CLASS 14 LIMITED LIFE INTANGIBLES ....... 36
GOVERNMENT GRANTS FOR CAPITAL PROPERTY ....................................................................................... 39
CAPITAL COST ALLOWANCE RESTRICTIONS – RENTAL BUILDINGS ............................................................... 39
COMPREHENSIVE EXAMPLE – CAPITAL COST ALLOWANCE AND CUMULATIVE ELIGIBLE CAPITAL ................... 44
PROPERTY INCOME ................................................................................................................................. 50
INTEREST ................................................................................................................................................. 50
DIVIDEND INCOME ..................................................................................................................................... 51
PROPERTY LOSSES ................................................................................................................................... 53
CALCULATING PROPERTY INCOME ............................................................................................................. 53
CAPITAL GAINS AND LOSSES................................................................................................................ 54
DEFINITIONS ............................................................................................................................................. 54
CALCULATION ........................................................................................................................................... 54
TAX PLANNING .......................................................................................................................................... 56

TAXES PAYABLE BY CORPORATIONS – BASIC RULES..................................................................... 57
CALCULATION OF CORPORATE TAX ........................................................................................................... 57
COMBINED FEDERAL AND PROVINCIAL TAX ................................................................................................ 63
CCPCS – SMALL BUSINESS DEDUCTIONS AND ASSOCIATED COMPANIES .................................. 64
CANADIAN CONTROLLED PRIVATE CORPORATION (CCPC)........................................................................... 64
SMALL BUSINESS DEDUCTION (SBD).......................................................................................................... 64
ASSOCIATED COMPANIES .......................................................................................................................... 67
SPECIAL INCENTIVES AND CREDITS .................................................................................................... 72
FEDERAL POLITICAL TAX CREDIT ............................................................................................................... 72
INVESTMENT TAX CREDIT .......................................................................................................................... 73
INTEGRATION, REFUNDABLE TAXES AND RDTOH............................................................................. 74
OBJECTIVE OF INTEGRATION ..................................................................................................................... 74
DIVIDEND GROSS UP AND TAX CREDIT ...................................................................................................... 75
CCPC’S AND INTEGRATION ........................................................................................................................ 77
Financial Management – Tax Problems and Solutions

FINANCIAL MANAGEMENT – TAX PROBLEMS..................................................................................... 82
FMT1 PROBLEM: BUSINESS INCOME - BAT COMPANY ................................................................................ 82
FMT2 PROBLEM: CCA - TOFU INC............................................................................................................ 83
FMT3 PROBLEM: CEC - SPROUT CORPORATION....................................................................................... 83
FMT4 PROBLEM: CCA - BLAKE INCORPORATED ........................................................................................ 84
FMT5 PROBLEM: CEC - GREENWOOD LIMITED ......................................................................................... 84
FMT6 PROBLEM: CCA - RANGER INC. ...................................................................................................... 85
FMT7 PROBLEM: CCA AND RENTAL INCOME - BETA CORPORATION .......................................................... 86
FMT8 PROBLEM: CAPITAL GAINS - MAGMA CORPORATION ........................................................................ 86
FMT9 PROBLEM: TAXABLE INCOME - JERMAT LTD. .................................................................................... 87
FMT10 PROBLEM: FEDERAL TAX PAYABLE - JEB CORPORATION LIMITED ................................................... 90
FMT11 PROBLEM: SMALL BUSINESS DEDUCTION - BOTSAL INC. ................................................................ 90
FMT12 PROBLEM: ASSOCIATED CORPORATIONS - COCO INC. ................................................................... 90
FMT13 PROBLEM: INVESTMENT TAX CREDIT - RESEARCHIT INC................................................................. 91
FMT14 PROBLEM: RDTOH - PELELUC INC. ................................................................................................ 91
FMT15 PROBLEM: TAXABLE INCOME AND TAX PAYABLE - ABC CORPORATION ........................................... 92
FINANCIAL MANAGEMENT – TAX SOLUTIONS .................................................................................... 94
FMT1 SOLUTION: BUSINESS INCOME - BAT COMPANY ............................................................................... 94
FMT2 SOLUTION: CCA - TOFU INC. .......................................................................................................... 95
FMT3 SOLUTION: CEC - SPROUT CORPORATION ...................................................................................... 96
FMT4 SOLUTION: CCA - BLAKE INCORPORATED ....................................................................................... 97
FMT5 SOLUTION: CEC - GREENWOOD LIMITED ........................................................................................ 98
FMT6 SOLUTION: CCA - RANGER INCORPORATED .................................................................................... 99
FMT7 SOLUTION: CCA AND RENTAL INCOME - BETA CORPORATION........................................................ 100
FMT8 SOLUTION: CAPITAL GAINS - MAGMA CORPORATION...................................................................... 101
FMT9 SOLUTION: TAXABLE INCOME - JERMAT LTD. ................................................................................. 102
FMT10 SOLUTION: FEDERAL TAX PAYABLE - JEB CORPORATION LIMITED................................................. 105
FMT11 SOLUTION: SMALL BUSINESS DEDUCTION - BOTSAL INC............................................................... 105
FMT12 SOLUTION: ASSOCIATED CORPORATIONS - COCO INC................................................................... 106
FMT13 SOLUTION: INVESTMENT TAX CREDIT - RESEARCHIT INC............................................................... 106
FMT14 SOLUTION: RDTOH - PELELUC INC. .............................................................................................. 106
FMT15 SOLUTION: TAXABLE INCOME AND TAX PAYABLE - ABC CORPORATION.......................................... 107

Financial Management – Corporate Finance

Table of Contents

SCOPE OF FINANCIAL MANAGEMENT................................................................................................ 109
THE FINANCIAL MANAGER ....................................................................................................................... 109
TIME VALUE OF MONEY ........................................................................................................................ 113
PRESENT VALUES FOR SINGLE AMOUNTS (PV OF AN AMOUNT) ................................................................ 114
PRESENT VALUES AND MULTIPLE CASH FLOWS (PRESENT VALUE OF AN ANNUITY) ................................... 116
PERPETUITIES......................................................................................................................................... 118
FUTURE VALUES FOR SINGLE AMOUNTS .................................................................................................. 119
FUTURE VALUES FOR MULTIPLE CASH FLOWS ......................................................................................... 122
CALCULATING THE DISCOUNT RATE......................................................................................................... 125
CALCULATING THE NUMBER OF PERIODS ................................................................................................ 127
COST OF CAPITAL.................................................................................................................................. 132
BONDS ..................................................................................................................................................... 135

PROCESS OF VALUING SECURITIES ......................................................................................................... 136
BOND FEATURES AND PRICES ................................................................................................................. 136
FEATURES OF BONDS ............................................................................................................................. 140
BOND RATINGS ....................................................................................................................................... 143
DETERMINANTS OF BOND YIELDS ............................................................................................................ 144
COMMON AND PREFERRED SHARES ................................................................................................. 148
PROCESS OF VALUING SECURITIES ......................................................................................................... 149
COMMON SHARES ................................................................................................................................... 149
PREFERRED SHARES .............................................................................................................................. 153
DEBT VS. EQUITY FINANCING .................................................................................................................. 156
CAPITAL BUDGETING (NPV) ................................................................................................................. 157
CAPITAL BUDGETING TERMINOLOGY ........................................................................................................ 158
CASH FLOWS .......................................................................................................................................... 160
TAX SHIELD ............................................................................................................................................ 162
MERITS AND LIMITATIONS OF NPV .......................................................................................................... 163
STEPS IN CALCULATING NPV .................................................................................................................. 164
COMPREHENSIVE EXAMPLE ..................................................................................................................... 164
OTHER METHODS OF PROJECT EVALUATION............................................................................................ 166
SUMMARY OF MERITS AND LIMITATIONS OF NPV, PAYBACK AND IRR ....................................................... 168
INTERNATIONAL CAPITAL BUDGETING DECISIONS ..................................................................................... 169
CAPITAL BUDGETING DECISIONS – NON-FINANCIAL FACTORS ................................................................... 170
CAPITAL RATIONING ................................................................................................................................ 170
IRR AND CAPITAL RATIONING................................................................................................................... 172
PAYBACK AND CAPITAL RATIONING.......................................................................................................... 172
BUY VS. LEASE....................................................................................................................................... 173
FINANCING THROUGH LEASING ................................................................................................................ 173
MERGERS AND ACQUISITIONS ............................................................................................................ 175
METHODS TO ACQUIRE AND FINANCING................................................................................................... 176
TYPES OF MERGERS AND ACQUISITIONS ................................................................................................. 176
REASONS FOR MERGERS AND ACQUISITIONS .......................................................................................... 177
BUSINESS VALUATIONS ....................................................................................................................... 179

FORMS OF BUSINESS ORGANIZATION............................................................................................... 181
SOLE PROPRIETORSHIP........................................................................................................................... 181
PARTNERSHIP ......................................................................................................................................... 182
CORPORATION ........................................................................................................................................ 183
JOINT VENTURE ...................................................................................................................................... 184
INCOME TRUST ....................................................................................................................................... 184
CHOOSING A STRUCTURE ....................................................................................................................... 184
FINANCIAL RISKS OF VARIOUS INVESTMENT TYPES ...................................................................... 185
DIRECT INVESTMENT ............................................................................................................................... 185
OUTSOURCING ........................................................................................................................................ 185
STRATEGIC ALLIANCES ............................................................................................................................ 186
MERGERS AND ACQUISITIONS ................................................................................................................. 186
FINANCIAL MARKETS AND INSTITUTIONS ......................................................................................... 187
FINANCIAL MARKETS ............................................................................................................................... 187
MARKET EFFICIENCY THEORY ................................................................................................................. 189
RISK AND RATES OF RETURN ............................................................................................................. 191
RELATIONSHIP BETWEEN RISK AND RETURN ............................................................................................ 191
MEASURING RISK .................................................................................................................................... 192
PORTFOLIOS ........................................................................................................................................... 194
PORTFOLIO THEORY ............................................................................................................................... 196
DIVERSIFICATION .................................................................................................................................... 197
THE SECURITY MARKET LINE (SML) AND CAPITAL ASSET PRICING MODEL (CAPM) .................................... 201
SHORT AND INTERMEDIATE TERM FINANCIAL PLANNING AND MANAGEMENT......................... 210
WORKING CAPITAL – GENERAL CONCEPTS .............................................................................................. 211
CASH MANAGEMENT ............................................................................................................................... 211
ACCOUNTS RECEIVABLE MANAGEMENT.................................................................................................... 212
INVENTORY MANAGEMENT ....................................................................................................................... 212
ACCOUNTS PAYABLE ............................................................................................................................... 213
SHORT-TERM FINANCING ........................................................................................................................ 215
LEASING AS A SOURCE OF FINANCING .................................................................................................... 219
VENTURE CAPITAL .................................................................................................................................. 219
FINANCIAL FORECASTING AND PLANNING....................................................................................... 220
FOREIGN EXCHANGE AND FINANCIAL MANAGEMENT.................................................................... 221

FOREIGN CURRENCY FLUCTUATIONS ....................................................................................................... 221
LEVERAGE AND CAPITAL STRUCTURE.............................................................................................. 223
OPERATING LEVERAGE............................................................................................................................ 223
FINANCIAL LEVERAGE.............................................................................................................................. 224
COMBINED OR TOTAL LEVERAGE ............................................................................................................. 225
DIVIDEND POLICY AND VALUATION.................................................................................................... 226
DIVIDEND POLICY .................................................................................................................................... 227
PROCEDURES IN DIVIDEND PAYOUTS ....................................................................................................... 228
STOCK SPLITS ........................................................................................................................................ 228
STOCK DIVIDENDS .................................................................................................................................. 228
STOCK REPURCHASES (TREASURY SHARES OR REPURCHASE AND CANCELLATION OF SHARES)............... 229
CAPITAL STRUCTURE ........................................................................................................................... 230
THEORY OF CAPITAL STRUCTURE ........................................................................................................... 230

Financial Management – Corporate Finance - Problems &
Solutions
FINANCIAL MANAGEMENT – CORPORATE FINANCE PROBLEMS.................................................. 243
FMC1 PROBLEM: FINANCIAL MANAGERS - MCQ ....................................................................................... 243
FMC2 PROBLEM: TIME VALUE OF MONEY - MCQ ..................................................................................... 245
FMC3 PROBLEM: TIME VALUE OF MONEY - RETIREMENT ......................................................................... 246
FMC4 PROBLEM: TIME VALUE OF MONEY - RETIREMENT ......................................................................... 246
FMC5 PROBLEM: TIME VALUE OF MONEY - PROJECT ............................................................................... 246
FMC6 PROBLEM: WACC - MCQ ............................................................................................................... 247
FMC7 PROBLEM: WACC - JHM CORPORATION.......................................................................................... 249
FMC8 PROBLEM: BONDS - MCQ .............................................................................................................. 250
FMC9 PROBLEM: BONDS - REAL ESTATE DEVELOPER .............................................................................. 250
FMC10 PROBLEM: BONDS ...................................................................................................................... 250
FMC11 PROBLEM: CAPITAL GROWTH MODEL - RENFROE ......................................................................... 251
FMC12 PROBLEM: NPV - EMITHAN FLYING COMPANY............................................................................... 251
FMC13 PROBLEM: NPV - ROCKYFORD CO. .............................................................................................. 252
FMC14 PROBLEM: NPV - BALGAVA COMPANY .......................................................................................... 253
FMC15 PROBLEM: NPV - S.W. APPLIANCES LTD...................................................................................... 254
FMC16 PROBLEM: DISCOUNTED CASH FLOW AND SPECIAL ORDER - TRATTER INC. .................................. 260
FMC17 PROBLEM: NET PRESENT VALUE – MAKE OR BUY - TRATTER INCORPORATED ............................... 262
FMC18 PROBLEM: CAPITAL BUDGETING (DCF) - RETIL LTD. ..................................................................... 265
FMC19 PROBLEM: CAPITAL BUDGETING (DCF) - MISTER DONUT INC. ....................................................... 265
FMC20 PROBLEM: CAPITAL BUDGETING (DCF) - LUNA MINING .................................................................. 266
FMC21 PROBLEM: MERGERS AND ACQUISITIONS - MCQ ........................................................................... 268
FMC22 PROBLEM: BUSINESS VALUATION - ORGANIZATIONS A & B ............................................................ 270
FMC23 PROBLEM: LONG-TERM FINANCING - MCQ .................................................................................... 271
FMC24 PROBLEM: FORECASTING - HOWARD COMPANY ............................................................................ 272
FMC25 PROBLEM: LONG-TERM FINANCING - HWB COMPANY .................................................................... 272
FMC26 PROBLEM: SHORT-TERM FINANCING - TRADE DISCOUNTS ............................................................. 273
FMC27 PROBLEM: LONG-TERM FINANCING - RIGHTS ................................................................................ 273
FMC28 PROBLEM: FINANCIAL MARKETS - MCQ ......................................................................................... 274
FMC29 PROBLEM: EOQ - ENGLISH BREAD COMPANY ................................................................................ 276
FMC30 PROBLEM: SHORT-TERM FINANCING - ZACHARIAH INC. ................................................................. 276
FMC31 PROBLEM: LEVERAGE ................................................................................................................. 277
FMC32 PROBLEM: LEVERAGE ................................................................................................................. 277
FMC33 PROBLEM: LEVERAGE - WASU COMPANY ..................................................................................... 278
FMC34 PROBLEM: CAPITAL STRUCTURE ................................................................................................. 278
FMC37 PROBLEM: CAPITAL STRUCTURE - RR COMPANY .......................................................................... 280
FMC38 PROBLEM: CAPITAL STRUCTURE - SIMARD COMPANY ................................................................... 280
FMC39 PROBLEM: FINANCIAL MANAGEMENT - CORPORATE FINANCE MCQ................................................ 281
FINANCIAL MANAGEMENT – CORPORATE FINANCE SOLUTIONS ................................................. 302
FMC1 SOLUTION: FINANCIAL MANAGERS - MCQ ....................................................................................... 302
FMC2 SOLUTION: TIME VALUE OF MONEY - MCQ ..................................................................................... 303
FMC3 SOLUTION: TIME VALUE OF MONEY - RETIREMENT ......................................................................... 303
FMC4 SOLUTION: TIME VALUE OF MONEY - RETIREMENT ......................................................................... 304
FMC5 SOLUTION: TIME VALUE OF MONEY - PROJECT .............................................................................. 305
FMC6 SOLUTION: WACC - MCQ ............................................................................................................... 306
FMC7 SOLUTION: WACC - JHM CORPORATION ......................................................................................... 307
FMC8 SOLUTION: BONDS - MCQ.............................................................................................................. 307
FMC9 SOLUTION: BONDS - REAL ESTATE DEVELOPER ............................................................................. 308
FMC10 SOLUTION: BONDS ...................................................................................................................... 308
FMC11 SOLUTION: CAPITAL GROWTH MODEL - RENFROE ........................................................................ 309

FMC12 SOLUTION: NPV - EMITHAN FLYING COMPANY .............................................................................. 310
FMC13 SOLUTION: NPV - ROCKYFORD CO............................................................................................... 311
FMC14 PROBLEM: NPV - BALGAVA COMPANY .......................................................................................... 312
FMC15 PROBLEM: NPV - S.W. APPLIANCES LTD...................................................................................... 313
FMC16 SOLUTION: DISCOUNTED CASH FLOW AND SPECIAL ORDER - TRATTER INC. ................................. 316
FMC17 SOLUTION: NET PRESENT VALUE – MAKE OR BUY - TRATTER INCORPORATED .............................. 318
FMC18 SOLUTION: CAPITAL BUDGETING (DCF) - RETIL LIMITED................................................................ 320
FMC19 SOLUTION: CAPITAL BUDGETING (DCF) - MISTER DONUT .............................................................. 321
FMC20 SOLUTION: CAPITAL BUDGETING - LUNA MINING ........................................................................... 323
FMC21 SOLUTION: MERGERS AND ACQUISITIONS - MCQ .......................................................................... 325
FMC22 SOLUTION: BUSINESS VALUATION - ORGANIZATIONS A & B ........................................................... 325
FMC23 SOLUTION: LONG-TERM FINANCING - MCQ ................................................................................... 326
FMC24 SOLUTION: FORECASTING - HOWARD COMPANY ........................................................................... 326
FMC25 SOLUTION: LONG-TERM FINANCING - HWB COMPANY.................................................................... 327
FMC26 SOLUTION: SHORT-TERM FINANCING - TRADE DISCOUNTS ............................................................ 327
FMC27 SOLUTION: LONG-TERM FINANCING - RIGHTS ............................................................................... 327
FMC28 SOLUTION: FINANCIAL MARKETS - MCQ ........................................................................................ 328
FMC29 SOLUTION: EOQ - ENGLISH BREAD COMPANY ............................................................................... 328
FMC30 SOLUTION: SHORT-TERM FINANCING - ZACHARIAH INC.................................................................. 329
FMC31 SOLUTION: LEVERAGE ................................................................................................................. 330
FMC32 SOLUTION: LEVERAGE ................................................................................................................. 330
FMC33 SOLUTION: LEVERAGE - WASU COMPANY ..................................................................................... 331
FMC34 SOLUTION: CAPITAL STRUCTURE ................................................................................................. 332
FMC37 SOLUTION: CAPITAL STRUCTURE - RR COMPANY ......................................................................... 333
FMC38 SOLUTION: CAPITAL STRUCTURE - SIMARD COMPANY .................................................................. 333
FMC39 SOLUTIONS: CORPORATE FINANCE MULTIPLE CHOICE.................................................................. 334

Tax Consequences of Various Financing
Methods
Skill Level: R/U A/A
5.2.5 a) Describes and determines the tax implications and tax treatment of
alternative methods of financing (e.g. debt, common and preferred equity
and leases) and explains how various tax variables affect business 9 9
decisions (e.g. capital budgeting, capital structure, mergers and
acquisitions, dividend policy, foreign investment, risk management, etc.)
R/U = Remembering and Understanding A/A = Application and Analysis
Debt Financing
For tax purposes, interest on debt is tax deductible provided it:
1. Is paid or is payable in the year,

2. Arises from a legal obligation,
3. Is payable on borrowed money used for the purpose of earning income (other than
Exempt income) from business or property, and
4. Is reasonable in amount.
Certain interest charges are non-deductible:
• interest on income taxes,

• interest on vacant land (add to cost base),
• interest during construction (capitalize to asset).
Equity Financing
Dividends paid on preferred and common shares are paid out of after-tax earnings. Dividend
payments may generate refunds of refundable taxes for private corporations (section (n) below).
Please report errors or omissions to ¤CMA Ontario, page 1

studymanual_errata@cmaontario.org Page 1

Lease Financing
For accounting purposes, leases are classified as either capital or operating leases. The deduction
for a capital lease consists of interest expense on a lease obligation and depreciation of an asset
under capital lease.
For tax purposes, different classification criteria exist and leases are more likely to be classified
as operating leases. The tax deduction is the full amount of the lease payment.
For tax purposes, a lease is classified as a capital lease if:
1. Title to the assets passes to the lessee automatically at the end of the lease term, or
2. The lessee is required to purchase the asset, or
3. The lessee has the option to purchase the asset during the lease term or at expiry on
terms that a reasonable person would exercise.
Page 2, ¤CMA Ontario Please report errors or omissions to

Page 2 studymanual_errata@cmaontario.org

Tax Principles and Concepts
5.2.5 Describes the tax consequences of finance and investment decisions for a
given organization
b) Describes the tax principles pertaining to the following: entities subject
to taxation, residency, types of income, filing and paying taxes, and 9
international tax treaties
Entities Subject to Tax

Individuals − individuals are subject to personal income tax (filed using a T1 form)
Corporations − corporations resident in Canada are subject to corporate income tax and
other specified taxes (e.g. capital tax)
Trusts − a trust is a relationship whereby a trustee is bound to administer

property (called trust property) over which he or she has control for the
benefit of others (called beneficiaries). Trusts are created when a person
transfers title of the property to the trustee. For tax purposes, trusts are
considered separate and distinct entities and, therefore, are taxed as a
separate taxpayer. In addition, the trust is considered to be an individual
for tax purposes and, therefore, individual tax laws are applicable.
Forms of Business
Proprietorship − represents the business of one person
− personal income tax laws are applicable
Corporations − represents a separate entity formed by incorporating

− incorporation can be federal or provincial
− corporate income tax rules are applied
Partnership − represents an agreement among two or more individuals or corporations.

− income is taxed in each partners’ hands, not at the partnership level,
therefore, if the partners are individuals, personal income tax laws are
applied and, if corporate, corporate income tax rules are applied.
− however, net income for tax purposes is calculated at the partnership
level


Limited Partnership − similar to partnerships, except each partner has limited their liability
with respect to the partnership
Joint Venture − taxation of joint ventures depends on the joint venture arrangement
− if a separate company is incorporated for the joint venture, corporate tax
rules apply to the corporation
− if the joint venture is a partnership arrangement, then partnership rules
apply
Types of Income
Business income
- defined as profit from business. Profit is not defined in the act and there are a
number of specific rules about amounts to be included or excluded. ‘Commercial
principles’ are used to determine business income. GAAP/IFRSis considered to
reflect commercial principles; however, there are a number of adjustments to
income determined under GAAP/IFRS to arrive at taxable income.
Property Income
- this is passive income earned as a return on investment. It includes dividends,
interest, rent and royalties.
- this does not include the gain from the sale of the investment itself (these amounts
are considered to be capital gains).
Employment Income
- this includes all income arising from employment, including salary, wages,
gratuities, stock options and specific benefits defined by the Income Tax Act.
Capital Gains or Losses

- represents the gain or loss on sale of capital item
- it is not the nature of the asset itself that determines whether profit on its sale is a
capital gain, but the use of the asset (e.g. the gain on the sale of land that was
originally acquired and used as part of an office complex would be considered a
capital gain, while gains realized by an entity that purchases and sells land
regularly for profit would not be eligible for capital gain treatment (these profits
would be considered business income).
Other Income and Deductions

- these items are specifically identified in sections 56 to 66 of the Income Tax Act
- other income refers to superannuation and pension income (including CPP and
Old Age Security), Employment Insurance benefits, alimony receipts, receipts
from RRSPs and deferred profit sharing plans
- other deductions include RRSP contributions, alimony payments, child care
expenses and moving expenses


Income for each of the above five categories is determined by applying the rules and formulas as
specified in the Income Tax Act. Note that whether the taxpayer is an individual or a
corporation, does not generally make a difference in the calculation of the above types of
income. For example, whether business income is earned by an individual or a corporation,
generally, the same basic rules for calculating business income apply.
To determine how a specific transaction or activity will be taxed, it is necessary to relate the
transaction/activity to each of the five categories (business income, property income,
employment income, capital gains/losses and other income and deductions). If the
transaction/activity falls within one of the categories, the rules for that specific category apply
when calculating the tax consequences. Items that do not fall within these five categories are not
taxed. Examples of non-taxable items (i.e. items that do not fall within the five above
categories) include lottery winnings and inheritances.
Tax Filing and Payment Obligations

Filing Obligations:
Individuals − on or before April 30 of the next year, unless the individual or his or her
spouse carried on a business in the year, in which case the filing
deadline is June 15
Deceased Individuals − filing deadline depends on date of death:

o after October and before the filing date (April 30 or June 15)
− must be filed by the later of:
six months after the date of death
the usual filing date (April 30 or June 15)
o up to October 31
− April 30th or June 15th, as applicable, of the following year
Corporations − within six months after the end of the taxation year
Trusts or Estates − within 90 days after the end of the taxation year


Instalments, Interest and Penalties
Individuals:
- individuals with mainly employment income:

- no instalments required because employers deduct tax directly from their salary
- exception: if the total tax liability exceeds the amount of tax withheld at source (i.e.
withheld by employer) by $2,000 in either of the two preceding years, quarterly
instalments must be made
- individuals with mainly business or property income
- instalment dates: March 15, June 15, September 15 and December 15 and final taxes
owing must be paid by April 30 of the following year
- instalment amount:
the least of:
1. one-quarter of estimated tax payable for the current year
2. one-quarter of the instalment base (tax payable excluding specified tax credits) of
the immediately preceding year
3. one-quarter of the instalment base for the second preceding year for the March
and June instalments and one half of the instalment base for the preceding
taxation year net of the March and June payments for the September and
December instalments
Interest:
Interest is charged on insufficient and late instalments from the date that the instalment should
have been made to the date that final payment is due (e.g. April 30). If a taxpayer files late,
interest is calculated from the date final payment is due until the amount is paid. The interest rate
is prescribed by CCRA and is changed each quarter.
Corporations:
Instalments
- payments must be made monthly
- if tax payable for the current or preceding year is less than $1,000, instalments are not
required
Interest
- interest is calculated in the same manner as for individuals


Penalties:
These penalties apply to both individual and corporate taxpayers.
Offense Penalty
Failure to file a return as and when required 5% of tax unpaid on the date the return was
due plus 1% per month of unpaid tax for
each month the return was late, up to 12
months
Failure to file a return as and when required 10% of tax unpaid on the date the return was
and taxpayer has been assessed a penalty for due plus 2% per month of unpaid tax for
this offense in the past three years each month the return was late up to 20
months
Failure to provide the information required $100 for each failure

on a prescribed form
Failure to file as and when required certain the greater of:

information return (e.g. partnership 1. $100
information, tax shelter information returns) 2. $25 per day to a maximum of one hundred
days
Failure to report income if there has been a 10% of the income the taxpayer failed to
previous failure to report income report
Knowingly under-reporting or neglecting to the greater of:

report income 1. $100
2. 50% of the additional taxes owing
Late or deficient instalments 50% of the interest in excess of the greater

of:
1. $1,000
2. 25% of the interest calculated as if no
instalments had been paid
Penalties applicable to individuals only:
Offence Penalty
Failure to provide a Social Insurance Number $100 for each failure
to a person required to make an information
return


Penalties applicable to partnerships only:
Offence Penalty
Failure to provide certain information returns $100 per partner per month to a maximum of
related to the partnership, a demand for the 24 months. This penalty is in addition to the
return has been made and a penalty for the penalty related to information returns.
same offence has been assessed within the
previous three years
International Tax Treaties:
Note that Canada has tax treaties with foreign countries to prevent double taxation. These tax
treaties override the Income Tax Act and therefore in situations in which there is a tax treaty the
treaty overrides the Income Tax Act.


Residency
5.2.5 b) Describes the tax principles pertaining to the following: entities subject
to taxation, residency, types of income, filing and paying taxes and 9
international tax treaties
Individuals
The definition of residency is not clearly provided in the Income Tax Act, however, past court
decisions provide common law guidance on whether or not an individual is a Canadian resident.
Note that residency does not mean citizenship. Canadian citizens can be non-residents and
individuals who are not Canadian citizens can be Canadian residents. Canada taxes individuals
based on residency, while the United States taxes individuals based on citizenship.
To be considered resident in Canada, the individual must maintain a "continuing state of

relationship" (ITA 250(3); IT-221R2) with Canada. Past court decisions have resulted in the
need to consider various factors collectively when determining residency. No one criterion is
more important than the other: each situation must be evaluated in terms of all the criteria.
These factors are:
a. the amount of time spent in Canada on a regular basis;
b. the motives for being present or absent;
c. the maintenance of a dwelling place in Canada while away and its accessibility;
d. the origin and background of the individual;
e. the general mode and routine of the individual's life; and
f. the existence of social and financial connections with Canada.
For example, an individual who:

a. resides in another country;
b. is employed in that other country;
c. maintains a dwelling in Canada, which is rented out, but is available on short
notice;
d. maintains formal social ties with clubs and other associations in Canada;
e. holds Canadian investments;
f. regularly visits Canada for short periods;
would be considered a Canadian resident.


Residency can also be established under the 'sojourning' law per the ITA. Under this clause of
the ITA, a person who 'sojourns' (a temporary stay) in Canada for 183 days or more is deemed to
be a Canadian resident. The time spent in Canada does not need to be continuous.
The CRA administrative policy is that an absence of less than two years indicates residency has
not been given up (i.e. the CRA considers the individual to be a resident of Canada); unless it is
established that all residential ties are severed. It is important to remember this is administrative
policy only and this policy is not in the Income Tax Act.
Part time residency occurs in the year an individual moves to or moves from Canada.
The residency requirements for individuals can be summarized as:

Type Criteria Tax Consequences
Full-time Maintain a continuing state of
Taxed on worldwide income
Resident relationship with Canada
Deemed Sojourned in Canada for 183 days
full-time or more. The days do not need to Taxed on worldwide income
Resident be continuous.
Occurs during the year a person
Part-time enters Canada with the intent of Taxed on worldwide income during the past year in which was
Resident moving to Canada or; alternatively resident resided in Canada
the year of exit
Non- Does not have a continuing state Taxed on employment income earned in Canada, business
resident of relationship with Canada income earned in Canada and on taxable capital gains on the
sale of taxable Canadian property. Taxable Canadian property
in this context (i.e. owned by a non-resident) refers to:
• Canadian real estate
• Property used in business carried on in Canada
• Shares of private corporations resident in Canada
• Shares of public corporations, if the non-resident owns >
25%
Non-residents are also subject to a separate tax applicable only

to non-residents “Part XIII Tax on Income from Canada of Non-
resident persons”. This tax is a 25% withholding tax, which is
often reduced to 15% due to tax treaties. This 25% withholding
tax is applied upon payment to the non-resident of the
following:
• Interest
• Dividends
• Pensions
• Royalties
• Gross rental income (i.e. total rental revenue, no deduction
of expenses). However, a non-resident can file an election
under section 216 to have rental revenue treated differently.
Note that Canada has tax treaties with foreign countries to prevent double taxation. These tax
treaties override the Income Tax Act and, therefore, in situations in which there is a tax treaty,
the above rules do not apply.


Corporations
All corporations incorporated in Canada (either federally or provincially) are considered resident
in Canada and subject to tax on worldwide income. A foreign corporation (i.e. a corporation
incorporated in a country other than Canada) may also be considered a Canadian resident. If a
foreign company's "central management and control" over the major policy affairs of a business
is exercised from within Canada, the corporation is deemed a Canadian resident. The 'central
management and control' test is a common law test and requires judgment in determining
whether the foreign company is a deemed resident. Important criteria in this evaluation include
the place where Board of Directors meet and the place where its books and records are located.
In addition, control is considered on a ‘de facto’ basis. That is, even though the Board of
Directors legally control a company (‘de jure’ control), actual or real; control could be exercised
by the company’s management, shareholders, parent company, etc. The residence of the ‘de
facto’ controlling party is central to the determination of residency and, therefore, the residency
of the corporation is dependent on the residence of the ‘de facto’ controlling party. Foreign
corporations that have operations in Canada but are controlled by management outside of Canada
are taxed on their Canadian operations.
The residency requirements for corporations can be summarized as:
Type Criteria Tax Consequences

Resident If incorporated in Canada Taxed on worldwide income
for entire fiscal year of
corporation
Deemed Resident Place where central Taxed on worldwide income
management and control for entire fiscal year of
actually abides (applies to corporation
corporations not incorporated
in Canada)


Tax Planning
5.2.5 c) Describes the principles of tax planning and income deferral 9
Tax Planning, Tax Evasion and Tax Avoidance:

Tax Evasion: knowingly underreporting tax payable (illegal)
Tax Avoidance: legally reducing tax by a series of transactions or schemes, which do not
represent the true situation (not illegal, but often challenged in court by the
CRA)
Tax Planning: legally reducing tax by carrying out various transactions or activities within
current legislation
Legal and Illegal Methods of Reducing Tax:
Tax Planning Tax Avoidance Tax Evasion

Taxpayer Goal To favourably Deliberate planning of To avoid taxes by
reduce taxes payable events and transactions to failing to disclose
within the object and circumvent the law and complete and/or
spirit of the law. avoid paying taxes. accurate information.
Legality Legal Not illegal Illegal – a criminal

offence
Transactions can be
ignored (Revenue Canada Is also a civil
does not allow the wrongdoing (Revenue
transaction). Canada can sue in civil
court).
Penalty None Arrears and interest plus Fine, possible

taxes owing and possible imprisonment, arrears
penalties. and interest plus taxes
owing.


Business Income
5.2.5 e) Explains and applies the taxation rules for calculating business income
and net income for tax purposes for a given organization, including
adjustments to accounting net income (e.g. income tax expense, non-
deductible expenses, reserves, depreciation vs. CCA, charitable donations
9 9
and other accounting expenses that are not included in net income for tax
purposes but are deducted in calculating taxable income, accounting vs.
taxable capital gains and losses, holdbacks, exempt income, accruals,
etc.)
5.2.5 i) Explains and applies the taxation rules pertaining to the calculation of
taxable income for a given organization (e.g. charitable donations and other 9 9
deductible gifts, loss carry-overs, taxable dividends, etc.)
Accounting Net Income vs. Business Income for Tax

Purposes
Accounting net income is calculated according to GAAP/IFRS. Business income for tax
purposes is calculated according to “sound commercial principles”. GAAP/IFRS is intended to
represent ordinary commercial principles and in the absence of specific legislation, the courts
often consider GAAP/IFRS when deciding cases. Business income for tax purposes is computed
with reference to several sources – the Income Tax Act, common law and GAAP/IFRS.
Business Income vs. Capital Gains

Capital gains are not expressly defined in the Income Tax Act (ITA); however, the ITA
prescribes how capital gains are calculated and the taxation thereon. Capital gains or losses
represent the gain or loss that occurs upon the sale of a capital item. Capital property has an
enduring benefit, while business income is the result of ordinary commercial operating activities.
At times, the courts have applied the analogy of a fruit-bearing tree. The tree itself is considered
to be a capital asset or investment that produces income in the form of fruit. Just like the sale of
the tree would be regarded as a capital transaction, the sale of an investment that can produce a
form of income from business or property can be regarded as a capital transaction.


Property Income vs. Business Income
Property income is passive, rather than active. It is considered a return on invested capital, with
little effort expended to earn it. Common property income items include rent, interest, dividends
and royalties.
Calculating Business Income

Note to candidates: The most important material related to calculating business income is the
‘Putting it Together’ section that is at the end of this section. It is strongly suggested that
candidates become familiar with using the ‘Putting it Together’ approach to calculating income
for tax purposes and taxable income. This approach is also commonly used to calculate Future
Tax Asset and Future Tax Liability, which is covered in the Financial Reporting section of this
manual.
Generally, business income includes all revenue less expenses incurred to earn that revenue.
However, there are a number of restrictions on the deductibility of various expenses. When
calculating business income for tax purposes, the easiest method is to start with pre-tax
accounting income and make adjustments as required by the ITA to arrive at business income.
Business income includes income from normal commercial operating activities plus the
following:
• adventures in the nature of trade
− the courts have developed a set of factors to consider (called “badges of trade”) to
determine if an event is capital in nature or an adventure in the nature of trade. If
considered to be an adventure in the nature of trade, the resulting profit is
considered to be business income and not capital. The ‘badges of trade’ are
beyond the scope of the syllabus and will not be discussed further.
• damages (e.g. through court settlements related to non-performance in business contracts)

− since the damages are usually intended to place the recipient in the same position
he/she would have been, the damages are considered business income
• damages for loss of property that is working capital in nature (e.g. inventory)
• profits from an illegal business

− although the business itself may violate other legislation, the profits from it are
taxable as business income
• profits from gambling, if the gambling is organized and of a business nature

− proceeds from personal betting or gambling are generally not taxable; however, if
an individual is a professional gambler or bookmaker, their profits are considered
to be business income
− the distinguishing factor is that the gambling is organized


• government subsidies or grants that are related to income (subsidies or grants that are
related to capital items, such as the purchase of capital equipment, are not considered
business income)
General Rules Limiting Deductions When Calculating

Business Income
The following are general rules limiting deductions:
• purpose test
Under paragraph 18(1)(a) of the ITA for an expense or outlay to be deductible it must:
a) be made or incurred by the taxpayer for the purpose of gaining, producing or
maintaining income; and
b) be expected to generate income related to the taxpayer’s business or property
• capital nature
Expenditures for capital items are not deductible as business expenses but are subject to
capital cost allowance (tax depreciation) or cumulative eligible capital deductions. These
subjects are discussed in the Capital Cost Allowance and Cumulative Eligible Capital
section of this manual.
• reserves
− no reserves can be deducted except as permitted under subsection 20(1) of the
ITA (discussed later)
− contingent liabilities, sinking fund and warranty reserves are not deductible
• personal or living expenses

− these are not deductible since they are not incurred to produce business income
• reasonableness test
− expenses are deductible only to the extent they are reasonable
− the reasonableness test applies to all deductions


Common Prohibited Deductions
Expenses incurred to produce tax-exempt revenue.
Reserves, except as noted in a later section, contingent liabilities and sinking funds.
Amounts paid/payable for the discount associated with issuing bonds, except as noted on next
page
Payments on income bonds or debentures (i.e. bonds or debentures based on income or profit)
Personal and living expenses
Recreational facility fees and club dues
Political contributions (a tax credit is provided for these)
Automobile expenses – limits the deductibility of amounts paid to an employee to $.52/kilometre

(2008) for the first 5,000 kilometres and $.46/kilometre thereafter (2009). In the Yukon,
Northwest Territories and Nunavut there is an additional $.04/kilometre (2009). Note to
candidates: Canada Revenue Agency had not published 2010 rates at the date of writing
(November 2010).
Income taxes, interest and penalties paid to CRA
Prepaid expenses – the tax treatment of prepaid expenses is identical to GAAP/IFRS; that is,
prepaid expenses cannot be fully deducted in the year paid, but are deductible in the year to
which the expenditure relates
Entertainment and Food and Beverage Expenses – limited to 50% of expenses
Interest on money borrowed for a passenger vehicle (used to earn business income) is limited to
the lesser of:
a) actual amount paid or payable
b) $300 for each 30 day period the automobile loan was outstanding (2008) [this can be
calculated as $10 per day]
Leasing costs of leasing a passenger vehicle are limited to $800 + GST + PST per month (2008)


Common Allowable Deductions
Capital cost allowance (discussed in a subsequent section)
Interest on money borrowed to earn income
Expenses of issuing shares or borrowing money – these must be amortized on a straight-line

basis over five years (i.e. 20% per year)
Premiums on life insurance used as collateral – deductible only when the life insurance policy is
used as collateral for a loan
Discount on Debt (e.g. discount on bonds payable) The discount is fully deductible at the earlier
of redemption or maturity if both the following conditions are met:
1. the debt is issued at not less than 97% of face value
AND
2. the yield to maturity is not more than 4/3 of the nominal or coupon rate
Reserves as specified by the ITA (discussed later in this section)

The reserve of the prior year must be added back into income and the current years
reserve is deductible.
Employer contributions to a Registered Pension Plan, profit sharing plan or deferred profit
sharing plan.
Lease cancellation fees
Landscaping of grounds expenses
Representation expenses with respect to obtaining a license, permit, franchise or trademark. For
these expenses the taxpayer has the option of deducting the full expenditure or one-tenth of the
expenditure in each year over 10 years.
Site investigation fees
Utilities services connection
Disability-related modifications and equipment (fully deductible in year of expenditure)
Convention expenses – limited to two conventions per year
Provincial capital taxes and payroll taxes


Inventory
Since there are many regulations related to inventory, these are addressed separately.
The tax rules related to inventory are:

• LIFO cannot be used to value inventory
• inventory must be valued at lower of cost or market OR all market (i.e. value all
inventory at market)
• if the business is an adventure in the nature of trade, must use cost (e.g. if a company or
individual has a speculative investment in land, he/she cannot write-down the investment
if the market crashes)
• opening inventory must equal last year’s closing inventory
• cannot change the method of accounting for inventory without approval
• unbilled W-I-P of a professional is valued at FMV; however, some professionals can
elect to value W-I-P at nil (these professionals are accountants, dentists, lawyers, medical
doctors, veterinarians and chiropractors)
• supplies and parts are valued at replacement cost
• artists can elect to value their inventory at nil
• depreciation charged to cost of goods manufactured (e.g. depreciation on manufacturing
equipment) must be adjusted since depreciation is not deductible (all capital assets are
subject to capital cost allowance). In addition, if depreciation is included in opening
inventory and closing inventory, it must also be adjusted. For example, assuming the
following facts:
Depr. included in
Total Cost
total cost
Opening inventory 100 20
COG manufactured 4000 800
4100 820
Ending inventory 200 40
COGS 3900 780
On the company’s financial statements, COGS of $3,900 would be subtracted to arrive at

income before taxes. When calculating income for tax purposes, the amount of
depreciation included in COGS must be added back to accounting income to calculate
income for tax purposes. Candidates should note they could be asked what the tax
consequence is for the depreciation included in just one component of COGS (i.e. impact
of depreciation included in opening inventory).


Reserves, Excluding Allowance for Doubtful Accounts
Reserves, contingent liabilities and sinking funds are not deductible, except as specifically
permitted by the ITA. Reserves that are allowed and, therefore, deductible are:
• reserves for loan guarantees of a financial institution
• reserve for goods not delivered and services not rendered (in accounting terms this means
unearned revenue), except as limited by subsection 20(6) [subsection 20(6) requires that a
reserve taken for food/drink or transportation that will be provided after the end of the
year must equal the amount taken into income; in essence this means there is zero impact
on income for tax purposes]
• the reserve for goods not delivered and services not rendered includes unearned rental
income; for unearned rental income, a reasonable reserve may be taken for rent received
or receivable in advance
• reserve for deposits on returnable containers, other than bottles
• generally, warranty reserves are not deductible; however, if a warranty reserve is set up at
an amount less than or equal to the amount paid after the end of the year to an insurer to
insure the warranty liability, the warranty reserve is deductible. Basically, this means if
the warranty is insured, a reserve can be taken for the amount paid to the insurer. Since
warranties are rarely insured, this means warranty reserves are rarely deductible.
• reserve for an amount not due until a later year under an instalment sales contract
(discussed separately later in this section)
• reserve for quadrennial survey with respect to ships
A reserve deducted in one year must be brought into income the following year and a new
reserve is deducted based on the taxpayer’s circumstances at that time.


Reserves for Doubtful Debts (Allowance for Doubtful
Accounts) and Bad Debts
The mechanism by which the allowance for doubtful accounts works in accounting is the amount
deducted from income in one year is added back the next year and a new allowance taken.
Example:
Year One:
Accounts receivable $1,280,000
Accounts receivable determined to be of doubtful collectability 143,500
Year Two:
Accounts receivable 1,431,400
Accounts receivable determined to be of doubtful collectability 164,900
The impact on the GAAP/IFRS financial statement would be:
Year 1:
DR bad debts expense 143,500
CR allowance for doubtful accounts 143,500
Year 2:
DR allowance for doubtful accounts 143,500
CR bad debts expense 143,500

The process of adding the Year 1 reserve back into income in Year 2 and taking a new reserve in
Year 2 in effect results in an expense on the income statement of $21,400 ($164,900 - $143,500).
The question is whether or not the $21,400 is considered a tax deductible expense. The answer
is yes, provided the allowance was determined by identifying specific accounts as being
doubtful. If the allowance was determined by applying a flat percentage to the total A/R balance
and is not determined with reference to specific accounts whatsoever, then the amount of
$21,400 would not be tax deductible and the company would have to go through the process of
identifying specific accounts, which are of doubtful collectability to determine the amount that is
tax deductible. For this reason, many companies calculate the allowance for doubtful accounts
for the GAAP/IFRS financial statements based on a review of specific accounts since it is
necessary to do this for tax purposes.
If an account is included in the allowance and it later is recovered, it is included in income in the
year recovered.


Example:
Part A:
Basic Info
Year 2
Pre-tax income per financial statements $715,200
Provision for uncollectible A/R recorded in the financial statements; 17,880

uncollectible A/R determined by reference to specific accounts
Year 1
Provision for uncollectible A/R recorded in the financial statements; 15,970
uncollectible A/R determined by reference to specific accounts
Tax Impact
The uncollectible A/R would have been included in the calculation of the $715,200. In preparing
the Year 2 financial statements the company would have posted the following entry:
DR allowance for doubtful accounts 15,970

CR bad debts expense 15,970
These entries result in a net bad debts expense of $1,910 ($17,880 DR - $15,970 CR). Since the
allowance was calculated with reference to specific accounts, the $1,910 is deductible and it is
not necessary to adjust the GAAP/IFRS based financial statements.
Part B:
Assume that at the beginning of Year 2, one of the accounts included in the Year 1 provision was
determined to be a bad debt and not just of doubtful collectability. The account receivable
amount for this customer was $2,100.
What is the impact on taxable income?
Solution:
When this account is determined to be bad, the following entry is booked in the financial
statements:
Allowance for doubtful accounts 2,100
Accounts receivable 2,100


Note that there is no impact on the income statement.
Since the amount was deducted in the income statement through the mechanism for recording the
allowance, there is no income statement impact.
Since the bad debt has already been recognized in income through the allowance method and
since the allowance was determined in reference to specific accounts there is no adjustment to
the financial statements for tax purposes.
Reserves for Instalment Sales

Note to candidates: reserves for instalment sales are rarely examined on the Entrance
Examination.
Sales of property other than land

For sales of property other than land and where payment will be made after the end of the tax
year and will be paid more than two years after the date of sale, then a reserve can be taken based
on the proceeds receivable. The reserve is based on the profit element in the amount due.
Reserves are not permitted when the sale occurred more than 36 months before the end of the tax
year. The reserve is calculated as follows:
gross profit × amount due after = reserve

gross selling price the end of the tax year
A reserve taken one year is added back into income the following year and a new reserve is
calculated. In addition, the ITA (subsection 20(8)) limits the reserve to three years (i.e. can claim
a reserve in year of sale – Year 2 and Year 3 only; in Year 4 the balance is taken into income).
Land Sales
Where land is sold in the course of a business of a taxpayer (e.g. a real estate developer) and
payment will be made in instalments after the end of the tax year, the taxpayer may claim a
reserve with respect to the sale price included in income, but not yet received. The reserve is
calculated based on the profit element only, not the sale price. In addition, the CRA, when
calculating the reserve only allows the calculation to be based on the seller’s “true equity”. This
means if there is an existing mortgage on the land, this must be factored into the calculation. For
example, if the selling price of a piece of land is $100,000, the gross profit on sale is $20,000 and
the buyer pays cash of $30,000 and gives the seller a mortgage for $70,000, the reserve would be
calculated as follows:


gross profit × amount receivable after = reserve
gross selling price the end of the tax year
$20,000 × $70,000 = $14,000

$100,000
Assuming that the seller already had an existing mortgage of $60,000 on the land and the buyer
paid cash and gave a second mortgage of $10,000, then the reserve is calculated as:
gross profit × amount = reserve

SP – existing mortgage receivable
(i.e. “true equity”)
$20,000 × $10,000 = $5,000

$100,000 – $60,000
If the mortgage of $60,000 was not existing and the seller had clear title to the property, the
seller, in contemplation of selling the property, took out a mortgage of $60,000 and the buyer
paid cash and gave a second mortgage of 10,000, then the reserve is calculated as:
$20,000 × $10,000 = $2,000

$100,000
In addition, the ITA (subsection 20(8)) limits the reserve to three years (i.e. can claim a reserve
in year of sale – Year 2 and Year 3 only; in Year 4 the balance is taken into income).
Reserves for Tax Purposes vs. Reserves per

GAAP/IFRSGAAP/IFRS/IFRS
Some of the reserves previously discussed (e.g. reserve for doubtful debts) are mirror images of
the treatment for GAAP/IFRS. If an item is treated identically for both GAAP/IFRS and tax
purposes, no adjustment is needed when adjusting net income per the financial statements to
taxable income.
Other Items – Charitable Donations

• charitable donations
− a corporation is allowed a deduction, whereas an individual is not allowed a
deduction, but receives a non-refundable tax credit


Other Items – Dividends
• dividends from Canadian corporations
− a corporation is not taxed on dividends received from other taxable Canadian
corporations, while an individual is taxed on this property income
− for CCPC’s, these dividends flow through the refundable dividend tax on hand
account
• dividends from foreign affiliates
− a corporation is not taxed on dividends received from foreign affiliates, while an
individual is taxed on this property income
Other Items – Loss Carryovers

Loss carryovers are the same for both individuals and corporations. There are two main loss
categories, net capital losses and non-capital losses.
• Net Capital Losses

Net capital losses represent the sum of taxable capital gains and allowable capital losses and
occur when losses exceed gains. Net capital losses can be carried back three years and forward
indefinitely to be applied against taxable capital gains. The inclusion fraction at which capital
gains and losses are taxable has varied over the years and, therefore, the taxable loss must be
converted to the rate in effect in the year in which the capital loss is deducted.
The inclusion rates for the various years are:

Year(s) Inclusion Rate
After October 17, 2000 1/2
February 28, 2000 – October 17, 2000 2/3
1990-February 27, 2000 3/4
1988-1989 2/3
1972-1987 1/2
For example, a capital loss of $15,000 which occurred on June 1, 2000 would be allowable at an
amount of $15,000 x 2/3 = $10,000. If this loss is carried forward to 2006 and is applied against
a gain of $40,000, the calculation would be:
Taxable capital gain

$40,000 x 1/2 $20,000
Application of loss carry forward
$10,000 x 3/2 x 1/2 7,500
Net taxable capital gain $12,500
Note that capital losses can only be deducted against capital gains and the carryover period for
capital losses is back three years and forward indefinitely.


• Non-Capital Losses
Losses, which are incurred as employment losses, business losses, property losses and allowable
business losses, are classified as non-capital losses. If these losses cannot be fully deducted
against other sources of income they can be carried back three years and forward seven years or
10 years, as applicable and applied against income in those years. Non-capital loses occurring in
tax years ending before March 23, 2004 can be carried forward seven years and non-capital
losses occurring in tax years ending after March 22, 2004 can be carried forward 10 years. Non-
capital losses that were earned in taxation years that end after 2005 (i.e. 2006 and onwards) can
be carried forward 20 years.
Non-capital losses can be applied against any source of income and can also be applied against
taxable capital gains.
• Farm Losses and Restricted Farm Losses

• Farm losses
These are the losses for taxpayers whose chief source of income is farming or fishing.
These losses are non-capital losses; however the carryover period is back three and
forward 10 years for losses incurred prior to 2006. For losses incurred after 2005, the
carry forward period is 20 years.
• Restricted farm losses

These are the losses from hobby farms (where the taxpayer’s chief source of income is
not from farming). In these circumstances, the amount of the farm loss that can be
deducted from other income in the current year is restricted. The amount of the loss that
can be deducted from other income in the current year is the least of:
1. The farming loss incurred
2. $2,500 plus the least of
(i) 1/2 x (farming loss minus $2,500)
(ii) $6,250
This means the maximum amount that can be deducted is $8,750, which represents a loss of
$15,000. Any loss exceeding this limit is not deductible in the current year, but can be carried
back three years and forward 10 years or 20 years (10 years for losses incurred before 2006 and
20 years for losses incurred after 2005). These losses that are carried over are known as
“restricted farm losses”. However, in the year the loss is carried over, it can only be deducted
against farming income.


Example of restricted farm losses:
Taxable farming loss is $22,000 and farming is not the chief source of income for the taxpayer.
The amount of the loss that can be deducted against any source of income in the current year is:
Least of:
1. The farming loss $22,000 22,000
2. $2,500 plus the least of
$8,250
(i) 1/2 x (22,000 – 2,500) 9,750
8,250
(ii) $6,250 6,250
The amount that can be deducted in the current year against any source of income is $8,250. The
amount that can be carried over is the remainder $22,000 – $8,250 = $13,750. However, the
$13,750, which is a ‘restricted farm loss’, in the carryover years can only be deducted against
farming income.
• Loss carryovers and change in control

A change in control can occur when shares are sold or transferred from one shareholder to
another shareholder(s). When a new shareholder or group of shareholders acquires control of a
corporation, the loss carry forward balances may be restricted as to use or eliminated entirely. A
change in control affects the loss carryover balances as follows:
• net capital losses
Any net capital loss carryover is deemed to expire at the time of change in control. This
means none of these losses can be utilized by the acquiring shareholder(s).
• non-capital losses
These losses do not expire, but can only be applied against income from the business that
generated the loss (if continued) or against income of a business that is similar to the
business that incurred the loss. In addition, in order to utilize the loss carry forward, the
business that incurred the loss cannot be terminated until the losses have been fully used.
When there is a change in control, the corporation’s tax year-end is deemed to be the date of the
change in control for tax purposes for the year of the change in control. The company can then
choose as their regular year-end any date within the next 53 weeks as the company’s year-end
date. In addition, depreciable property, eligible capital property and other capital property is
deemed to have been sold at market value, if market value is less than tax cost. This may give
rise to a terminal loss, which is included in the selling company’s income (loss), which may
result in an increased non-capital loss for the company’s final year. This loss is treated in
accordance with the change in control loss carryover provisions discussed above.


Summary of tax rules for losses:
Non-capital losses Restricted Restricted

Farm losses Farm losses
Non-capital losses occurring in tax Non-capital losses farm losses farm losses
occurring in occurring in
occurring in tax years ending after occurring in tax Net capital occurring in occurring in
tax years tax years
years ending after March 22, 2004 years ending prior losses tax years tax years
ending after ending prior
2005 and up to Dec. 31, to March 23, 2004 ending after ending prior
2005 to 2005
2005 2005 to 2005
Carry 3 years 3 years 3 years 3 years 3 years 3 years 3 years 3 years
back
period
Carry Do not
forward 20 years 10 years 7 years expire 20 years 10 years 20 years 10 years
period
Income Any source of Any source of Any source of Taxable Same as non- Same as non- Against Against
against income income income capital gains capital capital farming farming
which it only losses, losses, income only income only
can be against any against any
applied source of source of
income income
Annual none none none none none none none 2,500 + 1/2 of
limit the next 12,500
(max = 2,500 +
6,250 = 8,750)
Change of Losses carried Losses carried Losses carried Any losses

control forward do not forward do not forward do not carried
rules expire, but can expire, but can expire, but can forward
only be used only be used only be used deemed to
against income against income against income expire at
from the same from the same from the same date of
business or a business or a business or a change of
similar business similar business similar business control
Putting it All Together

As mentioned previously the easiest means of calculating taxable business income is to start with
net income per the financial statements and make adjustments to arrive at taxable income. The
schedule below outlines the most common reconciling items between financial statement income
(i.e. accounting income) and taxable income for a corporation.
Income per financial statements after income taxes (Accounting Income)
Add back any expenses deducted in the financial statements, which are not deductible for tax purposes
Income tax provision on financial statements (s. 18(1)(e))
Depreciation and amortization (s. 18(1)(b))
Accounting losses on sales of capital property or investments (under ITA treated as a capital. gain or loss, not
business income). This includes losses on AFS and HFT investments.
Commission/legal expenses paid on the purchase of an investment (shares, a factory, etc.) (s. 18(1)(b))
Legal/accounting expenses related to the issuance of shares, new debt (only 1/5 is deductible each year)
Foreign taxes
Interest and penalties on late income tax payments (s. 18(1)(t))
Increase in the financial accounting reserve for warranty expenses (s. 18(1)(e)
Donations to registered charities (s. 18(1)(a)) – deducted later under Division C* (deducted when calculating
taxable income (Div C), not income for tax purposes (Div B))
50% of meals and entertainment (s. 67.1)
Expenses in excess of a reasonable amount (s. 67)
Club membership dues (s. 18(1)(l))
Political donations (s. 18(1)(n)) (a credit is received for this)


Accrued bonuses still unpaid 180 days after year-end (s. 78(4))
Advertising in foreign media directed primarily to Canada. (s. 19, 19.1)
Property tax on vacant land (s. 18(2))
Life insurance premiums (if corporation is the beneficiary; and if not required for financing) (s. 18(1)(c))
Deduct any amounts deductible for tax purposes, which are not deducted on the financial statements
Site investigation costs, which have been capitalized (s. 20(1)(ee)
Amounts paid for landscaping business premises, which have been capitalized (s. 20(1)(aa)).
Capital cost allowance (CCA) (s. 20(1)(a))
Accounting gains on sales of capital property or investments(under ITA treated as a capital. gain or loss, not
business income). This includes gains on AFS and HFT investments.
Add Net taxable capital gains = Taxable (1/2) capital gains – allowable (1/2) capital losses
Net income under Division B [Income for tax purposes]
Deduct [Division C Deductions]

Charitable donations [s. 110.1(1)] (limited to 75% Net Income under Division B)
Dividends from taxable Canadian corporations [s. 112] [Corporations only, not individuals]
Loss carryovers:
Non-capital losses (back three years , forward seven years for losses arising in tax years ending before
March 23, 2004; for losses arising in tax years after March 23, 2004 to December 31, 2005 the carry
forward period is 10 years; for losses arising in tax years after 2005 the carry forward period is 20 years).
Net capital losses ( back three years, forward indefinitely; limited to Net taxable capital gains,
adjust to 1/2 if fraction from previous year is 3/4 or 2/3)
Taxable Income
Note that the above chart assumes the reserve for doubtful debts (AFDA) is identical to the tax
deduction allowed (i.e. the allowance was calculated with reference to specific accounts) and,
therefore, no adjustment is needed with respect to uncollectible accounts receivable.


Capital Cost Allowance and Cumulative Eligible
Capital
5.2.5 f) Explains and applies the taxation rules pertaining to capital cost
allowance, acquisitions and dispositions of depreciable capital property
9 9
(including recapture and terminal loss) and cumulative eligible capital for
a given organization
Accounting Amortization vs. CCA

Amortization for accounting purposes seeks to expense the cost of the asset over its period of
benefit, which is its useful life. On the other hand, capital cost allowance (CCA) is the annual
deductible portion of capital outlays and is normally computed at specified percentages. CCA is
only applicable to depreciable capital assets. CCA is not calculated in reference to the period of
benefit.
The Capital Cost Allowance (CCA) System

Note to candidates: Do not memorize classes and CCA rates. Historically, the CMA Entrance
Examination has provided CCA rate and class information in the examination question. Class
and rate information has been provided for reference purposes only.
Under the CCA system, depreciable property is grouped into prescribed classes. A taxpayer may
have a number of identical capital items; these are grouped together into one class and are treated
as one unit for the purposes of CCA.
The most common classes are:

Class 1 (4%) − most buildings or other structures, including component parts such as
electrical wiring and fixtures, plumbing, heating and central air
conditioning acquired after 1987;
Class 3 (5%) − buildings or other structures, including component parts acquired before
1988 and limited costs of an addition or alteration made after 1988;
Class 8 (20%) − miscellaneous tangible capital property, such as furniture, fixtures and
outdoor advertising signs (bought after 1987) and machinery or
equipment, such as photocopiers, refrigeration equipment, telephones
and tools costing $500 or more, not included in another class (i.e.
general default class for tangible capital property);


Class 9 (25%) − aircraft, including furniture or equipment attached to the aircraft and
spare parts;
Class 10 (30%) − automotive equipment, such as automobiles (except taxis and those
used in a daily rental business), vans, trucks, tractors, wagons and
trailers, and general-purpose electronic data processing equipment
with its systems software; including ancillary data processing
equipment, acquired after May 25, 1976 and before March 23, 2004
(or after March 22, 2004 and before January 1, 2005 if an election
in respect of the data processing equipment is made electing to treat
the data processing equipment as class 10).
Candidates are advised to note that effective March 23, 2004, a new
class, class 45 described below, was created for electronic data
processing (e.g. computer hardware with its systems software).
Class 10.1 (30%) − a passenger vehicle with a cost in excess of the limit prescribed for
paragraph 13(7)(g) (i.e. $30,000 if acquired after 2000) (in 2010 the
amount remains $30,000);
Class 12 (100% − tools, instruments and kitchen utensils costing less than $500
and no (effective January 1, 2006 the threshold amount was increased to
half $500 from $200) ; linen, uniforms, dies, jigs or moulds; rental video
year cassettes; computer software (this means application software, such
rule on as Microsoft Excel and Word, systems software (e.g. operating
specific systems software) is included in either class 10 or class 45, as
items) applicable);
Class 13 SL class − leasehold interest;
Class 14 SL class − patent, franchise, concession or license for a limited period;
Class 17 (8%) − roads, parking lots, sidewalks, airplane runways, storage areas or
similar surface construction;
Class 39 (25%) − property used in manufacturing or processing acquired after 1987
and before February 26, 1992;
Class 43 (30%) − manufacturing and processing machinery and equipment acquired
after February 25, 1992;
Class 44 (25%) − patents and rights to use patented information acquired after April
26, 1993, for a limited or unlimited period. (A taxpayer can elect
not to use class 44 for patents, in which case the property will be
classified as Class 14);
Class 45 (45%) − general purpose electronic data processing equipment and systems
software for that equipment, including ancillary data processing
equipment, acquired after March 22, 2004 and before March 19,
2007 is eligible for the 45% rate.


Class 46 (30%) − data network infrastructure equipment and systems software for that
equipment acquired after March 22, 2004
− data network infrastructure equipment eligible for Class 46 is
defined as:
Data network infrastructure equipment means network infrastructure
equipment that controls, transfers, modulates or directs data and operates
in support of telecommunications applications such as e-mail, instant
messaging, audio and video over the Internet protocol or web browsing,
web searching and web hosting, including data switches, multiplexers,
routers, remote access servers, hubs, domain name servers and modems,
but does not include
(a) network equipment (other than radio network equipment) that
operates in support of telecommunications applications, if the
bandwidth made available by that equipment to a single end-user
of the network is 64 kilobits per second or less in either direction,
(b) radio network equipment that operates in support of wireless
telecommunications applications unless the equipment supports
digital transmission on a radio channel,
(c) network equipment that operates in support of broadcast
telecommunications applications and is unidirectional,
(d) network equipment that is end-user equipment, including telephone
sets, personal digital assistants and facsimile transmission devices,
(e) equipment included in Class 10 or in Class 45,
(f) wires or cables or similar property, and
(g) structures;
Note that this definition excludes telephone equipment and facsimile

and, therefore, these items should be included in Class 8.
Class 50 (55%) − general-purpose electronic data processing equipment and systems
software for that equipment, including ancillary data processing
equipment, acquired after March 18, 2007 are eligible for a 55%
CCA rate. Note that this is the same description as Class 45; in
2007 the CCA rate on these assets was increased.
Class 52 (100%) − eligible computers and electronic equipment as per class 50 and
acquired after January 27, 2009 and before February
2011(Temporary class) not subject to the ½ year rule


Calculating CCA
The basic formula per the ITA is:
Undepreciated capital cost, beginning XX

Add: Purchases during year XX
XX
Deduct: Dispositions during the year at the lesser of (XX)
1. capital cost
2. proceeds of disposition
XX
Deduct: 1/2 of net purchases during the year, calculated as: Important: If
proceeds of
purchases XX disposition >
less: dispositions (at amount above) (XX) (XX) purchases, then
deduct zero.
A XX
Deduct: Capital cost allowance taken1
A x prescribed rate (XX)
XX
Add: 1/2 amount calculated above (denoted by A above) XX
Undepreciated capital cost, ending XX
1
Represents deduction for CCA for the year
An easier way to calculate CCA is by using CRA’s form:

1 2 3 4 5 6 7 8 9 10
Adjustment for
UCC after current year UCC at the
additions and additions (1/2 x Base amount CCA for the end of the
UCC at dispositions column 3 minus for CCA year (column year
the start Cost of Proceeds of (column 2 + column 4; if (column 5 7 x column 8 (column 5
Class of the additions in dispositions column 3 minus negative enter minus or an adjusted minus
Number year the year in the year column 4) 0) column 6) Rate % amount) column 9)
The maximum to deduct is If this amount is

the original cost. If the negative, take into
proceeds exceed the original income as recapture.
cost, there will be a capital
gain (discussed later) Total CCA claim for the year


CCA Rules
There are a number of rules related to calculating CCA:
• 1/2 year rule
This rule stipulates in the first and last year of ownership of a depreciable asset only 1/2
of the calculated CCA can be deducted. This rule applies to all classes except (i.e. does
not apply to these classes) the following classes/property:
− certified vessels
− some items listed in Class 12 (see below list of Class 12 property)
− Class 14 patents, franchise, concession or license for a limited period
− Classes 15 and 23
Common property to which the 1/2 year rule does not apply is:
Class Paragraph Property

12 (a) a book that is a part of a lending library
(b) chinaware, cutlery or other tableware
(c) a kitchen utensil costing less than $500
(e) a medical or dental instrument costing less than $500
(g) linen
(h) a tool costing less than $500
(j) a uniform
(k) rental apparel or costume, including accessories
14 a patent, franchise, concession or license for a limited period
• Available for use rule

− CCA cannot be claimed until the property is available for use by the taxpayer;
generally, the asset is available for use when it is delivered and capable of performing
the function for which it was acquired
• CCA is a permissive deduction

− the CCA rate for each class is the maximum CCA deduction allowed. A taxpayer
may choose to deduct less than the maximum or even none at all (a taxpayer may
want to claim nil CCA if in a taxable loss position)
• Short tax year rule

− in the first year or last year of operation, the tax year is not usually a full year; the
CCA calculated for the year must be prorated for the number of days the business
operated
− the short year rule is independent of the 1/2 year rule; that is, the 1/2 year rule must
be applied and then the resulting CCA amount must be prorated based on the number
of days in operation


• Ownership of property
− the taxpayer must have either title to the asset or all the incidents of title such as
possession, use and risk
• Disposition of property
− disposition can occur through selling the property, theft, destruction, confiscation,
expropriation or due to loss or abandonment without expectation of recovery
Dispositions of Depreciable Property – Recapture and

Terminal Losses
Assets that are part of a CCA pool may later be sold/disposed. The general rule is the proceeds
of disposition (i.e. selling price minus selling expenses) are deducted from the applicable CCA
pool. When disposing of a depreciable asset, three situations may arise. These situations and the
tax consequences of each are:
• the proceeds are less than the balance in the CCA pool
− in these situations, the balance of the pool will be positive and CCA continues to be
deducted in the normal manner, provided there are assets remaining in this class (i.e.
there are physical assets in the class); if the class balance is positive and there are no
assets remaining in the class, the balance is fully deducted, resulting in a nil balance
in the class. When the balance is fully deductible in this manner, this is known as a
terminal loss.
• the proceeds are more than the balance in the CCA pool, but less than the original cost
− in these situations, there is a negative balance in the pool; this negative balance is
taken into business income as ‘recapture’ (i.e. recapture or recovery of CCA amounts
previously deducted)
− in essence, a negative balance means the cumulative CCA that has been claimed at an
amount that is greater than the actual loss in value
• the proceeds are more than the balance in the CCA pool and more than the original cost
− in these situations the proceeds amount deducted from the CCA pool is limited to the
original cost, which still results in a negative balance in the pool; this negative
balance is taken into business income as ‘recapture’ (i.e. recapture or recovery of
CCA amounts previously deducted)
− the difference between proceeds of disposition and original cost is treated as a capital
gain and, therefore, is subject to the capital gains tax rules


These three situations can be depicted as:
Capital gain and recapture Recapture only Terminal loss

Proceeds
capital
gain
Original Original Original

cost cost cost
recapture
Proceeds
recapture
UCC UCC UCC
Terminal loss, if
there are no
physical assets
remaining in the
class
Proceeds
Autos and CCA

• Class 10.1 automobiles (automobiles > $30,000 plus GST and PST)
The capital cost of the automobile used as a basis to calculate CCA is restricted to a
maximum of $30,000 plus GST and PST for years after 2000 (for 2010, the threshold
remains at $30,000 plus GST and PST or HST).
If a taxpayer is registered for GST/HST, the taxpayer gets an input tax credit for the
GST/HST on the automobile; therefore, for any taxpayer registered for GST/HST, the
GST/HST should not be added to the cost of the vehicle.
Each class 10.1 automobile is placed in a separate class and CCA is calculated on each car
separately. That is, class 10.1 assets are not pooled (i.e. each automobile is considered to be
its own separate class).
In addition, the rules related to recapture and terminal losses do not apply to Class 10.1
automobiles. That is, when the vehicle is sold, neither a recapture of CCA nor a terminal loss
is permitted [ITA 13(2), 20(16.1)]. Since terminal losses are denied, a special CCA


calculation applies in the year of disposition (known as the terminal year). In the year of
disposition, CCA can be deducted at 1/2 of the CCA amount that would have been deducted
had the vehicle not been disposed of. To qualify for this 1/2 year rule, the taxpayer must
dispose of an automobile that was included in Class 10.1 and the vehicle must be owned by
the taxpayer at the end of the preceding year.
• Class 10 automobiles
If a vehicle used to earn business income costs less than $30,000 (plus GST and PST or HST)
it is included in Class 10. Automobiles in this class are subject to the normal CCA
calculations:
Business income (incorporated or

unincorporated)
CCA deduction yes
Recapture yes
Terminal losses yes
Computer Equipment and Systems Software

Since computer equipment rapidly becomes obsolete, there are special rules related to this type
of equipment. Normally this equipment would be included in Class 8 or 10; however, in
recognition of the rapid depreciation of these assets, the government created a separate class,
Class 45, which has a 45% or 55% CCA rate for these assets. Computer equipment purchased
after March 22, 2004 and before March 19, 2007 is eligible for a 45% CCA rate. Computer
equipment purchased after March 18, 2007 is considered to be Class 50 and is eligible for a 55%
CCA rate.
Straight-Line CCA Classes: Leasehold Improvements

and Class 14 Limited Life Intangibles
Leasehold Improvements (Class 13)
The CCA on leasehold improvements (Class 13) is not calculated using the declining balance
method, but is based on using a straight-line method. CCA on leasehold improvements is
the lesser of:
1. 1/5 of the capital cost of the leasehold interest
and
2. the capital cost of the leasehold interest divided by the life of the lease plus one
renewable-option period. The life of the lease is the number of full 12-month periods
from the beginning of the year in which the cost was incurred to the termination date
of the lease. The life of the lease plus one renewal option has a maximum threshold


of 40 (i.e. if the number of 12 month periods exceeds 40, then use 40). Note that if
the leasehold improvement is spent during the lease it is the remaining term plus one
renewal option that is used as the denominator.
Since leasehold improvements may occur in different years, it is necessary to calculate CCA for
each separate leasehold improvement expenditure (since Part 2 of the formula for calculating
CCA on leasehold improvements starts in the year of expenditure).
In the first year only 1/2 of the calculated CCA is allowed as a deduction.
Example:
A $25,000 leasehold improvement is made on a rented building by a tenant. The lease term is
six years, with two successive options to renew of four years and three years respectively.
CCA is calculated as:

The lesser of
1. 25000 ÷ 5 years = 5000
2500
2. 25000 = 2500
6+4
In the first year only, 1/2 of the CCA is deductible, so the CCA deduction allowed in the first
year is $1,250 ($2,500 x 1/2).
Limited Life Intangibles (Class 14)

CCA is calculated using a straight-line method for limited life intangibles. This class includes
patents, franchises, concessions or licenses. To calculate CCA, the capital cost of each property
is divided by the remaining legal life as at the acquisition date. The capital cost should be
prorated over the number of days in the remaining life. This means the CCA on an acquisition in
mid-year must be prorated from the date of acquisition to year-end. In addition, since each
property has a different legal life, CCA must be calculated separately for each property.
Patents may be classified as either Class 14 or Class 44. A patent or a right to use patented
information for a limited or unlimited period, which is acquired after April 26, 1993, is classified
as a Class 44 asset, which has a 25% declining balance rate. However, the taxpayer can elect the
property not be included in Class 44, in which case the asset is classified as a Class 14 asset and
CCA is calculated on a straight-line basis.
There are specific rules related to representation expenses (e.g. legal fees) for patents or
franchises. Expenditures for making a representation to obtain a franchise or patent can be
treated four different ways for tax purposes.


The taxpayer can:
• deduct the expenditure immediately [par 20(1)(cc)]
or
• deduct 1/10 of the amount each year for 10 consecutive years (cannot skip a year),
beginning in the year the expenditure is made [sec 20(9)]
or
• capitalize the cost as part of Class 14 or Class 44 (if the patent or franchise has a limited
life)
or
• capitalize the cost as eligible capital property
It is important to remember that Class 14 or 44 assets must have a limited life. If the intangible
has an indefinite life, it is treated as an eligible capital expenditure.
Capital Cost Allowance – Class 14 vs. Class 44

Since limited life patents can be classified as either Class 14 or Class 44, a summary of these two
classes is provided below. Unlimited life patents can be classified as either Class 44 or
cumulative eligible capital, so these are also addressed in the summary.
CLASS 14 CLASS 44 ELIGIBLE CAPITAL

PROPERTY
Patent, franchise or license for a Patent (or right to use a patent) for either a Patent (or right to use a
limited period limited or unlimited period. patent) for an unlimited
period.
Note that this class applies to Note that this class applies to patents only. Eligible capital property
patents AND franchise or includes all intangible assets,
licenses. not only patents.
Note that assets in this class Note that assets in this class may have Note that assets in this class
must have a limited life either a limited life or an unlimited life must have a unlimited life
CCA = straight-line over the life CCA = 25%, 1/2 year rule applies Eligible Capital Expenditure
(i.e. term) of the = cost x 75% = base used to
patent/franchise/license calculate deduction; rate =
7%, no 1/2 year rule
Must elect to have the patent treated as a

Class 44 asset. If it is a Class 44 asset
must be excluded from Class 14 (for
limited life patents) or eligible capital
property (unlimited life patents).
This means a limited life patent can be treated as either a Class 14 or Class 44 asset and an
unlimited life patent can be treated as either a Class 44 asset or eligible capital property.


Government Grants for Capital Property
The amount of government assistance (e.g. grant, subsidy, forgivable loan, reduction in tax,
investment allowance) received reduces the capital cost of depreciable property. This means
CCA is claimed on the net cost (cost minus government assistance) of the asset.
Capital Cost Allowance Restrictions – Rental

Buildings
When calculating CCA on a rental building, each building that costs $50,000 or more must be
put in its own class. These buildings are usually Class 1 (4% rate).
If the building is a rental building, CCA cannot be claimed if it creates a loss or increases a loss.
If more than one rental building is owned, the rental income (loss) for all buildings must be
netted together to determine the CCA deduction limitation.
If there is more than one building, which means that each building is considered a separate class,
the taxpayer can choose which building CCA is deducted against, subject to normal limitations
(maximum CCA = UCC x CCA rate).
Examples
Example 1:
Sara Mitchell owns one property and collected rents of $6,240 in 2010. Sara incurred deductible
expenses of $2,810 excluding capital cost allowance. The maximum amount of CCA Sara
would be able to claim on this building is $3,430:
Rental income $6,240

Expenses excluding capital cost allowance 2,810
Rental income before CCA on the building $3,430
The maximum CCA that is deductible is also subject to the normal CCA calculation (i.e. UCC x
CCA rate).
Example 2:
John Bertani owns a building and collected $9,360 in rent during 2010. He incurred $9,750
allowable deductible expenses. John will not be allowed to claim any capital cost allowance on
this building for 2008 as he cannot increase his rental loss by capital cost allowance:


Rental income $9,360
Deductible expenses excluding capital cost allowance 9,750
Rental loss before CCA on the building $(390)
However, John may deduct the $390 loss as deduction against his other income.
Example 3:
Wendy Lui owns two apartment buildings. A summary of her 2010 rental income is:
Building A Building B
Rent $22,100 $19,500
Deductible expenses excluding capital cost allowance 19,760 20,800
Rental income (loss) before CCA on the buildings $2,340 $(1,300)
Wendy can only claim $1,040 in capital cost allowance for the year because she must combine
her rental income on Building A with her rental loss on Building B to determine the net income
available for reduction by capital cost allowance.
Eligible Capital Property

Generally, eligible capital property refers to intangible property, which has an indefinite life.
Since these expenditures are capital in nature, the expenditure cannot be deducted as a business
expense. Similar to CCA, the CRA allows a yearly deduction for these capital expenditures. To
qualify as an eligible capital expenditure, an expenditure must meet a number of conditions (the
list of conditions is beyond the scope of the Entrance Examination).
Common eligible capital expenditures include the following:

• goodwill
• customer lists (generally the cost of a list that has an enduring benefit is considered a
capital outlay)
• trademarks
• patents, franchises, concessions and licenses that do not have a limited life (if they have a
limited life they are treated as Class 14 or 44 assets)
• initiation or admission fees (where it can be shown that the annual membership fees are
allowable deductions when calculating business income. For example, the entrance or
initiation fees paid to a stock exchange are eligible capital expenditures).
• expenses of incorporation, reorganization or amalgamation
• appraisal costs of a property for the purpose of producing business income
• legal and accounting fees incurred in an attempt to acquire shares of another corporation
(if the buying company intended on making the acquisition company part of a similar
business already carried on by the corporation)
• government rights

Page 40
studymanual_errata@cmaontario.org

The deduction for eligible capital expenditures is calculated as follows:
Cumulative eligible capital balance at end of preceding year xx
Add:
Cost of eligible capital property acquired during the year xx x 3/4 = xx
Subtotal xx A
Deduct:
Proceeds of sale (less disposition expenses) from the xx x 3/4 = xx B
disposition of all eligible capital property during the year
Cumulative eligible capital balance (A minus B) xx C
Current year deduction (C x 7%) xx D
Cumulative eligible capital, closing balance (C minus D) xx
Note that there is not a 1/2 year rule for eligible capital expenditures. For years starting after
December 21, 2000, the deduction must be prorated for short tax years based on the number of
days (e.g. first year and final year for a company usually are less than 365 days).
Dispositions of Eligible Capital Property

Note to candidates: Dispositions of eligible capital property is rarely examined on the Entrance
Examination.
When eligible capital property is disposed, 3/4 of the selling price (proceeds of disposition) is
deducted from the pool’s balance. This may result in the pool having either a negative or positive
balance. The tax consequences of either of these situations are:
• if the pool is negative:
− add to business income the amount that represents recapture of eligible capital
expenditures previously deducted
− if there is still a negative amount remaining after taking into consideration the
recaptured amount, 2/3 of the excess is added to business income; this 2/3
inclusion results in the income impact being the same as if it was treated as a
capital gain [3/4 x 2/3 = 50%, which is the capital gains inclusion rate]
• if the pool is positive:

− continue to deduct the yearly amount allowed (7% of the balance)
When a business terminates and there is a balance in the eligible capital property pool, this
balance is deducted from business income (akin to the terminal loss provisions of depreciable
capital property).


