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CFA Level 1 > Corporate Issuers > Flashcards

Corporate Issuers Flashcards

1
Q

Business structures

A

refer to how businesses are set up from a legal and organizational point of view. Key features of business structures include:
* The legal relationship between the business and its owners.
* Whether the owners of the business also operate the business, and if not, the nature of the relationship between its owners and operators.
* Whether the owners’ liability for the actions and debts of the business is limited or unlimited.
* The tax treatment of profits or losses from the business.

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2
Q

private placement

A

shares sold to accredited investors typically institutions or high net worth individuals

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3
Q

direct listing

A

an exchange agrees to buy existing shares

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4
Q

special purpose acquisition company (SPAC)

A

is a corporate structure set up to acquire a private company in the future - blank check companies

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5
Q

Compare the financial claims and motivations of lenders and owners

A

Debt is paid out first in event of default but also only has limited upside
Equity is paid out after everyone else but has potentially unlimited upside

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6
Q

primary stakeholders of a corporation

A
  • Shareholders
  • board of directors
  • Senior managers
  • Employees
  • Creditors
  • