CPA Canada PEP Finance Elective Quick Review

Exam Identity and Review Mindset

The CPA Canada PEP Finance Elective rewards candidates who can turn finance tools into practical recommendations. Memorizing formulas is not enough. In case-style practice, you usually need to:

1. Identify the decision being made.
2. Select the correct finance method.
3. Use case facts and reasonable assumptions.
4. Interpret the result.
5. Recommend an action that fits the organization’s objectives, constraints, and risks.

Use this page as a fast review before working through independent companion practice, original practice questions, a question bank, and timed mock cases.

High-Yield CPA Finance Response Strategy

The 5-Part Case Response Pattern

Fast Decision Map

    flowchart TD
	    A[Finance case issue] --> B{What decision is required?}
	    B --> C[Invest in project or asset]
	    B --> D[Value business or shares]
	    B --> E[Choose financing]
	    B --> F[Manage liquidity or working capital]
	    B --> G[Manage financial risk]
	    C --> C1[Use incremental after-tax cash flows, NPV, IRR, sensitivity]
	    D --> D1[Use DCF, normalized earnings, multiples, asset approach]
	    E --> E1[Compare debt, equity, lease, internal funds, covenants, control]
	    F --> F1[Use cash budget, CCC, receivables, inventory, payables]
	    G --> G1[Identify exposure; compare natural hedge, forward, option, swap]
	    C1 --> H[Recommend with assumptions and risks]
	    D1 --> H
	    E1 --> H
	    F1 --> H
	    G1 --> H

Financial Analysis and Planning

Ratio Review: Know the Story, Not Just the Number

Cash Conversion Cycle

\[ \text{Cash Conversion Cycle} = \text{Days Inventory Outstanding} + \text{Days Sales Outstanding} - \text{Days Payable Outstanding} \]

A longer cash conversion cycle usually means more cash is tied up in operations. But do not automatically recommend delaying supplier payments. Consider supplier relationships, discounts lost, credit terms, and reputational risk.

Forecasting Checklist

Before accepting a forecast, challenge:

• Revenue drivers: volume, price, market share, churn, contract terms.
• Margins: input costs, labour, shipping, FX exposure, scalability.
• Working capital: receivables growth, inventory build, supplier terms.
• Capital expenditures: maintenance vs expansion capex.
• Financing: interest rates, debt capacity, covenant headroom.
• Taxes: use case-provided rates and rules; do not assume unsupported rates.
• Terminal assumptions: growth should be sustainable and consistent with risk.

DuPont Logic

ROE can improve because of:

1. Higher profitability.
2. Better asset utilization.
3. More leverage.

A high ROE is not automatically good if it is driven mainly by excessive debt risk.

Time Value of Money, Risk, and Required Return

Core Discounting Logic

Finance decisions usually compare today’s cost with future cash flows adjusted for risk and timing.

\[ \text{PV} = \frac{\text{Future Cash Flow}}{(1+r)^t} \]\[ \text{NPV} = \sum_{t=1}^{n}\frac{\text{Cash Flow}_t}{(1+r)^t} - \text{Initial Investment} \]

Decision rule: accept a standalone project if NPV is positive, unless qualitative constraints override the result.

CAPM and Cost of Equity

\[ r_e = r_f + \beta (r_m - r_f) \]

Where:

• \(r_e\) = cost of equity.
• \(r_f\) = risk-free rate.
• \(\beta\) = systematic risk measure.
• \(r_m - r_f\) = market risk premium.

WACC

\[ \text{WACC} = \frac{E}{V}r_e + \frac{D}{V}r_d(1-T) \]

Where:

• \(E\) = market value of equity.
• \(D\) = market value of debt.
• \(V = E + D\).
• \(r_e\) = cost of equity.
• \(r_d\) = pre-tax cost of debt.
• \(T\) = tax rate.

Discount Rate Selection

Discount Rate Traps

• Using book-value weights instead of market-value weights when market values are available.
• Mixing real cash flows with a nominal discount rate.
• Discounting equity cash flows using WACC.
• Using the acquirer’s WACC for a target with very different business risk.
• Forgetting the after-tax cost of debt in WACC.
• Treating WACC as universal rather than project-specific.

Capital Budgeting and Investment Decisions

NPV Is Usually the Anchor

Equivalent Annual Annuity

Use when comparing assets or projects with different useful lives but similar repeated service needs.

\[ \text{EAA} = \text{NPV} \times \frac{r}{1-(1+r)^{-n}} \]

Choose the option with the higher EAA for benefits or the lower equivalent annual cost for cost-only alternatives.

