CFA Level 1 Corporate Issuers

CFA Level 1 Corporate Issuers Chapter 1 Organizational Forms, Corporate Issuer Features, and Ownership Lesson 1 Organizational forms of businesses Organizational forms of businesses Businesses Sole Trader or sole proprietorship Partnership Limited company Nonprofits Governments Sole trader or proprietorship Unlimited liability and individual controls business operations I.e. family owned business Passthrough business for tax purpose Operational simplicity and flexibility. Partnership General partnership Unlimited liability and shared control of business operations Service businesses and joint ventures Limited partnership One General partner with unlimited liability and limited partners Pass-through businesses for tax purposes Limited liability partnership (LLP) Does not require a general partner LLP are only permitted for professional services firms in the US Limited companies Allow greater access to financing and expertise for growth Private limited companies ( e.g. LLC) Limited liability for ALL owners Have legal limits on the number of owners and require votes for transferring ownership interest but are pass through businesses on tax P ublic limited companies – Corporations No legal restrictions on the numbers of owners or ownership transferability Taxed at the business level and again at the personal level if profits are distributed to shareholders Lesson 2 Key features of corporate issuers Legal identity Articles of incorporation Owner-manager separation BOD and management Owner/shareholder liability Not responsible for the debts of the corporation unless they guarantee them Limited liability External financing Equity Debt Taxation Double taxation Lesson 3 Publicly vs privately owned corporate issuers Public limited companies are not obliged to list their shares on an exchange Features distinguishing public and private companies The ability to transfer ownership between investors The process of issuing new shares Private companies investors are invited to purchase shares through a private placement Registration and disclosure requirements Three ways private companies go public IPO Direct Listing : no underwriter and no new shares are issued no capital is raised Acquisition Acquired by public companies SPAC (special purpose acquisition company) SPAC is a shell company or blank check company acquiring na private company sometime in the future Going from public to private The varieties of corporate owners National government Companies provide public goods Reasons that a country may reduce its ownership. Opportunities to bring in foreign capital and diversity the country economy a push for privatization and deregulation to potentially lower costs through competition and motivate innovation Chapter 2 Investors and other stakeholders Lesson 1 Financial claims of lenders and shareholders Debt versus equity Debt and equity claims Debtholders Lower risk for investors than equity Interest payments are tax deductible expense to reduce taxable income Equity investors Permanent capital available to issuers Debt versus equity: risk and return Return on equity (Net income / total equity) is higher when debt is used Greater potential shareholder return when debt financing is used – but also the greater risk The use of debt increases the variance in ROE Conflicts of interest among lenders and shareholders Shareholders seek to maximize residual cash flows or firm profits once other obligations are met Bondholders seek to maximize the likelihood that they will receive timely interest and principal payments prefer less risky projects Debt represents a cheaper financing source for companies and a lower risk for investors Equity holders a r e residual claimants to the company after all other stakeholders have been paid Lesson 2 Corporate stakeholders and Governance Stakeholder is an individual or group with a vested interest in a company Debt and equity investors BOD Managers who execute the boards strategy Customers Employees Governments Suppliers Shareholders versus stakeholders Shareholder theory of corporate governance Stakeholder theory of corporate governance ALL stakeholder interests not just those of shareholders I,e ESG Only shareholders have the right to participate in the governance of the firm Investors Public debtholders ( e.g. bondholders) Private debtholders ( e.g. banks lessors) : have direct access to the management and non-public information which lowers information asymmetry Board of directors Both inside directors (founders and current and former managers) and independent directors Single tier board structure in the US and the UK Two-tier corporate is common in continental Europe Supervisory board to oversee the activities of the BOD Staggered board where directors divided into groups elected separately in consecutive years common in Australia Managers Employees Customers Suppliers Governments Lesson 3 Corporate ESG Considerations ESG factors Environmental – conservation of the natural world Physical risks (damage to property stemming from extreme weather) or transition risk ( losses related to transition to a lower carbon economy) Environmental issues have historically been treated as externalities and have thus not been fully addressed in company’s financial