2018 CFA level 1 study note book4

B OOK 4 – C ORPORATE F INANCE , P ORTFOLIOReading Assignments and Learning Outcome Statements Study Session 10 – Corporate Finance: Corporate Governance, Capital Budgeting,and Cost of Ca

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Table of Contents

1 Getting Started Flyer

2 Table of Contents

3 Page List

4 Book 4: Corporate Finance, Portfolio Management, and Equity Investments

5 Reading Assignments and Learning Outcome Statements

6 Corporate Governance and ESG: An Introduction

1 LOS 34.a: Describe corporate governance

2 LOS 34.b: Describe a company's stakeholder groups and compare interests

of stakeholder groups

3 LOS 34.c: Describe principal–agent and other relationships in corporategovernance and the conflicts that may arise in these relationships

4 LOS 34.d: Describe stakeholder management

5 LOS 34.e: Describe mechanisms to manage stakeholder relationships andmitigate associated risks

6 LOS 34.f: Describe functions and responsibilities of a company's board ofdirectors and its committees

7 LOS 34.g: Describe market and non-market factors that can affect

stakeholder relationships and corporate governance

8 LOS 34.h: Identify potential risks of poor corporate governance and

stakeholder management and identify benefits from effective corporategovernance and stakeholder management

9 LOS 34.i: Describe factors relevant to the analysis of corporate governanceand stakeholder management

10 LOS 34.j: Describe environmental and social considerations in investmentanalysis

11 LOS 34.k: Describe how environmental, social, and governance factors may

be used in investment analysis

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1 Answers – Concept Checkers

7 Capital Budgeting

1 LOS 35.a: Describe the capital budgeting process and distinguish among thevarious categories of capital projects

2 LOS 35.b: Describe the basic principles of capital budgeting

3 LOS 35.c: Explain how the evaluation and selection of capital projects isaffected by mutually exclusive projects, project sequencing, and capitalrationing

4 LOS 35.d: Calculate and interpret net present value (NPV), internal rate ofreturn (IRR), payback period, discounted payback period, and profitabilityindex (PI) of a single capital project

5 LOS 35.e: Explain the NPV profile, compare the NPV and IRR methods whenevaluating independent and mutually exclusive projects, and describe theproblems associated with each of the evaluation methods

6 LOS 35.f: Describe expected relations among an investment's NPV,

company value, and share price

9 LOS 36.i: Calculate and interpret the beta and cost of capital for a project

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10 LOS 36.j: Describe uses of country risk premiums in estimating the cost ofequity.

11 LOS 36.k: Describe the marginal cost of capital schedule, explain why it may

be upward-sloping with respect to additional capital, and calculate andinterpret its break-points

12 LOS 36.l: Explain and demonstrate the correct treatment of flotation costs

3 LOS 37.c: Analyze the effect of financial leverage on a company's net

income and return on equity

4 LOS 37.d: Calculate the breakeven quantity of sales and determine thecompany's net income at various sales levels

5 LOS 37.e: Calculate and interpret the operating breakeven quantity ofsales

10 Working Capital Management

1 LOS 38.a: Describe primary and secondary sources of liquidity and factorsthat influence a company's liquidity position

2 LOS 38.b: Compare a company's liquidity measures with those of peer

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3 LOS 38.c: Evaluate working capital effectiveness of a company based on itsoperating and cash conversion cycles and compare the company's

effectiveness with that of peer companies

4 LOS 38.d: Describe how different types of cash flows affect a company's netdaily cash position

5 LOS 38.e: Calculate and interpret comparable yields on various securities,compare portfolio returns against a standard benchmark, and evaluate acompany's short-term investment policy guidelines

6 LOS 38.f: Evaluate a company's management of accounts receivable,

inventory, and accounts payable over time and compared to peer

companies

7 LOS 38.g: Evaluate the choices of short-term funding available to a

company and recommend a financing method

11 Self-Test Assessment: Corporate Finance

1 Self-Test Assessment Answers: Corporate Finance

12 Portfolio Management: An Overview

1 LOS 39.a: Describe the portfolio approach to investing

2 LOS 39.b: Describe types of investors and distinctive characteristics andneeds of each

3 LOS 39.c: Describe defined contribution and defined benefit pension plans

4 LOS 39.d: Describe the steps in the portfolio management process

5 LOS 39.e: Describe mutual funds and compare them with other pooledinvestment products

13 Risk Management: An Introduction

1 LOS 40.a: Define risk management

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2 LOS 40.b: Describe features of a risk management framework.