Example:
A company purchases a customer list in Year 1 for $20,000 and sells it in Year 2 for $25,000.
The tax consequences are:
Cumulative eligible capital account:

Year 1
Purchase $20,000 x 3/4 $15,000
Deduction for the year $15,000 x 7% (1,050)
Balance $13,950
Year 2
Sale $25,000 x 3/4 (18,750)
Negative balance at end of Year 2 $(4,800)
Business income for tax purposes, Year 2:

Recapture of amounts previously deducted $1,050
Taxable portion of excess 2,500
2/3 x (4800 - 1050)
Amount included in business income $3,550
Numbers check:
Total income statement impact per above:
Year 1 – Deduction $(1,050)
Year 2 – Recapture 1,050
Year 2 – Taxable portion of excess 2,500
Total $2,500
Check:
Year 1 – Deduction $(1,050)
Year 2 – Recapture $1,050
If sale of ECE treated as a capital gain, the

tax consequences are:
Selling price $25,000
Cost 20,000
Capital gain $5,000
x 50%
Taxable capital gain $2,500
The taxable portion of the excess agrees to
the amount that would have been taxed had it
been treated as a capital gain.
The negative balance in the account is set to zero.


There may be situations when a taxpayer would prefer to treat the gain on the sale of eligible
capital property as a capital gain, as opposed to a reduction of the cumulative eligible capital
pool. An election is available that allows a taxpayer to treat a gain on the disposition of eligible
capital property as a capital gain. To take advantage of this election, all of the following
conditions must be met:
• the property disposed must be eligible capital property of a business, but not goodwill;
• the cost of the property to the taxpayer must be determinable;
• the proceeds of disposition of the property must exceed the cost;
• the taxpayer’s exempt gains balance in respect of the business must be NIL;
• the taxpayer must elect under subsection 14(1.01) in the taxpayer’s return of income for
the year.
If these conditions are met, the following occurs:

• the proceeds of disposition are deemed to equal the cost of property, which results in
recapture as previously discussed
• there is a deemed disposition of the capital property at the actual proceeds of disposition
amount and the adjusted cost base is deemed to equal the original cost; this results in a
capital gain (proceeds minus original cost), which is treated in accordance with capital
gains tax rules
Example:
Assume the same facts in the previous example and the company elects to treat the gain portion
as a capital gain. The tax consequences are:
Cumulative eligible capital account:

Year 1
Purchase $20,000 x 3/4 $15,000
Deduction for the year $15,000 x 7% (1,050)
Balance $13,950
Year 2
Sale $20,000 x 3/4 (15,000)
Negative balance at end of Year 2 $(1,050)
Business income for tax purposes, Year 2:

Recapture of amounts previously deducted $1,050
Capital gain, Year 2:

Deemed proceeds $25,000
Deemed cost 20,000
Capital gain $5,000
Taxable capital gain (@ 50%) $2,500


Comprehensive Example – Capital Cost Allowance
and Cumulative Eligible Capital
Question:
The fiscal year of the Walters Company (“Walters”), a Canadian company located in Toronto,
Ontario, ends on December 31. On January 1, 2010, the UCC balances for the various classes of
assets owned by Walters are:
CCA UCC
rate balance
Class 1 – Building 4% $625,000
Class 8 – Office Furniture and Equipment 20% 155,000
Class 10 – Vehicles and
Computers Purchased Before 2005 30% 118,000
Class 13 – Leasehold Improvements S. Line 61,750
Class 43 – Manufacturing Equipment 30% 217,000
During 2008, the following asset acquisitions were made:
CCA UCC
rate balance
Class 8 – Office Furniture and Equipment 20% $27,000
Class 10 – Vehicles 30% 33,000
Class 12 – Tools 100% 34,000
Class 13 – Leasehold Improvements S. Line 45,000
Class 52 – Computer Hardware 100% 28,000
During this same period, the following dispositions occurred:
Class 8 – Used office furniture and equipment was sold for cash proceeds in the amount of
$35,000. The original cost of these assets was $22,000.
Class 10 – A delivery truck with an original cost of $23,000 was sold for $8,500.
Class 43 – Since the manufacturing operations will be performed by subcontractors in the

future, all manufacturing equipment was sold for total proceeds of $188,000.


Other Information:
1. The Company leases a building for $827,000 per year that houses a portion of its
manufacturing operations. The lease was negotiated on January 1, 2007 and has an original
term of eight years. There are two renewal options on the lease. The term for each of these
renewal options is four years. The company spent $78,000 on leasehold improvements
immediately after signing the lease. No further improvements were made until the current
year.
2. On February 24, 2010, one of the company’s cars was totally destroyed in an accident. At
the time of the accident, the fair market value of the car was $12,300. The proceeds from
the company's insurance policy amounted to $8,000. The original cost of the car was
$17,000.
3. The Class 10 vehicle purchased during the year was a delivery truck. The Class 12 tools
purchased are not subject to the half-year rule.
4. The Walters Company was organized in 2000 and has no balance in its cumulative eligible
capital account on January 1, 2010. During March, 2010, the company granted a
manufacturing license for one of its products to another Canadian company. This licensee
paid $87,000 for the licensing rights to manufacture this product.
5. It is the policy of the company to deduct maximum CCA in all years.
Required:
Calculate the maximum 2010 CCA that can be taken on each class of assets, the January 1, 2010
UCC balance for each class and any other 2009 income inclusions or deductions resulting from
the information provided.


Solution:
Class 1 – Building
The maximum CCA would be $25,000 [(4%) ($625,000)]. The January 1, 2010 UCC of Class 1
would be $600,000 [$625,000 minus $25,000].
Class 8 – Office Furniture and Equipment
CCA:
Opening UCC balance $155,000

Additions during fiscal year 27,000
Dispositions during fiscal year (Note 1) (22,000)
One-half net additions (27,000 – 22,000) x 1/2 (2,500)
CCA base $157,500
Capital cost allowance (20%) (31,500)
One-half net additions 2,500
Ending UCC balance $128,500
Note that $22,000 is used as this is the original cost. The maximum to deduct is the original
cost. If the proceeds exceed original cost, there will be a capital gain. In this case, the capital
gain is:
Selling price $35,000
Original cost 22,000
Capital gain $13,000
Taxable capital gain @ 1/2 $6,500
Some candidates find the method below easier to remember to calculate CCA:
Dispositions during fiscal year (22,000)
CCA calculations:
155,000 x 20% 31,000
CCA on the net additions/disposals (1/2 year rule):
(27,000 – 22,000) x 1/2 x 20% = 500 (31,500)


Class 10 – Vehicles – the required calculations for this class would be:
Opening balance $118,000

Dispositions during fiscal year:
Sale (8,500)
Proceeds received from insurance company Note 1 (8,000) (16,500)
One-half net additions (16,500 x 1/2) (8,250)
CCA base $126,250
One-half net additions 8,250
Ending UCC balance $ 96,625
Note 1: Note that the amount received from the insurance company on the destroyed vehicle is
treated as proceeds from a disposition. The fair market value is irrelevant.
Some candidates find the method below easier to remember to calculate CCA:
Dispositions during fiscal year (16,500)
CCA calculations:
118,000 x 30% 35,400
CCA on the net additions/disposals (1/2 year rule):
(33,000 – 16,500) x 1/2 x 30% = 2,475 (37,875)
Class 12 – Tools
The tools are eligible for a CCA rate of 100% and are not subject to the half-year rules on net
additions; therefore, the entire $34,000 can be deducted as CCA for the current year.
Class 13 – Leasehold Improvements
Recall that leasehold improvements are deducted over the term of the lease on a straight-line
basis. For the purposes of calculating the CCA deduction, the term of the lease would include the
first renewal option, beginning in the first period after the improvements were made. In the case
of the original improvements, the period to be used is 12 years. With respect to the
improvements during the current year, the write-off period will be nine years.


CCA calculation:
Opening balance $ 61,750

Additions 45,000
CCA base $106,750
Capital cost allowance:
First Improvements 78,000
Lease term + 1 renewal period = 8 + 4 ÷ 12 6,500
Current year improvements:
Total spent 45,000
Remaining lease term + 1 renewal term
Five years (2008 to 2012) + 4 = 9 ÷9
5,000
Half year rule x 1/2 2,500 (9,000)
Ending UCC balance $ 97,750
Class 43 – Manufacturing Equipment

There is a terminal loss on the manufacturing equipment. It is calculated as:
Opening balance $217,000
Disposition (proceeds) (188,000)
Terminal loss $ 29,000
All the assets in Class 43 have been retired (i.e. there are no physical assets in the class) and
there is still a $29,000 UCC balance. This balance is a terminal loss that is fully deductible in
the current year.
Class 52 – Computers
The rate for Class 50 is 100% and the class is not subject to the first year rule. The required
calculations for this class are:
Opening balance 0
Additions during fiscal year $28,000
Ending UCC balance $0
Cumulative Eligible Capital

The sale of the license is considered a sale of cumulative eligible capital and, therefore, the
cumulative eligible capital rules apply.


The calculations for the sale of the license are:
Opening balance 0
Proceeds of disposition [($87,000)(3/4)] ($65,250)
Balance ($65,250)
Addition to balance 65,250
Ending balance $0
The proceeds of $87,000 are included at 75% of the amount received. This results in a negative
balance of $65,250. The $65,250 is treated as:
− add to business income the amount that represents recapture of eligible capital
expenditures previously deducted
− if there is still a negative amount remaining after taking into consideration the
recaptured amount, 2/3 of the excess is added to business income; this 2/3
inclusion results in the income impact being the same as if it was treated as a
capital gain [3/4 x 2/3 = 50%, which is the capital gains inclusion rate]
Summary of the Results:

The maximum CCA for the year and the January 1, 2009, UCC balances can be summarized as:
January 1, 2009
Maximum CCA UCC
Class 1 $25,000 $600,000
Class 8 $31,500 $128,500
Class 10 $37,875 $96,625
Class 12 $34,000 Nil
Class 13 $9,000 $97,750
Class 43 Nil Nil
Class 52 $28,000 $0
In addition, the following income effects resulted:
Taxable capital gain on Class 8 assets [(1/2)($13,000)] $ 6,500

Terminal loss on Class 43 assets (29,000)
Income from license sale [(2/3)($65,250)] 43,500
Total taxable income impact $21,000


Property Income
5.2.5 g) Explains and applies the taxation rules for calculating interest, dividend
9 9
and other property income for a given organization
Property income is passive income arising from return on invested capital. Common property
income items are:
• interest
• dividends
• rents
• royalties
It is important to note that this income is passive; that is, there is not much effort expended on
earning this income. If there is significant time and effort spent on activities to earn this income,
then the income could be considered business income.
Interest
The term interest is not defined in the income Tax Act, but has been defined by the Supreme
Court of Canada as “the return or consideration or compensation for the use of retention by one
person of a sum of money, belonging to, in a colloquial sense, or owed to, another”. There may
be instances where a sum of money could be considered interest or capital. If considered capital,
the sum is taxed according to the capital gains and losses legislation.
Due to potential disputes with respect to taxing as a capital item as opposed to a property income
item (recall capital gains are taxed at a lower rate), the government has issued various rules and
regulations governing the computation of interest income as:
• Accrual rules
Interest income reported for tax purposes for corporations, partnerships and certain trusts
must be calculated based on the accrual method (the accrual method is required by
GAAP/IFRS also).
Interest income for individuals must be accrued to the anniversary date of the contract
giving rise to the interest income, regardless of whether the interest has been received.


• Accrued interest on bonds
The price of bonds sold part way through the year often includes a component for interest.
The interest component is included in income as interest.
• Loans made at a discount and repayable at par or made at par and repayable at a premium.
The Income Tax Act requires a situation where a payment can reasonably be regarded as
having both interest and capital components, the part that can be regarded as interest is
treated as such for tax purposes.
Payments made based on use or production (e.g. rents and royalties)
Payments received due to the use of or production from property is treated as property income.
Dividend Income
Individuals
Dividends from corporations resident in Canada are treated as property income. The amount that
is subject to tax is dependent on whether the dividend is considered ‘eligible’ or ‘other than
eligible’.
Eligible dividends:
Generally, dividends received from public corporations are considered eligible dividends.
Dividends received from private corporations are only considered eligible if the private
corporation paid tax at the general tax rate. That is, the private corporation did not claim special
tax reductions such as the small business deduction.
For eligible dividends, the amount subject to tax is the grossed up amount, which is 145% (e.g.
the dividend plus (45% x the dividend) or alternatively, the dividend x 1.45. The taxpayer then
receives a dividend tax credit, which is 19% of the grossed up amount.
‘Other than eligible’ dividends:

Dividends received from private corporations who claim the small business deduction, which
means corporate tax is paid at a lower rate, are eligible for the gross up and dividend tax credit,
although the rates are lower. These dividends are considered to be ‘other than eligible’
dividends. ‘Other than eligible’ dividends are grossed up by 25% and then the taxpayer
1
received a dividend tax credit of 13 /3% o r 13.33% of the grossed up amount.
It is up to the company who is paying the dividends to determine if the dividends are considered
eligible or other than eligible.
The purpose of the dividend gross up and corresponding tax credit is integration between
corporate tax and individual tax. Integration aims to eliminate double taxation.


Corporations pay dividends out of after tax dollars. That is, the company paid tax on the income
generated to pay the dividend. Taxing this income in the individual shareholders’ hands again
would result in double taxation. To avoid this double tax, a dividend gross up and dividend tax
credit was introduced. The gross up, which is either 45% or 25% of the dividend, is intended to
result in a taxable amount that approximates the corporation’s pre-tax earnings. The dividend tax
credit is to compensate the individual for the tax that the corporation has paid.
Example:
Eligible Other than Eligible

Dividends Dividends
[PUBLIC CO’S] [CCPC’s]
Dividend $100 $100

1 1
Gross up at 45% (eligible) and 25% (other than 45 25
eligible)
Grossed up dividend $145 $125
- tax is calculated on this amount
Federal tax at assumed rate of 29% $42.05 $36.25

2 2
Less: dividend tax credit (27.55) (16.67)
calculated as:
19% of the grossed up dividend for eligible
dividends and
131/3% of the grossed up dividend for other
than eligible dividends
Federal Tax Payable $14.05 $19.58
1
Gross up intended to result in a taxable amount that approximates the corporation’s pre-tax earnings.
2
Dividend tax credit is to compensate for the tax the corporation paid on the income earned to pay the
dividend.


Property Losses
It is impossible to have property losses from interest and dividends. However, rental properties
may have losses. These losses are treated as non-capital losses, which are deductible against all
other types of income. An exception is that losses created by taking capital cost allowance on the
rental building (not furniture and fixtures) are not deductible from non-rental income. Candidates
are advised that this concept has been tested on several occasions on the Entrance Exam – the
question can be framed as a capital cost allowance question with the capital cost allowance a loss
on the rental property is created. The loss is not deductible against other sources of income.
Therefore, it’s usually in the best interest of the taxpayer to not claim CCA or to only claim
sufficient CCA to place the taxpayer in a nil taxable income position. This topic is addressed
under the CCA section of this manual.
Calculating Property Income

Property income is the sum of interest, rents, royalties and dividends after applying the gross up:
Interest XX
Rent XX
Royalties XX
Grossed up dividend XX
Net property income XX


Capital Gains and Losses
5.2.5 h) Explains and applies the taxation rules pertaining to capital gains and
losses for a given organization and discusses tax planning principles 9 9
related to capital gains and losses
Definitions
Capital gain/loss: the gain or loss that occurs on the disposition of a capital
asset (both depreciable and non-depreciable)
Proceeds of disposition (POD): the amount received for disposing of a capital asset;
includes ‘deemed’ proceeds of disposition
Adjusted cost base (ACB): the cost of a capital asset, plus or minus specified
adjustments, if applicable.
Calculation
Calculating capital gain or loss for tax purposes:
Proceeds of disposition XX
Less:
Adjusted cost base XX
Plus: expenses of disposition XX XX
Capital gain or loss XX
Prescribed fraction 1 x 1/2
Taxable capital gain or loss XX
1
The current fraction is 1/2.
Adjusted Cost Base

The main issue in the calculation is the determination of the adjusted cost base (“ACB”). The
adjusted cost base for tax purposes would include the original historic cost of the assets.
However, the original cost may be subject to the following adjustments:


1. Addition of non-deductible business expenses (i.e. non-deductible interest and property taxes
on vacant land).
2. Reduction for any grants/assistance received in purchasing the asset.
3. Superficial losses – losses denied when an asset is sold and the same or similar asset is
repurchased within 30 days.
Capital Loss Carryovers

• Net Capital Losses
Capital losses are deductible only to the extent of capital gains. Any unused allowable capital
losses (“net capital losses”) may be carried back three years and forward indefinitely against
taxable capital gains of other years. The carry forward/back is carried out in Division C and the
calculation of taxable income.
The inclusion fraction at which capital gains and losses are taxable has varied over the years and,
therefore, the taxable loss must be converted to the rate in effect in the year the capital loss is
deducted.
The inclusion rates for the various years are:

Year(s) Inclusion Rate
After October 17, 2000 1/2
February 28, 2000 – October 17, 2000 2/3
1990-February 27, 2000 3/4
1988-1989 2/3
1972-1987 1/2
For example, a capital loss of $15,000 which occurred on June 1, 2000, would be allowable at an
amount of $15,000 x 2/3 = $10,000. If this loss is carried forward to 2008 and is applied against
a gain of $40,000, the calculation would be:
Taxable capital gain

$40,000 x ½ $20,000
Application of loss carry forward
$10,000 x 3/2 x ½ 7,500
Net taxable capital gain $12,500
Note that capital losses can only be deducted against capital gains and the carryover period for
capital losses is back three years and forward indefinitely.


Business Investment Losses
Business investment losses (“BIL”) are capital losses, which are treated preferentially. Business
investment losses are multiplied by ½ to obtain the allowable business investment loss (“ABIL”).
Unlike other allowable capital losses, ABILs may be deducted against any source of income.
Unused ABILs may be carried back three years and forward 20 against any source of income.
Any ABILs unused after 20 years may be carried forward indefinitely as part of the net capital
loss carry forward and used against taxable capital gains.
Capital Gains Reserves

A capital gains reserve may be deducted where the proceeds from the sale of a capital property
are not received 100% in the current taxation year. The reserve allows the taxable capital gain to
be spread over, at most, five taxation years. The amount of taxable capital gain recognized each
year will depend on the pattern of the proceeds receipts. A cumulative minimum equal to 20%
of the taxable capital gain must be included in income each year. If the cumulative percent of
proceeds received exceeds the cumulative minimum of 20% per year, taxation will be at the
cumulative percent of proceeds received. Otherwise, the cumulative minimum of 20% inclusion
will apply. Alternatively the reserve can be extended to 10 years for certain property, if disposed
of to a child, of small business shares or farm or fishing property.
This is accomplished through application of a “lesser of” calculation to determine the annual
reserve.
Lesser of:
a) Proceeds not yet due as of taxation year-end x total taxable capital gain
Total proceeds
b) 20% x (4 – number of preceding taxation years ending after disposition) x total
taxable capital gain
Tax Planning
There is a capital gains deduction of $375,000 ($750,000 x 1/2), which can be applied against
taxable capital gains on qualifying shares of a small business corporation and certain farming
property. There are no other capital gains deductions.


Taxes Payable by Corporations – Basic Rules
5.2.5 j) Explains and applies the taxation rules pertaining to the calculation of
Part I tax for a given organization (e.g. corporate surtax, federal tax 9 9
abatement, etc.)
k) Explains and applies the small business deduction and the rules
9 9
governing associated companies for a given organization
l) Explains and applies the special incentives and credits pertaining to the
calculation of taxes payable for a corporation (e.g. manufacturing and
9 9
processing profits deduction, foreign income tax credit, investment tax
credit, SR&ED incentives, etc.)
Calculation of Corporate Tax

There are two main types of corporations in Canada:
1. Public corporations
These are companies that are resident in Canada and are traded on a stock exchange
2. Canadian Controlled Private Corporations (CCPC’s)
These are corporations that are resident in Canada, do not qualify as public corporations
and are not controlled by non-residents of Canada.
3. Private corporations
The most extensive group of corporations in Canada are not controlled by another
corporation and may be a small, medium or large corporation. For most instances, the
treatment under the CCPC rules cover most private corporations, though others, such as
McCain Foods, do not qualify. McCain, though the world’s largest French fry
manufacturer, is a privately controlled corporation.
The overall format for calculating corporate income tax is:
Calculation of corporate tax

Federal tax:
Primary federal tax (rate x taxable income) xx
Abatement for provincial tax (10%) (xx)
xx
Federal surtax (rate x federal tax after abatement) no xx
longer applied
Refundable tax on investment income (CCPCs only) xx Note 1
xx


Less:
Small business deduction (CCPCs only) xx
Special reductions (discussed below) xx
Federal tax credits xx xx
Federal tax xx
Provincial tax
Primary provincial tax (rate x taxable income) xx
Specific provincial tax credits (xx) xx
Combined federal and provincial tax xx
Note 1: There is also an additional Part IV tax that is applied on certain dividends
received by a private corporation.
The various components of the calculation of corporate tax are:

• Primary federal tax and provincial abatement
Generally, the primary tax rate is 38%, which is applied to taxable income. In order to
allow provinces to impose a tax, the federal rate of 38% is reduced by 10% as a federal
abatement for provincial taxes. This means the basic rate is 28% (38% minus 10%) for all
corporations (both CCPCs, private and public corporations). The rates of 38% and 10%
apply in 2010.
• Federal surtax
The federal surtax was eliminated effective January 1, 2008.
• Refundable Part I tax on investment income

This tax is applied only to investment income and not active business income. This tax
applies to CCPC’s only, not public companies. This tax is applied at a rate of 6 2/3% to
investment income and is fully refundable to the corporation when dividends are paid out
to shareholders.
• Small business deduction

This reduction in tax is only available to CCPCs. The SBD reduces the normal federal tax
rate by 17%, so net federal tax is reduced to 11% (38% minus 10% abatement minus 17%
SBD). The SBD is applied to the first $500,000 of active business income or to the
corporation’s taxable income, whichever is lower. Two or more companies owned by
related individuals may have to share the $500,000 (2010) limit; the sharing of the small
business deduction limit occurs if the corporations are considered associated.
Example:
A CCPC has active business income of $140,000 and taxable income of $105,000 (after
deducting a loss carry over of $15,000 and charitable donations of $5,000). The SBD for
the 2010 year is:


17% of the least of
1. net Canadian active business income $140,000
2. Taxable income earned in Canada
(calculated as total taxable income minus foreign $105,000 $105,000
source income)
3. Annual limit (2010) $500,000
SBD percentage x 17%
Maximum SBD allowed $17,850
• Special reductions
The ‘general rate reduction’ applies to both public companies and CCPCs and is applied
to specific types of income:
− public companies federal tax is reduced 10% in 2010, 11.5% and 13% each year
afterwards. These rate reductions are applied to income other than income from
manufacturing and processing (M&P) activities. M&P income has a separate
reduction, which is also 10%, applied to it.
For a public company, the rate reduction is calculated by multiplying 9% times

taxable income minus income to which the M&P deduction has been applied.
− CCPCs
Any business income above the SBD threshold of $500,000 and to which no M&P
rate reduction has been applied is entitled to a federal tax rate reduction of 9%. In
addition, for a CCPC, these reductions do not apply to tax on investment income
(for a non-CCPC this reduction does apply to investment income).
The rate reduction for CCPCs is calculated as follows:
Taxable income earned in Canada

Minus: income to which SBD is applied
Minus: income to which M&P deduction is applied
Minus: aggregate investment income (since this income will benefit from the
refundable tax provision when it is distributed by the corporation, it must be
removed from income)
Income on which the rate reduction of 9% can be applied
For the purposes of the Entrance Examination, candidates should not memorize the
formula, but remember that generally, the amount to which the rate reduction is
applied for CCPCs is ABI above the SBD threshold ($500,000 in 2010) plus
income to which M&P has not been applied. An easy way to remember this is:


ABI amount
Total ABI
Apply either the M&P deduction of
10% or rate reduction of 10%, but not
both. Do not apply 17% SBD.
$500,000
Apply SBD of 17%, do not apply
M&P of 10% and do not apply rate
reduction of 10%.
0
• Manufacturing and processing deduction (M P deduction)

The M&P deduction is applied to profits from M & P activities. This deduction provides
an incentive to establish manufacturing facilities in Canada. The application of the M&P
deduction depends on whether a company is a CCPC or a public corporation.
− public corporations can apply a deduction of 10% against profits from M&P
activities
− CCPCs can also apply the 10% deduction; however, it can only be applied against
M&P profits in excess of the $500,000 small business deduction limit. In other
words, if a CCPC’s 2010 active business income is $500,000 and the entire
$500,000 is from M&P activities, the SBD of 17% is applied; however, the
company cannot also apply the 10% M&P deduction. In addition, the M&P
deduction cannot be applied to any income to which the rate reduction of 10% is
applied.
The following formula is used to calculate the M&P deduction.
Manufacturing MC + ML
profits eligible for = TC + TL x ADJUBI
M&P
Where:
MC = Manufacturing capital, determined as the annualized cost of all depreciable
property used directly in qualified manufacturing activities. This is
calculated as:
original cost of owned annual rent for
10% x ( property
+
leased property ) x 100/85
to a maximum of TC (below)
TC = Total fixed annual capital cost related to active business income earned in
Canada. This is calculated as:
original cost of owned annual rent for
10% x ( property
+
leased property) )


ML = Cost of M&P labour. This is calculated as:
Actual M&P
x 100/75
labour costs
to a maximum of TL (below)
TL = Total labour costs related to income earned in Canada
ADJUBI = Adjusted business income, which is active business income earned in

Canada, other than resource profits.
Note that this formula basically defines M&P profits in terms of capital employed in M&P
and labour costs.
Understanding the M&P deduction is important because it can impact how a business is
structured. For example, assume the following two situations:
Situation 1 Situation 2
Shareholders Shareholders
Corporation A Corporation A
Activity: Profit Activity: Profit
Retail $1,000,000 Retail $1,000,000
Mftg&Processing 100,000
$1,100,000
Corporation B
Activity Profit
Mftg&Processing $100,000
Under Situation 1, the maximum profit eligible for the 10% M&P deduction is $100,000,
since manufacturing is only carried on in Corporation B. Under Situation 2, the total profit
of $1,100,000 has an arbitrary formula applied to it. Assuming that the formula results in
30% of the profits being considered M&P, the M&P profits eligible for the 10% deduction
would be:
MC + ML
= 30% x $1,100,000 = $330,000
TC + TL
As this example illustrates, tax implications can influence how a corporation is structured.


• Provincial tax
Provincial corporate tax percentages are applied to corporate taxable income. These rates
vary from province to province. In addition, some provinces provide a deduction for the
first $500,000 (2010) of active business income of CCPCs and some provinces reduce the
tax rate for manufacturing profits. Since the Entrance Exam is a national exam,
candidates are not responsible for calculating provincial taxes.
A corporation operating in only one province will pay only that province’s provincial taxes.
However, when a corporation has a permanent establishment (i.e. an office, branch, warehouse
or factory) in another province, a proportion of the corporation’s profits are taxed in that
province. If a permanent establishment in another province exists, the proportion of taxable
income attributable to that province and, therefore, subject to that province’s tax, is determined
by considering both wages paid and gross revenue earned in that province. The formula is best
illustrated using an example:
Gross Revenue Salaries and Wages

Amount Percent Amount Percent Average %
Ontario 800,000 13.8% 130,000 10.3% ½ (13.8 + 10.3) = 12.05%
Alberta 3,200,000 55.2% 710,000 56.3% ½ (55.2 + 56.3) = 55.75%
Quebec 1,600,000 27.6% 360,000 28.6% ½ (27.6 + 28.6) = 28.1%
5,600,000 96.6% 1,200,000 95.2% ½ (96.6 + 95.2) = 95.9%
US 200,000 3.4% 60,000 4.8%
Total 5,800,000 100.0% 1,260,000 100.0%
Assuming the company’s total taxable income is $1,044,000, the portion attributable to each
province and, therefore, subject to that province’s provincial tax rate and/or provincial
incentives, if any, are:
Taxable income
of $1,044,000
Ontario 12.05% x 1,044,000 = 125,802
Alberta 55.75% x 1,044,000 = 582,030
Quebec 28.10% x 1,044,000 = 293,364
Although candidates are not responsible for calculating taxable income attributable to each
province, candidates should be able to explain the consequences of having a permanent
establishment(s) in different provinces.


Combined Federal and Provincial Tax
When considering the tax impact of transactions, it is useful to consider the combined federal
and provincial rate, depending on the type of corporation (CCPC vs. non-CCPC).
The rates for 2010 for CCPCs are:
CCPCs
1st 500,000 ABI > ABI > Invest.
of ABI 500,000, no 500,000, income
M&P w/ M&P
deduction deduction
Primary federal rate 38.00 38.00 38.00 38.00

Abatement for provincial tax (10.00) (10.00) (10.00) (10.00)
28.00 28.00 28.00 28.00
Surtax (eliminated effective 2008) 0 0 0 0
28.00 28.00 28.00 28.00
2+4 1+2
Rate reduction - (10.00) - -
1+4 1+2+
M&P deduction - - ( 10.00) -
4
1+4
SBD (17.00) - - -
11.00 18.00 18.00 28.00
3
Refundable Part I tax on invest. income - - - 6.67
11.00 18.00 18.00 34.67
Provincial taxes (assumed prov’l rates) 5.50 14.00 14.00 15.50
16.50 32.00 32.00 50.17
1. ABI that is eligible for the SBD is not eligible for the M&P deduction (i.e. cannot apply both the 17% (SBD) and the 10% (M&P deduction)
to the same income)
2. The rate reduction cannot be applied to income that has the SBD or M&P deduction applied to it.
3. This is the refundable Part I tax (6 2/3%), commonly referred to as ‘ART’, on investment income that CCPC’s pay. When dividends are paid
out to shareholders, this tax is refunded.
4. If a CCPC is part of an associated group of companies, the SBD and the rate reduction must be shared by all corporations in the group.
The rates for 2010 for non-CCPCs (e.g. public companies) are:
Non-CCPC’s
ABI from M&P ABI w/no Invest.
activities (i.e. w/ M&P income
M&P deduction) deduction
Primary federal rate 38.00 38.00 38.00

Abatement for provincial tax (10.00) (10.00) (10.00)
28.00 28.00 28.00
Surtax (eliminated effective 2008) 0 0 0
28.00 28.00 28.00
1 1 2
Rate reduction - (10.00) ( 10.00)
1 1
M&P deduction ( 10.00) - -
18.00 18.00 18.00
Provincial taxes (assumed prov’l rates) 14.00 14.00 14.00
32.00 32.00 32.00
1. The rate reduction cannot be applied to income that has the M&P deduction applied to it.
2. Note that non-CCPCs can apply the rate reduction of 10% to investment income, while a CCPC cannot. This is because CCPCs enjoy
refundable tax privileges on taxes paid on investment income. This reduction applies to non-CCPCs only and is applied to investment
income, other than capital gains and dividends received from Canadian corporations. The rate reduction that applies to capital gains is ½ of
this rate, which is consistent with the tax rules for capital gains. Since dividends received from Canadian corporations are deductible when
computing Part I tax, the rate reduction is not applied to these dividends. Note that although these dividends are not subject to Part I tax, they
may be subject to Part IV tax.
As discussed earlier, the rate reduction of 10% is applied to investment income for non-CCPCs; however, it is not applied to CCPCs (since
CCPC’s receive a refundable tax on investment income that is not available to public companies.)


CCPCs – Small Business Deductions and
Associated Companies
k) Explains and applies the small business deduction and the rules
9 9
governing associated companies for a given organization
Canadian Controlled Private Corporation (CCPC)

A CCPC is eligible for various tax incentives that are not available to non-CCPCs (e.g. public
companies). The most significant tax advantage is the small business deduction and tax rate
reduction, which were addressed in the previous section, but will be revisited.
A CCPC is defined as a corporation that is:

• private
• not controlled by a public corporation
• not controlled by a non-resident of Canada
Small Business Deduction (SBD)

Although the small business deduction was addressed in the ‘Taxes Payable by Corporations’
section of this manual, it is revisited in the context of the associated company rules.
As mentioned above, the small business deduction is an incentive available to CCPCs only.
The small business deduction is a credit against tax otherwise payable on active business income.
Passive business income, such as interest and rents, are not eligible for the small business
deduction.
The small business deduction is calculated as:

17% of the least of
1.Nnet Canadian active business income xx
2. Taxable income earned in Canada xx xx
(calculated as total taxable income minus foreign source income)
3. Annual limit of $500,000 xx
SBD percentage x 17%

Maximum SBD allowed xx


The annual threshold for the SBD in 2010 is $500,000. The limit was increased to $500,000
effective January 1, 2009 (the previous threshold was $400,000).
The annual limit means any active business income exceeding the threshold of $500,000 is not
eligible for the SBD.
The impact of the SBD on a CCPCs tax rate can be found by reviewing the tax rate charts in the
previous section.
It is important to note that the SBD is only applied against Canadian active business income
(ABI). Generally, this means income from Canadian operations and excludes investments and
property income. However, technically the ITA (ITA 125 (7)(a); ITA (129)(6) and IT-73R5) has
specifically defined ABI as:
“any business carried on by the corporation other than a specified investment

business or a personal services business and includes an adventure or concern in
the nature of trade”
Which means, any income from a specified investment, business or a personal services business,
is excluded from the definition of ABI and, therefore, the SBD cannot be applied to income from
either of these sources. These two terms have been defined in the ITA as:
• Specified investment business

- a business of which the principal purpose is to derive income from property
(interest, dividends, rents and royalties) unless the corporation employs
throughout the year more than five full time employees
Because these items (interest, dividends, rent and royalties) are classified as
specified investment business income, they are automatically disqualified from
the SBD. In addition, this income is not eligible for the 8.5% rate reduction.
There are two exceptions to the specified investment business rules, which are:
1. if a corporation has >five employees, it is not considered a specified
investment business and, therefore, its income is considered ABI and is
eligible for the SBD.
2. the business of leasing movable property (such as vehicles), but not real
property, is considered to be an active business and, therefore, income earned
in these types of businesses is eligible for the SBD.


• Personal services business
1. a business of providing services where:
(i) an individual who performs services on behalf of the corporation
or
(ii) any person related to the incorporated employee
is a specified shareholder (owns 10% or more of the shares of the corporation)

and
2. the incorporated employee would reasonably be regarded as an officer or
employee of the organization to which services are provided
3. unless
(iii) the corporation employs more than five full time employees
or
(iv) services are provided to an associated corporation
Generally, the personal services business rules ensure that an employed

individual cannot take advantage of the SBD by establishing a corporation and
having their earnings (‘salary’) paid to the corporation, in which case it would
be considered business income. In addition to these rules, a personal services
business corporation is not allowed any deductions from the personal services
business income of the corporation, other than salary, wages and other
benefits paid to the individual carrying out the work of the personal services
business. In addition, the corporation may only deduct amounts that would
have been deductible by an employee as costs incurred in selling
property/negotiating contracts. In essence, the personal services business
rules ensure there is not an advantage to an employee of setting up a
corporation and instead of being paid a salary, have their earnings paid to the
corporation.


Associated Companies
When two or more CCPCs are associated for tax purposes, the business limit for the small
business deduction must be shared among the associated corporations. In addition, the rate
reduction must be shared by associated corporations.
The definition of associated corporations depends on the definition of “related persons”.

Individuals are considered related to each other if they are direct-line descendants (e.g.
grandparents, parents, children, grandchildren, etc.) or if they are brothers, sisters, spouses or in-
laws. Excluded from the definition are cousins, aunts, uncles, nieces and nephews. The
definition of related individuals can be depicted as:
Related Individuals:
Parents and Grandparents-in-law Parents and Grandparents
Spouse Siblings
YOU
• Siblings of your spouse (e.g. in-laws) • Spouses of your
siblings (e.g. in-laws)
• Spouses of the siblings of your • Siblings of spouses
spouse (example 1 below) (example 2 below)
Children-in-law Children including:

• Adopted
• Born outside marriage
• Wholly dependent, under custody
and control
• Children of spouse
Descendents
Also for the purposes of the associated company rules, a person is deemed to be related to
her/him.


Basic Association Rules
Conceptually, two companies are associated when one company controls the other or both
companies are controlled by the same person or group of persons. However, there are specific
conditions that must be met for two or more companies to be considered associated. Note that all
of the conditions must be met to be considered associated. There are three main categories of
associated company rules:
1. Single controlling shareholder of each corporation.
In these situations, the conditions in ITA paragraph 256(1)(c) apply:
i. each of the corporations must be controlled, directly or indirectly in any manner

whatsoever, by a person (which includes an individual or another corporation)
(hereinafter referred to as the “control test”);
ii. the person who controls one of the corporations must be related to the person who
controls the other corporation (hereinafter referred to as the “related test”); and
iii. either of the two persons owns not less than 25% of the issued shares of any class,
other than a specified class (as defined below), of the capital stock of each
corporation (hereinafter referred to as the “cross-ownership test”)
Shares of a “specified class” are excluded from the cross-ownership conditions in subsection
256(1). The term “specified class” is defined [subsection 256(1.1)] to mean a class of shares
where:
a) the shares are neither convertible nor exchangeable;

b) the shares are non-voting;
c) dividends payable on the shares are fixed in amount or rate;
d) the annual rate of dividend on the shares, expressed as a percentage of the fair
market value of the consideration for which the shares were issued, does not
exceed the prescribed rate of interest at the time the shares were issued; and
e) the amount a holder of the shares is entitled to received on their redemption,
cancellation or acquisition by the corporation (or by a person not at arm’s length
with the corporation) cannot exceed the fair market value of the consideration for
which the shares were issued (usually, their paid-up capital) plus any unpaid
dividends.


This category can be illustrated as:
Two corporations each controlled by a single person who are related to each other and either
person holds 25% of the voting common shares of the other corporation.
Bob Bill
25%
100% 75%
BOB Co. BILL Co.
Bob and Bill are brothers and Bob owns 25% of BILL Co.; therefore, BOB Co. and BILL Co.
are associated.
2. Single controlling shareholder of one corporation and a group of controlling shareholders of

the other corporation.
In these situations, the conditions in ITA paragraph 256(1)(d) apply:
i. one of the corporations must be controlled, directly or indirectly in any manner

whatsoever, by one person; (control test)
ii. that person must be related to each member of a group of persons (not necessarily
a related group) that controls the other corporation; and (related test)
iii. that person must own not less than 25% of the issued shares of any class, other
than specified shares, of the capital stock of the other corporation (cross-
ownership test)
This category can be depicted as:
One corporation is controlled by a single person and the other corporation is controlled by a
group of persons. The single person is related to each person in the group and the single person
holds 25% of the voting common shares of the corporation.
Tom Dick Harry

John
100% 25% 25% 25% 25%
John Co. Group Co.


John is related to Tom, Dick and Harry and John owns 25% of Group Co.; therefore, John Co.
and Group Co. are associated.
3. Two group controlled corporations.

In these situations the conditions in ITA paragraph 256(1)(e) apply:
i. each of the corporations must be controlled, directly or indirectly in any manner

whatsoever, by a related group; (control test)
ii. each member of one of the related groups must be related to all of the members of
the other related group; and (related test)
iii. one or more members of both related groups must own, either alone or together,
not less than 25% of the issued shares of any class, other than a specified class, of
shares of the capital stock of the other corporation. (cross-ownership test)
This category can be depicted as:
Two group-controlled corporations whereby each member of one group must be related to all
members of the other group with one or more members alone or together own 25% of the
voting common shares of the corporation.
Sara Susan Samantha Larry Mo. Curley

12.5%
30% 35% 35% 22.5% 22.5% 30%
12.5%
GROUP CO. ONE GROUP CO. TWO
Sara, Susan and Samantha are related to Larry, Mo and Curley and Susan and Samantha own
25% of Group Co. Two, therefore, GROUP CO. ONE and GROUP CO. TWO are associated.
• Association with a third corporation

Where two corporations that would not otherwise be associated are both associated with a
third corporation, the ITA [256(2)] deems the two corporations to be associated with each
other. There is an exception to this deeming provision but the exception only applies for the
purposes of the SBD. If the third corporation is not a CCPC or if the third corporation elects
not to be associated with either of the other two corporations, then the third corporation
deeming rules do not apply. However, if the third corporation elects not to be associated
with the other two corporations, then the third corporation’s business limit for the purposes
of the SBD is deemed to be nil.


Example:
H and W are married and each has their own incorporated CCPC. H and W also set up a
management company to manage the administration of each business. The ownership
structure is as follows:
H W
100% c/shares 50% c/shares 50% c/shares 100% c/shares
Husband Inc. Mgmt Co. Wife Inc.
Husband Inc. and Mgmt Co. are associated due to the following:
• H controls Husband Inc. (due to 100% common share holdings) [control test]
• H and W (a related group) control Mgmt Co.. and H is related to each member of the
related group (recall that for the purposes of the associated company rules, an individual
is deemed to be related to him/herself) [related test]
• H owns 25% of the voting common shares of Mgmt Co. [cross ownership test]
Wife Inc. and Mgmt Co. are associated in the same manner as Husband Inc. and Mgmt Co..
Under the ‘association with a third company’ rules, Husband Inc. and Wife Inc. are deemed
to be associated.
However, under the exceptions, Mgmt Co.. can elect not to be associated with Husband Inc.
and Wife Inc. for the purposes of the SBD. If Mgmt Co.. files this election, its business
limit for the purposes of the SBD is deemed to be nil.
• deemed association
There is a deemed association rule where one of the main reasons for the separate existence
of two corporations is tax considerations. However, if a taxpayer can show a valid, non-tax
reason for the separate existence of a corporation, the deemed association rule does not
apply.


Special Incentives and Credits
5.2.5 m) Explains and demonstrates the integration of the corporate and personal
tax systems for business and investment income, including the effects of 9 9
the dividend gross up and dividend tax credit
Manufacturing and Processing Profits Deduction

This topic was covered extensively in the ‘Taxes Payable by Corporations’ section in this manual.
Candidates are advised to refer to that section for coverage of this topic.
Foreign Income Tax Credit (ITC)

Because Canadian residents are taxed on their worldwide income, Canada will levy tax on
foreign income, which may have already been taxed by the foreign country. Canada will allow a
taxpayer to claim a foreign tax credit for tax paid to another country, provided it does not exceed
the equivalent amount of Canadian tax paid on the income. As a result, if the foreign country tax
rate exceeds the Canadian tax rate, Canada will allow a credit equivalent to the Canadian tax
rate. The excess foreign tax cannot be claimed as a credit for Canadian tax purposes.
Federal Political Tax Credit

Political contributions are not deductible in computing income for tax purposes; however, a tax
credit against taxes payable is available. The credit is available to corporations in respect of
contributions made to federal political parties or candidates.
In 2008 the credit is:

a) 75% of the first $400 contributed
b) 50% of the next $350 contributed
1
c) 33 /3% of the next $525 contributed
The maximum credit is therefore $650 on contributions of $1,275 ($400 + $350 + $525). Any
contributions greater than $1,275 do not receive a credit and cannot be carried forward to another
year.
This credit is only available to individuals and is not available to corporations.


Investment Tax Credit
The investment tax credit (“ITC”) program is designed to stimulate investment in certain sectors
and areas of the country. In the event a corporation does not have tax payable, ITCs may be
carried back three years and forward 20 years. Currently, the following investment tax credit
programs are available in Canada:
Scientific Research and Experimental Development (SR&ED)

A tax credit of 20% of the amount expended on SR&ED (current expenses and new capital) is
available. Note that any tax credit received becomes income of the corporation in the year of
receipt.
For a CCPC with taxable income of $500,000 or less in the preceding tax year, the following
additional incentives are available
- an additional 15% ITC is available on the first $3 million of SR&ED

- 40% of the 20% ITC is refundable if the corporation did not have sufficient tax payable
to utilize the credit, and
- 100% of the 35% ITC on current expenditures is refundable if the corporation did not
have sufficient tax payable to utilize the credit.
Qualified Property
A tax credit of 10% of new capital asset purchases in the Atlantic Provinces and Gaspe is
available provided the assets are for use in manufacturing and processing, operating an oil or gas
well, extracting minerals, logging, farming or fishing.
Apprenticeship Job Creation Tax Credit

A tax credit of 10% of salaries and wages of eligible apprentices is available (max $2,000 per
apprentice per year for two years.)
Child Care Spaces Tax Credit

A tax credit of 25% of expenditures to create new licensed child care spaces is available (max
$10,000 per space)


Integration, Refundable Taxes and RDTOH
5.2.5 n) Explains and applies the taxation rules pertaining to special refundable
taxes (e.g. refundable portion of Part 1 tax, refundable dividend on hand, 9 9
dividend refund, refundable investment tax credit, etc.)
o) Explains and applies the taxation rules pertaining to the calculation of
total taxes payable for a given organization (e.g. Parts I, I.3, IV and IV.1 9 9
taxes, federal and provincial taxes, etc.)
Objective of Integration
‘Integration’ is an attempt by the tax system to recognize whether income is earned by a
shareholder through dividends or earned directly by the shareholder, the amount of tax paid on
the income should be the same. If integration did not exist, the following would occur:
Corporation:
Taxable income earned by the corporation $1,000
Income tax paid by the corporation at an assumed combined federal and
provincial rate of 38% 380
Remainder, assume it was paid out as a dividend to the shareholder $ 620
Shareholder:
Taxable income $ 620
Income tax paid by the corporation at an assumed rate of 34% 211
$ 409
Total tax paid on earnings of $1,000 (380 + 211) $ 591
Compare the total tax paid of $591 to the amount that would have been paid had the shareholder
earned the $1,000 directly, which is $340 ($1,000 × 34%). Without integration mechanisms, it is
obviously more beneficial to earn income directly as opposed to through a corporation.


The government has implemented several tools to address this inequity. The availability of these
mechanisms depend on whether the company is a public company or a CCPC. These tools are:
• Public companies:
⎯ dividend gross up and dividend tax credit
• CCPCs:
⎯ dividend gross up and dividend tax credit
⎯ Part IV refundable tax on portfolio dividends from a connected corporation
⎯ refundable 6 2/3 tax on investment income
⎯ refundable portion of Part I tax, which is 20% of Canadian source investment
income
Dividend Gross Up and Tax Credit

The dividend gross up is designed to increase the dividend received by the shareholder by the
total income tax paid by the corporation, such that the total grossed up dividend represents the
corporations’ pre-tax income. The dividend tax credit is meant to give the shareholder credit for
the total tax paid by the corporation. The amount of the gross up and dividend tax credit is
dependent on whether the corporation is a public corporation. Dividends from a public
corporation are grossed up 44% and the dividend tax credit is 18% of the grossed up dividend,
while dividends paid from a CCPC are grossed up 25% and the dividend tax credit is 13 1/3 % of
the grossed up dividend.
Corporations pay dividends out of after tax dollars. That is, the company has paid tax on the
income generated to pay the dividend. Taxing this income in the individual shareholders’ hands
again would result in double taxation. To avoid this double tax, a dividend gross up and dividend
tax credit was introduced. The gross up, which is either 44% or 25% of the dividend, is intended
to result in a taxable amount that approximates the corporation’s pre-tax earnings. The dividend
tax credit is to compensate the individual for the tax that the corporation has paid.
Summary of dividend gross up and tax credit:

Public Company CCPC
Eligible dividends Other than eligible
dividends
Gross up 44% 25%
Dividend tax credit 18% of the grossed 13 1/3% of the grossed

up dividend up dividend


Comparison of taxes on $1,000 without dividend tax credit, with dividend tax credit and earned
personally:
Income earned in a corporation
No With With Income
DTC & DTC & DTC & earned
a public co. a public co. a CCPC personally
Taxable income $1,000 $1,000 $1,000 $1,000
Corporate taxes (@ 38% for public co. and 21% for CCPC) Note 1 A 380 380 210 N/A
Cash available for dividends paid out as dividends 620 620 790 1,000
Gross Up at 44% for public and 25% for CCPC – 273 196 N/A
Taxable income for individual 620 893 986 1,000
Taxes at assumed rate of 34% B 211 304 335 340
Dividend tax credit @ 18% for public co. and 13 1/3% for CCPC C – (161) (131) –
Total individual taxes 211 143 204 340
Summary:
Income 1,000 1,000 1,000 1,000
Taxes – corporate 380 380 210 –
– personal 211 143 204 340
Total taxes 591 523 414 340
Net cash to individual 409 477 586 660
Note 1: Tax rate of 21% for the CCPC assumes the CCPC only earns active business income
(ABI) and all of the ABI is eligible for the SBD of 17 % (38% general rate minus 17% SBD =
21%).
Note that in this example, even with the dividend tax credit, full integration is not achieved. It is
only for CCPCs and the use of three other integration tools limited to CCPCs, Part IV tax on
portfolio and connected corporation dividends, refundable tax on investment income and the
refundable portion of Part I tax, that integration is better achieved. Remember, integration refers
to ensuring the combined corporate and personal tax on income earned through a corporation is
equal to the tax that would have been paid if the income had been earned directly by the
individual taxpayer. There should be no advantage to earning business income through a
corporation as opposed to earning it directly. Although the Canadian tax system is one of the few
in the world, which attempts to achieve integration, varying tax rates at both corporate and
individual level make it difficult to achieve perfect integration.


CCPC’S and Integration
This chart contains the essentials of the integration tools for a CCPC. Each of the elements are
discussed below.
Portfolio dividend income Investment

and dividends from Income
connected corporations
Included in Taxable Income
Pay Part I tax
Part IV tax
Additional Refundable portion
33 1/3 % of portfolio refundable tax of Part I tax
dividends and income
dividends received from 6 2/3% of 20% of Canadian
a connected co. investment income investment income not to
(payer co. received exceed Part I taxes
a refund)
RDTOH
1. opening balance
2. less prior year’s dividend refund
3. add: refundable Part I tax
4. add: 6 2/3% refundable tax
5. add: Part IV tax
6. closing balance
Corporation qualifies for

a dividend refund
Dividends paid Dividend refund

to shareholders equal to the lesser of:
a) 33 1/3 % of dividend paid out

b) RDTOH balance at the end of the year
Individual dividend
Gross up
and dividend credit
mechanism


Portfolio Dividends and Dividends from Connected Corporations
A tax, called the part IV tax on dividend income, must be paid by a corporation. When the
corporation pays a dividend to its shareholder(s), this tax is completely refunded.
Recall that for corporations, dividends received from other corporations is completely tax-free.
When calculating the corporations’ taxable income, they are excluded. This Part IV tax exists to
prevent individuals from incorporating and placing their investments in the corporation so the
dividends are tax-free. Therefore, this tax is paid when the corporation receives the dividend and
when a dividend is paid to the shareholder, the tax that was paid is refunded.
This tax is calculated as the sum of:

A. Canadian Source Dividends
1. 33 1/3% × dividends received from unconnected corporations
2. Dividend refund the paying corporation, which is a connected (defined below)
corporation, receives that is attributable to paying dividends to the receiving corporation
B. Foreign Source Dividends
1. 33 1/3% × dividends received from unconnected corporations, provided the dividend is
excluded from taxable income (i.e. by virtue of s113)
2. For connected foreign corporations, no Part IV tax is payable. This is because the foreign
corporation will not receive a dividend refund, as it is a foreign corporation and is not
subject to this aspect of Canadian tax law.
Connected corporations are corporations that are either

1. controlled by the dividend receiving corporation
OR
2. the dividend receiving corporation owns more than 10% of the voting shares of the
dividend paying corporation and the shares represent more than 10% of the fair market
value of all issued shares.
Investment Income – Refundable Portion of Part I Tax

Recall that investment income is not eligible for any of the special deductions such as the SBD
or the 8.5% rate reduction. This means at the federal level, investment income is taxed at the
highest rate of 28%. This refundable tax refunds 20%, which reduces the tax on investment
income to 8% (28% - 20% = 8%).
Investment income includes all income from property, both Canadian and foreign. Income from
property includes: rents, taxable capital gains (net of capital losses) and interest. It excludes
taxable dividends because these dividends are subject to Part IV tax.

Page 78

Investment Income – Additional Refundable Tax of 6 2/3%
This is another refundable tax on investment income. It was also created to prevent high income
individuals from incorporating and placing their investments in a corporation to pay less tax. The
tax is 6 2/3% of investment income. Without this tax, the combined federal and provincial
corporate tax rate is less than the highest marginal personal tax rate. This tax increases the
investment income tax so it is almost equal to the highest marginal tax rate.
The actual calculation is:

6 2/3% x lesser of:
1. Aggregate investment income
[defined as: net taxable capital gains – net taxable capital losses + interest + rent + royalties
+ dividends (all dividends) minus dividends deducted in calculating taxable income –
property losses
2. Taxable income minus the amount on which the SBD is computed
Refundable Dividend Tax on Hand (RDTOH) Account

Each of these three refundable taxes accumulate in an account called the RDTOH. When a
dividend is paid to the shareholder, the corporation receives a refund of the taxes paid at a rate of
$1 refund for every $3 paid out in dividends, to a maximum of the RDTOH balance.
The balance in the RDTOH account is calculated as:

Opening balance
- prior year’s dividend refund
+ refundable Part I tax of 20%
+ additional refundable tax on investment income of 62/3%
+ Part IV tax
Closing balance
Dividend Tax Credit

When the individual shareholder (person) receives the dividend, the shareholder is subject to the
dividend gross up and dividend tax credit, which is described earlier in this section.


Example:
Basic Data:
Moret Incorporated (“Moret”) had the following taxable income items, in Canadian dollars, for
the current year:
Taxable capital gains, excluding losses $75,000

Net capital losses 12,000
Interest income 30,000
Dividend income – portfolio investments
Received June 1 16,500
Received December 1 16,800
Dividend income – connected CCPC corporation (Note 1) 42,000
Dividend income – connected corporation located in US 37,500
Moret paid a dividend of $60,000 to its sole shareholder, Mr. Moretson, on December 3 of the
current year. Last year, Moret paid Mr. Moretson a dividend of $15,000.
Moret’s RDTOH balance at the end of last year was $186,000.
Note 1: Total dividends paid by the connected corporation were $210,000 and the total dividend
refund received by the connected corporation is $70,000.
Required:
Calculate the RDTOH balance at the end of the current year.


Solution:
RDTOH
balance
Beginning balance $186,000

Refund on prior year’s dividend:
$15,000 dividend, refund 15,000 × 1/3 (5,000)
$181,000
Current year’s additions

Connected Portfolio Investment Investment
Corporation Dividend Income Income
Dividend Income (20%) (6 2/3%)
Income (33 1/3%)
Taxable capital gains 75,000 75,000

Net capital losses (12,000) (12,000)
Interest income 30,000 30,000
93,000 93,000
× 20% × 6 2/3%
18,600 6,200 24,800
Portfolio dividends 16,500
Portfolio dividends 16,800
Dividends–Canadian. connected
companies
Tax: 14,000
42,000
70,000 x
210,000
Dividends – US connected --
companies – NO PART IV ON
THESE DIVIDENDS
33,300
× 33 1/3%
11,100 11,100
14,000 14,000
RDTOH ending balance 230,900


Financial Management – Tax Problems
FMT1 Problem: Business Income - Bat Company
Bat Co. provides you the following accounting information for its June 30, 2010 taxation year.
Revenues $3,000,000
Direct expenses (1,770,000)
Gross margin $1,230,000
Depreciation expense 850,000

Club dues 20,000
Meals and entertainment 60,000 (930,000)
Write-down of investments (500,000)
Net loss for accounting purposes ($200,000)
Additional information:
• Capital cost allowance (i.e. depreciation for tax purposes) is $800,000 for the year.
• Management decided to write-down the value of investments in subsidiaries. There was no
actual disposition of the investments.
Required:
Compute net income for tax purposes.


FMT2 Problem: CCA - Tofu Inc.
Tofu Inc. purchased a building in 2008 for $100,000. Tofu Inc. intended to use the building to
house one of its divisions. In 2010, the building is sold for $100,000 after Tofu Inc. decided to
discontinue the division. Tofu Inc. did not own any other buildings. Maximum CCA was
claimed each year.
The CCA rate is 4% per year.
Required:
Determine the impact of the disposition to Tofu Inc.

FMT3 Problem: CEC - Sprout Corporation
Sprout Corp. purchased in 2008 an existing business and acquires, among other assets, a
customer list for $20,000 and goodwill for $60,000. In 2010, the business is sold. Sprout Corp.
receives $40,000 for the customer list and $100,000 for the goodwill.
Required:
Track the Cumulative Eligible Capital Account (CEC) for the relevant years.


FMT4 Problem: CCA - Blake Incorporated
Blake Inc. leased office space for business use in 2003. The terms of the lease include a five
year initial term with two options for renewal of 2 years each. The annual rental charge for the
lease is $120,000 including parking. During 2004, Blake undertook significant improvements to
the leased office space, incurring costs of $80,000. Further improvements were made in 2005 at
a cost of $20,000.
Required:
a. Calculate the amount of CCA that Blake may claim in relation to the leasehold for 2005.
b. Blake anticipates further improvements in 2006 in the amount of $10,000 and wishes to
know the amount of CCA, which would be deductible in 2006.
FMT5 Problem: CEC - Greenwood Limited

On January 1, 2003, Greenwood Limited purchases another business. The purchase price
includes $100,000 with respect to goodwill. On January 1, 2003, the balance in the cumulative
eligible capital (CEC) account is nil. There are no further additions to the CEC account during
2004 or 2005. On February 1, 2005, Greenwood sells the business acquired in 2003 for
$550,000, including $250,000 in respect of goodwill.
Required:
a. Calculate the maximum deduction for CEC in each of the years and the income impact of
the sale in 2005.
b. Reconsider the facts outlined above. Calculate the income impact of the sale in 2006 if
the business acquired in 2003 is sold for $300,000 including an amount of $80,000 in
respect of goodwill.
c. How would your answer change if the business acquired was purchased on March 1,
2003 instead of January 1, 2003?


FMT6 Problem: CCA - Ranger Inc.
Ranger Inc., a Canadian public company with a December 31 year-end, has the following
balances in the CCA classes for its assets at January 1, 2005.
Class 1 (4%) – building $1,150,000

Class 43 (30%) – manufacturing equipment 217,000
Class 8 (20%) – office furniture and equipment 155,000
Class 10 (30%) – delivery trucks 67,000
During the year, Ranger Inc. decided to significantly alter its business model. As a result, the
following occurred:
1. Ranger Inc. sold its building and entered into a lease for a new office building. The
building, which originally cost $1,300,000, was sold for $1,400,000.

2. All manufacturing would be subcontracted. Accordingly, the manufacturing equipment
was sold for $180,000. The equipment was originally purchased for $250,000.
3. Additional office furniture was purchased at a cost of $27,000. In addition, office

furniture was sold for $35,000 (original cost $22,000).
4. Ranger Inc. sold one of its trucks for $20,000 (original cost $25,000) and purchased a
used truck for $8,000.
Required:
Calculate the maximum CCA claim for 2005. Identify any other tax issues arising from the
above transactions.


FMT7 Problem: CCA and Rental Income - Beta Corporation
Beta Corp. purchased two rental properties in 2006. Building X cost $40,000; building Y cost
$200,000. The buildings earned the following income or loss during fiscal 2006.
Building Building Total

X Y
Gross rental revenue $35,000 $88,000
Less: expenses (excluding CCA) (50,000) (70,000)
Income (loss) before CCA ($15,000) $18,000 $3,000
Both buildings qualify as Class 1 properties with a maximum CCA rate of 4%. Because building
Y has an original cost greater than $50,000, it must be placed in a separate CCA Class 1. Any
additions to Class 1 less than $50,000 would be pooled with the class containing building X.
The CCA rate is 4%.
Required:
Compute the maximum capital cost allowance that can be claimed for Beta Corp. in fiscal 2006.
FMT8 Problem: Capital Gains - Magma Corporation

In 2010, Magma Corp. disposed of two investments. Stock A was sold for $500,000 and cost
$345,000. Stock B was purchased for $195,000 and was sold for $150,000. The investments
were held as capital property. Magma Corp. paid $5,000 to a broker to dispose of each
investment.
Required:
Calculate the capital gain or loss for 2010.


FMT9 Problem: Taxable Income - Jermat Ltd.
Jermat Ltd. (“Jermat”) is a Canadian Controlled Private Corporation carrying on business in Canada.
Jermat is 100% owned and operated by Mr. Jermat. Jermat’s income statement for the year ended
December 31, 2009 is:
Jermat Ltd.
Income Statement
For the Year Ended December 31, 2009
Sales $3,000,000
Cost of goods sold 800,000
Gross profit 2,200,000
Salaries 350,000
Amortization 200,000
Other selling and administrative expenses 650,000

Operating income 1,000,000
Other income and expenses 56,000
Income before income taxes $944,000
The following additional information is available:
1. Salaries expense includes $50,000 for management bonuses. The bonus will be paid in
two equal instalments on January 15 and June 15, 2010.
2. “Other Selling and administrative expenses” include:

a. $12,100 paid for damages for breach of contract.
b. $10,200 related to landscaping the administrative office premises. The expected life
of the landscaping is 12 years.
c. $9,500 with regards to the theft by one of the employees.
d. $12,000 in respect of the president’s golf club membership. The president uses the
facility to entertain prospective clients. $4,000 of the $12,000 was for meals in the
club dining room.
e. $3,000 for baseball tickets to entertain clients.
f. $4,000 in respect of bond premium amortization.
g. appraisal fees on assets for sale in the amount of $2,500.
h. registered charitable contributions of $38,000, federal political donations of $3,000
and provincial political donations of $2,000.
i. premiums for the life insurance of the president’s wife $3,500.
j. $15,000 for property taxes on a parcel of land held for expansion. The expansion is
expected to commence in 2012.


3. The company provides a warranty on its products. The warranty liability was $28,000 on
January 1, 2009 and $37,000 on December 31, 2009.
4. The president traveled extensively during the year for sales purposes. Reimbursed
expenses amounted to $35,000 for travel, including $10,000 for meals and $10,000 for
accommodation.
5. The president paid his 16-year-old daughter $12,000 during the year for assistance in the
filing department. The full amount was deducted for accounting purposes.
6. The company issued new common shares during the year and incurred $20,000 for legal
and accounting fees. The fees were included in the amount charged to common shares.
7. "Other income and expenses" includes:
a. A gain of $100,000 on the sale of shares of a long-term investment. Jermat paid $20,000
for the shares in 1996 and sold them for $120,000 in 2009. Jermat received a down
payment of $30,000 on the sale. The remainder of the proceeds is due in $18,000
instalments on January 31, each year, commencing January 31, 2010.
b. Dividends received from taxable Canadian corporations

in which Jermat owns less than 5% of the issued shares $12,000
Dividends received from taxable Canadian corporations

in which Jermat owns 25% of issued shares $43,000
c. Sale of certain capital property:
Book
Cost Proceeds
Value
Marketable securities $10,500 $7,000 $10,500
Equipment — Class 43 42,000 11,200 15,000
Patent – Class 14 45,000 70,000 3,500
Government license 8,000 35,000 700
Trucks* 19,600 1,300 4,200
*The company has decided to lease its trucks in the future and, therefore,
disposed of all its trucks, the only assets in this class.


8. Jermat has the following unused losses:
Non-Capital Net Capital
Fiscal year ended December 31, 1998 $40,000 $ -

Fiscal year ended December 31, 2002 $160,000 $27,500
9. The company had the following balances in its tax accounts on January 1, 2009.
Depreciable property:
Class 3 (5%) $49,000

Class 8 (20%) 8,400
Class 10 (two-seat delivery van) (30%) 1,500
Class 14 35,900
Class 43 (30%) 35,000

Cumulative eligible capital: $29,650
10. The company made the following capital purchases during the year:
Building $315,000
Manufacturing machinery 87,000
11. During the year, the company made an improvement costing $7,000 to a leased
warehouse. The 15-year lease commenced 10 years ago and has two successive options to
renew of five years and three years, respectively.
Required:
Compute net income for tax purposes and taxable income for the year ended December 31, 2009.


FMT10 Problem: Federal Tax Payable - Jeb Corporation Limited
Jeb Corporation Limited (JEB), a Canadian incorporated company, operates a retail chain of
computer supply stores in Canada and abroad. JEB’s taxable income for its most recent year-end
was $862,000. JEB is taxable in three Canadian provinces and in two foreign countries on its
business income. JEB earns only business income.
JEB is 65% owned by non-Canadian residents. Its gross revenues are 83% earned in Canadian
provinces. Total salaries and wages paid in Canada are 77%.
JEB was not in a taxable position in either of the foreign countries.
Required:
Calculate JEB’s 2010 Part I federal tax payable.
FMT11 Problem: Small Business Deduction - Botsal Inc.

The taxable income for Botsal Inc. (Botsal) for the 2010 taxation year was $624,000. All
taxable income was generated from business activities with the exception of $2,000 in foreign
interest income, which 10% tax was withheld. Of the business income, $33,000 was earned
outside of Canada. The foreign taxes withheld on this business income were $5,500.
Botsal is associated with Latsob Inc. (Latsob) for Canadian tax purposes. The two corporations
have agreed to share the small business limit equally.
Required:
Determine the amount of small business deduction that Botsal may claim for 2010.
FMT12 Problem: Associated Corporations - Coco Inc.

Mrs. Winkler owns 100% of the shares of Coco Inc. Mrs. Winkler’s daughter, Annie, owns 70%
of the shares of Bobot Inc. The remaining shares of Bobot Inc. are held by Coco Inc.
Required:
Determine whether Coco Inc. and Bobot Inc. are associated corporations.


FMT13 Problem: Investment Tax Credit - Researchit Inc.
Researchit Inc. has current SR&ED expenditures of $500,000 and capital SR&ED expenditures
of $350,000. Researchit Inc. is a CCPC whose taxable income for the current and preceding tax
years is nil.
Required:
Determine the investment tax credits for Researchit Inc.

FMT14 Problem: RDTOH - Peleluc Inc.
Peleluc Inc. (“Peleluc”) is a Canadian controlled private corporation that produces and sells
gourmet cat food. Due to its overwhelming success, Peleluc was fortunate to invest its excess
cash flow in several profitable ventures.
It generated investment in earnings during 2010 consisting of $2,500 in interest, $12,000 in

dividends and $26,000 in capital gains. $8,000 of the dividends was received from a 25% equity
position in another profitable Canadian corporation that received a dividend refund of $10,000 in
respect of all dividends paid. The remaining $4,000 was received from various portfolio
investments.
Peleluc had $10,000 in net capital losses carried forward from 2009 and an RDTOH balance of
$6,000 at the end of 2009. During 2009, $27,000 of dividends was paid.
Peleluc’s taxable income for 2010 is $1.4 million.
Required:
Calculate the balance in the RDTOH account at the end of 2010 and the dividend refund for
2010.


FMT15 Problem: Taxable Income and Tax Payable - ABC
Corporation
ABC Corporation is a CCPC and manufactures children’s toys. Mr. and Mrs. ABC are the
shareholders and actively manage the business. Over the course of the fiscal year, the following
transactions occurred.
1) During the fiscal period, there was active business income of $550,000. All profits are
attributed to the M&P operations of the business.
2) ABC Corporation also owns a building on the other side of town, which they rent out.
Net rent for prior periods were normally much higher; however, this year, due to the
deteriorating condition of the building, much more was invested in maintenance and
repairs. Net rental income before CCA was $23,500. The maximum CCA available for
this building for deduction is $60,000.
3) During the course of the year, ABC made a donation of $10,000 to the Children's
Hospital and Mr. ABC, on behalf of the company, donated $15,000 to the Liberal Party
of Canada.
4) Depreciation expense of $34,000 was deducted.
5) In June, ABC disposed of a piece of equipment in Asset Class 12. The net book value of
this asset was $25,000; the asset was sold for proceeds of $15,000. There are four other
assets remaining in this asset class.
6) During the course of the year, ABC received dividends from non-connected Canadian
Corporations of $32,000 and interest of $5,000.
7) In August, ABC disposed of land they have owned since incorporation. The original cost
of the land was $12,000 and it sold for $150,000with associated costs of $7,500.
8) Losses Carried Over: (Expiration in Brackets)

Net capital losses (n/a) 100,000
Non-capital losses (1) 30,000
ABIL (2) 1,500
9) ABC reported meal and entertainment expense of $35,000 for the year.
10) The company has a maximum of $55,000 CCA available for deduction (excluding the
CCA for the building)
11) ABC reported Income for Accounting Purposes of $756,000.


Required:
Calculate the net income, taxable income and federal taxes payable for ABC Corporation’s fiscal
year.


Financial Management – Tax Solutions
FMT1 Solution: Business Income - Bat Company
Net loss for accounting purposes ($200,000)
Add back: expenses disallowed or limited for tax

purposes
Depreciation expense $850,000
Club dues 20,000
Meals and entertainment (50% of $60,000) 30,000
Write-down of investments 500,000 1,400,000
Less: expenses permitted for tax purposes

Capital cost allowance (800,000)
Net Income for tax purposes $400,000
• The write-down of investment will be recognized as a capital loss for tax purposes only
when the investments are actually disposed.
• The above shows net income for tax purposes can be positive even though there is a loss
for accounting. If management decided not to write-down the investment, then
accounting income would be $300,000 and net income for tax would remain unchanged
at $400,000. In other words, the arbitrary accounting entries (such as depreciation and
write-down of investment) have no effect on net income for tax.


FMT2 Solution: CCA - Tofu Inc.
The building is depreciable property and qualifies as a Class 1 (4%) asset. The half-year rule
applies in 2007, the year of acquisition.
Class 4
2008 UCC – beginning of year $0

Purchases during the year 100,000
$100,000
CCA (4% x $100,000 x 1/2) (2,000)
UCC – end of year $98,000
2009 UCC – beginning of year $98,000

CCA (4% x $98,000) (3,920)
UCC – end of year $94,080
2010 UCC – beginning of year $94,080

Disposal (100,000)
(5,920)
Recapture 5,920
UCC – end of year $0
The recapture of $5,920 in 2010 is a logical result because Tofu Inc. fully recovered the
$100,000 cost from the proceeds of disposition. Therefore, the deductions taken in 2008 and
2009 (total $5,920) were, in hindsight, excessive.
If Tofu Inc. were to purchase another building before the end of its 2010 taxation year, the

recapture of $5,920 would be deferred because the UCC balance would not be negative at the
end of the year. In that case, the recapture would effectively reduce the UCC (and hence the
future CCA deductions) on the newly acquired building.
Continuing with the example above, if the proceeds of disposition were $80,000 instead of
$100,000, then the UCC balance at the end of 2010 would be $14,080 (i.e. $94,080 UCC less
$80,000 proceeds). Since no other assets remain in Class 1, Tofu Inc. would be entitled to
deduct the $14,080 as a terminal loss. The net cost to Tofu Inc. of the building of $20,000
($100,000 original cost less $80,000 proceeds from sale) is recovered in the tax system as:
$5,920 total CCA in 2008 and 2009 and $14,080 in terminal loss.


FMT3 Solution: CEC - Sprout Corporation
CEC
2008
Additions Customer list (75% of $20,000) $15,000
Goodwill (75% of $60,000) 45,000
60,000
CECA (7%) (4,200)
CEC balance – end of 2007 $55,800
2009 CECA (7%) (3,906)
CEC balance – end of 2008 $51,894
2010
Disposal Sale of customer list (75% of $40,000) (30,000)
Sale of goodwill (75% of $100,000) (75,000)
($53,106)
Business income inclusion 53,106
CEC balance – end of 2009 $0
The sale of the customer list and goodwill results in a negative CEC pool fully taxable as
business income in 2010.
Note that the $53,106 is comprised of two components:

1. Recapture of previous ECE claims $8,106.
2. Capital gain on disposition of property $45,000 = 75% of $140,000 proceeds less $80,000
cost.
The capital gain component on the sale of property is taxed at 75% because of the rates used for
the ECE pool. However, all other capital gains are taxed at a rate of 50%. This inequitable
treatment caused CRA to put rules in place to allow taxpayers to adjust the inclusion rate on the
capital gain component to 50% for all dispositions after October 17, 2000. For the above
taxpayer, the adjusted amount of capital gain is 50% of $60,000 = $30,000 or 2/3 of $45,000.
The $30,000 is combined with the true recapture component of $8,106 to total a business income
inclusion of $38,106. This is preferable to a business income inclusion of $53,106.


FMT4 Solution: CCA - Blake Incorporated
a. 2005 CCA:
For 2004 improvement (over the remaining term of the lease

plus one renewal):
$80,000 / (5 -1 + 2) $13,333
For 2005 improvement (over the remaining term of the lease plus
one renewal):
$20,000/(5 - 2 + 2) x ½ year rule 2,000
$15,333
b. 2006 CCA
one renewal)
$80,000 / 5 -1 + 2 $13,333
one renewal)
$20,000/5 - 2 + 2 4,000
one renewal)
$10,000/5* x ½ year rule 1,000
$18,333
* although the calculation of remaining lease term plus one

renewal yields 5 – 3 + 2 = 4 years, the minimum years allowed

is five


FMT5 Solution: CEC - Greenwood Limited
a. 2003 Opening CEC balance $0
Addition: ¾ x $100,000 75,000
Deduction for CEC: 7% of $75,000 (5,250)
69,750
2004 Deduction for CEC: 7% of $69,750 (4,883)
64,867
2005 Disposition: ¾ x $250,000 (187,500)
$(122,633)
Breakdown of ($122,633):
Recapture of previous CEC deduction
($5,250 + $4,883) $10,133
Capital gain
($122,633 - $10,133) 112,500*
$122,633
Adjusted capital gain ($122,633 – 10,133)

x 4/3 x ½ = or 2/3 x $112,500 $75,000
* The capital gain is adjusted from a 75% inclusion rate to 50% to be

equivalent to a taxable capital gain calculation of ½ x ($250,000 -
$100,000) + recapture.
b. 2005 Opening CEC balance $64,867

Disposition: ¾ x $80,000 (60,000)
Terminal loss $ 4,867
c. The solution would not change from Parts ‘a’ and ‘b’ as the ½ year rule does not
apply to the CEC account.

Page 98

FMT6 Solution: CCA - Ranger Incorporated
Class 1 UCC $ 1,150,000
Disposition (1,300,000)
Balance ( 150,000)
Recapture $ 150,000
UCC nil
A taxable capital gain of 1/2 ($1,400,000 - $1,300,000) = $50,000 would also arise.
Class 43 UCC $ 217,000

Disposition (180,000)
Balance 37,000
Terminal loss $(37,000)
UCC nil
No allowable capital losses arise on disposition of depreciable property.
Class 8 UCC $155,000

Addition 27,000
CCA: $155,000 x 20%
+ (27,000 – 22,000) x 20% x ½ (31,500)
UCC $128,500
A taxable capital gain of 1/2 ($35,000 - $22,000) = $6,500 would also arise.
½ net amount rule is calculated on net of addition and disposition.

Class 10 UCC $67,000
Addition 8,000
CCA: ($67,000 – 12,000) x 30% (16,500)
UCC $38,500
The ½ net amount rule does not apply as the net additions are negative (i.e. dispositions
exceed additions).


FMT7 Solution: CCA and Rental Income - Beta Corporation
Maximum CCA:
Building Building Total
X Y
Original cost $40,000 $200,000

CCA at 4% $1,600 $8,000
Half-year rule for year of acquisition $800 $4,000 $4,800
The maximum CCA that could normally be claimed from rental income in fiscal 2006 is $4,800.
However, CCA cannot be claimed to create or increase a rental loss. Therefore, CCA is limited
to $3,000. The $3,000 CCA may be claimed from either the class containing building X or Y or
a combination of the two. Allocating the CCA between the two buildings should consider any
future sale prospects.
Net Income from Rental Property

Total
Income (loss) before CCA $3,000

Less: CCA on building Y (3,000)
Income (loss) before CCA $0
The benefit from $1,800 of CCA that could not be claimed is not lost. The UCC of the class is
only reduced by the actual CCA claimed. Therefore, the unclaimed amount of $1,800 remains in
the UCC of the class and will be considered in the calculation of maximum CCA allowable in
future years. The benefit of the unclaimed CCA is, therefore, not lost it is merely deferred.