reporting Social – consideration of people and relationships Lower a company’s costs through higher employee productivity, lower employee turnover Governance – standards for running a company Proxy statement, annual reports, and sustainability reports Company ownership and voting structure The results of evaluating the effects of environmental and social factors on firm performance are often less clear Evaluating ESG-related risks and opportunities Quantified in financial terms The effects of adverse ESG related events often differ depending on maturity Financial impacted is reflected in a company’s projected financial statement s and ratios Chapter 3 Corporate governance: conflicts, mechanisms, risks, and benefits Lesson 1 stakeholder conflicts and management Principal -agent relationship Conflicts arise where the interests of the principal and agent diverge, resulting in agency costs Shareholder, board directors and manager relationships Compensation is the principal tool used to align the interests of management and shareholders Manager and shareholder interests may diverge in the following ways Insufficient effort Inappropriate risk appetite Empire building: manager’s compensation are tied to business size which can incentivize managers to seek growth for growth’s sake Entrenchment Self-dealing Controlling and minority shareholder relationships Share ownership percentage, difference in shareholder voting scheme , and a share class with different voting rights varying degrees of control among shareholders Dual – class structure : permitting one group of shareholders to have disproportionate power and potentially override the will of the majority Company founders can maintain significant power over the organization Shareholder versus creditor interests Debtholders prefer that a company raise more equity and limited shareholder distributions The potential conflict is greater for long term debt Greater information asymmetry increases risk for shareholders and lenders Lesson 2 Corporate governance mechanism Corporate reporting and transparency Most jurisdiction do not require that private companies’ disclosures be audited Shareholder mechanism Shareholder meetings – annual general meeting (AGM) Board member elections Appointment of independent auditor Approval of annual financial statements, dividends and director and auditor compensation Extraordinary general meetings (EGMs) Special elections of board members, amendments to bylaws, merges and acquisitions, takeovers, and asset sales Shareholder activism Shareholder activists pressure management to act using tactics such as initiating proxy fights, proposing shareholder resolutions, and publicizing issues of contention Hedge funds are among the predominant shareholder activists Help stabilize a company’s strategic direction Although shareholder activism may involve social and political issues, shareholder activists’ primary motivation is to increase shareholder value . Shareholder litigation Shareholder derivative lawsuits legal proceedings initiated against the BOD, management who have failed to act for the benefit of the company Corporate takeovers Proxy contest Tender offers: an invitation to shareholders to sell their interests directly to a group seeking to gain control Hostile takeovers: acquire a company without the consent of the company’s management Creditor mechanisms Bond indenture : a legal contract that describes the structure of a bond, the obligations of the company and the rights of the bond holder Creditor committees : when a company is struggling to meet its obligations , an ad hoc committee may be formed Board and management mechanisms Board of directors Audit committee Should be composed solely of independent board members Nominating /governance committee Typically composed of independent members Appraises director and manager candidates and oversees the board election process Compensation /remuneration committee Develops and proposes remuneration policies for the directors All committee members to be independent Additional committees Risk committees common in financial services industry Employee mechanisms Employee stock ownership plan retain employees. Granted to employees based on service or performance criteria and often include vesting periods Customer and supplier mechanisms Contractual agreements Government mechanisms Laws and regulations Corporate governance codes Lesson 3 Corporate governance risks and benefits Operational risks and benefits Strong governance practices involve proper scrutiny and control at all corporate levels Legal, regulatory, and reputational risks and benefits Company’s reputation Financial risks and benefits Lower default risks are associated with a lower cost of debt Chapter 4 Working Capital and liquidity Lesson 1 Cash conversion cycle Activity ratios Cash conversion cycle: the amount of time between an issuer’s paying its suppliers and receiving cash from customers Cash conversion cycle = days of inventory on hand (DOH) + days sales outstanding (DSO) – days payable outstanding (DPO) In 2020 the average US listed company had a cash conversion ratio of 78 days. Pharmaceutical manufacturers tend to have long cash conversion cycles because they keep a considerable inventory on hand Shorten their