CFA Level 1 Corporate Issuers: Our Cheat Sheet

Note: this cheat sheet is updated for the latest 2023’s curriculum.

Since 2022, Corporate Finance has been renamed as Corporate Issuers with a major revision on the topic.

Although a relatively small topic weight, CFA Level 1 Corporate Issuers 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! 🙂

CFA Level 1 Corporate Issuers: An Overview

Corporate Issuers 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 Issuers 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. Kind of like Ethics where mastering it earlier generates a high return in investment for future levels.

CFA Level 1 Corporate Issuer’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 Topic 4 which contains 8 Learning Modules (LMs).

Here’s a summary of CFA Corporate Issuers chapter readings:

The topic of Corporate Issuers 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 Issuers 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.

LM1: Corporate Structures and Ownership

Business structures

Public and Private Corporations

Private company can go public via:

• IPO
• Direct Listing
• Acquisition either when a private company is acquired by a larger public company, or via a Special Purpose Acquisition Company (SPAC)

Public companies can go private via:

• Leveraged buyout (LBO)
• Management buyout (MBO)

Risk-return profile of equity vs debt

LM2: Introduction to Corporate Governance and Other ESG Considerations

Factors relevant to corporate governance and stakeholder management 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.

ESG Investment Strategies

Responsible investing:

• ESG integration (ESG investing): the practice of including material ESG factors in the investment process. A material factor here is defined as the ability to impact a company’s ability to deliver sustainable returns in the long term.
• Socially responsible investing (SRI): Choosing whether or not to invest in a company based on social and environmental profiles (e.g. choosing not investing in tobacco companies but a solar panel manufacturer).
• Thematic investing: Investment based on a single theme, e.g. climate change.
• Impact investing: Investing in companies to meet social and environmental targets, as well as financial returns.

ESG Investment Approaches

1. Negative screening
2. Positive screening
3. ESG integration
4. Thematic investing
5. Engagement / active ownership
6. Impact investing

ESG Factors Used in Investment Analysis

Environmental factors:

• Natural resource management
• Water conservation
• Pollution prevention
• Energy efficiency and reduced emissions
• Existence of carbon assets
• Compliance with environmental and safety standards

Social factors:

• Community impact
• Human rights and employees’ welfare
• Data privacy and security
• Access to affordable healthcare products

LM3: Business Models and Risks

Profitability and unit economics

\small Breakeven \space point=\frac{Fixed \space cost}{Contribution \space margin}=\frac{Fixed \space cost}{Unit \space price - Variable \space cost \space per \space unit}

Business models: financial implications

External factors:

• Economic conditions
• Demographics trends
• Sector demand
• Industry cost characteristics
• Political, legal and regulatory environment
• Social and political trends

Firm-specific factors:

• Firm maturity
• Competitive position
• Business model (asset light, lean startups, pay-in-advance)

Business models: risks

Macro risk:

• exchange rates
• interest rates
• economic activity
• legal and regulatory changes
• political instability
• country-specific risk

Business risk:

• Industry risks (cyclicality, industry structure, competitive intensity, competitive dynamics within the value chain, long term growth demand and outlook etc)
• Company-specific risks (competitive risk, product market risk, execution risk, capital investment risk, ESG risk)

Financial risk:

Operating leverage measures the sensitivity of operating profit (EBIT) to changes in revenue.

\small Operating \space Leverage= \frac{Contribution \space Margin}{EBIT} = \frac{Sales-Variable\space costs}{EBIT}

Financial leverage measures the sensitivity of net profit to a change in operating profit.

Financial \space Leverage=\frac{EBIT}{EBT}

Total \space Leverage=Operating \space Leverage  \space × Financial Leverage\newline
=\frac{Contribution \space Margin}{EBT}

LM4: Capital Investments

Basic principles of capital allocation

1. Decisions are based on cash flows, not accounting concepts. Include incremental after-tax cash flows, (positive/negative) externalities. Exclude sunk cost because it is already incurred.
2. Cash flows are not accounting net income or operating income.
3. Cash flows must account for opportunity cost.
4. Cash flows must be on an after-tax basis.
5. Timing of cash flows is vital.
6. Ignore financing costs, as it is already included in cost of capital.

Net present value (NPV)

NPV=\displaystyle \sum_{t=1}^n \frac{CF_t}{(1+R)^t} - Initial \space 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.

NPV vs IRR methods: Pros and Cons

Return on Invested Capital (ROIC)

ROIC=\frac{After \space tax \space net \space profit}{Average \space book \space value \space of \space invested \space capital}

Real options

Common capital allocation pitfalls

• Failure to include economic responses
• Misusing capital budgeting templates
• Pet projects
• Basing investment decisions on earning metrics (EPS, net income or ROE), instead of incremental cash flows
• Using IRR to make investment decisions, instead of NPV
• Poor accounting of cash flows
• Over or underestimating overhead costs
• Misestimating discount rate
• Spending all of the investment budget just because it is available
• Failure to consider investment alternatives
• Improper handling of sunk cost and opportunity costs

LM5: Working Capital

Corporate financing options

Managing and measuring liquidity

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.