Incremental Cash Flow Checklist

Include:

• Initial investment.
• Installation, training, setup, and required implementation costs.
• Incremental revenue.
• Incremental operating costs or savings.
• Opportunity costs.
• Working capital investment and recovery.
• Tax effects, including tax shields where case facts support them.
• Terminal value, salvage value, disposal costs, or remediation costs.

Exclude:

• Sunk costs.
• Allocated overhead that does not change.
• Financing costs if using WACC, to avoid double counting.
• Accounting depreciation as a cash outflow, while still considering tax effects if relevant.

Capital Budgeting Traps

Leasing, Buying, and Asset Replacement

Lease-vs-Buy Review

Decision rule: compare the present value of after-tax cash flows under each alternative. Do not decide based only on accounting classification or the lower monthly payment.

Asset Replacement Logic

Replace an asset when the incremental benefits of replacement exceed the incremental costs.

Include:

• Sale proceeds from old asset.
• Lost future operating costs/savings.
• New asset cost.
• Tax effects where relevant.
• Changes in productivity, downtime, quality, capacity, and maintenance risk.

Common trap: treating the old asset’s original cost as relevant. It is sunk.

Business Valuation

Valuation Method Selection

DCF Terminal Value

\[ \text{Terminal Value} = \frac{\text{FCF}_{n+1}}{r-g} \]

Use only when \(g\) is sustainable and lower than the discount rate. Small changes in \(r\) or \(g\) can materially change valuation, so sensitivity analysis is often important.

Enterprise Value to Equity Value Bridge

Normalizing Earnings

Adjust for:

• Owner-manager compensation above or below market.
• One-time legal settlements.
• Unusual gains or losses.
• Related-party transactions not at market terms.
• Non-recurring restructuring costs.
• Redundant assets or expenses.
• Unusual bad debts.
• Temporary supply chain, strike, or shutdown effects.
• Accounting policy differences.

Valuation Traps

• Mixing enterprise value multiples with equity earnings.
• Applying an EBITDA multiple to net income.
• Forgetting debt when moving from enterprise value to share value.
• Using public-company multiples for a small private business without risk adjustments.
• Ignoring customer concentration, key-person risk, or supplier dependence.
• Assuming synergies belong entirely to the seller.
• Treating the valuation result as precise instead of a range.

Mergers, Acquisitions, and Divestitures

Acquisition Analysis Checklist

Earnout Decision Rule

Earnouts can bridge valuation gaps when future performance is uncertain, but they create risk around:

• Metric manipulation.
• Post-closing control.
• Disputes over accounting policies.
• Integration decisions that affect earnout results.
• Timing of payments.

Use earnouts when uncertainty is significant and performance metrics can be clearly defined and monitored.

Financing and Capital Structure

Debt vs Equity

Short-Term vs Long-Term Financing

Covenant Review

Common covenant-related issues:

• Minimum current ratio.
• Maximum debt-to-equity.
• Minimum interest coverage.
• Maximum debt service coverage.
• Restrictions on dividends, acquisitions, asset sales, or new debt.

Candidate trap: recommending more debt without checking covenant headroom and cash flow capacity.

Dividend and Share Repurchase Review

For private companies, always consider shareholder objectives, fairness among shareholders, tax implications if case facts provide them, and liquidity needs.

Working Capital and Treasury Management

Cash Budgeting

A strong cash budget separates:

• Cash receipts from revenue recognition.
• Cash payments from expense recognition.
• Timing of payroll, rent, tax instalments, debt service, and capex.
• Seasonal peaks and troughs.
• Minimum cash balance.
• Borrowing availability and covenant limits.

Common trap: forecasting income statement profit and assuming cash is available.

Receivables Management

Inventory Management

Economic order quantity may be relevant if demand, order cost, and carrying cost are given.

\[ \text{EOQ} = \sqrt{\frac{2DS}{H}} \]

Where:

• \(D\) = annual demand.
• \(S\) = cost per order.
• \(H\) = annual holding cost per unit.

EOQ is a tool, not a conclusion. Also consider stockout risk, supplier reliability, perishability, storage limits, and customer service.

Payables Management

Stretching payables can improve short-term cash flow but may:

• Damage supplier relationships.
• Lose early-payment discounts.
• Trigger credit holds.
• Increase supply chain risk.
• Signal distress to lenders and suppliers.

Working Capital Improvement Checklist

Risk Management and Hedging

Identify the Exposure First

Hedge Instrument Selection

Hedging Traps

• Hedging an exposure that does not exist.
• Hedging the wrong amount or maturity.
• Confusing hedging with speculation.
• Ignoring credit risk of the counterparty.
• Forgetting liquidity implications of margin or collateral.
• Focusing only on expected payoff and ignoring risk reduction.
• Recommending options without acknowledging premium cost.

Cost of Capital and Capital Structure Sensitivities

What Changes WACC?