cash conversion cycle Reduce days of inventory on hand by discounting products of product lines with low demand Reduce days sales outstanding by offering PPD Increase days payable outstanding by negotiating supplier contract for longer term Working capital efficiency of business operations Total working capital = current assets – current liabilities Net working capital = current assets excluding cash and marketable securities – Current liabilities excluding short term and current debt A short cash conversion cycle is associated with a low ratio of working capital to sales and vice versa The amount of cash and marketable securities on hand does not affect the company’s cash conversion cycle Lesson 2 Liquidity Liquidity for an issuer refers to its ability to meet its short term liabilities Primary liquidity sources Cash and marketable securities on hand Borrowings Cash flow from the business : primary long term source of liquidity Cash flow from operations = cash received from customers + interest and dividends received on financial investments – cash paid to employees and supplies – tax paid to government – interest paid to lenders Free cash flow = cash flow from operations – investment in long term assets Secondary liquidity sources Suspending or reducing dividends to shareholders Delaying or reducing capital expenditures Issuing equity Renegotiating contract terms: short term debt to long term debt Selling assets Filling for bankruptcy Inventory liquidation Factors affecting liquidity: drags and pulls Drag on liquidity: when cash inflows lag Uncollected receivables Obsolete inventory Borrowing constraints Pull on liquidity: acceleration of cash outflows Making payments early Reduced credit limits Limits on short term lines of credit Low liquidity positions Measuring and evaluating liquidity Current ratios = CA/CL Quick ratio = (Cash and short-term marketable instruments + receivables) /CL Cash ratio = (cash + short term marketable instruments)/CL Most conservative because it measures the ability to settle near term obligations using only the most liquid assets Lesson 3 Managing working capital and liquidity Working capital management Permanent current assets (constant over period) and variable current assets Aggressive: smaller short term asset versus sales and greater reliance on short term liabilities Firms with lower profit margin may consider p ursuing a more aggressive working capital policy Conservative: more cash receivables and inventory relative to sales . The most costliest Firms in an early growth phase consider a conservative due to limited access to short term debt Greater reliance on long term financing Moderate strategy: lower financing cost versus conservative approach Liquidity and short term funding Chapter 5 Capital Investments and capital allocation Lesson 1 Capital investments Investments with a life of one year or longer which appear on the balance sheet as long term assets Non cash depreciation or amortization Not limited to PPE and tangible assets but also intangible assets Going concern projects /maintenance capital expenditures i.e. maintaining IT hardware and software, replacing assets nearing the end of the useful life lower risk match funding funding long term assets with shorter debt obligation introduces rollover risk or uncertain financing cost not required to disclose the amount of maintenance capital expenditures or the composition of total capital expenditures regulatory compliance projects increase a firm’s expenses with no added revenue but are required to avoid fines expansion of existing business may introduce execution risks new lines of business and other projects comp letely outside or only minimally related to its existing business Riskiest capital investments The capital allocation process is the process use d by a firm’s management and board to make capital investment based on both internal and public information ROIC and average invested capital Lesson 2 Capital Allocation Management seeks to deliver risk-adjusted returns greater than what investor could earn on similar risk investments elsewhere Steps in the capital allocation process Idea generation Investment analysis : forecasting the amount, timing, duration and volatility of an investments expected cash flows Planning and prioritization Monitoring and post investment review Analytical tools in the investment analysis NPV IRR Return on invested capital, an aggregate return measure NPV Invest if NPV >= 0 A necessary but not sufficient condition for making an investment Internal rate of return Discount rate that makes the NPV of an investment equal to zero Invest if IRR >= required rate of return for a capital investment /hurdle rate Limitation: Multiple IRRs exist if cash flows signs change more than once NPV should be used instead of IRR The most appropriate and theoretically sound criterion is the NPV Return on invested capital A profitability measure for the total capital the management has invested ROIC = after tax operating profit /average invested capital = (1-tax rate) * Operating profit / average total LT liabilities and equity Two paths to a high or increasing ROIC: profit margin and asset turnover ROIC can be compared to investors’ required rate of return Limitations and shortcomings of