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Section B – corporate Finance

Introduction to the Corporate Finance Section
The Corporate Finance section represents 20% of the CMA Part 2 exam.
thiS Section containS Six Separate topicS. they are:
1) Risk and Return
2) Long-term Financial Management
3) Raising Capital
4) Working Capital Management
5) Corporate Restructuring, Business Combinations and Divestitures;
6) International Finance.
Study unit 1: B.1. Financial riSk and return, typeS oF
Financial riSk
Risk is the possibility of having an unfavorable event occur.
Financial risk is risk that is connected to the financial health of the
company. Financial risk includes:
❖ Risk of an inability to access capital (equity and long-term debt)
❖ A lack of liquidity
❖ Risk of volatility of foreign currencies, interest rates, or commodity
prices
❖ Risk of investment losses.
riSk
Risk can be classified as either
➢ pure risk
➢ speculative risk.
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pure riSk
Pure risk is defined as the chance that an unwanted and detrimental
(harmful) event will take place.
Insurance is designed to address pure risk because pure risk yields only
a loss.
Speculative riSk
Speculative risk is the type of risk involved in investing. Speculative risk
is defined as the variability of actual returns from expected returns, and
this variability may be either a gain or a loss.

Types of
Financial Risk

systematic unsystematic
risk risk

SyStematic riSk (market riSk)

➢ It is risk that all investments are subject to.
➢ It is caused by economy wide factors that affect all investment
assets. Some examples of systematic risk are inflation,
macroeconomic instability such as recessions, major political
upheavals, and wars.
➢ Systematic risk cannot be diversified away.
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typeS oF SyStematic riSk include:

Market risk is the risk Interest rate risk (sometimes

inherent in an investment that called price risk or maturity risk) is
is traded on a market simply the risk that the value of an
investment will change over time
because it is traded on a
due to changes in the market rate
market and is subject to
of interest.
market movements.

Purchasing power risk is the Foreign exchange risk is the risk

risk that the purchasing that a transaction denominated
power of a fixed amount of in a foreign currency will be
money will decline as the impacted negatively by changes
in the exchange rate
result of inflation.

unSyStematic riSk (company riSk)

Unsystematic risk (also called company risk, specific risk, or nonmarket
risk) is risk that is specific to a particular company or to the industry in
which the company operates.
An example of unsystematic risk is a strike that halts production
at one company or at all the companies that employ members of the
striking union.
Unsystematic risk can be reduced through appropriate diversification.
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typeS oF unSyStematic.

1.Credit, or default, risk is the risk to a lender or an investor

in a debt security that a borrower will not be able to pay
the interest and repay the principal on a debt as they
become due.

Liquidity risk, or marketability risk, is the possibility that an

investment cannot be sold (converted into cash) for its
market value.

Business risk arises because

of the variability of an
individual company’s earnings
before interest Industry risk is risk
and taxes. that is specific to
companies in a
Business risk depends on
particular industry,
many factors such as:
such as the risk of
❖ The variability of
technological change
demand for the
that may make a
company’s products or
particular product
services over time.
obsolete.
❖ The variability of the
company’s selling prices
over time.
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return
Return is income received on an investment.
The annual rate of return is expressed as a percentage of the principal
amount invested.

exampleS:
#1: An investor invests $10,000 for one year and earns a $500 return on
the investment. At the end of one year, the investor receives back
$10,500. The investor’s annual rate of return on the investment is the
$500 income received divided by the $10,000 invested:

the relationShip Between riSk and return

the higher the potential return, the higher
the level of risk involved.
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capital aSSet pricing model (capm)

The capital asset pricing model (CAPM) is one tool that is frequently
used to estimate the investors’ required rate of return.
The investors’ required rate of return is the minimum return investors
will accept for an investment.
the capm Formula

