Study Session #11
Learning Outcome Statements
(Last revised 11/26/04)

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1. A. “An Overview of Financial Management”
The candidate should be able to
a) discuss potential agency problems of stockholders versus 1) managers and 2) creditors;
b) describe four mechanisms used to motivate managers to act in stockholders’ best interests.
B. “The Cost of Capital”
a) explain why the cost of capital used in capital budgeting should be a weighted
average of the costs of various types of capital the company uses;
b) calculate the component costs of 1) debt, 2) preferred stock, 3) retained earnings (three different
methods), and 4) newly issued stock or external equity;
c) define target (optimal) capital structure;
d) calculate a company’s weighted-average cost of capital;
e) calculate a company’s marginal cost of capital;
f) distinguish between the weighted-average cost of capital and marginal cost of capital;
g) explain the factors that affect the cost of capital and distinguish between those factors that can and
cannot be controlled by the company.
C. “The Basics of Capital Budgeting”
a) define capital budgeting;
b) calculate payback period, discounted payback period, net present value (NPV), and internal rate of
return (IRR) and evaluate capital projects using each method;
c) explain the NPV profile;
d) explain the relative advantages and disadvantages of the NPV and IRR methods, particularly with
respect to independent versus mutually exclusive projects;
e) explain the “multiple IRR problem” and the cash flow pattern that causes the problem;
f) explain why NPV and IRR methods can produce conflicting rankings for capital projects;
g) describe the role of the post-audit in the capital budgeting process.
D. “Cash Flow Estimation and Other Topics in Capital Budgeting”
a) distinguish between cash flows and accounting profits;
b) discuss the relevance to capital budgeting of the following: incremental cash flow, sunk cost,
opportunity cost, externality, and cannibalization;
c) explain the importance of changes in net working capital in the capital budgeting process;
d) determine by NPV analysis whether a project (expansion or replacement) should be undertaken;
e) compute each of the following for an expansion project and a replacement project: initial
investment outlay, operating cash flow over a project’s life, and terminal-year cash flow;
f) compare two projects with unequal lives, using both the replacement chain and equivalent annual
annuity approaches;
g) discuss the effects of inflation on capital budgeting analysis.
E. “Risk Analysis and the Optimal Capital Budget”
a) distinguish among three types of project risk: stand-alone, corporate, and market;
b) distinguish among sensitivity analysis, scenario analysis, and Monte Carlo simulation as risk
analysis techniques;
c) describe how the security market line is used in the capital budgeting process;
d) describe the pure play and accounting beta methods for estimating individual project betas;
e) discuss the procedure for developing a risk-adjusted discount rate;
f) define capital rationing.

F. “Capital Structure and Leverage,”
including Appendix 13A
a) define target (optimal) capital structure;
b) describe, and state the impact of changes in, factors that influence a company’s capital structure
decision;
c) explain business risk and financial risk and discuss factors that influence each risk;
d) explain and calculate the effects of changes in sales or earnings before interest and taxes (EBIT)
on earnings per share for companies with differing amounts of debt financing;
e) define operating leverage and explain how it affects a project’s or company’s expected rate of
return;
f) calculate the breakeven quantity of sales and determine the company’s gain or loss at various sales
levels;
g) define financial leverage and describe the relationship between financial leverage and financial risk;
h) discuss why the use of greater amounts of debt in the capital structure can raise both the cost of
debt and the cost of equity capital;
i) describe how changes in the use of debt can cause changes in the company’s earnings per share and
in the stock price;
j) distinguish between the value of a company and the value of the company’s common stock;
k) explain the effect of taxes and bankruptcy costs on the cost of capital, the optimal capital
structure, and the Modigliani and Miller (MM) capital structure irrelevance proposition;
l) compare the MM capital structure irrelevance proposition with the trade-off theory of leverage;
m) describe how a company signals its prospects through its financing choices;
n) calculate degree of operating leverage, degree of financial leverage, and degree of total leverage
G. “Dividend Policy”
a) describe the dividend irrelevance theory, the “bird-in-the-hand” theory, and the tax-preference
theory;
b) explain the dividend irrelevance theory in the context of the determinants of the value of the
company;
c) discuss the principal conclusion for dividend policy of the dividend irrelevance theory;
d) describe how any shareholder can construct his or her own dividend policy;
e) calculate, assuming a constant return on equity, a company’s dividend growth rate, given the
company’s dividend payout rate;
f) describe how managers signal their company’s earnings forecast through changes in dividend
policy;
g) describe the clientele effect;
h) describe the residual dividend model and discuss the model’s possible advantages or disadvantages
to the company;
i) describe dividend payment procedures, including the declaration, holder-of-record, ex-dividend,
and payment dates;
j) describe stock dividends and stock splits and explain their likely pricing effects;
k) discuss the advantages and disadvantages of stock repurchases and calculate the price effect of a
stock repurchase.

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