ROIC ROIC is an accounting not cash based measure ROIC is backward looking and can be volatile from year to year based on investment activity and business conditions Lesson 3 Capital Allocation Principles and Pitfalls Capital allocation principles After-tax cash flows Incremental cash flows only but examine broadly Capital allocation analysis should ignore sunk costs Timing of cash flows Capital allocation pitfalls Cognitive errors in capital allocation Internal forecasting errors Ignoring costs of internal financing : regardless of financing source , management should use appropriate risk-adjusted required rates of return to evaluate capital investments . Those funded by internally generated funds do not automatically get a lower r Cash flow from operations is equity financing Inconsistent treatment of inflation Behavioural biases in capital allocation Inertia : management anchor capital investment budgets to prior year amounts If capital investment each year is static or rising despite falling returns on investment Basing investment decisions on accounting measures such as EPS Managers have an incentive to increase accounting profitability measures. Many capital investments with high NPV can reduce these measures in the near term Pet project bias : projects that receive preferential treatment Failure to consider investment alternatives or alternative scenarios Lesson 4 real options Firms have alternatives, real options, that can alter the value of capital investments Real options are contingent on future events for a company Timing option Sizing option : an abandonment option Flexibility option: demand for a product exceeds capacity, exercise a price-setting option /production flexibility options Fundamental option Investment analysis without considering options Calculation of NPV with real options Project NPV = NPV (without options) – option cost + option value Decision trees and option pricing models Chapter 6 Capital structure Lesson 1 The cost of capital For an issuers , the required rate of return is cost of capital composed of the cost of debt and cost of equity Weighted average cost of capital (WACC) is what issuers use as r in NPV analysis and as the hurdle rate for IRR analysis WACC = cost of debt * weight of debt + cost of equity * weight of equity Cost of debt: debt investors required rate of return on debt financing If interest expense is tax deductible, we reduce the nominal cost of debt by multiplying by (1-tax rate) to obtain an after tax amount The weights of debt and equity are either their market value proportions or target weights provided by the management book value basis or market value weights The cost of equity . The cost of equity is higher than the cost of debt Distributions are not tax deductible Capital investments increase firm value if their returns exceed required rates of return The cost of debt and equity are not selected by management but are determined in financial markets by investors Lesson 2 Factors affecting capital structure Issuers desire a capital structures that minimizes WACC Determinants of the amount and type of financing needed Capital intensive businesses (businesses require a lot of assets) Low asset turnover – sales to total assets ratio Capital light businesses Technology sector and service businesses Corporate life cycle Early stage/startups Requires funding to develop and launch its product and service. Revenues are zero or minimal and the risk of business failure is high Only types of debt financing are leases and convertible debt (convert the debt to equity) Seek equity rather than debt financing Growth Business risk declines and free cash flows improves Equity remains the predominant source of financing Mature phase Positive free cash flow Determinants of costs of debt and equity Influenced by the same risk factors and tend to move together Top down factors: financial market conditions and industry conditions Issuer-specific factors : sales risks, profitability risks (operating leverage), financial leverage and interest coverage, collateral /type of assets owned by the firm Operating leverage = fixed cost /total cost Higher operating leverage experience a greater change in cash flow and profitability for a given change in revenue riskier The stability of profits results from a higher percentage of costs that are variable Interest coverage = profit before interest and tax es/interest expense High interest coverage ratio indicates the firm has lower financial leverage and less risk Lesson 3 Modigliani-miller capital structure propositions Managers cannot change a company’s value by simply changing its capital structure Assumptions Homogeneous expectations Perfect capital markets – no transactions costs, taxes bankruptcy costs Investors can borrow and lend at the risk free rate No agency costs Independent decisions Capital structure irrelevance (MM proposition I without taxes) The value of the levered company (VL) is equal to the value of the unlevered company (Vu) or V L = V U . The value of a company is determined solely by its expected future cash flows (not its relative use of debt versus equity capital). In the absence of taxes, the weighted-average cost of capital is unaffected by capital structure. Higher financial leverage raises the