CFA Level 1 Corporate Issuers: Our Cheat Sheet

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Note: this cheat sheet is updated for the latest 2022’s curriculum.

In 2022’s CFA curriculum update, 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

cfa level 1 corporate issuers cheat sheet

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 Study Sessions 9-10, which includes Reading 27-32.

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

Reading NumberSub-topicDescription
27Introduction 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.
28Uses of CapitalCovers 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? ​
29Sources of CapitalThis chapter explores a corporate’s financing options, considerations and factors that affect a firm’s financing choices.
30Cost of Capital – Foundational TopicsThis chapter introduces the concept of cost of capital, why it is important, its assumptions and how to estimate it.
31Capital StructureWe look at a firm’s capital structure (mix of debt and equity financing), and what factors affect this to achieve an optimal capital structure.
32Measures 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.

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.


Reading 27: Introduction to Corporate Governance and Other ESG Considerations

CFA Level 1 Corporate Issuers: Our Cheat Sheet 1

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

Reading 28: Uses of Capital

CFA Level 1 Corporate Issuers: Our Cheat Sheet 2

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

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.

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

Timing optionsOption to delay investments until more information is received.
Sizing optionsOption to expand, grow or abandon as the project progresses.
Flexibility optionsOption to alter operations once investment is made, such as changing prices, or increasing production.
Fundamental optionsOption to alter investment decision based on future events.

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

Reading 29: Sources of Capital

CFA Level 1 Corporate Issuers: Our Cheat Sheet 3

Corporate financing options

InternalExternal (financial intermediaries)External (capital markets)External (other)
After-tax operating cash flowsLines of credit (uncommitted and committed)Commercial paperLeasing
Accounts payableRevolving creditPublic and private debt
Accounts receivableSecured loansHybrid securities (convertibles and preferred equity)
Inventory and marketable securitiesFactoringCommon equity

Managing and measuring liquidity

Primary sources of liquiditySecondary sources of liquidity
Cash (bank accounts)Negotiating debt contracts
Short term funds (lines of credit)Liquidating assets
Cash flow managementFiling for bankruptcy

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

Reading 30: Cost of Capital – Foundational Topics

CFA Level 1 Corporate Issuers: Our Cheat Sheet 4

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 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
  • PMTt = interest payment in period t
  • rd = 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

re= rd + risk premium, where rd 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]

Reading 31: Capital Structure

CFA Level 1 Corporate Issuers: Our Cheat Sheet 5

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 (VL) equals the value of unlevered firm (VU).

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 re= cost of equity, r0= cost of capital of company financed only with equity and no debt, rd= 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.


Reading 32: Measures of Leverage

CFA Level 1 Corporate Issuers: Our Cheat Sheet 6

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(F-V)-F}{Q(F-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

Picture
  • 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 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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