FMT8 Solution: Capital Gains - Magma Corporation
Stock A Stock B
Proceeds of disposition A $500,000 $150,000
Cost $345,000 $195,000

Expenses of disposition 5,000 5,000
B (350,000) (200,000)
Capital gain (capital loss) A-B $150,000 ($50,000)
Taxable capital gain (1/2)

(allowable capital loss) $75,000 ($25,000)
The net taxable capital gain for 2010 is $50,000 ($75,000 - $25,000). If Magma Corporation’s
marginal tax rate is 40%, then the capital gain will attract $20,000 in taxes. Therefore, the
effective tax rate on the capital gain is 20% (i.e. 1/2 * 40% or $20,000 taxes / $100,000
economic gain).
Capital losses are only deductible against capital gains. If Magma Corporation. did not sell stock
A, then the allowable capital loss in stock B could not be used in 2010. Instead, the capital loss
could only be carried backthree 3 years or forward indefinitely and claimed against capital gains.


FMT9 Solution: Taxable Income - Jermat Ltd.
Income per financial statements $944,000
Adjustments:
Non-deductible club dues ($12,000 - $4,000) 8,000

Non-deductible portion of meals and entertainment expenses
($4,000 + $3,000) x 50% 3,500
Bond premium amortization – interest deductible as paid (4,000)
Appraisal fees – capitalize to asset 2,500
Charitable donations and political contributions – charitable
deductible in calculating taxable income, political eligible
for tax credit against taxes payable 43,000
Life insurance premium for president’s spouse – not for
purpose of earning income 3,500
Property taxes on vacant land – increase ACB of land 15,000
Increase in warranty liability – only deductible when paid 9,000
Non-deductible portion of travel meals and entertainment
expenses ($10,000) x 50% 5,000
Expenses of issuing shares 1/5 x $20,000 – deductible
over five years (4,000)
Book gain on sale of shares (100,000)
Taxable capital gain on the sale of shares
($120,000 - $20,000) = $100,000
Less capital gains reserve
lesser of
1) $100,000 x 20% (5 – 1 ) = $80,000
2) $100,000 x $90,000/$120,000 = $75,000
$25,000 x ½ 12,500
Book loss — securities ($7,000 – $10,500) 3,500
Book loss — equipment ($11,200 –$15,000) 3,800
Book loss — trucks ($1,300 – $4,200) 2,900
Book gain — patent ($70,000 – $3,500) (66,500)
Book gain — govt. license ($35,000 - $700) (34,300)
Taxable capital gain – patent [1/2 x ($70,000 - $45,000)] 12,500
A.C.L. — securities ($7,000 - $10,500) x 50% (1,750)
Amortization 200,000
Recapture — patent ($45K - $35.9K) 9,100
Terminal loss — trucks ($1,300 –$1,500) (200)
C.C.A. (Schedule 1) (32,650)
C.E.C.A. (Schedule 2) (238)
Net income for tax purposes $1,039,162


Donations to registered charities, not to exceed
$1,059,162 x 75% = $794,372 (38,000)
Dividends from taxable Canadian corporations
($12,000 + $43,000) (55,000)
Net capital losses (limited to net taxable capital gains of
($12,500 + $12,500 - $1,750)* (23,250)
Non-capital losses (40,000)
Taxable income $882,912
Excluded items:
Bonuses – deductible as paid within 180 days after the end of the tax year
Breach of contract – for the purpose of earning income; damages paid as part of a normal risk of
doing business
Landscaping – already fully deducted
Theft – normal risk of doing business
Salary to child – reasonable for services rendered
Schedule 1
Cl. 1. Cl. 3. Cl. 8. Cl. 10. Cl. 13. Cl. 14. Cl. 43.
4% 5% 20% 30% S.L. S.L. 30%
Jan. 1, 2009 U.C.C. Nil $49,000 $8,400 $1,500 Nil $35,900 $35,000
Purchases $315,000 — — — $7,000 — 87,000
Disposals — — — (1,300) — (45,000) (11,200)
Dec. 31, 2009 U.C.C. $315,000 $49,000 $8,400 $200 $7,000 $(9,100) $110,800

1
/2 net amt (157,500) — — — N/A — (37,900)
U.C.C. $157,500 $49,000 $8,400 $200 $7,000 $(9,100) $72,900
C.C.A. for 2009 (6,300) (2,450) (1,680) — (350)* — (21,870)
Terminal loss — — — (200) — — —
Recapture — — — — — 9,100 —
1
/2 net amt 157,500 — — — — — 37,900
Jan. 1, 2010 U.C.C. $308,700 $46,550 $6,720 Nil $6,650 Nil $88,9300
* Lesser of:
(a) 1/5 x $7,000 = $1,400
(b) $7,000/(5 + 5) = $ 700
$700 x ½ = $ 350


Schedule 2
C.E.C. — Jan. 1, 2009 $29,650
Govt. license ($35,000 x 3/4) (26,250)
$ 3,400
C.E.C.A. — 2009 @ 7% (238)
C.E.C. — Jan. 1, 2010 $ 3,162


FMT10 Solution: Federal Tax Payable - Jeb Corporation Limited
Basic 38% x $862,000 $327,560
Abatement 10% x $862,000 x (83% + (68,960)
77%)/2
General rate reduction 10% x $862,000 (86,200)

Part I federal tax payable $172,670
Note that JEB would not be eligible for the small business deduction as they are not a CCPC.
Nor would they be eligible for the M&P profits deduction as they carry on a retailing business.
Finally, none of their income was investment income and would not be eligible for the
refundable tax system. Consequently, their full taxable income would be eligible for the general
rate reduction as it was taxed at full rate.
FMT11 Solution: Small Business Deduction - Botsal Inc.

17% of the least of:
i) Canadian active business income
= $624,000 - $2,000 - $33,000 $589,000
ii) Taxable income – 10/3 FNBTC – 3 x FBTC

= $624,000 – 10/3 x $200 – 3 x $5,500 $606,833
iii) Business limit (shared equally per the question)
= ½ x $500,000 $250,000
SBD = 17% of $250,000 = $42,500.


FMT12 Solution: Associated Corporations - Coco Inc.
Coco Inc. and Bobot Inc. are associated corporations. Coco Inc. is controlled by Mrs. Winkler.
Bobot Inc. is controlled by Annie. Mrs. Winkler and Annie are related and Mrs. Winkler owns
25% or more of the shares of Bobot Inc. through Coco Inc.
FMT13 Solution: Investment Tax Credit - Researchit Inc.

Investment tax credit 35% x ($500,000 + $350,000)
$297,500
Refundable portion of ITC 40% x 35% x $350,000
+100% x 35% x $500,000 $224,000
FMT14 Solution: RDTOH - Peleluc Inc.

RDTOH end of 2009 $6,000
Less: dividend refund 1/3 x $27,000 Max (6,000)
Refundable Part I tax + 26 2/3% x ($13,000 - $10,000 + 1,467
ART $2,500 + $12,000 - $12,000)
Part IV tax 33 1/3 % x 4,000 1,333
Part IV tax 25% x $10,000 2,500
RDTOH end of 2010 $5,300
Dividend refund Lesser of 1/3 x $27,000 or $5,300

RDTOH balance

Page 106

FMT15 Solution: Taxable Income and Tax Payable - ABC
Corporation
Accounting Income $756,000
Add: Depreciation $34,000
Taxable capital gain1 65,250
Meals and entertainment (50%) 17,500
Accounting loss on disposal of assets (25,000 – 15,000) 10,000
Charitable donations 10,000
Political donation 15,000 151,750
Deduct: Accounting gain on disposal of land 130,500
CCA – rental building (limited to net income) 23,500
CCA 55,000 -209,000
Net income for tax purposes 598,750
Charitable donations -10,000
Dividends -32,000
Net capital loss carry over (limited to the taxable capital gain) -65,250
Non-capital loss carry over -30,000
ABIL -1,500
Taxable income $560,000
Taxes Payable
Federal tax (38%) $174,800
Federal abatement (10%) (46,000)
Net federal tax 128,800
Small business deduction 17% x $500,000 (85,000)

M&P 10% x $60,000 (6,000)
GRR 9% x nil Nil
Political donations tax credit max on $1,275 contribution (done personally) (650)
Additional refundable tax 6 2/3% x ($65,250 - $65,250 + $32,000 + $5,000 -
$32,000) 333
Total Part I tax 38,133
Part IV tax 33 1/3% x $32,000 10,667
Total federal taxes payable $48,150
1
Proceeds $150,000
Associated costs -7,500
Adjusted cost base -12,000
Capital gain $130,500
Taxable capital gain (50%) $65,250



Scope of Financial Management
5.1.1.1 a) Understands the scope of financial management
• Describes the primary activities, duties and skills of financial
9
managers
• Explains the primary goals of the finance function 9
• Identifies and describes the potentially conflicting goals of financial
management among stakeholders (e.g. managers, shareholders, debt- 9
holders, society) and understands the agency problem
The Financial Manager

In large corporations, the owners (i.e. shareholders) are usually not involved in the day-to-day
running of the corporation. The day-to-day running of the corporation is the responsibility of the
financial manager. The financial manager represents the shareholders’ interests and makes
decisions on their behalf.
The financial manager must address three core questions:
1. What long-term investments should the company take on? For example, the financial
manager must decide on lines of business and the property plant and equipment
needed.
2. How will the company obtain the long-term financing for the investment? Options
include issuing more shares or borrowing money.
3. How will the day-to-day (i.e. short-term) financial activities such as collecting
receivables and paying suppliers be managed?
The financial management function normally has a senior executive, such as a VP Finance or
Chief Financial Officer (CFO). The financial management function is split between two
functions, controllership and treasury. The controllership function deals with cost accounting,
financial accounting, tax payments and sometimes management information systems. The
treasury function is responsible for managing cash, financial planning (e.g. budgeting) and
capital expenditures.


Financial Management Decisions
The three questions mentioned above can be broken into three categories:
1. Capital Budgeting
Capital budgeting allows the financial manager to evaluate and manage long-term
investments.
2. Capital Structure
Capital structure refers to the mix of debt vs. equity a company uses to finance its
long-term activities.
3. Working Capital Management

Working capital management refers to the planning and management of the
company’s current assets and liabilities. This activity is the day-to-day management of
cash flows to ensure the company has sufficient resources to continue to operate.
Working capital management is concerned with issues such as how much cash and
inventory should be kept on hand, the policies for selling on credit, the collection of
receivables and how to obtain short-term financing.
Goals of Financial Management

For profit-oriented companies, the goal of financial management is to earn profit and add value
for the owners.
This goal can be achieved through various means:
• increasing profitability – through increased sales or reduced costs
• identifying investments and financing arrangements that favourably impact the share
price


Agency and Conflicting Goals of Management and Shareholders
The financial manager acts on behalf of the shareholders, which means the financial manager is
acting as an agent for the shareholders. In this type of agency relationship (manager as agent,
shareholder as principal only who hires the agent), there may be a conflict of interest in that the
manager may undertake actions that are in the best interest of the manager and not the
shareholder. This is known as an agency problem. The costs associated with decisions
management makes that are in management’s best interest, but not the shareholders’ best
interest, are known as agency costs. Agency costs can be indirect or direct.
Examples of agency problems and agency costs:

• Indirect Agency Costs
Management is deciding on a new investment that would increase the value of the
shares of the company; however, the investment carries some risk. If the new
investment is unsuccessful, the financial manager(s) may lose their jobs. Management
decides not to accept the new investment. The increase in value of the shares
associated with this investment is lost. This lost value is an indirect agency cost.
• Direct Agency Costs

There are two types of direct agency costs:
1. Corporate expenditures that benefit management but cost the shareholder. An
example is a corporate jet used by the CEO.
2. Expenditures required to monitor management. An example is the audit fees paid
to external auditors to ensure financial statements are accurate.
Addressing the Agency Problem

There are two means of addressing the agency problem, which relate to management
compensation and control of the company.
Management compensation:
If management’s compensation (e.g. bonuses) is tied to profit and increasing share value,
management has an incentive to act in a manner beneficial to shareholders. The management
compensation could be structured in two ways so that it is tied directly to both profit
maximization and share value. First, cash bonuses can be tied to profit levels. Second, stock
options can be issued to management. Since the value of the stock option increases with the
market price of the share, management has an incentive to increase the market price of
shares.
Control of the company:

Shareholders ultimately control a company because they elect the Board of Directors, who
are responsible for hiring and firing management. Senior management who are not
performing can be fired.


Other Stakeholders
In addition to management and shareholders’ interest in a company, there are other stakeholders
who have an interest in a company. These stakeholders are employees, customers, suppliers,
financers and the government representing the broader community. These stakeholders have
different interests in the company as the chart below illustrates.
Interest of stakeholders (list is not exhaustive)
Employees Suppliers Customers Financers Government
• compensation, • financial • product • ability to • taxes (income

rewards, viability quality and meet tax, property
benefits price debts tax, etc.)
• relationship • ability to meet • social • adherence to

with unions A/P as it comes responsibili laws and
due ty regulations
• terminations • purchasing levels, • financial

and layoffs expansion or viability
retraction plans (impacts job
• discrimination levels)
• safety at the • social

workplace responsibility


Time Value of Money
5.1.1.1 b) Time value of money
• Explains and applies the concept of time value of money and
9 9
compounding of interest
• Calculates future and/or present values of single amounts, annuities
and perpetuities under various conditions (e.g. even, uneven and 9
growing cash flow streams, constant and changing interest rates, etc)
• Differentiates and calculates effective annual rate (EAR) and annual
9 9
percentage rate (APR) of interest
• Differentiates nominal and real rates 9
• Calculates the impact of inflation on the time value of money 9
Note to candidates: Although the CMA Competency Map states candidates are required to
calculate “…future and/or present values…” the tables provided on the Entrance Examination
are present value tables. Future value tables are not provided. Therefore, this material
recommends candidates focus their studying of the time value of money on present values.
Future values have rarely been examined on the Entrance Examination.
Calculator Use:
The CMA Canada rules related to the Entrance Examination restricts the calculators that may be
used in the Entrance Examination to the following three models (as of the date of writing,
February 2009):
Hewlett-Packard 10BII
Texas Instrument BAII-Plus (including the professional model)
Sharp EL-738C
Note that restricts means other calculators will not be allowed. It is strongly suggested candidates
become familiar with the use of one of these calculators. Becoming familiar with the present and
future value functions will save time on the examination. A convenient way of following this
advice is to complete the illustrative examples below using your chosen calculator.
Overview
The time value of money refers to the fact that a dollar today can be invested, which means it
would increase to more than a dollar later. The ‘dollar today’ is the present value and the ‘more
than a dollar later’ is the future value. Note that this reflects the opportunity cost of money
relating to investment opportunities – inflation is a separate issue. .


Present Values for Single Amounts (PV of an Amount)
Present Values and Discounting

Present value calculates the amount required today, invested at a given rate, to obtain a certain
amount in the future.
In other words, it answers questions like “if I need $1,000 in five years, how much do I need to
invest today, assuming an interest rate of 6%?” or “if I were to receive $1,000 in five years, how
much would the $1,000 be worth today, assuming an interest rate of 6%?”
Present Values and Single Periods

If only one period is being considered, calculating the present value is straight forward.
Example
To have $5 at the end of one year, how much needs to be invested today, if the interest rate is
10%? This could also be stated as “what is the value today of $5 to be received at the end of one
year at an annual interest rate of 10%?”
Solution
1
Present value = FV x
(1 + r)
1 $5
Present value = $5 × = = 4.5455
1 + 10% 1.1
Check
Future value = PV x (1 + r)
= 4.5455 × (1 + .10)
= 5 (difference of one cent due to rounding)
As you can see, the present value formula for one period can be stated as:
1
Future amount ×
1+r
where r = interest rate

Page 114

Present Values and Multiple Periods
If multiple periods are involved, calculating present values is a little more difficult, but is still
relatively straight forward.
Example
You need $1,000 in two years and the annual interest rate is 7%. How much needs to be
invested today to ensure you have $1,000 in two years?
1 1,000
Present value = 1,000 × = = $873.4387
(1 + 7%)2 (1.07)2
Check
Future Value = investment × (1 + r)2 = 873.4387 × (1.07)2 = $1,000
As you can see, the present value formula for multiple periods can be stated as:
1
investment ×
(1 + r)t
where
r = interest rate
t = time periods
A note on terminology
Discount rate:
In these examples, r is the interest rate for a given period. Unless otherwise stated the interest
period is one year. It is also called the discount rate.
Present value interest factor:

The portion of the formula
1
(1 + r)t
is known as present value interest factor or PVIF. The formula sheet provided on the Entrance
Exam provides present value interest factors for both the present value of an amount and the
present value of an annuity.


Present Values and Multiple Cash Flows (Present
Value of an Annuity)
Similar to present valuing single amounts, present valuing multiple cash flows calculates the
value today of a future cash flow stream. When all values in the future cash stream are equal the
cash flows are called an annuity.
Example:
An investment will pay $1,000 at the end of each year for the next five years. At an annual
interest rate of 6%, what is the present value of this future cash flow stream today?
Solution
0 1 2 3 4 5
1,000 1,000 1,000 1,000 1,000
$ 943.40 × 1/1.06
890.00 × 1/1.062
839.62 × 1/1.063
792.09 × 1/1.064
747.26 × 1/1.065
$4,212.37
An easier method to calculate the present value is to use the present value tables provided in the
examination (the formula sheet provided at the examination provides present value factors for
the present value of an amount and the present value of an annuity).
Since this question represents an annuity (annuities discussed later) the present value tables can
be used.
Calculation:
Present value factor for an annuity at 6% for five periods is 4.2124.
Present value: $1,000 × 4.2124 = $4,212.40
You will note small rounding errors when you use tabulated values as opposed to computer or
calculator accuracy.


Annuities and Present Values
An annuity is a multiple cash flow stream where the cash flows are all the same amount. The
formula for calculating the present value of an annuity is:
There are two types of annuities:

• ordinary annuity – each of the cash flows occur at the end of each period. A common
example is a payment on a loan, which is usually made at the end of each period.
• annuity due – each of the cash flows occur at the beginning of each period. A common
example is a lease payment, which is usually made at the beginning of each period.
In the previous example, $1,000 per period for five periods, paid at the end of each period,
yielded a present value of $4,212.40.
This is an ordinary annuity. However, assume the payments of $1,000 were at the beginning of
the period. What is the present value?
Solution
0 1 2 3 4 5
$1,000 1,000 1,000 1,000 1,000
943.40 × 1/1.06
890.00 × 1/1.062
839.62 × 1/1.063
792.26 × 1/1.064
$4,465.28
Note that this is the same as calculating the present value for a four year annuity and adding one
payment at time zero.
Using the present value tables, the solution can be calculated as:
($1,000 × PV factor at 6%, t = 4) + 1,000
= (1,000 × 3.4651) + 1,000
= 4,465


OR
Add 1 to the present value factor for four periods and multiply:
$1000 × (3.4651 + 1)
= 1,000 × 4.4651
= 4,465.10
Recall that leases normally must be paid at the beginning of the period. In the lease section of
financial reporting in this manual, converting an ordinary annuity to an annuity due is addressed.
Therefore, not only do candidates need to know this concept for finance, it is also necessary for
financial accounting, specifically, capital leases (calculating the present value of minimum lease
payments).
Perpetuities
A perpetuity is when the cash flow stream continues forever – into perpetuity. An annuity has a
limited life, while a perpetuity continues forever. Perpetuities are also known as consols.
Calculating the present value of a perpetuity is:

C
Present Value =
r
where
C = periodic cash flow
r = periodic interest rate
A simple analogy can be made to calculating the value of an investment. Recall the formula for
calculating ROI is
income
ROI % =
investment
Assume you know the income and the ROI %. The investment can then easily be calculated as:
income
investment =
ROI %
The underlying concept is the same, except the present value is concerned with cash flows and
ROI is concerned with income, which may not be the same as cash flows due to the use of
accrual accounting.


Future Values for Single Amounts
Future Values and Compounding

Future value refers to the amount an investment would grow over a given period of time and at a
given interest rate.
Investing for a Single Period

Investing for a single period refers to the future value of investing for one single period.
Example:
An investment of $1,000 at 6% for one year would be worth $1,000 × (1 + .06) = $1,060 at the
end of one year. The $1,060 consists of the $1,000 principal plus $60 of interest. So, the future
value of $1,000 invested for one year at 6% is $1,060.
The formula for single period interest is stated as:
investment × (1 + r)
where:
r = interest rate
The amount of $60 is called the simple interest amount.
Investing for More than One Period

The process of investing and leaving the principal and interest to accumulate over more than one
period is called compounding.
Example
An investment of $1,000 is made at 6% interest per year and both the interest and principal are
left to accumulate for two years.
What is the value of the investment at the end of the two years?


The value of the investment is:
Future value = investment × (1 + r)t
where
r = interest rate
t = number of periods
The future value of this investment is $1,000 × (1 + .06)2 = $1,123.60
The $1,123.60 can be calculated as follows:
Interest Investment
6%
(investment × 6%)
Initial investment $1,000.00
Year 1 60.00 1,060.00
Year 2 63.60 1,123.60
The $1,123.60 can be broken into its components:
1. Return of initial investment $1,000.00

2. Interest on the $1000 in Year 1 60.00
3. Interest on the $1000 in Year 2 60.00
4. Interest on the $60 earned in Year 1
in Year 2 $60 × .06 (interest on interest) 3.60
$1,123.60
If there were many periods, it would be an arduous task to calculate this manually; therefore, it
is important to remember the formula
investment × (1 + r)t
where
r = rate
t = time periods.
The expression (1 + r)t is known as the future value interest factor (FVIF).
Note: Candidates must remember the formula for future value – neither the formula nor future
value interest tables are included in the formula sheet provided on the Entrance Exam. For this
reason, future values are rarely examined on the Entrance Examination.


Simple Interest and Compound Interest
Let’s say the $1,000 investment is made for two years, but the interest is not left with the
investment; therefore, no interest is earned on interest. In this case, it is easy to calculate the
total at the end of two years:
Principal $1,000
Interest
1,000 × 6% × 2 years 120
$1,120
Example – Comparison of Simple Interest and Compound Interest
Basic Data:
Amount invested (principal): $1,000

Interest rate: 8% per year
Time period: five years
Solution
Simple Interest Compound Interest

Interest: Interest:
$1,000 × 8% Balance balance × 8% Balance
$1,000 $1,000.00
80 1,080 $ 80.00 1,080.00
80 1,160 86.40 1,166.40
80 1,240 93.31 1,259.71
80 1,320 100.78 1,360.49
80 1,400 108.84 1,469.33
$400 $1,400 $469.33 $1,469.33
Note that the interest earned on the interest reinvested is $69.33, calculated as $469.33 - $400.


Future Values for Multiple Cash Flows
The previous calculations were for single amounts. Often, there is a need to calculate the future
value when there are multiple cash flows.
Future Values and Multiple Cash Flows

The easiest means to understand future cash flows is through an example.
Example # 1
Basic Data:
Deposit today (initial deposit): $100

Interest rate (annual): 8%
Additional deposit in one year: $100
How much will the total be at the end of the two years?
Solution
Time line:
0 1 year 2 years
Cash flows 100 100
× 1.08 108
Future value
208
× 1.08
$224.64
In this example, there are four elements:
• the principal amounts invested (100 + 100) $200.00

• interest earned Year 1 on initial amount invested 100 × 8% 8.00
• interest earned in the second year on the interest earned in the first year $8 × 8% .64
• interest earned in the second year on the Year 1 and Year 2 amounts invested 16.00
(100 + 100) × 8%
$224.64


Example # 2
Amount invested each year for five years (deposited at the end of each year) $2,000
Annual interest rate 10%
How much will be available at the end of five years?
Solution
0 1 2 3 4 5
$2,000 $2,000 $2,000 $2,000 $ 2,000.00
× 1.10
2,200.00
× 1.102
2,420.00
× 1.103
2,662.00
× 1.104
2,928.20
$12,210.20
In this example, note that it is assumed the amounts are deposited at the end of the year. All
future value and present value questions assume end of period cash flows. Unless the question
specifically states or makes it clear the cash flows occur at the beginning of the period, assume
the cash flows occur at the end.
Note that most financial calculators are preset (default) to assume cash flows occur at the end of
the period. You need to reset to calculate present or future values for questions where the cash
flows are at the beginning of the period.


Annuities and Future Values
To calculate the future value of an annuity, apply the following formula:
((1 + r)t - 1)
Annuity future value = C ×
r
where
C = cash flow
r = rate
t = number of periods
Example:
$2,000 per year is invested each year for 30 years at 8%. What is the future value of the
investment?
Future value = 2,000 x ((1 + .08) 30 - 1)

.08
= 2,000 x ((1.08)30 - 1
.08
= 2,000 x 113.2832
= $226,566.40
Do not memorize the formula – use a financial calculator!

Page 124

Calculating the Discount Rate
There may be occasions to calculate the discount rate (note that calculating the discount rate is
not commonly examined on the Entrance Examination). This can be carried out by using the
present value equation:
1
PV = FV x
(1 + r)t
Finding r for a single period investment
Assume the following basic data:
Initial investment $1,250

Amount in one year $1,350
Period one year
1
PV = FV x
(1 + r)t
1
1,250 = 1,350 x
(1 + r)1
= 1,350
1+r
1,250
= 1.08
r = .08 or 8%

Page 125

Finding r for multiple periods
Assume the following:
Initial investment $100

Amount in eight years $200
1
PV = FV x
(1 + r)t
1
100 = 200 x
(1 + r)8
200
(1 + r)8 =
100
= 2
Solving for r can be determined by

• taking the 8th root of both sides
• raising both sides to the power of 1/8 or .125
• using a future value table (not provided on the exam)
Candidates should have a financial calculator and learn how to use it.
The solution is 9.05% and was calculated using a financial calculator.


Calculating the Number of Periods
Calculating t, or number of periods, is also determined by manipulating the basic present value
formula. Note that this is rarely examined on the Entrance Examination.
Example
Amount required in five years $50,313

Amount available now $30,000
Interest rate 9%
Calculate how long it will take for the $30,000 to grow to $50,313.
1
PV = FV ×
(1 + r)t
1
30,000 = 50,313 ×
(1 + .09)t
(1.09)t = 50,313
30,000
= 1.6771
To solve the equation, you can use:

• future value tables
• a financial calculator
Since future value tables are not provided in the examination, it is only possible to solve using a
financial calculator.
In general, when problems like this arise, they are best solved using a spreadsheet. However,
the solution can also be found using a calculator as follows.
We have (1.09)t = 1.6771

Taking the log of both sides we have t * log 1.09 = log 1.6771
Therefore t = log 1.6771/ log 1.09, which is a calculation a financial calculator can undertake.
The solution is six periods.


A Special Note on Interest Rates – Effective Annual
Rates (EAR) vs. Annual Percentage Rates (APR)
Effective Annual Rates (EAR)

The interest rate quoted is not the effective annual rate.
Example:
Stated interest rate: 10% compounded semi-annually
Although the stated rate is 10%, the effective rate in this case is 10.25%, calculated as follows:
10% compounded semi-annually means the investment pays 5% every six months. Assume $1 is
invested for one year at 10% compounded semi-annually. The interest earned is:
$1.00 × .05 = .05
$1.05 × .05 = .0525
Total interest earned .1025
Effective annual rate = .1025 = .1025 or 10.25%

1.00
The 10% is known as the stated rate and the 10.25% is known as the effective annual rate
(EAR).
Note that if the stated rate is per year and the compounding period is annually, the stated rate and
the effective rate are equal.
The effective annual rate can be calculated as:

EAR = [1 + (Quoted rate/n)]n - 1
where
n = number of times the interest is compounded per period.
If the interest is compounded
daily n = 365
monthly n = 12
quarterly n = 4
semi-annually n = 2
Applying EAR formula to the example where 10% is compounded semiannually, we have
EAR = [1 + .10/2]2 -1 = 1.1025 – 1 = 10.25%
The easiest means of calculating the EAR is with a financial calculator. The formula is not
provided on the exam.


Annual Percentage Rates (APR)
The annual percentage rate is the amount loans are quoted at. The Canadian Bank Act requires
the interest rate on loans be quoted as the rate per period times the number of periods. For
example, if a bank is charging 1% per month on a loan, the bank must quote the APR as 12%
(calculated as 1% × 12 months). However, 12% is not the effective annual rate (EAR). The EAR
is this case is:
EAR = (1 + APR/12)12 - 1
= 1.0112 - 1
= 12.6825%
Note to candidates: On the examination please read carefully to determine if the question is
referring to EAR or APR.
Mortgage Considerations
Under the provisions of the Dominion Interest Act, revised statutes of Canada 1952, Chapter
102, Section 6, whenver any principal money or interest secured by a mortgage of real estate is,
by the same, made payable on the sinking fund plan or on any plan in which the payments of
interest and principal are blended, no interest whatsover shall be chargeable unless the mortgage
contains a statement showing the amounts of such principal and the rate of interest chargeable
thereon, calculated yearly or half yearly not in advance.
You have negotiated a mortgage in the amount of $400,000 with the stated nominal annual
interest of 6% and the mortgage document states interest will be calculated half yearly and not
in advance. You will make monthly blended payments of principal and interest and the
amortization period for the mortgage is 25 years.
Since interest cannot be computed in advance, but the lender requires monthly payments the
lender is require to, in effect, pay interest on the monthly payments made in advance of the
semi-annual compounding.
The effective semi-annual rate is 3% = 6%/2, so the monthly rate that yields 3% can be
computed as i in the following equation
(1 + i)6 -1 = 0.03. or i = (1.03)1/6 – 1 = 0.4939%. This percentage rate can be used in the normal
present value calcuations to find the loan amount needed to repay a $400,000 mortgage over 25
years (300 interest periods).


Real vs. Nominal Rates (Inflation and Interest Rates)
Real vs. Nominal Rates

It is necessary to distinguish between nominal rates and real rates:
Nominal rates: not adjusted for inflation
Real rates: the nominal rate adjusted for inflation.
Example
Initial investment $100.00

Value of investment in one year $115.50
Inflation rate 5%
Since the present value is $100 and the future value is $115.50, the rate of return is
15.50/100 = 15.50%. However, this 15.50% ignores the inflation rate of 5%.
If inflation is considered, the $115.50 received at the end of the year has a buying power that is
5% less in real terms. Therefore, the real dollar value of the investment is
115.50 = 110
1.05
This means that the real return is 10/100 = 10%.
The Fisher Effect

The Fisher Effect describes the relationship between nominal returns, real returns and inflation.
The Fisher Effect states that because investors are concerned with what they can buy with their
money, the investor requires a rate of return that compensates for inflation.
The Fisher Effect provides the following formula that describes the relationship between nominal
rates, real rates and inflation:
1+R = (1 + r) × (1 + h)
where
R = nominal rate
r = real rate
h = inflation rate

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This formula can be manipulated algebraically as:
1+R = (1 + r) × (1 + h)
R = (r + h) + (r × h)
The above formula for the nominal rate, R, can be broken into three components:
1. the real rate on the investment, r
2. compensation for the decrease in buying power of the original investment amount (due to
inflation)
3. compensation for the decrease in buying power of the income earned on the investment
(due to inflation).
Example
Real rate of return 10%

Inflation 8%
What is the nominal rate?
Solution
a)
R = (r + h) + (r × h)
= (.10 + .08) + (.10 × .08)
= .18 + .008 = .188 = 18.8%


Cost of Capital
5.1.1.1 c) Cost of capital
• Explains the concept of cost of capital and its relevance for valuing
9
risky assets
• Calculates the after-tax cost of debt and cost of preferred equity 9 9
• Calculates the cost of common equity using the dividend growth
9 9
model and the capital asset pricing model
• Explains and calculates the weighted average cost of capital (WACC) 9 9
• Understands the uses of WACC and how it is applied in financing
9
and investment decision making
• Understands the impact of flotation costs on WACC 9
Cost of capital is defined as the rate of return that must be earned on a project or other economic
activity to maintain the market value of the company (or its common shares). The cost of capital
is important in making capital purchase and equity decisions, such as capital budgeting,
establishing the optimum capital structure, lease vs. buy and managing working capital.
The cost of capital for organizations is a weighted average of the costs of the various components
of the capital structure of the organization. These components usually include debt, preferred
shares and common equity. The costs of these components are based upon the required yields
(i.e. market rates) in the financial markets.
Calculating Cost of Debt

Debt cost to an organization is defined as the average yield, after-tax, on its various types of
debt. This cost is not estimated strictly on the basis of the past interest rates incurred by the
organization, but rather is based upon current yields on securities of the same risk and maturity
structure. The marginal tax rate of the organization is used to compute the yield after tax.
Formula for cost of debt:
kb = k (1 – T) or ( 1 – T) I
F
k = interest rate
T = corporate tax rate
I = annual interest payment on debt
F = face value of debt


Calculating Cost of Preferred Shares
Preferred shares have a yield to maturity based upon the dividend to be paid divided by the price
per share. Note that this method incorporates the current value of the shares and not the issue
price or book value.
kp = Dp
NPp
Dp = stated annual dividend payment on shares

NPp = net proceeds on preferred share issue (or market value)
Calculating Cost of Common Shares

Common share returns can be estimated in several different ways.
a. The simplest and least relevant method looks at the historic yields on the common shares
over the recent past. These yields, while readily available, are not reliable because their
use would imply the recent past is likely to be repeated. Simply stated, the past in the
financial markets is not a reliable predictor of the future.
b. A second and more reliable method is the dividend growth method based upon the
Gordon valuation approach. The yield is equal to the expected dividend yield plus the
long-run expected growth rate. The dividend yield is equal to the expected dividend (the
same value as in the Gordon valuation model) divided by the current share price. The
growth rate is the same growth estimate as is used in the Gordon valuation model.
(The Gordon Growth Model formula is on the formula sheet provided in the Entrance
Examination.)
c. A third and also reliable method uses the CAPM. In this approach, the SML is used to
compute the required yield from financial market data and the beta of the common
shares. This model uses market driven data based on the systematic risk of the
organization. (The CAPM formula is on the formula sheet provided in the Entrance
Examination.)
Formula for Cost of Common Shares (Capitalization of Dividends with Constant Growth Rate or
Gordon’s Growth Model):
ke = D1 + g
NPe
D1 = dividend expected for period 1

NPe = net proceeds on common share issue (or market value)
g = annual long-term dividend growth rate


Formula for Cost of Common Shares (Capital Asset Pricing Model):
(
R j = R f + β j Rm − R f )
where Rj = expected rate of return on security
Rf = risk-free rate
Rm = expected return for the market portfolio
βj = beta coefficient for security j (measure of systematic risk)
Calculating Cost of Retained Earnings

kre = re = D1 + g
Pe
Pe = market price of a share

re = expected return on common equity
Weighted Average Cost of Capital (WACC)

The weighted average cost of capital or WACC is the combination of the costs of the various
components, using a weighted average formula. The main issue in using this formula is the
choice of weights. The most common approach is to use the current aggregate market values for
debt, preferred equity and common equity. Note that book values are often used, but they
are not generally as reliable unless the proportionate relationships among the various capital
components are the same in a historic sense as they are in the current financial markets. In
summary, use the following weights: first, optimal weighting for an optimal capital structure, if
known; second, market value of the components of cost of capital (debt, common shares,
preferred shares); and third, if the first two are not available, use weightings based on book
values.
The weights of each component of capital, debt, preferred shares and common shares is applied
to the cost of each to determine the WACC:
k = B kb + P kp + E ke
V V V
B = amount of debt outstanding

P = amount of preferred shares outstanding
E = amount of common equity outstanding
V = B + P + E = total value of organization


Bonds
5.1.1.1 d) Valuing stocks and bonds
• Describes the yield curve and discusses the theories explaining its
9
shape
• Calculates the current value (price) of bonds, preferred shares and
common shares based on the future benefits (cash flows) given a 9
discount rate
5.2.1.1 Sources of financing (e.g. public vs. private, debt vs. equity, etc.)
a) Describes the purpose and features (e.g. function, cash flow, risks,
investment characteristics and provisions, etc.) of various sources of
short- and long-term financing and financial instruments (e.g. bank
loans, money market instruments, working capital, venture capital, 9
common stock, preferred stock, notes, debentures, bonds, leases,
derivative securities such as warrants and options, convertible
securities, rights offerings, etc.)
b) Compares the features and relative merits of various sources of
financing and financial instruments available to a given organization 9 9
and calculates their effective costs and market values
c) Describes shareholder and creditor rights and determines the
9 9
return/yield of various types of financial instruments
d) Explains bond ratings, describes the various types of bonds and bond
9
provisions and explains related financial risk implications
e) Describes the various classes and features of stock and explains related
9
financial risk implications
f) Explains the types of financial risk exposure (e.g. transaction,
economic, interest rate, exchange rate, etc.) and explains the use of
9
various methods of hedging to manage financial risk (e.g. forwards,
futures, options, swaps, etc.)
Note that each of the CMA Competency Map requirements listed above have been extracted
from different subtopics in the financial management section of the CMA Competency Map,
specifically, the time value of money, valuing stocks and bonds and long-term financing. The
requirements with respect to bonds have been included in one area to facilitate efficient studying.
The elements of the CMA Competency Map included in this section have been bolded under the
“Skill Level” requirements listed above.


Process of Valuing Securities
Theoretically, the value of a security is the present value of the price paid (e.g. shares) or face
value (e.g. bonds) of the security, plus the present value of the income stream associated with the
security (dividends or interest). In reality, there are many factors affecting the price of a security
that are not under the control of the company (e.g. general economic conditions or inflation).
Bond Features and Prices

A bond is like an ‘interest only’ loan, where the borrower (bond issuer) pays interest to the
bondholder each period, but does not pay the principal amount (face value) until the maturity
date. Although a bond is really a loan, there are terms used that are specific to the bond markets:
Face value or par value:

amount that is borrowed and must be repaid at maturity
Coupon:
the stated interest rate on the bond and is used to calculate the interest paid to the bondholder
Bond Values and Yields

Interest rates fluctuate over time. However, the cash flows associated with a bond stay the same
because the coupon rate and maturity date are specified in the bond. The result is the price or the
value of a bond, fluctuates so the yield earned on the bond equals the current market rate.
Calculating the current value (price) of a bond considers the number of remaining periods until
maturity, face value, coupon rate and the current market rate (yield to maturity). The value of the
bond is calculated by present valuing both the face value and the interest cash flows using the
current market rate (also called the yield).
Example:
A bond has the following terms:

Face value $100,000
Coupon rate 8% paid semi-annually
Market rate 10%
Term five years

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Value of the bond:
Present value of face value at market rate
$100,000 x PVIFn = 10 i = 5
$100,000 x .614 $61,400
present value factor: .614
Note: When determining the PV, remember to use the correct number of periods, in this
case 10 because interest is paid twice a year, five years x two a year = 10 and the correct
interest rate, effective rate or yield and since interest is paid semi-annually, 10% / 2 = 5%.
In addition, the present value factor is PV of an amount, so be sure to use the correct PV
factor chart. These are all common errors on the Entrance Exam.
Present value of interest at market rate 30,888

10% semi-annual = 5% per period
five years = 10 periods
payment at end of period
present value factor: 7.722
$4,000 (interest received) x 7.722
Note: As above, the interest rate to use and the number of periods must be calculated
correctly based on the yield or effective rate and number of payments per year. In
addition, the present value factor for the interest portion is the PV of an annuity, so be
sure to use the correct PV factor chart. These are all common errors on the Entrance
Exam.
$92,288
Assume one year has expired and the market rate for bonds has increased to 12%. What is the
value (price) of the bond?
Solution:
Present value of face value at market rate
$100,000 x PVIFn = 8 i = 6
$100,000 x .627 $62,700
present value factor: .627
Note that the PVIF is foreight periods, calculated as four years x two and
the interest rate is based on the new market rate of 12%, 12% x 6/12 = 6%
Present value of interest at market rate 24,840

12% semi-annual = 6% per period
four years = eight periods
payment at end of period
present value factor: 6.210
$4,000 (interest received) x 6.210
$87,540
Note that bond valuation is also required in financial accounting, although in financial
accounting the CMA Competency Map requirements go one step further and require candidates
to calculate the discount or premium and amortization of it. This means bond valuation can be
examined in either financial reporting or financial management on the Entrance Examination.

Page 137

Interest Rate Risk
Market rates or yields fluctuate constantly. This means the value of a bond fluctuates constantly
due to market rate interest changes. The possibility the bond value will change due to market
interest rate changes is known as interest rate risk.
How much interest rate risk a bond has depends on how sensitive its price is to interest rate
changes. This sensitivity depends on two factors:
1. The longer the time to maturity, the greater the interest rate risk.
2. The lower the coupon (or stated) rate, the greater the interest rate risk.
Time to Maturity
The reason longer term bonds have greater interest rate sensitivity is because a large portion of
the bond’s value is due to the face value amount. If the bond is long-term, a small change in
interest rates can significantly impact the value (price of the bond) because the small change
impacts many periods.
Lower Coupon Rates
Recall that the value of a bond depends on two factors, present value of the face amount and
present value of the interest stream. If two bonds have the same maturity date and face value, but
have different coupon amounts, the a larger proportion of the total value of the bond with the
lower coupon comes from the face amount.
Example:
Bond 1 Bond 2
Bond face value $100,000 $100,000

Coupon (stated) rate 6% 10%
Current market rate (yield) 12% 12%
Term five years five years
Current value of the bond repayment:

Present value of face amount:
100,000 x PVIF n = 10, i = 6
100,000 x .558 55,800 72% 55,800 60%
Present value of interest stream:

Bond 1:
100,000 x 6% x 6/12 = 3,000
3,000 x PVIF n = 10, i = 6
3000 x 7.360 22,080 28%


Bond 2:
100,000 x 10% x 6/12 = 5,000
5,000 x PVIF n = 10, i = 6
5,000 x 7.360 36,800 40%
$77,880 100% $92,600 100%
Note that the value of the bond with the lower coupon rate is proportionately more dependent on
the face amount (the face amount comprises 72% of the bond’s value). As a result, when market
interest rates change, the value of the bond with the lower coupon will fluctuate more than the
bond with the higher coupon.
Calculating Yield to Maturity

There may be occasions when the price of a bond is given, as well as the coupon rate, face value
and term. With this information, it is possible to calculate the yield (or market rate).
Example:
Market price of bond $954.88
Face value $1,000
Coupon rate 8%, paid annually
Term six years
What is the yield (market rate)?
To calculate the yield manually requires trial and error (a financial calculator provides an answer
quickly and easily).
The value of the bond consists of two components, present value of an amount (i.e. present value
of the face amount) and present value of an annuity (i.e. present value of the interest payment
stream).
1,000
OR 1,000 × PVIF = ?
(1 + r)6
80 × 1 - [1/(1 + r)6]
OR 80 × PVIF = ?
r
$954.88


To calculate r requires trial and error. However, there is some direction. Since the price of the
bond is $954.88, the bond is selling at a discount. This means the yield rate must be higher than
the coupon rate of 8%.
Using trial and error at 10%:
PV of the face amount:

1,000 × PVIF n = 6, i = 10
1,000 × .564 = 564.00
PV of the interest:
80 × PVIF n = 6, i = 10
80 × 4.355 = 348.40
$912.40
Using trial and error at 9%:
PV of the face amount:

1,000 × PVIF n = 6, i = 9
1,000 × .596 = $596.00
PV of the interest:
80 × PVIF n = 6, i = 9 = 358.88
80 × 4.486
$954.88
Features of Bonds
All long-term debt, including bonds, are promises by the issuing company to pay the principal
when due and to make interest payments when requiredIn addition to these basic elements of
debt, there are other features as well.
Note that many of the features discussed here are not only applicable to bonds, but to debt in
general. To facilitate efficient studying, the terms of debt in general are included here.
Maturity
Short-term debt has a maturity of less than one year, intermediate term debt has a maturity of
between one to three or five years and long-term debt, theoretically, has a term of more than one
year, although long-term debt could be categorized into intermediate term and long-term.
This applies to all debt, not only bonds.

Page 140

Indenture (Deed of Trust)
The indenture is a written agreement between the corporation (the borrower) and its creditors
(lenders), which details the terms of the debt issue. Note that many of the features described here
apply to various forms of debt, not only bonds.
Generally the indenture covers the following provisions:
1. Basic terms of the bond

The indenture states the principal amount of the bond and the interest terms (coupon rate
and the dates paid).
The bonds can either be registered or be in bearer form. Registered bonds are bonds
whereby an external party, called the registrar, keeps a record of the ownership of each of
the bonds. Interest is paid to the registered owner. Bearer bonds are not registered and
holding the physical bond certificate is considered evidence of ownership. The holder of the
bond certificate detaches the interest coupons that are attached to the bond and mails them
to the corporation to receive payment of the interest.
2. Security
This refers to the security attached to debt.
Collateral means there is a pledge of some type of asset for the debt. If the debt is not
repaid, the debt holder can claim the asset. In bonds, collateral is sometimes a pledge of
common stock of the company.
Mortgage loans are secured by the property being mortgaged. If a mortgage is on specific
property, it is called a chattel mortgage. A blanket mortgage pledges all the real property
owned by the company as security.
Bonds are often unsecured. A debenture is unsecured debt, usually with a maturity of 10
years or more when issued. The term ‘note’ is generally used for debt instruments that are
unsecured and have a maturity of less than 10 years when originally issued.
3. Seniority
Seniority is the position debt holders have over other creditors. In the event of default by
the company, the seniority ranking determines the amount the debt holder will recoup.
Subordinated debt is debt that has a lower seniority ranking than other debt. In the event of
default, subordinated debt holders lose preference to specified creditors, which means the
subordinated debt holders will only be paid after the specified creditors have been paid.
A special mention of the seniority ranking of taxes owing is warranted. The ranking for
taxes owing depends on the type of tax that is owing.


Source deductions
These are paid out before secured creditors. If the corporation does not pay, the CRA can
seek amounts owing from the company directors.
This means these taxes owing would be first (among all creditors).
GST/HST/PST
Since these amounts are collected by companies on behalf of Her Majesty (government),
they are like a “trust” fund and are treated in the same light as a secured creditor in a
bankruptcy situation. For these taxes, if the corporation does not pay, the CRA can seek
amounts owing from the company directors.
This means these taxes would be below source deductions but likely above all other
creditors.
Income Taxes Owing

In a bankruptcy situation, these amounts are not secure. Just like other people who might
have accounts receivable amounts, the government would put in a claim for amounts
owing. Often the amount is not stated as usually the financial statements or income tax
returns have not been prepared. The important point would be that income taxes are
unsecured amounts.
This means the amounts owing would be on the same level as all other unsecured creditors.
4. Repayment
Bonds can be repaid in full at maturity or in part or full before maturity. To ensure
sufficient funds to repay the bonds, many companies use sinking funds. A sinking fund is a
fund to which the corporation makes regular payments and the fund is used to repay the
bond when it comes due. Sinking funds, are usually managed by a bond trustee.
5. Call provisions
A call provision in the terms of the bond allows the company to repurchase (“call”) part or
all of the bond at a stated price over a specified period of time.
Generally, the call price is more than the bond’s stated value (face value). The difference
between the call price and the stated value is the call premium. The call premium may be
stated as a percentage of the bond’s face value and usually declines over time.
The call provision is usually not operative during the first part of a bond’s life; normally,
the call provision starts later. For example, a bond may have a provision where it cannot be
called for 10 years. This is known as a “deferred call”. During the period it cannot be
called, it is said to be call protected.


Canada plus calls is an approach to creating call terms, which make it unattractive for the
issuer to call the bonds. These calls do not set a call price in the bond terms, but provide
that the call premium must equal the difference in interest between the original bond
interest and the interest on new bonds. This means the issuer does not benefit from calling
bonds and then replacing them with new bonds with a lower interest rate.
6. Protective (restrictive) covenants (applies to loans in general, not bonds)

Loans may have covenants that restrict a company’s actions.
Examples of covenants include:

Negative covenants
i) restrictions on dividends that can be paid
ii) assets cannot be pledged to other creditors
iii) major assets cannot be sold or leased without approval by the lender
iv) the company cannot issue additional long-term debt
Positive covenants
i) working capital must be maintained at a specified level
ii) audited financial statement must be provided to the creditor
iii) assets pledged as collateral or security must be kept in good condition
Bond Ratings
Bonds are rated by two leading bond rating companies, the Canadian Bond Rating Service
(CBRS) and the Dominion Bond Rating Service (DBRS). In the US, the leading bond rating
company is Standard & Poors (S&P). These bond rating services rate the credit-worthiness of the
bond; in other words, the likelihood the bondholder will get paid. This is also known as default
risk.
Bond ratings only measure default risk and do not measure interest rate risk (discussed earlier).
This means a bond can be highly rated, which means the risk of default is low, but the bond’s
prices are volatile because of the interest rate risk associated with the bond.
A summary of the ratings used by DBRS are:
AAA Bonds rated AAA are of the highest credit quality, with exceptionally strong protection
for the timely repayment of principal and interest.
AA Bonds rated AA are of superior credit quality and protection of interest and principal is
considered high.
A Bonds rated A are of satisfactory credit quality. Protection of interest and principal is
still substantial but the degree of strength is less than with AA-rated entities.


BBB Bonds rated BBB are of adequate credit quality. Protection of interest and principal is
considered adequate, but the entity is more susceptible to adverse changes in financial
and economic conditions or there may be other adversities present, which reduce the
strength of the entity and its rated securities.
BB Bonds rated BB are defined to be speculative, where the degree of protection afforded
interest and principal is uncertain, particularly during periods of economic recession.
B Bonds rated B are highly speculative with a reasonably high level of uncertainty as to
the ability of the entity to pay interest and principal on a continuing basis in the future,
especially in periods of economic recession or industrial adversity.
CCC Bonds rated CCC are highly speculative.
CC Bonds rated CC are extremely speculative.
C Bonds rated C are extremely speculative and are in immediate danger of default.
D Bonds rated D are currently in default of interest, principal or both.
Determinants of Bond Yields
The Term Structure of Interest Rates

Generally, short-term and long-term interest rates differ. The relationship between short-term
and long-term interest rates is known as the term structure of interest rates. The term structure of
interest rates tells us what nominal interest rates are on default-free, pure discount bonds of all
maturities. These rates can be considered to be ‘pure’ interest rates because there is no risk of
default and there is a one lump sum future payment.
When long-term rates are higher than short-term rates, the term structure is upward sloping and
when short-term rates are higher, the term structure is downward sloping.
The question is “what determines the shape of the term structure?” There are three main
components that define the term structure:
1. Real rate of interest (may be phrased as required rate of return on the Entrance Exam)
This is the rate investors require for investing their money.
2. Inflation rate
Investors demand a premium to compensate for future changes in inflation. This is
known as the inflation premium. The inflation premium is the portion of a nominal
interest rate that represents compensation for expected future inflation.
3. Interest rate risk

Recall that longer term bonds have a greater risk of loss due to changes in the market
interest rates then short-term bonds. Investors understand this risk; therefore, investors
investing in longer term bonds require a premium for bearing this risk. This is known
as interest rate risk premium.


The term structure of interest rates can be depicted as:
Ĺ Upward-sloping term structure
Nominal
interest
rate
Interest rate
Interest risk premium
rate
Inflation
premium
Real rate
Time to maturity
Ļ Downward-sloping term structure
Interest Interest rate Nominal

rate risk premium interest
rate
Inflation
premium
Real rate
Time to maturity


Bond Yields and the Yield Curve
If yields for Government of Canada bonds, which are considered to default free and highly
liquid, were plotted on a graph, the graph would look like this:
6.5
6
Bond Yields (%)
5.5
4.5
0 5 10 15 20 25 30
Years to maturity
Government of Canada Bond Yield Curve
This is called the Canada yield curve or the yield curve. The shape of the curve is a result of the
same factors as the term structure of interest rates: real interest rates, inflation rates and interest
rate risk. So, it can be concluded the shape of the yield curve for Canadian government bonds is
influenced by several factors: zero default risk (because they are considered to be default free),
high liquidity, real interest rates, inflation rates and interest rate risks. The question for investors
is the shape of the yield curve for corporate bonds and whether it is similar to the Canada yield
curve. The answer is no, because the corporate yield curve is subject to two other influences,
default risk and the liquidity of the bond. A corporate bond is not default free, which means there
is a risk the bond issuer will not pay. Investors demand a premium for bearing this risk, which is
called the default risk premium. The default risk premium is defined as the portion of a nominal
interest rate or bond yield that represents compensation for bearing the risk of default.


In addition to the default premium, investors demand a liquidity premium. Corporate bonds have
varying levels of liquidity. Liquidity refers to how active the market is for the bond, which
means the ability to quickly sell it. Some corporate bond issues do not trade on a regular basis,
which means it may be difficult to sell the bond. Investors prefer liquid bonds as opposed to non-
liquid bonds; therefore, if a bond is not liquid, investors demand a liquidity premium. Liquidity
premium is defined as the portion of the nominal interest rate or bond yield that represents
compensation for lack of liquidity.
The influences on the yield curve can be summarized as:
Canada yield curve Corporate bonds

(Government of Canada bonds) yield curve
Default premium None Yes

Liquidity premium None Yes
Real rate of interest Yes Yes
Inflation premium Yes Yes
Interest rate risk Yes Yes
Theories with respect to the Yield Curve

Three common theories for the shape of the yield curve are:
• Expectations Theory
The simplest theory is the theory of expectations, where investors use expectations of future
economic events to estimate the interest rate and the yield, required.
• Liquidity Preference Theory

This theory states that interest rates or yields have a built in allowance for the fact investors
prefer liquidity, given the choice. Thus, shorter terms to maturity would have a smaller
liquidity premium than longer ones and the differences in premiums from one period to the
next decrease over time toward zero. Eventually, the difference in liquidity premium
becomes irrelevant because an investor does not consider the difference between, say, 25
years and 26 years into the future as being significant.
• Segment Theory/Preferred Habitat

The final theory is actually an amalgamation of several different concepts. Originally, a
segmented financial market was considered to exist and investors stayed in their own
segment of the market. However, more recently the so-called “preferred habitat” theory has
replaced this belief. It holds that investors have a preferred maturity structure for their
investments and must be enticed to move from it to other maturity structures by appropriate
yield incentives.
Note that these three theories are not mutually exclusive. There is good reason to believe that
elements of all three are present in the financial markets.


Common and Preferred Shares
5.1.1.1 e) Valuing stocks and bonds
• Describes the yield curve and discusses the theories explaining its shape 9
• Calculates the current value (price) of bonds, preferred shares and
common shares based on the future benefits (cash flows) given a 9
discount rate
• Calculates the value (price) of a stock according to a variety of
approaches (e.g. dividend growth models, book value, liquidation
9
value, price/earnings multiples, present value of growth
opportunities (PVGO), etc.)
b) Compares the features and relative merits of various sources of
financing and financial instruments available to a given organization 9 9
and calculates their effective costs and market values
c) Describes shareholder and creditor rights and determines the
9 9
return/yield of various types of financial instruments
e) Describes the various classes and features of stock and explains related
9
financial risk implications
f) Explains the types of financial risk exposure (e.g. transaction,
economic, interest rate, exchange rate, etc.) and explains the use of
9
various methods of hedging to manage financial risk (e.g. forwards,
futures, options, swaps, etc.)
Note that each of the CMA competency requirements listed above have been extracted from
different subtopics in the financial management section of the Competency Map,. The
requirements with respect to common and preferred shares have been included in one area to
facilitate efficient studying. The CMA Competency Map requirements covered in this section
are in bold font.


Process of Valuing Securities
Theoretically, the value of a security is the present value of the price paid (e.g. shares) or face
value (e.g. bonds) of the security, plus the present value of the income stream associated with the
security (dividends or interest). In reality, there are many factors affecting the price of a security,
which are not under the control of the company (e.g. general economic conditions or inflation).
Common Shares
Common Share Valuation

Common shares differ from bonds because the future cash flows are unknown. The ultimate cash
flows depend on the future market price of the shares and the dividends paid. Generally, the price
of a share today is calculated as the present value of all the future dividends.
Growth and Common Shares

The impact of growth, which refers to increases in the dividend over time, is considered in three
separate circumstances:
1. Zero growth
2. Constant growth
3. Non-constant growth
1. Zero growth
The value of a zero growth common share is simple to calculate. Since common shares do
not have a maturity date, theoretically, the dividend stream extends to infinity. This is a
perpetuity. Recall that calculating a perpetuity is:
C
Value of Perpetuity =
r
Calculating the price (value) of a zero growth common share is identical, excepting
terminology. The value (price) of a zero growth share is:
Solution:
D
P0 =
r
where
P0 = price (or value) of the share
D = dividend (which is the cash flow)
r = the investor’s required return


Example:
A no growth common share pays dividends of $1 per year. What is the value (price) of a share
at a required rate of return of 16%?
Solution:
1.0
P0 = = $6.25 per share
.16
2. Constant growth
If a company’s dividends grow each year, the value (price) of the common shares is like a
growing perpetuity. Calculating the value (price) of a common share in this circumstance is
through the following formula:
D1
P0 =
r–g
where
P0 = price of the share today
D1 = dividends
r = required rate of return
g = growth rate
This is known as the dividend growth model or Gordon’s growth model and is easy to use.
Example:
Next year’s dividends (i.e. dividends at time D1) on a company’s shares are $2.50, the
required rate of return is 15% and the growth rate is 5%. What is the price of a share?
2.50
P0 = = $25
.15 - .05
This formula is not provided on the formula sheet provided on the exam. However, the
formula sheet does provide the formula for calculating the cost of common shares.
This formula can be easily manipulated into the price (value) formula. This being said, note
that the terminology for calculating the price (value) of a share from an investor’s perspective
is different than the terminology from the company’s perspective. An investor is concerned
with returns (r) while a company is concerned with cost (ke). These are the same thing, just
different words.


The formula provided on the formula sheet is:
Cost of Common Equity:
Cost of Common Shares (Capitalization of Dividends with Constant Growth Rate):
D1
____
ke = + g
NPe
where D1 = dividend expected for period 1

NPe = net proceeds on common share issue
g = annual long-term dividend growth rate
The formula can easily be manipulated to:

D1
______
NPe =
ke - g
This is the formula to calculate the value (price) of common shares. You need to remember
that NPe means Price (P0) and that ke means required rate of return (r).
3. Non-constant growth
This refers to a situation where there is zero growth at the beginning, but dividends start at a
later date and once the dividends begin, there is constant growth.
In these circumstances, it is necessary to calculate the price of the bond on the date that
dividends begin and there is constant growth and then present value to the present.
Example:
A startup company will not pay dividends for the first four years. At that time, dividends will
be paid at the end of Year 4 in the amount of $1.20 per share. The required rate of return is
16%. Once dividends begin, the dividend is expected to grow 6% per year. What is the price
of the share?
First, calculate the price of the share when dividends begin:
D1 1.20
P0 = = = $12 per share
r–g .16 - .06
Present value of shares to today

$12 × PV of amount, n = 4, i = 16%
= $12 × .552 = $6.624


Calculating Required Return
Formula for calculating r:
D1
r = + g
P0
where:
D1 = dividends at time 1
P0 = price of stock at time zero
g = growth rate
Note that this formula is identical the one provided on the formula sheet, except for terminology.
The formula sheet provides the formula from the company perspective, which refers to cost,
while the price (value) of shares refers to the required rate of return (r).
Common Share Features

Common shares are typically voting, which means the common shareholders elect the Board of
Directors. Preferred shareholders and bond holders do not have voting rights. Other rights that
common shareholders have are:
• the right to share proportionately in dividends paid to common shareholders
• the right to share proportionately in assets remaining after liabilities have been paid in
a liquidation
• the right to vote on important shareholder matters, such as a merger (usually at either
the annual general meeting or at a special meeting called to address the matter).
Common shareholders may also have what is known as preemptive rights. A preemptive right
means if the company is selling additional shares, the current shareholders have a right to buy
them before the common shares are offered to the public.
Dividends
Dividends are paid to shareholders and represent a return on the shareholders’ capital invested in
the company. For common shares, the Board of Directors determines the dividend payment.
Common share dividends are not mandatory, but are paid at the discretion of the Board of
Directors.


Characteristics of dividends include:
1. Dividends must be declared by the Board of Directors to become a liability. That is,
unless a dividend is declared, it is not a liability. This law prevents a corporation from
going bankrupt due to non-payment of dividends. This means no accounting entry is
recorded for dividends until they are declared.
2. Dividends are not tax deductible. They are paid out of after tax profits.
3. Dividends received by an individual shareholder (a person) are subject to the dividend

gross up and dividend tax credit.
Classes of Shares
Some companies have more than one class of common shares. These different classes are created
with unequal voting rights. The main purpose of creating different classes is to avoid unwanted
changes in control or to retain control within a small group. For example, Canadian Tire has two
classes of common shares, both are publicly traded, but one class is voting and one is not. Of the
voting shares, the majority (> 50%) are owned by members of the family that founded the
company.
Since majority ownership, which is > 50% of the voting shares, is required to control a company,
the non-voting shareholders could find themselves at a loss in the event of a takeover bid. To
protect these non-voting shareholders, companies may institute ‘coattail’ provisions for these
shareholders, which allow the non-voting shareholders to vote or convert their shares into voting
shares in the event of a takeover bid.
Preferred Shares
Preferred Share Valuation

Many preferred shares have a fixed dividend rate. This means the shareholder will receive a
fixed amount, usually stated as a percentage, on a regular basis, normally quarterly. This
dividend must be paid before any dividends can be paid to the common shareholders. The
dividend is paid to infinity (as long as the preferred shares exist).
This means the dividend stream is a perpetuity, which means the value (price) of preferred shares
is calculated in the same manner as perpetuity.


Example:
A preferred share pays dividends at 2.5% per quarter. If the dividends paid out each quarter are
$1, what is the price (value) of the shares?
Solution:
Price (Value) = $1.00 = $40
.025
Features of Preferred Shares

Preferred shares have preference over common shareholders in the payment of dividends and the
distribution of assets in the event of liquidation. Note that in the event of liquidation, preferred
shareholders rank before common shareholders, but after creditors such as bond holders.
Preferred shareholders do not have voting rights.
Stated Value
Preferred shares have a stated value. A cash dividend, which is a set amount, can be described as
an amount per share. For example, a set dividend of $2.25 on preferred shares with a stated value
of $25 actually represents a dividend yield of 9% ($2.25/$25).
Cumulative and Non-Cumulative Dividends

Dividends are not mandatory and a Board of Directors in any given year may decide to not pay
dividends, even though the dividend rate on preferred shares is set. Dividends on preferred shares
are either cumulative or non-cumulative, which impacts the ultimate payment of dividends in the
event dividends are not declared.
If a dividend is cumulative, it means if dividends are not declared in one year, they are carried
forward in arrears. When dividends are declared, both the past dividends (dividends in arrears)
and the current dividends are paid.
Non-cumulative dividends are not carried forward, which means if dividends are not declared in
any given year, the shareholder will not receive them.
If there are dividends in arrears, the cumulative dividends must be paid before any common
share dividends can be paid.


Preferred Shares – Debt or Equity?
Preferred shares have many features of debt – there is a stated value and the dividend rate is set.
In addition, there are various types of floating rate (adjustable dividends) preferred shares, which
is similar to variable rate debt. This means preferred shares can be similar to debt, even though it
is a form of equity from a legal, tax and regulatory perspective.
Preferred share dividend rates tend to be low, which raises the question, why invest in preferred
shares? When corporations invest in the shares of other corporations, the dividends received are
not taxed. This is covered in the tax section in this manual. Since this income is non-taxable,
while bond interest is taxable, there is a lower dividend rate on the preferred shares so the return
is not substantially different than investing in other instruments, such as bonds.
Preferred Shares and Taxes

Since preferred share dividends are not tax deductible and bond interest is, this has an impact on
the issuing company. In addition, for the receiving company (i.e. the investor, if a corporate
investor) the dividends are not taxable income, while bond interest is. The impact on both the
issuer and the corporate investor is:
Impact on net income of preferred share dividends vs. bond interest for the issuer:
Bonds Preferred Shares
Earnings before interest and taxes $100,000 $100,000
Interest (assumed amount) 10,000 N/A
90,000 100,000
Taxes at 40% 36,000 40,000
54,000 60,000
Dividends (assumed amount) N/A 10,000
Net increase in equity $54,000 $50,000
Difference of $4,000 is the tax benefit of the interest->lower

taxes were paid in the amount of 10,000x 40% = 4,000


Impact on net income of preferred share dividends vs. bond interest for the receiver (i.e. the
investor), if the investor is a corporation:
Income received $10,000 $10,000
Taxes on income received (assume (4,000) Not applicable
40% rate)
Net income to the receiver (investor) $6,000 $10,000
From the perspective of the investing corporation, taxes are

lower if dividends are received since dividends from Cdn.
companies are non-taxable for corporations
Debt vs. Equity Financing

The differences between debt (see previous section on bonds) and equity can be summarized as:
Debt
Advantages Disadvantages
• interest is tax deductible • interest must be paid regardless of net
income/cash flows
• interest paid does not bear any relationship • debt may have restrictive covenants
to a company’s net earnings; therefore,
there is less focus on income ‘smoothing’
• control is not diluted by issuing debt • principal must be repaid at maturity (if
financed through share issuance, no
repayment required)
• if inflation rate is high, debt is repaid in • decreases future borrowing capacity
cheaper dollars
Equity
Advantages Disadvantages
• no repayment required • dividends are not tax deductible
• dividends are not required, excepting • dilutes control of a corporation (if voting
preferred shares that have a stated dividend rights attached to shares issued)
amount
• improves debt-to-equity ratio • as more shares are issued the market value
per share decreases
• usually more expensive to issue shares than
debt (underwriting costs, legal and
accounting fees etc.)


Capital Budgeting (NPV)
5.1.1.1 e) Capital budgeting
• Explains the key motives for making capital expenditures (e.g. expansion,
9
replacement, renewal, etc.) and the steps in the capital budgeting process
• Defines and explains the use of various methods of project evaluation (e.g.
net present value, payback period, internal rate of return (IRR), 9
profitability index (i.e. benefit/cost ratio, etc.)
• Explains the concept of incremental cash flows, sunk costs, terminal cash
9
flows and opportunity costs
• Identifies, defines and computes the relevant cash flows of a capital
project (e.g. capital outlay, opportunity costs, after-tax operating cash
flows, cash flows from ownership and disposal of depreciable property 9 9
such as tax shields from CCA and salvage, cash flows from investment in
and recovery of working capital, etc.)
• Determines relevant cash flows of a project from a set of forecasted
9
financial statements (income statement, multi-year balance sheets)
• Describes and explains the selection of the appropriate discount rate to use
9
for net present value (NPV) calculations
• Calculates the (NPV) of a project 9
• Calculates the payback period of a project 9
• Calculates the internal rate of return (IRR) of a project 9
• Calculates the profitability index of a project 9
• Describes and explains the pitfalls of using the IRR and payback methods
9
for project evaluation and selection
• Applies the various capital budgeting methods to various situations (e.g.
when projects are/are not mutually exclusive and/or independent, when 9 9
projects have different durations, when one asset is replacing another, etc.)
• Explains and applies techniques for selecting among capital projects when
9 9
faced with limited funds (e.g. capital rationing, ranking approach, etc.)
• Explains the key motives for making capital expenditures (e.g. expansion,
9
replacement, renewal, etc.) and the steps in the capital budgeting process
• Defines and explains the use of various methods of project evaluation (e.g.
net present value, payback period, internal rate of return (IRR), 9
profitability index (i.e. benefit/cost ratio, etc.)
• Explains alternative approaches to dealing with risk in evaluating capital
9
projects (e.g. sensitivity analysis, adjust the discount rate, etc.)
• Explains and considers the impact of various factors (e.g. political risk,
discount rate, foreign exchange, etc.) in international capital budgeting 9
decisions


Net Present Value
NPV (net present value) analysis, a capital budgeting tool, is a method used to determine
whether an investment is financially attractive. This method computes the net present value of all
incremental cash flows associated with an investment and deems the investment financially
acceptable if the sum of the cash flows (the net present value) is positive.
Capital Budgeting Terminology

The following terms reflect tax related concepts used in net present value analysis.
CCA: capital cost allowance; represents the amount of depreciation for tax purposes that can be
deducted in a year
UCC: undepreciated capital cost; represents the balance remaining after yearly CCA is deducted
for tax deductible investments
CCA rate: the rate of yearly depreciation for tax purposes
Capital cost classes: classes of assets, each of which has a prescribed CCA rate
Capital gain: recovery of capital greater than original cost
Recapture: represents recovery of previously deducted CCA; is the amount the selling price
(“proceeds of disposal”) exceeds UCC up to the original cost:
Selling price (proceeds)
Capital gain
Original cost
Recapture of
previously
deducted CCA
UCC


It is important to remember the amount of proceeds deducted from a class cannot exceed the
original cost. Recapture only occurs when the balance in the class is negative. When this
occurs, the negative balance is included in taxable income. Since recapture is included in taxable
income, the organization's tax liability increases; therefore, recapture is an outflow.
Terminal loss: represents loss due to selling price being lower than UCC – in effect, CCA was
insufficient:
Original cost
UCC
Terminal loss, if there are no physical assets remaining

in the class
Selling price (proceeds)
Terminal loss reduces tax liability; therefore, is an inflow. It is important to remember that
terminal losses are tax deductible only when there are no more physical assets in the class. If
there are assets remaining, then the terminal loss is not deductible and there is not an inflow.
Capital loss: arises only on non-depreciable assets, as depreciable assets are subject to the
terminal loss provisions
Tax shield: represents tax benefit from purchasing a tax-deductible asset
Salvage value: (also known as disposal value or terminal value) is the expected cash proceeds
when investment is sold, often at the end of its useful life. Salvage has two
impacts:
1. cash inflow at disposal (present value of an amount)
2. reduces the present value of the CCA tax shield


Cash Flows
Examples of common cash flows:
Non-recurring
• initial investment
• recapture or terminal loss
• salvage value
• increased working capital requirement at the beginning of a project and release of
this working capital at the end of the project
Recurring:
• incremental yearly revenue
• yearly cost savings
Cash flows may also be deferred annuities, where the first payment or receipt does not take place
until more than one period has expired. Calculation of the present value of these cash flows is
illustrated as:
Time line:
$$ $$ $$ $$ $$ $$
$$$
Calculate the
present value using
the present value of
an annuity
$$$
Calculate the
present value
using the present
value of an
amount


Discount Rate
This represents the rate to use to discount cash flows. The cost of capital commonly used for this
rate is the weighted average cost of capital, as this cost of capital represents the cost of all
sources of capital. The WACC is dependent on the capital structure of the organization; using
the WACC in capital budgeting assumes the risk associated with any investment proposal will be
close to the average risk of the organization. The cost of capital is also known as the hurdle rate,
cut off rate, target rate or required rate of return. Note that since discounting cash flows at the
weighted average cost of capital reflects capital costs, no capital items such as dividends or
interest payments are considered in the net cash flow analysis of investments.
The Impact of Taxes on Cash Flows

Taxes impact cash flows because expenditures that are tax deductible have a lower net cost to a
company and taxable cash receipts have a lower cash inflow to the company. For example, rent
of $5,000 for a building is tax deductible. Since it is tax deductible, the after tax cost, assuming a
40% tax rate, is $3,000 ($5,000 – ($5,000 X 0.4) = $3,000).
On the other, hand taxable cash receipts of $20,000 have an after tax value of $12,000 ($20,000
– ($20,000 X 0.4) because the company must pay tax on the $20,000.
The Impact of Taxes on the Discount Rate

If using after-tax cash flows to calculate NPV, the discount rate must be adjusted for the tax
impact. To adjust one factor and not the other skews results because, for example, pre-tax cash
flows discounted at an after-tax discount rate would result in a higher NPV than pre-tax cash
flows discounted at a pre-tax discount rate. The organization’s weighted average cost of capital
is an after tax rate so it is consistent with net present value analysis in the presence of taxes.


Tax Shield
Purchasing a depreciable asset that is tax deductible through CCA results in a benefit to the
purchaser. The present value of this benefit must be incorporated into the NPV calculation to
determine whether or not the investment is viable. In addition, CCA tax shield lost on disposition
of the investment must be taken into consideration.
CCA tax shield formula for a new asset, assuming no disposition:
PV of CCA = Cdt x (2 + k)
tax shield d+k 2 (1 + k)
= Cdt x (1 + .5k)
d+k (1 + k)
Where:
C = capital cost
d = CCA rate
t = tax rate
k = cost of capital or discount rate
This formula is provided on the Entrance Examination so it does not need to be memorized.
If the asset will be disposed of prior to its useful life, there will be lost CCA tax shield on the
disposal proceeds. This must be incorporated into the CCA tax shield formula:
PV of CCA = Cdt x (1 + 0.5k) - Sn x dt

n
tax shield d+k (1 + k) (1 + k) (d + k)
Where:
S = salvage value
n = time period
Note that the second part of the formula is subtracting the present value of the lost tax shield on
salvage.


If the asset is not newly acquired (e.g. you are considering selling an asset you have had for
several years and need to determine the PV of the tax shield you will lose by selling) the CCA
tax shield formula is:
PV of CCA = UCC x dt
tax shield d+k
Where:
UCC = undepreciated capital cost of asset
Candidates often have difficulty understanding why it would be necessary to calculate the CCA
for an ‘asset that is not newly acquired”. Suppose a company is deciding on whether to buy a
new machine and dispose of the old machine. When the old machine is disposed of, there will
not be any future CCA tax shield on the old machine. Therefore, when deciding whether to
purchase the new machine, management of the company needs to take into consideration the
CCA tax shield on the old machine that will be foregone if the new machine is purchased. In
these instances, the formula, PV of the CCA tax shield on an asst that is not newly acquired,
would be used
Merits and Limitations of NPV

Merits:
• considers the time value of money
• calculates based on absolute dollar value and not percentages; therefore, the decision
maker can sum up the NPV of various different investment opportunities to determine
the total impact of any combination of projects
• can use varying discount rates, which is useful in addressing risk – the longer the
project, the greater the risk that cash flows will not materialize. For example,
assuming a six year project life, a discount rate of 12% could be used for the first
three years and 15% for the subsequent three years
Limitations:
• long-term cash flow forecasting may be difficult to obtain
• assumes cash flows occur at the end of the period
• there could be goal incongruency if management is evaluated on a different basis than
the potential investment. For example, if management is evaluated on ROI,
management may not undertake an investment because it decreases their ROI;
however, the investment may have a positive NPV, which indicates the investment
should be undertaken since it would benefit the company. To avoid this, management
should not be evaluated solely on ROI in the short-term.


Steps in Calculating NPV
• Identify all the incremental cash flows associated with the investment. If analysis is after tax,
determine after-tax cash flows of cash flows subject to tax.
• Determine discount rate. If analysis is after tax use the after tax required return. Compute the
present value of all cash flows
• Calculate the tax savings due to CCA tax shield and tax shield on terminal losses and
calculate tax cost on recapture.
• Sum the present value amounts determined in step 3 and 4. A positive NPV indicates an
investment is viable, while a negative NPV indicates the investment is not worthwhile.
Comprehensive Example
Initial cost $100,000
Life of project 6 years
Annual cash inflows $12,500
Residual (salvage) value $11,000
CCA rate 30%
Discount rate, pre-tax 20%
Working capital required $18,000
(starting at Year 1, released at end of project)
Additional cash inputs required for maintenance (tax deductible):
At end of Year 3 $2,000
At end of Year 4 $1,500
Tax rate 40%
Cash Flows:
A B AxB
Post-Tax Post-Tax Present Outflow
Pre-tax Amount Discount Rate Value Present or
Year Amount (Note 2) (Note 1) Factor Value Inflow
Non-recurring:
1 $100,000 $100,000 12% 1 $100,000.00 O
3 2,000 1,200 12% .712 854.40 O
4 1,500 900 12% .636 572.40 O
1 18,000 18,000 12% 1 18,000.00 O
6 18,000 18,000 12% .507 9,126.00 I
6 11,000 11,000 12% .507 5,577.00 I
Net outflow $104,723.80 O
Recurring:
1-6 12,500 7,500 12% 4.111 $30,832.50 I


Notes:
1. Post-tax discount rate = 20% x (1 - .40) = 12%

2. For all items subject to tax, post-tax amount = pre-tax amount x (1 – tax rate)
= pre-tax amount x (1 - .4)
Tax Shield:
Cdt x (1 + 0.5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= (100,000 x .3 x .4) x (1 + (.5 x .12)) - 11,000 x (.3 x .4)

6
(.30 + .12) (1 + .12) (1 + .12) (.3 + .12)
= 12,000 x 1.06 - 11,000 x .12

(.42) 1.12 1.9738225 .42
= (28,571.42 x .9464285) – (5572.9428 x .2857142)
= 27,040.816 – 1,592.2688
= 25,448.55 (rounded)
NPV = $104,723.80 outflow – 30,832.50 inflow – 25,448.55 inflow

= $48,442.75 net outflow or negative NPV
Note that candidates may get slightly different answers due to rounding and differences in the
number of decimal places set in your calculator. In this regard, storing intermediate calculations
in your calculator will reduce the size of rounding errors since calculators use the amounts stored
internally, which usually have more significant digits than the amounts displayed.


Other Methods of Project Evaluation
Internal Rate of Return (IRR)

Also known as the time adjusted rate of return, IRR is the discount rate at which the present
value of expected cash inflows equals the present value of expected cash outflows (i.e. PV of
cash inflows = PV of cash outflows). In other words, it is the rate at which NPV = 0. If the
calculated IRR is greater than the required rate of return, the investment should be accepted.
Calculating IRR
If annual cash flows are constant, it is relatively easy to compute the IRR.
Example:
Investment = $3,433
Annual cash flows at end of each year for five years = $1,000
3433
Present value interest factor =
1000
= 3.433
Looking up 3.433 on a present value of annuity table (n=5) shows this investment earns
14%. If the calculated present value interest factor lies between two values on the table, a
percentage return can be determined using interpolation.
If annual cash flows are not constant, the IRR is calculated by trial-and-error to find the rate of
return that equates the present value of cash outflows to the present value of cash inflows. Many
financial calculators can compute the internal rate of return.
Merits of IRR
• considers the time value of money
Limitations of IRR
• difficult to calculate
• if cash flows cycle between positive and negative, there may be multiple values of IRR
• ignores varying sizes of investments in competing projects
• the IRR is in percentages, not in absolute dollars
• cannot combine the IRR's of different projects to derive an IRR on the combination of
projects
Risk and IRR

To address risk, guidelines can be set; so only projects meeting a minimum IRR are accepted.
For example, if a company’s normal rate of return is 16%, a threshold of 19-20% could be set.
This allows a margin of error of 3-4%, which reduces the risk of accepting projects that
ultimately do not meet the normal rate of return of 16%.


