Your Cheat Sheet to… CFA Level I: Corporate Finance

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By Tamara Bonn, CFA | LinkedIn

The Cheat Sheet articles are a series of articles, each focusing on one specific topic area of the CFA exam for one specific CFA level. In each Cheat Sheet article, we will cover the basics of what you need to know before diving into the material – what it’s about in a nutshell, how significant is it in the CFA exams, real-life applications, and tips for the CFA exams. You should aim to read each relevant Cheat Sheet article before you start studying the topic area to get you to a flying start.

For this article, we will look at Corporate Finance for CFA Level I.


What is the weighting of this topic in the CFA exams?
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The Study Session on Corporate Finance is 7% of the Level 1 CFA exam. One can expect between 16-18 questions from this material on exam day (split between the AM and PM session). The Study Session is further broken down into six specific readings (detailed below) with an expectation that each reading will test a couple key LOS’s. 

What is Corporate Finance about, in a nutshell? 
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For Level I Candidates, the Corporate Finance topic area is a very big picture overview of the fundamentals a company will use to evaluate their investing and or financing decisions.

​There are six readings in this topic, summarised below:

Corporate Governance and ESG
How to set companies up with the right policies
Capital Budgeting
How companies decide where to spend their money
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. 

Literally, 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? ​

Cost of Capital
Company money has a cost. Here’s how to calculate it
Leverage
How to borrow money and profit from it
You’ll learn to evaluate the cost of capital of a company through various calculations and methods. For example, the LOS will focus on your understanding of the the following approaches: YTM, debt-rating, CAPM, DDM, or bond-yield plus risk-premium approach.

​Try not to get overwhelmed with all the various approach and envision how each approach logically makes sense as per its name.

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 FRA so pay close attention.

Dividends and Share Repurchases
How companies allocate their earnings when they profit
Working Capital Management
How to make sure your company stays liquid
There is a lot of detail, but focus on the “basics” first – i.e. if a company has earnings, what options do they have?

​The concept of knowing why a cash dividend and a share repurchase of the same amount are equal to a shareholders’ wealth is VERY important and highly testable. ​

Again, 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. 


Why should I care about this in real life?
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It’s fundamental to finance
The topic of Corporate Finance is a relatively interesting reading and I find it does provide some practicality compared to other study sessions. Firstly, understanding the basics of NPV is a fundamental skill anyone in Finance should be reasonably expected to know as a professional. If one can foresee the cost of a project delivering a negative return before investing, millions of dollars may potentially be saved. 

It helps you decide which investments to make
As an investor, analyst or company management; this topic provides the basic toolkit to look at a project / investment and quantitatively explain why it may or may not work over the long-run. What does a discount rate really mean and what is the realized return? These are very important concepts and widely used in “real life” so it is applying theory and practice together. 

It deepens your understanding
Additionally, many people who work in Corporate Finance will know that models such as these are purely done through Excel – not by hand. The CFAI curriculum challenges one to really know the fundamental basics first, by forcing calculations and formulas to be thought-out by hand – not automatically by a computer. This helps deepen your understanding and allows one to think intuitively (and less robotically). Always a plus if you are trying to impress someone in your next job interview! 


Tips for the exam you should know
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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.

If you need help on calculator techniques, you can check out our own 300 Hours calculator guide.

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 CFAI 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. 

Note – in Level II, Corporate Finance repeats and tests a lot of the same fundamental concepts, so if you can gain a solid understanding this round, it will save you time and agony when you are studying for Level II. Once you can understand this topic, it is very easy to pick-it up again even if it is a few months later. Also, we’re talking way into the future now – but for Level III the weighting for Corporate Finance drops to 0%. Embrace it now as it’s short-lived and not worth testing a third time for the CFAI! 


How does Corporate Finance get tested?
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As mentioned above, Corporate Finance is divided into six individual readings so one can reasonably expect a few questions on each topic.

A typical and relatively “moderate” calculation question might be like this one below: 


An analyst must compute the firm’s WACC using the dividend discount model. He assumes that the before-tax cost of new debt is 8%, tax rate 30%, target debt-to-equity ratio 0.8033, stock price $40, next year’s dividend $2, estimated growth rate 7%. The firm’s WACC is closest to: 

A.  10.1%
B. 9.1%
C. 8.8% 

B is correct. 

Cost of equity = D1/P0 + g = $2.00 / $40 + 7% = 5% + 7% = 12% 
D/(D + E) = 0.8033 / 1.8033 = 0.445 
WACC = [(0.445)(0.08)(1-0.30)] + [(0.555)(0.12)] = 2.5% + 6.6% = 9.1% 

A is incorrect as the candidate calculates the WACC but fails to adjust for the tax rate of 30%. 

C is incorrect as the candidate fails to correctly use the target debt-to-equity ratio and instead assumes equal weights of 0.50 for debt and equity. 


An analyst is told that his company’s long-term debt-to-equity ratio is 0.45.  Recently, the ratio has increased to 0.65. The analyst must determine the impact and effect on the asset beta and equity beta of the firm due to the increased use of leverage. Which of the following statements is correct? 

A. The asset beta and the equity beta will both rise. 
B. The asset beta will remain the same and the equity beta will rise. 
C. The asset beta will remain the same and the equity beta will decline. 

B is correct. The asset beta does not change, but the equity beta will increase with higher debt. Recall that the asset beta is often referred to as “unlevered beta” as it reflects the business risk of the assets. The market risk of the owners = B equity. If a company is 100% equity financed, the equity beta = the asset beta. The equity beta will change as a company’s financial risk changes but the asset beta will remain constant. 
βasset = βdebt wd + βequity we

or

βasset = βdebt (D / D+E) + βequity (E / D+E)


More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by: 

Zee Tan
Author: Zee Tan

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