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! 🙂
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:
Learning Module # | Sub-topic | Description |
---|---|---|
1 | Corporate Structures and Ownership | A brief introduction to firm structures, compares private vs public companies and discusses the principal-agent relationship. |
2 | Introduction to Corporate Governance and Other ESG Considerations | Basically 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. |
3 | Business Models and Risks | Explains various types of business models and types of risks companies face. |
4 | Capital Investments | Covers 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? |
5 | Working Capital | This chapter explores a corporate’s financing options, considerations and factors that affect a firm’s financing choices. |
6 | Cost of Capital – Foundational Topics | This chapter introduces the concept of cost of capital, why it is important, its assumptions and how to estimate it. |
7 | Capital Structure | We look at a firm’s capital structure (mix of debt and equity financing), and what factors affect this to achieve an optimal capital structure. |
8 | Measures of Leverage | Leverage 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.
Sole Trader | General Partnership | Limited Partnership | Corporation (Limited Companies) |
---|---|---|---|
Extension of owner | Set by partnership agreement | Set by partnership agreement | Legal identity is separated from owners |
Owner operated | Partner operated | Operated by GP | Operated by management team voted by shareholders |
Owner has unlimited liability | Partners share unlimited liability | GP has unlimited liability, LPs have limited liability | Limited business liability for shareholders |
Business profits taxed as personal income | Business profits shared & taxed as personal income | Business profits shared & taxed as personal income | Business profits are taxed twice (double taxation): corporation and dividend tax |
Owner’s risk appetite and capital constrains business growth | Partners’ risk appetite and capital constrains business growth | GP’s ability, partners’ risk appetite and capital constrains business growth | Financed with equity and debt |
Private company can go public via:
Public companies can go private via:
Investor’s perspective | Equity | Debt |
---|---|---|
Return potential | Unlimited | Limited to interest and principal payments |
Maximum loss | Initial investment | Initial investment |
Investment risk | Higher | Lower |
Investment interest | Maximize company value (net assets less liabilities) | Timely repayment |
Responsible investing:
Environmental factors:
Social factors:
\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}
External factors:
Firm-specific factors:
Macro risk:
Business 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}
NPV=\displaystyle \sum_{t=1}^n \frac{CF_t}{(1+R)^t} - Initial \space outlay
IRR is the discount rate (r) such that NPV is 0.
NPV method | IRR 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. |
ROIC=\frac{After \space tax \space net \space profit}{Average \space book \space value \space of \space invested \space capital}
Timing options | Option to delay investments until more information is received. |
Sizing options | Option to expand, grow or abandon as the project progresses. |
Flexibility options | Option to alter operations once investment is made, such as changing prices, or increasing production. |
Fundamental options | Option to alter investment decision based on future events. |
Internal | External (financial intermediaries) | External (capital markets) | External (other) |
---|---|---|---|
After-tax operating cash flows | Lines of credit (uncommitted and committed) | Commercial paper | Leasing |
Accounts payable | Revolving credit | Public and private debt | |
Accounts receivable | Secured loans | Hybrid securities (convertibles and preferred equity) | |
Inventory and marketable securities | Factoring | Common equity |
Primary sources of liquidity | Secondary sources of liquidity |
---|---|
Cash (bank accounts) | Negotiating debt contracts |
Short term funds (lines of credit) | Liquidating assets |
Cash flow management | Filing 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
Objectives of short-term borowing strategies:
Factors influencing a company’s short-term borrowing strategies:
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
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:
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}
r_e = R_F + \beta_i [E(R_m)-R_F]
re= rd + risk premium, where rd is cost of debt
Adjusted \thickspace \beta=\frac{2}{3}(Unadjusted \thickspace \beta)+\frac{1}{3}{(1.0)}
\beta_U=\beta_E \Bigg[\frac{1}{1+(1-t)\frac{D}{E}}\Bigg]
\beta_{E'}=\beta_U \Big[{1+(1-t)\frac{D'}{E'}}\Big]
This proposition states that the market value of a company is not affected by its capital structure, assuming:
This means that value of the levered firm (VL) equals the value of unlevered firm (VU).
V_L=V_U
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.
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
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.
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}
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}
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 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.
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View Comments
Maybe static trade-off theory should be added to the summary :)
DFL formula should be P-V not F-V
Thanks for spotting that shivani! corrected ;)