Payback
This method measures the amount of time to recover the initial investment.
The formula is:

Payback period = Investment
Net annual cash inflow
Example:
Potential Investments
A B A÷B
Investment Annual Cash Payback
Flow
Machine A $150,000 $50,000 3.0 years
Machine B $100,000 $40,000 2.5 years
Machine B should be purchased because it has a shorter payback period.
Limitations of the payback method

• ignores the time value of money – treats a dollar earned in, say, three years the same as a
dollar earned today
• ignores profit earned after payback of the initial investment. If the useful life of the machines
in the above example issix years for both machines, Machine A would have total cash flows
of $300,000 ($50,000 x 6) and Machine B would have cash flows of $240,000 ($40,000 x 6).
The net cash flows are:

A B
Annual cash flows $300,000 $240,000
Initial investment 150,000 100,000
$150,000 $140,000
As can be seen, Machine A is the better investment, ignoring the time value of money
and considering total cash flows.
Merits of payback method

• this method is simple and can be calculated quickly; therefore, can be considered a guideline
in determining which investment to consider further (good tool for preliminary screening of
projects)
• easily understood
• highlights liquidity (project with a short payback more liquid than a project with a long
payback)
• the above likely explains why the payback method is the most widely used method for
evaluating investments


Risk and Payback
To address the risk associated with investments, companies can set guidelines for the payback
period. A high-risk project must meet a shorter payback period to be accepted and vice versa for
low risk projects.
Profitability Index
The profitability index is equal to the sum of the present value of the future cash flows divided
by the initial investment. If the PI > 1, then the project is accepted. The PI is used in situations
where we have capital rationing, i.e. we have more positive NPV projects than we have funds to
invest in. We use the profitability index to rank the projects and accept the ones with the highest
PIs until you run out of funding.
Summary of Merits and Limitations of NPV, Payback

and IRR
Merits
NPV Payback IRR
• considers time value of • easy to calculate • considers time value of
money money
• use absolute dollar • analysis can be performed
amounts, which eases quickly
analysis of various
investment project
combinations
• can incorporate varying • often used as a general
discount rates, which guide before more
allows greater flexibility in extensive analysis is
accounting for risk undertaken (used as a
screening tool)
• easily understood
• highlights liquidity


Limitations
NPV Payback IRR
• requires long-term • does not recognize time • difficult to calculate
forecasting of cash flows, value of money
which may be difficult to
obtain
• assumes all cash flows • ignores cash flows after • ignores varying sizes of
occur at the end of the the payback period investments in competing
period projects and their dollar
profitability
• these flows represent the
profit on the investment
International Capital Budgeting Decisions

Factors impacting international capital budgeting decisions:
• political risk: an investment located in a politically unstable country has

increased uncertainty. This risk can be accounted for by increasing
the discount rate, increasing required IRR or reducing the payback
period threshold.
• cash flows: since the investment is in a foreign investment, it is important to
consider the uncertainty of cash flows. This risk can be addressed
similarly to political risk or sensitivity analysis (e.g. “what if”
analysis) can be undertaken
• discount rate: the discount rate used must reflect the cost of capital in the foreign
country or must be adjusted to take into consideration the
uncertainty of cash flows.
• foreign exchange risk fluctuations in foreign exchange rates can greatly impact
anticipated cash flows. Fluctuations can be estimated through
review of historical fluctuations and monitoring of general
economic conditions in the foreign country.


Capital Budgeting Decisions – Non-Financial Factors
It is important to consider qualitative factors in any capital budgeting decision. Both financial
and non-financial factors must be weighed. A positive NPV indicates a project must be accepted;
however, negative non-financial consequences may outweigh the financial benefit, ultimately
resulting in declining a project. Examples of qualitative factors to consider include:
• consistency with corporate strategy, policies and objectives
• management's attitude towards risk
• social, political and technological impact of the investment on the organization and the
surrounding environment
• whether access to capital is limited
• public perception
• corporate citizenship responsibilities
• impact on employees
• relationship with government
• relationship with customers
• brand or company image
• intangibles/immeasurables such as potential lawsuits from possible health and safety
failures
• if the investment is in a different industry or business than the company, the project may be
difficult to manage or the company may need to hire a manager
• if the investment is outside Canada, management should consider the availability of
supplies or other necessary resources
Capital Rationing
When there are several investment opportunities and limited funds, companies must select which
mix of projects to accept. This is called capital rationing.
NPV and Capital Rationing

To rank projects, a profitability index is frequently used. A profitability index is the NPV of net
future cash inflows divided by the initial cash outflow.


Example:
A B B÷A
Present
Value of
Initial Net Cash Profitability
Projects Investment Inflows Index Ranking
A $600,000 $870,000 1.45 4
B 310,000 471,200 1.52 3
C 450,000 720,000 1.60 2
D 500,000 900,000 1.80 1
Using the ranking, along with qualitative factors, a decision about which projects to accept can
be made.
NPV, Capital Rationing and Mutually Exclusive Projects

When projects are mutually exclusive and there are various projects competing for limited funds,
an analysis based on total NPV of all projects plus profitability index can provide additional
insights that are not provided by using only the profitability index.
Example:
A B B÷A
Present
Value of
Initial Net Cash Profitability
Projects Investment Inflows Index
A $500,000 $750,000 1.5
B 900,000 1,260,000 1.4
C 800,000 1,160,000 1.45
D 815,000 1,304,000 1.6
E 525,000 630,000 1.2
F 125,000 147,500 1.18
Assume projects A and B are mutually exclusive and available funds are limited to $2,640,000.


Analysis:
The projects are ranked using the profitability index and present values are compared.
Combination 1 including Project A Combination 2 including Project B
Project Investment Profitability PV of cash Project Investment Profitability PV of cash
Required Index inflows Required Index inflows
D $815,000 1.6 $1,304,000 D $815,000 1.6 $1,304,000
A 500,000 1.5 750,000 A excluded – A + B are mutually exclusive
C 800,000 1.45 1,160,000 C 800,000 1.45 1,160,000
B excluded – A + B are mutually exclusive B 900,000 1.40 1,260,000
E 525,000 1.2 630,000 E excluded – insufficient funds
F excluded – insufficient funds F 125,000 1.18 147,000
$2,640,000 $3,844,000 $2,640,000 $3,871,000
NPV = $1,204,000 NPV = $1,231,000

($3,844,000 - $2,640,000) ($3,871,000 - $2,640,000)
Conclusion: combination 2 is best as it results in higher net present value.
Note that although the profitability index for Project A is higher than Project B, ultimately
Project B is accepted because the combination of projects allowed by selecting B provides a
higher overall net present value.
IRR and Capital Rationing

Under the IRR method of evaluating projects, projects with the highest IRR are accepted in
descending order of IRR until the maximum spending limit is reached.
Payback and Capital Rationing

Under the payback method, projects with the shortest payback are accepted until the maximum
spending limit is reached.


Buy vs. Lease
5.1.1.1 f) Buy vs. lease
• Identifies, explains and assesses the reasons for leasing 9
• Identifies and describes the various types of leases (e.g. operating,
9
financial/capital, direct, sale-leaseback, leveraged)
• Applies the NPV method to a lease vs. buy situation from the
9
perspective of both the lessee and lessor and interprets the results
Note to candidates: An extensive example has not been provided as the decision to buy vs. lease
is merely application of the capital budgeting process described in the previous section.
Financing through Leasing

Reasons for leasing:
• does not require immediate cash
• avoids risk of obsolescence
• has fewer restrictions than bank financing
• if an operating lease, obligation is not recognized on the balance sheet
• often lessor provides maintenance and ongoing support during the lease
• may provide tax advantages – requires a comparison of CCA amount to deductible lease
payment
Disadvantages of leasing:
• often has a higher interest cost than bank debt
• may have a buyout clause requiring the lessee to buy the property at the end of the lease
(there is a risk the buyout amount may be greater than FV)
• in the long-term, often has a higher cost than buying the property
• if a building or land lease, may need lessor’s permission to make improvements
• if capital improvements are made, their benefit is lost if the lease is not renewed
• if lease is too long, lessee may experience obsolescence


Categories of leases:
• Service Lease
- involves both financing and maintenance services
- often has a cancellation clause allowing the lessee to cancel before the expiration date
• Financial Lease
- involves financing only
- usually non-cancellable
• Sale and Leaseback
- agreement whereby a company sells an asset and immediately leases it back
- provides a company with immediate cash and continual use of the property
• Leveraged Lease
- involves a third party
- the lessor borrows money from the lender to buy an asset, then leases it to another party
DCF: Leasing vs. Buying

The lease vs. buy decision is a discounted cash flow analysis that essentially discounts
incremental cash flows. Because this is a financing decision, all cash flows are discounted at the
after-tax borrowing rate.
Example: The Roberts Company has the option of buying some computer equipment with a
three-year life for $72,000 or leasing it at a payment of $27,000 per year over three years. If the
cost of borrowing is 10%, the tax rate is 40%,and the CCA rate for the asset is 30%. Should the
company lease or purchase? Assume obsolescence in three years in any case.
In a lease vs. buy situation, the ‘buy’ and ‘lease’ cash flows are always discounted at the
after-tax incremental borrowing rate of the organization. In this case, 10%(1-.4) = 6%.
Cost to buy avoided $72,000

Tax shield forgone: (72,000*.30*.40) / (.06 + .30) * (1.03 / 1.06) (23,321)
PV of lease payments: $27,000 x 0.6 = $16,200
$16,200 + PV of additional two payments of $29,701 (45,901)
(N = 2, I = 6, PMT = 16,200, Solve for PV = $29,701)
Net advantage to leasing $2,778
The net advantage to leasing is positive, therefore, we should lease the asset.


Mergers and Acquisitions
5.1.1.2 Describes the financial considerations involved in mergers and acquisitions
(see also F1.2.6.2)
a) Identifies and describes the basic legal forms of acquisitions (e.g. merger,
consolidation, acquisition of stock, acquisition of assets) and the 9
classifications of acquisitions (e.g. horizontal, vertical, conglomerate)
b) Differentiates takeovers and acquisitions, describes the different ways in
which a takeover can be achieved and explains the defensive tactics used 9
to resist a takeover
c) Explains the motives for mergers and acquisitions (e.g. synergy, revenue
9
enhancement, cost reduction, tax considerations, etc.)
d) Differentiates between tax-free and taxable acquisitions and explains
9
conditions for determining the tax status of the acquisitions
e) Calculates the value of the target company to the acquiring company,
9
including the value of synergies
f) Explains and calculates the impact of acquisitions on earnings per share 9 9
g) Explains the accounting principles underlying the accounting treatment
9
of mergers and business combinations (see also F6.1.8)
5.2.1.3 Type of investment (e.g. direct investment, outsourcing, strategic alliance,

merger, acquisition, etc.)
a) Describes and assesses the financial risks associated with various types
9
of investment, including international aspects
Definitions
Merger or statutory amalgamation: combination of two or more companies into one
Acquisition of shares: ownership of a corporation is purchased by another

corporation or individual through purchase of its shares
Acquisition of assets: only the assets of the corporation are acquired; debt may or
may not be assumed by the purchaser
Exchange of shares: a corporation may be acquired by issuing shares of the

acquiring corporation to the shareholders in return for the
shareholders’ shares in the corporation being acquired


Methods to Acquire and Financing
The acquisition can take place in several different ways and it can be financed in a number of
different ways as well. Acquisitions can be:
a. mergers or statutory amalgamations, a merger of equals where two organizations join
forces;
b. acquisition of stock where one company acquires all the shares of another organization
as a going concern; or
c. acquisition of assets where the acquirer obtains a specific package of assets from another
organization.
These acquisitions can be financed by:

a. paying cash;
b. providing shares in the acquiring organization;
c. providing other securities of the acquiring organization.
The purchase of another organization has a set of rules that must be followed. In cases where a
certain percentage of the shares of an organization have been obtained, then the acquirer must
declare the intention to acquire and make a formal offer to all shareholders. The organization
being acquired has the right to refuse the offer and take certain actions to defend itself. The
financial markets often call these methods “poison pills”. Some acquisitions are quite friendly as
the two organizations agree in advance on the terms and conditions of the merger. Some are
unfriendly, where two organizations engage in a legal skirmish, sometimes even a full-scale legal
war, which can be acrimonious and expensive.
Types of Mergers and Acquisitions

The reasons for acquisitions and mergers are often not clear, but there are three basic types that
can be differentiated:
a. the horizontal merger, where similar organizations join together;
b. the vertical merger, where an organization acquires a supplier or distributor to strengthen
its hold on its market by acquiring other parts of the production or distribution process; or
c. the conglomerate merger, where two different organizations with different lines of
business join together.
The impact of taxes on acquisitions depends on the financing methods used. Some acquisitions
are tax-free, while others are taxable. Acquirers need to look at the financing of the merger and
its probable tax impacts. Cash acquisitions, in particular, have significant tax implications.
Generally, the intention in acquisitions is to enhance shareholder value. Whether that is the
result or not depends a great deal on what is done after the acquisition. The primary benefits
should be operating synergies so the sum of the parts is greater than the parts individually. Thus,
earnings or profits should increase in a more than proportionate manner.


The financial accounting implications of business combinations are a special area of study. The
accounting methods are not a financial consideration, but rather are defined so the transaction is
recorded in what is considered an appropriate manner. The idea of these accounting rules should
be that they have no effect on the decision to acquire or merge with another organization.
Reasons for Mergers and Acquisitions

Most takeovers fall into two broad categories as defined by their motives. Disciplinary
acquisitions are intended to correct non-value-maximizing behaviour by the target's
management. Such behaviour might be a combination of excessive growth or unrelated
diversification, lavish consumption of perquisites and excessive employee compensation, as well
as the failure to manage the organization’s assets efficiently. The purpose of the disciplinary
acquisition is to improve the target company's existing operations. Because the intent is to
correct the poor performance of existing managers, many disciplinary takeovers tend to be
hostile in nature.
In contrast, synergistic acquisitions tend to be friendly. This type of combination exploits

strategic fit so the value of the combined entity is greater than the value of the individual parts.
For example, suppose Company A is considering the acquisition of Company B in order to take
advantage of synergies between the two cornpanies. If VA and VB are the market values of A and
B respectively, then the potential for a successful merger will exist if the value of the combined
entity, VA+B, exceeds the sum of their market values on a stand-alone basis. That is, the
precondition for a successful merger between A and B is that the companies are expected to be
worth more together than apart:
VA+B > VA + VB
This inequality will hold only if the operating cash flows of the two companies, when combined,
exceed the sum of their operating cash flows as separate companies. In other words, the merger
must bring about synergies that lead to an increase in revenue or a reduction in cost. Otherwise,
there is no economic rationale for merging.
Synergies can be generated in a number of ways. Among the more important ones are the
following.
1. To exploit economies of scale or scope: By acquiring organizations dealing in similar

products or markets, the buyer may reduce costs by combining production, purchasing,
administrative services and research and development, and eliminating duplicate
facilities, projects and operations.


2. To enter new markets: Certain acquisitions may be justified because they enable the
company to
• obtain proprietary processes like patent, copyright or trademark rights unavailable
through conventional licensing arrangements.
• obtain new selling and distribution channels in current and new markets.
• acquire new products that complement or supplement its existing product line.
3. To supplement managerial skills: When the buyer's management team is unable to

address the challenges and opportunities in fields in which the buyer is now active or in
which it intends to operate in the future, it may decide to acquire a company that does
have the requisite management skills.
4. To gain market power: Mergers can also consolidate market power and limit competition.
Buying a competitor is a way to do this; however, such activities may run afoul of
antitrust laws. A more subtle form of market power is possible when an
organizationengages in horizontal integration by acquiring organizations in the same
broad line of business. By increasing its market share, a company's bargaining power
with its suppliers and customers can be strengthened.
5. To acquire technical skills in industries in which technical know-how or rapid

obsolescence of existing technology is the rule.


Business Valuations
5.1.1.3 Describes the methods of business valuation
a) Identifies and explains important factors underlying business valuations
(e.g. assessing risk and growth potential, earnings sustainability, seller 9
vs. buyer perspective, reliability of historical information, etc.)
b) Calculates the worth of a business using a variety of valuation methods:
• Asset approaches (e.g. net book value, net realizable value) 9
• Earnings approaches (e.g. earnings multiples) 9
• Cash-flow-based approaches (e.g. net present value) 9
What causes the synergies or enhancements of shareholder value in acquisitions? How can
organizations be sure to achieve them? What is needed is a close look at where these synergies
can be found. Usually, they come from revenue increases, cost reductions, tax savings or lower
costs of capital. But, in addition to recognizing these potential gains, the organization must be
sure to achieve them. Achieving synergies is often not easily done.
Business valuation is a critical part of acquisitions and IPOs. What creates value? Generally the
process of valuation involves a critical look at a number of factors:
a. risk
b. growth potential
c. accuracy and reliability of past financial information
d. maintaining the benefits of the past, including customers and suppliers
e. differing perspectives of seller and buyer.
The calculations of value can be done in several different ways, while incorporating the above
factors.
a. Asset valuation methods, including net book value and net realizable value, incorporate
the valuation of the assets and liabilities. Where book values are not reliable, then the
net realizable value is used. Note that the best method for asset and liability valuation
would be market values, but these are often not available. Thus, book values become the
starting point for valuation, while realizable value is an adjustment to book values to
allow for less or more on realization in a sale. After all, what something is worth is what
someone else is willing to pay for it.
b. Earnings methods, such as the earnings multiple approach, use the expected earnings in
the next period or an average of the next several fiscal years combined with some
earnings multiple like the Price/Earnings ratio (P/E). The P/E is based upon similar
companies in the marketplace and is used as a multiplier to estimate the value. In some
of the mergers and valuations seen recently, the P/E ratio is assumed to be 50 or even 100


times expected earnings. This kind of ratio builds in an expected growth factor for the
foreseeable future of 20% or 30%. Many high technology stocks being issued have such
incredibly high P/E ratios when they are sold, they must grow at unbelievable rates for
the indefinite future – something no organization has ever done before and something
these organizations are not likely to do either. Such growth implications from high P/E
ratios must be kept in mind when valuing organizations. The historical average of P/E
ratios in the financial markets is about 10 to 15. There is no reason to assume this range
has suddenly become irrelevant or that high technology stocks are immune to this
standard in the long run. Growth will slow down and reality will set in.
c. Cash flow methods, such as net present value (NPV), are typically similar to the capital
budgeting methods used in finance. Cash flows for the foreseeable future are estimated
and then a net present value is calculated for these cash flows. To simplify the approach,
sometimes an above normal growth rate is assumed forfive or 10 years and then a static
cash flow or a cash flow with a stable growth rate is assumed thereafter.
The cash flow method used most often in business valuations is the present value of free
cash flows. Free cash flows are defined as:
Earnings before taxes and interest (1 – t)
Add depreciation
Less capital spending and investments in working capital
The projected free cash flows of the organization are then discounted at the
organization’s WACC to obtain a measure of its value. As in any capital budgeting
exercise, the terminal value in the past year should reflect the present value of cash flows
beyond the initial evaluation period. Because we are interested in the target's value to the
acquiring organization, the cash flow estimates must incorporate the consequences of any
changes the acquirer expects to make to the target's current method of operation.
The annual cash flows calculated in this way ignore financing flows such as interest on
debt, debt repayment and preferred stock dividends. These free cash flows represent the
cash flows that would be available to compensate all sources of capital used to finance
the acquisition. Discounting these free cash flows at the "appropriate" weighted average
cost of capital yields the value of the assets.
The procedure outlined above establishes the maximum amount that should be paid for
the assets of the target. Subtracting from the target's estimated value those liabilities not
included in the forecast of working capital needs gives us the value of the target's equity.
Dividing this equity value by the number of the target's common shares outstanding gives
us an estimate of the maximum price per share that could be offered.
Note that business valuation is not an exact science and these methods can and, often do, lead to
different answers. It is up to the valuator to determine which method is more reliable and what
value or range of values is appropriate. In theory, the best approach is to adjust the cash flow or
income figures and then use a reliable estimate for the interest rate or P/E ratio. However, this is
easier said than done.


Forms of Business Organization
5.2.1.2 Forms of business organization (e.g. corporation, sole proprietorship,
partnership, joint venture and income trust)
a) Describes the various forms of business organization 9
b) Explains, assesses and differentiates between the financial risks
9
associated with the various forms of business organization
The types of business organization include the following:

• sole proprietorship
• partnership
• corporation
• joint venture
• income trust
Sole Proprietorship
A sole proprietorship is a simple business structure where one individual controls the business
personally, without the benefit of a separate legal structure. From a legal standpoint, the business
is completely identified with the proprietor. The vast majority of operating businesses are sole
proprietorships, especially those in retail trade, agriculture and services. Most sole
proprietorships are quite small and account for a relatively low proportion of total monetary
transactions in Canada. But millions of sole proprietorships in existence testify to the advantages
offered by this form of business organization. Foremost among these advantages, especially for
new businesses, is simplicity. Other forms of business organization require elaborate forms and
fees and are governed by detailed legal strictures. Although a sole proprietorship may require
some form of provincial or municipal operating license, little else is required and the owner may
save considerable cost and paperwork.
Sole proprietorships also have other advantages. With few legal requirements, this type of
organization offers the owner a unique degree of control and flexibility. Any income generated
by the sole proprietorship has to be taken into income by the individual in the year incurred. For
tax purposes, sole proprietorship year-ends are December 31 to coincide with the taxation year of
the individual.
Counterbalancing these advantages are a number of potentially serious disadvantages. The most
significant of these is unlimited liability. Because the sole proprietor is, in effect, the business,
they are liable for all debts and other liabilities incurred by the business and risk losing even
non-business personal property. If, for example, the company defaults on a loan, the sole


proprietor may lose a home as well as a business. In recent years, many new sources of business
liability have appeared, such as product liability. Thus, the sole proprietor is at considerable risk.
A second problem for sole proprietors is the difficulty of obtaining financing. Because the ability
to borrow capital for expansion is limited by the proprietor's personal creditworthiness, profitable
expansion may have to be forgone. Sole proprietors may also have difficulty borrowing when the
business has financial problems. Another disadvantage of sole proprietorship is lack of
continuity. When the proprietor dies, so does the business, to the possible detriment of
employees and heirs.
Partnership
A partnership is defined as an association of two or more persons conducting a business.
Traditionally, all members of the partnership share equally in managing the enterprise and the
profits.
Partnerships offer a number of unique advantages. Unlike sole proprietors, partners have an
easier time obtaining financing because they may pool their resources to obtain credit; the ability
to borrow is backed up by their combined personal creditworthiness. Like sole proprietorships,
the partnership structure allows considerable management flexibility, though this depends upon
the expertise of individual partners.
Compared with corporations, partnerships experience less government control and generally
need not file any papers or formally adopt a specific organizational structure. Nevertheless, most
partnerships are based on a written agreement among the partners that spells out their relative
duties and rights. These agreements can be quite complex.
However, the partnership structure retains most of the disadvantages of the sole proprietorship.
Overall partnership liability is unlimited and includes all the personal assets of the partners. This
situation is ameliorated somewhat, though, by risk-sharing among the partners. In addition, a
different form of partnership, known as a limited partnership, can limit liability. A partnership
may include limited partners who invest money but do not participate in management. These
partners risk only the amount they invest in the organization. The law places specific restrictions
on this limited partnership structure, however, and all such partnerships must include at least one
general partner who is subject to full personal liability.
Other disadvantages parallel those of sole proprietorships. The death or retirement of a partner
automatically dissolves the organization, severely limiting continuity. However, partnership
agreements and partnership insurance (including a Buy-and-Sell Agreement) can significantly
reduce problems arising from the demise of one partner. Typical partnership interests cannot be
transferred without the unanimous consent of other partners, which also limits owner flexibility
and the ability to obtain new sources of capital.


Corporation
The corporation is the best-known form of business organization and, unlike the others, is
precisely defined by law. Corporations represent a small fraction of the total number of Canadian
businesses, but have the lion's share of total revenues and profits. Corporations are typically
larger and more closely regulated than other business structures.
Establishing a corporation is considerably more complex than setting up other forms of business
organization. A remarkable number of legal requirements cover corporate ownership; there are
filing requirements, taxes, fees and rules governing structure and ownership. Large corporations
usually also have a complex internal structure.
Although the shareholders theoretically own the corporation, individual shareholders generally
have little influence on management. Some major corporations have thousands or even millions
of shareholders. Shareholders are represented by a Board of Directors that exercise ultimate
responsibility in many matters.
The corporate structure offers a number of substantial advantages to the entrepreneur. Paramount
among these advantages is limited liability; because the corporation is recognized as an
independent legal entity, liability generally extends only to corporate resources and not to the
personal assets of the owners. A significant exception exists, however, where the owners have
undercapitalized the corporation; in this case, creditors may "pierce the corporate veil" and insist
on personal guarantees from the entrepreneur before extending the loan.
A second important advantage of corporations is their ability to raise additional money for
business expansion. A corporation may borrow money from conventional sources, depending on
its creditworthiness. It may also raise money through equity financing. In this process, the
company issues securities, known as shares of stock, for sale to the public. Purchasers become
part-owners of the corporation, with shares proportionate to their investment.
Corporations also allow relative ease and flexibility in the transference of ownership interest and
can continue to exist even after the death or departure of the original owners.
The corporate structure is not without its disadvantages, however. The complicated process of
forming a corporation may represent a considerable disadvantage, especially to a small or new
business. Ongoing compliance costs may also be considerable because certain corporate
activities, such as the issuance of new securities, are governed by a large and complex body of
regulatory law. In large corporations, the complex corporate structure also results in relative
inflexibility for management and lack of control for owners. Finally, corporations face a different
tax situation, one that, for example, requires more regular tax payments than is the case for sole
proprietors.


Joint Venture
A joint venture represents a partnership between two or more companies to cooperate on a
specific project or line of business. Joint ventures are typically organized in a corporate form.
What distinguishes a joint venture is regardless of the percentage ownership of the joint venture,
each venturer has equal voting rights for purposes of decision making. For example, assume
Company A and Company B form the joint venture AB. Company provides 60% of the capital
and Company B provides 40% of the capital. Although the profits will be distributed based on
the percentage ownership, both Company A and Company B will have an equal number of votes.
Income Trust
An income trust is a corporate form that holds income-producing assets. Its shares are traded
much like stocks. Income is passed on to the unit holders (investors) through regular periodic
distributions. The main advantage of an income trust is the distribution of income to investors.
Choosing a Structure
There are no hard and fast rules regarding the best form of organization for a given enterprise.
Each structure has its own unique advantages and disadvantages, all of which must be considered
in setting up a business. But size is often an important consideration. For new businesses,
especially relatively small ones, the sole proprietorship is probably preferable, so long as no
major liability is contemplated. As the enterprise grows, its owners should consider changing to a
partnership or to a corporation, since these forms of business are better suited to the new
financial needs and risks of the operation. In general, the choice of an appropriate form of
business organization would certainly be influenced by: a) expected business size/profitability;
b) tax considerations; c) potential legal liability; and d) expected need for capital and the
potential sources of capital.

Page 184

Financial Risks of Various Investment Types
5.2.1.3 Type of investment (e.g. direct investment, outsourcing, strategic alliance,
merger, acquisition, etc.)
a) Describes and assesses the financial risks associated with various types
9
of investment, including international aspects
Note to candidates: Material related to types of investments is included in the strategic

management section of this manual. The relevant portions are reprinted here to remind
candidates that this material can be examined in either strategic management or financial
management on the Entrance Examination.
Direct Investment
A direct investment is defined as an investment that is sufficiently large to affect a company's
subsequent decisions. This is sometimes a majority ownership, but sometimes it is just a
significant minority ownership. Usually this direct investment is facilitated through share
ownership.
Reasons for direct investment vary, from controlling a supplier, to capital appreciation of the
underlying shares. Owning shares, either as a majority owner or significant minority, subjects
the owner to the financial health of the company (i.e. the investee company). This means if the
company has poor financial results, dividends will be reduced or not paid at all and capital
appreciation of the shares will not occur. In the worst case scenario, common shares could
become worthless.
Outsourcing
Outsourcing is the purchase of a good or service from an external supplier. Outsourcing is an
effective and often necessary approach as few organizations can afford to develop internally all
the skills and technologies needed to get and keep a competitive advantage. Attempting to build
competencies in all areas can cause an organizationto become overextended and thus decrease
their competitiveness. When an organizationoutsources activities in which it lacks competence,
it frees up time and resources, which can be focused on those areas where it is capable of
building strong competencies leading to a competitive advantage. Companies can investigate
how effectively they are performing their internal activities by examining their profit pools
and/or conducting activity based costing and/or doing a cost benefit analyses. The results should
be compared to the cost of outsourcing the less strategically relevant activities remembering that


outsourcing an activity to an outside source that has strong expertise in a particular area can
result in improved performance and savings for the organization and added value for the
company stakeholders.
There are some things that must be considered carefully when outsourcing. The first
consideration is an organizationshould never outsource anything that is currently a source of
competitive advantage for them. For example, companies should exercise extreme caution when
they outsource activities that can result in a potential decrease in an organization’sability to
innovate. The second consideration is managers need to be capable of creating and managing
partnerships in a strategic manner so that the internal management can fully benefit from the
work done by their partners. Management must have the ability to oversee and govern the
partnership arrangement as well as help the organization adapt to changes that inevitably occur
when an organization’s structure and operations change.
Strategic Alliances
This type of structure entails cooperation between competitors. An alliance represents a
collaborative agreement between competitors whereby each competitor contributes a distinctive
item, such as technology, distribution ability, basic research or manufacturing capacity.
A risk with strategic alliances is too much information or transfers of skills and/or technology
may occur (i.e. more than intended in the initial agreement). This can result in loss of future
earnings, as one party may take advantage of the knowledge learned in the alliance.

This is addressed in the previous ‘Merger and Acquisition’ section in this manual.


Financial Markets and Institutions
5.2.2 Describes appropriate methods of managing investment portfolios and
financial instruments for a given organization, including the evaluation of
portfolio risk
a) Describes and differentiates the various financial markets and institutions
(e.g. primary and secondary markets, money and capital markets, 9
international financial markets, financial intermediaries, etc.)
b) Explains the concept of market efficiency and its relevance to pricing of
9
an investment in widely and thinly traded assets and securities
Financial Markets
This is a forum whereby suppliers of funds (e.g. savers) and users (e.g. borrowers) of funds are
brought together. Suppliers provide cash to users and earn a return either through interest or
appreciation in value.
The interrelationship between the financial markets, the company and the debt holders or
shareholders can be depicted as:


Financial
Markets Company raises cash on
ST Debt the financial markets

LT Debt
Shares
Company uses cash raised in financial markets

to invest in current and fixed assets
Profit earned on the assets is:
used to pay reinvested in the used to pay interest to debt

taxes company to acquire holders or dividends to
more assets shareholders
The term ‘financial markets’ is broad. There are various markets that comprise the financial
markets. These are primary and secondary markets, money and capital markets and intermediary
markets. These are described below.
Primary and Secondary Markets

Primary market: This is for new issuances of shares or debt. When a public company wishes to
raise funds, it can do so by issuing new shares or new debt to the general public.
Secondary market: This is for previously issued securities (shares or debt). The value this market
places on securities is the perceived worth (i.e. fair value) of the company. An example of a
secondary market is the Toronto Stock Exchange.
Money Markets and Capital Markets

Money market: This is the short-term (less than one year) market for debt instruments, which are
highly liquid and have a low default rate. Equity securities (e.g. common shares) are not traded
on this market. This market is useful when a public company requires short-term credit.
Capital markets: This is the long-term market in which long-term debt and shares are traded.
Debt instruments in this market earn higher returns than those in money markets, but have
greater default risk. This market provides security valuations that are useful for assessing the
worth of a company.


Other Types of Markets
Intermediate and long-term debt markets: as the names imply, companies issue medium or long-
term debt on these markets. Generally, the longer the term, the higher the return, as there is
greater uncertainty.
International financial markets: This market handles international financial transactions between
Canada and other countries. These markets determine foreign exchange rates.
Derivatives markets: The derivatives securities markets have not added additional sources of
capital to the marketplace, but rather they added new risk management tools to the financial
markets, making old sources of capital less risky. Derivative securities are intended to provide
the opportunity for financial market participants to trade risk, based upon contractual
arrangements that place limits on potential losses. Options (puts and calls), futures contracts,
forward contracts and swaps all provide benefits to financial market participants, depending on
the terms and conditions of the contracts. In addition, there are more exotic derivatives that
combine the characteristics of various other derivatives to create even more specialized tools for
risk management.
Market Efficiency Theory

This theory postulates that in an efficient market, the price of a share represents its true value, in
that all information related to a company’s shares are reflected in its price. This theory assumes a
perfect market and no individual or group trading the security has sole access to information
(insider trading).
An efficient market benefits the economy because in an efficient market the true worth of the
company is known at all times.
There are three types of market efficiency: weak form efficiency, semi-strong form efficiency
and strong form efficiency:
• Weak form efficiency
− All historical information is reflected in the price
− Technical analysis and fundamental (ratio) analysis will not lead to superior returns
− Most markets are at least this efficient
• Semi-strong form efficiency

− all currently available public information is reflected in current prices
− reacting to “news” will be too late and will not lead to superior returns
− most markets in developed economies are this efficient


• Strong form efficiency
− all information (public and private) is reflected in current prices
− even insiders cannot earn superior returns
− no markets are this efficient
The efficient market theory indicates markets should be trusted since most prices represent a
consensus of the fair market value.
There is significant empirical evidence to support the idea that markets are weak-form efficient
and no useful information can be gleaned from examining past changes in stock price. Further, a
number of academic studies – known as event studies because they examine the stock market's
reaction to specific events – show the market reacts quickly to announcements of earnings or
dividend changes or unexpected mergers. In other cases, the event announcement may have a
negligible effect on the price of a stock because the market already anticipated the news from
other sources. The market's reaction to changes in an organization’sfinancing and dividend
decisions will depend, in large measure, on whether the news is truly new and how the market
interprets the data.
The idea that the market is strong-form efficient has not been warmly welcomed by investment
professionals. Why? If market prices reflect all information, both public and private, then efforts
to find inside information in order to beat the market would be a waste of time; after all, this
information is already imbedded in security prices. Proponents of strong-form market efficiency
would, therefore, contend that no one can beat the market on a consistent basis over time. Money
managers, of course, make a good living by convincing investors they can beat the market
through superior security selection.


Risk and Rates of Return
5.2.2 Describes appropriate methods of managing investment portfolios and
financial instruments for a given organization, including the evaluation of
portfolio risk
c) Describes the concepts of and relationship between return on investment
9
and risk
d) Describes and calculates the expected return of an investment and a
portfolio of investments using various methods (e.g. dollar amount, 9 9
percentage, average, etc.)
e) Identifies and explains the common approaches and statistical measures
used in finance to assess and measure asset and portfolio risk (e.g.
9
sensitivity analysis, probability distributions, variance, standard
deviation, covariance, correlation, beta, etc.)
f) Explains how financial markets value risk and how investors trade off
9
risk against expected returns
g) Explains the concept of diversification and how it relates to portfolio risk 9
h) Describes and differentiates systematic and unsystematic risk 9
i) Explains the concepts, uses and importance of the security market line,
market portfolio, market risk premium, risk-free rate, beta and the capital 9
asset pricing model (CAPM)
j) Calculates the expected return of a security using the CAPM 9
Relationship between Risk and Return

Risk is defined as the potential variability in future cash flows or the actual return will deviate
from the expected return. There is a risk return tradeoff so investments with the least amount of
risk have the lowest level of returns. Conversely, investments with higher risk have a return
premium attached to them. Government of Canada Treasury bills have the least amount of risk
attached to them and for this reason the T-bill rate is known as the risk-free rate of return.
Investors who require a higher rate of return analyze the risk inherent in an investment and attach
a premium to the return to compensate for assuming the risk. In other words, the minimum
acceptable rate of return for an investor is equal to the risk-free rate plus a return premium to
compensate for the risk associated with the investment. This can be stated as:
required (or expected) = risk free + market risk

rate of return rate premium
rm = rf + risk premium


Stated another way, the market risk premium equals
risk premium = r m - rf
The risk free rate is represented by Canadian Treasury bills.
Measuring Risk
Measuring risk is useful when comparing investment opportunities. Common measures used are
variance, standard deviation and the coefficient of variation (derived from variances).
Important: The knowledge level required for this topic is R/U or

remembering/understanding, not A/A or application/analysis. In addition,
candidates only need to ‘identify and explain’, not calculate.
Variances from Expected Returns

Expected returns
The expected return on an investment is the sum of various levels of estimated return, multiplied
by the probability of each level of return. This concept is identical to the concepts covered in
Expected Values (see Management Accounting notes). In essence, the expected value is the
arithmetic mean or average of all possible outcomes.
Example:
The following estimates of annual returns from owning shares in Remmit Inc. are based on
historical returns:
Rate of Probability of
Return Occurrence
0% 10%
7.75% 20%
18% 25%
25% 35%
32% 10%
100%
The expected return is calculated as follows:
expected return = (0% × .10) + (7.75% × .20) + (18% × .25) + (25% × .35) + (32% × .10)
= 18%


Variance and Standard Deviation
The variance is a statistical measure representing the dispersion of a random variable. The
standard deviation is the square root of the variance. Expected values indicate the average, while
variance and standard deviation measure dispersion (i.e. differences between the expected value
(average) and actual results).
Calculating variance and standard deviation
The basic formula for variance is:

2
expected value of actual return - expected return
The standard deviation is calculated as:
2
expected value of actual return - expected return
In the above calculations, the variance represents the sum of the squared deviations (between
actual and expected return) multiplied by the probability of their occurrence.
Example:
Using the data presented previously, Remmit Inc.’s variance and standard deviation are
A B A–B (A – B)2
Probability x
Actual rate of Expected rate Squared squared
return of return Deviation deviation Probability deviation
0% 18% -18% 324 .10 32.4%
7.75% 18% -10.25% 105 .20 21%
18% 18% 0 0 .25 0%
25% 18% 7% 49 .35 17.15%
32% 18% 14% 196 .10 19.6%
1.00
Variance = 90.15%
Standard deviation = 90.15 = 9.49%


Interpreting the results:
Since the variance and standard deviation measure the dispersion or deviations from the expected
value, they are a measure of risk. However, considering these results in isolation does not assist
in an investment decision. To determine if an investment is good or bad, the standard deviation
needs to be compared to the standard deviation of alternative investments.
Example:
An alternative investment, Noah Inc., has an expected return of 18%, but has a standard
deviation of 7.20%.
Recap:
Expected Return Standard Deviation
Remmit Inc. 18% 9.49%
Noah Inc. 18% 7.20%
Although both companies have the same expected return, Remmit is riskier, since it has a higher
standard deviation. This means the variability in returns (between expected and actual) is greater
in Remmit than Noah.
Portfolios
Portfolios refer to owning a group of investments as opposed to an individual security. The
expected return of a portfolio is calculated as the sum of the expected returns for each individual
security in the portfolio multiplied by its weight (usually determined by the amount of money
invested in each security).
Example:
An investor has invested in three securities, A, B & C. Numerical data is:
Amount Expected
invested Weight return1
A $200 2/10 25%

B 300 3/10 18%
C 500 5/10 10%
$1,000
1
The method to calculate expected returns was shown previously.

Page 194

The expected return of the portfolio is calculated as follows:
expected return weight expected weight expected weight expected

of portfolio = of A return + of B return + of C return
of A of B of C
= 2/10 (25%) + 3/10 (18%) + 5/10 (10%)
= 5% + 5.4% + 5%
= 15.4%
Risk of a Portfolio – Correlation between securities

As discussed previously, risk is the variability of future returns and is measured by the variance
and standard deviation. Measuring the risk of a portfolio (i.e. group of investments) is not a
function of summing the standard deviations of each investment multiplied by their weight. This
is because there may be relationships among the returns provided by the investments held within
a portfolio. Correlation is a statistical measure that measures the relationship between two sets of
values. It measures whether the two investments move together (e.g. both increase) or move in
opposite directions (as one increases the other decreases). Correlation coefficient assume values
between +1 and –1. A positive (+) sign indicates the investments move together in the same
direction, whereas a minus (-) sign indicates they move in opposite directions.
The numerical value indicates the strength of the correlation. If the correlation coefficient is near
zero, the linear relationship is not strong. If it is near +1 or –1, the linear relationship is strong.
The degree of correlation between investments is important because this determines the degree to
which diversification reduces the overall risk of the portfolio. For example, imagine two
perfectly positively correlated investments (i.e. correlation factor is +1). Owning these two
investments will not have any diversification effect because the investments move in the same
direction. Therefore, if one investment’s return drops by 10%, the second investment will do the
same, resulting in a net overall drop of 10%. On the other hand, if the two investments are
perfectly negatively correlated, they travel in opposite directions. If one of the investments drops
10%, the other investment increases 10%. The net overall result is zero percent drop.


Covariance
Covariance is a measure of the extent to which a pair of investments are expected to vary
together. In other words, it is the relationship between the variance (recall the variance formula
shown earlier) of one security to the variance of another security.
Calculating the covariance of pairs of securities within a portfolio incorporates the correlation
between the two securities and the standard deviation of each security. Recall that the standard
deviation is derived from the variance. The formula is:
covariance of = correlation coefficient × standard deviation × standard deviation

securities A & B between A & B of security A of security B
The standard deviation of the portfolio is calculated as follows. The securities in the portfolio are
securities A and B.
standard = Variance ( A + B )
deviation
= (WA2 × std devA2) + (WB2 × std devB2) + 2 WAWB × correlation × std dev × std dev
b/w A & B of A of B
Where
WA2 = weight (percentage) of funds invested in security A

WB2 = weight (percentage) of funds invested in security B
std devA and std devB = standard deviations of securities A and B
Note that the formula incorporates the covariance of the securities, which in turn incorporates the
correlation coefficient of the securities.
Portfolio Theory
Portfolio theory refers to the practice of assessing the risk of an individual investment in the
context of its contribution to the overall risk of a portfolio (e.g. group) of investments, rather
than assessing the investments individually based on the individual investments’ possible
deviations from expected returns. In other words, securities are evaluated relative to their impact
on overall portfolio risk, not on their individual risk characteristics.


Diversification
Diversification is defined as the process of investing in various different securities, rather than a
single security, in order to reduce risk.
Diversification reduces risk because of the correlation and covariance effect discussed earlier.
Studies of common shares listed on the Toronto Stock Exchange (TSX) (note that the TSX
restructured and became the TSX Venture Exchange in 2002, but is still known as the Toronto
Stock Exchange) have shown the standard deviation (a measure of risk) of a portfolio decreases
as the number of securities in the portfolio increases. Significant decreases in the standard
deviation of a portfolio were seen when the number of different securities was increased to 10.
Once past 10 securities, further decreases in the portfolio’s standard deviation were seen, but
they were small.
Diversification works by decreasing unsystematic risk (also known as unique or diversifiable

risk). Systematic risk, also known as market risk, cannot be reduced by diversification.
Unsystematic risk is a risk that affects only one or a small group of stocks. It is risk arising from
events restricted (e.g. unique) to one or a few companies. Examples of unsystematic risk are a
strike at Ford, a significant lawsuit that curtails activity, such as the Napster copyright lawsuit; or
development of a successful new drug by a pharmaceutical company.
Unsystematic risk is diversifiable because in a portfolio the effects of unsystematic risk on one
security offsets the unsystematic risk on another security, thereby reducing the overall risk effect.
Market risk is the risk arising from general economy-wide conditions. Generally, securities have
a tendency to move together in response to general market conditions. Regardless of the number
of securities held in a portfolio, a recession has a negative impact on all securities in the
portfolio. Conversely, a booming economy has a positive impact on all securities in the portfolio.
Market risk is non-diversifiable, as it arises from overall market conditions.


Unsystematic (unique) risk and market (systematic) risk:
Portfolio standard deviation
Unsystematic (unique) risk
Systematic (market) risk
1 5 10 15
Number of securities


Measuring Systematic (Market) Risk
Measuring market risk is important because, theoretically, this measures the ultimate risk for an
investor. Since unsystematic (unique) risk can be eliminated through diversification, investors
are rewarded only for assuming systematic (market) risk. The systematic risk principle states that
“the reward for bearing risk depends only on the systematic risk of an investment”. Therefore,
the expected return on a security depends on that securities’ systematic risk.
Systematic risk of an investment is measured by the investment’s beta coefficient. The beta is a
measure of an investment’s sensitivity to market movement. It is calculated as:
investment return
market return
This relationship can be illustrated as:
Return on security A
16%
return on
market
__ 10% +
__
beta of A = slope = 16 = 1.6

10
Therefore, for every 1% change in the market return, there is a 1.6% change in the security’s
return.
An investment that moves perfectly with market moves has a beta of 1. That is, for each change
in the market return there is an equal amount of change in the investment’s return.


Calculating a Portfolio’s Beta
A portfolio’s beta is the weighted average of the betas of the securities comprising the portfolio:
portfolio beta = (WA × BetaA) + (WB × BetaB) +…. (WN × BetaN)
Where:
WA and WB = proportion of total funds in security A and B respectively
BetaA and BetaB = beta of security A and B
WN = proportion of total funds in appropriate security
BetaN = proportion of beta in appropriate security
Example: Total risk vs. beta
Two securities, Security A and B, have the following standard deviations and betas.
Security A Security B
Standard deviation 40% 20%

Beta .50 1.50
Which security has:

Greater total risk?
Greater systematic risk?
A higher risk premium?
Since Security A has a higher standard deviation, it has higher total risk, although it has less
systematic risk (beta is lower than Security B).
Since total risk is the combination of systematic and unsystematic risk combined, Security A has
greater unsystematic risk. The standard deviation is higher than Security B and since the standard
deviation is a measure of total risk, A’s total risk is higher than B’s. However, A’s beta, which is
a measure of systematic risk, is lower than B’s beta, which means A has less systematic risk than
B.
Recall that since unsystematic risk can be eliminated through diversification, investors are
rewarded (i.e. earn a risk premium) only for assuming systematic (market) risk. Since B has a
higher beta, it has higher systematic risk. This means B has a higher risk premium and a greater
expected return, despite the fact it has less total risk.

Page 200

The Security Market Line (SML) and Capital Asset
Pricing Model (CAPM)
Beta and the Risk Premium

Assume there is a portfolio that consists of two assets,Ssecurity A and a risk-free asset (e.g.
Canadian T-bill). Varying possibilities of the expected return of the portfolio can be calculated
by adjusting the weights of each asset in the portfolio.
Example:
Portfolio consists of two assets, Security A and a risk-free asset. The returns and betas are:
Returns Beta Weight
Security A 20% 1.6 25%
Risk-free asset 8% 0 75%

(risk-free rate)
100%
The return on this portfolio:
expected return weight expected weight of return on

on portfolio = of A return + risk-free risk-free
of A asset asset
= (.25)(.20) + (.75)(.08) = 11%
The portfolio beta is:
Portfolio weight Beta weight of beta of

Beta = of A of A + risk-free risk-free
asset asset
= (.25)(1.6) + (.75)(0) = .40


If the weights of each of the assets,Security A and the risk-free asset, are adjusted to different
levels, the portfolio’s expected return and beta changes are:
Weights
Percentage Percentage Portfolio Portfolio
of of risk-free Expected Beta
Security A asset Return
0% 100% 8% 0.0
25% 75% 11% 0.4
50% 50% 14% 0.8
75% 25% 17% 1.2
100% 0% 20% 1.6
These points can be plotted on a graph:
portfolio expected return

(E(Rp))
E(RA) - Rf = 7.50%
ȕA
E(RA) = 20%
Risk-free rate 8%
1.6 = ȕA Portfolio beta

(ȕp)


The slope of the line that results from plotting the points on a graph is:
E(RA) - Rf
slope =
ȕA
Where:
E(RA) = expected return
Rf = risk-free rate
ȕA = beta of A
(.20 - .08)
slope =
1.6
= 7.5%
This 7.5% is the risk premium of Security A. This means, for every unit of systematic risk,
Security A has a risk premium of 7.5%. This is also stated as Security A has a reward-to-risk
ratio of 7.5%.
Using the risk-to-reward ratio

Calculating the risk-to-reward ratio for one security in isolation does not help an investor.
Investors need to consider the risk-to-reward ratio of various securities to determine where to
invest their funds.
Assume an investor invests in Security A, with a risk-to-return ratio of 7.5% (calculated above)
or Security B. Assume Security B has an expected return of 16% and a beta of 1.2%. If the
investor’s portfolio consists of a risk-free asset that has a rate of 8% and Security B, the
portfolio’s return and beta at different weights for each of the assets is:
Weights
Percentage Percentage Portfolio Portfolio
of of risk-free expected beta
Security B asset return
0% 100% 8% 0.0
25% 75% 10% 0.3
50% 50% 12% 0.6
75% 25% 14% 0.9
100% 0% 16% 1.2


Plotting the portfolio’s return and beta on a graph results in:
Portfolio expected return

(E(Rp))
E(RB) - Rf = 6.67%
E(RB) = 16% ȕB
Rf = 8%
1.2 = ȕB Portfolio beta

(ȕp)
The risk-to-reward ratio (i.e. the slope) for B is:

E(RA) - Rf
slope =
ȕA
= (.16 - .08)
1.2
= 6.67%
The risk-to-reward ratio for the securities is:
A B
Risk-to-reward ratio 7.50% 6.67%


What does this mean? The higher risk-to-reward ratio for Security A indicates for any given
level of systematic risk, as measured by beta, some combination of Security A and the risk-free
asset always provides a larger return. In other words, Security A is a better investment than
Security B. This can clearly be seen if Security A and B are both shown on the same graph:
Portfolio expected return Asset A

(E(Rp))
= 7.50%
E(RA) = 20% Asset B
= 6.67%
E(RB) = 16%
Rf = 8%
Portfolio beta (ȕp)

1.2 = ȕA 1.6 = ȕA
Impact of Different Risk to Reward ratios

Consider the impact the risk-to-reward ratios have on investors – in a well organized, active and
competitive market, investors would invest in A and not in B. This market pressure would cause
Security A’s price to increase and B’s price to decrease. Since the prices are changing, the rate of
return changes. A’s price increases, which means its return decreases, and B’s price decreases,
which means its return increases. This buying and selling would continue until the two assets are
on exactly the same line, which means the risk-to-reward ratio for each is the same. This is the
fundamental relationship between risk and return in an active and well-functioning market. This
fundamental principal can be stated as:
“The reward-to-risk ratio must be the same for all the securities in the market.”
Since, in equilbrium, all securities must have the same risk-to-reward ratio, if a security’s risk-to-
reward ratio falls above the line or below the line, there will be sufficient buying or selling of the
security such that the risk-to-reward eventually falls on the line.


Example:
There are two securities, Avone and Besel, with the following beta’s and expected returns:
Expected
Beta Return
Avonce 1.3 14%

Besel 0.8 10%
The risk-free rate is 6%.
Compare these two investments.
Solution:
Calculation of risk-to-reward ratio:
Avone Besel
Expected return - risk free rate .14 - .06 .10 - .06

beta 1.3 .8
Risk-to-reward ratio 6.15% 5.0%
The risk-to-reward ratios indicate Besel is overpriced because the risk-to-reward ratio of Besel is
less than Avone.
This could also be stated as Avone is underpriced because its risk-to-reward ratio is higher than
Besel’s.
In an active and properly functioning market, buying and selling activity on each security would
be such that their risk-to-reward ratio would eventually equalize.
Security Market Line Defined

The line that resulted from plotting the expected returns and beta coefficients is known as the
security market line (SML). As you have seen, this line depicts the relationship between
systematic risk and expected returns.


The SML and the Market Return
If all the securities in the market were plotted, what would the SML look like? By definition the
slope of the SML is
Expected return – risk free rate
beta
Since the beta of the market is 1 (i.e. the combined betas of all the securities trading on a market
must add up to one), this formula can be shortened to:
Expected - Risk-free
market return rate
This is known as the market risk premium.
security market line
rm
Risk
Expected return
premium
rf
Risk free return
Systematic risk (beta)


The Capital Asset Pricing Model (CAPM)
The CAPM states the relationship between an individual security’s expected return and its
sensitivity to systematic risk, as measured by beta, is linear. The previous discussion on the SML
and the risk-to-reward ratio is the CAPM.
Any security in the market must plot on the SML (if it doesn’t, buying and selling will occur
until it does). This means any particular security’s risk premium is the market’s risk premium.
This can be stated as:
expected return on a security - risk free rate = expected - risk free

beta of the security market return rate
Rj -Rf = Rm - Rf
ȕj
where Rj = expected return on security j

Rf = risk-free rate
ȕj = beta of security j
Rm = expected return on the market
This formula can be manipulated into:

Rj = Rf + ȕj (Rm - Rf)
where Rj = expected return on security j

Rf = risk-free rate
ȕj = beta of security j
Rm = expected return on the market
This formula, Rj = Rf + ȕj (Rm - Rf) is the CAPM formula (note that this formula is provided on
the formula sheet provided at the exam).
Note that the CAPM formula states the expected return of any security is a function of the risk-
free rate plus the risk premium and the risk premium impact will always vary in direct proportion
to the security’s beta.

Page 208

Example:
A security has a beta of 1.3, the risk-free rate is 4%, the market risk premium is 8.6%. What is
the expected return of the security using CAPM?
Solution:
= 4% + 1.3(8.6) = 4% + 11.18% = 15.18%
If the beta doubled to 2.6, what would the expected return be?
= 4% + 2.6(8.6) = 4% + 22.36% = 26.36%


Short and Intermediate Term Financial Planning
and Management
5.2.3 Describes the impact of working capital management, financial
forecasting and planning, and foreign exchange on a given organization’s
treasury function
a) Explains, describes and applies principles of short and intermediate
term financial planning and management
• Describes working capital management and explains its
importance to the financial management function of the 9
organization
• Explains the relationship between liquidity and return 9
• Explains and applies the principles of and techniques used for
managing cash, accounts receivable, inventory, accounts
9 9
payable, short-term loans and other components of working
capital, in both domestic and international settings
Note to candidates: The CMA Competency Map requirements related to short-term financing
have been combined in one location to facilitate efficient studying.

Page 210

Working Capital – General Concepts
The working capital position of the organization is the difference between its current assets and
the current liabilities. The management of current assets and current liabilities is often referred
to as working capital management.
Liquid assets can be readily converted into cash with a high degree of certainty about the
resulting price. With a high degree of liquidity comes a cost in terms of the yield that can be
achieved. There is a trade-off between liquidity and yields (return) – lliquidity has a cost in
terms of lower yields.
Relationship between liquidity and return (yield):
The rate of return on current assets is usually less than the return on fixed assets. Therefore,
when liquidity is improved (i.e. there are more current assets than fixed assets) the total return
earned decreases (liquidity ↑, return ↓).
Cash Management
Lower yields on liquid assets are one of the reasons why the management of cash and other
liquid assets is important. Cash provides the lowest yield of all liquid assets and should be
maintained only at levels needed to support ongoing activities. The question, of course, is what
are the cash needs of an organization? The primary needs are transaction and precautionary
needs; the former is used to meet day to day needs, while the latter is kept as a risk reduction tool
to avoid any unpleasant surprises. Modelling cash management needs is a complicated
mathematical process and, for organizations with large amounts of cash flows, a detailed model
is often advisable. For smaller organizations, however, the complexity of the process can be
considerably reduced. With good banking relationships and common sense, cash management
can be relatively easy.
Cash management refers to managing cash such that the amount of cash held is optimal. A
corporation should know its cash needs, sources of cash, amount available and the amount that
can be spent.
To determine the amount of cash to have on hand, management needs to take into consideration:
• liquidity position
• date of debt maturity
• ability to borrow
• expected cash flows
• risk preferences
• availability of a line of credit


In recent years the role of EFT (electronic funds transfer) and EDI (electronic data interchange)
have made cash management easier. Suppliers and employees can be paid at specified times
through EFT. EDI is often used to order new inventory. The use of these tools eliminates
paperwork and therefore reduces processing costs.
Accounts Receivable Management

Accounts receivable (A/R) are the next most liquid asset after cash, but require a somewhat
different set of management skills. These are debts owed to the organization by customers. It is
not just an issue of the speed with which these accounts are collected, but also the risk that some
debts will never be repaid. Accounts must be managed both for the speed of collection and for
the certainty they will be paid. Thus, credit policies of the organization become an issue in the
management of accounts receivable.
There is a cost of holding accounts receivable, as the cash amount is not available for use in
income producing activities. To reduce accounts receivable, a company can introduce various
policies.
• credit policy
- perform credit checks on new customers
- monitor customers’ financial position and decrease credit limits accordingly
- establish early payment terms or charge interest on late payments
- sell by cash on delivery to extremely high-risk customers
• billing policy
- bill customers immediately after sale
- invoice at the date the order is placed, not the shipping date
• collection policy
- monitor the aging of accounts receivables
- use collection agencies if necessary
- have credit insurance for unusual bad debt losses
Inventory Management
Inventories are the least liquid of current assets. The speed with which they can be turned into
cash depends on the nature of the inventory and the nature of the business in which the
organization operates. Inventory must be managed to ensure inventory levels are kept to a
minimum. There is a trade-off between inventory carrying costs and the benefits of holding
inventory. High inventory levels result in high carrying costs and insufficient inventory levels
result in potential lost sales due to stock outs and production slowdowns.


Common inventory management practices:
• use of models, such as EOQ, to ensure the optimum amount of inventory is ordered
• reduce lead time by introducing JIT or MRP
• dispose of obsolete items to reduce carrying costs
• monitor inventory levels carefully
• keep minimal levels of inventory for high risk items, such as computers, fashion
items and perishables
Accounts Payable
Accounts payable (A/P) or trade credit are liabilities of the organization owed to others. These
accounts occur in the normal course of business and are often called spontaneous financing.
Generally, accounts payable are a prime source of funds for organizations because they allow
delays in payments for goods and services received. Often creditors will encourage the
organization to pay its accounts by offering trade discounts. These discounts can have a
significant cost based on the opportunity cost of not taking them. A standard example is 2/10,
net 30, where a cash discount of 2% is offered if payment is made in 10 days, while full payment
is required in 30 days.
Accounts payable should be managed so payments are made at the last possible moment,
resulting in improved cash flows. Common accounts payable management practices:
• stretch A/P (pay at last possible moment)
• make payments in instalments
• monitor liquidity ratios, such as current asset to current liability ratio or acid test
• coordinate payment of payables with timing of cash receipts
• take advantage of trade discounts
Trade Discounts
When trade discounts (e.g. 2/10, net 30) are offered, not taking them results in a significant cost.
There is an opportunity cost of not taking advantage of the discount.
There are two different methods of calculating the opportunity cost of not taking the trade
discount. Which one to use is dependent on whether you are asked to calculate the effective
annual rate (EAR) or the annual percentage rate (APR). (Note to candidates – on the
examination please read the question carefully to determine whether it is asking for the EAR or
the APR. If the question does not indicate which to use, assume it requires you to calculate the
EAR.)


Formula for EAR:
365
DD-EPD
discount
EAR = 1+ 1 - discount - 1
Where:
discount = discount offered
DD = due date
EPD = early payment date
Formula for APR:

discount 365
APR = x
1 - discount DD - EPD
Where:
Discount = discount offered
DD = due date
EPD = early payment date
Note to candidates: Most financial calculators calculate the APR and the EAR, so rather then
memorizing this formula, consider using a financial calculator on the exam.
Example:
Invoice = $100
terms = 2/10, n/30
Calculation of the Opportunity Cost – EAR calculation:

365
DD-EPD
discount
EAR = 1+ 1 - discount
- 1
365
1 + - 1
30 - 10
EAR = .02
(1 - .02)
EAR = [1 + .020408] 18.25 - 1

= 1.4458 - 1
= 44.58%

Page 214

Calculation of the opportunity cost – APR calculation:
discount 365
APR = x
1 - discount DD - EPD
.02 365
= x
(1 - .02) (30 – 10)
= .020408 x 18.25
= 37.24%
Calculating EAR using BA2 Plus calculator
Trade discount is 2%, if paid within 10 days and n/30
Cost of the trade discount:

Future value = 100
Present value = 98, calculated as 100-2
N = (30-10)/365 OR 20/365
To calculate the trade discount on BA2 Plus, input the following:

FV -100
PV 98
N 20/365 =
Compute I/Y
Note that either the FV or PV must be entered with a minus sign. If it is not, an “error 5”
message will appear.
The answer is 44.58%.
Short-Term Financing
Other forms of short-term financing also exist, as well as trade credit, but these require specific
arrangements with creditors such as banks or other financing organizations. Banks provide what
are called lines of credit or revolving credit to organizations to allow them to manage their
working capital. Usually the collateral for such loans will be accounts receivable, inventories or
both. Other types of short-term financing can be obtained from money markets in the form of
commercial paper. These are short-term loans provided by lenders for terms of 90 to 360 days,
usually without specific collateral. Sometimes, however, organizations can provide collateral in
the form of accounts receivable.

Page 215

The cost of short-term financing is usually based upon the prime rate charged by the chartered
banks. Most of the time, organizations pay a small premium over the prime rate for working
capital financing; the interest cost moves with the prime rate. In the case of commercial paper,
the rate is set at issue, usually by selling the paper at a discount from its face value. The issuer
must pay the face value at maturity. There can also be issue costs associated with commercial
paper that must be considered in its cost.
Bank Loans
Short-term bank loans are repayable within one year or less and may be secured or unsecured.
Types:
• Overdraft
í An agreement with a bank to allow an account balance to become negative.
í Usually overdraft protection is limited.
í Interest charged on overdrafts is usually higher than interest on bank loans.
• Lines of credit
í An arrangement whereby the amount a customer can borrow is limited.
í The amount granted depends on the credit worthiness of the borrower.
• Revolving loan agreements
í In a revolving loan arrangement, the borrower can borrow at any time to a specified
limit.
í Usually these agreements extend beyond one year and can be regarded as
intermediate term financing.
• Transaction loans
í Represents borrowing for one specific purpose (e.g. a contractor borrowing to
construct a condominium).
í When the project is complete, the borrower repays the loan.
í These loans are made on a case by case basis and a borrower’s cash flow ability is
heavily scrutinized.
Money Market Lending

Large companies often use money market instruments to borrow on a short-term basis. As these
securities are unsecured, companies must be credit worthy.
Types of Instruments
• Commercial paper
í Represents a short-term negotiable promissory note
í Normally sold in multiples of $100,000
í May be sold at a discount or on an interest bearing basis
í Usually is less expensive than borrowing from a bank
• Bankers acceptances
í Often used to finance inventory sold but in transit
í Sold in multiples of $100,000 with terms of 30 to 180 days
í Often used by Canadian importers to finance imported inventory

Page 216

Cost of Short-Term Financing
Cost of Fixed Rate Bank Loans:
The cost of borrowing should be calculated using the effective annual rate (EAR). The general
formula for the EAR in the context of loans can be stated as:
365
Days outstanding
interest
EAR = 1+ Net amount of financing
- 1
Calculating the EAR of the loan is dependent on whether the total amount of the loan is received
by the borrower or the amount received is reduced by the interest. A loan may have terms
whereby the borrower does not receive the total amount of the loan, but the loan amount minus
the interest. This impacts the EAR.
Example:
Compare the before tax cost of a borrowing $50,000 for 60 days at 8%, assuming that: 1. interest
is added to the total amount owing; and 2. interest is deducted from the 50,000, so the borrower
receives less than $50,000.
Solution:
1. EAR with the borrower receiving $50,000.
Amount of interest paid = 50,000 x 8% x 60/365 = 657.53
365
60
657.53
EAR = 1+ 50,000
- 1
= 8.272%
2. EAR with the borrower receiving $50,000 minus 657.53 = 49,342.47

Amount of interest paid = 50,000 x 8% x 60/365 = 657.53
365
60
657.53
EAR = 1+ 49,342.47
- 1
= 8.386%

Page 217

Cost of Variable Rate Bank Loans:
First, it is necessary to calculate the interest paid on the loan and then calculate the EAR using
the formula above. The interest paid should be calculated using weighted average and then
calculate EAR using the interest paid amount.
Example
Calculate the cost of a variable rate loan at prime + 2% for 150 days. The prime rates are 6.25%
for the first 50 days, 7% for the next 72 days and 6.75% for the next 28 days.
Solution:
Calculation of interest paid:
Prime Prime + 2% Days Dollars
outstanding interest
6.25% 8.25% 50 $565.07
7.00% 9.00% 72 887.67
6.75% 8.75% 28 335.62
150 $1,788.36
Calculation of EAR:
365
150
1,788.36
EAR = 1+ 50,000
- 1
= 8.928%


Leasing as a Source of Financing
Leasing has become a popular form of short-term, intermediate-term and long-term financing.
Three basic categories of leases exist, namely the operating lease, the capital lease and the
financial lease. Operating leases generally involve providing for the use of an asset or assets
with some level of maintenance of the assets so they remain fit for use. Thus, these leases tend
to be short-term in nature, often for a year or less. The capital lease involves leasing an asset for
essentially its useful life. This type of lease is considered, for tax and accounting purposes, to be
equivalent to ownership, but the user of the asset never acquires ownership. The financial lease
involves providing the use of an asset for a fixed period of time, usually less than its useful life,
but this type of lease obligates the user to take care of the asset as if it was owned. The financial
lease is strictly a means of allowing an organization to acquire the use of the asset without
ownership. The lessor provides no additional services to the lessee.
Leases can be evaluated by using standard net present value (NPV) techniques. Usually the cost
of funds assumed is higher than a standard loan, but the risks of obsolescence are avoided if this
is a concern. In addition, since the organization that leases is often not able to afford to
purchase, the lease provides a slightly higher priced form of financing.
Venture Capital
Venture capital is money invested in companies that do not have access to conventional sources
of financing, such as bank loans or money markets. The funds may be lent at initial startup or
expansion. Venture capital is high risk because these companies are in startup or growth stages
and do not have a sufficient credit history to borrow from traditional sources. In Canada, venture
capital is frequently provided by the government, although there are private venture capital
companies. Due to the high risk of these companies, venture capitalists require a high rate of
return on money invested. Venture capitalists may require control of the investee or,
alternatively, include covenants in the debt agreement. Although a venture capitalist may have
control over the Board of Directors, venture capitalists normally do not participate in the direct
management of the company.


Financial Forecasting and Planning
5.2.3 Describes the impact of working capital management, financial forecasting
and planning, and foreign exchange on a given organization’s treasury
function
b) Explains and applies principles of financial forecasting and planning
• Understand the financial planning process (e.g. forecasting
future profitability, the need for cash and the need for
financing, etc.) and applies cash flow planning principles to 9 9
forecast cash flows and plan long-term and short-term sources
and uses of funds
• Develops pro forma financial statements using various
approaches (e.g. percentage of sales, judgmental, growth, etc.)
9
and understands the benefits and weaknesses of using these
approaches
This topic has the same underlying principles as cash budgeting and budgeting, which is covered
in the budgeting section in the ‘Performance Management” section of this manual. Candidates
are advised to refer to that section. Please keep in mind this topic could be examined in either
the Performance Management or the Financial Management section of the examination, since it
is listed in both areas of the CMA Competency Map.
The critical issue in the long-term success of any organization is its ability to plan its financial
needs with a significant degree of reliability. Both long-term and short-term financial needs
require careful planning. In addition, the uses of these funds will dictate to some degree the
sources that are most suitable.
In addition to cash planning, the organization will try to plan its overall financial position by
developing pro forma financial statements. These are based on anticipated sales, cash flows,
expenses and profits. Cash planning is just one part of the financial planning process involved in
preparing pro forma financial statements.
Note that the financial statements organizations prepare today require a statement of changes in
financial position based upon sources and uses of cash. The planning of these sources and uses is
of considerable importance to avoid unpleasant surprises at the end of the fiscal year.
Pro forma financial statements are typically prepared under the assumption the company
undertook various large scale projects or proposals. Preparing these statements allows the
company to see the impact the project has on the entire financial statements.


Foreign Exchange and Financial Management
5.2.3 Describes the impact of working capital management, financial
forecasting and planning, and foreign exchange on a given organization’s
treasury function
c) Describes the impact of foreign exchange on financial management
• Explains the relationships among currencies (e.g. fixed,
floating), how foreign exchange rates are determined, what
9
causes exchange rates to change and the impact of
currency fluctuations
• Describes the similarities and differences between
domestic and international sources of capital and financial 9
management
• Applies various methods of hedging to manage foreign
9
exchange risk
Note to candidates: methods of hedging is covered in the Financial Reporting Section of this
manual and will not be repeated here.
Foreign Currency Fluctuations

The exchange rate reflects the price of a foreign currency in terms of the domestic currency. If
we treat foreign currency like any other good, its price will be determined by supply and
demand. If there is more currency being supplied than is being demanded at the going price (if
there is excess supply for the currency), then its price will fall in terms of the domestic currency
until demand and supply are equated. This drop in price means the foreign currency will
depreciate in relation to the domestic currency. This decline in the value of the foreign currency
is the same as the decline in the value of beef if there are more steers produced. If the supply of
beef increases and the demand for beef stays unchanged, the only way the beef market will clear
is if the price of beef drops.
If the exchange rate is treated as the price that clears the market for a given currency, then we
must ask what determines the supply and demand of the currency. The traditional approach to
determining exchange rate, an approach which uses the supply-and-demand framework, views
the exchange rate as the price that brings about equilibrium between the demand for and supply
of domestic currency in exchange for foreign currency. These "demands and supplies" reflect, in
turn, international transactions in goods, services and financial assets.


When Canada purchases goods from Germany, it pays for them in currency or in barter. If it
exports as much to Germany as Germany exports to Canada, the balance of trade between the
two countries is in equilibrium and no further currency transactions are needed. But if Canada
exports less than it imports, it must make up for the deficit by paying in currency. If Germany
accepts dollars as payment, then Canada can use dollars to pay the difference between its imports
and exports. The larger the deficit, the greater the supply of dollars find their way into the
German market,but Germany only have a demand for so many dollars. As Canada gives them
more and more dollars to meet its deficit, an excess supply of dollars is created and the dollar
must depreciate relative to the Euro.
If Germany does not want all the dollars, it can sell them to another country that has an excess
demand for dollars. Such an excess demand will occur if that country imports more from Canada
than it exports; therefore, the dollars are needed to make up the difference. Germany will sell its
excess dollars at whatever price the market will bear. The world price for dollars will be
determined by the net world demand for dollars compared with the net world supply of dollars. If
Canada is faced with a trade deficit with all countries, then all countries will eventually find they
are holding more dollars than they want at the going exchange rate. For example, Germany may
try to sell its dollars to Britain, only to find Britain also has more dollars than it wants. The only
way Germany can get rid of its excess supply of dollars is to sell them at a discount. Instead of
trading them to Britain at the going rate of, say, $1.50 per pound, it must sell them at, say
$1.60/pound. In such a case, the dollar has depreciated relative to the British pound.
The exchange rate for the dollar will depreciate until supply and demand are equal. If Canada
continues to finance its trade with dollars, rather than with exports of goods and services, then it
will continue to increase the supply of dollars abroad and the dollar will continue to depreciate.

Page 222

Leverage and Capital Structure
5.2.4 Describes policies that affect the capital structure and cost of capital for a
given organization (i.e. policies regarding capital financing, debt and equity
requirements and dividends)
a) Capital financing, operations and leverage
• Describes the concepts of financial and operating leverage,
9
operating breakeven, financial risk and business risk
• Calculates financial, operating and total leverage as well as
9
operating breakeven and interprets the results
• Explains the impact of financial, operating and total leverage
9
on earnings per share (EPS)
Operating Leverage
Operating leverage (“DOL” – Degree of Operating Leverage) represents the amount of fixed
operating costs included in the income statement. It is directly related to the business risks,
although it is not a measure of business risk. The degree of operating leverage measures the
sensitivity of a organization’s operating income (i.e. EBIT) to a change in sales. In other words,
it is is a measure of volatility of earnings before interest and taxes (operating income) relative to
a change in sales.
A DOL of 3.0 means that a 1% increase in sales would lead to a 3% increase in earnings before
interest and taxes.
The formula is similar to the breakeven formula:
Formula:
% change in EBIT
% change in sales
OR
x (SP – VC)
x (SP – VC) – FC

Page 223

Where:
x = volume of sales, in units
SP = selling price
VC = variable costs
FC = fixed costs, excluding interest and taxes
OR
DOL = Contribution Margin / Earnings before Interest and Taxes (operating income)
A company with high fixed costs has a high degree of operating leverage. High fixed costs
indicate high risk because these costs cannot be reduced in the event of a short run decline in
sales. The limitation of operating leverage is it uses accounting income and not cash flows.
Using cash flows rather than accounting income is a truer measure of operating risk.
Financial Leverage
Financial leverage is the proportion of a company’s assets that are financed with debt rather than
equity. It is directly related to financial risk and is sometimes considered a measure of financial
risk.
The degree of financial leverage (DFL) is the measure of volatility of net income relative to a
change in operating income.
A DFL of 1.5 means a 3% increase in earnings before interest and taxes would lead to a 3% x 1.5
= 4.5% increase in net income and net income before taxes.
Formula:
% change in EPS
% change in EBIT
OR
EBIT
EBIT – interest
Note that EBIT minusiInterest is also earnings before taxes.
Financial leverage is also measured by various financial ratios, such as debt-to-equity or times-
interest-earned.

Page 224

If a company’s debt position is too high, there will be negative consequences:
• potential insolvency
• financing terms are restrictive (e.g. unreasonably high interest rates and repayment
terms)
The higher a company’s financial leverage, the higher the financial risk, therefore, the higher the
cost of capital.
Combined or Total Leverage

This is the combination of operating and financial leverage. Combined leverage is the product of
the two measures of leverage and it provides a measure of the overall leverage and its impact on
earnings per share. It represents the proportion of fixed costs that represent risk to the
organization. It is measured by determining the impact of a change in sales on EPS.
Formula:
% change in EPS
% change in sales
OR
operating leverage x financial leverage
OR
x (SP – VC)
x (SP – VC) – FC – I
Where:
x = sales in units
SP = selling price
VC = variable cost
FC = fixed cost
I = interest


Dividend Policy and Valuation
5.2.1.4 Distribution of profits (e.g. cash dividends, stock repurchase, stock split and
stock dividends)
f) Describes the criteria used to determine whether profits should be
9
reinvested or paid out as dividends
g) Describes how various methods of distributing profits affect the financial
9
risk of a given organization
requirement and dividends)
c) Dividend policy
• Explains the concept of dividend policy 9
• Describes the factors considered in the development of a
dividend policy (e.g. legal rules, cash position, contractual
constraints, growth constraints, tax position of shareholders,
9
potential dilution of ownership, market considerations, access
to capital markets, corporate control, international factors,
etc.)
• Describes the procedures involved in dividend payments 9
• Describes the impact of cash dividends, stock splits and stock
dividends on capital structure and the position of the 9
shareholders
• Explains the reasons for low dividend payout, high dividend
9
payout and repurchase of shares
Note to candidates: The CMA Competency Map requirements related to dividend distributions
have been combined in one location to facilitate efficient studying.


Dividend Policy
Criteria in determining dividend policy:
• Availability of cash
The amount of cash available restricts the amount of dividends that can be paid.
• Investor expectations
Investors buy stock for two reasons – dividends and capital appreciation. Investors purchasing
a company for the dividend income stream expect a certain dividend payout amount.
• Internal requirements
A company may need financing and rather than borrowing externally, choose to finance
internally. Using retained earnings is the least costly source of financing.
Factors to consider in developing dividend policy:
• Legal or contractual restrictions

- cash dividends cannot be paid out of the share account
- most long-term debt issues have restrictive covenants with respect to dividend payouts
• Control
- if dividend payout is too high, a company may need to sell more shares to raise funds,
resulting in a dilution of control for current shareholders
• Signaling
- a stable dividend policy signals to shareholders a company is successful and,
therefore, a worthwhile investment
• Tax position of shareholders
- investors in a high tax bracket prefer a low dividend payout and higher capital gains
(capital gains are taxable at 50% of the gain)
• Access to capital markets
- if a company cannot raise money externally, it needs to finance from internal sources,
which impacts the dividend payout
• Market rates of return
- Dividend policy should take into consideration the rate or return earned on similar
investments, as investors expect the same rate.


