Contents Learning Outcome Statements (LOS) Study Session 10—Corporate Finance (1) Reading 33: Corporate Governance and ESG: An Introduction Exam Focus Module 33.1: Stakeholder Management Module 33.2: Factors Affecting Corporate Governance Key Concepts Answer Key for Module Quizzes Reading 34: Capital Budgeting Exam Focus Module 34.1: Capital Projects, NPV, and IRR Module 34.2: Payback Period, Project Rankings Key Concepts Answer Key for Module Quizzes Reading 35: Cost of Capital Exam Focus Module 35.1: Weighted Average Cost of Capital Module 35.2: Project Cost of Capital Key Concepts Answer Key for Module Quizzes Study Session 11—Corporate Finance (2) Reading 36: Measures of Leverage Exam Focus Module 36.1: Measures of Leverage Key Concepts Answer Key for Module Quiz Reading 37: Working Capital Management Exam Focus Module 37.1: Working Capital Management Key Concepts Answer Key for Module Quiz Topic Assessment: Corporate Finance Topic Assessment Answers: Corporate Finance Study Session 12—Portfolio Management (1) Reading 38: Portfolio Management: An Overview Exam Focus Module 38.1: Portfolio Management Process Module 38.2: Pooled Investments Key Concepts Answer Key for Module Quizzes Reading 39: Portfolio Risk and Return: Part I Exam Focus 10 Module 39.1: Returns Measures Module 39.2: Covariance and Correlation Module 39.3: The Efficient Frontier Key Concepts Answer Key for Module Quizzes Reading 40: Portfolio Risk and Return: Part II Exam Focus Module 40.1: Systematic Risk and Beta Module 40.2: The CAPM and the SML Key Concepts Answer Key for Module Quizzes Study Session 13—Portfolio Management (2) Reading 41: Basics of Portfolio Planning and Construction Exam Focus Module 41.1: Portfolio Planning and Construction Key Concepts Answer Key for Module Quiz Reading 42: Risk Management: An Introduction Exam Focus Module 42.1: Risk Management Introduction Key Concepts Answer Key for Module Quiz Reading 43: Fintech in Investment Management Exam Focus Module 43.1: Fintech in Investment Management Key Concepts Answer Key for Module Quiz Topic Assessment: Portfolio Management Topic Assessment Answers: Portfolio Management Study Session 14—Equity Investments (1) Reading 44: Market Organization and Structure Exam Focus Module 44.1: Markets, Assets, and Intermediaries Module 44.2: Positions and Leverage Module 44.3: Order Execution and Validity Key Concepts Answer Key for Module Quizzes Reading 45: Security Market Indexes Exam Focus Module 45.1: Index Weighting Methods Module 45.2: Uses and Types of Indexes Key Concepts Answer Key for Module Quizzes Reading 46: Market Efficiency Exam Focus Module 46.1: Efficient Markets 11 12 13 14 Key Concepts Answer Key for Module Quiz Study Session 15—Equity Investments (2) Reading 47: Overview of Equity Securities Exam Focus Module 47.1: Types of Equity Investments Module 47.2: Foreign Equities and Equity Risk Key Concepts Answer Key for Module Quizzes Reading 48: Introduction to Industry and Company Analysis Exam Focus Module 48.1: Industry Analysis Module 48.2: Pricing Power and Company Analysis Key Concepts Answer Key for Module Quizzes Reading 49: Equity Valuation: Concepts and Basic Tools Exam Focus Module 49.1: Dividends, Splits, and Repurchases Module 49.2: Dividend Discount Models Module 49.3: Relative Valuation Measures Key Concepts Answer Key for Module Quizzes Topic Assessment: Equity Investments Topic Assessment Answers: Equity Investments Formulas List of Pages 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 vii viii ix x xi xii xiii xiv 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 81 82 83 84 85 86 87 88 89 90 91 92 93 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 174 175 176 177 178 179 180 181 182 183 184 185 186 187 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 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appropriate for a young firm still in a high growth phase LOS 49.i The P/E ratio based on fundamentals is calculated as: If the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, it may be justified in having a higher P/E ratio Price multiples are widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons LOS 49.j The price-earnings (P/E) ratio is a firm’s stock price divided by earnings per share The price-sales (P/S) ratio is a firm’s stock price divided by sales per share The price-book value (P/B) ratio is a firm’s stock price divided by book value per share The price-cash flow (P/CF) ratio is a firm’s stock price divided by cash flow per share Cash flow may be defined as operating cash flow or free cash flow LOS 49.k Enterprise value (EV) measures total company value: EV = market value of common and preferred stock + market value of debt − cash and short-term investments EBITDA is frequently used as the denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors LOS 49.l Asset-based models value equity as the market or fair value of assets minus liabilities These models are most appropriate when a firm’s assets are largely tangible and have fair values that can be established easily LOS 49.m Advantages of discounted cash flow models: Easy to calculate Widely accepted in the analyst community FCFE model is useful for firms that currently not pay a dividend Gordon growth model is useful for stable, mature, noncyclical firms Multistage models can be used for firms with nonconstant growth Disadvantages of discounted cash flow models: Inputs must be forecast Estimates are very sensitive to inputs For the Gordon growth model specifically: Very sensitive to the k − g denominator Required return on equity must be greater than the growth rate Required return on equity and growth rate must remain constant Firm must pay dividends Advantages of price multiples: Often useful for predicting stock returns Widely used by analysts Easily calculated and readily available Can be used in time series and cross-sectional comparisons EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the P/E ratio cannot be used Disadvantages of price multiples: P/E ratio based on fundamentals will be very sensitive to the inputs May not be comparable across firms, especially internationally Multiples for cyclical firms may be greatly affected by economic conditions P/E ratio may be especially inappropriate (The P/S multiple may be more appropriate for cyclical firms.) A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa Negative denominator results in a meaningless ratio; the P/E ratio is especially susceptible to this problem A potential problem with EV/EBITDA multiples is that the market value of a firm’s debt is often not available Advantages of asset-based models: Can provide floor values Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated May be increasingly useful for valuing public firms if they report fair values Disadvantages of asset-based models: Market values of assets can be difficult to obtain and are usually different than book values Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value Asset values can be difficult to value during periods of hyperinflation ANSWER KEY FOR MODULE QUIZZES Module Quiz 49.1 B If the analyst is more confident of his input values, he is more likely to conclude that the security is overvalued The market price is more likely to be correct for a security followed by many analysts and less likely correct when few analysts follow the security (LOS 49.a) C One example of a present value model is valuation based on the present value of future cash flows available to equity holders (LOS 49.b) C Both a 50% stock dividend and a 3-for-2 stock split will increase the number of shares by 50%, while neither will affect value of the company Therefore, the decrease in the share price should be the same in either case (LOS 49.c) B The chronology of a dividend payout is declaration date, ex-dividend date, holder-of-record date, and payment date The ex-dividend date is the cutoff date for receiving the dividend: stocks purchased on or after the ex-dividend date will not receive the dividend (LOS 49.d) Module Quiz 49.2 A For the constant growth model, the constant growth rate (g) must be less than the required rate of return (k) (LOS 49.e) C The share value is 7.0 / 0.0775 = $90.32 (LOS 49.f) B ($40 + $2) / 1.15 = $36.52 (LOS 49.g) B Using the constant growth model, $1(1.05) / (0.10 − 0.05) = $21.00 (LOS 49.g) C ($1.25 / 1.11) + [1.56 / (0.11 − 0.05)] / 1.11 = $24.55 (LOS 49.g) C $1(1.25) / 1.1 + [$1(1.25)2 / (0.10 − 0.06)] / 1.1 = $36.65 (LOS 49.g) B The constant growth DDM assumes that the dividend growth rate is constant The most likely choice here is the bread and snack producer Auto manufacturers are more likely to be cyclical than to experience constant growth A biotechnology firm in existence for two years is unlikely to pay a dividend, and if it does, dividend growth is unlikely to be constant (LOS 49.h) Module Quiz 49.3 B The fundamental P/E ratio is sensitive to its inputs It uses the DDM as its framework, and the denominator k − g in both has a large impact on the calculated P/E or stock value (LOS 49.i) B Using the earnings multiplier model, 0.6 / (0.15 − 0.07) = 7.5× (LOS 49.j) B Enterprise value is market value of equity plus market value of debt minus cash and short-term investments (LOS 49.k) A The energy exploration firm would be most appropriately valued using an assetbased model Its near-term cash flows are likely negative, so a forward-looking model is of limited use Furthermore, it has valuable assets in the form of drilling rights that likely have a readily determined market value The paper firm would likely not be appropriately valued using an asset-based model because high inflation makes the values of a firm’s assets more difficult to estimate An assetbased model would not be appropriate to value the software firm because the firm’s value largely consists of internally developed intangible assets (LOS 49.l) B Results that may not be comparable across firms are considered a disadvantage of valuation models based on price multiples (LOS 49.m) TOPIC ASSESSMENT: EQUITY INVESTMENTS You have now finished the Equity Investments topic section The following Topic Assessment provides immediate feedback on how effective your study has been for this material The number of questions on this test is equal to the number of questions for the topic on one-half of the actual Level I CFA exam Questions are more exam-like than typical Module Quiz or QBank questions; a score of less than 70% indicates that your study likely needs improvement These tests are best taken timed; allow 1.5 minutes per question After you’ve completed this Topic Assessment, you may additionally log in to your Schweser.com online account and enter your answers in the Topic Assessments product Select “Performance Tracker” to view a breakdown of your score Select “Compare with Others” to display how your score on the Topic Assessment compares to the scores of others who entered their answers An investor purchased 550 shares of Akley common stock for $38,500 in a margin account and posted initial margin of 50% The maintenance margin requirement is 35% The price of Akley, below which the investor would get a margin call, is closest to: A $45.00 B $54.00 C $59.50 Adams owns 100 shares of Brikley stock, which is trading at $86 per share, and Brown is short 200 shares of Brikley Adams wants to buy 100 more shares if the price rises to $90, and Brown wants to cover his short position and take profits if the price falls to $75 The orders Adams and Brown should enter to accomplish their stated objectives are: Adam Brown A Limit buy @ 90 Limit buy @75 B Limit buy @ 90 Stop buy @ 75 C Stop buy @ 90 Limit buy @ 75 Which of the factors that determine the intensity of industry competition is most likely to be affected by the presence of significant economies of scale? A Threat of entry B Threat of substitutes C Power of suppliers Price-to-book value ratios are most appropriate for measuring the relative value of: A a bank B a manufacturing company C a mature technology company An index of three non-dividend paying stocks is weighted by their market values One of the index stocks splits 2-for-1 during the year, but no shares are sold The total return of this index for the year is: A less than the price return of the index B equal to the price return of the index C greater than the price return of the index Financial intermediaries that buy securities from and sell securities to investors are best described as: A dealers B brokers C investment bankers Among the types of assets that trade in organized markets, asset-backed securities are best characterized as: A real assets B equity securities C pooled investment vehicles Which of the following market indexes is likely to be rebalanced most frequently? An index that is: A price weighted B value weighted C equal weighted Rogers Partners values stocks using a dividend discount model and the CAPM Holding all other factors constant, which of the following is least likely to increase the estimated value of a stock? A An increase in the next period’s expected dividend B A decrease in the stock’s systematic risk C A decrease in the expected growth rate of dividends 10 Brandy Clark, CFA, has forecast that Aceler, Inc., will pay its first dividend two years from now in the amount of $1.25 For the following year, she forecasts a dividend of $2.00 and expects dividends to increase at an average rate of 7% for the foreseeable future after that If the risk-free rate is 4.5%, the expected market risk premium is 7.5%, and Aceler’s beta is 0.9, Clark would estimate the current value of Aceler shares as being closest to: A $37 B $39 C $47 11 The industry that is classified the more cyclical sector under a commercial industry classification scheme is: A personal care products B food C apparel 12 Compared to a passive investment strategy, active management, on average: A cannot outperform if markets are weak-form efficient B can outperform if markets are weak-form efficient but not semistrong-form efficient C can outperform if markets are semistrong-form efficient but not strong-form efficient 13 Malley, Inc., is a manufacturer of sports apparel Pruett, Inc., produces cardboard boxes for packaging In a typical industry classification system from a commercial index provider, in which sectors are these firms most likely to be classified? Malley, Inc Pruette, Inc A Consumer staples Basic materials and processing B Consumer discretionary Basic materials and processing C Consumer staples Industrial and producer durables 14 Assuming the value effect persists over time, which of the following strategies would be most likely to earn positive abnormal returns? Purchase stocks with: A low dividend yields B high market-to-book ratios C low price-to-earnings ratios TOPIC ASSESSMENT ANSWERS: EQUITY INVESTMENTS B The price below which the investor would receive a margin call is: (Study Session 14, Module 44.2, LOS 44.f) C Adams should enter a stop buy at 90, which will be executed only if the stock price rises to 90 Brown should enter a buy order with a limit at 75 because he wants to buy stock to close out his short position if he can purchase it at 75 (or less) (Study Session 14, Module 44.2, LOS 44.g) A Economies of scale represent a barrier to entry into an industry Existing competitors are likely to be operating on a large scale that new entrants would find difficult and expensive to develop, reducing the threat of entry (Study Session 15, Module 48.2, LOS 48.g) A Price-to-book value is an appropriate measure of relative value for firms that hold primarily liquid assets, such as banks Manufacturing companies typically have a large proportion of fixed assets for which the book value (historical cost less depreciation) may be less relevant as a measure of their economic value A mature technology company likely has valuable intangible assets, such as patents and human capital, that may not be reflected fully (or at all) on the balance sheet (Study Session 15, Module 49.3, LOS 49.i) B Because the stocks in the index not pay dividends, there is no difference between the price return and the total return of the index (Study Session 14, Module 45.1, LOS 45.b) A Dealers maintain