Sensitivity Analysis: When to Use It

Use sensitivity analysis when the recommendation depends heavily on uncertain assumptions such as:

• Sales volume.
• Selling price.
• Gross margin.
• Exchange rate.
• Discount rate.
• Terminal growth rate.
• Working capital investment.
• Salvage value.
• Synergy realization.
• Interest rate.

A strong response says which variables matter most and what management should monitor.

Governance, Ethics, and Professional Judgment

Finance recommendations should be technically sound and professionally responsible.

Governance Considerations

Ethics Traps

• Manipulating forecasts to justify a preferred project.
• Ignoring downside scenarios to secure financing.
• Failing to disclose conflicts.
• Recommending a transaction that benefits one stakeholder unfairly.
• Treating covenant avoidance as a purely technical exercise rather than a transparency issue.
• Using aggressive assumptions without labelling them as aggressive.

Integration With Accounting, Tax, and Strategy

The CPA Canada PEP Finance Elective is finance-focused, but finance cases often require integration.

Candidate trap: spending too much time on a non-finance issue when the required is clearly a finance decision. Integrate only to the extent it affects the recommendation.

Formula Quick Reference

“If You See This, Think This” Review Table

Common Candidate Mistakes

Technical Mistakes

• Using the wrong discount rate.
• Forgetting tax effects in after-tax analysis.
• Including sunk costs.
• Ignoring opportunity costs.
• Double-counting interest expense and WACC.
• Mixing enterprise value and equity value.
• Using EBITDA multiples on net income.
• Ignoring working capital recovery.
• Treating terminal value as certain.
• Comparing projects with different lives without adjustment.

Case-Writing Mistakes

• Not answering the required.
• Providing calculations without interpretation.
• Listing pros and cons without a recommendation.
• Ignoring case constraints such as liquidity, covenants, ownership control, or strategy.
• Spending too long on low-value issues.
• Making unsupported assumptions.
• Failing to explain why a method was selected.
• Forgetting to state limitations of the analysis.
• Not prioritizing risks by decision impact.

Recommendation Mistakes

Weak recommendation:

“The company should consider the project because the NPV is positive.”

Stronger recommendation:

“The company should proceed with the project if management can secure financing without breaching covenants and if the sales volume assumption is validated. The NPV is positive under the base case, but sensitivity analysis shows the decision is highly dependent on achieving the forecast gross margin.”

Mini Response Templates

Capital Budgeting Template

1. Issue: Determine whether the investment creates value and fits constraints.
2. Quant: Calculate NPV using incremental after-tax cash flows.
3. Sensitivity: Test key assumptions such as sales, margin, capex, discount rate.
4. Qualitative: Consider strategic fit, operational capacity, financing, risk.
5. Recommendation: Accept/reject/defer with conditions and next steps.

Valuation Template

1. Purpose: Acquisition, sale, shareholder buyout, financing, dispute, planning.
2. Method: Explain why DCF, multiples, earnings, or asset method is appropriate.
3. Adjustments: Normalize earnings and identify non-operating assets/debt.
4. Range: Present valuation range, not false precision.
5. Recommendation: State price guidance, negotiation position, and due diligence needs.

Financing Template

1. Need: Amount, timing, duration, purpose.
2. Options: Debt, equity, lease, internal funds, vendor financing, hybrid.
3. Quant: Cost, cash flow impact, covenant impact, dilution.
4. Qualitative: Control, flexibility, risk, lender/investor expectations.
5. Recommendation: Choose financing that matches asset life, risk, and strategy.

Hedging Template

1. Exposure: Currency, interest, commodity, credit, liquidity.
2. Amount/timing: Quantify the exposure.
3. Alternatives: Natural hedge, forward, option, swap, insurance.
4. Tradeoffs: Cost, certainty, upside, complexity, counterparty risk.
5. Recommendation: Hedge only the exposure that aligns with risk policy.

Topic Drill Priorities

Use topic drills and original practice questions to pressure-test the areas most likely to expose weak understanding.

Final Quick Review Checklist

Before a timed practice case or mock exam, ask:

• Did I answer the actual required?
• Did I use case facts instead of generic theory?
• Did I choose the correct finance method?
• Are my cash flows incremental and after tax where appropriate?
• Did I match discount rate to cash flow risk?
• Did I avoid double counting financing costs?
• Did I explain what the calculation means?
• Did I include qualitative factors that could change the decision?
• Did I address liquidity, covenants, control, and stakeholder constraints?
• Did I give a clear recommendation?
• Did I state key assumptions and next steps?

Practical Next Step

After reviewing this Quick Review, move directly into CPA Finance topic drills and original practice questions. Focus on one area at a time, then debrief with detailed explanations until you can explain not only the calculation, but also the recommendation, risks, and business judgment behind it.