CFA - 10 & 11. Corporate Finance

CFA – 10 & 11.
Corporate Finance
Corporate Governance
- Shareholder theory – most important to maximise shareholder returns; minimise
conflicts between insiders and shareholders
- Stakeholder theory – beyond interests of only its shareholders
o Stakeholder theory does not mean all stakeholders should have the right to
participate in the governance. Indeed, only shareholders have such right
- Shareholders
o Shareholders maintain control over the company through their power to elect the
board of directors and vote for resolutions
o Shareholder activism – compelling the company to act, to improve shareholder
value
 Cumulative voting allows minority shareholders to accumulate and vote
 Cross-shareholdings prevent shareholder activism because the cross-held
companies implicitly support each other
o Dual-class structure – to separate voting control from economic ownership –
company insiders carry superior voting rights to others
- Board of directors
o Shareholder-director relationship – principal-agent relationship
o Executive (internal) directors – employees of the company
o Non-executive (external) directors – not employees of the company
o One-tier structure – a single board of directors composed of executive and non-
executive directors
o Two-tier structure – two separate boards
 Supervisory board – primarily composed of non-executive directors, overseeing
management board
 Management (executive) board – composed of executive directors
o CEO duality – CEO also serves as the board’s chairperson, decreasing shareholder
protection
o Duty of care – act on a fully-informed basis, in good faith, with due diligence and
care
o Duty of loyalty – act in the interests of company and shareholders
- Stakeholder management frameworks
o General meetings
 Ordinary resolutions – simple majority of votes, such as election of directors
 Special resolutions – supermajority of votes
 Proxy voting – allow shareholders to authorise another individual to vote on
their behalf – most common
o Audit function
 Internal audits – independent internal audit function
 Audit committee to recommend external auditors
o Remuneration policies
 Primary goal – aligning interests of managers with those of shareholders
 Incentive plans
 Say on pay – shareholders to vote on executive remuneration
- ESG considerations
o Environmental and social factors have been adopted in investment analysis more
slowly than governance factors
o ESG implementation approaches
 Sustainable investing
 Responsible investing
 Thematic investing – focus investments within a specific theme
 Impact investing – ESG along with measurable financial returns
 Negative screening (most common) – exclude investments in certain sectors
 Positive screening/best-in-class
Capital Budgeting
- Assumptions
o Cash flows based on opportunity costs
o After-tax cash flows
o Ignore intangible costs and benefits, which should result in cash flows at some other
times
o Ignore financing costs (e.g. interest costs), which are reflected in required rate of
return
- Investment decision criteria
o Net Present Value (NPV)
 Projects with positive NPVs theoretically increase shareholder value, value of
the company and value of its stock
o Internal required rate of return (IRR)
 For nonconventional cash flows (cash flows that change signs more than once
during the project’s life), there may be multiple IRR or no IRR
o Payback period
 Years required to recover investment (ignore time value of money)
 Ignore cash flows after payback period is reached
o Discounted payback period
 Years required for cumulative discounted cash flows to recover investment
o Profitability index
 Invest if PI > 1, do not invest if PI < 1

- NPV profile
o Crossover rate – the rate at which two projects have the same NPV
Cost of Capital
- Rate of return required by suppliers of capital – bondholders and shareholders
- After-tax cost of debt is generally lower than both cost of equity

- Marginal tax rate, but not average tax rate
- Target capital structure – proportion of capital source
o Forecasted market value, but not current market value
o Without target capital structure, we either use company’s current capital structure
(use market value, but not book value), or average of competitors’ capital structures
- Cost of debt
o Yield to maturity (YTM) – annual return
- Cost of preferred stock
- Cost of common equity

o Capital Asset Pricing Model (CAPM) (most popular)
 Use equity beta – measure of financial risk, but not asset beta – business risk
 Pure-play method
 1st step – un-lever equity beta to get asset beta of comparable company
 2nd step – lever asset beta to get equity beta of project
Higher debt-to-equity ratio of project will increase equity beta, while asset
beta does not change
 (Developing country) country risk premium upon equity risk premium of
developed country
 Country risk premium
= sovereign yield spread*(S.D. of equity market relative to bond market)
o Dividend Discount Model
o Bond yield plus risk premium
- Maybe required to calculate the cost of capital for the new project solely, or the cost of
capital of the whole company after the project
- WACC and Capital budgeting
o When more and more capital is raised
 Increasing marginal cost of capital
 Decreasing marginal return of investment (investment opportunity schedule)
o Optimal capital budget
Leverage
- Business risk
o Business risk = sales risk + operating risk
o Sales risk – uncertainty about price and quantity
o Operating risk – use of both variable and fixed operating costs
 Degree of operating leverage
(Contribution margin/operating income)
- Financial risk – use of debt financing (fixed financing cost)

o Degree of financial leverage
(Operating income/profit before tax)
- Total leverage
o Degree of total leverage
DTL = DOL*DFL = (contribution margin/profit before tax)
- Break-even point
- Operating break-even point
Working Capital Management

- Liquidity
o Operating cycle = days of inventory + days of receivables
o Net operating cycle (cash conversion cycle) = days of inventory + days of
receivables – days of payables
- Accounts receivables management
o Credit terms
 1/10 net 30 = 1% discount if paid within 10 days, or pay full in 30 days

CFA - 10 & 11. Corporate Finance

Uploaded by

Copyright:

Available Formats

CFA - 10 & 11. Corporate Finance

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

CFA - 10 & 11. Corporate Finance

Uploaded by

Copyright:

Available Formats

CFA – 10 & 11.

 Invest if PI > 1, do not invest if PI < 1

- After-tax cost of debt is generally lower than both cost of equity

- Cost of common equity

 2nd step – lever asset beta to get equity beta of project

(Contribution margin/operating income)

- Financial risk – use of debt financing (fixed financing cost)

(Operating income/profit before tax)

- Operating break-even point

Working Capital Management

You might also like