inventories of securities and buy them from and sell them to investors Brokers not trade directly with clients but find buyers for and sellers of securities to execute customer orders Investment banks are primarily involved in assisting with the issuance of new securities (Study Session 14, Module 44.1, LOS 44.d) C Asset-backed securities represent claims to a portion of a financial asset pool (Study Session 14, Module 44.1, LOS 44.c) C An equal-weighted index is not equal weighted after even one day, unless all stocks in the index change by the same percentage A change in share price preserves the weightings in a value-weighted index and preserves the weightings in a price-weighted index unless the price change results from a stock split or stock dividend (Study Session 14, Module 45.2, LOS 45.f) C Other things equal, a decrease in the expected growth rate of dividends (g) will decrease the value of a stock estimated with the dividend discount model According to the CAPM, a decrease in the stock’s systematic risk would decrease the required return on equity, increasing the DDM value of future dividends Other things equal, an increase in a company’s next dividend will increase share value (Study Session 15, Module 49.2, LOS 49.e) 10 B The required rate of return on Aceler shares is 4.5 + 0.9(7.5) = 11.25% Note that the expected market risk premium = E(Rmkt) – Rf , so there is no need to subtract the risk-free rate The dividend at t = 3, $2.00, is expected to grow at 7% for the foreseeable future, so the DDM value of Aceler shares at t = is / (0.1125 – 0.07) = 47.06 The t = value of the shares is (47.06 + 1.25) / 1.11252 = $39.03 (Study Session 15, Module 49.2, LOS 49.g) 11 C Food and personal care products are typically included in the “consumer staples” sector of commercial classification systems Apparel is included in the “consumer discretionary” sector, which is more cyclical than the “consumer staples” sector (Study Session 15, Module 48.1, LOS 48.d) 12 B One of the implications of market efficiency is that if markets are semistrongform efficient, active portfolio management cannot consistently outperform (achieve positive risk-adjusted returns relative to) a passive strategy (Study Session 14, Module 46.1, LOS 46.e) 13 B Apparel manufacturers are typically classified as consumer discretionary Packaging firms are typically classified as basic materials and processing (Study Session 15, Module 48.1, LOS 48.b) 14 C The value effect refers to value stocks outperforming growth stocks on a riskadjusted basis Value stocks have low price-to-earnings or market-to-book ratios, or high dividend yields Growth stocks have high price-to-earnings or market-tobook ratios, or low dividend yields If the value effect persists over time and is not the result of inadequate adjustment for risk, buying value stocks will produce positive abnormal returns (Study Session 14, Module 46.1, LOS 46.f ) FORMULAS WACC = (wd)[kd (1 − t)] + (wps)(kps) + (wce)(kce) after-tax cost of debt = kd (1 − t) cost of preferred stock = kps = Dps / P cost of common equity: kce = Rf + β[E(Rm) − Rf] kce = bond yield + risk premium unlevered asset beta: project beta: cost of common equity with a country risk premium: operating cycle = average days of inventory + average days of receivables cost of trade credit = where: days past discount = number of days after the end of the discount period sample covariance from historical data: standard deviation for a two-asset portfolio: equation of the CML: total risk = systematic risk + unsystematic risk capital asset pricing model (CAPM): E(Ri) = Rf + βi[E(Rmkt) − Rf] preferred stock valuation model: one-period stock valuation model: infinite period model: multistage model: earnings multiplier: expected growth rate: g = (retention rate)(ROE) where: All rights reserved under International and Pan-American Copyright Conventions By payment of the required fees, you have been granted the non-exclusive, non-transferable right to access and read the text of this eBook on screen No part of this text may be reproduced, transmitted, downloaded, decompiled, reverse engineered, or stored in or introduced into any information storage and retrieval system, in any forms or by any means, whether electronic or mechanical, now known or hereinafter invented, without the express written permission of the publisher SCHWESERNOTES™ 2019 LEVEL I CFA® BOOK 4: CORPORATE FINANCE, PORTFOLIO MANAGEMENT, AND EQUITY INVESTMENTS ©2018 Kaplan, Inc All rights reserved Published in 2018 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-7874-7 These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.” Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2018, CFA Institute Reproduced and republished from 2019 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.” Disclaimer: The SchweserNotes should be used in conjunction with the original readings as set forth by CFA Institute in their 2019 Level I CFA Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes ... 11 4 11 5 11 6 11 7 11 8 11 9 12 0 12 1 12 2 12 3 12 4 12 5 12 6 12 7 13 5 13 6 13 7 13 8 13 9 14 0 14 1 14 2 14 3 14 4 14 5 14 6 14 7 14 8 14 9 15 0 15 1 15 2 15 3 15 4 15 5 15 6 15 7 15 8 15 9 16 0 16 1 16 2 16 3 16 4 16 5 16 6 16 7 16 8 16 9... 17 0 17 1 17 2 17 3 17 4 17 5 17 6 17 7 17 8 17 9 18 0 12 8 12 9 13 0 13 1 13 2 13 3 13 4 13 5 13 6 13 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