cost of equity (MM proposition II without taxes) MM Proposition II without taxes tells us that adding any amount of lower-cost debt capital to the capital structure is always perfectly offset by an increase in the cost of equity, resulting in no change in the company’s WACC. Cost of equity increases with debt to equity ration with an intercept equal to cost of capital and slope equal to the quantity R0-Rd Higher leverage raises the cost of equity but does not change firm value or WACC The increase in the cost of equity must exactly offset the greater use of lower cost debt Firm value with taxes (MM proposition I with taxes ) In the presence of corporate taxes , the value of the levered company is greater than that of the all equity company by an amount equal to the tax rate multiplied by the value of the debt In the presence of taxes, a profitable company can increases its value by using debt The higher the tax rate, the greater the benefit of using debt in the capital structure VL = Vu + tD , According to MM Proposition I with corporate taxes, the value of the levered company is greater than that of the unlevered company by an amount equal to the tax rate multiplied by the value of the debt ( tD ), defined as the present value of the debt tax shield. Cost of capital (MM Proposition II with taxes) With taxes, as debt increase, the company’ W ACC decreases the company’s value increases In the presence of taxes, the cost of equity rises as the company uses more debt but at a slower rate than in the no-tax case As the company’s uses of debt increases, its WACC decreases and its value increases In the presence of taxes, the use of debt is value enhancing and at extreme, 100% debt is optimal Cost of financial d i stress The heightened uncertainty regarding a company’s ability to meet its obligations To consider about the tax effect for the cash analysis To revisit Lesson 4 Optimal capital structures Static trade-off theory of capital structure : V L = V U + tD ? PV ( Costs of financial distress). Vu represents the value of an unlevered or all equity firm The present value of financial distress costs out weights the tax value beyond the optimal amount of debt point Target capital structure is often expressed using book value for the following reasons Market values can fluctuate substantially and seldom impact the appropriate level of borrowing For management, the primary concern is the amount and types of capital invested by the company, not in the company. Capital structure policy is alig n ed to measures used by third parties Target weights and WACC Pecking order theory and agency costs Investors and issuers have asymmetric information Managers give first preference to financing methods with the leas t potential information content (internally generated funds) and last preference to methods with the most potential information content (public equity offerings) Perking order theory : Asymmetric information. There is no optimal capital structure, and a firm’s capital structure reflects its historic need for external financing. Issuers tend to issue equity when management believes the stock is overvalued Free cash flow hypothes i s: higher debt levels discipline managers by forcing them to manage the company efficiently and use cash wisely Chapter 7 business models Lesson 1 defining the business model Business model features The customers and the market (Who) Segmenting customers by geography, demographics, seasonal or life cycle timing and behaviour Product or service offering ( what and often why) Channels (Where) Selling the firm’s products or services and delivering them to customers Direct sales complex or highly margin products or services Traditional channel strategy: manufacturer to wholesaler to retailer to end customer Omnichannel strategy : relies on both digital and physical channels to complete a sale Pricing (how much) Price takers commodity producers Pricing power Pricing and revenue models Price discrimination Common pricing models Tiered pricing: different prices to different buyers based on volume purchased and product features Dynamic pricing: seasonal pricing Value based pricing : based on the value received by the customers Action/reverse auction models Pricing models used by firms selling multiple or complex products Bundling: incentivized to buy them together Razor, razor bl ad e pricing Add-on pricing The value proposition (who + what + where + how much) Business organization and capabilities Value chain : the systems and processes in a firm that create value for its customers Supply chain : sequence of processes involved in the creation of a product, both within and external to a firm. Lesson 2 Business Model Types Conventional business models Each industry sector tends to have its own version of these conventional models Business model variations Private label or contract manufacturers Value added resellers Licensing arrangements Business model innovation Software as a service (SaaS) Price: monthly fees rather than upfront license Customer: broader, owing to pricing Network effects and platform business models Network effects refer to the increase in value of a network to its users as more users join Crowdsourcing: users contribute directly to a product or service. i.e. tiktok