Procedures in Dividend Payouts
Steps
• Board of Directors declare a dividend, stating the amount, record date and payment date.
This is the declaration date.
• The date of record is the date at which a list of shareholders is prepared. Only these
shareholders will receive a dividend.
• Brokerage firms set an ex-dividend date, which is two trading days before the record date.
This allows sellers and buyers time to deliver and receive the shares.
• Dividends are paid to shareholders on record at the payment date.
Stock Splits
A share is split into two or more shares. For example, in a two for one stock split, 100 shares
become 200 shares. Stock splits often take place to reduce the market price of shares to make
them more attractive to investors. There is no impact on control because an investor's
proportionate share of holdings remains the same as before the split.
Stock Dividends
New shares are issued to shareholders as a dividend in lieu of cash. There is no impact on control
as each shareholder retains the same proportionate interest in the company.
Similarities between stock dividends and stock splits:

• more shares are outstanding
• no impact on control
• no cash paid out
• total shareholders’ equity remains the same


Stock Repurchases (Treasury Shares or Repurchase
and Cancellation of Shares)
Reasons to repurchase shares:

• Adjust capital structure
A company may need to repurchase its shares to decrease equity. For example, a
company may need to ‘clean up’ its balance sheet to make the company more
attractive to potential acquirers.
• Defensive tactic in a hostile takeover bid
The fewer shares outstanding, the more concentrated the control. The controlling
shareholders can vote against the takeover bid or refuse to sell their shares.
• As an alternative to paying cash dividends
Rather than paying dividends, a company can repurchase its shares at fair market
value, with the shareholders receiving capital gains.
Reflect management’s opinion that the current share price is undervalued


Capital Structure

requirement and dividends)
b) Debt and equity requirements
• Explains the theory of capital structure (e.g. mix of debt and equity
financing, firm value vs. stock value, effect on cost of equity capital, 9
M&M propositions I and II, probability of bankruptcy and tax benefits)
• Determines the impact of changes in debt-to-equity ratio on the return on
9
equity, return on assets and weighted average cost of capital
• Compares the return on equity and the return on assets and explains the
9
relevance of the weighted average cost of capital
• Explains the concepts of financial distress and bankruptcy costs and
discuss their role in limiting the degree of financial leverage selected by 9
an organization
• Describes how organizations determine an optimal capital structure (e.g.
pecking order theory, static trade-off theory, agency costs of free cash 9
flow, etc.)
Theory of Capital Structure

Capital structure refers to the proportion of the various sources of funds (e.g. debt, common
shares and preferred shares) a company employs. The goal of capital structure decisions is to
maximize the market value of the company through an appropriate mix of the various sources.
The resulting optimal capital structure minimizes the overall cost of capital, while maximizing
the value of the organization.
Recall that the weighted average cost of capital (WACC) is a weight of all of the various types of
capital a company employs. Minimizing the WACC maximizes the value of the organization
since this lowers the cost of carrying the various sources of capital. The optimal capital structure
is the one that results in the lowest possible WACC.
When determining an optimal capital structure, it is important to consider the impact leverage
has on the payoffs to shareholders. Financial leverage, which is dependent on the amount of debt
a company has, can significantly impact the payoffs to shareholders, although it may or may not
affect the overall cost of capital. The impact of leverage on shareholders can be seen by
considering the impact of leverage on EPS (earnings per share) and ROE (return on equity).


Assume the following two scenarios (taxes are ignored for simplicity):
Scenario A Scenario B
Assets $8,000,000 $8,000,000
Debt $0 $4,000,000
Equity 8,000,000 4,000,000
$8,000,000 $8,000,000
Share price $20 per share $20 per share

Shares outstanding 400,000 200,000
Interest rate 10% 10%
Impact on EPS and ROE:

Scenario A Scenario B
EBIT (assumed) $1,000,000 $1,000,000

Interest 0 400,000
$1,000,000 $600,000
ROE
$1,000,000 ÷ $8,000,000 12.5%
$600,000 ÷ $4,000,000 15%
EPS
$1,000,000 ÷ 8,000,000 $2.50
$600,000 ÷ 4,000,000 $3
The above table shows the proportion of debt-to-equity can greatly impact the payoff to
shareholders as measured by EPS and ROE.


The impact of financial leverage, using the previous table, on payoffs to shareholders can be
depicted as:
EPS
With debt (i.e. with
(in $) financial leverage)
Advantage to debt
Without debt (no

financial leverage)
2 Indifference point
Disadvantage to debt
400 800 1200

-1 EBIT (in 000s),
no taxes
-2
The above graph shows two important items:

• The slope of the line “with debt” is steep. This indicates EPS is sensitive to changes
in EBIT and, therefore, increasing financial leverage (i.e. increasing debt) can have a
significant impact on EPS
• The “with debt” and “without debt” lines intersect, at which point EPS is identical
under each capital structure. This is the indifference point (i.e. point at which amount
of debt vs. amount of equity does not impact EPS).


Capital Structure and the Cost of Equity Capital
One of the most common theories with respect to capital structure was proposed by Modigliani
and Miller and is known as M&M Proposition I. M&M’s Proposition I states that the value of an
organization is completely independent of its capital structure. In other words, the amount of
debt vs. equity an organizationemploys has no bearing on an organization’s value. The easiest
means of understanding this concept is to view it pictorially:
Value of a organization = total assets; Value of a organization = total

liabilities (debt) plus equity must assets; liabilities (debt) plus
equal total assets equity must equal total assets
40% equity 40% debt
60% debt 60% equity
Assume: Assume:
Debt = 60% Debt = 40%
Equity = 40% Equity = 60%
Therefore, the total value of an organization(total assets) does not have any relationship to the
debt vs. equity ratio. The formula for M&M’s proposition I is:
Vu = EBIT/REu = VL = EL+ DL
Where:
Vu = value of the unlevered organization
VL = value of the levered organization
EBIT = perpetual operating income
REu = equity required return for the unlevered organization
EL = market value of equity
DL = market value of debt
Note to candidates: Calculation questions with respect to M&M are not common, however,
theory questions have appeared on the examination.


Cost of Equity Capital and Financial Leverage: M&M Proposition II
The WACC formula, ignoring the cost of preferred shares, is:
k = B kb + E ke
V V

V = B + E = total value of organization
kb = cost of debt
ke = cost of equity
The WACC is also used as a measure of the required rate of return on the organization’s overall
assets, however, the formula changes slightly as:
RA = B kb + E ke
V V
RA = required rate of return
This formula can be algebraically rearranged to:
ke = RA + (RA – kb) x B/E
where:
ke = cost of equity
kb = cost of debt
RA = required rate of return
This rearranged formula is M&M’s Proposition II, which states the cost of equity depends on
three things:
• required rate of return on the company’s assets (RA)
• the cost of debt (kb)
• the company’s debt-to-equity ratio, B/E


M&M’s Proposition II can be shown graphically:
ke
Cost
of
Capital
(%)
Slope = RA – kb
WACC = RA
kb
Note that at the y
intercept the
company has zero
debt & therefore
WACC = ke Debt-to-equity ratio
This graph shows as debt increases (i.e. leverage increases, which results in the debt-to-equity
ratio increasing), the increase results in an increase in the cost of equity. This is because in a
highly levered organization, the investors required rate of return increases because of the
increased risk associated with the higher debt (the company must be able to ensure sufficient
earnings to pay the debt). Note that in the graph, WACC is not impacted by the deb- to-equity
ratio – WACC is the same regardless of the D:E ratio. This is another way of stating M&M’s
Proposition I, which is the overall cost of capital is not impacted by its capital structure. As
shown, the fact that the cost of debt is lower than the cost of equity is exactly offset by the
increase in the cost of equity borrowing. The change in capital structure weights (E/V and B/V)
is exactly offset by the change in cost of equity (ke), so the WACC stays the same.


M&M Propositions I and II with Corporate Taxes
Debt financing has an advantage over equity financing in that interest is tax deductible. This tax
deduction results in an interest tax shield (i.e. present value of the tax savings due to being able
to deduct interest) that increases the value of the organization.
Example:
There are two companies, Company A and Company B who have identical assets and operations.
Company A has no debt (i.e. is unlevered) and Company B has $1,000 of perpetual bonds on
which it pays 8% per year. The tax rate is 30%. The impact of the debt is :
Company A Company B
(no debt; (with debt;
unlevered) levered)
EBIT (identical since each company

has identical operations) $1,000 $1,000
Interest 0 80
Taxable income 1,000 920
Taxes @ 30% 300 276
Net income 700 644
Cash flow (assume EBIT represents cash

flow):
EBIT $1,000 $1,000
Taxes 300 276
700 724
Cash flow to:

Shareholders 700 644
Bond holders 0 80
700 724
Therefore, the total cash flow to Company B, which is levered, is $24 more. This is because
Company B’s taxes, which are a cash outflow, are $24 less than Company A. This tax savings
($24 in this example) is known as the interest tax shield. Since the bond is perpetual, this $24
per year would be generated each year, forever and, therefore, Company B is worth more than
Company A by the value of this perpetuity. The total value of the tax shield can be calculated as:


Present value yearly cash flow
=
of perpetuity required rate of return
OR
1
= yearly cash flow
Required rate of return
= $24
.08
= $300
The value of the interest tax shield can also be calculated as:
Value of (tax rate x discount rate x debt)

=
interest tax shield discount rate
= tax rate x debt
= .30 x 1,000
= $300
The fact that company B is levered (i.e. has debt) results in it being worth more than Company
A. This is M&M’s Proposition I with taxes, which states the value of a levered organization
exceeds that of an unlevered organization by the value of the present value of the interest tax
shield. Stated algebraically, this means:
VL = VU + (tax rate x debt)
where
VL = value of levered organization
VU = value of unlevered organization
Continuing the previous example, assume that Company A, the unlevered company, has a cost of
equity capital of 10%. The value of company A is calculated as follows:
(1 – tax rate)
VU = EBIT x
unlevered cost of capital
(1 – .30)
VU = 1,000 x
.10
VU = $7,000


Therefore, the value of the levered company, Company B, is:
= 7,000 + (.30 x 1,000)
= 7,000 + 300
= 7,300
where
VL = value of levered company
VU = value of unlevered company
The relationship between the levered company and the unlevered company can be depicted
graphically:
VL = Vu + (tax rate x debt)

Value of
the org.
Impact on value due to

VL = 7,300 the present value of the
tax shield, tax rate x debt
Vu = 7,000
value of the unlevered org.
1,000
Total debt
As can be seen, the value of the organization increases as total debt increases because of the
interest tax shield. This is the basis of M&M Proposition I with taxes. Note that in this case, for
each $1 increase in debt the value of the organization goes up $.30.


WACC, M&M’s Proposition II and Taxes
Recall that the WACC formula, without considering taxes, is:
k = B kb + E ke
V V
where:
ke = cost of equity
kb = cost of debt
V=B+E
The WACC can be adjusted for taxes as:
K= B kb x (1 – tax rate) + E ke
V V
M&M’s Proposition II states the cost of equity is calculated as:
Ke = ȡ + (ȡ – kb) x B/E
where:
ȡ = cost of capital for an unlevered company (e.g. cost of equity for the unlevered company)
This can also be adjusted for taxes as:
Ke = ȡ + (ȡ – kb) x B/E x (1 – tax rate)
In the previous example, for Company B, the levered company, the cost of equity is calculated
as:
Ke = ȡ + (ȡ – kb) x B/E x (1 – tax rate)

= .10 + (.10 - .08) x (1,000/6300) x (1 - .30)
= 10.22%
Note that equity, E, was calculated as:
Total value of the company – debt
= 7300 – 1000 = 6300


The WACC for Company B, the levered company, is therefore:
B Kb x (1-tax rate) + E
k = k
V V e
1000 6300
k = .08 x (1-.30) + .1022
7300 7300
= 9.6%
Therefore, without debt, the WACC is 10.22% and with debt the WACC is 9.6%.
The relationship between debt and taxes and their impact on the value of an organizationis:
Cost of Capital
ke = 10.22%
(cost of equity
for unlevered org.)
ȡ = 10%, cost
ȡ = 10% of capital for
WACC = 9.6% WACC unlevered org.
8% x (1 - .3) = 5.6% kb x (1 – tax rate)
cost of debt
Debt / Equity ratio
As the graph shows, as debt increases, the WACC decreases.


Optimal Capital Structure
The previous discussion make it appear as if it is desirable to have a high debt amount and low
equity, since the more debt an organizationuses, the lower the WACC. However, this ignores the
potential for insolvency if debt levels become too high. Recall that with debt, interest and
principal payments must be made, while with equity, particularly common shares, dividend
payments are not mandatory. The cost of not being able to meet debt payments is called
bankruptcy (or potential bankruptcy) costs. These bankruptcy costs include costs such as direct
bankruptcy costs (e.g. legal and administrative costs) and indirect bankruptcy costs which are
financial distress costs (the indirect costs of management focusing on trying to avoid bankruptcy
as opposed to running the business). Therefore, an optimal capital structure lies somewhere
between 100% debt financing and 100% equity financing:
100%
100% debt equity
financing financing
Optimal capital structure lies somewhere between these two extremes
The static theory of capital structure states that a company should borrow up to the point the tax
benefit from an extra dollar in debt is exactly equal to the cost of financial distress. This is called
the static theory because it assumes the organization’s assets and operations are fixed (i.e.
operating leverage is fixed) and it only considers possible changes in the D:WE ratio. The static
theory is, in essence, M&M with corporate taxes, plus the impact of financial distress and can be
depicted as:


VL = Vu + (tax rate x debt)
Value of
the firm
Fin’l distress costs
maximum PV of tax shield

value of
the org.
Vu Vu
value of unlevered org.
optimal
amount of debt Total Debt
Note that this graph is identical to the M&M graph with corporate taxes, except the impact of
financial distress costs have been added. There are several observations from this graph:
− Vu, the value of an unlevered organization, is M&M’s Proposition I without taxes,
which states the value of the organization is unaffected by capital structure. Since
this proposition ignores taxes, the present value of the interest tax shield is ignored
and, therefore, there is no advantage to debt.
− Vu, the value of the levered organization, is M&M Proposition I, with taxes (the only
difference between Vu and VL is the present value of the interest tax shield)
− The maximum value of the organization is the point at which the benefit (due to
lowered taxes since interest is deductible) from an extra dollar is debt is equal to the
cost of financial distress; the optimal amount of debt is at this point.
Other Factors Affecting the Choice of Capital Structure

There are several other factors that can affect the choice of capital structure. These are:
• growth rate and stability of sales
• industry norms
• composition of assets
• management’s risk preferences


Problems
FMC1 Problem: Financial Managers - MCQ
1. Financial managers have an obligation to undertake some specific activities in the
financial management of the organization. Which of the following best describes these
activities?
a. Investing and financing
b. Investing, financing and funds management
Financial Management – Corporate Finance Problems

c. Financing only
d. Liquidity management
e. None of the above describes the activities.
2. Treasury management has been added to the traditional roles of the financial manager.
Which of the following best describes the functions of treasury management?
a. Development of strategies for capital formation
b. Planning tax strategies and ensuring compliance in all jurisdictions
c. Analysis and interpretation of economic events and their impact on capital
formation
d. Cash and funds management activities
e. All of the above
3. The Chief Financial Officer (CFO) of the organization has a number of duties to fulfil
within the organization. Which of the following is not one of those duties?
a. Financial forecasting and planning
b. Investment and financing decisions for the organization
c. Decisions about suppliers and trade credit terms
d. Interaction with capital suppliers and capital markets
e. Coordination with other, non-financial parts of the organization
4. The financial management goal of the organization is defined as which of the following?
a. Maximization of profits
b. Maximization of corporate wealth
c. Maximization of shareholder wealth
d. b. or c. depending on where you live in the world
e. None of the above


5. There are some operational difficulties in maximizing wealth, whether defined as
shareholder wealth or corporate wealth. What are the primary difficulties facing the
organization in maximizing wealth?
a. Valuation of shares is difficult and often inaccurate.
b. The point of view with respect to wealth, that is, whose point of view to take, is
not clear, leading to conflicting points of view on valuation of wealth.
c. Agency issues cause conflicts in valuation of organizations.
d. a. and b. are both true.
e. All of a., b. and c. are true.
6. Often there are stakeholders other than shareholders and managers that have an impact on
organizations. For example, political, social and environmental rules can have an impact
on the organization. How should financial managers react to these rules?
a. Financial managers should do the minimum to meet the requirements of the rules.
b. It is incumbent on financial managers to follow not only the letter of the law but
the spirit as well. Therefore, financial managers should go beyond the rules to be
“good corporate citizens”.
c. All investments in projects to meet these rules should be considered and evaluated
just like any other project requiring capital. Only if the NPV is positive should
the project be undertaken.
d. The first consideration should be shareholder wealth and all such decisions should
be considered in the light of this concept.
e. Either a. or b. is possible.


FMC2 Problem: Time Value of Money - MCQ
1. When a loan of $100,000 is taken from a lender, an agreement is reached that it will be
paid in five equal annual instalments, with an effective interest rate of 8% per annum,
beginning in one year. What is the amount of the annual payment?
a. $24,389
b. $25,709
c. $25,046
d. $23,191
e. $21,631

2. A loan of $50,000 is to be repaid in equal monthly instalments over 24 months in the
amount of $2,353.67. What is the effective annual interest rate on this loan?
a. 12%
b. 13%
c. 12.5%
d. 12.7%
e. 12.8%
3. An organization has earnings of $5 per share and 1,000,000 shares outstanding. When all
earnings are paid out as dividends and shareholders require a 15% yield on their
investment, what is the value of a share?
a. $30
b. $33.33
c. $36
d. $45
e. $50
4. Assuming the same data as in question 3, if investments are available in the next period
requiring that no dividends be paid, at what point are shareholders indifferent as to
whether they receive dividends or not? Assume dividends will be resumed as before in
subsequent years.
a. The investments must yield at least the WACC.
b. The investments must have long-term growth potential.
c. The NPV of the investments must be positive at 10%.
d. The investments must yield an IRR of 15%.
e. None of the above is true.


FMC3 Problem: Time Value of Money - Retirement
Assume you wish to retire 30 years from now and you will want at least $5,000 per month to live
on. To work this out roughly, you decide to assume a $60,000 annual income, received at the
beginning of the year, instead. You assume an interest rate of 6% per annum on your investments
both before and after retirement. What is the amount you will have to put away at the end of
each year to reach this goal, assuming you live 20 years after retirement?
FMC4 Problem: Time Value of Money - Retirement

You just inherited a large sum of money and are trying to determine how much you should save
for retirement and how much you can spend now. For retirement, you deposit today (January 1,
0) a lump sum in a bank account paying 10% compounded annually. You don't plan on touching
this deposit until you retire in five years (January 1, 5). You plan on living for 20 additional
years and expect to die on December 31, 2024. During your retirement, you would like to receive
an income of $50,000 per year on the first day of each year, with the first payment on January 1,
5 and the final payment on January l, 2024. Complicating this objective is your desire to have
one final three-year vacation e to play golf in Europe. To finance this, you want to receive
$250,000 on January 1, 2021 and nothing on January 1, 2022 and January 1, 2023, as you will be
away. In addition, after you die (December 31, 2024), you would like to have a total of
$1,000,000 to leave to your children.
Required:
How much must you deposit in the bank at 10% on January 1, 0, in order to achieve your goal?
FMC5 Problem: Time Value of Money - Project

A project will generate cash flows of $2,500,000 next year. These cash flows will grow at a rate
of 6% per year for 20 years. What is the value of this project if you require a return of 14%?

Page 246

FMC6 Problem: WACC - MCQ
1. An organization is trying to estimate its cost of equity capital using two standard models,
the dividend growth model and the CAPM. At the moment, the CAPM approach has
provided a value of 13% and the dividend growth approach has provided an estimate of
11%. Which of these two values is correct and why?
a. The CAPM approach is correct because it uses market driven factors in the
calculations.
b. The dividend growth approach is correct because it is based upon firm specific
information, which is likely to be more reliable.
c. Neither approach may be correct. If they were correct, then they would be

approximately the same. Since they differ, it is possible both are wrong.
d. Both approaches could be correct. They are based on different assumptions and,
consequently, are likely to differ because of differing assumptions. Since the cost
of equity is uncertain, either approach could be used.
e. An average of these two values would be the most appropriate as it would capture
the best of both estimates.
2. An organization has decided to estimate its cost of equity capital from the dividend
growth model. The following data is known:
Expected dividend = $3.30
Anticipated growth rate = 6%
Required yield on the market portfolio = 12%
Risk free rate = 5.5%
Organizational beta = 1.6
Stock price as of today = $30
What is the best estimate of the cost of equity?

a. 17%
b. 15.9%
c. 16.45%
d. 11%
e. 12%


3. An organization wishes to estimate its weighted-average cost of capital (WACC) from
the following information.
Expected market portfolio return = 12%
Risk free rate = 6%
Dividend expected = $2
Stock price = $24
Beta value = .9
Expected growth rate = 3%
Current yield on debt = 7% before tax
Expected marginal tax rate = 40%
Preferred share yield = 6%
Approximate proportions desired in the capital structure:
Debt = .4
Preferred = .1
Common = .5
What is the best estimate of the WACC?

a. 7.95%
b. 7.98%
c. 8%
d. 11.4%
e. Either a. or b. is correct.

Page 248

FMC7 Problem: WACC - JHM Corporation
Given the following information, what is JHM Corporation's weighted average cost of capital?
Common stock 2,000,000 shares outstanding

Market price = $30 per share
ß = 0.90
Preferred shares 100,000 shares outstanding, par value $100

Each share is currently selling for $125
Annual dividend per preferred share = $10

Bonds 25,000 bonds outstanding
$1,000 face value for every bond
8% semi-annual coupon, YTM = 10%
10 years to maturity
Rm 13%
Risk-free rate 6%
Tax rate 34%


FMC8 Problem: Bonds - MCQ
1. A bond, with a face value of $1,000, is selling to yield 8% per annum, compounded semi-
annually. The coupons are payable semi-annually, as well, in the amount of $50. If there
are six years to maturity, what should the current market price of the bond be?
a. $1,000.00
b. $1,093.85
c. $1,081.15
d. $1,092.49
e. None of the above
2. The following information is known about the Teall Corporation. It had a dividend last
year of $2.25 per share. Its expected return, based on investor requirements, is 12%. The
long run growth rate is expected to be 7%. The expected market return is 10%. What
should the approximate value of its share price be in the marketplace?
a. $45
b. $32.14
c. $48.20
d. $80.33
e. $120.50
FMC9 Problem: Bonds - Real Estate Developer

A real estate developer has a $100 million bond issue with sinking fund payments required
annually every six months, to coincide with interest payments of 9%, payable semi-annually. If
the sinking fund payments are to be used to retire the bonds at the maturity date in 10 years and
the funds are to be invested in Government of Canada bonds with 8% coupons payable semi-
annually, what amount must be put aside every six months to achieve this goal?
FMC10 Problem: Bonds

You just purchased a bond with a face value of $100,000, a coupon rate of 8% (paid semi-
annually) and 15 years remaining to maturity at a yield to maturity of 10%.
a. How much have you paid for this bond?

b. Assume you sell the bonds in six months (the day after receiving the next coupon
payment) at a yield to maturity of 8%. What was your income and capital gain return on this
bond?


FMC11 Problem: Capital Growth Model - Renfroe
The Renfroe Company just declared a dividend of $5 per share. It is expected the company’s
earnings and dividends will grow at a rate of 25% next year, 20% the following year and 18%
the year after that. Afterwards, earnings and dividends are expected to grow at a constant rate of
5%.
a. If you expect a rate of return of 12% on this stock, what would you expect to pay for a
share of the Renfroe Company stock today?
b. Calculate the income return and capital gain return on the stock for the first two years.

FMC12 Problem: NPV - Emithan Flying Company
The Emithan Flying Company (EFC), a small, chartered airline, is reviewing a new capital
investment in a computer to upgrade their maintenance facilities. The initial total cash outlay for
the system is estimated at $100,000 and includes all hardware, software and installation. The
portion of the total cost for the software is $20,000. The salvage value of the system is expected
to be $10,000. EFC believes use of the new system can lead to operational savings of $30,000
per year over the current manual system. The capital cost allowance (CCA) class for the
computer hardware is Class 10 (30%) and for the software is Class 12 (100%). The organization
also has other assets in these classes. The organization’s tax rate is 40% and their cost of capital
is 12%. The useful life is eight years.
Required:
Compute the NPV of the new system.


FMC13 Problem: NPV - Rockyford Co.
Rockyford Co. must replace some machinery. The machinery has a book value of $5,000 and its
disposal price is $0. One possible alternative is to invest in new machinery that would cost
$40,000. The new machinery would produce annual operating savings of $12,500 and would
have a useful life of five years. The terminal value of the new machinery would have a salvage
value of $0. The investment of new machinery would require an additional investment in
working capital of $3,000, which would increase by 10% a year. If Rockyford accept this
investment proposal, the disposal of the old machinery and the investment in the new machinery
would take place on January 1, 6. Rockyford is subject to a 40% income tax rate.
Rockyford plans to finance the new machinery partially through debt by taking out a loan of
$30,000 requiring annual payments of $8,117.11. The following is the loan amortization
schedule:
Date Payment Interest Principal Balance

Jan. 1, 6 30,000.00
Dec. 31, 6 8,117.11 3,300.00 4,817.11 25,182.89
Dec. 31, 7 8,117.11 2,770.12 5,346.99 19,835.90
Dec. 31, 8 8,117.11 2,181.95 5,935.16 13,900.74
Dec. 31, 9 8,117.11 1,529.08 6,588.03 7,312.71
Dec. 31, 2010 8,117.11 804.40 7,312.71 -
The new machinery would belong to a special class for purposes of calculating capital cost
allowance. This special class allows the fast write-off of equipment over two years on the
straight-line basis and is subject to the half rate rule, i.e. the machinery would be depreciated
25% in the first year, 50% in the second and 25% in the third.
The company's weighted average cost of capital is 12%.
Required:
Calculate the net present value of this proposal.


FMC14 Problem: NPV - Balgava Company
Balgava Company plans to replace an old piece of equipment that is obsolete and expected to be
unreliable under the stress of daily operations. The equipment is fully depreciated and will have
no salvage value.
A piece of equipment being considered would provide annual cash savings of $7,000 before
income taxes. The equipment would cost $18,000 and would be depreciated on the straight-line
basis for both book and tax purposes. It would have no salvage value at the end of five years.
The company is subject to a 40% tax rate and has a 14% weighted average cost of capital.

Assume all operating revenues and expenses occur at the end of the year.
Required:
a. Calculate the after-tax payback period.

b. Calculate the after-tax NPV.
c. Calculate the after-tax PI.
d. Calculate the after-tax IRR.


FMC15 Problem: NPV - S.W. Appliances Ltd.
S.W. Appliances Ltd. (SWA) is a Canadian manufacturer of appliances for the household and
commercial markets. SWA markets its products in both Canada and the United States. Over the
past 20 years, SWA expanded its operations by acquiring smaller appliance manufacturing
companies.
In 0, SWA operated 10 divisions with combined sales of just under $1 billion. Each of the 10
divisions is regarded as an investment centre. Managers of each division are responsible for
achieving a target divisional return on assets (ROA) of 30%. Divisional ROA is calculated by
dividing divisional income (i.e. income before interest, taxes, bonuses and head office
administration) by divisional assets (i.e. working capital plus net fixed assets). Divisions that
meet or exceed the target ROA are awarded a bonus. The bonus is calculated as 2% of divisional
assets for meeting the target, plus an additional 1% for each five percentage points of divisional
ROA in excess of the 30% target (e.g. 2% for ROA of 30% to 34%, 3% for ROA of 35% to 39%,
4% for ROA of 40% to 45%, etc.). Divisional managers are responsible for distributing the
bonus. Most divisional managers distribute the bonus to all divisional employees based on their
salary or wage levels.
Although divisions usually achieved the target ROA, the overall corporate profit had steadily
declined over the past few years to the point the corporate after-tax ROA for 0 was only 8%.
In early January 1, the president of SWA called a meeting of his executive committee to discuss
short and long-term corporate strategy.
President: Corporate ROA has decreased for three years in a row. When we set up the divisional
target a few years ago, I thought the overall corporate ROA would be at least 12%, as long as the
average divisional ROA exceeded 30%. Why has the corporate ROA decreased when the
average divisional ROA has been greater than 30% in each of the past three years?
Controller: My preliminary investigation reveals that some of the older divisions are achieving
ROA's of over 40% and overall interest expenses and total bonuses increased significantly during
the past three years. We should consider charging the divisions for interest and bonuses. We
cannot afford to continue paying large bonuses when overall profitability is declining.
President: Is there anything else causing our declining profitability?
VP Marketing: Our market share has been declining steadily. Sales have increased an average of
5% per year over the past five years, while the total appliance market expanded at a rate of about
10% per year. Divisional managers report that product quality and pricing are competitive, but
production throughput is too slow to satisfy some of their major customers, despite having plenty
of available capacity. Some large accounts have been lost because our divisions could not deliver
orders within 10 days of the order being placed.


VP Manufacturing: I've also met with divisional managers. Most of them feel production
throughput would be vastly improved if labour-intensive operations were replaced with
automated systems. However, they know the increased asset base will make it close to
impossible to achieve the target ROA and, therefore, they would lose their bonuses despite
increasing sales and productivity. For example, the refrigerator division manager and I studied
the feasibility of replacing his existing equipment with fully automated, computer controlled
equipment (see Exhibit 1). Once the study was complete, the refrigerator division manager
indicated he would rather live with the current system, unless he was guaranteed in writing to
receive a bonus of at least 2% of divisional assets.
Controller: I also looked at the possibility of automating all of the divisions' manufacturing
processes. It would cost about $30,000,000, which we'd have to raise externally and now is not

the best time to do this. Interest rates are at a peak and our debt:equity ratio would more than
double. Currently, our debt:equity ratio is slightly below the industry average. Also, automation
will change our fixed:variable cost structure making the company more vulnerable to short-term
fluctuations. A project of this magnitude would have to cover a minimum after-tax cost of capital
of 12%.
President: Well, something has to be done. We previously tried to replace old equipment with
new equipment without changing the labour-intensive operations despite the protests of
divisional managers, but we only accomplished manufacturing cost savings for a short period
and overall profit growth did not improve. I think it's time to call in a consultant to evaluate our
situation. We'll meet again next week to review the consultant's report.
Immediately after the meeting, the president contracted Lee Roberts, a management consultant,
to review SWA's situation and to provide recommendations to improve overall company
profitability. The president requested the following:
1. A calculation of the incremental bonus for the refrigerator division for each of the next three
years assuming it automates its operations and the bonus system remains unchanged (i.e.
difference in bonus using current equipment vs. using automated equipment).
2. A net present value analysis of replacing the refrigerator division's current equipment with
fully automated, computer controlled equipment.
As a first step, Lee obtained from the controller projected divisional asset data for the refrigerator
division for the next three years (see Exhibit 2).


Required:
As Lee Roberts, prepare a report to the president of S.W. Appliances Ltd. Your report should
include all the information requested by SWA's president as well as any other information or
recommendations you feel may be necessary for the future health of the company.
Exhibit 1
Feasibility Study for Automating the Refrigerator Division
Benefits of Automating
1. The average production time for a single refrigerator (i.e. throughput time) would be reduced
from 14 days to three days resulting in a $2,000,000 reduction in average inventory levels.
2. Quality and cost control would be improved resulting in a reduction of variable costs from
79% of sales to 62% of sales.
3. Complete production scheduling flexibility would result in faster delivery to
customers.
4. Better quality control and customer service would result in the expected sales growth
increasing from 8% per year to 20% per year for the next three years.
5. By automating now, the refrigerator division would be the first in its industry to do so, giving
it a competitive advantage.
Costs of Automating
1. Fixed production overhead costs (other than depreciation) would increase to $15,000,000 per
year.
2. Severance pay of $3,300,000 would have to be paid in 1, but would be amortized over three
years.
3. Capital costs and related information would be:
New equipment - capital cost $50,000,000
- disposal value at end ofthree3 years $20,000,000
Current equipment - disposal value now $3,000,000
- disposal value three years from now NIL
Capital cost allowance rate for current and new equipment 20%
Corporate effective income tax rate 40%

Page 256

S.W. Appliances Ltd. – Refrigerator Division
Budgeted 1 Divisional Income Statements
(in 000s)
Current Automated
System System
Sales – 0 $100,000 $100,000

Percentage increase in 2001 8% 20%
Sales – 1 108,000 120,000

Direct materials 47,520 50,400
Direct labour 27,000 6,000
Variable overhead 5,400 12,000
Variable selling and administration 5,400 6,000
Total variable costs 85,320 74,400
Contribution margin 22,680 45,600
Depreciation - building 500 500

- equipment 1,000 10,000
Other fixed production costs 4,000 15,000
Severance - 1,100
Fixed selling and administration 8,000 8,000
Total fixed costs 13,500 34,600
Divisional income $ 9,180 $11,000

Divisional assets $21,240 $59,800
Divisional return on assets 43.2% 18.4%
Divisional bonus $850 NIL


Exhibit 2
S.W. Appliances Ltd. – Refrigerator Division
Projected Divisional Assets As at December 31
(in 000s)
Current System
1 2 3
Cash $ 6,000 $ 6,000 $ 6,000

Accounts receivable 10,800 11,664 12,597
Inventory 5,000 5,000 5,000
Current assets 21,800 22,664 23,597
Current liabilities (7,560) (8,165) (8,818)
Working capital 14,240 14,499 14,779
Building 10,000 10,000 10,000

Accumulated depreciation – bldg. (5,000) (5,500) (6,000)
Equipment 15,000 15,000 15,000
Accumulated depreciation – equip. (13,000) (14,000) (15,000)
Net fixed assets 7,000 5,500 4,000
Divisional assets $21,240 $19,999 $18,779
Automated System
1 2 3
Cash $ 6,000 $ 6,000 $ 6,000

Accounts receivable 12,000 14,400 17,280
Inventory 3,000 3,000 3,000
Current assets 21,000 23,400 26,280
Current liabilities (8,400) (10,080) (12,096)
Working capital 12,600 13,320 14,184
Building 10,000 10,000 10,000

Accumulated depreciation – bldg. (5,000) (5,500) (6,000)
Equipment 50,000 50,000 50,000
Accumulated depreciation – equip. (10,000) (20,000) (30,000)
Deferred severance 3,300 3,300 3,300
Amortization – severance (1,100) (2,) (3,300)
Net fixed assets 47, 35,600 24,000
Divisional assets $59,800 $48,920 $38,184

Page 258

Notes:
1. Under both systems, a minimum cash balance of $6 million should be maintained.

2. Average accounts receivable amount to 10% of sales and average current liabilities amount
to 7% of sales.
3. Depreciation and amortization are calculated on a straight-line basis.

Page 259

FMC16 Problem: Discounted Cash Flow and Special Order -
Tratter Inc.
Tratter Incorporated (“TI’) sell units of a product to retailers, who sell it to the consumer. The
selling price is $22.40 per unit. In recent years, TI has been operating at the capacity of the
equipment, which is approximately 700,000 units per year.
The cost of producing the units is:
Per
unit
Material $5.60
Direct labour 4.48
Factory overheads:
Variable 1.68
Allocated fixed 1.12
Equipment depreciation .42
Selling, delivery and administration .56
Total cost per unit $13.86
The selling, delivery and administration costs are specific to the units (i.e. are directly related to
the units) and are variable.
The equipment used to produce the units is old and will have to be replaced within the next few
years. Its book value is $364,000, although it could be sold on the open market for $42,000.
A major retailer that is not a regular customer has approached TI and made a special offer to buy
920,000 units per year for at least four years. These units would be identical to the regular line,
except the packaging would bear the retailers logo and trademark. The retail chain proposes a
price of $14 per unit.
Since TI does not have the capacity to produce the additional units (the proposed special order of
920,000 units) for the large chain store, TI would have to buy new equipment to have the
capacity to accept the special order. TI is considering replacing the old equipment with new
equipment, which will triple the capacity of the old equipment. The additional capacity would
provide sufficient capacity for both the special order and for regular production.


Information related to the new equipment is:
• The greater efficiency of the machine would result in a 10% saving in material cost and
25% saving in labour cost.
• Variable overhead is applied based on direct labour dollars and with the new equipment,
the cost structure relationship between direct labour and variable overhead will not
change.
• Depreciation would increase from $.42 per unit to $1.12 per unit
• There would also be the added cost of the interest on the loan to buy the equipment.
• The fixed overhead allocation would increase because the allocation is based partially on
the cost of the equipment in use.
• The selling, delivery and administration cost is less per unit on the special order of
920,000 units by half, but the selling and administration cost of the regular units would

not change with the new equipment.
• The interest cost is 12% per annum on the $8,960,000 loan that would be required to
purchase the new equipment. This loan would be a bank loan and would have a five year
term.
• The total cost of the new equipment is $11,000.
TI's cost of capital is 14% before income tax.
Required:
Perform the necessary calculations to determine whether TI should accept the special order of
920,000 additional units per year.


FMC17 Problem: Net Present Value – Make or Buy - Tratter
Incorporated
You work for Tratter Incorporated (“TI”) and are considering three alternatives to replace an
outdated machine:
(1) building a general purpose machine
(2) buying a special purpose machine, this has more features than a general purpose machine
(3) buying a general purpose machine
Information related to these three separate alternatives is.
Alternative 1: Building a General Purpose Machine
The machine can be built by the company without affecting current production and revenue
producing activity. The machine is estimated to have a useful life of five years and will not have
any salvage value at the end of the five years.
Costs to build the machine are estimated as:
Material and parts $132,000

Direct labour (DL$) 216,000
Variable overhead (50% of DL$) 108,000
Fixed overhead (25% of DL$) 54,000
$510,000
Alternative 2: Buy a Special Purpose Machine
The special features related to this new machine means the company could accept new contracts
it would not have been able to accept with the old machine.
This machine requires only one operator and output per hour increases 25% from the current
output. Maintenance costs are also reduced significantly. However, the special features will
require extensive training for the operators. The operators will need to spend 26 weeks at the
supplier’s location to learn how to operate the equipment. While the company’s operators are
being trained, the supplier will provide an operator to run the new equipment. This operator is to
be paid the same amount as the current operators (paid by TI). The cost of travel and lodging for
the operators while they are receiving training at the supplier’s location, which is located 0
kilometres away from TI’s facilities, is C$3,000 per week.
The machine costs $1,500,000 and the supplier guarantees a salvage value of $60,000 at the end
of five years. It is available immediately.


Alternative 3: Buy a general purpose machine
The price of this machine is $700,000 and costs associated with this machine are the same as the
general purpose machine built by the company (same as alternative 1). However, the salvage
value of the machine is much less and is estimated to be $15,000 in five years. This machine is
available immediately.
Other information is:
The current machine has no salvage value and its book value is zero
The discount rate before taxes is 8%
Additional cost and revenue information for each alternative is provided in the attached exhibit.

Required:
Determine which alternative is best for the company using NPV. Ignore taxes and the CCA tax
shield in your answer.
For alternative # 1 assume the machine would be available immediately (i.e. no months will be
discounted for the time it takes to build the machine.


Cost and Revenue Information
on an Annual Basis1
Alt. 1 Alt. 2 Alt. 3

Build Buy Buy
General Special General
Purpose Purpose Purpose
Equipment Equipment Equipment
Supervisor (fixed cost) $48,000 $48,000 $48,000
Operators:
- required 2 1 2
- wages and benefits $28/hour $28/hour $28/hour
- standard hours per year per 2,000 2,000 2,000
operator, no overtime
Insurance $7, $12,000 $7,
Maintenance 62,400 28,800 62,400
Capacity (sales)2 468,000 585,000 468,000
Direct Materials 46,800 46,800 46,800
Variable Overhead 50% of DL$ 50% of DL$ 50% of DL$
Fixed Overhead (including depr.) 25% of DL$ 25% of DL$ 25% of DL$
Depreciation Method 5 years 5 years 5 years

Straight-line Straight-line Straight-line
1
Assumes single shift operation will continue.
2
The 25% increase in productivity is assumed to result in a 25% increase in sales.

Page 264

FMC18 Problem: Capital Budgeting (DCF) - Retil Ltd.
Retil Ltd. is considering purchasing a machine for $350,000. Retil Ltd. estimates it can save
$58,000 per year for the next seven years due to increased efficiency resulting from using this
machine. In addition, the machine is capable of producing a new product. Retil Ltd. estimates the
operating income from this new product will be $11,000 per year for the next seven years. At the
end of seven years, Retil Ltd. estimates the machine can be sold for $50,000. However, the
machine will require major maintenance at the end of four years, which is estimated to cost
$12,600. The machine has a useful life of 12 years and Retil Ltd. intends on depreciating the
machine using the straight-line method. The machine is eligible for a CCA tax deduction at 30%.
Retil Ltd.’s minimum desired after tax rate of return is 14%. Since Retil Ltd. is not a CCPC,

Retil Ltd. is subject to a 40% tax rate.
Required:
1. Should Retil Ltd. purchase the machine?
FMC19 Problem: Capital Budgeting (DCF) - Mister Donut Inc.

Mister Donut Inc. must replace its current donut machines and has a choice of two different
machines:
Machine A Machine B
Cost of machines $180,000 $220,000
Annual maintenance 14,000 12,000
Useful life of machines 8 years 11 years
CCA rate 30% 30%
Savage value at end of eight and 11 years respectively $60,000 $75,000
Yearly savings due to purchasing new machines $38,000 $56,000
Mister Donut Inc.’s minimum pre-tax desired rate of return is 20%. Mister Donut Inc. is subject
to a tax rate of 40%.
Required:
1. Which machine should be purchased?


FMC20 Problem: Capital Budgeting (DCF) - Luna Mining
Luna Mining Company Inc. (LMC) was incorporated to develop mineral deposits in Canada’s
north. In 1992, the company discovered a promising quartz ore body in the Northwest
Territories, just outside the town of Carlsbad. Preliminary sampling indicated high
concentrations of several valuable minerals including gold, silver and platinum. In 1, the mine
shaft was constructed along with a processing plant and administrative offices. The development
of the mine led to the economic revival of the town of Carlsbad. During 1, 20 new homes, a
sixty-unit trailer park and several new businesses were established.
Mining and processing operations began in January 2 and have continued without interruption
since that date. During 3, the company removed 1,,000 tons of ore from the mine; this level of
production is expected to continue for the next 25 years. Overall, the company hopes to earn a
15% pre-tax profit on sales, although this has not been met in recent years. The cost of
transporting personnel and materials between Carlsbad and the closest railway link during the
summer months has become prohibitive. Furthermore, the northern isolation of Carlsbad has
resulted in a high turnover of production and administrative personnel.
During the winter, food and supplies are brought to the mine and the town of Carlsbad from the
town of Fargo on a winter road built over the frozen tundra and lakes. Fargo is LMC’s closest
link to a railway line. Once the supply trucks are emptied, processed minerals are loaded for
shipment to outside markets. The total cost of winter road transportation was $3,000,000 in 3.
This cost was split equally between LMC and the residents of Carlsbad. During the spring,
summer and fall periods, all shipments between Fargo and the mine site have to be made by float
plane and helicopter. LMC spent a total of $5,500,000 on these flights during 3. No figures were
available on summer transportation expenditures for local businesses and residents.
The high cost of transporting supplies and personnel to the mine site and getting processed
minerals to the outside market is of great concern to the management of LMC. They are
considering the option of building a railroad from Carlsbad to Fargo. Preliminary studies
indicated construction of the railroad would cost $75,000,000 and a train (engine, box cars,
caboose and a passenger car) would cost an additional $15,000,000. With the railroad, LMC
would be able to charge the residents of Carlsbad for freight and passenger fares for trips to and
from Fargo. It is estimated the revenue collected from freight and passenger fares would amount
to $570,000 per year. The operating and maintenance costs (not including interest and
depreciation) for the railroad would be $240,000 and $140,000 per year, respectively. LMC
expects the railroad and train to last 25 years with no salvage value at the end of that time.
Money to finance the purchase of the train and construction of the railroad would be borrowed at
a rate of 10% per annum (post-tax). The capital cost allowance for the railroad and train are set at
4% and 10%, respectively and LMC would depreciate the fixed assets for financial reporting
purposes using the straight-line method. Management believes the railroad would eliminate the
need for summer air freight and winter roads between Carlsbad and Fargo. Also, administrative
costs ($1,250,000 in 3) would be reduced by 25% because LMC would no longer have to pay
large isolation bonuses to key personnel. The effective corporate tax rate is 40%


If construction were to begin in the summer of 4, the railway would be ready for use by January
5. Before a railroad could be built, LMC would have to obtain permission from the Territorial
government and the town councils of Carlsbad and Fargo. It appears some opposition to this
proposal may exist from some members of the councils and various levels of government.
Everyone is concerned about the impact of the railroad on the caribou calving grounds. On the
other hand, it appears building the railroad would create new employment opportunities in both
towns and stimulate growth throughout the region. LMC has petitioned the federal government
for a 50% subsidy to offset the costs of building the railroad and buying the train. Early
indications are this request may be approved if approval is obtained from all other concerned
parties.
Should the subsidy be granted, LMC would receive all revenue and incur all operating and

maintenance costs of the railroad and train. However, only the cost of the railroad and train after
the subsidy would be subject to depreciation and capital cost allowance.
Required:
1. Analyze the economic feasibility of building the railroad.


FMC21 Problem: Mergers and Acquisitions - MCQ
1. In a merger or acquisition, there are significant tax implications for the shareholders of
both the acquired and the acquiring organizations. What is likely to cause these tax
consequences for the shareholders of the acquired organization?
a. An acquisition that involves acquiring stock or assets is generally taxable for the
acquiring organization but does not affect the acquired organization.
b. An acquisition that involves payment with debt securities or cash has the
possibility of creating tax consequences for the shareholders of the acquired
organization.
c. An acquisition that involves a merger or amalgamation of two organizations has
significant tax consequences for the acquired organization.
d. The exchange of shares in an acquisition has severe tax consequences for the
acquired organization’s previous owners.
e. There are no tax consequences for either the acquired organization or the
acquiring organization if they are both Canadian.
2. Which of the following statements best represents the differences among horizontal,
vertical and conglomerate acquisitions?
a. Horizontal acquisitions involve similar types of organizations, while
conglomerate acquisitions do not. Vertical acquisitions involve acquisitions of
foreign organizations in the same lines of business.
b. Vertical acquisitions involve extending the organization’s ownership to suppliers
or distributors of its products and services or to other parts of the production or
distribution process. Conglomerate acquisitions involve related businesses, while
horizontal acquisitions involve unrelated organizations.
c. Conglomerate acquisitions involve the acquisition of unrelated businesses, while
horizontal acquisitions involve acquiring organizations in the same or closely
related lines of business. Vertical acquisitions involve a combination of a
horizontal and conglomerate acquisition at the same time.
d. Conglomerate acquisitions involve the acquisition of unrelated businesses, while
horizontal acquisitions involve acquiring organizations in the same or closely
related lines of business. Vertical acquisitions involve extending the
organization’s ownership to suppliers or distributors of its products and services
or to other parts of the production or distribution process.
e. None of the above statements is a true representation.


3. Two all equity companies are combining. Company A has total earnings of $2 million,
shares outstanding of one million and a share price of $30. Company B has total earnings
of $1 million, shares outstanding of one million and a price per share of $20. Company
A is offering Company B’s shareholders a total of 500,000 of its shares for all of
Company B’s shares. This will be a friendly amalgamation and the value of the
combined organization after the amalgamation will be $55 million. What will be the
price per share, EPS and P/E ratio for the combined organization?
a. Price = $25, EPS = $1.50, P/E ratio = 16.67
b. Price = $30, EPS = $2, P/E ratio = 15
c. Price = $20, EPS = $1, P/E ratio = 20
d. Price = $36.67, EPS = $2, P/E ratio = 18.33

e. These calculations are not possible with the information provided.
4. A number of possible sources of gains exist in the event of synergies from acquisitions.
What are these possible sources of gains? Select the most appropriate items from the
following list.
a. Revenue enhancement
b. Cost reduction
c. Tax gains
d. Both a. and b.
e. All of a., b. and c.
5. The principles of business valuation involve consideration of many different aspects of

the acquired and acquiring organizations. Of the following items, which are most likely
to be significant in the valuation process?
a. Risk and growth prospects
b. Historical information about and locations of the organizations involved
c. Management efficiency and capabilities
d. Both a. and c.
e. All of the above


FMC22 Problem: Business Valuation - Organizations A & B
The following information is available with respect to Organizations A and B as they consider
merging in a friendly amalgamation.
Organization A Organization B
Market value of assets $10 million $12 million

Market value of debt $2 million $6 million
Earnings (latest year) $500,000 $400,000
Price/earnings ratio 24 30
Expected cash flows
(Next year) $900,000 $750,000
Expected yield 12% 16%
Expected growth rate
of cash flows 6% 1%
Provide an estimate of the market value of the assets of the combined organization, the estimated
value using the earnings method and the estimated value of the expected future cash flows.
Assume no synergies are available. What is the likely range of values of the combined
organization?

Page 270

FMC23 Problem: Long-Term Financing - MCQ
1. There are a number of advantages to going public in an initial public offering (IPO).
These advantages include which of the following?
a. Shareholder diversification
b. Increased liquidity
c. An established value for the organization
d. Only a. and b.
e. All of a., b. and c.
2. Which of the following are disadvantages of going public?

a. Disclosure requirements
b. Prevention of self-dealing
c. Thin trading of shares
d. Increased costs
e. All of the above.
3. In the small organization, the primary source of funds is:

a. Chartered banks.
b. Trade credit.
c. Commercial paper.
d. Government subsidies.
e. Both a. and b.


FMC24 Problem: Forecasting - Howard Company
Given the following information about the Howard Company, estimate its expected financing
needs in the next fiscal period.
Sales 4,000 Current Assets 600

Cost of Sales 3,200 Fixed Assets 2,600
Operating Income 800 Total Assets 3,200
Taxes (40%) 320
Net Income 480 Current Liabilities 400
Dividends Paid 240 Long-term Debt 1,000
Owners’ Equity 1,800
Total Liabilities and
Owners’ Equity 3,200
Sales growth is expected to be 15% and the percentage of sales method* is used to forecast
financing needs. The dividend pa out ratio is expected be the same in the next period. Tax rates
will not change and the fixed assets are being used at full capacity.
* cost of sales, current assets, fixed assets and current liabilities will grow at the same
rate as the increase in sales
FMC25 Problem: Long-Term Financing - HWB Company

The HWB Company has the following ratios applicable to its income statements and balance
sheets:
Assets/Sales 1.2
Liabilities/Sales 0.6
Profit Margin 12%
Dividend Pay Out Ratio 60%
Most Recent Year’s Sales $100 million
What is the maximum sales growth that can be achieved without resorting to an increase in long-
term debt, assuming these ratios will remain constant?

Page 272

FMC26 Problem: Short-Term Financing - Trade Discounts
What is the cost of not taking a discount if the terms of payment are?
a. 3/15, net 60
b. 2/10, net 30
Which is better from the point of view of the trade credit grantor and why?

FMC27 Problem: Long-Term Financing - Rights
An organization has the opportunity to issue a rights-offering to provide $30 million for some
urgently needed computer technology upgrades. The current share price is $40 and five million
shares are outstanding. If the price per share in the rights offering is $30, what is the value of a
right and the e-rights price of the shares?


FMC28 Problem: Financial Markets - MCQ
1. Financial markets depend on market efficiency and arbitrage to develop accurate
valuations for securities. How, if at all, do these concepts assist in valuation of
securities?
a. Market efficiency implies the inclusion of all relevant information in security
prices and arbitrage is just another way of saying the law of one price applies to
security pricing, so the same or similar securities have essentially equal prices in
different markets or market segments.
b. Market efficiency is not necessary for security pricing, but arbitrage is necessary
for prices to be equal in different markets or market segments where the same or
similar securities are sold.
c. Market efficiency is likely to exist in a complete sense in financial markets and
arbitrage is not necessary.
d. If market efficiency exists, then arbitrage is implied in the concept of efficiency
and the two are really the same concept. Therefore, market efficiency is all that is
needed.
e. Neither market efficiency nor arbitrage is necessary for accurate and reliable
security valuation.
2. The financial markets consist of many components, including money markets, capital
markets, primary and secondary markets, and derivative securities markets. What
differentiates the derivative securities markets from the other components of the financial
markets?
a. Derivative securities markets are where speculators take uncovered positions in
various options, futures or swaps to provide liquidity for the derivative securities
markets.
b. Derivative securities markets are where the securities are derived from various
underlying securities. Thus, they do not supply additional capital to the financial
markets, but provide risk reduction tools for financial managers.
c. Derivative securities markets provide specialized forms of capital for
organizations, which would not be available in conventional financial markets
around the world.
d. Derivative securities markets are international in scope and involve large,
international banks and other financial institutions.
e. Derivative securities markets in Canada are centred in Montreal and provide
Canadian organizations access to a number of exotic sources of additional capital
by connecting with other derivative securities markets around the world.


3. Options, forward contracts and futures contracts differ in some rather important ways.
What are these differences?
a. Options provide a right but not an obligation, while both forward contracts and
futures contracts are obligations.
b. Options provide the right to buy (call option) or to sell (put option) a security or
commodity, while forward contracts and futures contracts lock in prices on
commodities or securities for future delivery.
c. A long forward or futures position is like a call option, while a short forward or
futures position is like a put option, except the option is a right but not an
obligation.

d. The holder of the option always exercises the option, but forward contracts and
futures contracts are usually settled before their expiry dates in cash.
e. All of a., b. and c. are true.
4. Compute the required return on the following security using the security market line
(SML). The security has a beta of 1.2. The risk free rate is 6% and the expected return
on the market portfolio is 12%. What is the estimated required return?
a. 12%
b. 14.4%
c. 13.2%
d. 20.4%
e. It cannot be computed from the information given.
5. A number of methods are used to measure the risk of a security. One of the most
common is to the look at the dispersion of its return. What measures of dispersion are
commonly used to measure portfolio risk?
a. standard deviation
b. variance
c. coefficient of variation
d. variance and covariance
e. all of the above


FMC29 Problem: EOQ - English Bread Company
The English Bread Company buys 5.2 million tonnes of wheat annually. The wheat is purchased
in multiples of 10,000 tonnes. Ordering costs, including removal costs, are $8,000 per order.
Annual carrying costs are 2% of the purchase price per tonne of $250. A safety stock of 150,000
tonnes is maintained. Delivery takes four weeks.
Compute the economic order quantity (EOQ) and the level of inventory at which an order should
take place to prevent drawing down the safety stock.
FMC30 Problem: Short-Term Financing - Zachariah Inc.

Zachariah Inc. is proposing a change in its credit policy that would relax credit terms from the
existing terms of 1/10, net 30 to 2/20, net 40 in the hopes of securing new sales. The following
information is available:
New sales level (all credit) $12,000,000

Original sales level (all credit) $10,000,000
Contribution margin ratio 40%
Percent bad debt losses on new sales level 4%
Percent bad debt losses on original sales level 3%
New average collection period 26 days
Original average collection period 15 days
WACC 10%
Cost of goods sold as a percentage of sales 70%
Inventory turnover on new sales level 7
Inventory turnover on original sales level 5
Tax rate 40%
What is the net annual benefit of changing to the new credit policy?


FMC31 Problem: Leverage
An organization is a single product company selling a product at $20 per unit, with fixed costs of
operations of $1 million and variable costs per unit of $10. The organization is paying $500,000
of interest charges on its debt. Compute the degree of operating leverage, the degree of financial
leverage and the degree of combined leverage for this organization for a sales level of ,000 units.
What does the value of the degree of combined leverage imply about the increase in the earnings
per share if total sales increase?

FMC32 Problem: Leverage
An organization has the option of financing an expansion project with one of the following three
alternatives:
a. debt financing at 8% in the amount of $20 million
b. common share financing to net $20 per share, with the issue of 1,000,000 new
shares, to add to the 1.5 million existing shares
c. preferred share financing at 6% in the amount of $20 million.
The organization has no existing debt and expects operating earnings before taxes to be $4.3
million in the next year. Taxes are 40% on income. For each of the three alternatives, what is
the estimated EPS? Which is the best alternative? If the operating income decreased to $1.3
million, would this have any impact on the decision?


FMC33 Problem: Leverage - Wasu Company
Wasu Company’s statement of income for the year ended December 31, 6 is:
Sales $2,000,000
Variable costs 1,,000
Contribution margin 800,000
Fixed costs 350,000
Operating income 450,000
Interest expense 150,000
Net income before taxes 300,000
Income taxes 90,000
Net income $210,000
Required:
a. Calculate Wasu Company’s: (i) degree of operating leverage; (ii) degree of financial
leverage; and (iii) degree of total leverage.
b. Assume that sales for the year 7 are expected to increase by 15%
over 6. Prepare a projected statement of income for 7 and explain how the calculation in
part (a) relates to the increased numbers in your projected statement of income.
FMC34 Problem: Capital Structure

It is often said an organization should select its optimal capital structure and maintain it. How is
the optimal capital structure defined and under what conditions would it exist?
a. The optimal capital structure is one that maximizes shareholder wealth and exists when
there are no taxes, transaction costs or other frictions in the financial markets.
b. The optimal capital structure is the one that minimizes the weighted average cost of
capital (WACC) and exists when the cost of equity capital is estimated with the Capital
Asset Pricing Model (CAPM).
c. The optimal capital structure is the one that minimizes the WACC and exists when the
tax advantages of debt are maximized and when the costs of financial distress are not
significant.
d. The optimal capital structure does not exist for an organization and there are no
conditions under which it will exist.
e. The optimal capital structure depends on the cultural environment and, as such, exists
only when all the various stakeholders agree it exists.


The market value of an organization with $500,000 of debt is $1,700,000. EBIT are expected to
be a perpetuity. The pre-tax interest rate on debt is 10%. The company is in the 40%- tax bracket.
If the company was 100%- equity financed, the equity holders would require a 20%- return.
a. What would the value of the organization be if it was financed entirely with equity?
b. What is the net income to the shareholders of this levered organization?

An all-equity organization is subject to a 40%- corporate tax rate. Its equity holders require a
20%- return. The organization’s initial market value is $3,500,000 and there are 175,000 shares
outstanding. The organization issues $1 million of bonds at 10% and uses the proceeds to
repurchase common stock.
Assume there is no change in the costs of financial distress for the organization. According to
MM, what is the new market value of the equity of the organization?


FMC37 Problem: Capital Structure - RR Company
RR Company, an all-equity company, generates perpetual earnings before interest and taxes
(EBIT) of $2.5 million per year. RR's after-tax; all-equity discount rate is 20%. The company's
tax rate is 40%.
a. What is the value of RR?
b. If RR adjusts its capital structure to include $600,000 of debt, what is the value of the
company?
c. Explain any difference in your answers.
d. What assumptions are you making when you are valuing Streiber?
FMC38 Problem: Capital Structure - Simard Company
The Simard Company has perpetual EBIT of $4 million per year. The after-tax, all-
equity discount rate r0 is 15%. The company's tax rate is 40%. The cost of debt capital is 10%
and Nikko has $10 million of debt in its capital structure.
a. What is Simard's value?
b. What is Simard's WACC?
c. What is Simard's cost of equity?


FMC39 Problem: Financial Management - Corporate Finance
MCQ
1. Which of the following is NOT accurate?
A. To calculate the expected risk premium, one needs to compute the expected return on the
risky asset and the certain return on the risk free asset.
B. The risk premium is the difference between the return on a risky asset and on the market
portfolio.
C. The expected return on an asset is equal to the sum of the possible returns multiplied by
their probabilities.

D. Comparison of two different risky assets is often made easier by computing the expected
return on each.
E. Expected returns depend on the expected states of the economy and their associated
probabilities.
2. Which of the following is NOT true about computing expected portfolio return and variance?
A. You need to calculate the weight of each asset relative to the total portfolio to compute
the portfolio return, but not compute the portfolio variance.
B. Portfolio return can be calculated with the expected return and weight of each asset.
C. You can use the portfolio return to help compute the portfolio variance.
D. The portfolio return and variance are dependent on the possible states of nature.
E. The portfolio variance is not generally a weighted average of the variances of the assets
in the portfolio.
3. If the actual return on an investment is equal to the expected return, then it is likely that:
A. When investors estimated the expected return, they incorrectly weighed all the
information that they believed would bear on the investment.
B. Interest rates changed unexpectedly after the expected return was computed.
C. Even though the expected return was incorrect, the normal return was estimated
accurately.
D. Some anticipated information about the investment was revealed after the expected return
was computed.
E. Investors used all relevant information that was available when computing the expected
return.


4. Diversification works because:
I. unsystematic risk exists
II. grouping stocks into a portfolio guarantees a positive return on investment
III. market risk can be reduced if not eliminated
A. I only
B. II only
C. III only
D. II and III only
E. I, II and III
5. Which of the following is another description for systematic risk?
A. Unique risk
B. Market risk
C. Company specific risk
D. Diversifiable risk
E. Asset risk
6. Which of the following statements regarding beta is NOT true?
A. It is a measure of systematic risk.

B. A beta that is less than one represents lower systematic risk than a beta greater than one.
C. Generally speaking, the higher the beta the higher the expected return.
D. A beta of one indicates an asset is totally risk free.
E. The risk premium of an asset will increase if the beta of the asset increases.
7. The CAPM shows the expected return for a particular asset depends on:
I. the amount of unsystematic risk
II. the reward for accepting systematic risk
III. the pure time value of money
IV. the amount of systematic risk
A. I only
B. II on1y
C. I, III and IV only
D. II, III and IV only
E. I, II, III and IV


8. The appropriate discount rate on a new capital investment is:
I. the minimum expected rate of return the investment must earn to be accepted
II. the cost of capital
III. the rate of return capital investments of similar risk earn in the market
IV. the internal rate of return on the project
A. II only
B. III only
C. I, II and III only
D. I, II and IV only

9. You are looking at two different stocks. Cara Limited has a beta of 1.25 and Smith
Incorporated has a beta of .95. Which statement is true about these investments?
A. Cara Limited is a better addition to your portfolio.

B. Smith Incorporated is a better addition to your portfolio.
C. The expected return on Cara Limited will be the lower of the two.
D. The expected return on Smith Incorporated will be the higher of the two.
E. The stock in Smith Incorporated has a lower risk premium than Cara Limited.
10. Which of the following would be included in unsystematic risk?

I. lower trade deficit than expected
II. higher GDP than expected
III. IBM, a public company, has lower sales than expected
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
11. Which of the following would be included in systematic risk?

I. Higher than expected research and development costs for a pharmaceutical company
II. Lower interest rates than expected
III. Lower sales than expected for a retail chain store
A. I only
B. II only
C. III only
D. I and III only
E. I, II and III


12. Which of the following would increase a company's systematic risk?
I. the company increases its debt-to-equity ratio
II. higher interest rates than expected
III. the company's CEO is unexpectedly killed in an automobile accident
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
13. All else being equal, actions or events that cause a company’s returns to be more highly
correlated with the changes in the economy will (increase/decrease/not affect) the company's
systematic risk.
A. increase B. decrease C. not affect
14. Which of the following pairs of terms are synonymous?

I. unsystematic risk and diversifiable risk
II. market risk and non-diversifiable risk
III. total risk and beta
A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
15. No matter how many risky assets a person invests in, _____________ risk can never be
eliminated.
I. unsystematic
II. market
III. systematic
IV. non-diversifiable
A. I only
B. II only
C. III only
D. IV only
E. II, III and IV only


16. An asset's systematic risk is measured by its:
A. standard deviation of returns

B. expected return
C. variance of returns
D. unexpected component of returns
E. beta
17. What is the expected return on asset A if it has a beta of 1.3, the expected market return is
14% and the risk-free rate is 6%?

A. 7.8% B. 9.0% C. 14.0% D. 15.0% E. 16.4%
18. What is the expected market return if the expected return on asset A is 16% and the risk-free
rate is 7%? Asset A has a beta of .9.
A. 9% B. 10% C. 14% D. 17% E. 20%
19. Asset A has an expected return of 18% and a beta of 1.4. The expected market return is 14%.
What is the risk-free rate?
A. 0.6% B. 1.2% C. 3.0% D. 4.0% E. 6.0%
20. Asset A has an expected return of 15% and a beta of .95. The risk-free rate is 5%. What is the
market risk premium?
A. 1.72% B. 8.75% C. 10.53% D. 12% E. 13.57%
21. Using the information below, which security has the greatest expected return?
Standard Deviation Beta
Security X 35% 1.75
Security Y 68% 1.06
Security Z 24% 1.22
The risk premium is positive on security X, Y and Z.
A. Security Y, because it has the largest standard deviation

B. Security X, because it has the largest beta coefficient
C. Security Z, because it has the smallest standard deviation but a large beta coefficient
D. It is not possible to determine given the information provided


22. Suppose you purchase a zero coupon bond for $664.08 that has a face value of $1,000 and
matures in eight years. What is the implicit interest, in dollars, paid in the first year of the
bond’s life?
A. $34.86 B. $38.84 C. $44.55 D. $45.01 E. $52.50
23. Prime Incorporated intends on issuing 10 15-year, $1,000 zero-coupon bonds. If each bond
has a yield of 10%, how much will Prime Incorporated receive when the bonds are issued?
Ignore issuance and flotation costs.
A. $1,.00
B. $1,827.00
C. $2,393.92
D. $8,880.00
E. $10,000.00
24. What is the yield-to-maturity on a 15-year, $1,000, zero coupon bond that currently has a
market value of $375.39?
A. 4.40% B. 5.60% C. 5.97% D. 6.75% E. 7.32%
25. When the shares in a public company lose value as a result of the company issuing additional
shares, the shareholders in the company have suffered from ________________.
A. a rights offering
B. indirect issuance costs
C. dilution
D. ex-rights
E. excessive spread
26. An arrangement between a bank and a business that allows the business to periodically
borrow up to a pre-specified limit, without specified repayment terms for the principal, is a:
A. long-term loan commitment

B. operating line of credit
C. compensating balance
D. field warehouse financing
E. credit guarantee

Page 286

27. Which of the following is NOT true?
A. a line of credit is an agreement under which an organization is authorized to borrow up to

a specified amount
B. a secured line of credit does not have any collateral requirements
C. in a factoring arrangement, the default risk on the accounts remains with the seller of the
accounts receivable
D. a compensating balance requirement tied to a loan arrangement raises the effective
interest rate the borrower must pay on the loan
E. as a business owner and regular short-term borrower, it would generally be more
comfortable to have an operating line of credit than a collateralized mortgage

28. A company is experiencing short-term cash flow problems. The easiest means to resolve this
problem is:
A. applying for a line of credit

B. drawing on an existing, unused line of credit
C. issuing new long-term bonds
D. drawing on its good credit rating to apply for a short-term unsecured loan
E. drawing on its good credit rating to apply for a secured loan
29. Abril Limited, a large company, is attempting to do things: 1) raise badly needed cash, and 2)
reduce the level of its accounts receivable. Which of the following options would best meet
both of these needs simultaneously?
A. obtaining an unsecured short-term loan

B. assigning its receivables on a short-term loan
C. factoring its receivables
D. applying for a line of credit
E. securing any short-term credit with an inventory lien
30. A large company with a strong credit rating needs to borrow money for the next 90-180 days.
The company would likely obtain the best interest rate by:
A. obtaining an unsecured line of credit

B. factoring its receivables
C. issuing commercial paper
D. obtaining a loan secured by its inventory
E. issuing long-term bonds


31. Which of the following is a source of cash?
I. issuing commercial paper
II. reducing accounts payable
III. factoring accounts receivable
IV. selling inventory on credit
A. I only
B. III only
C. I and III only
D. II and III only
E. I, III and IV only
32. Which of the following is a use of cash?

I. increasing accounts payable
II. factoring accounts receivable
III. reduction of inventory that results from increased sales
IV. retiring short-term loans
A. I only
B. IV only
C. I and IV only
D. II and III only
E. III and IV only
33. A company is preparing a short-term financial plan. Which of the following questions would
the organization most likely NOT consider when creating the plan?
A. How much cash should be kept on hand?

B. Should the company cancel and redeem its outstanding bonds?
C. How much short-term borrowing should be employed?
D. How much credit should be extended to customers?
E. Should the organization issue commercial paper or apply for a short-term bank loan?
34. Assuming a beginning current ratio higher than 1.0, which of the following activities will
decrease net working capital?
I. sale of inventory (at book value) on credit
II. using cash to pay off short-term note
III. selling marketable securities in order to pay dividends
A. I only
B. II only
C. I and II only
D. I, II and III
E. III only


35. The period of time required for the organization to acquire inventory, sell the finished goods
and collect the accounts receivable is called the:
A. accounts receivable period

B. inventory period
C. accounts payable period
D. cash cycle
E. operating cycle
36. ____________ falls with increases in the level of inventory, while ____________ increase
with increases in the level of inventory.

A. Carrying costs; shortage costs B. Shortage costs; carrying costs
C. Carrying costs; stock out D. Shortage costs; order
37. Tyler Limited needs to raise cash quickly. The CFO has arranged for Tyler Limited to sell
receivables with a face value of $1,000,000 to Canada Bank Group for $940,000, payable
immediately. Under the agreement, Canada Bank Group is responsible for collecting the
receivables. This is an example of:
A. assignment of receivables
B. a line-of-credit security arrangement
C. a conventional factoring arrangement
D. a maturity factoring arrangement
E. an assigned factoring arrangement
38. Your company purchased a piece of land seven years ago for $150,000 and subsequently
incurred $75,000 in improvements. The current book value of the property is $225,000.
There are three options for the future use of the land: 1) the land can be sold today for
$375,000; 2) the land can be leased to another party on a long-term basis; or 3) your
company can destroy the past improvements and build a factory on the land. In consideration
of the factory project, what amount (if any) should the land be valued at?
A. the present book value of $225,000

B. the sales price of $375,000
C. the sales price of $375,000 less the book value of the improvements since they will be
destroyed anyway
D. whichever amount represents the greatest opportunity cost, that is, the best alternative use
you must forgo in order to build the factory
E. the property should be valued at zero since it is a sunk cost


39. A capital investment, which results in the company “breaking even” financially, is an
investment that meets which of the following:
I. accounting rate of return = Return on Equity
II. net Present Value = 0
III. net income = 0
IV. debt-to-equity ratio = 1.0
A. I only
B. II only
C. I, III and IV only
D. III only
E. I, II, III,
40. A machine costs $60 and requires $35 in maintenance for each year of its three-year life.
After three years, the machine will be replaced. Suppose the machine is depreciable on a
straight-line basis over its three-year life to a salvage value of $15. It will be sold for $15
after three years. Assuming a tax rate of 34% and an after-tax discount rate of 14%, what is
the NPV for the machine?
A. $113.63 B. $126.27 C. $131.15 D. $98.63 E. $103.51
41. Your company currently sells regular furniture. The controller has asked you to analyze
introducing a new line of high -end furniture. Which of the following are relevant costs?
I. $,000 spent on research and development last year on high-end furniture.
II. Land you already own, but may be used for the project, which has a market value of
$700,000.
III. $300,000 drop in sales of regular furniture if oversized rackets are introduced.
A. I only
B. II only
C. III only
D. I and III only
E. II and III only
42. Which of the following is a valid reason for leasing?
A. taxes may be reduced by leasing

B. off-balance sheet financing for operating leases
C. may result in higher income
D. it can provide 100% financing
E. all of the above are valid reasons for leasing


43. Which of the following is NOT a benefit of leasing?
A. taxes may be reduced by leasing

B. reduces future obsolescence risk for the leased asset
C. leasing may encumber fewer assets than borrowing
D. leasing is an alternative method to obtain financing
E. a capital lease increases the debt-to-equity ratio
44. In terms of riskiness, lease cash flows are most similar to the lessee’s cash flows attributable
to _____________.

A. unit sales
B. net income
C. employee labour costs
D. common equity financing
E. debt financing
45. Which of the following is the relevant rate for evaluating a lease from the viewpoint of the
lessee?
A. the cost of issuing new common stock

B. the pre-tax cost of issuing debt
C. the after-tax cost of issuing debt
D. the organization’s cost of capital
E. the cost of retained earnings


Use the information below to answer questions 46 to 50.
You work for Sunny Golf Limited, a golf course that is considering leasing a fleet of golf carts to
transport golfers around the golf course. These carts qualify for a 40% CCA rate. Because of
their heavy use, they have no value after 5 years. The carts could be leased for $12,000 per year
for five years or purchased now for $48,000. Further, a 10% pre-tax cost of capital and a 40% tax
rate is applicable to all parties involved in the lease. Assume the purchase and lease payments
are made at the beginning of the year (@ T=0, T=1, etc.) and CCA tax shield is taken at the end
of each year.
46. Given the above information, should you lease or buy? For this question only, ignore the
CCA half year rule.
A. Lease, it saves you $372.
B. Buy, it saves you $15,954.
C. Buy, it saves you $8,052.
D. Buy, it saves you $372.
Lease or buy, it doesn't matter. Because of taxes, they are the same.
47. If Sunny Golf Limited decided to lease, what are the cash flows in the first year (T=0) and
the fifth year (T=4)?
First Fifth
year year
A 36,960 -5,949
B. 37,179 -5,949
C. 36,960 -4,073
D. 37,179 -4,073
E. 36,960 4,073
48. What would the lease payments have to be for both the lessee and the lessor to be indifferent
to the lease?
A. $11 B. $11,861 C. $12,800 D. $14,954 E. $17,917
49. Assuming Sunny Golf Limited pays no taxes, what are the company’s cash flows in the first
year (T=0) and fourth year (T=3)?
First Fourth year
year
A -$48,000 $0
B. $48,000 $0
C. $36,000 $0
D. $36,960 $1,992
E. -$36,960 $1,992


50. Assuming Sunny Golf Limited pays no taxes, at what lease payment would the lease begin to
be profitable for the company?
A. $9,455 B. $11,511 C. $11,833 D. $12,265 E. $13,993
******************************************************************************
51. You work for a laundry delivery service that is considering leasing a fleet of trucks. These
trucks qualify for a 40% CCA rate. Because of their heavy use, they have no value after five
years. You could lease them for $5,700 per year for five years or purchase them now for
$22,500. Further, a 10% pre-tax cost of capital and a 30% tax rate is applicable to all parties
involved in the lease. Assume the first payment was made at T=0. Should you lease or buy?

A. lease, it saves you $561
B. buy, it saves you $8,250
C. buy, it saves you $562
D. lease, it saves you $8,250
E. lease or buy, it doesn't matter. Because of taxes, they are the same.
52. Which of the following is NOT accurate regarding the dividend growth model approach to
estimating the cost of equity capital?
A. a key advantage to this model is its low degree of complexity

B. the results from this model are not sensitive to changes in the dividend growth rate
C. one method of estimating future growth rates is the use of historical growth rates
D. the model works particularly well for companies that maintain a reasonably steady
growth in dividends
E. this model does not explicitly consider risk
53. A company that uses its WACC as a hurdle rate without considering the risk involved in a
investments will:
I. tend to become riskier over time
II. tend to accept unprofitable projects over time
III. likely see its WACC rise over time
IV. tend to accept projects with risks lower than those of existing operations
A. I and II only
B. II and III only
D. I, II and IV only
E. II, III and IV only


54. When a company estimates the cost of capital for each of its divisions for the first time, it
will likely find:
A. the divisions are being rewarded for decreasing their risk

B. higher earning divisions will be less risky than the lower earning divisions
C. a low earning division will be ignored in capital allocation even though it tends to
maintain lower levels of risk
D. its divisions are of basically the same risk
E. the highest divisional cost of capital will approximately equal the organization’s overall
cost of capital
55. Which of the following are potential problems associated with the use of the dividend growth
model to compute the cost of equity?
I. the estimated cost of equity is sensitive to the estimated dividend growth rate
II. the approach does not explicitly consider risk
III. the approach requires one to assume the dividend growth rate will remain constant
A. I only
B. III only
C. II only
D. I and III only
E. I, II and III
56. Big Money Limited’s common stock is currently selling at $37.86 per share. You expect the
next dividend to be $5.30 per share. If the company has a dividend growth rate of 6%, what
is its cost of equity?
A. 12.50% B. 13.40% C. 16.75% D. 18.50% E. 20%
57. Treasury bills currently have a return of 8%. The market risk premium is 9%. If Company A
has a beta of 1.35, what is its cost of equity?
A. 4.78% B. 9.42% C. 12.78% D. 20.15% E. 20.78%
58. EDI Institute sold a 20-year bond issue eight years ago. It pays a 10% annual coupon and has
a $1,000 face value. If the current price per bond is $1,110.17, what is the cost of debt?
A. 8.0% B. 8.6% C. 9.0% D. 10.0% E. 10.5%


59. Weiller Limited has preferred stock outstanding, which pays a dividend of $4 per share
annually. The current price is $50 per share. What is its cost of preferred equity?
A. 8.0% B. 9.0% C. 10.0% D. 11. 0% E. 12.5%
Use the information below to answer questions 60 and 61.
Johanson Manufacturing is considering an investment in new manufacturing equipment. The

equipment costs $,000 and will provide annual after-tax inflows of $40,000 at the end of each of
the next seven years. The organization’s debt-to-total assets ratio is 50%, its cost of equity is
14% and its pre-tax cost of debt is 8%. The organization’s tax rate is 40%. Assume the project is

of approximately the same risk as the organization.
60. What is the weighted average cost of capital?

A. 11.0% B. 9.4% C. 8.6% D. 7.4% E. 6.0%
61. What is the NPV of the proposed project?

A. $80,000 B. $64,117 C. -$1,356 D. -$23,232 E. -$65,726
******************************************************************************
62. A company is considering a project that will generate perpetual cash flows of $30,000 per
year beginning next year. The project has the same risk as the organization’s overall
operations and must be financed externally. Equity costs 16% and debt costs 7%. The
organization’s debt/equity ratio is 1.5. What is the most the organization could pay for the
project and still earn its required return?
A. $275,027
B. $283,019
C. $302,539
D. $303,216
E. $1,250,000
63. Which of the following is accurate regarding financial leverage?