Where:
R = Investors’ required rate of return
RF = Risk-free rate of return (U.S. Treasury securities)
β = Beta coefficient
RM = Expected rate of return for the market portfolio.
The MARKET risk premium
It is the difference between the expected return for the market
portfolio and the risk-free rate.
(RM − RF).
SPECIFIC STOCK risk premium
This is the risk premium that investors require to purchase that specific
stock.
(β [RM − RF]).
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Beta (β)
“Beta,” the letter “β” in the Greek alphabet, measures how a security’s
historical returns have compared to the returns of the market portfolio.
A security’s beta is a measurement of the security’s systematic risk.
the meaningS oF SpeciFic valueS oF Beta are:
Beta = 1.0:
➢ An individual security with a beta of 1.0 has historically had the
same systematic (unavoidable) risk as that of the market portfolio.
➢ The returns for the security have historically moved in the same
direction and in the same amount as the market’s returns have
moved.
➢ if the market has historically fallen by 3%, the stock’s market price
has also fallen by 3%.
Note: The beta for the market portfolio is defined as 1.0.
Beta > 1.0: aggressive securities.
➢ For example, if the security’s return has historically increased by
an average of 10% when the market portfolio’s return has
increased by 8%, the security has a beta of 1.25.
➢ when the market return has historically decreased by 8%, the
security’s return has historically decreased by 125% of 8%, or by
10%.
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➢ A beta greater than 1.0 means that the individual security has
historically been more volatile (had more unavoidable risk) than
the market portfolio.
Beta < 1.0: defensive securities
➢ A beta between zero and 1.0 means that the individual security
has historically been less volatile (had less unavoidable risk) than
the market portfolio.
➢ For example, if the market’s return has historically increased by
10% and the security’s return has increased by an average of only
6%, the security has a beta of 0.60.
Beta = 0:
➢ The security may be a risk-free security.
➢ no correlation (relationship) between that security’s return and
the return of the market portfolio.
Beta < 0: A negative beta (less than zero)
➢ means the security’s returns have historically moved counter to (in
the opposite direction of) those of the market portfolio.
➢ if a stock has a beta of −0.5, that means when the market has
historically increased by 6%, this security has decreased by 3%,
half as much and in the opposite direction.
➢ Similarly, if the market has decreased by 10%, a stock with a beta
of −0.5 has increased in value by 5%.
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The Security Market Line (SML)

The Security Market Line is the graphical representation of the Capital
Asset Pricing Model.
It represents the predicted investors’ required rate of return for an
average security in the market at each level of beta according to the
Capital Asset Pricing Model.
An example of a graph of the Security Market Line follows.
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The expected return for the market portfolio (RM) is 4.0%, and the risk-
free rate (RF) is 0.5%.
On the graph, the SML intersects the y-axis at the risk-free rate (RF),
0.5%, which is also the point at which beta = 0.
The beta of the market portfolio is always 1.0.
RM=4%
the risk premium for the market portfolio is 3.5%, calculated as (RM
−RF), or (4.0% − 0.5%).
An individual security’s risk premium varies in direct proportion to its
beta. On the preceding graph:
• The investors’ required rate of return for an individual security with a
beta of 2.0 is 7.5%, calculated as 0.5% + [2.0 x (4.0% − 0.5%)] = 7.5%.
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Using the Security Market Line

Stock A is currently a good investment because its beta is 0.5, and at its
current market price, it is providing a 4% return.
On average, investors require a 2% return for a stock with a beta of 0.5,
but since Stock A is providing a higher (4%) return, it is underpriced.
Stock C, however, is NOT a good investment. The return for Stock C
(2%) is less than the investors’ 5.75% required rate of return for an
investment with a beta of 1.5, so Stock C is overpriced.
A Change in the Risk-Free Rate
If the risk-free rate changes from 0.5% to 1.5%, then the y-intercept of
the SML will change from 0.5% to 1.5% and the Security Market Line
will move upward.
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A Change in Investors’ Risk Aversion

If the risk aversion of investors in general changes, the slope of the
Security Market Line will change.
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Portfolio Risk and Return

❖ A portfolio is a collection of assets that is managed as a group.
❖ For an individual investor, a portfolio would probably consist of a
group of stocks and other marketable securities.
❖ For a company, a portfolio could consist of different marketable
securities, shares of other companies, and debt of other companies.
Portfolio theory
It is also called modern portfolio theory, is an investment
philosophy that seeks to construct an optimal portfolio of
securities according to an individual investor’s preferences
with respect to risk and return.
Efficient portfolio
It offers the highest possible expected return for a
given level of risk or offers the lowest possible risk
for a given level of expected return.
Diversification.
❖ The key to constructing a portfolio is diversification.
❖ Diversification in investing is the practice of investing in a variety
of securities so that a loss affecting one of the securities will have
minimal effect on the whole portfolio.
Asset allocation
It is the process of selecting assets to combine in a portfolio to achieve
the best risk/return tradeoff possible.
Correlation and the Coefficient of Correlation (r) in Portfolio Theory
➢ The correlation coefficient measures the strength and the
direction of the relationship between the 2 variables.
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➢ Either the same direction or the opposite direction.

➢ The correlation coefficient (r) is expressed as a number between
−1 and +1.
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