3 LOS 40.c: Define risk governance and describe elements of effective riskgovernance

4 LOS 40.d: Explain how risk tolerance affects risk management

5 LOS 40.e: Describe risk budgeting and its role in risk governance

6 LOS 40.f: Identify financial and non-financial sources of risk and describehow they may interact

7 LOS 40.g: Describe methods for measuring and modifying risk exposuresand factors to consider in choosing among the methods

14 Portfolio Risk and Return: Part I

1 LOS 41.a: Calculate and interpret major return measures and describe theirappropriate uses

2 LOS 41.b: Describe characteristics of the major asset classes that investorsconsider in forming portfolios

3 LOS 41.c: Calculate and interpret the mean, variance, and covariance (orcorrelation) of asset returns based on historical data

4 LOS 41.d: Explain risk aversion and its implications for portfolio selection

5 LOS 41.e: Calculate and interpret portfolio standard deviation

6 LOS 41.f: Describe the effect on a portfolio's risk of investing in assets thatare less than perfectly correlated

7 LOS 41.g: Describe and interpret the minimum-variance and efficientfrontiers of risky assets and the global minimum-variance portfolio

8 LOS 41.h: Explain the selection of an optimal portfolio, given an investor'sutility (or risk aversion) and the capital allocation line

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15 Portfolio Risk and Return: Part II

1 LOS 42.a: Describe the implications of combining a risk-free asset with aportfolio of risky assets

2 LOS 42.b: Explain the capital allocation line (CAL) and the capital marketline (CML)

3 LOS 42.c: Explain systematic and nonsystematic risk, including why aninvestor should not expect to receive additional return for bearing

nonsystematic risk

4 LOS 42.d: Explain return generating models (including the market model)and their uses

5 LOS 42.e: Calculate and interpret beta

6 LOS 42.f: Explain the capital asset pricing model (CAPM), including itsassumptions, and the security market line (SML)

7 LOS 42.g: Calculate and interpret the expected return of an asset using theCAPM

8 LOS 42.h: Describe and demonstrate applications of the CAPM and theSML

9 LOS 42.i: Calculate and interpret the Sharpe ratio, Treynor ratio, M2, andJensen's alpha

16 Basics of Portfolio Planning and Construction

1 LOS 43.a: Describe the reasons for a written investment policy statement(IPS)

2 LOS 43.b: Describe the major components of an IPS

3 LOS 43.c: Describe risk and return objectives and how they may be

developed for a client

4 LOS 43.d: Distinguish between the willingness and the ability (capacity) totake risk in analyzing an investor's financial risk tolerance

5 LOS 43.e: Describe the investment constraints of liquidity, time horizon, taxconcerns, legal and regulatory factors, and unique circumstances and theirimplications for the choice of portfolio assets

6 LOS 43.f: Explain the specification of asset classes in relation to asset

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17 Self-Test Assessment: Portfolio Management

1 Self-Test Assessment Answers: Portfolio Management

18 Market Organization and Structure

1 LOS 44.a: Explain the main functions of the financial system

2 LOS 44.b: Describe classifications of assets and markets

3 LOS 44.c: Describe the major types of securities, currencies, contracts,commodities, and real assets that trade in organized markets, includingtheir distinguishing characteristics and major subtypes

4 LOS 44.d: Describe types of financial intermediaries and services that theyprovide

5 LOS 44.e: Compare positions an investor can take in an asset

6 LOS 44.f: Calculate and interpret the leverage ratio, the rate of return on amargin transaction, and the security price at which the investor wouldreceive a margin call

7 LOS 44.g: Compare execution, validity, and clearing instructions

8 LOS 44.h: Compare market orders with limit orders

9 LOS 44.i: Define primary and secondary markets and explain how

secondary markets support primary markets

10 LOS 44.j: Describe how securities, contracts, and currencies are traded inquote-driven, order-driven, and brokered markets

11 LOS 44.k: Describe characteristics of a well-functioning financial system

12 LOS 44.l: Describe objectives of market regulation

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19 Security Market Indexes

1 LOS 45.a: Describe a security market index

2 LOS 45.b: Calculate and interpret the value, price return, and total return of

6 LOS 45.f: Describe rebalancing and reconstitution of an index

7 LOS 45.g: Describe uses of security market indexes

8 LOS 45.h: Describe types of equity indexes

9 LOS 45.i: Describe types of fixed-income indexes

10 LOS 45.j: Describe indexes representing alternative investments

11 LOS 45.k: Compare types of security market indexes

2 LOS 46.b: Distinguish between market value and intrinsic value

3 LOS 46.c: Explain factors that affect a market's efficiency

4 LOS 46.d: Contrast weak-form, semi-strong-form, and strong-form marketefficiency

5 LOS 46.e: Explain the implications of each form of market efficiency for

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fundamental analysis, technical analysis, and the choice between activeand passive portfolio management.

