CFA Level 1 Corporate Finance: Our Cheat Sheet

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Although a relatively small topic weight, CFA Level 1 Corporate Finance is one of those topics that is highly interlinked with FRA and Quantitative Methods, therefore mastering this relatively light topic should pay dividends (sorry) for your overall exam.

To help you with your revision, we decided to create our Cheat Sheet series of articles, which focuses on one specific topic area for each CFA Level.

More Cheat Sheets will be published in the coming weeks, sign up to our member’s list to be notified first.

By referring to the CFA Learning Outcome Statements (LOS), we prioritize and highlight the absolute key concepts and formula you need to know for each topic. With some tips at the end too!

Use the Cheat Sheets during your practice sessions to refresh your memory on important concepts.

Let’s go – don’t forget to bookmark and come back to this often! 🙂

Contents


CFA Level 1 Corporate Finance: An Overview

cfa level 1 corporate finance cheat sheet

Corporate Finance is a central topic across all Level 1 and 2 of the CFA exams, and drops off in Level 3. Its relatively low topic weighting is deceptive, given how integrated corporate finance concepts are in finance.

In Level 2, Corporate Finance repeats and tests a lot of the same fundamental concepts, so if you can gain a solid understanding in Level 1, it will save you time and agony when you are studying for Level 2. Kinda like Ethics where mastering it earlier generates a high return in investment for future levels.

CFA Level 1 Corporate Finance’s topic weighting is 8%-12%, which means 14-22 questions of the 180 questions of CFA Level 1 exam is centered around this topic.

It is covered in Study Sessions 10-11, which includes Reading 31-35.

Here’s a summary of Corporate Finance chapter readings:

Reading NumberSub-topicDescription
31Introduction to Corporate Governance and Other ESG ConsiderationsBasically discusses how to set companies up with the right policies.

This section has a bit of overlap with Ethics, but the questions are usually less subjective.​ Put your Ethics hat on and think from the perspective of an investor when you read the LOS statements; and remember, independence is ALWAYS important.
32Capital BudgetingCovers how will a company budget their capital assets and how will they decide to invest in certain projects.

You must have a solid understanding of net present value (NPV) as this is the core of Corporate Finance.​

As much as this session focuses on calculations, there is also quite a bit of theory in understanding various methods and the pros/cons of each, given a certain situation. Does a project make sense economically, and if so, at what cost? ​
33Cost of CapitalLooks at general principles of revenue and expense recognition, non-recurring items and EPS in the income statements that you’ll come across in financial analysis.
34Measures of LeverageLeverage is, essentially, the practice of borrowing money to make more money faster. This increased return obviously comes at an increased risk so it’s important to know how to measure leverage.​

Candidates must understand and calculate the measures of leverage and the impact debt can have (both positively and negatively) on a company’s bottom-line. This section has some calculations that also overlap with Financial Reporting & Analysis so pay close attention.
35Working Capital ManagementAgain, FRA is intertwined here.

Candidates should have a solid understanding of a company’s working capital, which is thoroughly covered in FRA readings. Then, this reading looks at working capital from a strategic standpoint and explores it from a C-level executive’s viewpoint.

The topic of Corporate Finance is a relatively interesting reading and I find it does provide some ‘real life’ practicality compared to other study sessions. It teaches a very big picture overview of the fundamentals a company will use to evaluate their investing and or financing decisions.

In essence, the CFA Level 1 Corporate Finance topics teaches you:

practical fundamentals of finance, e.g. net present value (NPV) concept;
how to decide which investments to make.
– why working capital management is important.


Reading 31: Introduction to Corporate Governance and Other ESG Considerations

CFA Level 1 Corporate Finance: Our Cheat Sheet 1

Key areas of corporate governance assessed in investment analysis

  • Economic ownership and voting control: e.g. dual class structures, power to elect board members.
  • Board of directors representation: assess whether the current skillset, expertise and diversity in board of directors meet the current and future needs of the firm.
  • Remuneration and company performance: analysts must check if the executive remuneration are aligned with performance of the company.
  • Investors in the company: examine the investor structure for cross shareholdings, affiliated stakeholders and activist shareholders.
  • Strength of shareholder rights: analysts need to assess the strength of shareholders’ rights vs other comparable companies
  • Managing long-term risks: analysts need to form a view of management quality and their ability to manage long-term risks to the firm.

Reading 32: Capital Budgeting

CFA Level 1 Corporate Finance: Our Cheat Sheet 2

Basic principles of capital budgeting

  • Include incremental after-tax cash flows, (positive/negative) externalities and opportunity costs.
  • Exclude sunk cost (because already incurred) and financial costs (as already included in cost of capital) from calculation of operating cash flows.
  • Timing of cash flows is vital.

Net present value (NPV)

NPV=t=1N=CFt(1+r)tInitial Outlay

  • For independent projects:
    • If NPV > 0, accept project;
    • If NPV < 0, reject project.
  • For mutually exclusive projects: accept the project with the highest (positive) NPV.

Internal rate of return (IRR)

IRR is the discount rate (r) such that NPV is 0.

  • For independent projects:
    • If IRR > required rate of return, accept project;
    • If IRR < required rate of return, reject project.
  • For mutually exclusive projects:
    • accept the project with the higher IRR, as long as IRR > required rate of return.
    • use the NPV rule if NPV and IRR rules conflict.

Payback period

Payback period is the number of years required for the cumulative cash flows to equal initial investment.

However, this metric doesn’t take into account the time value of money, nor considers the risk of the project.