For references of formulae for liquidity and activity ratio, please refer to Reading 20 in FRA for the full list. Here are 2 additional ones not covered in FRA:

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

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

Evaluating short term financing choices

Objectives of short-term borowing strategies:

• Ensure sufficient capacity to handle peak cash needs
• Maintain sufficient sources of credit
• Borrow at cost effective rates

Factors influencing a company’s short-term borrowing strategies:

• Sizes and creditworthiness
• Legal and regulatory considerations
• Sufficient access
• Flexibility of borrowing options

LM6: Cost of Capital – Foundational Topics

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 = w_dr_d (1-t) + w_pr_p + w_er_e

Cost of debt

Yield to maturity approach:

P_0=\displaystyle\sum_{t=1}^n\big[\frac{PMT_t}{(1+\frac{r_d}{2})^t}\big]+\frac{FV}{(1+\frac{r_d}{2})^n}

where:

• P₀ = current market price of bond
• PMT_t = interest payment in period t
• r_d = yield to maturity
• n = number of period to maturity
• FV = maturity value of the bond

Cost of preferred stock

r_P=\frac{Dividend \thickspace per \thickspace share \thickspace of \thickspace preferred \thickspace stock}{Current \thickspace preferred \thickspace stock \thickspace price \thickspace per \thickspace share} = \frac{D_P}{P_P}

Cost of equity

Capital asset pricing model (CAPM) approach

r_e = R_F + \beta_i [E(R_m)-R_F]

Bond yield plus risk premium method

r_e= r_d + risk premium, where r_d is cost of debt

Estimating beta

Blume’s method of beta adjustment

Adjusted \thickspace \beta=\frac{2}{3}(Unadjusted \thickspace \beta)+\frac{1}{3}{(1.0)}

Unlevered asset beta for a comparable company

\beta_U=\beta_E \Bigg[\frac{1}{1+(1-t)\frac{D}{E}}\Bigg]

Relevered project beta for target company

\beta_{E'}=\beta_U \Big[{1+(1-t)\frac{D'}{E'}}\Big]

LM7: Capital Structure

Modigliani-Miller (MM) Propositions

MM Proposition 1 (without taxes)

This proposition states that the market value of a company is not affected by its capital structure, assuming:

• Investors have homogenous expectations
• Perfect capital markets
• No agency cost
• Investors can borrow and lend at risk free rate
• Financing and investment decisions are independent

This means that value of the levered firm (V_L) equals the value of unlevered firm (V_U).

V_L=V_U

MM Proposition 2 (without tax)

This proposition states that cost of equity increases with debt-to-equity ratio (financial leverage).

r_e=r_0+(r_0-r_d)\frac{D}{E}

where r_e= cost of equity, r₀= cost of capital of company financed only with equity and no debt, r_d= cost of debt, D/E = debt to equity ratio.

As leverage increases, cost of equity increases but not cost of debt or WACC.

MM Proposition 1 (with Taxes)

With taxes included, this proposition states that the value of a levered company equals the value of unlevered company plus value of debt tax shield.

V_L=V_U+tD

MM Proposition 2 (with Taxes)

With taxes included, this proposition states that cost of equity increases with debt-to-equity ratio (financial leverage), with an adjustment for tax rate.

r_e=r_0+(r_0-r_d)(1-t)\frac{D}{E}

The cost of equity increases as leverage increases, but not as quickly compared to the case without taxes. Cost of debt remains constant.

Thus, WACC reduces as firm increases leverage, increasing the value of the firm.

LM8: Measures of Leverage

Degree of operating leverage (DOL)

DOL=\frac{\% \thickspace change \thickspace in\thickspace operating\thickspace income}{\% \thickspace change \thickspace in\thickspace units\thickspace sold}=\frac{Q(P-V)}{Q(P-V)-F}

Degree of financial leverage (DFL)

DFL=\frac{\% \thickspace change \thickspace in\thickspace net \thickspace income}{\% \thickspace change \thickspace in\thickspace operating\thickspace income}=\frac{Q(P-V)-F}{Q(P-V)-F-C}

Degree of total leverage (DTL)

DTL=\frac{\% \thickspace change \thickspace in\thickspace net \thickspace income}{\% \thickspace change \thickspace in\thickspace units\thickspace sold}=DOL \times DFL = \frac{Q(P-V)}{Q(P-V)-F-C}

Breakeven

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

Q_{BE}=\frac{F+C}{P-V}

Operating breakeven point is the number of units produced and sold at which operating income is zero.

Q_{OBE}=\frac{F}{P-V}

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

CFA Level 1 Corporate Issuers Tips

• Practice using your calculator
  • In comparison to some of the more difficult study sessions such as Derivatives, or subjective sessions like Ethics – Corporate Issuers 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 and updated continuously. 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:

• CFA Level 1 Cheat Sheets series: Quant Methods | Economics | FRA | Derivatives | Fixed Income | Equity Investments | Ethics | Alt Investments | Portfolio Management
• CFA Level 1: How to Prepare and Pass CFA in 18 Months
• CFA Level 1 Tips: Top 10 Advice from Previous Candidates
• 18 Actionable Ways to Improve Your Study Memory
• How to Study Effectively: Proven Methods that Work for CFA, FRM and CAIA
• The Ultimate Guide to CFA Practice Questions