6 LOS 46.f: Describe market anomalies

7 LOS 46.g: Describe behavioral finance and its potential relevance to

understanding market anomalies

21 Overview of Equity Securities

1 LOS 47.a: Describe characteristics of types of equity securities

2 LOS 47.b: Describe differences in voting rights and other ownership

characteristics among different equity classes

3 LOS 47.c: Distinguish between public and private equity securities

4 LOS 47.d: Describe methods for investing in non-domestic equity securities

5 LOS 47.e: Compare the risk and return characteristics of different types ofequity securities

6 LOS 47.f: Explain the role of equity securities in the financing of a

22 Introduction to Industry and Company Analysis

1 LOS 48.a: Explain uses of industry analysis and the relation of industryanalysis to company analysis

2 LOS 48.b: Compare methods by which companies can be grouped, current

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industry classification systems, and classify a company, given a description

of its activities and the classification system

3 LOS 48.c: Explain the factors that affect the sensitivity of a company to thebusiness cycle and the uses and limitations of industry and companydescriptors such as “growth,” “defensive,” and “cyclical.”

4 LOS 48.d: Explain how a company's industry classification can be used toidentify a potential “peer group” for equity valuation

5 LOS 48.e: Describe the elements that need to be covered in a thoroughindustry analysis

6 LOS 48.f: Describe the principles of strategic analysis of an industry

7 LOS 48.g: Explain the effects of barriers to entry, industry concentration,industry capacity, and market share stability on pricing power and pricecompetition

8 LOS 48.h: Describe industry life cycle models, classify an industry as to lifecycle stage, and describe limitations of the life-cycle concept in forecastingindustry performance

9 LOS 48.i: Compare characteristics of representative industries from thevarious economic sectors

10 LOS 48.j: Describe macroeconomic, technological, demographic,

governmental, and social influences on industry growth, profitability, andrisk

11 LOS 48.k: Describe the elements that should be covered in a thoroughcompany analysis

23 Equity Valuation: Concepts and Basic Tools

1 LOS 49.a: Evaluate whether a security, given its current market price and avalue estimate, is overvalued, fairly valued, or undervalued by the market

2 LOS 49.b: Describe major categories of equity valuation models

3 LOS 49.c: Describe regular cash dividends, extra dividends, liquidatingdividends, stock dividends, stock splits, and reverse stock splits, includingtheir expected effect on shareholders' wealth and a company's financial

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4 LOS 49.d: Describe dividend payment chronology

5 LOS 49.e: Explain the rationale for using present value models to valueequity and describe the dividend discount and free-cash-flow-to-equitymodels

6 LOS 49.f: Calculate the intrinsic value of a non-callable, non-convertiblepreferred stock

7 LOS 49.g: Calculate and interpret the intrinsic value of an equity securitybased on the Gordon (constant) growth dividend discount model or a two-stage dividend discount model, as appropriate

8 LOS 49.h: Identify characteristics of companies for which the constantgrowth or a multistage dividend discount model is appropriate

9 LOS 49.i: Explain the rationale for using price multiples to value equity, howthe price to earnings multiple relates to fundamentals, and the use ofmultiples based on comparables

10 LOS 49.j: Calculate and interpret the following multiples: price to earnings,price to an estimate of operating cash flow, price to sales, and price tobook value

11 LOS 49.k: Describe enterprise value multiples and their use in estimatingequity value

12 LOS 49.l: Describe asset-based valuation models and their use in estimatingequity value

13 LOS 49.m: Explain advantages and disadvantages of each category of

24 Self-Test Assessment: Equity Investments

1 Self-Test Assessment Answers: Equity Investments

25 Formulas

26 Copyright

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B OOK 4 – C ORPORATE F INANCE , P ORTFOLIO

Reading Assignments and Learning Outcome Statements

Study Session 10 – Corporate Finance: Corporate Governance, Capital Budgeting,and Cost of Capital

Study Session 11 – Corporate Finance: Leverage and Working Capital ManagementSelf-Test Assessment: Corporate Finance

Study Session 12 – Portfolio Management

Self-Test Assessment: Portfolio Management

Study Session 13 – Equity Market Organization, Market Indexes, and MarketEfficiency

Study Session 14 – Equity Analysis and Valuation

Self-Test Assessment: Equity Investments

Formulas

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R EADING A SSIGNMENTS AND L EARNING O UTCOME

39 Portfolio Management: An Overview

40 Risk Management: An Introduction

41 Portfolio Risk and Return: Part I

42 Portfolio Risk and Return: Part II

43 Basics of Portfolio Planning and Construction

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STUDY SESSION 13

Reading Assignments

Equity and Fixed Income, CFA Program Level I 2018 Curriculum

(CFA Institute, 2017)

44 Market Organization and Structure

45 Security Market Indexes

47 Overview of Equity Securities

48 Introduction to Industry and Company Analysis

49 Equity Valuation: Concepts and Basic Tools

LEARNING OUTCOME STATEMENTS (LOS)

STUDY SESSION 10

The topical coverage corresponds with the following CFA Institute assigned reading:

34 Corporate Governance and ESG: An Introduction

The candidate should be able to:

a describe corporate governance (page 1)

b describe a company’s stakeholder groups and compare interests of

stakeholder groups (page 2)

c describe principal–agent and other relationships in corporate governanceand the conflicts that may arise in these relationships (page 3)

d describe stakeholder management (page 4)

e describe mechanisms to manage stakeholder relationships and mitigateassociated risks (page 4)

f describe functions and responsibilities of a company’s board of directors andits committees (page 5)

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g describe market and non-market factors that can affect stakeholder

relationships and corporate governance (page 7)

h identify potential risks of poor corporate governance and stakeholder

management and identify benefits from effective corporate governanceand stakeholder management (page 9)

i describe factors relevant to the analysis of corporate governance and

stakeholder management (page 9)

j describe environmental and social considerations in investment analysis.(page 11)

k describe how environmental, social, and governance factors may be used ininvestment analysis (page 12)

35 Capital Budgeting

a describe the capital budgeting process and distinguish among the variouscategories of capital projects (page 18)

b describe the basic principles of capital budgeting (page 19)

c explain how the evaluation and selection of capital projects is affected bymutually exclusive projects, project sequencing, and capital rationing.(page 21)

d calculate and interpret net present value (NPV), internal rate of return (IRR),payback period, discounted payback period, and profitability index (PI) of asingle capital project (page 21)

e explain the NPV profile, compare the NPV and IRR methods when evaluatingindependent and mutually exclusive projects, and describe the problemsassociated with each of the evaluation methods (page 29)

f describe expected relations among an investment’s NPV, company value,and share price (page 32)

36 Cost of Capital

a calculate and interpret the weighted average cost of capital (WACC) of acompany (page 41)

b describe how taxes affect the cost of capital from different capital sources.(page 41)

c describe the use of target capital structure in estimating WACC and howtarget capital structure weights may be determined (page 43)

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d explain how the marginal cost of capital and the investment opportunityschedule are used to determine the optimal capital budget (page 44)

e explain the marginal cost of capital’s role in determining the net presentvalue of a project (page 45)

f calculate and interpret the cost of debt capital using the yield-to-maturityapproach and the debt-rating approach (page 45)

g calculate and interpret the cost of noncallable, nonconvertible preferredstock (page 46)

h calculate and interpret the cost of equity capital using the capital assetpricing model approach, the dividend discount model approach, and thebond-yield-plus risk-premium approach (page 47)

i calculate and interpret the beta and cost of capital for a project (page 49)

j describe uses of country risk premiums in estimating the cost of equity.(page 51)

k describe the marginal cost of capital schedule, explain why it may be

upward-sloping with respect to additional capital, and calculate and

interpret its break-points (page 52)

l explain and demonstrate the correct treatment of flotation costs (page 54)

STUDY SESSION 11

37 Measures of Leverage

a define and explain leverage, business risk, sales risk, operating risk, andfinancial risk and classify a risk (page 66)

b calculate and interpret the degree of operating leverage, the degree offinancial leverage, and the degree of total leverage (page 67)

c analyze the effect of financial leverage on a company’s net income andreturn on equity (page 70)

d calculate the breakeven quantity of sales and determine the company’s netincome at various sales levels (page 72)

e calculate and interpret the operating breakeven quantity of sales (page 72)

38 Working Capital Management

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a describe primary and secondary sources of liquidity and factors that

influence a company’s liquidity position (page 81)

b compare a company’s liquidity measures with those of peer companies.(page 82)

c evaluate working capital effectiveness of a company based on its operatingand cash conversion cycles and compare the company’s effectiveness withthat of peer companies (page 84)

d describe how different types of cash flows affect a company’s net daily cashposition (page 84)

e calculate and interpret comparable yields on various securities, compareportfolio returns against a standard benchmark, and evaluate a company’sshort-term investment policy guidelines (page 85)

f evaluate a company’s management of accounts receivable, inventory, andaccounts payable over time and compared to peer companies (page 87)

g evaluate the choices of short-term funding available to a company andrecommend a financing method (page 90)

STUDY SESSION 12

39 Portfolio Management: An Overview

a describe the portfolio approach to investing (page 102)

b describe types of investors and distinctive characteristics and needs of each.(page 103)

c describe defined contribution and defined benefit pension plans (page 104)

d describe the steps in the portfolio management process (page 105)

e describe mutual funds and compare them with other pooled investmentproducts (page 105)

40 Risk Management: An Introduction

a define risk management (page 114)

b describe features of a risk management framework (page 115)

c define risk governance and describe elements of effective risk governance.(page 115)