A. whenever a company’s debt increases faster than its equity, financial leverage decreases
B. leverage is most beneficial when EBIT is relatively low
C. increasing financial leverage will always increase the ROE and EPS of the stockholder
D. the level of financial leverage that produces the highest firm value is the one most
beneficial to shareholders
E. all of the above are accurate


64. Which of the following statements regarding leverage is/are correct?
I. the ultimate effect of leverage depends on the organization’s EBIT
II. if things go poorly for the organization, leverage provides an even greater return to
shareholders, as measured by ROE and EPS, than would be possible with no leverage
III. as an organization levers up, shareholders are exposed to more and more risk
IV. the benefits of leverage will not be as great in an organization with substantial
accumulated losses or other types of tax shields as for an organization without many
tax shields
A. I and III only
B. I and IV only
C. III and IV only
D. I, III and IV only
65. When choosing a capital structure, the objective of the organization should be to:
A. choose the one that maximizes the current value of the stock
B. choose the one that minimizes the value of the organization
C. choose the one that maximizes the organization’s WACC
D. choose the one that results in the greatest possible interest tax shield
E. choose any capital structure since capital structure is always irrelevant
66. The target capital structure is the debt-to-equity ratio which:

I. minimizes the value of the organization
II. minimizes the organization’s weighted average cost of capital
III. maximizes the market price of the organization’s common stock
IV. maximizes earnings per share
A. I only
B. II and III only
C. III only
D. I and IV only
E. I, II and III only
67. Which of the following statements is/are true regarding corporate borrowing?
I. increasing financial leverage increases the sensitivity of EPS and ROE to changes in
EBIT
II. the effect of financial leverage depends on the company's EBIT -- leverage is
favourable when EBIT is relatively high and leverage is unfavourable when EBIT is
relatively low
III. high leverage magnifies the returns to shareholders (as measured by ROE)


A. I only
B. II only
C. III only
D. I and II only
E. I, II and III
68. The required return on the assets of Kamil Limited is 10%. Debt cost is 6% before-tax for
Kamil Limited. Assuming a capital structure of 50% debt and 50% equity, what is the cost of
equity? The tax rate is 34%.
A. 10.0% B. 12.6% C. 15.1% D. 16.0% E. 18.7%

69. Williams Limited has expected EBIT of $1,110, debt with a face and market value of $3,000
paying a 7% annual coupon and an unlevered cost of capital of 14%. If the tax rate is 34%,
what is the value of the organization?
A. $3,718 B. $5,309 C. $6,253 D. $7,572 E. $9,089
70. An unlevered organization has a net income after tax of $660,000. The unlevered cost of
capital is 15% and the corporate tax rate is 34%. What is the value of this organization?
A. $1,000,000 B. $2,266,667 C. $3,333,333 D. $4,400,000 E. $8,000,000
71. McKenzie Incorporated has expected EBIT of $3,300, debt with a face and market value of
$4,000 paying a 9% annual coupon and an unlevered cost of capital of 12%. If the tax rate is
39%, what is the value of the equity of McKenzie Incorporated?
A. $9,335 B. $14,335 C. $18,335 D. $22,245 E. $25,625
72. An organization’s marketable securities account is currently comprised of one-year corporate

bonds and three-month Treasury Bills. If the organization chooses to shift its policy and
invest 100% in T-Bills, it would likely reduce the _____________ of its marketable
securities portfolio.
I. maturity risk
II. marketability risk
III. taxability
IV. default risk
A. I and II only
B. II and IV only
D. II, III and IV only


73. Which of the following is true regarding opportunity costs and the size of the cash balance
held by an organization?
A. there is no relationship between cash balances and opportunity costs

B. the higher the cash balance, the lower the opportunity cost
C. if an organization can reduce its collection float, opportunity costs will fall and the
optimal cash balance for the organization will be increased
D. the higher the cash balance, the higher the opportunity costs in terms of the interest
income that could be earned in the next best use
E. if an organization can reduce its collection float, opportunity costs will rise and the
optimal cash balance for the organization will be decreased
74. A manager using the EOQ model can compute ___________ to account for delivery times.
A. carrying costs
B. safety stocks
C. restocking costs
D. reorder points
E. theft losses
75. Reorder costs for at cows at Gregko Limited are $500 and carrying costs are $25. What is the
optimal reorder quantity?
A. 50
B. 100
C. 125
D. 500
E. Not enough information to calculate
76. Reorder costs for cows at Sasasha Incorporated are $900, carrying costs are $54 and unit
sales are $7,500. What is the optimal reorder quantity?
A. 125
B. 141
C. 447
D. 500
E. Not enough information to calculate
Use the information below to answer questions 77 to 82.
Krohl Limited maintains an average inventory of 1,000 units. The carrying cost per unit per year
is estimated to be $1. Krohl Limited places an order for 500 units the first of each month and the
order cost is $4.


77. What are the total carrying costs under the current system?
A. $500 B. $600 C. $700 D. $800 E. $1,000
78. What are the total restocking costs under the current system?
A. $25 B. $48 C. $95 D. $140 E. $198
79. What is the economic order quantity (EOQ)? (round to the nearest whole number.)
A. 110 units

B. 219 units
C. 312 units
D. 401 units
E. 500 units
80. What is the average inventory using the EOQ?
A. 110 units
B. 219 units
C. 312 units
D. 401 units
E. 500 units
81. What are the total carrying costs using the EOQ?
A. $24 B. $55 C. $110 D. $225 E. $335
82. What are the total restocking costs using the EOQ?
A. $110 B. $145 C. $190 D. $340 E. $680
******************************************************************************
83. You will take delivery of a US dollar 60 days from today but you want to lock in the price
now. _______________ is the price of this transaction today.
A. the cross-rate
B. the spot exchange rate
C. the forward exchange rate
D. the London Interbank Offer Rate
E. the swap rate


84. An agreement to trade currencies based on the exchange rate today for settlement within two
business days is called a _____________.
A. backward trade
B. forward trade
C. futures trade
D. triangle arbitrage transaction
E. spot trade
85. According to today’s exchange rate posted on the Bank of Canada website, you can exchange
C$1 for two Euros today. Thus, the ___________ is .50 Euros.
A. backward rate
B. forward rate
C. futures rate
D. triangle rate
E. spot rate
86. According to today’s exchange rate posted on the Bank of Canada website, the spot exchange
rate is Euro 1 = C$.83. The six-month forward exchange rate is Euro 1 = C$.67. Which
statement below is true?
I. The Euro is selling at a discount relative to the Canadian dollar.
II. The Euro is selling at a premium relative to the Canadian dollar.
III. The Canadian dollar is selling at a discount relative to the Euro.
IV. The Canadian dollar is selling at a premium relative to the Euro.
A. I only
B. II and IV only
C. and III only
D. I and IV only
E. II and III only
87. According to today’s exchange rate posted on the Bank of Canada website, the spot exchange
rate is Euro 1 = C$0.81. The six-month forward exchange rate is Euro 1 = C$0.95. Which
statement below is true?
I. The Euro is selling at a discount relative to the Canadian dollar.
II. The Euro is selling at a premium relative to the Canadian dollar.
III. The Canadian dollar is selling at a discount relative to the Euro.
IV. The Canadian dollar is selling at a premium relative to the Euro.


A. I only
B. II and IV only
C. I and III only
D. I and IV only
E. II and III only
88. The 60-day forward rate for Japanese Yen is 112.16 per C$1. The spot rate is Yen 103.9 per
C$1. In 60 days, you expect to receive Yen500,000. If you agree to a forward contract, how
many Canadian dollars will you receive in 60 days?

A. $4,458
B. $4,812
C. $5,312
D. $51,950,000
E. $56,080,000


Solutions
FMC1 Solution: Financial Managers - MCQ
1. b. All three of the activities noted are financial management activities.
2. e. All of the activities noted are part of the treasury management function as
described by the Financial Executives Institute.
3. c. This is not usually the CFO’s decision, as it would be delegated to others in the
organization. Usually, purchasing will make such decisions subject to corporate
guidelines already established by the CFO.
4. d. This is the most correct response, but some will answer c. because of the
strong belief in Anglo-American markets that shareholders are the most
important. However, outside of these markets, corporate wealth for a diverse
group of stakeholders is considered most important and not just shareholder
wealth.
5. e. All three difficulties exist in the financial markets. Share values are
not easy to compute, the stakeholder group is not clear and agency issues
generally exist.
6. e. The minimum requirements will not break the law, but the appearance of
being a “good corporate citizen” is important in a political sense. It depends on
how much the management and ownership want to satisfy the political masters.
NPV rules and shareholder wealth must be subordinated to the regulations of the
jurisdiction in which the organization operates.


FMC2 Solution: Time Value of Money - MCQ
1. c N = 5, I = 8, PV = $100,000, Solve for PMT = $25,046
2. d Monthly interest rate:

N = 24, PV = $50,000, PMT = -2353.67, Solve for I = 1%
EAR = 1.0112 – 1 = 12.7%
3. b. The share price is 5/0.15 = $33.33 as there is no growth if all

earnings are paid in dividends.
4. d. The investments must provide a yield equal to the opportunity cost,

or the yield foregone by shareholders. That is 15%.
Financial Management – Corporate Finance Solutions

FMC3 Solution: Time Value of Money - Retirement
Amount required at time of retirement =

N = 19, I = 6, PMT = $60,000, Solve for PV = $669,487
$669,487 + the first payment of $60,000 = $729,487
Annual investment required:

N = 30, I = 6, FV = $729,487, Solve for PMT = $9,227


FMC4 Solution: Time Value of Money - Retirement
PV of pension annuity = $50,000*PVIFA10%,20*PVIF10%,4

N = 20, I = 10, PMT = $50,000
Solve for PV = 425,678
N = 4, I = 10, FV = $425,678
Solve for PV = $290,744
PV of golf tour = $250,000*PVIF10%,21

N = 21, I = 10, FV = $250,000
PV of three years of pension annuity foregone

N = 3, I = 10, PMT = $50,000
N = 20, I = 10, FV = $124,343

PV of inheritance = $1,000,000*PVIF10%,25
N = 25, I = 10, FV = $1,000,000
Money to be deposited now = $290,744 + 33,783 – 18,483 + 92,296 = $398,340


FMC5 Solution: Time Value of Money - Project
First, we calculate the present value, assuming we are dealing with a perpetuity:
PV = $2,500,000 / (.14 - .06)

= $31,250,000
We then calculate the present value of the perpetuity at time = 20.
Cash flow of project at t=21:

N = 20, I = 6, PV = $2,500,000
Solve for FV = $8,017,839
Present value of project at t=20 =
PV20 = $8,017,839 / (0.14 - .06)

= $100,222,988
The present value of this amount at t=0:

N = 20, I = 14, FV = $100,222,988
Solve for PV = $7,292,397
Present value of the project = $31,250,000 – 7,292,397 = $23,957,603


FMC6 Solution: WACC - MCQ
1. d. It is entirely possible both estimates are correct, based on their

inherent assumptions. There is no reason to assume one is better than the other
unless it can be established beyond a reasonable doubt the values for the
parameters of one estimate are clearly inferior, that is less accurate. Combining
the two values will not help because it just “muddies the waters”. If the estimates
of the parameters are reliable in both models, then one is just as good as the other
and it becomes a choice as to what to use, based upon other available data about
the company, which is not supplied. Therefore, no judgement on superiority is
possible.
2. a. The best estimate for the model requested is based on the dividend yield
+ growth rate, which in this case is:
3.3/30 + .06 = .11 + .06 = .17
Therefore, the cost of equity is 17%.
3. e. The estimate for WACC depends on the cost of equity capital; therefore, are
two possible estimates. The CAPM approach says the cost of equity = 6% + .9 *
6% = 11.4%. The dividend growth approach says the cost of equity is 2/24 + .03
= .1133 or 11.33%.
The WACC equals:

.1 * .06 + .4 * .6 * .07 + .5 * cost of equity = 7.95 or 7.98, depending on
which of the above two is used for cost of equity.
The first term is the cost of preferred times the preferred proportion. The second
term is the cost of debt after tax (.6 * .07) times the debt proportion and the third
term is the cost of equity times the equity proportion.
Either value is correct or there is little to choose between them.


FMC7 Solution: WACC - JHM Corporation
E = $2,000,000 x $30 = $60,000,000

Ke = 6% + .9(13% - 6%) = 12.3%
P = $125 x 100,000 = $12,500,000

Kp = 10 / 125 = 8%
Kb = 10%(1-.34) = 6.6%
B: N = 20, I = 5, PMT = $1,000,000, FV = $25,000,000

Solve for PV = $21,884,447, say $21,884,000
V = $60,000,000 + 12,500,000 + 21,884,000 = $94,384,000
WACC = [21,884 / 94,384 x 6.6%] + [12,500 / 94,384 x 8%]

+[60,000 / 94,384 x 12.3%]
= 10.4%

FMC8 Solution: Bonds - MCQ
1. b. N = 12, I = 4, PMT = 50, FV = 1000, Solve for PV = $1093.85
2. c. The dividend must be increased to the expected value from its current, past year’s
level. The calculation is: 2.25 * 1.07 = 2.4075 or approximately $2.41.
The share price, therefore, is: $2.41 / (.12 - .07) = 2.41 / .05 =$48.20


FMC9 Solution: Bonds - Real Estate Developer
The amount required is the future value of an annuity for 20 periods at 4% to equal $100 million.
To compute this, the following is done: $100,000,000 / 29.778 (future value at 4% for 20
periods) = $3,358,184
Therefore, an amount of $3,358,184 must be invested every six months to achieve the goal.
FMC10 Solution: Bonds
a. N = 30, I = 5, PMT = 4,000, FV = $100,000

b. You will sell the bond for $100,000 since the coupon rate = YTM.
Income yield = $4,000 / 84,628 = 4.7%

Capital gain yield = ($100,000 – 84,628) / 84,628
= $15,372 / 84,628
= 18.2%


FMC11 Solution: Capital Growth Model - Renfroe
a. D1 = $5(1.25) = $6.25
D2 = $6.25(1.20) = $7.50
D3 = $7.50(1.18) = $8.85
D4 = $8.85(1.05) = $9.2925
P3 = $9.2925 / (0.12 – 0.05)

= $132.75
P0 = PV of $6.25 to be received N = 1
+ PV of $7.50 to be received N = 2
+ PV of $8.85 + 132.75 to be received N = 3
= $5.58 + 5.98 + 100.79
= $112.35
b. P1 = PV of $7.50 to be received N = 1
+ PV of $8.85 + 132.75 to be received N = 2
= $6.70 + 112.88
= $119.58
P2 = + PV of $8.85 + 132.75 to be received N = 1

= $126.43

Year Income Return Capital Gain Return Total Return
1 $6.25 / $112.35 (119.58 – 112.35) / 112.35
= 5.6% = 6.4% 12%
2 $7.50 / 119.58 (126.43 – 119.58) / 119.58

= 6.3% = 5.7% 12%


FMC12 Solution: NPV - Emithan Flying Company
Initial investment $(100,000)
Tax shield on computer hardware:

[($80,000 x 0.30 x 0.40) / (0.30 + 0.12)]
x (1.06/1.12) $21,633
Tax shield on software*

1st year: FV = $10,000 x 40%, N = 1, I = 12, PV = 3,571
2nd year: FV = $10,000 x 40%, N = 2, I = 12, PV = 3,189 28,392
Operational savings: PMT = $30,000 x 0.60, N = 8, I = 12, PV = 89,418
Salvage value: N = 8, I = 12. FV = $10,000, PV = 4,039
Tax Shield lost on computer hardware:

($4,039 x 0.30 x 0.40) / (0.30 + 0.12) (1,154)
Net present value $20,695
* Note that Class 12 is subject to the half-year rule.


FMC13 Solution: NPV - Rockyford Co.
Initial investment $(40,000)
Tax shield on machinery -

Year 1: FV = $40,000 x 25% x 40%, N = 1, I = 12, PV = $3,571
Year 2: FV = $40,000 x 50% x 40%, N = 2, I = 12, PV = 6,378
Year 3: FV = $40,000 x 25% x 40%, N = 3, I = 12, PV = 2,847 12,796
Annual operating savings: PMT = $12,500 x .6, N = 5, I = 12, PV = 27,036
Working capital requirements:

Initial working capital requirement: $(3,000)
Year 1 increase: 3,000 x 10%
FV = $300, N = 1, I = 12, PV = (268)
Year 2 increase: FV = 300 x 1.1 = 330, N = 2, I = 12, PV = (263)
Release of working cap.: FV = $4,835 N = 5, I = 12, PV = 2,744 (1,548)
Net present value $(1,716)

Note that the debt financing (interest and principal) is not considered in the net present value
calculations since these are implicitly taken into account in the discounting process.


FMC14 Problem: NPV - Balgava Company
Annual cash flow
Annual cash savings: $7,000 x 0.6 $4,200
Tax shield on depreciation: $18,000 / 5 x 0.40 1,440
$5,640
a. $18,000 / 5,640 = 3.2 years
b. Initial investment $18,000

Present value of annual cash flows
N = 5, I = 14, PMT = $5,640, PV = 19,363
Net present value $1,363
c. $19,363 / 18,000 = 1.08
d. N = 5, PV = -18,000, PMT = $5,640, Solve for I = 17.1%


FMC15 Problem: NPV - S.W. Appliances Ltd.
A. Impact of automating on bonuses for the refrigerator division -
2001 2002 2003

Current System -
Sales (8% increase) $108,000 $116,640 $125,971
CM =21% of sales 22,680 24,494 26,454
Fixed costs 13,500 13,500 13,500
Divisional income $ 9,180 $ 10,994 $ 12,954
Divisional assets $ 21,240 $ 19,999 $ 18,779
Divisional ROA 43% 55% 69%
Divisional bonus % 4% 7% 9%
Divisional bonus $ 850 $ 1,400 $ 1,690
Proposed System -
Sales (20% increase) $120,000 $144,000 $172,800
CM =38% of sales 45,600 54,720 65,664
Fixed costs 34,600 34,600 34,600

Divisional income $ 11,000 $ 20,120 $ 31,064
Divisional assets $ 59,800 $ 48,920 $ 38,184
Divisional ROA 18% 41% 81%
Divisional bonus % 0% 4% 12%
Divisional bonus $ 0 $ 1,957 $ 4,582
Difference with current system $ (850) $ 557 $ 2,892


B. NPV analysis of automating the refrigerator division:
Present value of increased after-tax cash flows before CCA and severance
2001 2002 2003

Contribution margin
Proposed system $45,600 $54,720 $65,664
Current system 22,680 24,494 26,454
Change 22,920 30,226 39,210
Increased fixed production
costs ($15,000 -4,000) -11,000 -11,000 -11,000
(Increased) decreased bonus 850 -557 -2,892
Increase in cash flow 12,770 18,669 25,318
Times after tax rate 0.6 0.6 0.6
After tax increase 7,662 11,201 15,191

PV of increase in cash flow $6,841 $8,929 $10,813
Total $26,583
Present value of incremental investment in working capital -
2001 2002 2003

Current system
Incremental investment in W/C -$14,240 -$259 -$280
Recovery in 2003 14,779
-$14,240 -$259 $14,499
Proposed system
Incremental investment in W/C -$12,600 -$720 -$864
Recovery in 2003 14,184
-$12,600 -$720 $13,320
(Increase)/ decrease in working

capital increment $1,640 -$461 -$1,179
PV of incremental working capital $1,464 -$368 -$839


Project NPV Calculation:
Initial investment: $50,000 – 3,000 $(47,000)
Present value of tax shield

[($47,000 x 0.20 x 0.40) / (0.20 + 0.12)] x (1.06/1.12) 11,121
PV of salvage value: N = 3, I = 12, FV = $20,000 14,235
Present value of tax shield lost -

($14,235 x 0.20 x 0.40) / (0.20 + 0.12) (3,558)
Present value in incremental cash flows (previous page) 26,583
Present value of decreased investment in working capital

(previous page) 257
Severance payment: $3,300 x 0.6 (1,980)
Net present value $(342)


FMC16 Solution: Discounted Cash Flow and Special Order -
Tratter Inc.
a) Special order and discounted cash flow
Regular line:
Old equip New Equip Increased
CM
Contribution margin:
Selling price 22.40 22.40
Variable costs:
Material 5.60 5.60 – (5.60 x .10) 5.04
Labour 4.48 4.48 – (4.48 x 25%) 3.36
Variable overhead 1.68 VOH rate1.68/4.48 = 1.26
. 375 therefore new
VOH is 3.36 x 0.375
SD&A .56 .56
Total variable 12.32 10.22
costs
CM per unit 10.08 12.18
Volume x 700,000 x 700,000

Total CM $7,056,000 $8,526,000 $1,470,000
Special Order:
Contribution margin:
Selling price 14.00
Variable costs:
Material Calculated above 5.04
Labour Calculated above 3.36
Variable overhead Calculated above 1.26
SD&A Regular rate of .56 x 50% .28
Total variable costs 9.94
Contribution margin per unit 4.06
Volume x 920,000
Total contribution margin $3,735,200

Page 316

Discounted Cash Flow Analysis
Note that the appropriate interest rate to use is 14% and the correct period is four years.
Annual increase in CM:

Regular production 1,470,000
Special order 3,735,200
5,205,200
PV of cash flows:
Increase in CM
$5,205,200 x 2.914 (PV factor, i = 14%, n = 4) $15,167,953 Inflow
Cost of new equipment 11,200,000

Less: sale of old equipment (42,000)
11,158,000 $11,158,000 Outflow
NPV of cash flows $4,009,953 positive inflow
Recommendation:
It is recommended that the company accept the new order and purchase the new equipment,
since the NPV is positive. However, it is important to note that TI will have excess capacity at
the end of the contract for the special order with the major retail chain.

Capacity Utilization with special order:
Capacity of new equipment (700,000 x 3) 2,100,000
Capacity utilization with special order:

Regular production (assumes no increase in sales of regular units) 700,000
Special order 920,000 1,620,000
Excess capacity 480,000
Capacity utilization after contract with retailer expires:

Capacity of new equipment (700,000 x 3) 2,100,000
Capacity Utilization:
Regular production (assumes no increase in sales of regular units) 700,000
Excess capacity 480,000

Page 317

FMC17 Solution: Net Present Value – Make or Buy - Tratter
Incorporated
A. Yearly cash flows for each alternative
Yearly cash flows:

Alt 1 Alt 2 Alt 3
Build Buy Buy
General Special General
Sales $468,000 $585,000 $468,000

Variable expenses
Operators (2,000 hrs. x $28) 112,000 56,000 112,000
Insurance 7,200 12,000 7,200
Maintenance 62,400 28,800 62,400
Direct materials 46,800 46,800 46,800
Variable OH (50% of DL$) 56,000 28,000 56,000
Total variable cost 284,400 171,600 284,400
$183,600 $413,400 $183,600
B. Cost to purchase or build for each alternative
Note that fixed overhead is irrelevant. The fixed overhead will be incurred regardless of the
alternative and, therefore, it is irrelevant.
Alt 1: Cost to build general purpose machine
Material and parts $132,000

Direct labour 216,000
Variable overhead 108,000
$456,000 (no salvage value)
Alt 2: Cost of Buying Special Purpose Machine
Purchase Price (given in question) $1,500,000 ($60,000 salvage value)

Lodging costs re: training ($3,000 x 26 weeks) 78,000
$1,578,000
Alt 3: Cost of Buying General Purpose Machine
Purchase Price (given in question) $700,000 ($15,000 salvage value)


C. NPV of each alternative
Alt 1 Alt 2 Alt 3

Build General Buy Special Buy General
Yearly cash flows:
Present value of yearly cash flows
for five years (see previous page)
General purpose machine:

$183,600 x PVA, 5 yrs., 8%
= $183,600 x 3.993 $733,115 $733,115
Special purpose machine:
$413,400 x PVA, 5 yrs. 8%
= $413,400 x 3.993 $1,670,706
Cash to purchase/build
1
(see previous page) (456,000) (1,578,000) (700,000)
Present value of salvage value NIL

$60,000 x PV, 5 yrs., 8%
= $60,000 x .681 40,860
$15,000 x PV, 5 yrs., 8%
= $15,000 x .681 10,215
Net present value $277,115 $133,566 $43,330

Positive Positive Positive
Recommendation: The best alternative is alternative 1; build the machine, as it has a higher net
present value than the other two alternatives.


FMC18 Solution: Capital Budgeting (DCF) - Retil Limited
Present value of cash flows
A B AxB
Post-Tax Pos- Tax Present Outflow
Pre-tax Discount Value Present or
Description Year Amount Amount Rate Factor Value Inflow
Non-recurring Cash Flows:

Purchase 1 $350,000 $350,000 14% 1.00 $350,000 O
Overhaul 4 12,600 7,560 14% .592 4,476 O
Salvage 7 50,000 50,000 14% .400 20,000 I
Net outflow $334,476 O
Recurring Cash Flows:
Savings 1-7 $58,000 34,800 14% 4.288 $149,222 I
New product 1-7 $11,000 6,600 14% 4.288 28,301 I
Net inflow $177,523 I
Tax Shield:
Cdt x (1 + 0.5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= (350,000 x .3 x .4) x (1 + (.5 x .14)) - 50,000 x (.3 x .4)

7
(.3 + .14) (1 + .14) (1 + .14) (.3 + .14)
= 42,000 x 1.07 - 50,000 x .12

.44 1.14 2.5022686 .44
= (95,454.55 x .9385964) – (19,981.867 x .272727)
= 89,593.30 – 5,449.60
= $84,143.70
NPV:
Nonrecurring cash flows $334,476 Outflow
Recurring cash flows 177,523 Inflow
Tax shield 84,144 Inflow
Net outflow or negative NPV $72,809 Outflow


FMC19 Solution: Capital Budgeting (DCF) - Mister Donut
Machine A:
Present value of cash flows:
A B AxB
Post-tax
Post-Tax Discount Present
Pre-tax Outflow or
Rate Value Present
Description Year Amount Inflow
Amount (20% x 1 - Factor Value
.40))
Nonrecurring Cash Flows:

Purchase 1 $180,000 $180,000 12% 1.000 $180,000 O
Salvage 8 60,000 60,000 12% .404 24,240 I
Recurring Cash Flows:
Maintenance 1-8 14,000 8,400 12% 4.968 $41,731 O
Savings 1-8 38,000 22,800 12% 4.968 113,270 I
Tax Shield:
Cdt x (1 + .5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= (180,000 x .3 x .4) x (1 + (.5 x .12)) - 60,000 x (.3 x .4)

8
(.3 + .12) (1 + .12) (1 + .12) (.3 + .12)
= 21,600 x 1.06 - 60,000 x .12

.42 1.12 2.4759629 .42
= (51,428.571 x .9464285) – (24,232.996 x .2857142)
= 48,673.465 – 6,923.711
= $41,749.75
NPV of Machine A:
Net outflow or negative NPV $42,471 Outflow


Machine B:
Present value of cash flows:
A B AxB
Post-Tax Post-tax Present
Pre-tax Present Outflow
Description Year Discount Value
Amount Amount Value or Inflow
Rate Factor
Nonrecurring Cash Flows:

Purchase 1 $220,000 $220,000 12% 1.000 $220,000 O
Salvage 11 75,000 75,000 12% .287 21,525 I
Recurring Cash
Flows:
Maintenance 1-11 12,000 7,200 12% 5.938 42,754 O
Savings 1-11 56,000 33,600 12% 5.938 199,517 I
Tax Shield:
Cdt x (1 + .5k) - Sn x dt
n
d+k (1 + k) (1 + k) d+k
= (220,000 x .3 x .4) x (1 + (.5 x .12)) - 75,000 x (.3 x .4)

11
(.3 + .12) (1 + .12) (1 + .12) (.3 + .12)
= 26,400 x 1.06 - 75,000 x .12

.42 1.12 3.4785495 .42
= (62,857.142 x .9464285) – (21,560.71 x .2857142)
= 59,489.79 – 6,160.20
= $53,329.59
NPV of Machine B:
Net inflow (positive NPV) $11,618 Outflow


Comparison of machine A and B:
Machine A Machine B
NPV $42,471 Negative $11,618 Positive
Since machine B has a positive NPV, Mister Donut Inc. should purchase machine B.
FMC20 Solution: Capital Budgeting - Luna Mining

The following outlines the relevant costs and revenues of the proposed construction of a railway
by LMC between Carlsbad and the town of Fargo:
Capital Cost:
Cost of railroad = 50 kms x $1,500,000 per km $75,000,000
Cost of train and cars 15,000,000

Total capital cost 90,000,000
Less: federal subsidy ($90,000,000 x 50%) 45,000,000
Total net capital cost $45,000,000
Annual Cash Flows:
Revenue from freight and passenger fares 570,000
Savings on administration costs ($1,250,000 x 25%) 312,500
Savings on winter road costs ($3,000,000 x 50%) 1,500,000
Savings on helicopter and float plane costs 5,500,000
Total revenue and incremental cost savings 7,882,500
Costs:
Operations 240,000
Maintenance 140,000
Total costs 380,000
Net cash flow per year before taxes 7,502,500
Taxes ($7,502,500 x 40%) 3,001,000
Net cash flow per year after taxes 4,501,500
Present value of annuity for 25 years @ 10% x 9.077
Total present value of annual cash inflows after tax $40,860,116


Present value CCA tax shield:
Railroad Train
Capital cost (C) $37,500,000 $7,500,000
Capital cost allowance rate (d) 4% 10%
Tax rate (T) 40% 40%
Cost of capital (k) 10% 10%
CdT x (2 + k)
(d + k) (2(1 + k))
= CdT x (1 + 0.5k) $4,090,909 $1,431,818 $5,522,727

(d + k) (1 + k)
Net present value of proposed railway:
Capital cost $(45,000,000) Outflow

Present value of annual cash inflows after-tax 40,860,116 Inflow
Present value of CCA tax shield 5,522,727 Inflow
Net present value of proposed railway $1,382,843
The net present value of the project is positive (i.e. $1,382,843) suggesting the project is
economically feasible, but only if LMC is granted a 50% subsidy from the government. The net
present value of the project would be negative without the government subsidy (i.e. $90,000,000
- $40,860,116 - $11,045,454 = outflow of $38,094,430).

Page 324

FMC21 Solution: Mergers and Acquisitions - MCQ
1. b. The use of debt or cash creates a situation where shareholders

of the acquired organization might have capital gains taxes to pay immediately. If
shares are used instead, these capital gains are not immediately taxable. None of
the other answers are true.
2. d. This is the most correct description of the three types of

acquisitions. All the others contain errors or incorrect information.
3. d. The combined organization is worth $55 million and has 1.5

million shares. This means the price per share is $36.667. The combined
earnings are $3 million, which gives an EPS = $2. The P/E ratio = 36.667/2 =
18.33.
4. e. All the items mentioned in a., b. and c. are possible synergistic

gains from an acquisition.
5. d. The risk and growth prospects are critical to future value in an

acquisition and the capabilities of management in taking full advantage of these
prospects are critical. Historical information is less likely to be significant unless
one can be sure that history will repeat itself. Also, location is becoming
irrelevant in today’s business environment.

FMC22 Solution: Business Valuation - Organizations A & B
Market value of combined assets = 10 + 12 = 22 or $22 million.

Market value based on price earnings ratios = 24 * .5 + 30 * .4 = 24 or $24 million.
Market value based on cash flows = [.9 / (.12-.06) + .75 / (.16 - .01)]
= 15 + 5 = 20 or $20 million.
The range of values would appear to be $20 million to $24 million.

Page 325

FMC23 Solution: Long-Term Financing - MCQ
1. e. All three advantages in a., b. and c. are true in an initial

public offering.
2. e. All four disadvantages could exist once an organization has publicly

traded shares.
3. e. Both trade credit and bank loans are primary sources of funds for
small businesses. Commercial paper is not available and one would hope
government subsidies were not important.
FMC24 Solution: Forecasting - Howard Company
The income statements and balance sheets will look as follows, in the next period.
Sales 4,600 Current assets 690

Cost of sales 3,680 Fixed assets 2,990
Operating income 920 Total assets 3,680
Taxes 368
Net income 552 Current liabilities 460
Dividends paid 276 Long-term debt 1,000
Owners’ equity 2,076
Total liabilities and
owners’ equity 3,536
Therefore, financing needs are 144 (3,680 – 3,536).

Page 326

FMC25 Solution: Long-Term Financing - HWB Company
The increase in sales is defined as g. Therefore, new sales equal 100(1 + g). The increase in
sales is 100g. Additional funds needed are equal to zero.
Therefore:
0 = 1.2(100g) – 0.6(100g) – 0.12(0.4)[100(1 + g)]
0 = 120g – 60g – 4.8 – 4.8g
55.2g = 4.8
g = 4.8/55.2 = 0.087 or 8.7%
Therefore, the maximum growth without external financing is 8.7%.
FMC26 Solution: Short-Term Financing - Trade Discounts
A: (1 + 3/97)365/45 – 1 = 28%
B: (1 + 2/98)365/20 – 1 = 44.6%

From the point of view of the grantor of credit offering these terms, there are two different
factors to consider. One is the cost of giving a lower discount in the second case and the second
is the lower cost but longer period before cash is received in the first case. There is a trade-off
between the cost of the discount and the time it takes to get the cash. It depends on the position
of the trade credit grantor as to which one is better. Can the organization afford to wait the extra
30 days to receive the cash? Or should the shortest possible payment period be used? One is not
necessarily better than the other and there is no definitive answer as to which one is better.
FMC27 Solution: Long-Term Financing - Rights
The organization must issue 30,000,000/30 or one million shares. The organization is currently
worth $40 * 5 million or $200 million. The issue will raise $30 million and there will be six
million shares after the issue of the rights. Therefore the value of the shares, ex-rights, will be
230 million/6 million = 38.33 per share. The value of the right is 40 – 38.33 or $1.67 per right.


FMC28 Solution: Financial Markets - MCQ
1. a. The concepts of market efficiency and arbitrage are really not the same and imply
slightly different things. Thus, both are really necessary for effective security
valuation. Some would argue that efficiency implies arbitrage, but that does not
have to be true from one market or segment of the market to another.
2. b. Derivative securities markets do not supply additional capital but do provide risk
management tools. Speculators do not provide liquidity on purpose, but rather
they are looking for a profit. All of the other answers are partly true but not
totally. Derivative securities markets are domestic and international and not just
international and financial institutions are not the only participants. Any answer
implying that additional capital is supplied is misleading or incorrect.
3. e. The first three statements are all true. Options are rights but not obligations and
forward and futures contracts lock in prices for future delivery. In addition, a
long position in forward or futures contracts is like a call option, the option to
buy, while a short position is like an option to purchase. However, the option
always leaves open the right to refuse to exercise, while forward and futures
contracts do not.
4. c. The formula is: risk free rate plus beta times (the return on market less the risk
free rate) = 6% + 1.2 (12% - 6%) = 6% + 7.2% = 13.2%
5. d. While all of the measures mentioned are used quite extensively in finance,
variances and co-variances are used to measure portfolio risk.
FMC29 Solution: EOQ - English Bread Company

The EOQ calculation is:
EOQ = √ (2 * 8,000 * 5,200,000) / (0.02 * 250)

= 128,996.1
This represents an order quantity of 128,996 tonnes, but since orders must be placed in multiples
of 10,000 tonnes, then the order must be 130,000 tonnes each time.
An order should be placed when the inventory level is 550,000 tonnes.
Weekly usage is 5,200,000/52 = 100,000 per week.

Reorder point is four weeks’ sales plus the safety stock =
4 * 100,000 + 150,000 = 550,000 tonnes.


FMC30 Solution: Short-Term Financing - Zachariah Inc.
The % of customers taking the discount before is:
Let x = % of customers taking the discount
Then: 10(x) + 30(1-x) = 15
x = 75%
The % of customers taking the discount after is:

Let x = % of customers taking the discount
Then: 20(x) + 40(1-x) = 26
x = 70%
Incremental contribution margin:

$2,000,000 x 40% $800,000
Incremental bad debts

Before: $10,000,000 x 3% $300,000
After: $12,000,000 x 4% 480,000 (180,000)
Incremental discounts:
Before: $10,000,000 x 1% x 75% $75,000
After: $12,000,000 x 2% x 70% 168,000 (93,000)
Incremental operating cash flows 527,000

x 0.60
After-tax incremental operating cash flows 316,200
Carrying charges on incremental working capital -
Accounts receivable -
Before: $10,000,000 / 365 x 15 days $410,959
After: $12,000,000 / 365 x 26 days 854,795
Increase in A/R $443,836
Inventory -
Before: $10,000,000 x 70% /5 $1,400,000
After: $12,000,000 x 70% / 7 1,200,000
Decrease in inventory $ 200,000
Carrying charge = ($443,836 – 200,000) x 10% (24,384)
Incremental impact of change in policy $291,816


FMC31 Solution: Leverage
Degree of operating leverage
= [200,000 (20 – 10)] / [200,000 (20 – 10) – 1,000,000] = 2.0
Degree of financial leverage

= [200,000 (20 – 10) – 1,000,000] / [200,000 (20 – 10) – 1,000,000 – 500,000]
= 2.0
Degree of combined leverage = 2 * 2 = 4
Any sales increase will cause an increase in EPS of four times the percentage sales increase.
Thus, a 10% sales increase will cause a 40% EPS increase.
FMC32 Solution: Leverage

EPS calculations for each alternative (in thousands):
Common Debt Preferred

Operating Income 4,300 1,300 4,300 1,300 4,300 1,300
Interest 1,600 1,600
Earnings before taxes 4,300 1,300 2,700 -300 4,300 1,300
Taxes 1,720 520 1,080 -120 1,720 520
Net income 2,580 780 1,620 -180 2,580 780
Preferred dividends 1,200 1,200
Earnings available for
common shareholders 2,580 780 1,620 -180 1,380 -420
EPS 1.032 0.312 1.080 -0.120 0.920 -0.280
Based on the information above, the debt appears to be the best alternative at an income level of
$4.3 million, although only by a slight margin. This assumes, of course, that the net income
figure is correct. When income drops, the other alternatives become quite unsuitable and
common shares are a far less risky choice.

Page 330

FMC33 Solution: Leverage - Wasu Company
a. i. DOL = CM / EBIT = $800,000 / 450,000 = 1.7778
ii. DFL = EBIT / (EBIT – I) = $450,000 / (450,000 – 150,000) = 1.50
iii. DTL = DOL*DFL = 1.7778 x 1.50 = 2.6667
b. Sales ($2,000,000 x 1.15) 2,300,000

Variable costs (1,200,000 x 1.15) 1,380,000
Contribution margin 920,000
Fixed costs 350,000
Operating income 570,000
Interest expense 150,000
Net income before taxes 420,000
Income taxes 126,000
Net income $294,000
The degree of operating leverage tells us that a 1% increase in sales will lead to a
1.7778% increase in operating income. Alternatively, a 15% increase in sales will
lead to a 15% (1.7778) = 26 2/3% increase.
Check: $450,000 x 1.26667 = $570,000

The degree of financial leverage tells us that a 1% change in operating income will
lead to a 1.5% change in net income before taxes. In this case, operating income
increased 26 2/3%; therefore, we would expect net income before taxes to increase
by 26 2/3% (1.5) = 40%.
Check: $300,000 x 1.4 = $420,000
The degree of total leverage tells us that a 1% change in sales will lead to a
2.6667% change in net income before taxes. In this case, sales increased 15%;
therefore, we would expect net income before taxes to increase by 15% (2.667) =
40%. (as predicted by the degree of financial leverage)

Page 331

FMC34 Solution: Capital Structure
c. This answer is the most correct of the ones provided. The WACC is minimized or the
value of the organization (shareholder wealth) is maximized, as noted in the answers to
a., b. and c., but the other conditions that must be met include the maximization of the tax
shelter and minimization of financial distress costs.

a. VL = $1,700,000
VL = VU + Dtc
VU = VL – Dtc
= 1,700,000 – (500,000)(.4)
= $1,500,000
b. If the organization was all equity, it would earn: $1,500,000 x 20% = $300,000
With debt, we subtract interest of $500,000(10%)(.6) = $30,000
Income accruing to shareholders = $300,000 – 30,000 = $270,000
Check: V = D + E
1,700,000 = 500,000 + 1,200,000
RL = RU + (RU – RD)(D/E)(1-t)
= .20 + (.20 - .10)(5,000/12,000)(.6)
= .225
E = 270,000 / .225
= $1,200,000

VL = VU + Dtc
= 3,500,000 + 1,000,000(.4) = $3,900,000
V=E+D
E=V–D
= $3,900,000 – 1,000,000
= $2,900,000

Page 332

FMC37 Solution: Capital Structure - RR Company
a. VU = EBIT (1-t) / RU
= 2,500,000(.6) / .20
= $7,500,000
b. VL = 7,500,000 + 600,000(.4)
= $7,740,000
c. Debt creates a tax shield for the organization. This has value and accounts for the
increase in the value of the organization.
d. No cost of financial distress. Debt is constant and the interest date on debt is constant.
FMC38 Solution: Capital Structure - Simard Company

a. VL = VU + Dtc
VU = EBIT (1-t) / RU
= 4,000,000(.6) / .15

= $16,000,000
= 16,000,000 + 10,000,000(.4) = $20,000,000
b. V=D+E
20 = 10 + 10
RL = RU + (RU – RD)(D/E)(1-t)
= .15 + (.15 - .10)(1)(.6)
= 18%
WACC = (1/2)(.10)(.6) + (1/2)(.18)

= 12%
Alternatively: WACC = EBIT(1-t) / VL

= 4,000,000(.6) / 20,000,000
= 12%
c. See part (b).


FMC39 Solutions: Corporate Finance Multiple Choice
1. B The risk premium is the difference between the return on a risky asset and on the market
portfolio.
This statement is inaccurate since the risk premium is calculated as the difference
between the return on a risky asset and the return on a risk free asset (e.g. Canadian
government treasury bills).
2. A You need to calculate the weight of each asset relative to the total portfolio to compute
the portfolio return, but not to compute the portfolio variance
Since the portfolio’s variance is a calculation of its actual return compared to expected,
the weighting of each asset in the portfolio is taken into consideration (i.e. when
calculating expected and actual returns of the portfolio.
3. E Investors used all relevant information available when computing the expected return
If the expected return equals the actual return, investors used all information available
when computing the expected return.
4. A. I only (unsystematic risk exists)
Diversification reduces unsystematic risk. Market risk (also known as systematic risk)
cannot be reduced by diversifying.
5. B. Market risk
The terms market risk and systematic risk are synonymous.
6. D A beta of one indicating an asset is totally risk free is incorrect. A beta of 1.0 means
there is perfect correlation between market risk and an individual security’s risk.
7. D II, III and IV only
8. C I, II and III only


9. E The stock in Smith Incorporated has a lower risk premium than Cara Limited.
10. C III only (lower sales for IBM than expected.)
Since unsystematic risk is diversifiable risk, “III lower sales for IBM than expected”, is
correct since “I lower trade deficit than expected” and “II higher GDP than expected” are
included in market (systematic) risk.
11. B Lower interest rates than expected
Since virtually all companies are subject to interest rates, this factor is not diversifiable
and is included in systematic risk.
12. D I and II only
I is included because the company has increased the impact of interest rates on its return
and II because interest rates are included in market risk.
13. A Increase
14. D I and II only

15. E II, III and IV only
The terms market risk, systematic risk and non-diversifiable risk are synonymous. This
risk cannot be eliminated.
16. E Beta


17. E 16.4%
Given:
Beta (ȕ) = 1.3 rm = 14% rf = 6%
Required: Find expected return
Solution:
Note that the CAPM formula is on the formula sheet provided in the examination.
r = rf + ȕ ( rm – rf)
r = 6% + 1.3(14% - 6%)
r = 16.4%
18. D 17%
Given:
r = 16% rf = 7% Beta (ȕ) = 0.9
Required: Find rm (expected market return)
r = r f + ȕ ( r m – rf )
r – rf = ȕ ( r m – rf )
r – rf + rf = rm
ȕ
rm = 16% - 7% + 7%
0.9
=10% + 7%
= 17%
19. D 4%
Given:
r = 18% Beta (ȕ) = 1.4 rm = 14%
Required: Find rf (risk free rate)
r = r f + ȕ ( r m – rf )
r = rf + ȕ r m – ȕ rf
r - ȕ rm = rf – ȕ rf = rf (1 – ȕ)

Page 336

rf = r - ȕ rm
(1 – ȕ)
= 18% - 1.4 (14%)

1 – 1.4
= -1.6
-0.4
= 4%
20. C 10.53%
Given:
r = 15% rf = 5% Beta (ȕ) = 0.95
Required: Find the risk premium (rm – rf)

r – rf
rm = + rf
ȕ
15% - 5%
= + 5%
0.95
rm = 15.53%
r m – rf = 15.53% - 5%

= 10.53%
21. B Security X, because it has the largest beta coefficient.
22. A $34.86
Given:
Future value (FV) = $1,000
n =8
Present value = $664.08
Required: Find i (interest) in dollars


Solution:
FV = Present value (1 + i)n
1,000 = 664.08 (1 + i)8
1,000 = (1 + i)8
664.08
(1.5058)1/8 = 1 + i
8
1+i = 1.5058
1+i = 1.052497
i = 5.25%
interest = Present value (i)

= 664.08 (5.25%)
= $34.86
23. C $2,393.92
Given:
Number of bonds = 10
Face value (FV) = $1,000
Coupon = zero
n = 15
I = ytm = 10%
Required: Find proceeds (or present value), denoted P0
Solution:
FV
P0 =
(1 + i)n
1,000
=
(1.10)15
1,000
=
4.1772
= 239.392/bond
Proceeds = 10 bonds x 239.392/bond

= $2,393.92

Page 338

24. D 6.75%
Given:
n = 15
Future value (FV) = $1,000
Coupon = zero
Present value (P0) = 375.39
Required: Find i, or yield-to-maturity
Solution:
FV = P0 (1 + i)n
FV
= (1 + i)n
P0
1/n
FV
i = –1
P0
1/15
1,000
i = –1
375.39
i = (2.6639)0.0667 – 1
i = 6.75%

25. C Dilution
26. B Operating line of credit
27. C In a factoring arrangement, the default risk on the accounts receivable transfers to the
purchaser of the receivable. When factoring receivables, the purchaser of the receivables
assumes the risk of default.
28. B Drawing on an existing, unused line of credit
29. C Factoring its receivables
Factoring receivables meets both needs – provides cash and reduces accounts receivable.

Page 339

30. D Obtaining a loan secured by its inventory
31. C I and III only (issuing commercial paper and factoring accounts receivable)
32. B IV only (retiring short-term loans)
33. B Should the company cancel and redeem its outstanding bonds
34. E III only (selling marketable securities in order to pay dividends)
35. E Operating cycle
36. B Shortage costs; carrying costs
37. C A conventional factoring arrangement
38. D Whichever amount represents the greatest opportunity cost, that is, the best alternative
use you must forgo in order to build the factory
39. B II only (NPV = 0)
40. E -$103.51
NPV:
Cost of machine (60.00)

Operating costs (53.63) (35 x .66) x (PVFA 3 14%)=23.10 x 2.322
Proceeds from sale 10.12 15 x (PVF 3 14%)=15 x .675
(103.51)
41. E II and III only (land you already own, but may be used for the project, with a market
value of $700,000; and $300,000 drop in sales of regular furniture if high end furniture is
introduced.)
42. E All of the above are valid reasons for leasing


43. D A capital lease increases the debt-to-equity ratio. [Generally, this is not seen as a benefit,
as increases in the debt-to-equity ratio reduce future borrowing capacity.]
44. E Debt financing
45. C The after-tax cost of issuing debt
46. D Buy, it saves you $372.
BUY:
Cost to purchase (48,000.00)
Tax shield gained 16,223.13 (48,000 x .40) x (.40/.40+.06) x (2+.06/2 x 1.06)
(31,776.86)
LEASE:
after tax lease payment = 12,000 x .60=7,200
NPV of lease payments (32,148.00) 7,200+7,200(PVFA 4 6%)= 7,200+7,200(3.465)
Difference:
Lease 32,148.00
Buy 31,776.86
371.34 Savings from buying

47. D 37,179 ; -4,073
Pre-tax cost of capital= 10%

Tax rate = 40%
After tax cost of capital = 10%*(1-.40)=6%
@T=0
Cost to purchase ($48,000)
Tax shield gained $3,621 CCA (40%)*1/2 year rule*.40=48,000*.40*1/2*.40=3,840
Discounted to the beginning of the year
=3,840*(PVF16%)=3,621
Total cost of purchase $44,379
Lease payment $7,200 12,000 x .60=7,200
Cash inflow from leasing @T=0 Î44,379-7,200=$37,179


@T=4
Year1 Year2 Year3 Year4 Year5

(T=0) (T=1) (T=2) (T=3) (T=4)
UCC @ beginning of year 48000 38400 23040 13824 8294

CCA (40%) (9600) ½ year rule (15360) (9216) (5529) (3317)
UCC @ end of year 38400 23040 13824 8294 4976 ÅTerminal
Loss b/c
trolleys have
no value after 5
years
Tax Shield from CCA $1,251 3317 x (PVF16%) x .40=1,251(discounted to Beginning of year)
Tax Shield from Terminal Loss $1,876 4976 x (PVF16%) x .40=1,876(discounted to Beginning of year)
Total Tax Shield @ T=4 $3,127 1,251 + 1,876=3,127
Lease Payment $7,200 12,000 x .60=7,200
Cash outflow from leasing @T=4 Î7,200-3,127=4,073
48. B $11,861
NPV to Buy NPV of Lease Payments
31,776.86 = Lease Payment + Lease Payment (PVFA4 6%)

31,776.86 = Lease Payment + Lease Payment (3.465)
31,776.86 = 4.465 x Lease Payment
7116.86 = Lease Payment, after tax
7,116.86/.60 = 11,861.46 (before tax Lease Payment)
49. C $36,000; $0
BUY:
Cost to Purchase @ T=0 (48,000)
Tax shield gained @ T=0 0
(48,000)
LEASE:
Lease Payment @ T=0 (12,000)
Difference:
Lease 48,000
Buy 12,000
36,000 Cash inflow from leasing @ T=0


T=0 T=1 T=2 T=3 T=4
Buy 48,000 0 0 0 0
Lease 12,000 12,000 12,000 12,000 12,000
Cash flow 36,000 24,000 12,000 0 -12,000
(36,000-12,000) (24,000-12,000) (12,000-12,000)
50. B $11,511
NPV to Buy NPV of Lease Payments
48,000 = Lease Payment + Lease Payment (PVFA4 10%)

48,000 = Lease Payment + Lease Payment (3.170)
48,000 = 4.170 x Lease Payment
11,510.80 = Lease Payment
51. C Buy, it saves you $561

BUY:
Cost to Purchase (22,500)

Tax shield gained 5556.77 (22,500*.30) x (.40/.40+.07) x (2+.07/2*1.07)
(16,943.23)

LEASE:
After tax lease payment = 5,700 x .70=3,990
NPV of Lease Payments (17,504.13) 3,990+3,990(PVFA 4 6%)= 3,990+3,990(3.387)
Difference:
Lease 17504.13
Buy 16,943.23
560.90 Savings from buying
52. B The results from this model are not sensitive to changes in the dividend growth rate
53. C I, II and III only (tend to become riskier over time; tend to accept unprofitable projects
over time; and likely see its WACC rise over time)
54. C A low earning division will be ignored in capital allocation even though it tends to
maintain lower levels of risk.


55. E I, II and III (The estimated cost of equity is sensitive to the estimated dividend growth
rate.. The approach does not explicitly consider risk. The approach requires one to
assume the dividend growth rate will remain constant.)
56. E 20%
Given:
P0 = 37.86
D1 = 5.30
g = 6%
Required: Find ke
Solution:
D
ke = +g
NPe
5.30
= + 6%
37.86
= 14% + 6%
= 20%
57. D 20.15%
Given:
rf = 8%
(rm - rf) = 9%
Beta (ȕ) = 1.35
Required: Find ke
Solution:
ke = rf + (rm - rf) ȕ
ke = 8% + 9% (1.35)
ke = 20.15%


58. B 8.6%
Given:
n = 20 – 8 = 12
Face value (FV) = $1,000
Price (or present value), (P0) = 1,110.17
Coupon = 10%
Required: Find interest rate, cost of debt, kd

Solution:
P0 = coupon PVIF + face value PVIF
kd,12 kd,12
1,110.17 = 1000 (10%) PVIF + 1000 PVIF

kd,12 kd,12
Interest rate approximation:

i coupon + (FV - P0) /n
=
(FV + P0) /2
100 + (1,000 – 1110.17)/12

=
(1000 + 1110.17)/2
90.8192

=
1055.085
= 8.6%
59. A 8.0%
Given:
Dp = 4 NPp = 50
Required: Find cost of preferred equity, kp
Solution:
Dp
Kp =
NPp
4
=
50
= 8%


60. B 9.4%
Given:
Debt/total asset, D/TA = 50%
Pre-tax cost of debt, kd = 8%
Cost of equity, ke = 14%
Tax rate, t = 40%
Required: Find WACC
Solution:
D E
___ ____
WACC = (kd) (1 – t) + (ke)
TA TA
= 50% (8%) (1 – 40%) + 50% (14%)

= 2.4% + 7%
= 9.4%
61. C -$1,356
D E
WACC = Kd + Ke
V V
WACC = ((.08 x .60) x 1/2) + (.14 x 1/2)

WACC = .024+.07
WACC = .094
NPV:
Equipment (200,000)
a/f tax cash flows 198,644 40,000 x (PFVA7 9.4%)
(1,356)
Note the present value tables do not have a discount value for 9.4% but if you were to use
a factor of 9% the answer is close. (We chose to keep this solution “close” and not
perfect since many candidates will be using calculators that can perform the present and
future value functions on the Entrance Examination. Typically, these calculators provide
an answer “close” to the actual choice on the examination, but not exact.)


62. B $283,019
Given:
ke = 16%
kd = 7%
Debt/equity, D/E = 1.5% (could be stated as 1.5:1)
Annuity = $30,000
Required: Find maximum price for the project (present value or PV)
Solution:
PMT Annuity
PV = =
r WACC
D E
_______ ________
WACC = (kd) + (ke)
D+E D+E
1.5 1.0
___________ ___________
= (7%) + (16%)
1.5 + 1.0 1.5 + 1.0
= 60% (7%) + 40% (16%)

= 10.60%
PV = Annuity

WACC
= 30,000
10.60%
= $283,019
63. D The level of financial leverage that produces the highest firm value is the one most
beneficial to stockholders.
64. D I, III and IV only (The ultimate effect of leverage depends on the organization’s EBIT.
As an organization levers up, shareholders are exposed to more and more risk. The
benefits of leverage will not be as great in a organization with substantial accumulated
losses or other types of tax shields as for a organization without many tax shields.)
65. A Choose the one that maximizes the current value of the stock


66. B II and III only (minimizes the organization’s weighted average cost of capital and
maximizes the market price of the organization’s common stock)
67. E I, II and III (increasing financial leverage increases the sensitivity of EPS and ROE to
changes in EBIT. Increasing financial leverage increases the sensitivity of EPS and ROE
to changes in EBIT. High leverage magnifies the returns to shareholders (as measured by
ROE).)
68. D 16.0%
D E
WACC = Kd + Ke
V V
.10 = (.06 x .66) x 1/2 + Ke x 1/2

.10 = .0198 + Ke x 1/2
.0802 = Ke x 1/2
Ke = .1604 (or 16.0%)
69. C $6,253
Value of unlevered organization:
VU = EBIT x (1-tax rate)/unlevered cost of capital
VU = 1,110 x (1-.34)/.14
VU = 5,232.85
Value of levered
organization:
VL = 5,232.85 + (.34 x 3,000)
VL = 6,252.85
70. D $4,400,000
4,400,000 = 660,000/.15


71. B $14,335
Value of unlevered organization:
VU = EBIT x (1-tax rate)/unlevered cost of capital
VU = 3,300 x (1-.39)/.12
VU = 16,775
Value of levered organization:

VL = VU +(tax rate x debt)
VL = 16,775 + (.39 x 4,000)
VL = 18,335
Value of equity:
VE = VL - debt
VE = 18,335 - 4,000
VE = 14,335
72. E I, II, III and IV (maturity risk; marketability risk; taxability; and default risk)
73. D The higher the cash balance, the higher the opportunity costs in terms of the interest
income that could be earned in the next best use

74. D Reorder points
75. E Not enough information
Economic Order Quantity (EOQ):
EOQ = 2SO
C
= _2 x S x 500
C
Since S is not given, cannot determine.


76. D 500
EOQ = 2SO
C
= _2 (7500) (900)
54
= 250,000 = 500
77. E $1,000
Total carrying cost = average inventory x carrying cost /unit

= 1000 x $1
= $1,000
78. B $48
Restocking cost = number of purchase orders per year x reorder cost

= 12 x $4
= $48
79. B 219 units
EOQ = 2SO
C
= _2 (500) (12 x 4)
1
= 48,000 = 219 units


80. A 110 units
Average inventory = EOQ

2
= 219 = 110
2
81. C $110
Total carrying cost = EOQ x unit carrying cost

2
= 219 x $1 = $110
2
82. A $110
Total restocking cost = S
x O
EOQ
= 500 (12) (4)

219
= 110

At EOQ, carrying cost = ordering cost
83. C The forward exchange rate
84. E Spot trade
85. E Spot rate
86. D I and IV only (the Deutsche mark is selling at a discount relative to the dollar. The dollar
is selling at a premium relative to the Deutsche mark.)
87. E II and III only (The Deutsche mark is selling at a premium relative to the dollar. The
dollar is selling at a discount relative to the Deutsche mark.)


88. A $4,458
JPY 500,000
Dollars to be received =
60 day FWD rate
500,000
=
112.16
= $4,458


Strategic Management

Table of Contents
MISSION AND VISION STATEMENTS ................................................................................................... 353
VISION STATEMENTS ............................................................................................................................... 355
MISSION STATEMENTS ............................................................................................................................ 356
ROLE OF VISION AND MISSION STATEMENTS IN PERFORMANCE AND ALIGNMENT OF ORGANIZATIONAL
ACTIVITIES .............................................................................................................................................. 356
THE VISION AND MISSION STATEMENTS AND CORPORATE CULTURE.......................................................... 357
EXTERNAL SCAN - PESTE .................................................................................................................... 359
DESCRIPTION OF PESTE ........................................................................................................................ 359
EXTERNAL SCAN – PORTER’S FIVE FORCES.................................................................................... 363
PORTER’S FIVE FORCES.......................................................................................................................... 363
VALUE CHAIN ANALYSIS AND PROFIT POOLS ................................................................................. 366
THE VALUE CHAIN................................................................................................................................... 366
USING THE VALUE CHAIN FOR SEGMENTATION ANALYSIS .......................................................................... 369
PROFIT POOL ANALYSIS .......................................................................................................................... 372
INTERNAL SCAN – STAKEHOLDER ANALYSIS.................................................................................. 374
STAKEHOLDER ANALYSIS ........................................................................................................................ 374
INTERNAL SCAN –RESOURCE/CAPABILITY/CORE COMPETENCE ANALYSIS ............................. 375
RESOURCE/CAPABILITY/CORE COMPETENCE ANALYSIS............................................................................ 375
TARGET CUSTOMERS AND TARGET MARKETS................................................................................ 378
MARKET SEGMENTATION ......................................................................................................................... 378
LEVELS OF STRATEGY – CORPORATE LEVEL STRATEGY............................................................. 383
OVERVIEW .............................................................................................................................................. 383
OBJECTIVES OF CORPORATE STRATEGY – CREATING SYNERGY ............................................................... 383
TYPES OF DIVERSIFICATION ..................................................................................................................... 384
LEVELS OF STRATEGY – BUSINESS LEVEL STRATEGY ................................................................. 385
OVERVIEW .............................................................................................................................................. 385
GENERIC BUSINESS LEVEL STRATEGIES .................................................................................................. 385
FIRST MOVER ADVANTAGE ...................................................................................................................... 387
OUTSOURCING........................................................................................................................................ 388
LEVELS OF STRATEGY – FUNCTIONAL LEVEL STRATEGY ............................................................ 389
OVERVIEW .............................................................................................................................................. 389
BUSINESS STRATEGIES AND THE INDUSTRY LIFE CYCLE............................................................. 390
THE PRODUCT LIFE CYCLE ...................................................................................................................... 390
STRATEGIES FOR EACH STAGE ................................................................................................................ 391
BUSINESS STRATEGIES – THE COST LEADERSHIP STRATEGY .................................................... 393
DIFFERENTIATION STRATEGY ............................................................................................................. 395

DIVESTITURE/DOWNSIZING STRATEGY .............................................................................................396
WHEN A DIVESTITURE STRATEGY IS APPROPRIATE ...................................................................................396
METHODS OF RESTRUCTURING ................................................................................................................396
INTEGRATION STRATEGY .....................................................................................................................399
INTEGRATION STRATEGIES .......................................................................................................................399
DOMESTIC AND INTERNATIONAL GROWTH STRATEGIES ..............................................................402
MOTIVES FOR INTERNATIONAL GROWTH ...................................................................................................402
INTERNATIONAL, MULTI-DOMESTIC, GLOBAL AND TRANSNATIONAL STRATEGIES .........................................403
RISKS IN ENTERING INTERNATIONAL MARKETS .........................................................................................404
TYPES OF FOREIGN COUNTRY ENTRY STRATEGIES ...................................................................................405
VENTURES AND STRATEGIC ALLIANCES ..........................................................................................406
JOINT VENTURES / PARTNERSHIPS ...........................................................................................................406
STRATEGIC ALLIANCES ............................................................................................................................407
MERGERS AND ACQUISITIONS ............................................................................................................408
OVERVIEW OF MERGERS AND ACQUISITIONS ............................................................................................408
WHY MERGERS AND ACQUISITIONS FAIL ..................................................................................................409
MANAGING THE POST-MERGER PHASE ....................................................................................................410
ORGANIC GROWTH ................................................................................................................................411
DEFINITION OF ORGANIC GROWTH ...........................................................................................................411
METHODS OF ACHIEVING ORGANIC GROWTH............................................................................................411
CORPORATE SOCIAL RESPONSIBILITY..............................................................................................413
CORPORATE SOCIAL RESPONSIBILITY ......................................................................................................413
BEST PRACTICES IN STRATEGY FORMULATION..............................................................................414
ORGANIZATIONAL DESIGN...................................................................................................................415
TYPES OF ORGANIZATIONAL STRUCTURES ...............................................................................................415
CENTRALIZED VS. DECENTRALIZED STRUCTURES .....................................................................................418
SPAN OF CONTROL..................................................................................................................................418
TALL VS. FLAT STRUCTURES ....................................................................................................................418
COMPLEXITY ...........................................................................................................................................418
CORPORATE CULTURE .........................................................................................................................420
BOUNDARY SYSTEMS ...........................................................................................................................422

BOUNDARY SYSTEMS ..............................................................................................................................422
CODES OF CONDUCT ...............................................................................................................................423
POLICY AND PROCEDURE MANUALS .........................................................................................................424
BALANCED SCORECARD ......................................................................................................................425
THE BALANCED SCORECARD ...................................................................................................................425
MONITORING AND UPDATING STRATEGY..........................................................................................427
BEST PRACTICES IN STRATEGY IMPLEMENTATION ........................................................................428

Mission and Vision Statements
1.1.1 Identifies components of mission and vision statements for a given
organization
1.1.1.1 Describes vision in terms of a desired future state
a) Understands that vision is a fundamental statement of an organization’s
9
values, aspirations and long-term goals
b) Explains components of a successful vision and outlines reasons an
9 9
organization’s vision may fail
c) Formulates an organization’s vision 9
1.1.1.2 Describes mission in terms of product or service, geographic area and
stakeholders served
a) Understands that a mission statement focuses on an organization’s present
business scope whereas a vision statement focuses on where the 9
organization wants to be in the future
b) Evaluates if a mission statement outlines an organization’s purpose,
business and core values, as well as establishes a basis for competition and 9 9
competitive advantage
c) Explains why mission statements should address the needs of multiple
9
stakeholders
d) Formulates an organization’s mission statement and updates it as the
9 9
organization’s competitive context changes
1.1.2 Explains the role of mission and vision statements in organizational

performance for a given organization
1.1.2.1 Describes how mission and vision statements are used to set goals/objectives
for the organization
a) Understands that goals/objectives convert the mission and vision into
specific performance targets (i.e. results and outcomes the organization 9
wants to achieve)
b) Understands the criteria for setting meaningful goals/objectives (e.g.
9
specific, measurable, appropriate, attainable, realistic, timely, tangible)
c) Formulates both financial and non-financial goals/objectives with specific,
short-term and long-term measurable targets that aim towards fulfilling 9 9
the mission/vision of the organization
1.1.2.2 Describes how mission and vision statements align all organizational
activities
a) Understands that strategy identifies how the mission, vision and
goals/objectives will be achieved in light of the organization’s situation 9
and prospects
b) Explains how mission and vision statements assist in the evaluation of
9
strategic alternatives


c) Understands that resource allocation should align with the organization’s
9
mission, vision and strategy
1.1.3 Explains how mission and vision statements impact corporate culture and
9
public image for a given organization
Overview of Vision and Mission Statements

A vision statement answers the question “What do we want to become?” In other words, in the
long-term, the mission statement defines what the company is striving to become. A clear vision
provides a foundation for developing an appropriate and sufficient mission statement. A vision
statement is future oriented.
Many organizations have both a vision statement and a mission statement, while other
organizations combine the vision and mission statement into one statement.
A mission statement is a declaration of a company’s “reason for being”. A mission statement

answers the question “What is our business?” Generally, a mission statement includes the
products or services offered, who are its customers and how those customers needs are met.
Vision vs. Mission
The difference between a vision statement and a mission statement can be summarized as:
Vision Mission
Answers the question: Answers the question:
What do we want to become? What is our business?


Vision Statements
A vision statement has more strategy making value than a mission statement because it gives the
organization a strong identity and provides long-term direction by articulating the organization’s
long-term goals. Essentially a vision statement is an extension of the mission statement.
Properly constructed vision statements not only help companies avoid aimless decision-making,
but they also help prepare an organization for the future. They guide managerial decision
making and encourage employee commitment to the organization by conveying the
organization’s identity and long-term direction.
Vision statements are more likely to fail when:

• They are based upon inaccurate or incomplete mission statements – strong mission
statements provide a firm foundation for realistic vision statements.
• An organization neglects to carry out a thorough and forward-looking SWOT* analysis
(*which outlines an organization’s strengths, weaknesses, environmental opportunities
and threats) before drafting the vision statement.
• Individuals constructing them are ill informed, not realistic and/or their judgment is poor.
• They are expressed in monetary rather than strategic terms – the vision is not to make a
profit, rather the focus is what value will be created in the future to ensure a profit is
made (or in the case of a non-profit organization, some long-term goal should be
realized).
• They are too generic, vague or ambiguous to define the organization accurately to its
various stakeholders and guide managerial decision-making in a definitive way. A good
mission/vision statement is not generic; it must be limited enough to uniquely define a
company but not so narrow that it prevents a company from leveraging its core
competencies (the resources and capabilities enabling an organization to do something
well that is integral to being a success in a particular industry) and exercising its strategic
intent to attain future goals. Strategic intent is demonstrated when a company relentlessly
pursues ambitious long-term goals that force the company to extend or stretch itself to
achieve well beyond its current position.
• Cultural norms, beliefs and traditions are incompatible with the vision.
• The information system is not properly aligned and adequate for the organization’s needs.
• There is a lack of strategic commitment.
• A strategic and managerial discontinuity exists.
• There is an unsteady and inadequate implementation of the strategic plan.
• The statement is not used as a motivating tool and/or it isn’t a living statement.
• Upper management fails to provide the necessary resources and incentives to encourage
organizational members to strive in order to achieve the vision.


Mission Statements
Good mission statements are distinctive and unique, not generic. This is not a “one size fits all”
exercise where the most eloquent slogan wins. An ideal mission statement should be brief (250
words or less) and include the following components as they relate to the organization:
• the organization’s major products and/or services

• customers and markets
• technology
• concern for employees
• concern for all stakeholders
• philosophy, including business, core values and beliefs
• concern for public image, survival, growth and profitability
(Source: David, F., (2009). Strategic Management, 12th edition, Pearson Prentice Hall, p. 61)
All the above components of a mission statement are determined according to an organization’s
current business scope; whereas, the vision statement can include these things, but adds the extra
component about where the organization wants to go in the future.
Role of Vision and Mission Statements in Performance

and Alignment of Organizational Activities
Mission and vision statements are essentially the foundation of the strategic management
process. Weak vision and mission statements result in unstable foundations on which to build
strategic and financial objectives. This can lead to lower performance.
Managing strategically requires an organization to pay close attention to a correct ordering of

management tasks. First, organizations must carefully analyze their internal and external
environment in order to discern what they are about, what they ideally should be and what the
proper course of action would be to reach that goal. This precedes the development of any
strategy. The mission, which encapsulates the nature and direction of the organization, is a key
consideration for the development of any strategic alternatives. Organizations must pay close
attention to the external environment, as well as monitoring their competitor’s actions before
accepting or rejecting any strategic alternatives. The mission and vision statements assist in the
evaluation of strategic alternatives by framing the parameters and focusing the organization’s
energies in a particular direction. The strategy identifies how the mission, vision and
goals/objectives will be achieved in light of the organization’s situation and prospects. Giving
life to a company’s strategy requires a prerequisite amount of tangible and intangible resources.
It is essential to obtain employee buy-in of the mission and vision statements. Typically positive
reinforcement and financial incentives provide the impetus to motivate employees to fulfill the
strategic mission/vision.

Page 356

The Vision and Mission Statements and Corporate
Culture
As the foundation of the strategic management process, vision/mission statements not only
impact the corporate culture, but are also shaped by the existing corporate culture. If the
vision/mission statements are embraced by the organization, they are powerful statements that
direct the organization shaping not only future actions, but also organizational culture. Living
the mission and vision statements gives a company a particular character that creates a public
image for the organization.
Examples of Vision and Mission Statements:
THE BELLEVUE HOSPITAL

Vision Statement
The Bellevue Hospital is the LEADER in providing resources necessary to realize the
community's highest level of HEALTH throughout life.
Mission Statement
The Bellevue Hospital, with respect, compassion, integrity and courage, honours the
individuality and confidentiality of our patients, employees and community, and is progressive in
anticipating and providing future health care services.
U.S. POULTRY & EGG ASSOCIATION

Vision Statement
A national organization, which represents its members in all aspects of poultry and eggs on both
a national and an international level.
Mission Statement
1. We will partner with our affiliated state organizations to attack common problems.
2. We are committed to the advancement of all areas of research and education in poultry
technology.
3. The International Poultry Exposition must continue to grow and be beneficial to both
exhibitors and attendees.
4. We must always be responsive and effective to the changing needs of our industry.
5. Our imperatives must be such that we do not duplicate the efforts of our sister organizations
6. We will strive to constantly improve the quality and safety of poultry products.
We will continue to increase the availability of poultry products.


JOHN DEERE, INC.
Vision Statement
John Deere is committed to providing Genuine Value to the company's stakeholders, including
our customers, dealers, shareholders, employees and communities. In support of that
commitment, Deere aspires to:
• Grow and pursue leadership positions in each of our businesses.
• Extend our pre-eminent leadership position in the agricultural equipment market
worldwide.
• Create new opportunities to leverage the John Deere brand globally.
Mission Statement
John Deere has grown and prospered through a long-standing partnership with the world's most
productive farmers. Today, John Deere is a global company with several equipment operations
and complementary service businesses. These businesses are closely interrelated, providing the
company with significant growth opportunities and other synergistic benefits.
U.S. GEOLOGICAL SURVEY (USGS)

The Vision of USGS is to be a world leader in the natural sciences through our scientific
excellence and responsiveness to society's needs.
The mission of USGS is to serve the Nation by providing reliable scientific information to
• describe and understand the Earth
• minimize loss of life and property from natural disasters
• manage water, biological, energy and mineral resources; and enhance and protect our
quality of life


External Scan - PESTE
1.2.1 Performs an external scan for a given organization (i.e. identifies an
organization’s external opportunities and threats using various models such
as PESTE, Porter’s Five Forces and SWOT)
1.2.1.1 Describes and conducts Political, Economic, Socio-Demographic,

Technological and Environmental (PESTE) analysis
a) Understands where to obtain information on PESTE factors 9
b) Identifies relevant PESTE factors and their potential impact on an
9 9
organization
Note to candidates: For the purpose of the Entrance Examination, candidates should focus on
understanding the elements of a PESTE, as well as identifying which category an item may fall
under in a PESTE analysis.
Description of PESTE
The purpose of an external audit is to identify opportunities that are favourable for an
organization and threats the organization should avoid. This external audit should not list every
possible factor that could influence a business, but should identify key factors. Strategies chosen
should take advantage of opportunities and/or minimize the impact of threats.
External forces can be categorized into five categories:
1. Economic
Refers to general economic conditions, such as disposable income, unemployment rates,
interest rates, foreign exchange rates, tax rates, etc. Trends in various economic conditions
impact industries. For example, sales for luxury goods fluctuate with fluctuations in
disposable income.
2. Social, cultural, demographic and environmental forces

These factors impact almost every product or service. Changes in these factors greatly
influence how companies operate and the strategic decisions they make. For example, the
Canadian population is aging, which means health care needs are increasing and the future
the need for long-term care facilities will increase. Another example is the increasingly
stringent laws related to the environment and the public’s increasing awareness of the
environment. This increased public awareness has led to “green” products and services,
such as organic (pesticide-free) lawn care.


3. Political, governmental and legal forces
This refers to both the political environment and changes in legislation. These can have a
major impact on an organization and can represent either opportunities or threats. For
example, prior to governmental deregulation of the telecom industry, Bell Canada held a
monopoly over telephone service in most of Canada. Subsequent to deregulation, other
telecom services providers entered the market and Bell Canada was forced to become more
competitive.
4. Technological forces
Technological changes can significantly impact organizations. The advent of the Internet,
which brought worldwide accessibility to information, as well as potential new markets in
foreign countries, changed the way many companies sold their product. Technological
innovation has resulted in new products and services, such as Research in Motion’s
“Blackberry”, which allows remote access to e-mail.
5. Competitive forces
This refers to rival companies. Understanding who competitors are and the strength of their
products or services is a critical element to take into consideration when formulating
strategies. However, obtaining information on competitors can be difficult, particularly if
the competition is a private company. News related to public companies is often reported
in the media, but news related to private companies is not.
These categories can be categorized into the PESTE acronym:

P – Political and Legal Factors
E – Economic Factors
S – Socio-Cultural/Demographic Factors
T – Technology
E – Environmental Factors
Items to take into consideration in each category include:

P – Political and Legal Factors
• Laws (such as antitrust laws and foreign ownership laws)
• Levels of regulation and deregulation
• Taxation rates
• Membership in trade blocs
• Quotas, tariffs and duties
• Greater influence of lobbying groups
• Increasing interdependency between business and government
• Issues related to health, safety, fairness and labour training laws
• Government and the private sector’s degree of commitment to education (many modern
businesses require educated workers)


E – Economic Factors
• GDP (gross domestic product)
• Trade agreements (GAAT and NAFTA)
• Inflation and employment rates
• Income distribution
• Personal and savings rates
• Wage rates
• Real disposable income per capita
• Real discretionary income per capita
• Retail sales aggregate and consumption per capita
• Transportation costs per capita
• Inventory to sales ratio
• Orders for durable goods
• Exchange rates for US/CDN, US/EURO, US, YEN
• Business inventories, business capital investment
• Average housing prices, annual home construction starts
• Relevant commodity prices (such as oil or coffee)
• Orders for non-defence capital goods (indicator of business investment plans)
• Wholesale price index, consumer price index, commodities price index
• Consumer confidence, investor confidence, producer confidence
• Labour productivity, capital productivity, total factor productivity
S – Socio-Cultural/Demographic Factors
• Level of diversity
• Age distribution of population
• Ethnic distribution – multi-cultural and multi-ethnicity (need for a greater level of
understanding of the role of hierarchical order, group harmony, duty over rights,
formality and self control, etc.)
• Education distribution (percentage with public school, high school, undergraduate and/or
graduate degrees)
• Regional distribution of population in country
• Income distribution by percentage
• Population size, growth and density
• Annual births/deaths, fertility rates, mortality rates
• Average percentage of home ownership
• Family/household size and the number of people working in a unit
• How people live, including their attitudes, values and preferences


T – Technology
• Development of machines, tools, robots, equipment
• Institutions and activities involved with the creation of new knowledge and the
translation of knowledge into new outputs, materials, products and processes, which can
increase speed and efficiency as well as shorten product life cycles and reduce production
costs.
• Intellectual property, know-how, processes
• World Wide Web
• Product innovations
• Biotechnology
• Satellite imaging and high-tech medical instruments/treatments
• Increased opportunities to manipulate financial systems (money laundering, tax evasion)
E – Environmental Factors
• Environmental protection agencies (environmental NGOs)

• Consumer environmental awareness levels
• Political environmental will
• Environmental ethics
• Trend towards environmental protection
• Availability of environmental options (i.e. clean energy options)
• Availability of natural resources
• Ecological trends and variations (i.e. global climate change)


External Scan – Porter’s Five Forces
1.2.1 Performs an external scan for a given organization (i.e. identifies an
organization’s external opportunities and threats using various models such
as PESTE, Porter’s Five Forces and SWOT)
1.2.1.2 Describes and conducts Porter’s Five Forces competitive/industry analysis

a) Explains how each of the five basic competitive forces can impact the
9
profitability and strategic planning of an organization
b) Applies the Porter’s Five Forces model to explain why some industries
9 9
are more profitable than others
c) Prepares a competitor analysis 9 9
d) Explains the role of competitors 9
e) Understands how PESTE factors may impact the direction and intensity
9
of the Five Forces over time
f) Applies Porter’s industry analysis to identify external opportunities and
9 9
threats for an organization
Porter’s Five Forces
Competitive/Industry Analysis
Porter’s Five Forces Model was created by Michael Porter and is widely used in developing
strategies. This model is:
Potential Development of Substitute Products
Bargaining Power of Rivalry Among Bargaining Power of

Suppliers Competing Companies Consumers
Potential New Competitors


These five forces are summarized as:
i. Rivalry among competing organizations

This is the most powerful of the five forces. An organization can only be successful to
the extent its rivals are not successful or, in other words, to the extent their strategies
provide a competitive advantage over competitors. The intensity of rivalry varies in
different industries; however, generally, it intends to increase as more competitors enter
the market, as competitors become more equal in size and capability and as demand
decreases. Rivalry also increases when consumers are able to switch brands easily, when
barriers to leaving the market are high, when fixed costs are high, when the product is
perishable, when rival organizations are diverse in strategies, origins and culture and
when mergers and acquisitions are common in the industry.
ii. Potential entry of new competitors (barriers to entry)

As new organizations enters a particular industry, the intensity of competition increases.
However, there are natural barriers to enter a market. Examples of barriers include:
− economies of scale
− technology and/or specialized knowledge
− customer loyalty or brand preference
− large capital requirement
− lack of sufficient distribution channels
− government regulation policies
− tariffs
− lack of access to raw materials
− ownership of patents
− market saturation
iii. Potential development of substitute products

Many industries face competition from substitute products. For example, plastic
container manufacturers face competition from glass and aluminum can producers. If
consumers substitute another product, manufacturers must be careful when pricing
because once the price becomes too high, the consumer will switch to the substitute.
Competition from substitute products increase as the price of the substitute product
decreases and as the consumers’ switching costs decrease (switching costs refer to the
cost to switch from one product to another).
iv. Bargaining power of suppliers

The intensity of competition in an industry is impacted by the bargaining power of
suppliers. This is particularly true when there are only a few raw material substitutes, a
large number of suppliers or when switching raw materials is expensive.
A backward integration strategy may be pursued when an organization wants to gain

control over supply. This strategy eliminates this force.


v. Bargaining power of consumers (buyers)
If a customer is large (buys large volume), that customer’s buying power can
significantly impact the intensity of competition in an industry. Large buyers may be in
a position to negotiate a lower selling price or other features, such as extended warranties
or free or low-cost maintenance packages.