Discounted payback period (DPB)

Discounted payback period is the number of years required for the cumulative discounted cash flows to equal initial investment.

However, this metric doesn’t consider any cash flows beyond the payback period is reached.


Average accounting rate of return (AAR)

Average accounting rate of return=Average net incomeAverage book value

The disadvantage of this metric is that it is based on accounting numbers and ignores the time value of money.


Profitability index (PI)

Profitability index=PV of future cash flowsInitial investment                                =1+NPVInitial investment

Invest in project if PI > 1, reject project if PI < 1.

PI > 1 when NPV is positive.


NPV vs IRR methods: Pros and Cons

NPV methodIRR method
Pros: It’s a direct measure of value uplift in the firm.Pros: It shows the return on each $ invested, and allows a direct comparison with the required rate of return.
Cons: It doesn’t consider project size.Cons: It may conflict with NPV analysis, or have multiple IRRs or no IRR for projects with unconventional cash flows. It also incorrectly assumes that intermediate cash flows are reinvested at IRR rate.

Reading 33: Cost of Capital

CFA Level 1 Corporate Finance: Our Cheat Sheet 3

Weighted average cost of capital (WACC)

WACC is the cost of each component of capital (debt, preferred stock and common equity) in the proportion they are used in a company.

WACC = wdrd (1-t) + wprp + were


Cost of preferred stock

rp=Dividend per share of preferred stockCurrent preferred stock price per share    =DpPp


Cost of equity

Capital asset pricing model (CAPM) approach

re=RF+βiERmRF    CAPM    =RF+βiERmRF+Country risk premium   Revised CAPM  

Dividend discount model (DDM)

re=D1P0+gwhere g = sustainable growth rate                =earnings retention ratio×ROE                =1DEPS×ROE

Bond yield plus risk premium method

re= rd+ risk premium, where rd is cost of debt


Project beta

Unlevered asset beta for a comparable company

βasset=βequity11+(1t)DE

Relevered project beta for target company

βproject=βasset1+(1t)DE


Reading 34: Measures of Leverage

CFA Level 1 Corporate Finance: Our Cheat Sheet 4

Degree of operating leverage (DOL)

DOL=% change in operating income% change in units sold         =Q(PV)Q(PV)F


Degree of financial leverage (DFL)

DFL=% change in net income% change in operating income        =Q(FV)FQ(FV)FC


Degree of total leverage (DTL)

DTL=% change in net income% change in units sold        = DOL×DFL        =Q(PV)Q(PV)FC

Breakeven

Breakeven point is the number of units produced and sold at which net income is zero, where revenue equals cost.

QBE=F+CPVOperating breakeven point is the number of units produced and sold at which operating income is zero.

QOBE=FPV

where Q = quantity, P = price, V = variable cost per unit, F = fixed operating cost, C = fixed financial cost.


Reading 35: Working Capital Management

CFA Level 1 Corporate Finance: Our Cheat Sheet 5

Liquidity management

  • Primary sources of liquidity: sources of cash from day-to-day operations, e.g. cash balances, short term funding, collections/payments management.
  • Secondary sources of liquidity: sources of cash that may negatively impact the company’s financial position, e.g. negotiating debt agreements, filing for bankruptcy, liquidating assets.
  • Drags on liquidity means delayed/reduced cash inflows, e.g. bad debt, late/uncollected receivable payments.
  • Pulls on liquidity means accelerated cash outflows, e.g. earlier debt repayment.

Measures of liquidity (in addition to the ones in FRA)

Operating cycle

Operating cycle = Number of days of inventory + Number of days of receivables

Net operating cycle

Net operating cycle = Number of days of inventory + Number of days of receivables – Number of days payables


Yield on short-term investments (covered in Quant Methods)

Discount basis yield

Discount basis yield=FPF×360Twhere F = face value, P = purchase price, T = number of days to maturity.

Money market yield

Money market yield=FPP×360T                                    =Holding period yield ×360T

Bond equivalent yield

Bond equivalent yield=FPP×365T                                    =Holding period yield ×365T


Cost of trade credit (CTC)

Trade discounts (for example, “3/10 net 30” means that 3% discount is available if paid within 10 days, else the balance must be paid within 30 days).

The cost of trade credit (CTC) is the annualized cost of not taking the early repayment trade discount.

Cost of trade credit=1+% discount1% discount365# days post discount period1


CFA Level 1 Corporate Finance Tips

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  • Practice using your calculator
    • In comparison to some of the more difficult study sessions such as Derivatives, or subjective sessions like Ethics – Corporate Finance should be a relatively easy section to pick-up some points and time on exam day.
    • There are not a lot of ways a calculation question can be modified for this section, so if you have a solid understanding of the fundamentals – you should be set.
    • Practice using your calculator and get familiar with how to solve for various NPV questions as that is guaranteed to show up and be tested.
    • Check out our BA II Plus guide or HP 12C calculator guide for relatively unknown tips and techniques when using your CFA calculator.
  • Lots of formulae, but don’t just memorize
    • Although this section at first glance may appear to be heavily formula based, do not skim over the basic theoretical concepts that the LOS mentions.
    • These can often be where the CFA Institute tries to deliver a trickier question versus a typical punch and crunch calculation.
    • A helpful tip that I find is to go through the LOS one by one and hand-write all the formulas that are described as “calculate” or “evaluate” as this will give you an overview of things you can quickly start to memorize, without getting lost in all the detail.

More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by signing up to our member’s list to get notified.

Meanwhile, here are other related articles that may be of interest:

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