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d explain how risk tolerance affects risk management (page 115)

e describe risk budgeting and its role in risk governance (page 116)

f identify financial and non-financial sources of risk and describe how theymay interact (page 116)

g describe methods for measuring and modifying risk exposures and factors

to consider in choosing among the methods (page 117)

41 Portfolio Risk and Return: Part I

a calculate and interpret major return measures and describe their

appropriate uses (page 125)

b describe characteristics of the major asset classes that investors consider informing portfolios (page 128)

c calculate and interpret the mean, variance, and covariance (or correlation)

of asset returns based on historical data (page 129)

d explain risk aversion and its implications for portfolio selection (page 132)

e calculate and interpret portfolio standard deviation (page 133)

f describe the effect on a portfolio’s risk of investing in assets that are lessthan perfectly correlated (page 134)

g describe and interpret the minimum-variance and efficient frontiers of riskyassets and the global minimum-variance portfolio (page 136)

h explain the selection of an optimal portfolio, given an investor’s utility (orrisk aversion) and the capital allocation line (page 137)

42 Portfolio Risk and Return: Part II

a describe the implications of combining a risk-free asset with a portfolio ofrisky assets (page 148)

b explain the capital allocation line (CAL) and the capital market line (CML).(page 149)

c explain systematic and nonsystematic risk, including why an investor shouldnot expect to receive additional return for bearing nonsystematic risk.(page 153)

d explain return generating models (including the market model) and theiruses (page 155)

e calculate and interpret beta (page 156)

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f explain the capital asset pricing model (CAPM), including its assumptions,and the security market line (SML) (page 158)

g calculate and interpret the expected return of an asset using the CAPM.(page 162)

h describe and demonstrate applications of the CAPM and the SML (page163)

i calculate and interpret the Sharpe ratio, Treynor ratio, M 2, and Jensen’salpha (page 165)

43 Basics of Portfolio Planning and Construction

a describe the reasons for a written investment policy statement (IPS) (page174)

b describe the major components of an IPS (page 174)

c describe risk and return objectives and how they may be developed for aclient (page 175)

d distinguish between the willingness and the ability (capacity) to take risk inanalyzing an investor’s financial risk tolerance (page 176)

e describe the investment constraints of liquidity, time horizon, tax concerns,legal and regulatory factors, and unique circumstances and their

implications for the choice of portfolio assets (page 176)

f explain the specification of asset classes in relation to asset allocation (page178)

g describe the principles of portfolio construction and the role of asset

allocation in relation to the IPS (page 179)

STUDY SESSION 13

44 Market Organization and Structure

a explain the main functions of the financial system (page 189)

b describe classifications of assets and markets (page 191)

c describe the major types of securities, currencies, contracts, commodities,and real assets that trade in organized markets, including their

distinguishing characteristics and major subtypes (page 192)

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d describe types of financial intermediaries and services that they provide.(page 195)

e compare positions an investor can take in an asset (page 198)

f calculate and interpret the leverage ratio, the rate of return on a margintransaction, and the security price at which the investor would receive amargin call (page 200)

g compare execution, validity, and clearing instructions (page 201)

h compare market orders with limit orders (page 201)

i define primary and secondary markets and explain how secondary marketssupport primary markets (page 205)

j describe how securities, contracts, and currencies are traded in driven, order-driven, and brokered markets (page 206)

quote-k describe characteristics of a well-functioning financial system (page 208)

l describe objectives of market regulation (page 209)

45 Security Market Indexes

a describe a security market index (page 218)

b calculate and interpret the value, price return, and total return of an index.(page 218)

c describe the choices and issues in index construction and management.(page 219)

d compare the different weighting methods used in index construction (page219)

e calculate and analyze the value and return of an index given its weightingmethod (page 221)

f describe rebalancing and reconstitution of an index (page 225)

g describe uses of security market indexes (page 226)

h describe types of equity indexes (page 226)

i describe types of fixed-income indexes (page 227)

j describe indexes representing alternative investments (page 228)

k compare types of security market indexes (page 229)

46 Market Efficiency

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a describe market efficiency and related concepts, including their importance

to investment practitioners (page 237)

b distinguish between market value and intrinsic value (page 238)

c explain factors that affect a market’s efficiency (page 238)

d contrast weak-form, semi-strong-form, and strong-form market efficiency.(page 239)

e explain the implications of each form of market efficiency for fundamentalanalysis, technical analysis, and the choice between active and passiveportfolio management (page 240)

f describe market anomalies (page 241)

g describe behavioral finance and its potential relevance to understandingmarket anomalies (page 244)

STUDY SESSION 14

47 Overview of Equity Securities

a describe characteristics of types of equity securities (page 250)

b describe differences in voting rights and other ownership characteristicsamong different equity classes (page 251)

c distinguish between public and private equity securities (page 252)

d describe methods for investing in non-domestic equity securities (page253)

e compare the risk and return characteristics of different types of equitysecurities (page 254)

f explain the role of equity securities in the financing of a company’s assets.(page 255)

g distinguish between the market value and book value of equity securities.(page 255)

h compare a company’s cost of equity, its (accounting) return on equity, andinvestors’ required rates of return (page 256)