Value Chain Analysis and Profit Pools
1.2.2.1 Describes and performs value chain analysis
a) Uses the value chain to describe an organization in terms of the primary
9 9
and support activities it undertakes to deliver value
b) Demonstrates how value creation in an organization can be improved by
9 9
identifying and influencing the drivers of each activity
c) Applies value chain analysis to identify potential strengths (i.e. activities
that enhance an organization’s ability to compete) or weaknesses of an 9 9
organization (i.e. activities that are better performed by rivals)
1.2.1.3 Describes and conducts profit pool analysis (i.e. identifies where the
money is being made along the industry value chain) (see also 3.2.2)
a) Disaggregates the industry value chain (i.e. documents the flow of
goods from raw material suppliers to the end consumer) into different 9 9
segments
b) Identifies segments in the industry value chain to dominate and then
9 9
formulates strategies to improve organizational profitability
The following information on the Value Chain has been extracted from CMA Canada’s
Management Accounting Guideline “Value Chain Analysis for Assessing Competitive
Advantage”. It has been reprinted with permission.
The Value Chain

The value chain is defined as the internal processes or activities a company perform “to design,
produce, market, deliver and support its product”. The value chain is broken into two major
categories of business activities: primary activities and support activities.
Primary activities are directly involved in transforming inputs into outputs and in delivery and
after-sales support. These are generally also the line activities of the organization. They include:
• Inbound logistics. Material handling and warehousing;
• Operations. Transforming inputs into the final product;
• Outbound logistics. Order processing and distribution;
• Marketing and sales. Communication, pricing and channel management; and
• Service. Installation, repairs and parts.


Support activities support primary activities and other support activities. They are handled by the
organization’s staff functions and include:
• Procurement. Purchasing of raw materials, supplies and other consumable items as well as
assets;
• Technology development. Know-how, procedures and technological inputs needed in every
value chain activity;
• Human resource management. Selection, promotion and placement; appraisal; rewards;
management development; labour/employee relations; and
• Company infrastructure. General management, planning, finance, accounting, legal,
government affairs and quality management.
Example of the Value Chain
This example has been extracted from CMA Canada’s Management Accounting Guideline
“Value Chain Analysis for Assessing Competitive Advantage”. It has been reprinted with
permission.


Identifying and Influencing the Drivers of Each Activity
When applying the value chain analysis tool, it is necessary to identify the drivers of each of the
activities (both primary and support activities).
Organizations use the value chain approach to identify and understand the cost of their internal
processes or activities. The principal steps of internal cost analysis are:
• identify the organization’s value-creating processes;
• determine the portion of the total cost of the product or service attributable to each value-
creating process;
• identify the cost drivers for each process;
• identify the links between processes; and
• evaluate the opportunities for achieving relative cost advantage.
Once the drivers have been identified, it is necessary to determine what influences these drivers.
Once the influences have been identified, an organization is able to take action to improve areas
requiring improvement and to eliminate actions that do not add value to end product or service.
Value Chain Analysis and Identification of Strengths or Weaknesses

The value chain can be used as a tool to identify an organizations strengths and weaknesses. It is
a matter of identifying the strengths and weaknesses associated with each of the primary and
support activities in the value chain:
Primary Activities Strength +/or Weakness Support Activities Strength +/or

Weakness
• Inbound logistics. Simply identify how the activity • Procurement. Purchasing of Simply identify how the
Material handling and is or contributes to the raw materials, supplies and activity is or contributes to
warehousing organization’s strength or other consumable items as well the organization’s strength
weakness as assets or weakness
• Operations. Simply identify how the activity • Technology development. Simply identify how the
Transforming inputs is or contributes to the Know-how, procedures and activity is or contributes to
into the final product organization’s strength or technological inputs needed in the organization’s strength
weakness every value chain activity or weakness
• Outbound logistics. Simply identify how the activity • Human resource management. Simply identify how the
Order processing and is or contributes to the Selection, promotion and activity is or contributes to
distribution organization’s strength or placement; appraisal; rewards; the organization’s strength
weakness management development; or weakness
and, labour/employee relations;
and
• Marketing and sales. Simply identify how the activity • Company infrastructure. Simply identify how the
Communication, pricing is or contributes to the General management, activity is or contributes to
and channel organization’s strength or planning, finance, accounting, the organization’s strength
management weakness legal, government affairs and or weakness
quality management
• Service. Installation, Simply identify how the activity
repairs and parts is or contributes to the
organization’s strength or
weakness

Page 368

Using the Value Chain for Segmentation Analysis
Industries are sometimes collections of different market segments. Vertically integrated
industries are good examples of a string of natural businesses from the source of raw material to
the end use by the final consumer. Several organizations in the paper and steel industries are
vertically integrated. Not all organizations in an industry participate in all segments.
If the nature and intensity of Porter’s five forces or the core competencies vary for various
segments of an industry, then the structural characteristics of different industry segments need to
be examined. This examination will reveal the competitive advantages or disadvantages of
different segments. An organization may use this information to decide to exit a segment, to
enter a segment, reconfigure one or more segments or embark on cost reduction or differentiation
programs.
Differences in structure and competition among segments may also mean differences in key
success factors among segments. Using the value chain approach for segmentation analysis,
Grant (1991) recommends five steps:
i) identify segmentation variables and categories;
ii) construct a segmentation matrix;
iii) analyze segment attractiveness;
iv) identify key success factors for each segment; and
v) analyze attractiveness of broad vs. narrow segment scope.
Identify Segmentation Variables and Categories

There may be literally millions of ways to divide up the market into segments. Typically, an
analysis considers between five and 10 segmentation variables. These variables are evaluated on
the basis of their ability to identify segments for which different competitive strategies are (or
should be) pursued.
The selection of the most useful segment defining variables is rarely obvious. Industries may be
subdivided by product lines, type of customer, channels of distribution and region/geography.
The most common segmentation variables considered are type of customer and product related,
as illustrated in Exhibit 10 [reproduced on the following page].


Exhibit 10 – Approaches to Defining Segmentation Variables
Customer Characteristics
Geographic Small communities as markets for discount stores
Type of organization Computer needs of restaurants vs. manufacturing organizations vs. banks vs. retailers
Size of company Large hospital vs. medium vs. small
Lifestyle Jaguar buyers tend to be more adventurous, less conservative than buyers of Mercedes
Benz and BMW
Sex The Virginia Slims cigarettes for women
Age Cereals for children vs. adults
Occupation The paper copier needs of lawyers vs. bankers vs. dentists
Produce-related Approaches
User type Appliance buyer – home builder, remodeler, homeowner
Usage The heavy potato user – the fast-food outlets
Benefits sought Dessert eaters – those who are calorie-conscious vs. those who are more concerned with
convenience
Price sensitivity Price-sensitive Honda Civic buyer vs. the luxury Mercedes Benz buyer
Competitor Those computer users now committed to IBM
Application Professional users of chain saws vs. the homeowner
Brand loyalty Those committed to IBM vs. others
This example has been extracted from CMA Canada’s Management Accounting Guideline
“Value Chain Analysis for Assessing Competitive Advantage”. It has been reprinted with
permission.
The first set of variables describes segments in terms of general characteristics unrelated to the
product involved. Thus, a bakery might be concerned with geographic segments, focusing on one
or more regions or even neighbourhoods. It might also divide its market into organizational types
such as at-home customers, restaurants, dining operations in schools, hospitals and so on.
Demographics can define segments representing strategic opportunities such as single parents,
professional women and elderly people.
The second category of segment variables includes those related to the product. One most
frequently employed is usage. A bakery may employ a different strategy in serving restaurants
that are heavy users of bakery products than restaurants that use fewer bakery products.
Segmenting by competitor is useful because it frequently leads to a well-defined strategy and a

strong positioning statement. Thus, a target customer group for the Toyota Cressida consists of
buyers of high-performance European cars such as the BMW. The Cressida is positioned against
the BMW as offering comparable performance for a substantially lower cost.
Construct a Segmentation Matrix

After customer- and product-related variables have been selected for identifying different
segments, a segmentation matrix can be developed. Two or more dimensions may be used to
partition an industry.
For example, restaurants could be divided into four dimensions: type of cuisine, price range, type
of service (e.g. sit-down, buffet, cafeteria, take-out, fast food) and location.


A segmentation matrix for the British frozen food industry is presented in Exhibit 11. Five types
of product and five channels of distribution are used to construct the two dimensional
segmentation matrixes consisting of 25 potential segments. However, not every cell in the matrix
may be relevant. Empty cells may represent future opportunities for products or services.
Analyze Segment Attractiveness

Competitive assessments using industry structure analysis or core competencies analysis can also
be used to evaluate the profitability of different segments. However, the competitive focus shifts
to an analysis of the different segments.
For example, in the frozen food industry segmentation, independent grocers and caterers may be
willing to substitute fresh fruits and vegetables for frozen goods. Therefore, the threat of
substitutes within the segments and from outside sources must be carefully examined.
In addition, the interrelationship among segments must be carefully considered. For example,
caterers may purchase frozen food items from supermarkets at bargain prices. Segments may be
natural buyers, sellers or substitutes for one another.
In the automobile industry, the luxury car and sports car segments were high-priced, high-margin
products with less intense competition than other automobile segments. The introduction of
high-quality, lower priced Acura, Lexus and Infiniti autos changed the competitive structure of
these high-priced segments.
Identify Key Success Factors for Each Segment

Quality, delivery, customer satisfaction, market share, profitability and return on investment are
common measures of corporate success. In this regard, each segment must be assessed using the
most appropriate key success factors. Cost and differentiation advantages should be highlighted
by these measures.
Examination of differences among segments in buyers’ purchase criteria can reveal clear
differences in key success factors.
Analyze Attractiveness of Broad vs. Narrow Segment Scope

A wide choice of segments for an industry requires careful matching of an organization’s
resources with the market. The competitive advantage of each segment may be identified in
terms of low cost and/or differentiation.
Sharing costs across different market segments may provide a competitive advantage. For
example, Gillette broadened its shaving systems to include electric shavers through its 1970
acquisition of Braun. Lipton recently entered the bottled iced-tea market.
On the other hand, when the Toro Company broadened its distribution channels for its snow
blowers and lawnmowers to include discount chains, it almost went bankrupt. Feeling betrayed, a
number of Toro’s dealers dropped its products.


Taking a narrow segment focus may leave an organization vulnerable to competitors. For
instance, by relying solely on its lemon-lime soft drink, 7-Up left itself at a competitive
disadvantage to Coca-Cola and Pepsi. Recently, Hallmark Cards Co. began to market its
premium image greeting cards through discounters. Hurt by discounters, some of Hallmark’s
9,000 independent specialty shops began selling cards from Hallmark’s competitors.
In many industries, aggressive organizations are moving toward multiple-segment strategies.

Campbell Soup, for example, makes its nacho cheese soup spicier for Texas and California
customers, offers a Creole soup for Southern markets and a red-bean soup for Hispanic areas. In
New York, Campbell uses promotions linking Swanson frozen dinners with the New York
Giants football team; in the Sierra mountains, skiers are treated to hot soup samples. Developing
multiple strategies is costly and often must be justified by an enhanced aggregate impact.
Some organizations decide to avoid or abandon segments because of limited resources or

because of uncertain attractiveness. For example, in the 1960s, IBM decided not to enter the
mini-computer segment. This allowed upstart Digital Equipment Corp. to dominate this segment
of the computer industry. General Electric abandoned the computer industry completely. Under
CEO Jack Welch, GE’s major segments must be first or second in market share or risk being
sold.
A segment justifying a unique strategy must be of worthwhile size to support a business strategy.
Furthermore, the business strategy needs to be effective with respect to the target segment in
order to be cost effective. In general, it is costly to develop a strategy for a segment. The
question usually is whether or not the effectiveness of the strategy will compensate for this added
cost.
Profit Pool Analysis

For ongoing organizations, it is possible to look at historical data by mapping the profit pools
associated with the different value chain activities. Profits can be identified by developing profit
and loss statements for the different value chain activities; even activity based costing and other
managerial accounting techniques can be useful in helping management understand more
accurately what types of activities are contributing to profitability. The industry profit pool is
made up of total profits earned in an industry at all the points along the value chain (the value
chain traces the path of a product as it moves from the raw material stage to the final consumer).
By mapping the industry’s profit pool, it is possible to assess how effectively value chain
activities are being managed overall.
Understanding what the primary sources of profit are is important because it identifies the areas
in which money is being made and lost. When conducting profit pool analysis in individual
organizations, management can identify and focus their resources more strategically in those
value chain activities where the greatest profits can be made. This is different than looking at
the outcomes of different decisions from a revenue point of view. Looking at profits rather than
just revenues lets an organization know how effectively it is using its resources and whether

Page 372

the various areas are covering their associated costs. Profit pool analysis can be extremely
valuable when making investment decisions concerning the different value chain activities. It
can provide evidence for either abandoning or investing in certain parts for the value chain
(weak, unprofitable areas may be outsourced so areas where profits are being realized can be
further developed) so that overall profitability of the organization can occur. There are four steps
to follow when identifying profit pools: (Source: Hitt, M., Ireland, D. and R. Hoskisson, (2007). Strategic
Management Competitiveness and Globalization, 7th ed., p. 26)
1. Clearly define the pool’s boundaries.

2. Estimate the overall size of the profit pool.
3. Estimate the size of the value chain activities in the pool. What are the important
sources of profit (i.e. quality, design, marketing, distribution, etc.)?
4. Reconcile the calculations.


Internal Scan – Stakeholder Analysis
1.2.1.4 Describes and conducts stakeholder analysis
a) Identifies key organizational stakeholders (e.g. suppliers, community,
employees, unions, clients and government) and their relative influence 9 9
on the organization
b) Prepares mission statements and strategies that reconcile the interests of
9 9
various stakeholders
Stakeholder Analysis
Stakeholders have been defined as “any individual or group who can affect or is affected by the
actions, decisions, policies, practices and goals of the organization”. In other words, any group
impacted by the actions of the company is stakeholders. Stakeholders have been categorized into
primary and secondary stakeholders, as listed below.
Primary stakeholders:
• owners
• customers
• employees
• suppliers
• shareholders
• Board of Directors
• creditors (e.g. financers)
Secondary stakeholders:
• governments
• competitors
• interest groups
• general community
The above lists are not exhaustive. Any group or person who is impacted by the actions of an
organization is a stakeholder.
When creating a mission or vision statement, it is critical to consider the stakeholders needs and
wants. An organization must maintain performance at a sufficient level to maintain the
participation of key stakeholders. The first step in this process is to consider the stakeholders
when creating the vision and mission statement.


Internal Scan –Resource/Capability/Core
Competence Analysis
1.2.2 Performs an internal scan for a given organization (i.e. identifies an
organization’s internal strengths and weaknesses using various models such
as value chain analysis, core competence analysis, etc.)
1.2.2.2 a) Understands why some resources/capabilities/core competencies may

9 9
enable an organization to attain a competitive advantage
b) Applies resource/capability/core competence analysis to identify potential
strengths and weakness of an organization (e.g. a strong reputation that
9 9
results in consumers being willing to pay more for the product or service
is a resource strength)
c) Identifies and appraises the resources/capabilities/core competencies of an
organization 9 9
d) Applies the value chain to identify an organization’s

9 9
resources/capabilities and core competencies
a) Understands why some resources/capabilities/core competencies may
9 9
enable an organization to attain a competitive advantage
Resource/Capability/Core Competence Analysis

A resource/capability/core competence analysis is a tool that can be used to assist a company in
identifying its strengths and weaknesses. Identifying a company’s strengths and weaknesses is
the internal part of the SWOT.
How the Tool is Used:

How this tool is used to identify competitive advantage is depicted on the following page.


Identify Resources
Includes both:
*Tangible resources
*Intangible resources
Capability to deploy
the resources
identified in the first
step
The resources available

(identified in the first
step) and the capability
to deploy those
resources (the second
step) leads to a
company having a core
competence.
Core competencies
provide competitive
advantages.
Each of the above components is described in the following pages.
Resources
Resources represent the inputs into a company’s production (or service) processes. Resources
are either tangible or intangible. Tangible resources are items that can be seen and quantified.
Intangible resources cannot be seen and are generally difficult to quantify.
The first step in the resource/capability/core competence analysis is to identify the resources an
organization currently has. Examples of intangible and tangible resources are.


Tangible Resources:
• Financial
- the company’s borrowing capacity
- the company’s ability to generate internal funds
• Organizational
- the company’s formal reporting structure and formal planning, controlling and
coordinating systems
• Physical resources
- physical assets, such as the plant and equipment
• Technological Resources
- Stock of technology, such as patents, trademarks, copyrights and trade secrets
Intangible Resources:
• Human Resources
- Knowledge and talent of employees
- Trustworthy employees
- Talented managers
- Strong organizational routines and procedures
• Innovation Resources
- Scientific capabilities
- Capacity to develop innovative ideas
• Reputational Resources
- Reputation with customers
- Brand name and company image
- Perceptions of product quality, durability and reliability
- Reputation with suppliers
- For efficient, effective, supportive and mutually beneficial interactions and relationships
Capabilities
Resources by themselves do not create a competitive advantage. It is the ability to utilize the
resources to create a core competency that is critical. The foundation of capabilities is the skills,
talents and expertise of the company’s employees. These employees develop an organization’s
capabilities over time by developing, carrying and exchanging information and knowledge
Core Competencies
The resources available, which are identified in Step 1 and the capability to use those resources,
which is developed over time, lead to a company having a core competence. These core
competencies can be exploited such that they provide a competitive advantage for the company.
Core competencies can be defined as activities a company does well compared to its competitors
or activities a company undertakes that add unique value to its goods or services.


Target Customers and Target Markets
1.2.3 Analyzes target customers and target markets for a given organization’s
products/services
a) Segments markets using product and buyer characteristics 9 9
b) Determines factors needed to succeed in each market segment 9 9
c) Evaluates attractiveness of each market segment by comparing an
organization’s products/services in each buyer segment and profit 9 9
potential with those of its rivals
d) Applies market segmentation to position an organization’s
9 9
products/services
Market Segmentation
Market segmentation involves aggregating prospective buyers into groups with common needs
and required benefits that will respond similarly to some market action. Markets can be
segmented by categorizing product or buyer characteristics (see below). This enables an
organization to effectively address its potential customers and, thereby, maintain or win more
market share (and presumably more profit). Even in the not-for-profit sector, segmentation
occurs so client needs can be addressed more effectively. Market segments consist of relatively
homogeneous groups of prospective buyers in terms of their wants, consumption patterns and
behaviours. A segment is different from a sector. For example, young middle-income
homebuyers would be a sector rather than a segment because these buyers will differ in what
they want in a home. Marketers do not create the segments. Their task is to identify the
segments and decide which to target. Due to the fact the wants of segment members are similar
(but not identical), it is often a good idea to present market offerings that are somewhat flexible
rather than presenting one standard offering to all of a segment’s members. A flexible market
offering consists of the product and service elements all segment members’ value as well as
discretionary options (perhaps for an additional charge) some members’ value. For example, a
vacation package may offer hotel and meals but charge extra for alcoholic beverages.
Segments are fairly large and attract several competitors; niches are fairly small and may attract
one or two competitors. Marketers usually identify niches by dividing a segment into sub-
segments. A niche is a more narrowly defined customer group than a segment. In an attractive
niche, customers have a distinct set of needs and will pay a premium to the organization that best
satisfies their needs. Niches gain certain economies through specializations. The low cost of
Internet marketing has led to many small start-ups aimed at niches. This can work well with
products customers do not need to see and touch.
Market segments can be constructed in many ways. In Canada, four typical ways markets are
segmented are by geographic, demographic, psychographic and behavioural.


Geographic segmentation divides markets according to where people live. Marketers have
noticed that Canadians differ in terms of both needs and preferences depending on where they
live. For example, the Québec market has many distinct characteristics. A product manager may
segment on the basis of region after looking at census of metropolitan areas and determining that
customers have unique needs in those regions.
Demographics include age, gender, education, income, occupation, race, religion, nationality,
social class, family size, stage in the family life cycle and the generation group. Marketers often
use several of these when segmenting, with age and gender being particularly common. There
are various labels applied to the many different age brackets based on when people were born.
For example, there are six different age classifications that tend to exhibit similar purchasing
patterns:
1) GI generation (born 1901–1924) – shaped by hard times and the Great Depression,
financial security is one of their core values, they tend to be conservative spenders and
civic minded;
2) Silent Generation (born 1925-1946) – trusting conformists who value stability, they are
not involved in civic life and extended families;
3) Baby Boomers (born 1947-1966) – great acquisitors, they are value- and cause-driven,
despite indulgences and hedonism;
4) Generation X (born 1967-1977) – cynical and media-savvy, they are more alienated and
individualistic;
5) Generation Y or echo boomers (born 1978-1994) – edgy, focused on urban style, they are
more idealistic than Generation X; and
6) Millennials (born 1995-2002) – multicultural, they will be tech savvy, educated, grow up
in affluent society and have big spending power.
(Source: Tsui, Bonnie, (2001). “Generation Next”, Advertising Age, January 15, pp. 14-16).
Psychographic segmentation combines psychology and demographics to better understand

consumers. Buyers are divided into different groups on the basis of psychological/personality
traits, lifestyles and values. People within the same demographic group can exhibit different
psychographic profiles. Psychographics can include personality traits such as compulsiveness,
gregariousness, authoritarianism, ambitiousness as well as lifestyle characteristics like whether
someone is culture orientated, sports orientated, outdoor orientated or a crafter.
Behavioural segmentation divides consumers into groups on the basis of their knowledge of,
attitude toward, use of or, response to, a product. There are several ways to divide consumer’s
behavioural responses. The marketer can segment based on the consumer’s stage of readiness.
For example, is the buyer aware, informed, interested and desirous, and intending to buy? Usage
rate can also be used to segment. A person can be labelled as being a light, medium or heavy
user. The 80/20 rule states that 80% of an organization’s sales are obtained from 20% of its
customers. User status is also important. Someone can be a non-user, ex-user, potential user,
first-time user, regular user or an occasional user. Buyers can also be segmented according to
occasions such as Valentine’s Day, Christmas and Easter as well as when they develop a need to


purchase or use a product. For example, air travel is triggered by business, vacation or family
occasions. A fifth method of segmentation is by benefits sought. Are customers looking for
quality, service, economy and speed? Loyalty status can be used to segment (none, medium,
strong, absolute – must be careful that brand loyalty should not be confused with habit,
indifference, low price, high switching costs or the unavailability of other brands). Loyalty
status buyers are also referred to as either hard-core loyals, split loyals, shifting loyals and
switchers.
There is also the Conversion Model, developed to measure the strength of the consumer’s
psychological commitment to brands as well as their openness to change in order to determine
how easily a consumer can be converted to another choice. The model assesses commitment
based on factors such as consumer attitudes toward and satisfaction with current brand choices in
a category and the importance of the brand selection decision in the category. (Source: Kotler, P.
and K.Keller (2006). “Identifying market segments and targets” in Marketing Management, 12th ed., p. 257-258).
Attitude toward a product can also be used to segment. Typically, there are five attitude groups
in a market. They include characteristics such as: enthusiasm, positivity, indifference, negativity
and hostility.
In addition to looking at behavioural issues, marketers must also consider the roles assumed
during a buying decision. Generally, people play five roles in a buying decision – initiator,
influencer, decider, buyer and user. The role assumed would partly determine the way that the
marketer interacts with the potential client.
Business markets can also be segmented using some of the same variables used in consumer
segmentation, as well as some additional variables considered. Like consumer-based
organizations, businesses dealing with organizational buyers may also ask the following
questions:
What demographic variables do they wish to address and what industries do they wish to
serve? In North America, organizations are categorized by the North American Industry
Classification System (NAICS) – some organizations have more than one NAICS code
because they operate in more than one industry
What geographic areas do they wish to serve (domestic, multi-domestic, international,
global)? What size organization do they want to serve? Estimate market size to see if it is
worth pursuing.
What behavioural variables do they consider by looking at benefits sought (e.g. quality,
customer service, low price), usage rate, user status, loyalty status, purchase method
(centralized, decentralized, individual, group) and type of buy (new buy, modified rebuy,
straight rebuy).
Some experts have combined geographic, demographic and behavioural segment variables used
in segmenting organizational markets to produce a segmentation concept known as
firmographics. Firmographics incorporates organizational characteristics such as location, size
of organization, industry category, corporate activities, business and buying objectives as well as
characteristics of the corporation of the organization (e.g. income distribution of employees, age,

Page 380

gender and education). Organizations with distinguishing firmographics are then grouped into
market groups and products to be sold are segmented into groups. This isn’t an issue if an
organization has only one product, but if it has multiple products, they need to be grouped in a
way buyers can relate to by setting up product groups.
The final step would be to develop a market product grid and estimate the size of the markets.
Developing a product grid means labelling the market (horizontal rows – your potential market)
and products (vertical columns – your market offerings) and then indicating the size of the
market in each cell or estimating the market product combination. From this, a target market
should be chosen. Choosing too narrow a segment can prevent an organization from reaching its
needed sales volume and profits; however, going too broad may spread marketing efforts too
thin. In addition, if there is a lot of competition, is this expected to continue?
To select the target segment, we look at market size, expected growth, competitive position, cost
of reaching segment and compatibility with the organization’s objectives and resources.
Organizations should only address market segments that meet the following key criteria:
1) Measurable –segment characteristics like size and purchasing power are measurable
2) Substantial – segments must be profitable enough to be worth serving
3) Accessible – segments can be effectively reached and served
4) Differentiable – segments are distinguishable and respond to different marketing mix
elements and programs
5) Actionable – effective programs can be formulated for attracting and serving segments
Product positioning refers to the place an offering occupies in consumer’s minds on important
attributes relative to competitive products. In contrast product repositioning involves changing
the place an offering occupies in a consumer’s mind relative to competitive products. There are
two main approaches in positioning a product in the market:
1) Head-to-head positioning, which involves competing directly with competitors on similar
product, attributes in the same target market.
2) Differentiating positioning involves seeking a less competitive smaller market niche in
which to locate a brand. Companies also follow a differentiation strategy among brands
in their own product line to try to minimize cannibalization of a brand’s sales or shares.

Page 381

In order to properly position, an organization needs to be aware of consumer perceptions. In
determining a brand’s position and the preference of consumers, companies obtain three types of
data from consumers:
1) Important attributes for product class
2) Judgments of existing brands with respect to these attributes
3) Ratings of ideal brand attributes
From this data, a perceptual map can be made. This displays in two dimensions the location of
products or brands in the minds of consumers so a manager can take marketing actions based on
how consumers perceive competing products or brands relative to their own.
Once the organization has decided what opportunities to pursue, it must determine how many to
target at one time. Increasingly, organizations are pursuing multiple opportunities in order to
better define target groups. This has led some market researchers to propose a more need-based
market segmentation approach. Roger Best proposed a seven-step approach to more clearly
define and segment markets:
1) Needs-Based Segmentation, where customers are grouped based on similar needs and
benefits solved in response to a particular consumption problem.
2) Segment Identification, where demographics, lifestyles and usage patterns make a distinct
segment actionable.
3) Segment Attractiveness, where attractiveness criteria such as market growth, competitive
intensity and market access are considered.
4) Segment Profitability examines how much in terms of profits can be made in the
segment?
5) Segment Positioning creates a “value proposition” and product-price positioning strategy
based on the segment’s unique consumer needs and characteristics.
6) Segment “Acid Test”, where segment storyboards are used to test the attractiveness of
each segment’s positioning strategy.
7) Marketing Mix Strategy looks at expanding the segment positioning strategy by adding
the elements of the product mix (product, place, promotion and price)
(Source of above framework: adapted from Robert J. Best, Market-Based Management,
Upper Saddle River, NJ: Prentice Hall, 2000)

Page 382

Levels of Strategy – Corporate Level Strategy
1.2.4 Describes different levels of strategy (corporate, business and functional) for
1.2.4.1 Describes an organization’s corporate level strategy

a) Assesses the potential to create synergies between an organization’s
9 9
business units
b) Evaluates the industries in which an organization should compete 9 9
c) Evaluates different types of diversification (e.g. related and unrelated) 9 9
d) Understands ways to create value through corporate restructuring 9
Overview
Corporate strategy focuses on three questions:
1. What businesses should the corporation be in? For example, PepsiCo was in three businesses:
soft drinks, snack foods (Frito-Lay) and fast foods (KFC, Taco Bell and Pizza Hut).
2. How should the head office manage its business units? (e.g. centralized vs. decentralized,
inputs vs. outputs)
3. How will governance be handled? (Corporate governance and its relationship with the Board,
shareholders and stakeholders)
Objectives of Corporate Strategy – Creating Synergy

The goal of the corporate strategist is to achieve synergy (when the whole is worth more than the
sum of its parts) between the business units. The technical term for synergy is “economies of
scope”; it is also known as “strategic fit” or “strategic relatedness”. Note that “relatedness” or
“strategic fit” does not only refer to a similarity of products, it also refers to a similarity of
business practices in which activities or competencies can be shared to produce synergy (i.e.
sharing to prevent duplication of costs). When fit exists, the business units are related; when no
fit exists, business units are considered to be unrelated. It is the sharing that produces synergy
and is commonly referred to as achieving economies of scope. Economies of scope arise when it
is less costly for two or more businesses to operate under the same corporate umbrella than it
would be to function independently. Cost savings can come from interrelationships (or sharing
tasks or functions) anywhere along the businesses’ value chains. Diversifying into related
businesses facilitates synergy can strengthen resources, capabilities and competencies and lead to

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a competitive advantage. The achievement of synergy has been called “creating corporate
advantage” by Professor Cynthia Montgomery at the Harvard Business School.
It is now widely accepted in financial markets and among corporate strategists that an
organization should not diversify into unrelated businesses (in the absence of synergy).
Moreover, time has demonstrated this is not an effective way to grow a company. Some people
argue that unrelated diversification is a good way for an organization to diversify risk for their
shareholders, but it is not an organization’s responsibility to diversify risk for its shareholders;
rather an organization should focus on how it’s going to maintain and grow the business.
Types of Diversification
Organizations vary by the degree of diversification. The following classification scheme can be
used to assist in the analysis of the corporate strategy.
• Single Business - >95% of revenues are from one business unit (e.g. Coca-Cola)
• Dominant Business – between 70% to 95% of revenues are from one business unit
• Related Diversified – less than 70% of revenues are from one business unit
(e.g. PepsiCo)
• Unrelated Diversified – multiple businesses that are not related to one another
(e.g. Hanson)
In adopting a strategy of diversification, the corporate manager should examine every acquisition
or start-up with a view to achieving a sharing of activities or transfer of competencies between
the business units. For example, Gillette acquired Duracell, which was considered a related
business because Gillette could share the costs of the distribution channel between Gillette
products and the battery products. Phillip Morris entered the beer industry by acquisition and
then transferred key marketing people from the cigarette business to the beer business, as the
marketing strategies were similar.
There are two forms of related diversification, concentric and horizontal. Concentric
diversification involves adding new related products or services and horizontal diversification is
used to offer new, unrelated products or services to current customers.
Corporate strategies can be grouped under five broad categories:

• Vertical integration
• Forward vertical integration (i.e. acquiring or starting a business to distribute or sell
your organization’s products)
• Backward vertical integration (i.e. acquiring a supplier or supplying own inputs)
• Related and unrelated diversification
• Geographic diversification into new markets (e.g. Coca Cola entering China)


Levels of Strategy – Business Level Strategy
1.2.4.2 Describes an organization’s business level strategy

a) Understands that business level strategies outline how an organization
attains and sustains competitive advantages (e.g. identifies what
9
customers to target, what products/services to sell to these customers, how
to produce, sell and deliver the products/services)
b) Explains benefits of being a first mover vs. a second mover 9
c) Evaluates what activities an organization should perform itself vs.
9 9
outsource
Overview
While corporate managers attempt to create “corporate advantage” (among their businesses), it is
the role of business unit managers to achieve a “sustainable competitive advantage” (in each of
their businesses) by taking the core competencies created by the different functional areas in the
organization and combining them to exploit opportunities in the environment. The primary task
at the business level is to ensure competitive advantages accrue when an organization’s products
are preferred over the offerings of other organizations. Competitive advantage is normally
secured by offering a product that is preferred and/or one that is attractive because of its price.
Generic Business Level Strategies

Michael Porter has argued that every business faces only four generic strategies at the business
unit level. He also states the organization faces two choices:
1. Whether to compete in the entire market (e.g. automobiles such as Ford) or in a segment
or niche of the larger market (e.g. Mercedes).
2. Whether to compete on cost (e.g. basic groceries like flour and sugar) or on
uniqueness/differentiation (e.g. specialty condiments).


These two fundamental choices produce four generic strategies:
• Broad cost leadership strategy
• Broad differentiation strategy
• Focused low cost strategy
• Focused differentiation strategy
Generic Business Level Strategies

Source of Competitive Advantage
Cost Uniqueness
Broad Cost Differen-

Target
Market Leadership tiation
Breadth of
Competitive
Scope
Focused
Narrow Focused
Target Differen-
Market Low Cost
tiation
Transparency
Transparency 4-10
4-10
(Diagram adapted from Michael Porter’s book Competitive Advantage: Creating and Sustaining Superior
Performance, 1998)
The choice of a particular business strategy is a function of the analysis of the external
environment and industry environments identified the opportunities and threats as well as the
analysis of the organization that identified the strengths and weaknesses in the value chain.
(More information on business level strategies will follow in sections 1.2.5.1 and 1.2.5.2)
Market Strategies
Another way of looking at strategies at the business level is to use the marketing strategies
framework. Market penetration, market development and product development are referred to as
intensive strategies. Basically, in order to bring an existing product to a different level of
competitive advantage, concentrated efforts must be invested.
Market Penetration
A market penetration strategy aims to increase market share for existing products or services.
Increasing the market share of a product can mean increasing the number of stores or the number


of locations where the product is being sold. It can also result from increased marketing to create
more demand by current customers.
Market Development
A market development strategy seeks to develop a new geographic market for existing products
or services. An example is Beavertails, which was developed as an Ottawa-Rideau canal winter
treat. You can now buy Beavertails in other places such as La Ronde in Montreal, Mont-
Tremblant and even Florida. The same applies to McDonald’s as it has diversified in many
countries (including Russia).
Product Development
Some companies advertise their products as “new” and “improved” in order to build up the sales.
A product development strategy aims to improve sales through either improving existing
products or services or by developing a new product or service. Improving existing products or
services is usually less expensive than developing a new product. Overall, a product or service
normally has a life cycle and a mature company will try to have products at different stages of
development at any time. Reference to the application of this strategy is explained in the product
life cycle of the marketing module.
First Mover Advantage

Another type of strategy available to a few companies is being a first mover or, in other words,
being first to market with a new product or service offering. This approach, although expensive
(pioneering organization incurs all new product development costs for example), can yield a
multitude of advantages to a company that successfully employs it. The primary advantage of
being a first mover is the company has the opportunity to establish a reputation as an industry
leader. If the company is fortunate, its product may become synonymous with the company’s
name – for example tissues are referred to as Kleenex and photocopiers are often called Xerox
machines. Another advantage available to the first mover is they can set the standard for the
industry, lock in their customers and then offer additional products based on that standard. First
movers can also secure access to rare resources and gain new knowledge of key factors and
issues. First movers are also the first to move along the learning curve and, in this position, they
may gain efficiencies sooner and be able to reduce prices and create a barrier to entry, keeping
new competitors out of the market. Strategic management literature indicates the greatest level
of benefits accruing to first movers is found when there are a group of competitors who are close
in size and resources. If competitors are not similar in size, larger competitors can wait while
others make significant initial investments and mistakes, then respond later with greater
efficiencies and resources. Moreover, first mover advantages can dissipate if pioneering costs are
prohibitive and the loyalty of first time buyers is weak. Also, if it is relatively easy for
latecomers to get into the market, first mover advantages will be short-lived. Another risk faced
by first movers is there can be unexpected problems and costs.
Although second movers forgo the advantages that accrue to the first mover (especially in terms
of market share), if they respond quickly to the first mover and enter the market ahead of the late
movers and laggards, there are a number of benefits. A second mover is an organization that


reacts to a first mover’s competitive action normally by imitating the first mover and entering the
market with a similar and sometimes improved product. The successful second mover has the
opportunity to study the first mover and make product improvements and avoid making many of
the mistakes made by the first mover. If technology is advancing rapidly, second movers can
often leapfrog first mover’s products with improved second-generation products. The second
mover can also save money. As it is not the first to bring the product to market, it does not have
to spend as much money creating awareness and “buzz” about the product. Second movers also
have time to develop processes and technologies that may be more efficient than those adopted
by the first mover, producing a product that provides greater customer value than the first
mover’s product.
Outsourcing
Outsourcing is simply the purchase of a value-creating activity from an external supplier.
Outsourcing is an effective and often necessary approach as few organizations can afford to
develop internally the skills and technologies needed to get and keep a competitive advantage.
Attempting to build competencies in all areas can cause an organization to become overextended
and thus decrease their competitiveness. When an organization outsources activities in which it
lacks competence, it frees up time and resources, which can be focused on those areas where it is
capable of building strong competencies leading to a competitive advantage. Companies can
investigate how effectively they are performing internal activities by examining profit pools
and/or conducting activity based costing and/or doing a cost benefit analyses. The results should
be compared to the cost of outsourcing the less strategically relevant activities keeping in mind
that outsourcing an activity to an outside source with strong expertise in a particular area can
result in improved performance and savings for the organization and added value for the
company’s stakeholders.
There are things that must be considered carefully when outsourcing. The first consideration is
an organization should never outsource anything that is currently a source of competitive
advantage for them. For example, companies should exercise extreme caution when outsourcing
activities that could result in a potential decrease in an organization’s ability to innovate. The
second consideration is managers need to be capable of creating and managing partnerships in a
strategic manner so internal management can fully benefit from work done by their partners.
Management must be able to oversee and govern the partnership arrangement as well as help the
organization adapt to changes that inevitably occur when an organization’s structure and
operations change.


Levels of Strategy – Functional Level Strategy
1.2.4.3 Describes an organization’s functional level strategy

a) Prepares functional level strategies that are internally consistent,
consistent with the strategies of other functions (e.g. marketing, 9 9
production, HR, finance) and integrated with the business level strategy
Overview
Once the business strategy has been determined, it is the role of the business managers and the
functional managers to choose which functional strategies will support the business strategy.
Functional strategies are developed and implemented in all the functional areas of a business.
They become the game plans for the business. They also detail how key activities will be
managed.
Functional expertise is crucial to an organization since development of an organization’s

functional abilities framed within its culture, can lead to the development of core competencies
(the key source of competitive advantage). Developing strong functional abilities depends partly
upon having strong property rights (the rights an organization gives to its members to receive
and use organizational resources including pensions and benefits) that motivate employees.
Strong functional abilities are also dependent upon having the correct structure. The choice of an
organizational structure is in part dependent on the size of the organization, the type of work
being done and the importance of the different functional areas. For example, in companies
where research and development is crucial to the company’s success, a flatter decentralized
structure with small teams tends to be more effective. To reinforce the norms and values that
emphasis teamwork and cooperation, employees must be given strong property rights and a share
in the organizational profits. This is in contrast to a nuclear power plant where a hierarchical
mechanistic type of structure is most suitable. For functional expertise to develop, the functional
managers must be able to work together so company goals can be achieved in the most efficient
manner.


Business Strategies and the Industry Life Cycle
1.2.5 Describes competitive business strategies at different stages of a given
industry’s life cycle
a) Understands how competitive strategies can create competitive advantage 9
b) Understands competitive rivalry, competitive behaviour and competitive
dynamics at the offering level and how this can change through the 9
industry life cycle
c) Evaluates and recommends appropriate business strategies for an
9 9
organization at a given stage of the industry life cycle
The Product Life Cycle

The product life cycle refers to the different stages that reflect the life of a product in the market
with respect to development, which translates to costs and sales. Each of the four stages of the
product life cycle poses different challenges, opportunities and problems to the manufacturer.
During each stage, profits will be different and will require different marketing, financial,
manufacturing, purchasing and human resource strategies.
The different stages in a product life cycle are:
1. Market introduction stage
• costs are high
• sales volume is low; often there is little, if any, profit
• there tends to be no or, very little, competition (the competitors watch for acceptance
before competing)
• demand has to be created; consumers need to be made aware of the product
• customers have to be prompted to try the product
2. Growth stage
• costs are reduced due to economies of scale
• distribution channels are developed
• sales volume increases significantly
• profitability is achieved
• customers are aware of the product
• competition begins to increase with a few new players in establishing market
• prices are set to maximize market share/maximize profitability

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3. Mature stage
• costs are low as the product is well established
• sales volume peaks
• increase in competitive products
• prices tend to drop due to the increasing number of competing products
• there is an attempt at brand differentiation and feature diversification, as each competitor
seeks to differentiate from other competitors
• profits begin to decline
4. Saturation and decline stage

• sales volume declines or stabilizes
• prices and, therefore, profitability, diminishes
• increasing profit at this stage requires production/distribution efficiency, rather than
increased sales
Strategies for Each Stage

The characteristics of each stage will determine the strategies that should be employed.
Introduction Stage
The characteristics of this stage from a strategy perspective are:
• products are unfamiliar to consumers
• market segments not well defined
• product features not clearly specified
• competition tends to be limited
Therefore, strategies need to be focused on developing the product and getting users to try it as
well as generating exposure for the product so it becomes well known and standard.
Growth Stage
• strong increases in sales
• attractive to potential competitors
• primary key to success is to build consumer preferences for specific brands (brand loyalty)
Therefore, strategies need to be focused on developing brand recognition/loyalty, differentiate

the product from competitors and expending the resources necessary to support value chain
activities.


Mature Stage
• total industry demand slows
• market becomes saturated
• direct competition becomes predominant
• marginal competitors begin to exit
Therefore, strategies need to be focused on efficiency in manufacturing and lower costs. During
the maturity stage, customers become more price-sensitive, so lowering costs becomes
important.
Saturation/Decline Stage
• industry sales and profits begin to fall
• strategic options become dependent on the actions of rivals
Therefore, strategies need to be focused on maintaining market share, exiting the market or
exiting specific segments. Another strategic option is to consolidate with other competitors.


Business Strategies – The Cost Leadership
Strategy
1.2.5.1 Describes cost leadership strategy
a) Identifies sources of cost advantages within an industry 9
b) Assesses an organization’s cost position relative to its rivals 9 9
c) Recommends cost reduction tactics that improve an organization’s cost
9 9
leadership position
d) Outlines competitive risks in following a cost leadership strategy 9 9
This strategy focuses on reducing cost through efficiency. It is often used for products that are
standardized and can be produced in high volumes at low cost. Producing high volumes allows a
company to achieve economies of scale. Implicit in producing high volumes is that consumer
demand is also high. For this reason, the products most conducive to this type of strategy are
standardized products that can be produced at low cost and be made available to a large
consumer base. To maintain the low cost strategy, companies must continuously search for cost
reductions in all aspects of the business. This also includes the distribution network. Since this
strategy requires the product be made available to large numbers of customers, it is necessary to
have a distribution network that allows for the most extensive distribution possible.
This strategy usually requires significant market share or preferential costs for raw materials,
components, labour or some other raw material. If a company does not have either of these
advantages (market share or preferential costs for one or more of the raw materials), the strategy
could easily be imitated by competitors.
Companies attempt to maintain a low cost base by controlling production costs, increasing their
capacity utilization, controlling material supply or product distribution and minimizing other
costs including research and development and advertising.
Sources of cost reduction can be:

• the results of process engineering
• products designed so that manufacturing them is easy
• access to inexpensive capital
• labour costs and productivity improvements
• tightened cost control
• employing new technology
• enhancing or increasing capacity utilization
• incentives based on meeting cost targets


Examples of companies that employ low cost strategies include low-cost charter airlines and
discount supermarkets.
The most important aspect of implementing a cost leadership strategy is the need to continuously
seek cost reduction opportunities across every aspect of the business, from manufacturing to
distribution, to the final sale of the product to the final consumer. Attempts to reduce costs will
spread through the whole business process from manufacturing to the final stage of selling the
product. Any process that does not minimize costs needs to be changed or it could be outsourced
to a company that can carry out the process at a lower cost.
The cost efficiencies gained throughout the process will enable a company to charge a price
lower than competition, which ultimately results in higher sales, since competitors cannot match
the low cost. If the low cost can be maintained for longer periods of time, the result is an increase
in market share. However, it should be noted that if the competitor is able to alter its operations
so it can offer customers the same low price, then the competitive advantage will no longer exist.


Differentiation Strategy
1.2.5.2 Describes differentiation strategy
a) Identifies sources of differentiation in terms of customer’s preferences 9
b) Assesses an organization’s differentiation position relative to its rivals 9 9
c) Recommends ways to increase customer’s willingness to pay, which
9 9
improve an organization’s competitive position
d) Outlines competitive risks in following a differentiation strategy 9 9
e) Understands how organizations can combine the advantages of cost and
9 9
differentiation strategies (e.g. best value strategy)
The differentiation strategy refers to the creation of a product or service seen by the consumer as
being unique in some way. The uniqueness of the product allows the company to charge a
premium for its product. The differentiation can take many forms, such as:
• specialty design
• brand image
• technological features
• customer service
This strategy often results in brand loyalty and brand loyalty results in lowered sensitivity to
price. This means increased costs can be passed on to the consumer. In addition, consumer
loyalty often is a barrier to entry for new competitors. Examples of companies using the
differentiation strategy are Apple and Mercedes Benz.


Divestiture/Downsizing Strategy
1.2.5.3 Describes divestiture/downsizing strategy
a) Understands the situations for which a divestiture strategy may be
9
appropriate
b) Describes ways to restructure an organization 9
When a Divestiture Strategy is Appropriate

A divestiture is selling a division or part of an organization. It may be desirable to raise funds for
another acquisition, as part of a retrenchment (e.g. selling marginally profitable product lines) or
because that part of the business may not fit well with the company’s other business activities.
Guidelines for considering when divestiture may be appropriate (per Fred R. David’s “How Do
We Choose Among Alternative Growth Strategies?”):
• When an organization has pursued a retrenchment strategy and failed to accomplish

needed improvements.
• When a division needs more resources to be competitive than the company can provide.
• When a division is responsible for an organization's overall poor performance.
• When a division is a misfit with the rest of an organization; this can result from radically
different markets, customers, managers, employees, values or needs.
• When a large amount of cash is needed quickly and cannot be obtained reasonably from
other sources.
• When government antitrust action threatens an organization.
Methods of Restructuring
An organization restructures when it changes its set of businesses or its financial structure.
When failed acquisitions are sold off, companies typically undertake a restructuring strategy.
Restructuring organizations tend to have less slack (additional uncommitted resources) and,
therefore, find it difficult to absorb as many errors, thus making an organization vulnerable. An
organization can be restructured through both growth and non-growth strategies. Although most
strategies assume a corporate strategy of growth, many organizations also pursue non-growth
strategies such as downsizing, downscoping, leveraged buyouts, divestiture and liquidation.
These strategies are commonly used when an industry is in the decline stage; however, they are
also used as a way to restructure an organization when an organization determines they do not
have the competitive capabilities required to compete successfully in a particular market (due to

either changes in its internal or external environment). In fact, the overall result of using these
strategies can be positive if a company uses them as a way to restructure its organization,
improve its effectiveness and prepare for the future.
Downsizing
Although downsizing was once thought to be indicative of organizational decline, the business
world now accepts downsizing as a legitimate restructuring strategy. When a company
downsizes, it reduces the number of its employees and/or the number of operating units. This
may or may not change the composition of the businesses in its portfolio. Downsizing is not a
quick fix. Research has shown that major downsizing efforts have contributed to lower returns
for North American organizations (moderate-sized layoffs may improve performance*). Many
organizations view employees as costs rather than human capital. In contrast, some investors
fear long-term strategic competitiveness may be negatively impacted when an organization loses
the knowledge and experience of long-term employees. In addition, investors may respond
negatively if they assume downsizing occurs as a consequence of other problems in a company.
These factors suggest that downsizing is more of a tactical (short-term) approach than a strategic
(long-term) approach. However, one unexpected positive result of downsizing is laid off
employees sometimes start new businesses. (*Source: Nixon, R., Hitt, M., Lee, H. and Jeong, E. (2004).
“Market reactions to corporate announcements of downsizing actions and implementation strategies”, Strategic
Management Journal, 25:1121-1129)
Downscoping
When an organization downscopes, it divests at least one business that is unrelated to its core
business. Many organizations downsize and downscope simultaneously. When downscoping, an
organization must avoid eliminating key employees from its core businesses as this may
jeopardize one or more core competencies. An organization is often able to refocus itself in a
more positive direction after a reduction in the breadth and number of businesses in its portfolio.
This can lead to increased effectiveness, as the organization is often better able to manage the
remaining businesses. Downscoping typically results in more overall positive outcomes than one
finds in leveraged buyouts.
Leveraged Buyouts
There are three types of leveraged buyouts: whole-firm buyouts, management buyouts and
employee buyouts. A leveraged buyout is a restructuring strategy that involves buying all of an
organization’s assets in order to take an organization private. A common reason for a buyout is
to protect against unpredictable financial markets. Going private allows the owners to focus on
entrepreneurial activities with the potential to initiate a rebirth of the business and stimulate
growth. It is referred to as leveraged because these transactions normally involve high levels of
debt financing. High levels of debt increase the organization’s risk exposure. To support debt
repayment, the new owners typically sell a number of assets.


Divestiture
Divestiture consists of selling part of an organization by either spinning it off as an independent
company or selling it. This is often done when it is determined a business is a misfit (poor
cultural fit or a lack of economies of scope or scale) or there is a lack of compatibility between
businesses in a portfolio. Divestiture may also be warranted if unfavourable changes in an
industry have made it too challenging for an organization to maintain profitability.
Liquidation
Liquidation involves selling all company assets and terminating its existence. Some businesses
are just not worth saving. An early liquidation normally benefits the stakeholders more than if a
business waited for bankruptcy to occur since prolonging an organization’s existence only drains
assets.

Page 398

Integration Strategy
1.2.5.4 Describes integration strategy
a) Evaluates the benefits and risks associated with various integration
9 9
strategies (e.g. vertical, horizontal)
Integration Strategies
Vertical integration strategies allow an organization to gain control over distributors, suppliers
and/or competitors (i.e. control over the distribution channel).
There are two types of vertical integration strategies: forward integration and backward
integration. Another integration strategy is horizontal integration, which involves obtaining
ownership or control over competitors.
• Forward Integration
This involves gaining ownership or control over distributors or retailers (i.e. control sale or
distribution to the consumer). An example would be the acquisition of an office supply store
chain by a forest products company. The forest products company not only manufactures the
paper, but also controls the sale to consumers through ownership of the chain of office supply
stores.
An often successful method of achieving forward integration is through franchising. In a

franchise relationship the franchisor sells the rights to sell a product or service under a
branded name to a franchisee. The franchisee pays an upfront fee, as well as royalties, to the
franchisor. Franchising allows rapid expansion because costs and opportunities are spread
among many individuals (i.e. franchisees).
According to Fred R. David, in “How Do We Choose Among Alternative Growth

Strategies?” (Managerial Planning 33, no. 4 (January – February 1985): 14 – 17, 22), there
are six guidelines that indicate when forward integration may be effective:
When an organization's present distributors are especially expensive, unreliable or

incapable of meeting the organization's distribution needs.
When the availability of quality distributors is so limited as to offer a competitive
advantage to those organizations that integrate forward.
When an organization competes in an industry that is growing and is expected to
continue to grow markedly; this is a factor because forward integration reduces an
organization's ability to diversify if its basic industry falters.


When an organization has both the capital and human resources needed to manage the
new business of distributing its own products.
When the advantages of stable production are particularly high; this is a consideration
because an organization can increase the predictability of the demand for its output
through forward integration.
When present distributors or retailers have high profit margins; this situation suggests
that a company profitably could distribute its own products and price them more
competitively by integrating forward.
• Backward Integration
This strategy involves obtaining ownership or control of an organization’s suppliers. This

may be desirable when an organization’s current suppliers are not dependable, are too costly,
have poor quality or cannot meet an organization’s needs.
According to Fred R. David, in “How Do We Choose Among Alternative Growth

Strategies?” there are seven guidelines that indicate a backward integration strategy might be
appropriate:
When an organization's present suppliers are especially expensive, unreliable or

incapable of meeting the organization’s needs for parts, components, assemblies or raw
materials.
When the number of suppliers is small and the number of competitors is large.
When an organization competes in an industry that is growing rapidly; this is a factor
because integrative-type strategies (forward, backward and horizontal) reduce an
organization's ability to diversify in a declining industry.
When an organization has both capital and human resources to manage the new business
of supplying its own raw materials.
When the advantages of stable prices are particularly important; this is a factor because
an organization can stabilize the cost of its raw materials and the associated price of its
product(s) through backward integration.
When present suppliers have high profit margins, which suggests the business of
supplying products or services in the given industry is a worthwhile venture.
When an organization needs to acquire a needed resource quickly.
• Horizontal Integration
This strategy involves obtaining ownership or control over competitors. Merging, acquiring
or otherwise taking over a competitor allows for increased economies of scale and enhanced
competencies. However, it should be noted that increased economies of scale often are only
achieved when the merged businesses are in the same industry. This is because there is
greater potential for eliminating duplicate facilities when the companies operate in the same
industry. When there is a merger of two unrelated businesses, these economies of scale are
often not achieved because there is limited duplication.


Five guidelines for when to consider horizontal integration (Fred R. David’s “How Do We
Choose Among Alternative Growth Strategies?”) are:
When an organization can gain monopolistic characteristics in a particular area or region

without being challenged by the federal government for “tending substantially” to
reduce competition.
When an organization competes in a growing industry.
When increased economies of scale provide major competitive advantages.
When an organization has both the capital and human talent needed to successfully
manage an expanded organization.
When competitors are faltering due to a lack of managerial expertise or a need for
particular resources an organization possesses; note that horizontal integration would
not be appropriate if competitors are doing poorly because, in that case, overall industry
sales are declining.


Domestic and International Growth Strategies
1.2.6 Describes domestic and international growth strategies for a given
organization
a) Explains motives for domestic and international growth 9
b) Evaluates the advantages and disadvantages of different international
9 9
strategies (e.g. international, multi-domestic, global and trans-national)
c) Outlines risks in entering international markets 9 9
d) Evaluates different types of foreign country entry strategies (e.g. export,
9 9
licensing, alliances, wholly-owned subsidiary)
Motives for International Growth

There are several reasons why an organization pursues international growth:
• Sales expansion
Three factors often result in companies attempting to increase sales through international
expansion:
1. Maturity of the domestic markets

A company whose products are in the final stages of the product life cycle, the maturity stage
or the decline stage, can expect decreasing or flat sales of its products. To increase sales, the
international market may be pursued. [Recall the product life cycle consists of four stages,
introduction, growth, maturity and decline. During the maturity stage, sales start to slow and
during the decline stage, sales drop off more rapidly.]
2. Slower domestic rates of growth than foreign growth rates

Different countries are in different stages of economic growth, which impacts demand. If a
foreign country has a higher sales growth rate, it may be advantageous to pursue that market
more aggressively. Examples include the recent significant economic growth experience by
China and India.
3. Opportunity to obtain new product capabilities

If a foreign product has capabilities not currently available in North America, it may be
advantageous to pursue foreign opportunities, with the goal of using the product capabilities
in the foreign country in Canada.


• Cost reduction
Companies competing based on price are constantly seeking opportunities to reduce costs.
Expanding to international sites may reduce costs by spreading fixed expenses over increased
sales, produce using cheaper inputs (both raw materials and labour) or by achieving vertical
integration.
• Backward and/or forward integration
Expanding to a foreign country may be desirable to achieve backward or forward integration.

This can result in advantages such as creating bargaining power with suppliers or customers and
minimizing stock out costs.
• Risk-reduction motives
To smooth sales (i.e. reduce swings in sales and profits), a company may enter a foreign market
with different timing for its business cycle. Entering a foreign market decreases dependence on
existing customers and suppliers.
International, Multi-Domestic, Global and Transnational

Strategies
Multi-domestic, global and transnational strategies are:
• Multi-domestic
The parent company in Canada allows each of its foreign-country operations to act mainly
independently. Characteristics of multi-domestic organizations are:
- decentralized strategic and operating decisions to the company located in each country;
this allows units to create products specific to local markets
- customized products that meet local customers’ specific needs and preferences
- compete in industry segments most affected by differences among local countries
• Global
The parent company integrates its operations that are located in different countries.
Characteristics of multi-domestic organizations are:
- the company offers standardized products across the various countries, with the
competitive strategy being dictated by the parent company
- emphasizes economies of scale
- strategic and operating decisions are centralized at the parent company, with
interdependent strategic business units operating in each country; the parent company
integrates across the strategic business units in each country
- is less responsive to local market opportunities (due to offering standardized products
in different countries)


• Transnational
The parent company develops different capabilities and contributions in different countries
and shares them across integrated worldwide operations.
Characteristics of multi-domestic organizations are:
- Global coordination and local flexibility are critical; it requires building a shared vision
and commitment from individual units through an integrated network
Risks in Entering International Markets

The risks in entering international markets can be categorized into two broad categories, political
and economic.
Political risks
• government instability in the foreign country
• conflict or war
• government regulations (and the changing of those regulations)
• conflicting and diverse legal authorities
• potential nationalization of private assets
• government corruption
• government bureaucracy
• changes in government policies
Economic risks
• fluctuations in foreign currency rates
• monetary regulations and changes in these regulations (for example, many countries have
regulations limiting the amount of capital that can be removed from the country; this means
profits earned may not be able to be repatriated back to the parent company)
In addition to the political and economic risks, it is important that companies examine the
cultural environment in the foreign country and ensure its products and marketing is appropriate
for the culture. The cultural environment includes:
• sellers must examine the ways consumers in different countries think about and use
products before planning a marketing program.
• business norms vary from country to country.
• companies that understand cultural nuances can use them to their advantage when
positioning products internationally


Types of Foreign Country Entry Strategies
Methods to enter a foreign country include exporting, licensing, alliances and setting up a
wholly-owned subsidiary. Each of these is described below.
• Exporting
- this is the lowest cost method to establish operations in a foreign country (compared to
the other alternatives); often it involves establishing a contractual relationship with a
local distributer
- transportation costs are high
- there may be tariffs imposed by the foreign country
- control over distribution is limited
• Licensing
- cost to expand internationally is low
- the licensee has the risk (i.e. the licensee takes on the risk of the product not selling
well)
- there is no control over the manufacturing and the marketing of the product; the
licensee has this control
- returns many not be as high as direct sales, as the licensee pays licensee fees and/or
royalties
- there is a risk the licensee may use the product inappropriately or perhaps imitate the
product
• Strategic alliances
This represents an agreement between two parties, whereby each party contributes different
skills and each party takes on some of the risk. Characteristics of strategic alliances are:
- shared risks and resources
- facilitates the development of core competencies for each party
- the resources required to enter the foreign market is less than establishing a subsidiary
in the location
- there may be incompatibility, conflict or lack of trust with partner, discovered at a later
date
- some alliances may be difficult to manage
• Establishing a Wholly Owned Subsidiary

This involves establishing a new corporation in the foreign country. Characteristics of this
method:
- it is often costly
- it is more complex than other alternatives, as it involves understanding and complying
with government regulations of the foreign country
- there is full control over product production and distribution


Ventures and Strategic Alliances
1.2.6.1 Describes joint ventures
a) Explains why organizations may choose to form a joint venture or an
9
alliance
b) Understands the risks of alliances and joint ventures 9
c) Describes different types of alliances and joint ventures 9
d) Explains why alliances and joint ventures may fail and describes
9
attributes of successful alliances and joint ventures
e) Explains how to manage joint ventures and alliances 9
Joint Ventures / Partnerships

A joint venture is when two or more companies form a new separate company and each has an
equal ownership in the new, separate company. The purpose is to capitalize on an opportunity.
A partnership represents an agreement between two or more companies. A partnership may be

preferable over forming a new separate entity due to decreased complexity, reduced accounting,
etc.
Other types of co-operative arrangements include research and development partnerships (a

partnership focused solely on R&D), cross-licensing agreements and joint-bidding consortia.
Joint ventures, partnerships and cooperative arrangements allow companies to enhance

networking, globalize operations and to minimize risk.
“Strategic partnering” has become more common because it has proven to be an effective way of
enhancing corporate growth. Strategic partnering can occur using many forms, such as
outsourcing, information sharing, joint marketing and joint research and development.
Forming a joint venture or partnering, as opposed to acquiring another company, is often

required due to globalization. Gaining presence in a foreign country with its different culture
and market is often more effectively undertaken because a partner or venturer already present in
that country often already has a substantial presence or, at the very least, is knowledgeable about
that country’s culture and market characteristics.

Page 406

Although partnering or joint ventures can be an effective means of growth, joint ventures or
partnerships may fail. Common problems causing a joint venture or partnership to fail are:
1. Managers who must collaborate daily in operating the venture are not involved in
forming or shaping the venture.
2. The venture may benefit the partnering companies, but may not benefit customers who
complain about poorer service or criticize the companies in other ways.
3. Both partners may not support the venture equally. If supported unequally, problems
arise.
4. The venture may begin to compete more with one of the partners than the other.
Guidelines to consider whether a joint venture would be appropriate:

• When a privately owned organization is forming a joint venture with a publicly owned
organization; there are some advantages to being privately held, such as closed ownership;
there are some advantages of being publicly held, such as access to stock issuances as a
source of capital. Sometimes, the unique advantages of being privately and publicly held
can be synergistically combined in a joint venture.
• When a domestic organization is forming a joint venture with a foreign company; a joint
venture can provide a domestic company with the opportunity for obtaining local
management in a foreign country; thereby, reducing risks such as expropriation and
harassment by host country officials.
• When the distinct competencies of two or more organizations complement each other
especially well.
• When a project is potentially profitable but requires overwhelming resources and risks; the
Alaskan pipeline is an example.
• When two or more smaller organizations have trouble competing with a large organization.
• When there exists a need to introduce a new technology quickly.
Strategic Alliances
This type of structure entails cooperation between competitors. An alliance represents a
collaborative agreement between competitors whereby each competitor contributes a distinctive
item, such as technology, distribution ability, basic research or manufacturing capacity.
A risk with strategic alliances is too much information or transfers of skills/ technology occurs
(i.e. more than intended in the initial agreement).
A good example of an effective alliance is the Star Alliance in the airline industry. The Star
Alliance had 16 airlines as of early 2004, including Air Canada, United Airlines and Lufthansa,
to name a few. In the increasingly difficult airline industry, competing as a group makes it easier
for each airline in the alliance to survive.


1.2.6.2 Describes mergers and acquisitions
a) Explains the advantages and disadvantages of mergers and acquisitions 9
b) Explains how mergers and acquisitions can improve corporate
9
competitiveness
c) Explains why mergers and acquisitions may fail and describes attributes
9
of successful mergers and acquisitions
d) Explains how to manage the post-merger and acquisition integration
9
phase
Overview of Mergers and Acquisitions

A merger is a strategy through which two organizations enter into an agreement to integrate their
operations on a fairly coequal basis and thus unite to become one enterprise.
An acquisition results when one organization buys controlling or 100% interest, in another
organization with the intention of making the acquired organization a subsidiary business within
its portfolio. Normally, a larger organization purchases a smaller organization, but the reverse
can also occur. When this occurs, the acquired organization comes under the control of the
acquiring organization.
Another form of acquisition (called a takeover) occurs when a target organization does not
bother to solicit the acquiring organization’s bid. As many takeover attempts are not desired by
the target organization’s managers, they are referred to as hostile takeovers. Takeovers are
particularly common during economic downturns when it becomes more obvious, which
organizations are in a precarious position and are thus great targets. If both organizations are in
favour of the acquisition, it is termed a friendly merger.
There are many reasons why organizations, even ones that have been fierce rivals, may want to
merge. Mergers and acquisitions can improve corporate competitiveness because they:
• increase market power;
• yield economies of scale (two organizations are bigger than one);
• provide access to new suppliers, distributors, customers, products and creditors;
• provide new technologies;
• increase access to funds when there is a depressed stock market (therefore, it maybe
unproductive to raise money by issuing stock);
• improve capacity utilization, reduced entry barriers;


• make better use of sales staff;
• share research and development costs;
• obtain products to market more quickly;
• reduce risk if development costs are shared;
• increase diversification;
• avoid excessive competition;
• increase opportunity to learn and develop;
• reduce tax obligations, and
• take advantage of deregulation and technological change (making it easier to merge).
Why Mergers and Acquisitions Fail

Research suggests that approximately 20% of all mergers and acquisitions are successful, 60%
post disappointing results and the final 20% are failures.
(Source: Schmidt, J., “Business perspectives on mergers and acquisitions” in J.A. Schmidt, ed., Marketing Mergers
Work, Alexandra, VA: Society for Human Resources Management, (2002): 23-46)
The key reasons for failure include:

• integration difficulties, as it is always challenging to merge two organizations (different
cultures and systems);
• large debt load (no slack resources);
• inability to achieve synergy;
• lack of due diligence and thus a poor choice of organization to acquire;
• too much diversification;
• too large an acquisition;
• challenges integrating different organizational cultures;
• morale problems due to layoffs and relocations;
• inadequate evaluation of target (not a good fit), and
• managers too focused on making acquisitions rather than making acquisitions work.
There are some factors that can improve the probability of having a successful merger or
acquisition:
• horizontal acquisitions tend to be more favourable because they increase market power
by exploiting synergies;
• establishing friendly relationships with the acquiring organization before finalizing the
deal;
• the more related the acquired organization is to the purchasing organization, the greater
the probability of the acquisition being successful;
• if organizations possess similar characteristics such as similar strategies and managerial
styles;


• if marketing of the combined organization improves economies of scope, and
• if the excess capacity and assets that do not complement the new entity of the merged
organization are divested.
Managing the Post-Merger Phase
To better manage the post-merger and acquisition phase, companies should:

• do an overall assessment of the merged organization and eliminate excess capacity and
assets in order to create more slack resources to make investments;
• continue to focus on innovation by investing in research and development (do not expect
the acquired organization to substitute for innovation);
• be flexible and adaptable so the organization can adjust to the many changes that occur
post-merger and successfully integrate the two organizations. This also helps the merged
organization obtain synergistic benefits;
• maintain valuable human resources in the acquired organization, and
• maintain a low to moderate debt position.


Organic Growth
1.2.6.3 Describes organic growth
a) Evaluates methods to achieve organic growth (e.g. product-market
exploitation, product development, market development, product-market 9 9
diversification)
b) Outlines the risks of using organic growth 9
c) Explains how to manage organic growth 9
Definition of Organic Growth

Organic growth refers to the growth rate a company can achieve by increasing output and
enhancing sales. This excludes any profits or growth acquired from takeovers, acquisitions or
mergers. Takeovers, acquisitions and mergers do not bring about profits generated within the
company and, therefore, are not considered organic. In simple terms organic growth means the
sales and profits generated solely by internal efforts.
Methods of Achieving Organic Growth

The methods of achieving organic growth can be depicted as:
Products
Existing Products New Products
Current Markets Market Penetration Product development
New Markets Market development Diversification
Each of the sections of the matrix is defined as:
Market penetration
• Increasing sales of current products in existing markets
Since this involves no change in the basic product line(s) or the market(s) served, it is the
least risky.


Product Development
• Selling a new product to existing markets; often involves creating related products current
customers would be interested in purchasing.
Selling related products may not be risky; however, introducing completely new products
may be risky as a company’s current customer base may not purchase the new product. This
means the company may need to develop an entirely new customer base, which can be
expensive and take time.
Market Development
• Selling existing products to new markets; this involves expanding the customer base
This could involve expanding to international markets to develop the customer base.
Diversification
• Developing new products and sell them in new markets.
This is the highest risk and most expensive, as it involves new products, which requires time
and effort to develop as well as developing new markets, which is expensive and can take a
long time.

Page 412

Corporate Social Responsibility
1.2.7 Describes a corporate social responsibility strategy for a given organization
a) Describes how companies can demonstrate social responsibility 9
b) Makes a business and moral case for corporate social responsibility 9 9
c) Formulates a strategy that satisfies the triple bottom line (i.e. economic,
9 9
environmental and social criteria)
Corporate Social Responsibility

Organizations need to have a social policy that impacts managerial decision-making at the
highest levels of the organization and builds social capital. Social policy should be reflected in
the company’s mission and vision statements. Social policies have an impact on both public
image and profitability. A socially responsible mission statement sets the foundation for a
socially responsible organization. This should be followed by objectives and an overall strategy
that reflects this attitude. Moreover, the way in which the strategy is implemented is also crucial
to demonstrating a socially responsible approach.
The impact of business on society and vice versa is increasing. More is expected of business
than ever before. It is no longer enough for companies to just provide employment. Managers
are mandated to consider the needs of consumers, communities, minorities, environmentalists
and other groups.
Social capital is a critical asset that involves relationships inside and outside the organization that
assists the company in accomplishing its tasks and creating value for its customers and
shareholders. Having social capital means an organization has the necessary social relationships
needed to conduct business effectively.
Another key part of gaining social capital involves establishing relationships that benefit the
organization less directly, such as those formed with the external stakeholders in the community
or society at large. Exhibiting a strong sense of corporate social responsibility in this context
becomes “good will”, which can build the brand name and reputation of the company and, if well
managed, can lead to above average returns.
An example of a social cause that can build social capital is demonstrating a concern for the
environment. Environmental awareness is needed in many aspects of a business such as
purchasing, product design, manufacturing, transportation, packaging and product disposal (a
cradle to grave approach). Effectively, managing environmental affairs can create social capital
by creating positive relationships with stakeholder groups.

Page 413

Best Practices in Strategy Formulation
1.2.8 Describes best practices and current innovations in strategy formulation in a
given industry (e.g. strategies for the Internet economy, strategies for finding
9
a unique niche to gain competitive advantage such as the Blue Ocean
strategy)
Candidates are advised to keep up-to-date on current innovations and best practices by reading
CMA Magazine and CMA Canada Management Accounting Guidelines, which can be found at
www.cma-canada.org. As best practices and current innovations are continually evolving, it is
up to the candidate to keep current through reading literature published by CMA Canada.
Note to candidates: This topic is rarely examined.


Organizational Design
1.3.1 Describes the elements of organizational design that would help a given
organization achieve a given strategy
1.3.1.1 Describes the relative merits of simple, divisional and matrix designs 9 --
1.3.1.2 Describes the relative merits of centralized and decentralized designs 9 --
1.3.1.3 Describes the relative merits of a narrow and broad span of control 9 --
The structure of an organization is the formal means by which it coordinates the activities of
employees to accomplish its objectives. All organized human activity requires two forms of
structure: the division of labour into the various tasks that need to be performed and the
coordination of these tasks to produce the organization’s outputs. In an organization, different
members of the work force are assigned component tasks necessary to achieve the organization’s
mission. These component tasks are called roles. Organizational structure is the skeleton of an
organization that captures the relationships among the different roles of the organization.
Types of Organizational Structures
Simple (Functional)
This structure is organized according to function (sales, finance etc.). This form is most
appropriate when there is a need for collaboration and expertise within a function, the
environment is stable and when there are only a few products. However, this form is slow to
respond to change and may result in less innovation.
Example of a functional structure:
Chief Executive Officer
Marketing Operations Comptroller
Market Shipping
Develop- Sales Purchasing Manufacturing and Finance Accounting
ment Receiving


Divisional (also known as Product)
This structure is organized by products, markets or geography. Each division has its own
production, marketing and other resources. The goal of this structure is coordination within
product lines or markets. This structure is appropriate for companies producing many products or
is customer focused. This form may lead to losses in economies of scale, duplication of effort
and little cooperation among divisions.
Example of a divisional structure:
Executive Vice-President
Information Consumer
Systems Products
Group Group
Computer Copying Appliances Hardware

Division Division Division Division


Matrix (also known as Hybrid)
This structure is a hybrid of functional and product structures. It is useful in environments where
there is a high need for constant interchange between functions and product issues, project
oriented environments or uncertain environments. Employees report to managers in both the
functional and product divisions, thus this structure has a dual command or dual hierarchy
feature.
Example of a matrix structure:
Executive Vice President
Projects Research and Marketing Financial

Manufacturing Development Manager Manager
Manager Manager
Manager
Manager Engineers Marketing Financial

Project Manufacturing and Personnel Experts
Alpha Personnel Scientists

Beta Personnel Scientists

Gamma Personnel Scientists
= Functional command relationships
= Project command relationships


Centralized vs. Decentralized Structures
Decentralization is the degree to which decision making is delegated to lower levels in an
organization; therefore, centralization is the extent to which decision making is concentrated in a
specific centre (usually head office). Centralization of decision making has the advantage of
control, because decisions can be monitored. However, centralization has disadvantages in that it
may put excessive demands on the decision makers (in terms of time, effort and skill), it reduces
the organization’s flexibility and it can strain the communication system as information must be
channelled quickly and consistently between the decision maker and those that carry them out.
Decentralization offers increased flexibility and employees develop greater decision making
skills.
Span of Control
This refers to the number of employees who report to a single supervisor. The span of control has
an influence on the height of an organization. For example, if the span of control becomes too
large, another layer may be added.
Tall vs. Flat Structures

Tall vs. flat structure refers to the number of levels of authority and the width (or size) of each.
Tall organizations have more levels, while flat organizations have fewer.
Complexity
Complexity refers to the degree of division of labour and specialization and can occur
horizontally or vertically.
Horizontal Differentiation
This is when work is divided up and allocated among people at the same level. Horizontal
differentiation usually results in departmentalization (discussed earlier). The difference between
line and staff functions is a form of horizontal differentiation, which reflects differences in
responsibilities.


Vertical Differentiation
This refers to the division and allocation of supervisory responsibilities among levels of
management. Vertical differentiation is increased by adding more levels of supervisors between
management and operating employees. This often occurs to improve coordination or control.
Note that horizontal and vertical differentiation is closely related to span of control.
Spatial Differentiation
This occurs when work is carried out in different physical locations. It is more difficult to
coordinate the activities of groups of employees who work in different locations.


Corporate Culture
1.3.2 Describes how management control frameworks align a given organization’s
resources and success factors with strategy
1.3.2.1 Describes belief systems, organizational cultures and corporate values
a) Understands the role an organization’s belief systems, culture and values
9
play in implementing strategy and strategic control systems
b) Assesses and recommends changes to an organization’s belief systems,
9 9
culture and values with respect to implementing a chosen strategy
A company’s culture is made up of beliefs about how business ought to be conducted, values and
principles of management, patterns of “how things are done” and stories illustrating a company’s
values, traditions, taboos and ethical standards. Culture comes from the company founder or
early leader, influential individuals or work groups, traditions, management practices, employee
attitudes, organizational politics, policies, vision, strategies, traditions and relationships with
stakeholders. Managers generally stamp strategies with their own personal values, ambitions and
business philosophies, attitudes toward risk and ethical beliefs and values.
Culture must be examined as a part of an internal analysis since culture can contribute to or
hinder successful strategy execution. The requirements for successful strategy execution may or
may not be compatible with culture. Therefore, culture can dominate the strategic moves a
company will consider or reject. If an organization finds its proposed strategy does not fit with
its culture, the organization should adapt its culture (although this will take some time) since a
close match between culture and strategy promotes effective strategy execution.
Anything as fundamental as implementing a new or different strategy involves aligning the

organization’s culture and structure with the requirements for competent strategy execution.
Organizations must choose organizational structures that are compatible with the types of
cultures they wish to foster, since obtaining a good fit between organizational design and culture
can give rise to the development of core competencies. For example, mechanistic structures give
rise to cultures that have predictability and stability as the desired end states; whereas organic
structures are associated with cultures that have innovation and flexibility as end states.
If an organization has a positive culture, it can be maintained by having continuity of leadership,
selecting new employees based on how their personalities “fit”, systematically indoctrinating
new employees, reinforcing core values, honouring employees who display cultural ideals and
visibly rewarding those who follow cultural norms.


Strategy supportive cultures have positive effects on organizational energy, work habits and
operating practices; they provide standards, values, informal rules and peer pressures that
nurture, motivate and promote positive strategy execution as well as strengthen employee
identification with the company. Positive cultures stimulate people to take on the challenge of
realizing the company’s vision, doing their jobs competently and enthusiastically, and
collaborating with others to execute the chosen strategy. Strategy supportive cultures are also
more likely to accept change, meet customer needs and develop needed capabilities.
Strong culture organizations exhibit a genuine concern for the well-being of customers,
employees and shareholders. Weak culture organizations are characterized by politicized
internal environments where issues are resolved on the basis of turf, there is hostility to change,
experimentation and efforts to alter status quo are discouraged and managers are typically more
concerned about process than about results. Along with a must-be-invented here syndrome, there
is also an aversion to look outside for superior practices.