48 Introduction to Industry and Company Analysis

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a explain uses of industry analysis and the relation of industry analysis tocompany analysis (page 263)

b compare methods by which companies can be grouped, current industryclassification systems, and classify a company, given a description of itsactivities and the classification system (page 263)

c explain the factors that affect the sensitivity of a company to the businesscycle and the uses and limitations of industry and company descriptorssuch as “growth,” “defensive,” and “cyclical.” (page 266)

d explain how a company’s industry classification can be used to identify apotential “peer group” for equity valuation (page 267)

e describe the elements that need to be covered in a thorough industryanalysis (page 268)

f describe the principles of strategic analysis of an industry (page 268)

g explain the effects of barriers to entry, industry concentration, industrycapacity, and market share stability on pricing power and price

competition (page 270)

h describe industry life cycle models, classify an industry as to life cycle stage,and describe limitations of the life-cycle concept in forecasting industryperformance (page 272)

i compare characteristics of representative industries from the various

economic sectors (page 274)

j describe macroeconomic, technological, demographic, governmental, andsocial influences on industry growth, profitability, and risk (page 274)

k describe the elements that should be covered in a thorough companyanalysis (page 275)

49 Equity Valuation: Concepts and Basic Tools

a evaluate whether a security, given its current market price and a valueestimate, is overvalued, fairly valued, or undervalued by the market (page283)

b describe major categories of equity valuation models (page 284)

c describe regular cash dividends, extra dividends, stock dividends, stocksplits, reverse stock splits, and share repurchases (page 285)

d describe dividend payment chronology (page 286)

e explain the rationale for using present value models to value equity anddescribe the dividend discount and free-cash-flow-to-equity models (page286)

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f calculate the intrinsic value of a non-callable, non-convertible preferredstock (page 290)

g calculate and interpret the intrinsic value of an equity security based on theGordon (constant) growth dividend discount model or a two-stage dividenddiscount model, as appropriate (page 291)

h identify characteristics of companies for which the constant growth or amultistage dividend discount model is appropriate (page 296)

i explain the rationale for using price multiples to value equity, how the price

to earnings multiple relates to fundamentals, and the use of multiplesbased on comparables (page 297)

j calculate and interpret the following multiples: price to earnings, price to anestimate of operating cash flow, price to sales, and price to book value.(page 297)

k describe enterprise value multiples and their use in estimating equity value.(page 302)

l describe asset-based valuation models and their use in estimating equityvalue (page 303)

m explain advantages and disadvantages of each category of valuation model.(page 305)

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The following is a review of the Corporate Finance principles designed to address the learning outcome statements set forth by CFA Institute Cross-Reference to CFA Institute Assigned Reading #34.

factors into the portfolio selection process is presented

LOS 34.a: Describe corporate governance.

CFA ® Program Curriculum, Volume 4, page 6

In the CFA Institute publication, The Corporate Governance of Listed Companies: A Manual for Investors 1 , corporate governance is described as “the system of

internal controls and procedures by which individual companies are managed Itprovides a framework that defines the rights, roles and responsibilities of variousgroups within an organization At its core, corporate governance is the

arrangement of checks, balances, and incentives a company needs in order to

minimize and manage the conflicting interests between insiders and external

shareowners.”

Under shareholder theory, the primary focus of a system of corporate governance

is the interests of the firm’s shareholders, which are taken to be the maximization

of the market value of the firm’s common equity Under this theory, corporategovernance is primarily concerned with the conflict of interest between the firm’smanagers and its owners (shareholders)

The focus of corporate governance under stakeholder theory is broader; it

considers conflicts among the several groups that have an interest in the activitiesand performance of the firm These groups include shareholders, employees,

suppliers, and customers, among others

LOS 34.b: Describe a company’s stakeholder groups and compare interests of stakeholder groups.

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The following have been identified as the primary stakeholders of a corporation.

Shareholders have a residual interest in the corporation in that they have claim to

the net assets of the corporation after all liabilities have been settled Shareholdershave voting rights for the election of the board of directors and for other importantcorporate matters, which gives them effective control of the firm and its

management They have an interest in the ongoing profitability and growth of thefirm, both of which can increase the value of their ownership shares

The board of directors has a responsibility to protect the interests of shareholders;

to hire, fire, and set the compensation of the firm’s senior managers; to set thestrategic direction of the firm; and to monitor financial performance and otheraspects of the firm’s ongoing activities

Typically, the firm’s executives (most-senior managers) serve on the board of

directors, along with directors who are not otherwise employed by the firm In aone-tier board structure, both company executives and non-executive board

members serve on a single board of directors In some countries, boards have atwo-tier structure in which the non-executive board members serve on a

supervisory board that oversees a management board, made up of company

executives

Senior managers typically receive compensation (remuneration) that is made up of

a salary, a bonus based on some measure of company performance, and perquisites(e.g., expense accounts, use of company planes, special retirement benefits,

vacation time off) Their interests can be expected to include continued

employment and maximizing the total value of their compensation Executive

bonuses are typically tied to some measure of firm performance, giving seniormanagers a strong interest in the financial success of the firm

Employees also have an interest in the sustainability and success of the firm They

have an interest in their rate of pay, opportunities for career advancement, training,and working conditions

Creditors supply debt capital to the firm and are primarily owners of the firm’s

outstanding bonds and banks that have made loans to the firm Providers of debtcapital to the firm do not typically have a vote in firm management and do notparticipate in firm growth beyond receiving their promised interest and principalpayments The interests of creditors are protected to varying degrees by covenants

in their debt agreements with the firm

Suppliers of resources to the firm have an interest preserving an ongoing

relationship with the firm, in the profitability of their trade with the firm, and in thegrowth and ongoing stability of the firm As they are typically short-term creditors

of the firm, they also have an interest in the firm’s solvency and on-going financialstrength

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LOS 34.c: Describe principal–agent and other relationships in corporate

governance and the conflicts that may arise in these relationships.

The principal-agent conflict arises because an agent is hired to act in the interest of

the principal, but an agent’s interests may not coincide exactly with those of theprincipal Consider an insurance agent who is paid a commission on policies written

It would be in the agent’s interest to write insurance policies on people or propertythat are not good risks, in order to maximize commission income The principal (theowners of the insurance company) does not want to issue policies that are bad risks

as that is a money- losing proposition Insurance companies mitigate this conflict byimposing underwriting standards for the policies they will issue and by continuing towork only with agents who consistently act in the company’s best interest

Conflicts of interest between shareholders and managers or directors

In the context of a corporation, shareholders are the principals (owners), and firmmanagement and board members (directors) are their agents Managers and

directors may choose a lower level of business risk than shareholders would Thisconflict can arise because the risk of company managers and directors is moredependent of firm performance compared to the risk of shareholders, who holddiversified portfolios of stocks and are not dependent on the firm for employment.Conflicts may also arise when directors who are also managers favor managementinterests at the expense of shareholders or when directors favor one group ofshareholders at the expense of another

There is also an information asymmetry between shareholders and managers

because managers have more and better information about the functioning of thefirm and its strategic direction than shareholders do This decreases the ability ofshareholders or non-executive directors to monitor and evaluate whether managersare acting in the best interests of shareholders

Conflicts between groups of shareholders

A single shareholder or group of shareholders may hold a majority of the votes andact against the interests of the minority shareholders Some firms have differentclasses of common stock outstanding, some with more voting power than others Agroup of shareholders may have effective control of the company although theyhave a claim to less than 50% of the earnings and assets of the company

In the event of an acquisition of the company, controlling shareholders may be in aposition to get better terms for themselves relative to the terms forced on minority

shareholders Majority shareholders may cause the company to enter into related

party transactions, agreements or specific transactions that benefit entities in

which they have a financial interest, to the detriment of minority shareholders

Conflicts of interest between creditors and shareholders

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Shareholders may prefer more business risk than creditors do because creditorshave a limited upside from good results compared to shareholders Equity ownerscould also act against the interests of creditors by issuing new debt that increasesthe default risk faced by existing debt holders, or by the company paying greaterdividends to equity holders, thereby increasing creditors’ risk of default.

Conflicts of interest between shareholders and other stakeholders

The company may decide to raise prices or reduce product quality in order to

increase profits to the detriment of customers The company may employ strategiesthat significantly reduce the taxes they pay to the government

LOS 34.d: Describe stakeholder management.

LOS 34.e: Describe mechanisms to manage stakeholder relationships and mitigate associated risks.

Stakeholder management refers to the management of company relations with

stakeholders and is based on having a good understanding of stakeholder interestsand maintaining effective communication with stakeholders The management ofstakeholder relationships is based on four types of infrastructures:

1 The legal infrastructure identifies the laws relevant to and the legal recourse

of stakeholders when their rights are violated

2 The contractual infrastructure refers to the contracts between the company

and its stakeholders that spell out the rights and responsibilities of the

company and the stakeholders

3 The organizational infrastructure refers to a company’s corporate

governance procedures, including its internal systems and practices that

address how it manages its stakeholder relationships

4 Governmental infrastructure comprises the regulations to which companies

are subject

With respect to the company’s relationship with shareholders, there are standardpractices These practices are required by corporate laws and similar in many

jurisdictions, although there are some differences across countries

Corporations typically hold an annual general meeting after the end of the firm’s

fiscal year At the general meeting, company management provides shareholderswith the audited financial statements for the year, addresses the company’s

performance and significant actions over the period, and answers shareholderquestions