Boundary Systems
1.3.2 Describes how management control frameworks align a given organization’s
resources and success factors with strategy
1.3.2.2 Describes the boundary systems, such as codes of conduct, policy manuals
and procedures
a) Understands the role an organization’s boundary systems play in
9
implementing strategy and strategic control systems
b) Assesses and recommends changes to an organization’s boundary systems
9 9
with respect to implementing the chosen strategy
Boundary Systems
Boundary systems establish rules of the game and identify actions and pitfalls employees must
avoid. Boundary systems are based on the “power of negative thinking”. It works like this: if a
manager wants an employee to do something, are they better off telling them what to do or what
they should not do? With boundary systems, the answer is the latter. It is believed telling people
what to do through the establishment of policies, procedures and rulebooks discourages initiative
and creativity that can be unleashed by empowered, entrepreneurial employees. Telling people
what they should do is thought to stifle innovation and creativity.
In contrast, telling them what not to do allow innovation within clearly defined limits. Boundary
systems stated in negative terms act as the organization’s brakes, outlining the areas where
employees must not go. There is an underlying assumption people are ethical and want to do the
correct thing. It is believed pressure in the workplace to achieve results is what causes employees
to bend the rules. Entrepreneurial individuals can misinterpret the line between acceptable and
unacceptable. Normally, ethics codes are expressed in positive terms; what one should do rather
than what one should not do. Like the Ten Commandments, boundary systems are expressed as
the set of rules one should not break or boundaries one should not cross over. Many companies
find setting strict boundaries for employees is essential, since breaking certain rules can have
profoundly negative impacts. Unfortunately, boundary systems are usually not put in place until
after a public scandal.


Codes of Conduct
Company ethics are the moral values, beliefs and rules that establish the appropriate way for
organizational stakeholders to deal with one another, the organization and the external
environment. They are an amalgamation of societal ethics, professional and individual, and
evolve through negotiation, compromise and bargaining between stakeholders.
Adherence to an ethical code requires that the CEO communicate values and ethics to all
employees through employee training programs, management involvement and strong
endorsement. Any applicants who do not exhibit compatible character traits should be screened
out during the hiring process. Guidelines to prevent unethical behaviour must be established and
unethical behaviour must be punished. Ethics should be mentioned in the mission statement and
whistle blowing (reporting incidents of dishonest or unethical behaviour without fear of reprisal)
should be an acceptable practice. Larger organizations can even create a position for an ethics
officer. Company activities must be conducted within bounds of what is considered ethical and
in the public interest and corporate social responsibility should be celebrated and practiced.
Highly ethical organizations respond positively to emerging societal priorities and expectations
and demonstrate a willingness to take required action ahead of regulatory confrontation; there
should also be a willingness to be a “good citizen” in the community.
In order to ensure fairness among stakeholders, property rights must be considered. For
example, shareholders expect some form of return on their investment (normally the strongest
property rights); employees expect respect for their worth and devoting their energies to the
organization; customers expect reliable, safe products and services; suppliers and distributors
expect an equitable relationship with an organization; and a community expects businesses to be
good citizens in their community.
A culture based on ethical principles is vital to long-term strategic success. Some topics found in
company ethics codes include issues surrounding:
• supplier and distributor relations
• fairness in marketing practices
• using inside information
• conflicts of interest
• corrupt practices
• acquiring information
• political activities
• use of company assets
• proprietary information
• pricing
Some benefits of ethical behaviour in business include the regulation of the pursuit of self-
interest, maintenance of legality, people not wasting time trying to decide what is appropriate
and upholding fair competition (based on price and quality), which yields gains for consumers
and creates a positive reputation effect; acting ethically promotes the good of society.


Policy and Procedure Manuals
Many organizations have policy and procedures manuals. For example, they normally contain
job descriptions for all the positions in the organization; therefore, they are useful for orientating
and training new employees. They spell out the proper way to do things and can be useful as a
reference. Policy and procedure manuals are time consuming to create and keeping them up to
date means they must be reviewed regularly. The downside of policy and procedure manuals is
they are so seldom used and are often left on a shelf and only consulted when it is time to review
them again. However, the process of writing and reviewing can be valuable as it forces
managers to rationalize and assess how things are done in the organization.


Balanced Scorecard
1.3.2.3 Describes the performance measurement and incentive system (e.g. the
Balanced Scorecard)
a) Understands the role an organization’s performance measurement and
incentive system plays in implementing strategy and strategic control 9
systems
b) Assesses and recommends changes to an organization’s performance
measurement and incentive system with respect to implementing the 9 9
chosen strategy
Note to candidates: This material is identical to the Balanced Scorecard material presented in the
Performance Measurement section of this manual. The CMA Competency Map lists this topic in
both sections, which means this topic could appear in either the Performance Management or the
Performance Measurement sections of the Entrance Examination. This material is included in
both sections of this manual to emphasize this fact to candidates.
The following material has been extracted from the CMA Canada Management Accounting
Guideline ‘Applying the Balanced Scorecard”. It has been reprinted with permission.
The Balanced Scorecard

The balanced scorecard is a focused set of vital financial and non-financial measures of
performance. The Balanced Scorecard was initially put forth by Robert Kaplan and David
Norton in the 1990s.
The four categories [financial, customer, internal business processes, learning and growth] in
Kaplan and Norton’s Balanced Scorecard can be described as:
i) Financial
The first category on the Kaplan and Norton balanced scorecard is financial. Managers
devising financial measures should ask themselves, “How can we show our strategy is
succeeding financially?” At the highest level, long-term profitability and stock price
growth demonstrate financial success of the strategy. But managers should also consider
financial measures particular to their strategy. If the organization is young and on a high-
growth trajectory, sales growth by sales channel may be a critical financial measure. If the
organization operates in a mature business, cash flow may be the right measure. If it falls
in between, economic profit, a measure that charges the company for the cost of equity
capital, may be the correct measure.


ii) Customer.
The second category in the Kaplan and Norton model is the customer perspective.
Managers devising customer measures should ask themselves, “How can we show we’re
delivering to customers the value they expect?” At the highest level, many companies track
customer satisfaction. But other measures are necessary, like customer retention, market
share and share of wallet (i.e. share of a customer’s business in a particular product or
service line). Companies may also devise specific surveys. For example, Eastman
Chemical surveys companies to find out how they score Eastman on “customer value”.
iii) Internal business process.

The third category in the Kaplan and Norton model is internal business. Managers
developing measures for this perspective should ask, “What processes must we excel at to
deliver value to our customers?” For example, Analog Devices measures chip yield, cycle
time, on-time delivery and parts per million defects to gauge the performance of
manufacturing processes. CIGNA Property & Casualty, the Philadelphia insurer acquired
by Ace Ltd. of Bermuda, developed a system to measure underwriting quality (by survey)
and loss ratio (claims paid divided by premium collected) to gauge the quality of its
underwriting processes.
iv) Learning and growth.

The fourth category in the Kaplan and Norton model is learning and growth. For this
perspective, managers should ask, “What action must the company take to prepare the
people and organization for the future?” As an example, CIGNA Property & Casualty
developed measures for competency development, key staff turnover and acquisition of
key staff. Whirlpool developed measures of variables such as completion of cultural
milestones and, by survey, strength of leadership, commitment and diversity. The measures
in the learning and growth perspective stress re-skilling, systems development, change
procedures and development of personal and organizational capabilities.

Page 426

Monitoring and Updating Strategy
1.3.2.4 Describes the system for continuous monitoring and updating of an
organization’s strategy
a) Understands the role an organization’s strategic monitoring system plays
9
in implementing strategy and strategic control systems
b) Assesses and recommends changes to an organization’s strategic
9 9
monitoring system with respect to implementing the chosen strategy
c) Understands the role the Board of Directors plays in monitoring and
9
updating an organization’s strategy (see F2.3.1.1)
It is not sufficient that an organization implement a chosen strategy, it is critical to monitor and
adapt strategies to changing environmental conditions. A strategy, which is successful today,
may not be successful tomorrow.
It is the role of both senior management and the Board of Directors to continually monitor the
success of an organization’s current strategies and adapt or, alternatively, develop new strategies.


Best Practices in Strategy Implementation
1.3.3 Describes best practices and current innovations in strategy implementation
9
in a given industry (e.g. strategy mapping, entrepreneurial orientation)
Candidates are advised to keep up-to-date on current innovations and best practices by reading
CMA Magazine and CMA Canada Management Accounting Guidelines, which can be found at
www.cma-canada.org. As best practices and current innovations are continually evolving, it is
up to the candidate to keep current through reading literature published by CMA Canada.
Note to candidates: This topic is rarely examined.


Internal Control, Risk Management and Governance

Table of Contents
Internal Control
ROLE OF INTERNAL CONTROL AND INTEGRITY, ETHICS AND COMPETENCE ............................ 429
SEGREGATION OF DUTIES ....................................................................................................................... 429
ACCESS CONTROLS, AUTHORITY LIMITS, VALIDITY CHECKS ...................................................................... 430
INTERNAL CONTROLS AND EFFICIENCY AND EFFECTIVENESS .................................................................... 430
INFORMATION SYSTEMS AND THE CONTROL SYSTEM ................................................................................ 430
THE CONTROL ENVIRONMENT ............................................................................................................ 431
INTEGRITY AND ETHICAL VALUES ............................................................................................................. 432
COMMITMENT TO COMPETENCE ............................................................................................................... 432
BOARD OF DIRECTORS OR AUDIT COMMITTEE .......................................................................................... 432
MANAGEMENT’S PHILOSOPHY AND OPERATING STYLE .............................................................................. 433
ORGANIZATIONAL STRUCTURE................................................................................................................. 433
ASSIGNMENT OF AUTHORITY AND RESPONSIBILITY ................................................................................... 434
HUMAN RESOURCE POLICIES AND PRACTICES.......................................................................................... 434
RISK IDENTIFICATION AND ANALYSIS ............................................................................................... 435
EXTERNAL RISKS .................................................................................................................................... 435
INTERNAL RISKS ..................................................................................................................................... 435
COMMUNICATION................................................................................................................................... 436
CONTROL ACTIVITIES ........................................................................................................................... 437

INFORMATION SYSTEM CONTROLS ........................................................................................................... 438
MONITORING........................................................................................................................................... 440
ROLES AND RESPONSIBILITIES FOR INTERNAL CONTROL ........................................................... 441

ROLES AND RESPONSIBILITIES ................................................................................................................. 441
EXTERNAL AUDITORS ATTESTATION OF INTERNAL CONTROL EFFECTIVENESS ..................... 443
EXTERNAL AUDITOR ATTESTATION RE: INTERNAL CONTROL ..................................................................... 443
SOX AND INTERNAL CONTROL............................................................................................................ 444
THE SARBANES OXLEY ACT OF 2002 – SECTION 302 AND 404 REQUIREMENTS ........................................ 444
STEPS IN THE CONTROL PROCESS.................................................................................................... 446
STEPS IN THE INTERNAL CONTROL PROCESS ........................................................................................... 446
STEPS IN DEVELOPING SPECIFIC CONTROLS ............................................................................................ 447
CONTROL WEAKNESSES...................................................................................................................... 448
INHERENT WEAKNESSES OF INTERNAL CONTROL ..................................................................................... 448
CONTROLS TO ADDRESS INHERENT WEAKNESSES.................................................................................... 449
EMPLOYEE RESPONSES TO CONTROL.............................................................................................. 450
BEHAVIOURAL RESPONSES TO CONTROL ................................................................................................. 450
ROLE OF THE EXTERNAL AUDITOR.................................................................................................... 451
THE EXTERNAL AUDIT RISK MODEL ......................................................................................................... 451

INTERNAL CONTROL PROBLEMS........................................................................................................453
IC1 PROBLEM: INTERNAL CONTROL - MCQ .............................................................................................453
INTERNAL CONTROL SOLUTIONS .......................................................................................................457
IC1 SOLUTION: INTERNAL CONTROL - MCQ.............................................................................................457
Risk Management
ENTERPRISE RISK MANAGEMENT ......................................................................................................459
DRIVERS OF INCREASED RISK AWARENESS ..............................................................................................461
APPROACHES TO RISK MANAGEMENT.......................................................................................................461
THE PROCESS OF RISK MANAGEMENT .....................................................................................................462
RISK MANAGEMENT FOR SPECIFIC BUSINESS FUNCTIONS .........................................................................465
INFORMATION RISK ..................................................................................................................................465
RISK ASSESSMENT IN DUE DILIGENCE ......................................................................................................465
COMPREHENSIVE RISK MANAGEMENT ......................................................................................................466
Governance
GOVERNANCE.........................................................................................................................................467
ROLE AND RESPONSIBILITIES OF THE BOARD OF DIRECTORS .....................................................................468
COMMITTEES OF THE BOARD OF DIRECTORS ............................................................................................468
IMPROVING THE PERFORMANCE OF CORPORATE BOARDS .........................................................................471

Role of Internal Control and Integrity, Ethics and
Internal Control
Competence
2.1.2.1 Discusses the objectives and role of internal control with respect to integrity,
ethical values and competence
• Explains how an organization’s integrity and internal controls are
9
dependent on proper segregation of duties
• Explains how internal controls, such as access controls, authority limits
and validity checks, provide reasonable assurance of the accuracy of an
organization’s accounting records and discourage fraud and 9
misappropriation of assets
• Discusses how internal controls, such as selection and training of
employees, improve the efficiency and effectiveness of an organization’s 9
operations
• Explains the role information systems play in an organization’s control
9
system
• Recognizes ethical considerations in making business decisions 9
Segregation of Duties
First, it is important to understand what segregation of duties entails. There are three general
guidelines for segregation of duties:
• separation of the custody of assets from accounting
This protects a company from defalcation. If a person has both custody of the asset and is
responsible for accounting for it, there is a risk the person may use or steal the asset for
personal gain and adjust the accounting records to cover their tracks.
• separation of authorization of transactions from custody of related assets

As with separation of asset custody from asset recordkeeping, it is important to segregate
authorization and custody, otherwise, the risk of defalcation increases. For example, the same
person should not authorize the payment of an invoice and sign the cheque in payment of the
bill.
• separation of operational responsibility from record keeping responsibility

If individual departments or divisions are responsible for preparing their own reports, the
individual unit would have a bias to show improved results. To ensure information is free
from bias, record keeping is often performed by a different department.


Access Controls, Authority Limits, Validity Checks
Access controls, authority limits and validity checks help ensure an organization’s financial
reporting is accurate, as well as discourage fraud. Access controls, which can be either physical
or within the organizations computer system, ensure the company’s records cannot be tampered
with by unauthorized individuals. Authorization controls are used to ensure employees carry out
authorized transactions only. These controls can be either manual, such as requiring a
supervisors signature on transactions exceeding a certain amount or automated. Validity checks
refer to ensuring that the financial data is input is approved and represents actual economic
events. An example is a computer program that compares the name of a vendor with a vendor
list maintained within the organization’s database when cheques to pay accounts payable are
prepared.
Internal Controls and Efficiency and Effectiveness

Internal controls are not only designed to ensure accurate financial reporting and compliance
with regulations, but should also be designed to ensure the organization’s operations achieve
objectives related to effectiveness and efficiency.
Internal controls should be in place to ensure processes are doing what they are intended to do
(i.e. achieving their objectives) and doing so in an efficient manner (i.e. making good use of
available resources).
Information Systems and the Control System

Information systems play a critical role in implementing control systems, since many controls
can be automated. For example, an employee may be authorized top process transactions up to a
limit of $25,000; the computer system can be programmed so the employee is unable to input
any transactions exceeding this amount.
In addition, computer systems can log attempts to misappropriate a company’s assets or other
such unauthorized activity. These logs are reviewed and any necessary action can be taken.


The Control Environment
Internal Control
2.1.2.2 Explains the impact of the following on overall organizational control:
management’s philosophy and leadership style organizational structure,
assignment of authority and responsibility, personnel policies and
procedures, and the external environment
a) Explains how the following improve an organization’s control
environment and reduce the potential for deviant employee
behaviour: corporate code of conduct, strong ethical culture, 9
organizational structure, assignment of authority and
responsibility, and personnel policies and procedures
b) Explains how the integrity of the CEO and senior management
9
set the “tone from the top”
c) Explains how an organization’s control environment is affected
by the external environment (both domestic and international),
9 9
evaluates the effectiveness of internal controls in light of changes
in the external environment and proposes improvements
2.1.2.3 a) Understand the elements of the control environment (e.g. culture,

ethical values, integrity, commitment to competence, personnel
policies and procedures, management’s philosophy and
leadership style, organizational structure, methods of assigning
authority and responsibility, participation by those charged with
governance) and explains how each contributes to the
organization’s control system
The control environment refers to the overall ‘tone’ the organization has towards internal control.
This attitude toward internal control sets the foundation for all other components of internal
control; it provides discipline and structure to the creation of internal controls. The control
environment is broken into the following factors:
• Integrity and ethical values

• Commitment to competence
• Board of Directors or Audit Committee
• Management’s philosophy and operating style
Each of these is discussed below.


Integrity and Ethical Values
This consists of:
• Management Example
Management sets an example by conducting business with employees, suppliers,
customers, investors, creditors, insurers, competitors and auditors, etc. in an ethical
manner and insisting others do so as well.
• Codes of Conduct
The existence and enforcement of codes of conduct and other policies regarding
acceptable business practice, conflicts of interest or expected standards of ethical and
moral behaviour. The codes of conduct may be formal or informal.
• Unrealistic Pressures
This refers to pressure to meet unrealistic performance targets, which can be indirect
pressure or direct pressure by basing compensation on achieving the unrealistic
performance targets.
Commitment to Competence
This consists of:
• Formal or informal job descriptions that define tasks for particular jobs.
• Analysis of the knowledge and skills needed to perform jobs adequately (e.g. through
proper interviews for potential employees, adequate screening of applicants skills etc.)
Board of Directors or Audit Committee

The Board of Directors and the Audit Committee set the overall ‘tone from the top’. In other
words, the attitude an organization has towards internal control is largely determined by the
Board of Directors attitude towards internal control.
Other considerations for the Board of Directors are:

• Independence of the Board of Directors and its Audit Committee
Independence from management is necessary so difficult and probing questions are
raised, should the need arise.
• Frequency and Timeliness of Meetings

Frequency and timeliness meetings are held with the chief financial officer, internal
auditors and external auditors.


• Sufficiency and Timeliness of Information provided to the Board of Directors
Internal Control
The Board of Directors and the Audit Committee must receive sufficient information on a
timely basis to allow monitoring of management’s objectives and strategies, the
organization’s financial position and operating results, and terms of significant
agreements.
In addition, the Board needs to be apprised of sensitive information, investigations and improper
acts on a timely basis in order to address the issues.
Management’s Philosophy and Operating Style

In addition to setting the tone from the top, the following factors must be considered:
• Nature of business risks accepted

This refers to whether management enters into high risk business proposals or is overly
conservative in accepting risk.
• Frequency of interaction between senior management and operating management

This is particularly important when operating from geographically separate locations.
• Attitudes and actions toward financial reporting

This includes mechanisms to address disputes over application of accounting treatments
(e.g. selection of conservative vs. liberal accounting policies; whether accounting
principles have been misapplied, important financial information not disclosed or records
manipulated or falsified.)
Organizational Structure
This refers to:
• Appropriateness of the entity’s organizational structure
The structure must be able to provide the necessary information flow to manage its
activities.
• Adequacy of definition of key managers’ responsibilities and their understanding of these

responsibilities.
• Adequacy of knowledge and experience of key managers in light of responsibilities.


Assignment of Authority and Responsibility
This consists of:
• Assignment of responsibility and delegation of authority
Employees need both the responsibility and the authority to deal with organizational
goals and objectives, operating functions and regulatory requirements, including
responsibility for information systems and authorization for changes.
• Appropriateness of control-related standards and procedures, including employee job

descriptions.
• Appropriate numbers of people, particularly with respect to data processing and

accounting functions, with the requisite skill level relative to the size of the entity and
nature and complexity of activities and systems.
Human Resource Policies and Practices

This refers to:
• Extent to which policies and procedures for hiring, training, promoting and compensating
employees are in place.
• Appropriateness of remedial action taken in response to violations from approved
policies and procedures.
• Adequacy of employee candidate background checks, particularly with regard to prior
actions or activities considered to be unacceptable by the entity.
• Adequacy of employee retention and promotion criteria and information gathering
techniques (e.g. performance evaluations) and relation to the code of conduct or other
behavioural guidelines.


Risk Identification and Analysis
Internal Control
2.1.2.3 b) Understands the role of risk assessment in the development of internal
controls for a given organization and the processes it uses to identify 9
business risks and decide on actions that address those risks
An organization’s performance can be at risk due to internal or external factors, which can affect
the company’s stated or implied objectives. An entity’s risk assessment process should be
comprehensive and consider risks that may occur. There are two types of risks that need to be
considered, external and internal.
The risk analysis process needs to be thorough and relevant and include:
• estimating the significance of a risk
• assessing the likelihood of the risk occurring
• considering how the risk should be managed
External Risks
The organization needs to ensure there are adequate mechanisms to identify risks arising from
such external factors as:
• technological developments
• changing customer needs or expectations
• competition
• new legislation or regulation
• natural catastrophes
• economic changes
Internal Risks
The organization needs to ensure there are adequate mechanisms to identify risks arising from
such internal factors as:
• disruption in information systems
• quality of personnel hired and methods of training and motivation
• change in management responsibilities
• nature of the entity’s activities and employee accessibility to assets
• unassertive or ineffective Board or Audit Committee


Communication
2.1.2.3 d) Understands how a given organization communicates roles and
9
responsibilities pertaining to internal control and reports exceptions
This refers to:

• The effectiveness with which employees’ duties and responsibilities are communicated.
Examples include proper job descriptions and meetings with supervisors to ensure both
the supervisor and employee understand the tasks involved in a job.
• Establishment of channels of communication for people to report suspected

improprieties. An example includes an anonymous whistle blowing phone line or e-mail
address.
• Receptivity of management to employee suggestions of ways to enhance productivity,

quality or other similar improvements. If management pays attention to and/or acts on
employee suggestions, employees are more apt to communicate to management more
often.
• Adequacy of communication across the organization (for example, between purchasing

and production operations), the completeness and timeliness of information and its
sufficiency to enable people to carry out their responsibilities effectively.
• Openness and effectiveness of channels with customers, suppliers and other external
parties for communicating information on changing customer needs.
• Extent to which outside parties have been made aware of the organization’s ethical
standards.
• Timely and appropriate follow-up action by management resulting from communications

received from customers, vendors, regulators or other external parties.


Control Activities
Internal Control
2.1.2.3 e) Explains how an organization’s control activities (e.g. IT controls,
physical controls, approvals, verifications, supervision and security of
9 9
assets) help ensure management directives are carried out (see also
2.1.2.1)
Control activities refer to policies (which establish what should be done) and procedures (the
actions of people to carry out policies) to help ensure management guidelines or rules identified
as necessary to address risks are carried out. Policies and procedures can be divided into three
categories:
• operations
• financial reporting
• compliance
Various controls may be put into place to ensure objectives are met. Internal control activities
include:
1. Preventative – used to prevent errors or inappropriate actions from occurring and function
prior to activities or transactions. Examples: Credit checks, separation of duties,
supervisory reviews, accuracy checks etc.
2. Detective – intended to detect errors or inappropriate actions after they have occurred.
Detective controls being in place in and of themselves are a type of preventative control.
Example: Bank reconciliations.
3. Corrective – correct the problems identified by detective controls. Example: An edit in
an application problem that detects errors in coding.
4. Directive – emphasize positive actions and results and specify certain activities.
Example: Management telling a foreman to hire local workers when possible.
5. Compensating – are in place because of possible shortcomings with other controls. They
are fail-safe controls and introduce redundancy. Example: Someone other than the
person responsible for disbursements doing the bank reconciliation compensates for the
detective control, the bank reconciliations and shortcomings.
Control activities are not carried out for their own sake or because they seem to be “the right and
proper” thing to do. They serve as mechanisms for and are very much a part of managing the
achievement of objectives. The following are examples of major types of control activities
designed to keep companies “on track” toward achieving their objectives:
• Top level reviews.

Major organizational initiatives, plans or projects are tracked to measure performance
against targets. Management actions taken to follow-up on problem areas identified in
this type of reporting are considered control activities.


• Functional or departmental management
Managers who are directly responsible for running various departments or areas check
reports and compare results to targets.
• Information processing
Various controls should be in place to check accuracy, completeness and proper
authorization for transactions. Entry data is checked, numerical sequences of transactions
are accounted for, balances are compared and reconciled, exceptions are acted upon and
reported, if necessary, changes to existing systems and development of new ones are
controlled and access to information is appropriately authorized.
• Physical controls
Assets such as equipment, inventories, supplies, securities and cash are periodically
counted and the number compared with control records. In addition, doors should be
locked where necessary.
• Performance indicators.
Performance indicators can be used to serve both operational and financial reporting
control purposes. Relating different sets of data, along with analysis of the relationships
and investigative and corrective actions, can serve as control activities.
• Segregation of duties.
Job duties or responsibilities are divided among different people to reduce the risk of
error or fraud.
Information System Controls

Information system controls can be broken into two types, general controls and application
controls.
General Controls
• Data center operations
Controls include job setup and scheduling, operator actions, backup and recovery
procedures and contingency or disaster recovery planning. In sophisticated environments,
capacity planning and resource allocation and use are also included.
• System software.
Controls should cover the effective acquisition, implementation and maintenance of
system software – operating system, data base management systems, telecommunications
software, security software and utilities.

Page 438

• Access security
Appropriate access should be authorized for those needing the systems to perform desired
Internal Control
work. A variety of practices can be used to grant or limit access; for example, use of
passwords or user IDs.
• System development methodology

Controls must be in place to provide a structure for system design, implementation,
documentation requirements, approvals, testing and maintenance. Since systems
development is typically high cost, it is necessary to ensure an appropriate and effective
structure is in place.
Application Controls
Application or program controls are fully automated (i.e. performed automatically by the
computer system) and are designed to ensure the complete and accurate processing of data from
input through output. These controls vary based on the business purpose of the specific
application. These controls may also help ensure the privacy and security of data transmitted
between applications. Categories of application controls may include:
• Completeness checks – controls that ensure all records were processed from initiation to
completion.
• Validity checks – controls that ensure only valid data is input or processed.
• Identification – controls that ensure all users are uniquely and irrefutably identified.
• Authentication – controls that provide an authentication mechanism in the application
system.
• Authorization – controls that ensure only approved business users have access to the
application system.
• Problem management – controls that ensure all application problems are recorded and
managed in a timely manner.
• Change management – controls that ensure all changes on production environment are
implemented with preserved data integrity.
• Input controls – controls that ensure data integrity are fed from upstream sources into the
application system.

Page 439

Monitoring
2.1.2.3 f) Understands that monitoring the components of the internal control
system, making improvements and adjusting the system for changes in
9
conditions are necessary to maintain and improve the system’s
effectiveness
Monitoring refers to the following three subsets of activity:

1. Ongoing Monitoring by Departmental Management and Employees
2. Separate Evaluations (e.g. by Internal Audit)
3. Reporting Deficiencies
1. Ongoing Monitoring by Departmental Management and Employees

This refers to:
• Extent to which personnel, in carrying out their regular activities, obtain evidence as to
whether the system of internal control continues to function and problems that are
identified are acted upon.
• Extents to which communications from external parties corroborate internally generated
information or indicate a problem, and this communication is acted upon.
• Periodic comparison of amounts recorded by the accounting system with physical assets.
• Responsiveness to internal and external auditor recommendations on means to strengthen
internal controls.
• Extent to which training seminars, planning sessions and other meetings provide
feedback to management on whether controls operate effectively.
• Whether personnel are asked periodically to state whether they understand and comply
with the entity’s code of conduct and regularly perform critical control activities.
2. Separate Evaluations
This consists of:
• Scope and frequency of separate evaluations of the internal control system.
• Appropriateness of the evaluation process.
• Whether the methodology for evaluating a system is logical and appropriate.
• Appropriateness of the level of documentation.
3. Reporting Deficiencies
This refers to:
• Existence of mechanism for capturing and reporting identified internal control
deficiencies.
• Appropriateness of reporting protocols.
• Appropriateness of follow-up actions.


Roles and Responsibilities for Internal Control
Internal Control
2.1.2.4 Identifies the steps in the process of developing and maintaining a system of
internal controls, including the roles and responsibilities of various
stakeholders and internal audit
a) Explains why senior management owns an organization’s control system 9
b) Explains why the accounting/finance/IT staff are primarily responsible
for the development and maintenance of an organization’s internal 9
control system
c) Explains why the Board of Directors and the Audit Committee establish
guidelines and provide oversight regarding an organization’s control 9
system
d) Explains why the internal auditor tests and suggests improvements to an
organization’s control system, but should not develop or maintain the 9
system
g) Explains the effects of computer-based information systems on internal
9
control, business ethics and fraud
The following excerpt from ‘Internal Control — Integrated Framework’ published by COSO
(Committee of Sponsoring Organizations) best describes the roles and responsibilities for
internal control.
Roles and Responsibilities

Everyone in an organization has responsibility for internal control:
• Management
The chief executive officer is ultimately responsible and should assume "ownership' of
the system. More than any other individual, the chief executive sets the "tone at the top"
that affects integrity and ethics and other factors of a positive control environment.
• Board of Directors
Management is accountable to the Board of Directors, which provides governance,
guidance and oversight. A strong, active Board, particularly when coupled with effective
upward communications channels and capable financial, legal and internal audit
functions, is often best able to identify and correct such a problem.


• Internal Auditors
Internal auditors play an important role in evaluating the effectiveness of control systems
and contribute to ongoing effectiveness. Because of organizational position and authority
in an entity, an internal audit function often plays a significant monitoring role.
• Other Personnel
Internal control is, to some degree, the responsibility of everyone in an organization and,
therefore, should be an explicit or implicit part of everyone's job description.


External Auditors Attestation of Internal Control
Internal Control
Effectiveness
2.1.2.4 e) Explains why external auditors may attest to the effectiveness of an
9
organization’s control system
External Auditor Attestation Re: Internal Control

The Sarbanes-Oxley Act requires the annual report contain an internal control report that:
• states the responsibility of management for establishing and maintaining an adequate

internal control structure and procedures for financial reporting, and
• contains an assessment, as of the end of the company’s fiscal year, of the effectiveness of
the internal control structure and procedures of the company for financial reporting.
The external auditor must attest to and report on the above assessment as a part of the audit
process. For this reason, public companies, which must comply with the Sarbanes-Oxley Act,
require the external auditor attests to the effectiveness of the company’s control system.


SOX and Internal Control
2.1.2.4 f) Understands how laws and regulations, such as Section 404 of the
Sarbanes Oxley Act of 2002 and Canadian Securities Administrators
9
Multilateral Instruments 52-111 and 52-109, impact an organization’s
internal control system
Note to candidates: For the purposes of the Entrance Examination, candidates should understand
that SOX exists and its purpose. Candidates are advised to limit the time spent studying this
topic.
The below has been extracted from CMA Canada’s Management Accounting Guideline
“IDENTIFYING, MEASURING AND MANAGING ORGANIZATIONAL RISKS FOR
IMPROVED PERFORMANCE”. It is reprinted with permission of CMA Canada.
The Sarbanes Oxley Act of 2002 – Section 302 and 404

Requirements
The Sarbanes-Oxley Act of 2002 creates new requirements for managers and accounting
professionals related to corporate governance, including the responsibilities of directors and
officers, the regulation of accounting firms that audit public organizations, corporate reporting
and enforcement. Sections 302 and 404 particularly have created significant new requirements
related to internal control and the assessment of risk.
Under Section 302, the chief executive and financial officers of each publicly reporting company
are required to certify each periodic (i.e. quarterly and annual) report filed or submitted to the
SEC. The chief executive officer and chief financial officer must personally sign the
certification— another executive under a power of attorney cannot sign the certification. Section
302 requires the certification to cover the review of the report, its material accuracy and fair
presentation of financial information, disclosure controls and internal accounting controls.
The internal control requirements in Section 404 represent the more important aspects of the act
to a corporation and its external auditors. Management always has been responsible for preparing
periodic financial reports; external auditors reviewed those financial numbers and certified they
were fairly stated as part of their audit. Under the Sarbanes-Oxley Act, management is now
responsible for documenting and testing its internal financial controls in order to prepare a report
on their effectiveness.


More specifically, management’s process for evaluating the effectiveness of the company’s
internal controls must include:
Internal Control
• Determination of what controls are significant, which should include controls over
transactions (routine, non-routine, estimation and judgment), fraud, controls on what
other significant controls are dependent on the financial statement close process and the
locations or reporting entities to be included in the evaluation;
• The documentation of controls related to management’s assertion, including each of the
five COSO definitions of internal control, controls designed to detect or prevent frauds or
errors in significant accounts, transactions or disclosures, the financial statement close
process and controls over safeguarding of assets;
• Evaluation of design and most effective combination of manual and IT controls;
• Evaluation of the operating effectiveness by the testing of controls by internal audit or
third parties under the direction of management or a self-assessment process that includes
procedures to verify controls are working effectively. Inquiry alone is not adequate; and
• Determination of what control deficiencies constitute significant deficiencies or material
weaknesses (Sheridan, 2003).
A self-assessment alone is not enough without the documentation and testing to back it up. The
external auditors also review the supporting materials leading up to the internal financial controls
report to assert the report is an accurate description of the internal control environment. The
report should cover key information such as risk control description, specification of those
performing the control, types of controls, frequency, evidence and results of testing from an
efficiency point of view.


Steps in the Control Process
2.1.2.4 h) Outlines and explains the steps in the control process (e.g. developing
objectives, measuring results, comparing actual performance against
objectives, analyzing the causes of differences, determining appropriate 9
managerial action, taking appropriate action and continually
reappraising)
i) Explains the process of developing controls to mitigate a specific internal
risk (e.g. define the risk, estimate the magnitude/impact of the risk,
estimate the likelihood of the risk, identify alternative controls, perform a
9
cost/benefit analysis for each alternative, select a control, implement the
chosen control, continuously monitor to ensure the control is achieving
its objective)
Steps in the Internal Control Process

1. Development of objectives
2. Measurement of results
3. Comparison of actual performance against objectives
4. Analysis of the causes of differences
5. Determination of appropriate managerial action
6. Taking action
7. Continuing reappraisal
Step 1: Development of Objectives

This refers to the objective of internal control. For example, the objective of implementing limits
on granting credit is to reduce losses from bad debts. The objective of an internal audit would be
to determine if the introduction of limits actually resulted in the reduction of bad debt losses.
Steps 2 and 3: Measurement of Results and Comparison to Objectives

This is a measurement of the risk the internal control was designed to address. In the example
above, a measurement could be bad debt losses as a percentage of sales after the credit limits
were introduced, compared to the percentage prior to the introduction of the control.


Step 4: Analysis of Causes of Difference
If the impact of the control was ineffective, it is important to determine why so corrective action
Internal Control
can be taken. If the credit granting control mentioned above is not effective, reasons could
include the control is not being followed or the limits are still too high.
Step 5: Determination of Appropriate Managerial Action

Managerial action must take place to address the differences. Managerial action could take many
different forms, such as, implementing monitoring controls or implementing alternative controls.
Step 6: Taking Action

It is important management take the recommended course of action from internal auditors.
Ultimately management is accountable to the Board of Directors and, therefore, must take action.
Step 7: Continuing Reappraisal

Constant reappraisal of controls is necessary to determine if the control is still effective. If new
controls or additional controls are required, they can be implemented.
Steps in Developing Specific Controls

The eight steps involved in developing controls to address specific risks are:
1. Define the risk
2. Estimate the magnitude/impact of the risk
3. Estimate the likelihood of the risk
4. Identify alternative controls
5. Perform a cost/benefit analysis for each alternative
6. Select a control
7. Implement the chosen control
8. Continuously monitor to ensure the control is achieving its objective


Control Weaknesses
2.1.2.5 Describes the potential control problems in established processes (e.g. with
respect to segregation of duties, data entry and output quality) and suggests
changes to correct deficiencies that are discovered
a) Identifies inherent weaknesses in an organization’s control system
(e.g. human error, management override, collusion, unauthorized use,
virus attacks, theft) and proposes improvements (e.g. input controls,
9 9
independent checks, access controls, disaster recovery, security,
preventive/detective/corrective controls, quality assurance, timely
recording and reporting documentation)
b) Evaluates the cost/benefit of existing and proposed internal controls 9 9
Inherent Weaknesses of Internal Control

There are inherent limitations of internal controls. It is not possible to completely eliminate risks.
Common limitations include:
• Human Error
Human error can never be eliminated. In addition, people can suffer from fatigue or
stress, which increases the risk of human error.
• Management Override
Although controls may be in place, management is often in a position to override those
controls.
• Access
Access to assets should be restricted. However, often it is not possible to limit access to
specific areas. For example, in a large manufacturing plant, it would be virtually
impossible or not cost beneficial to limit access so the employee could only access his
own work area.
• Inconsistent Adherence to Control Procedures

Control procedures may not be consistently followed. This could be due to human error
or a lack of understanding of the importance of the control procedure.


• Conflicts of Interest
An employee may be in a position where he/she is in a conflict of interest position. For
Internal Control
example, an employee with ownership or financial interest in a supplier or a customer of
their employer may want the employer to purchase from or sell at favourable rates to the
company in which he/she has an interest.
• Collusion
Two employees work together to carry out an impropriety to circumvent the control
system.
Controls to Address Inherent Weaknesses

Authorization procedures ensure every transaction is duly authorized and can be general or
specific.
Segregation of duties ensures no employee or group is in a position to perpetrate and conceal

errors or fraud in the normal course of his/her duties. Functions that must be segregated are:
custody of assets, operating responsibility with respect to those assets and responsibility for
recording or reporting transactions in those assets.
Documentation procedures are important because they: (1) help ensure all other desirable
controls are established; (2) help ensure all employees understand their responsibilities and
procedures; and (3) safeguard the investment in systems design when employees turn over. This
includes preparation of procedure and policy manuals, job descriptions, etc.
Accounting records and procedures ensure: (1) prompt preparation of accurate records; and (2)
timely reporting of accounting data to users.
Physical controls restrict access to assets, both directly and indirectly.
Independent internal verifications allow an employee to review the accuracy and propriety of
another employee’s work. These reviews should: (1) be done by an employee who is unrelated
to and independent of the employee they are reviewing; (2) be made frequently; and (3) report
errors promptly to the employee for corrective action.


Employee Responses to Control
2.1.2.6 Identifies common employee responses to control and describes methods to
deal with such behaviours
a) Identifies behavioural responses to control (e.g. creation of budget slack,
data manipulation, negative attitudes), evaluates the potential of these 9 9
responses occurring in a given situation
b) Suggests possible ways to reduce the impact of negative responses to
control (e.g. code of business conduct and ethics, positive corporate 9 9
culture, participation, communication of rationale for control)
Behavioural Responses to Control

Controls are either resisted or embraced. Often, if an employee has not participated in the
development of the control, the control is not understood and is resisted. When designing and
enforcing controls, it is important to consider employee reactions to the control. To ensure
controls are understood and, therefore, more likely to be accepted, an organization should
communicate with employees the purpose of the control. If an employee does not understand the
control, he/she will find it meaningless and restrictive and likely perform the control
inconsistently.
Employees are sometimes unable or unwilling to act in the best interests of the organization.
Inability can be overcome through training, procedures and policies. Unwillingness is more
problematic, but can be mitigated through positive incentives such as bonuses, profit sharing,
promotions and other rewards that link desirable efforts or results with extrinsic benefits.
In some situations, managers can avoid control problems by allowing no opportunities for
improper behaviour by:
1. Replacing employees with capital investments, where possible,
2. Centralize control,
3. Share the risk with an outside body, such as an insurance company, and
4. Eliminate activities or operations entirely through sub-contracting or divestiture.
Employees may engage in a variety of behaviours for self-interest. Three methods for
employees to manipulate information include smoothing, gaming and data falsification.


Role of the External Auditor
Internal Control
2.1.2.7 Describes the role of the external auditor
a) Understands the audit planning process and the expectations of the
9
external auditor
b) Understands the audit risk model (ARM) and auditor liability 9
The External Audit Risk Model

Acceptable audit risk is a measure of how willing the auditor is to accept that the financial
statements may be materially misstated after an unqualified (‘clean’) opinion is issued. In other
words, the risk the auditor is willing to accept of wrongly issuing a “clean opinion”. This risk
level is affected by:
• The number of external users relying on the financial statements and the extent of their
reliance (e.g. how widely disbursed is the organization’s ownership; is it going public?)
• Likelihood the client will have financial problems after the audit is completed
• Integrity of management (the less integrity management has, the lower audit risk the
auditor will be willing to accept).
The audit risk model or ARM, is designed to quantify the risks associated with an audit and
consists of inherent risk, control risk and detection risk. These risks are defined as:
Inherent risk (IR)

Inherent risk has been defined by the International Standards on Auditing (ISA 400) as
‘the susceptibility of an account balance or class of transactions to misstatement that could be
material, individually or when aggregated with misstatements in other balances or classes,
assuming there were no related internal controls'. In other words, this is the risk of a significant
misstatement occurring because of the nature of the organization’s business.
Control risk (CR)

Control risk measures the likelihood a material misstatement(s) relating to the financial
statements will not be prevented or detected on a timely basis by the client's internal control
system. In other words, this risk measures risk of controls failing to catch a significant
misstatement (i.e. internal controls fail).


Detection risk (DR)
Detection risk is defined as the likelihood a material misstatement will be not detected by the
auditor's substantive testing. It is important to note that detection risk indicates the risk the
auditor is willing to "live with" given his desired audit risk and his assessment of inherent and
control risk. This means if the detection risk is high, the auditor is willing to accept a high
detection risk and will do less substantive testing compared to a situation where the detection
risk is low. In simple terms, detection risk is the risk that the audit evidence the external auditor
collects won’t identify significant misstatements. If the auditor sets detection risk at a high
amount, the auditor accepts the risk that a significant misstatement won’t be detected, which
means less evidence is required.
The ARM combines the above-noted risks in a formula and uses the results to determine how
much audit evidence is required. The formula is:
Audit Risk = IR x CR x DR
Given the explanations of the relevant terms above, the purpose of this equation is to determine
detection risk, which then indicates to the auditor how much substantive testing has to be
performed to arrive at the desired audit risk.


Internal Control Problems
IC1 Problem: Internal Control - MCQ
1. Which of the following is not an objective of internal control?
a. Effectiveness and efficiency of operations
b. Achievement of earnings per share targets
c. Reliability of financial reporting
d. Compliance with applicable laws and regulations
2. Recent models of control emphasize the following as critically important for internal
control.
a. Values
b. International expansion
c. Computerization of systems
d. The Internet
Internal Control - Problems

3. Which of the following refers to making required purchases at the most favourable
prices?
a. Economy.
b. Efficiency.
c. Effectiveness.
d. Internal control.
4. Which is an example of a conflict of interest?

a. Lack of internal controls
b. A long-term employee
c. A nephew who works for his uncle
d. A vendor list
5. Which is not a limitation of internal control?

a. Human error
b. Carelessness
c. Fatigue and stress
d. Policies and procedures
6. A failure of the internal control system to attain intended results may be due to each of
the following, except for:
a. When employees fail to act in the interests of the organization
b. Competition is more severe than anticipated
c. The control system is designed inappropriately
d. The control system fails to detect a control is not working


7. In designing systems of internal control, the following must exist:
a. A balance between costs and benefits.
b. Activity based costing
c. Variable costing
d. Budgets
8. Which is not a step in the control cycle?

a. Develop objectives
b. Measure results
c. Provide incentives
d. Continuous reappraisal
9. Which is not one of the five types of controls?

a. Compensating
b. Annual
c. Preventive
d. Corrective
10. Which control emphasizes positive actions?

a. Preventative
b. Detective
c. Corrective
d. Directive
11. Compensating control exists to do all of the following, except for:

a. To compensate for possible shortcomings
b. To compensate employees
c. To introduce redundancy
d. To be a fail-safe control
12. The following represent sets of activities that should be separated from one another for
internal control purposes, except for:
a. Activities from costs
b. Custody of assets from recording of assets
c. Systems development from maintenance
d. Reconciliation from recording
13. Decentralization creates internal control problems because of all the following, except
for:
a. There is confusion about the objectives of the overall organization
b. Decentralized decision makers have interests that differ from the overall organization
c. The existence of more decision-makers creates coordination problems
d. Decentralized decision-makers have access to better information

Page 454

14. Why might an excessive span of control lead to internal control problems?
a. The manager might not be able to effectively supervise subordinates
b. There are too many subordinates
c. There are too few managers
d. The structure would be too tall or too flat
15. Internal control can be reinforced with:

a. Policies and procedures
b. Managers
c. Moral and ethical values
d. The audit committee
16. Why is computerization a threat to internal control?

a. There is no or minimal "paper trail"
b. Too fast to see the transactions
c. Minimal involvement of employees
d. The processing is distributed
17. Which employee group has tended to monitor internal control in the past but has been
Internal Control - Problems

downsized in recent years to the detriment of effective internal control?
a. Professionals
b. Middle managers.
c. Audit Committee.
d. Senior managers.
18. Internal control is necessary because:

a. Organizations are large
b. Organizations have many products or services
c. Employees do not always do what the organization desires
d. Organizations operate in many geographical locations
19. Which of the following is not a method employees use to manipulate information?
a. Smoothing
b. Gaming
c. Decentralization
d. Data falsification
20. Gaming exists when an employee:

a. Alters his/her actions to manipulate a performance indicator
b. Accelerates or delays the planned flow of information
c. Falsifies information
d. Steals from his/her employer


21. Organizational controls include all but:
a. Purposes, authorities and responsibilities
b. Organization structure
c. Plans
d. Decision authority
22. Operational controls include all but:

a. Budgets
b. Job descriptions
c. Established policies and procedures
d. Accounting and information systems
23. Personnel controls include all but:

a. Recruitment policies and procedures
b. Employee orientation and training policies and procedures
c. An organization structure
d. Supervision of employees


Internal Control Solutions
IC1 Solution: Internal Control - MCQ
1. b
2. a. Values of employees, especially collectively, are perceived as critically important

for internal control.
3. a.
4. c Also called nepotism.
5. d Policies and procedures improve internal control rather than limit it.
6. b
7. a The other answers have nothing directly to do with internal control.
8. c Although important, incentives are not part of the control cycle.
9. b
10. d The other items deal with negative actions.
11. b.
12. a
13. d Item (d) is an advantage of decentralized decision making and not an associated
internal control problem.
14. a Effective supervision is essential for internal control.
Internal Control - Solutions

15. c The other items are part of the system of internal control, but values can reinforce
the system of internal control.
16. a
17. b
18. c
19. c


20. a
21. c Plans are actually operational controls and not organizational controls.
22. b Job descriptions are organizational controls.
23. c The organization structure is an organization control.

Page 458

Enterprise Risk Management
Risk Management
R/U A/A
2.2.1 Defines and distinguishes among strategic risk, operational risk, reporting
9
risk and compliance risk for a given organization
a) Defines and gives examples of the types of strategic risk (e.g.
economic, industry, social, political, organizational, strategic 9
transaction, technological)
b) Defines and gives examples of the types of operational risk (e.g.
environmental, financial, business continuity, innovation, commercial, 9
project, human resources, health and safety, property, reputation)
c) Defines and gives examples of the types of reporting risk (e.g.
information accuracy, reporting reliability, completeness of financial 9
information, efficiency of the process for internal decision making)
d) Defines and gives examples of the types of compliance risk (e.g. legal
9
and regulatory, control, professional)
2.2.2 Identifies external risks (including political, environmental and social risk)
9
for a given organization
2.2.2.1 Describes the external risks related to the organization’s strategic

objectives, the impact of those risks and the necessity for risk management
a) Explains how enterprise risk management can benefit an organization 9
b) Describes methods of identifying external risks related to an
organization’s strategic objectives (e.g. SWOT, PEST, process flow 9
analysis, brainstorming)
c) Describes techniques for risk measurement and evaluation (e.g.
benchmarking, probabilistic models, sensitivity models, scenario
analysis) and calculates the expected losses of an external risk for a 9 9
given organization using probabilities (magnitude of the monetary loss
times probability of occurrence)
d) Understands that to assess the necessity for managing a risk, the
benefits of successfully managing the risk should be weighed against 9
the expected losses of the risk occurring
2.2.2.2 Explains potential shifts in the external environment and implications of

such shifts for a given organization’s exposure to risk
a) Discusses potential risky events resulting from shifts in the external
environment (e.g. shifts in consumer demand, new competitor entering
9
core markets, decrease in supply of essential input, change in
government regulations)
b) Discusses the implications of a shift in the external environment on a
9
given organization’s exposure to risk

Page 459

R/U A/A
2.2.2.3 Discusses acceptable risk levels
a) Outlines the role of the Board of Directors in setting risk levels for an
9
organization
b) Understands that determination of acceptable risk levels involves
assessing how the risk affects the organization’s ability to achieve its 9
objectives
2.2.3 Describes an appropriate risk response strategy, including procedures for

managing risk for a given organization
a) Discusses the following risk response alternatives and the conditions
under which each would be appropriate: accept, share, transfer, 9
reduce/mitigate, avoid
b) Performs a cost/benefit analysis for each of the risk response
alternatives being considered in relation to a specific situation for a 9 9
given organization
c) Discusses policies and procedures to ensure the chosen risk response
9
is effectively carried out
Risk is an inescapable element of competing in a market economy. Organizations must be able

to evaluate many types of risk including political, social, environmental, technological,
economic, competitive and financial.
The COSO publication entitled Enterprise Risk Management – Integrated Framework, describes
the underlying principles of risk management. However, other more detailed publications must
also be taken into consideration. These include the Sarbanes-Oxley and Canadian Securities
Administrators releases, as well as the CMA Canada released Risk Management Payoff Model.
Improved risk measurement and management produces organization-wide benefits such as

enhanced working conditions, allocation of resources to the risks that really matter and sustained
or improved corporate reputation.
The objectives of the CMA Risk Management Payoff Model guideline are:
• To provide a comprehensive overview of risk management and highlight the role of risk
identification and measurement within the risk management process.
• To create a broader framework for risk identification.
• To describe key elements of a measurement model for success in dealing with risks
strategically and operationally; including inputs and processes that lead to risk-related
outputs and overall organizational success (outcomes).
• To outline specific drivers related to these inputs, processes, outputs and outcomes.


• To provide specific performance metrics so management can better prepare for, measure
and manage risks.
Risk Management
• To demonstrate the calculation of return on investment for risk management initiatives.
The target audience of the CMA guideline includes Boards of Directors, members of audit
committees, external auditors, CEOs, CFOs, senior management teams and accounting internal
audit and finance professionals that face the challenges of risk assessment analysis and control.
Drivers of Increased Risk Awareness

High-profile collapses due to accounting scandals and corporate failures demonstrated the
potential consequences of failing to adopt even the basic principles of risk management as a key
component of good corporate governance. As a result, in the US, the SOX regulations, and in
Canada, the Canadian Securities Administrators Instruments were implemented to meet the
rising concerns of shareholders.
SOX caused important changes in public accounting, corporate governance and internal audit.
SOX states the reporting of financial results was insufficient and required organization do more,
including having greater control over the quality of the processes and controls used to report
these results.
Complying with SOX and the Canadian equivalent regulations is expensive and time-consuming.
However, the potential benefits of the new requirements can be improved internal control
processes, better decision making, increased reliability of information for external users and
enhanced investor confidence.
The new and greater risks in the business environment coupled with the new regulatory
requirements has resulted in greater responsibility shifting to corporate Boards, audit committees
and the internal audit function.
Approaches to Risk Management

The silo approach has been favoured in the past, with different types of risk (e.g. insurance,
technology, financial, etc.) being managed independently in separate departments with little or
no coordination between various departments within the organization.
Risk can be viewed as uncertainty, hazard or opportunity. Tradition risk management has
concentrated on the two former views, attempting to reduce the variance between anticipated
outcomes and actual results. In contrast, organization-wide risk management systems create,
protect and enhance shareholder value by managing the uncertainties that could affect the
achievement of the organization’s objectives either positively (opportunity) or negatively
(hazard).


Currently, the major publications addressing the growing importance of comprehensive and
integrated risk management include:
• AICPA and CICA, 2000 publication
• COSO Internal Control Integrated framework – 1992
• COSO Enterprise Risk Management – Integrated Framework – 2004
The Process of Risk Management

Step 1 – Event Identification
While the CEO is the organization’s chief risk management officer, decision makers at all levels
should consider risk identification a critical part of their job. Managers and employees alike
should learn to spot the warning signs of risks.
Risks can be classified as one of four general types:

• Strategic Risks (economic, industry, strategic transaction, social, technological, political,
organizational)
• Operational Risks (environmental, financial, business continuity, innovation, commercial,
project, HR, health and safety, property, reputational)
• Reporting Risks (information, reporting)
• Compliance Risks (legal and regulatory, Control, Professional)
This classification scheme should only define a risk universe and provide a sample listing of
organizational risks. Each organization should establish a working list of the risks most relevant
to its own businesses and business environments.
Step 2 – Risk Assessment

For each risk identified, an organization must assess the risk. This includes:
• Assessing the magnitude, monetary loss or severity of the negative effect of the event
• Assessing the impact of an incident, especially the duration
• Assessing the probability of an incident
Traditionally, qualitative techniques for risk measurement and evaluation include:

benchmarking, probabilistic models and non-probabilistic models. In order to quantify the real
costs of a risk, its correlation with other risks must be considered.
Determining the costs of a potential risk, if it materializes, as well as the benefits that may be
provided by an appropriate response to the risk, should be assessed. The quantification of both
costs and benefits then makes it possible to determine the payoff of a risk management initiative.

Page 462

The Risk Management Payoff Model
Risk Management
This model describes the key factors for corporate success in risk management. These include
the critical inputs and processes needed for success in risk management outputs, which then
reduce the cost of risk and increase revenues. Finally, the payoff of risk management is
determined by its contribution to overall organizational success or outcomes, in terms of
shareholder value. The key components to this model are inputs, processes, outputs and
outcomes.
Inputs include: the external environment, internal environment, strategy, structure, systems and
resources, risk management strategy. The organization’s ability to develop an appropriate
internal environment to respond to external forces, to anticipate risk and allocate resources in its
corporate strategy and to develop specific risk management strategies to deal with the risk
effectively is critical and is reflected in the strategic fit.
Processes include: risk management leadership, risk management structure and risk management
systems. Key risk management systems include measurement and rewards, event identification,
risk assessment, risk response, control activities and information and communication monitoring.
Outputs can be classified as intermediate or final. Intermediate outputs include: compliance

with regulations, business process continuity, enhanced working environment, improved
resource allocation, enhanced internal reporting, improved external reporting, improved
organizational reputation and reduced earnings volatility. Final outputs include: reduced costs,
increased revenues and increased program effectiveness.
Outcomes include: organizational success and shareholder value.
Step 3 – Risk Response

Using the quantification process outlined in the Risk Management Payoff Model, the
organization can determine the most appropriate response to a given risk and assess the
effectiveness of the risk management processes and controls already in place. If these are found
to be insufficient or excessive, management can reallocate capital or resources.
In general, risk responses include:

• Acceptance – no action taken to affect risk likelihood or impact
• Sharing – risk likelihood or impact reduced by transferring or otherwise sharing a portion
of the risk
• Transfer – risk passed to an independent third party at a reasonable economic cost under
a legally enforceable arrangement
• Reduction or mitigation – action taken to reduce likelihood or impact or both
• Avoidance – exiting the activities that give rise to risk


Step 4 – Control
Control policies and procedures are needed to help ensure the chosen risk responses are carried
out properly and in a timely manner. Such activities typically include:
• Top-level reviews
• Direct functional or activity management
• Segregation of duties
• Use of physical controls
• Use of information processing
• Use of performance indicators
As risks change over time, ongoing evaluation of policies and procedures designed to manage
and control said risks is needed.
Step 5 – Information and Communication

Employees at all levels must understand the definition of risk, the corporate attitude to risk, the
organization’s exposure to different risks, the consequences of those risks and the organization`s
response to them. This information may be communicated through employee manuals, bulletins
and corporate intranet. Specifically, the risk communication should convey:
• the importance and relevance of an effective risk management framework
• the organization’s risk-related strategic objectives
• the organization’s risk appetite (risk tolerance); and
• the role and responsibilities of personnel in effecting and supporting the risk management
efforts.
Step 6 – Monitoring
All aspects of the risk management process need to be monitored due to constant changes in
businesses and circumstances.
Generally, monitoring can be done in one of two ways: through ongoing activities or by means
of stand-alone evaluations. If the ongoing activities are extensive and effective, the need for
separate evaluation projects decreases.

Page 464

Risk Management for Specific Business Functions
Risk Management
Risk management challenges are faced by all organizations, not only at the organization level,
but also at the functional level. As a result, specific business functions will find it useful to apply
the Risk Management Payoff Model in order to identify, measure, respond to, control and
monitor risks more carefully, as well as calculate the payoffs of risk management initiatives.
Information Risk
Information risk is the heart of risk management, yet is itself a source of risk. Information
technology plays a critical role in many companies today; however, most companies do not have
a formal process in place to identify potential risks associated with IT. IT risk strategies must be
integrated with the organization’s overall business risk strategies.
It is the responsibility of senior management to clarify what data should be protected, how
sensitive this information is, how much protection is needed for different types of data and how
much risk the organization is willing to accept.
Risk Assessment in Due Diligence

When considering mergers or acquisitions, organizations must assess risk as part of its due
diligence. Among the risks associated with mergers and acquisitions are those related to the
conversions of existing systems and the initiation of new systems. These include risks associated
with IT, HR and other key areas. Additional risk is associated with the need for integration and
conversions to be completed within a short period of time so the new organization can conduct
business seamlessly after the merger or acquisition is formally completed.
The Risk Management Payoff Model represents a useful tool that can be applied in the context of
due diligence to risks encountered both in the merger or acquisition process and in the continuing
operations of the new organization.

Page 465

Comprehensive Risk Management
Today, the risk management perspective is shifting from a fragmented, ad hoc and narrow
approach to one that is integrated, continuous and broadly focused. Organizations can make risk
consideration a part of the decision-making process by:
• articulating the organization’s risk management attitude in the mission statement and
strategic objectives
• communicating the risk management philosophy, specifically the link between risk
management and strategy
• consistently incorporating risk awareness in the budgets
• instilling risk awareness in the corporate culture
• conducting risk education and training to ensure employees understand how risks can be
identified and managed
• articulating risk policies and tolerances through the use of analytical tools and risk
assessments
• introducing mechanisms to connect performance evaluation and incentive to risk
management initiatives
• making risk assessment a required annual exercise within the business units


Governance
Governance
R/U A/A
2.3.1 Understands the role of governance for a given organization
2.3.1.1 Defines the role and responsibilities of the Board of Directors

a) Explains the duties of a member of the Board of Directors (e.g. duty of
care, knowledge, loyalty, due diligence and reasonable business 9
judgment)
b) Explains the responsibilities of the Board of Directors (e.g. appoint,
monitor and compensate the CEO, prepare a CEO succession plan,
monitor risk levels, appoint external auditor, ensure regulatory 9
compliance, monitor external communications, approve strategic plan
and strategic decisions)
c) Evaluates the quality of the Board of Directors in terms of carrying out
9 9
its duties and responsibilities
d) Explains how the Sarbanes Oxley Act of 2002 and the Canadian
Securities Administrators Multi-lateral Instruments (e.g. MI 58-101) 9
impact Board governance
2.3.1.2 Defines the relationships between members of management (including the

CEO and CFO), the Board of Directors, the owners (e.g. shareholders,
government, etc.) and the other stakeholders of a profit-oriented, not-for-
profit and public sector organization
a) Explains the duties of each party with respect to achieving effective
governance 9
b) Understands how various Board committees (e.g. audit, executive, CEO
9
compensation committee, nominating, etc.) facilitate good governance
c) Explains the role internal audit plays in ensuring good governance 9
d) Explains the role external auditors play in ensuring good governance 9
e) Explains the role regulatory bodies play in ensuring good governance 9
f) Explains the role other stakeholders play in ensuring good governance 9
2.3.1.3 Defines the nature of information required by the Board of Directors to

fulfill its mandate
a) Identifies and discusses the financial and non-financial data that should
9
be reported to the Board of Directors
b) Identifies and discusses the budget and industry benchmarking data (if
9
applicable) that should be reported to the Board of Directors
c) Identifies and discusses the internal and external developments and
9
trends that should be reported to the Board of Directors
d) Understands that updates and reports on risk monitoring and
9
compliance should be reported to the Board of Directors


R/U A/A
e) Explains how peer assessment of members of the Board of Directors
9
can improve Board governance
2.3.2 Identifies the role of a given organization’s code of corporate conduct and
ethical values with respect to governance issues and the accomplishment 9
of the organization’s strategic objectives
2.3.3 Identifies and explains the role that a given organization’s management
incentives play in maintaining organizational compliance
Describes effective managerial reward and incentive systems and
explains how they can align management actions with the interests of the 9
organization’s stakeholders
Role and Responsibilities of the Board of Directors

Overall, the responsibilities of the Board of Directors are to provide leadership, make prudent
and objective decisions, and implement effective internal controls. The Board represents the
interests of the shareholders and, thus, must always keep the bests interests of the organization
and its shareholders in mind.
The Board is responsible for:

• the development of the corporate strategy of the organization
• the selection of the CEO
• the planning for CEO and senior management succession
• the implementation of internal controls within the organization
• the hiring of independent external auditors
Committees of the Board of Directors

The Board of Directors and management of the organization should have a strong and
constructive relationship. However, while harmonious and workable environments are expected,
‘groupthink’ or similar thinking at all times from Board members, is not what the corporation
necessarily needs in order to attain the best possible solutions; challenging ideas and positions
must also be possible.
In order for the Board of Directors to carry out its duties and responsibilities adequately, a
number of committees are necessary. These include:


The Audit Committee – Usually a committee of experts in the area of finance and auditing. If
there is not enough expertise internally, it is recommended external professionals are recruited to
assist the committee. It is recommended the audit committee’s members be composed of only
Governance
independent/external directors. The committee chair must report to the Board regularly and
annually.
The Executive Committee – If it is impractical to delegate sufficient authority to the CEO, a

Board may wish to maintain an executive committee to make key decisions. Executive
committees are more common in the not-for-profit sector.
The CEO Compensation Committee – This committee determines objectives and targets to be
achieved by the CEO in order to obtain various levels of compensation. Most compensation
committees use external consultants in the determination of compensation packages and pay.
This committee often ensures succession planning for senior management and can be
responsible, if there is no executive committee, for CEO evaluation and performance review.
The Nomination Committee – Identifies and evaluates candidates for nomination to the Board.
This committee is often the point of contact for shareholders input into the nominating process.
Canadian Securities Administrators Multilateral Instruments

MI 58-101/201
National Instrument 58-101 requires an issuer to provide disclosure addressing a number of
corporate governance practices, including the following:
• composition and practices of the Board of Directors

• mandate of the Board of Directors
• position descriptions of the Chair of the Board, the chair of each Board committee and
the CEO
• measures for orientation for new directors and continuing education for existing directors
• process for nomination of directors
• process for determining compensation of directors and officers
• committees of the audit, compensation and nominating committees
• whether or not the Board, Board committees and directors are regularly assessed and, if
so, process used
National Policy 58-201 sets out a series of recommended corporate governance guidelines:
Board of Directors – should have a majority of independent directors and an independent chair.
If there is no independent chair, an independent director should be appointed “lead director”.
Regular meetings and a written mandate with certain specified features must also be present.
Position Descriptions – needed for Chair of the Board, Chair of each Board committee and the
CEO


Orientation and Continuing Education – Board must adopt measures for orientation for new
directors and continuing education of existing directors
Nominating Committee – should be given the authority to engage an outside advisor and be
formed of independent directors with a written charter covering certain specified features.
Compensation Committee – should be made up of independent directors and is responsible for

certain specified matters, including evaluating CEO performance and compensation and making
recommendations to the Board with respect to officer and director compensation and incentive
plans, and reviewing executive compensation disclosure.
Regular Board Assessments – the Board, Board committees and each director should be
regularly assessed with regard to their effectiveness and contribution.
CMA Canada Management Accounting Guideline – Measuring and

Improving the Performance of Corporate Boards
Governance concerns relate to practices of both corporate Boards and senior managers. The
question being asked is whether the decision-making process and the decisions themselves are
made in the interest of shareholders, employees and other stakeholders or whether they are
primarily in the interests of the executives. Furthermore, the concerns relate to both the reality
and perception of Board competence, diligence and ethics and include issues such as executive
compensation, Board independence, Board oversight, succession planning and adequate and
accurate transparency.
This guideline is direct at three primary issues. How Boards of Directors can:
• use a variety of performance metrics to improve both the evaluation and management of
performance of Boards of Directors and individual Board members;
• use performance metrics to improve the evaluation and governance of both corporate
performance and CEO performance; and
• use performance measurement and strategic management systems for communicating the
performance of Boards of Directors, the corporation and the CEO to external
stakeholders.
The guideline is directed at the leadership required of Boards of Directors and senior corporate
executives to improve corporate performance and the measures, systems and reporting necessary
to support good governance. Strategic management systems, like the balanced scorecard, can
help companies establish the drivers of good Board performance and how that performance
affects shareholder value.


Improving the Performance of Corporate Boards
Governance
The Roles and Responsibilities of Boards
There are standards of conduct that directors must meet in fulfilling their responsibilities to their
organizations. These are typically defined in the corporation’s bylaws, in numerous statutes and
regulations and in court precedents. Examples include: duty of care, duty of loyalty and duty of
obedience.
Boards of Directors assume a central role in governance as their primary duty is to promote the
long-term interests of the corporation. The Board has a fiduciary duty to represent the owners’
interest in protecting and creating shareholder value and monitor and evaluate whether the
company is managed well to achieve long-term success.
As such, the Board assumes three core responsibilities:

• oversight of strategic direction and risk management. This is related to the development
and implementation of the company’s mission, values and strategy. It also includes
careful review of corporate processes of risk identification, monitoring and management.
Specific reviews of financial objectives, plans, major capital expenditures and other
significant material transactions are also part of the Board’s responsibility.
• ensuring accountability. Ensuring corporation is providing both internal and external
stakeholders with reliable information for decision making and implementing the systems
and structures that ensure accountability and ethical behaviour.
• evaluating performance and senior level staffing. Evaluating corporate performance, the
performance of the CEO and other senior executives and evaluate its own performance.
Elements of Superior Board Performance

Numerous decisions concerning Board operations will have significant impact on Board
performance. These include decisions related to: 1) Board composition; 2) structure; and 3) the
supporting processes and systems. Based on various guidelines, codes of best practices,
requirements from stock exchanges and regulations, the key inputs and processes leading to
superior Board performance are identified.
Corporations make important choices in Board composition (inputs) that have a significant
impact on Board performance. The Board structure and systems (processes) also significantly
affect the Board decisions and performance. The manner in which the Board prepares,
deliberates and decides on important decisions is affected by the Board’s composition and does
affect the Board’s success at fulfilling its roles and responsibilities and improving Board
performance (outputs), ultimately improving corporate performance (outcomes). Further,
continuous feedback provides the basis for improvement for the directors, the Board and the
corporation.


Inputs:
1) Board Composition – should comprise a panel of objective overseers that counsel

corporate managers and monitor performance
2) Independence – must limit CEO influence on director selection. Done through

nominating new directors solely through nominating committee, i.e. independent
directors.
3) Skills and Knowledge – Board members should possess both functional knowledge in the
traditional areas of business as well as industry specific knowledge for the company.
Personal qualities such as integrity, business sense, sound judgment, communication
skills and commitment are all equally important.
4) Board Size – studies show Boards of nine to13 individuals is ideal for most companies.
Processes:
1) Systems and Structure – decisions about the Board’s structures and systems are primary
processes that will affect the Board’s performance. These include decisions about
leadership of the Board, how the agenda is set and the way the Board is organized.
2) Leadership of the Board – Board leadership must be independent and solely devoted to
providing oversight and fulfilling a fiduciary duty to the shareholders. Boards should set
the agendas to their meetings (as opposed to the CEO) and have access to all employees
at all times to answer any questions they have.
3) Committee Structure – typically companies have three Board committees:
Audit Committee – responsible for four elements: internal controls and risk assessment;
internal and external auditing processes; financial reporting; and compliance with laws,
regulations and codes of ethics.
Compensation Committee – responsible for developing monitoring, evaluating and

providing oversight to the corporate compensation programs.
Governance/Nominating Committee – responsible for recommending nominees for Board

membership as well as reviewing succession plans for senior management and
developing and monitoring the functions of the various committees of the Board and the
Board itself, and reviewing the performance of senior management.


Outputs and Outcomes:
Governance
1) Monitoring and Evaluating Corporate Performance
Typically done through standard accounting information, but this has limitations of
measuring success. Performance measures must include both financial and non-financial
metrics, should be linked to strategy and include a combination of input, process, output
and outcome measures.
Balanced Scorecard for Evaluating Corporate Performance – is a strategic management

system that links performance to strategy using a multi-dimensional set of financial and
non-financial performance metrics. It focuses on the financial dimension, the customer
dimension, the internal business processes dimension and the learning and growth
dimension.
2) Monitoring and Evaluating the Board’s and Individual Board Member’s

Performance
The Board evaluation should be focused on how it can improve the Board’s inputs and
processes so the Board’s contribution to overall corporate performance can be increased.
Balanced Scorecard for Evaluating Board’s Performance
The four dimensions of the Board’s balanced scorecard are: the financial dimension; the
stakeholders’ dimension; the internal process dimension; and the learning and growth
dimension
3) Monitoring and Evaluating the CEO’s Performance – among the many benefits
associated with carefully planned and designed CEO performance evaluation systems are:
providing a basis for evaluating and rewarding CEO performance.
Evaluating needs and performance of the management team and succession; providing
clear indicators of current and future CEO needs for growth and learning.
Balanced Scorecard for Evaluating CEO’s Performance
The four dimensions of the CEO’s balanced scorecard are: the financial dimension; the
stakeholders’ dimension; the internal process dimension; and the learning and growth
dimension


CMA Canada Management Accounting Guideline – Strategic
Management of Information for Boards
Identifying Informational and Educational Needs:

Pressures for increased transparency and a more active role in directors’ oversight have created
an urgent need for organizations to examine whether they provide their Boards both with quality
information and effective educational programs.
Factors Driving Informational Needs
There are three specific drivers of information strategy:
1) Board’s roles and responsibilities include ensuring accountability, ensuring senior level
staffing and performance evaluation, and ensuring strategic oversight.
2) Governance guidelines and investors’ pressures: both corporate governance guidelines

and governance rating services influence Board practices and, therefore, their need for
information.
3) New rules and regulations: regulatory requirements, particularly for public companies,
powerfully drive information strategy.
Current Situation
Results of recent surveys show that although Boards are getting considerable information
concerning financial performance, operating performance, annual strategic planning and major
capital expenditures, they are getting less information about long-term strategy, data to monitor
and evaluate the strategies, and risk management. Furthermore, they are getting even less
information about the external environment, organizational performance and alternate strategies
management considered.
Formulating and Information Strategy – Determining Informational Content:

What information should directors receive in order to fulfill each of the three core
responsibilities (ensuring accountability, ensuring senior level staffing and performance
evaluation and providing strategic oversight)? For each of the responsibilities a list of topics on
which directors should be informed is listed.
Ensuring Accountability
To effectively monitor accountability, which includes ensuring their corporations are providing
various stakeholders with complete and reliable information on matters that can affect them and


mechanisms for complying with legal and regulatory requirements are in place and functioning
effectively, Boards should receive information on three main topics:
Governance
Financial Issues – usually managed by audit committee; includes annual audited financial
statements, quarterly financial statements, annual information form, quarterly and annual
MD&A's and earnings press releases. Also, reports from internal and external auditors on
internal controls must be given to the audit committee.
Corporate Behaviour/Key Stakeholders’ Management Issues – includes reports on the company’s

performance on social and environmental issues and compliance with business standards and
codes of ethics. Also includes external reports on social issues published by the company and
information on the company pension plan.
Corporate Governance Issues – typically under the governance committee. Includes any
information dealing with the evaluation of Board performance, as well as disclosure of corporate
governance guidelines. May include external reports obtained from time to time on the
company’s governance practices.
Ensuring Senior Level Staffing and Performance Evaluation
The following information should be received by either the Board or its compensation committee
members in order to properly staff and evaluate the CEO and other senior management positions:
• report on compensation policy, including performance targets and objectives
• performance report on identified targets, including surveys and interviews from various
stakeholders
• report on company performance
• benchmarking report – executive compensation package
• report on compensation – from outside consultant
• report of succession planning
• report on management development activities
The following information should be received by either the Board or its compensation committee
members in order to properly staff and evaluate the Board of Directors:
• report on Board compensation
• report on Board performance, including individual performance
• report on directors’ orientation and educational programs
• updates on trends and regulations regarding compensation issues
Ensuring Strategic Oversight
Directors need to understand the company’s internal and external environment to help them
assess the effectiveness of strategies. The CIMA and IFAC have proposed a strategic scorecard
to help provide a good framework that guides Boards on the type of information they should
receive, which includes information on: strategic position; strategic options; strategic
implementation; and strategic risks.


Information Sources
Directors must supplement information received from management by getting information from
other sources, including other stakeholders, to develop an independent opinion on major
decisions. Companies must determine their procedures for how directors will access this
information. Key issues include:
• access to management and company external stakeholders
• access to independent advisors
• access to the Board
Implementing the Information Strategy – Operational Issues:

Several supporting factors are essential to the success of a new information strategy. They are:
Setting the Agenda
The majority of information that a Board receives relates to topics discussed during Board and
committee meetings. If the CEO controls the agenda, then the CEO controls what the Board
hears, discusses and votes on. Therefore, directors should be given the opportunity to add topics
to the agenda on their own. Furthermore, a Board briefing should accompany the agenda and
supporting material. This document succinctly highlights the current issues facing the company.
Presenting the Information
Establish the appropriate format of information going to the Board will avoid information
overload and permit directors to focus on important relevant issues. Information should be given
both orally and through written reports. Also, information must be:
• relevant
• concise
• complete
• clear
• balanced
Communicating the Information – Developing a Board Intranet
Although public sector and non-profit organizations often use their regular websites to include
Board-related information, many companies have developed intranets to limit access. Sensitive
information that would not be desirable to share with the public can be put on the intranet and all
Board members can have unlimited access. Using this resource, directors can locate and share
knowledge and data, collaborate and communicate in real time.


Effective development of an intranet requires several stages:
• setting goals and objectives
• identifying directors’ informational needs
Governance
• specifying information categories
• deciding on technical aspects
• testing a prototype model with directors
• organizing a training session for directors
• evaluating the intranet
Building Competencies – Orientation and Educational Programs
If companies are going to provide more information to their Boards, they must also evaluate
whether they have the ability to assimilate and comprehend this information. Directors who do
not have these competencies may not be able to fully participate.
Orientation programs can ensure new directors become familiar with business operations and the
industry and have a clear understanding of their role on the Board. Site visits, meetings with
chairs and top executives, formal presentations and a directors’ manual are typical elements of a
director orientation program. Directors’ manuals usually include:
• company information (code of ethics, by-laws, organizational charts, company history)
• strategic plans (mission statements, corporate goals, action plans, major programs)
• Board information (charters, members with biographies, committees, roles and
responsibilities, governance guidelines, minutes from recent meetings, committee reports,
Board and committees’ calendar)
• financial information (annual reports, proxy statements, analysts’ reports)
• industry information (articles, associations, sector analysis, competitor information)
• contact lists
Beyond orientation programs, educational programs should build and maintain director’s
competencies on a variety of topics relevant to their responsibilities. Both internal and external
program can and should be used.
Strategic Management of Board Information – Steps to Implementation
Step 1 – Situation Analysis – understanding and shared vision of the Board’s information needs.
Step 2 – Strategy Formulation – details specific topics on which the Board wants information.
Step 3 – Strategy Implementation – includes evaluating operational issues and ensuring
information is provided in a useful format; may include designing an intranet.
Step 4 – Evaluation and Control – the quality of the strategy and directors’ satisfaction is
essential.



Financial Management, Strategic Management, Risk Management and Governance, 2011 edition
CMA Entrance Examination Study Manual with Problems and Solutions
CMA Entrance
Examination Study
Manual with Problems
and Solutions
Financial Management, Strategic Management,

Risk Management and Governance
2011 Edition
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Financial Management, Strategic Management, Risk Management and Governance, 2011 edition

CMA Entrance Examination Study Manual with Problems and Solutions

Financial Management, Strategic Management,

CMA Fin & Tax BlueCover 2011 V1.indd 1 3/30/11 10:27 AM

© 2010 Certified Managements Accountants of Ontario. All rights reserved. ®/™

CMA Study Manual_3 Tax Fin_l V1.indd 1 3/30/11 4:19 AM

Financial Management - Tax

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Financial Management - Tax

TAX PRINCIPLES AND CONCEPTS .......................................................................................................... 3

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Financial Management – Tax Problems and Solutions

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Financial Management – Corporate Finance

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Financial Management – Corporate Finance

BONDS ..................................................................................................................................................... 135

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FOREIGN EXCHANGE AND FINANCIAL MANAGEMENT.................................................................... 221

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R/U = Remembering and Understanding A/A = Application and Analysis

1. Is paid or is payable in the year,

Certain interest charges are non-deductible:

• interest on income taxes,

Please report errors or omissions to ¤CMA Ontario, page 1

CMA Study Manual_3 Tax Fin_l V1.indd 13 3/30/11 4:19 AM

For tax purposes, a lease is classified as a capital lease if:

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Entities Subject to Tax

Trusts − a trust is a relationship whereby a trustee is bound to administer

Corporations − represents a separate entity formed by incorporating

Partnership − represents an agreement among two or more individuals or corporations.

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CMA Study Manual_3 Tax Fin_l V1.indd 15 3/30/11 4:19 AM

Capital Gains or Losses

Other Income and Deductions

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Tax Filing and Payment Obligations

Deceased Individuals − filing deadline depends on date of death:

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- individuals with mainly employment income:

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These penalties apply to both individual and corporate taxpayers.

Failure to provide the information required $100 for each failure

Failure to file as and when required certain the greater of:

Knowingly under-reporting or neglecting to the greater of:

Late or deficient instalments 50% of the interest in excess of the greater

Penalties applicable to individuals only:

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International Tax Treaties:

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R/U = Remembering and Understanding A/A = Application and Analysis

To be considered resident in Canada, the individual must maintain a "continuing state of

For example, an individual who:

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