Corporate laws dictate when the annual general meeting may occur and how themeeting must be communicated to shareholders Typically, anyone owning shares is

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permitted to attend the annual general meeting, to speak or ask questions, and tovote their shares A shareholder who does not attend the annual general meeting

can vote her shares by proxy, meaning she assigns her right to vote to another who

will attend the meeting, often a director, member of management, or the

shareholder’s investment advisor A proxy may specify the shareholder’s vote onspecific issues or leave the vote to the discretion of the person to whom the proxy isassigned

Ordinary resolutions, such as approval of auditor and the election of directors,require a simple majority of the votes cast Other resolutions, such as those

regarding a merger or takeover, or that require amendment of corporate bylaws,

are termed special resolutions and may require a supermajority vote for passage,

typically two-thirds or three-fourths of the votes cast Such special resolutions can

also be addressed at extraordinary general meetings, which can be called anytime

there is a resolution about a matter that requires a vote of the shareholders

When there are multiple board member elections at one meeting, some companies

use majority voting and some use cumulative voting With majority voting, the

candidate with the most votes for each single board position is elected With

cumulative voting, shareholders can cast all their votes (shares times number of

board position elections) for a single board candidate or divide them among boardcandidates Cumulative voting can result in greater minority shareholder

representation on the board compared to majority voting

Minority shareholders may have special rights by law when the company is acquired

management, finance, or industry strategy In a one-tier board, there is a single

board of directors that includes both internal and external directors Internal

directors (also called executive directors) are typically senior managers employed bythe firm External board members (also called non-executive directors) are thosewho are not company management Non-executive directors who have no other

relationship with the company are termed independent directors Employee board

representatives may be a significant portion of the non-executive directors

In a two-tier board structure, there is a supervisory board that typically excludes

executive directors The supervisory board and the management board (made up ofexecutive directors) operate independently The management board is typically led

by the company’s CEO

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With a one-tier board, the chairman of the board is sometimes the company CEO.While this was common practice in the United States historically, separation of theCEO and chairman of the board functions has become more common in recent

years When a lead independent director is appointed, he has the ability to call

meetings of the independent directors, separate from meetings of the full board.Currently, the general practice is for all board member elections to be held at the

same meeting and each election to be for multiple years With a staggered board,

elections for some board positions are held each year This structure limits theability of shareholders to replace board members in any one year and is used lessnow than it has been historically

Board responsibilities

The board of directors is elected by shareholders to act in their interest Boardmembers are typically mandated by corporate law to be fully informed and to usedue diligence and their expertise in fulfilling their obligation to act in the interests ofthe company and its shareholders

The board of directors is not involved in the day-to-day management of the

company; that responsibility rests with senior management The duties of the boardinclude responsibility for:

Selecting senior management, setting their compensation and bonus

structure, evaluating their performance, and replacing them as needed

Setting the strategic direction for the company and making sure that

management implements the strategy approved by the board

Approving capital structure changes, significant acquisitions, and large

Ensuring the quality of the firm’s financial reporting and internal audit, as well

as oversight of the external auditors

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An audit committee is responsible for:

Oversight of the financial reporting function and implementation of accountingpolicies

Effectiveness of the company’s internal controls and the internal audit

function

Recommending an external auditor and its compensation

Proposing remedies based on their review of internal and external audits

A governance committee is responsible for:

Oversight of the company’s corporate governance code

Implementing the company’s code of ethics and policies regarding conflicts ofinterest

Monitoring changes in relevant laws and regulations

Ensuring that the company is in compliance with all applicable laws and

regulations, as well as with the company’s governance policies

A nominations committee proposes qualified candidates for election to the board,

manages the search process, and attempts to align the board’s composition withthe company’s corporate governance policies

A compensation committee or remuneration committee recommends to the board

the amounts and types of compensation to be paid to directors and senior

managers This committee may also be responsible for oversight of employee

benefit plans and evaluation of senior managers

A risk committee informs the board about appropriate risk policy and risk tolerance

of the organization, and oversees the enterprise-wide risk management processes

of the organization

An investment committee reviews and reports to the board on management

proposals for large acquisitions or projects, sale or other disposal of company assets

or segments, and the performance of acquired assets and other large capital

expenditures

The number and size of board committees will depend on the size, complexity, andnature of the business Regulations often require that firms have audit committees.Financial services firms are often required to have a risk committee as well Somecompanies combine two functions into one committee The composition of a boardcommittee is often based on its function, with audit committees, compensationcommittees, and governance committees often made up of only non-executive orindependent directors

LOS 34.g: Describe market and non-market factors that can affect stakeholder

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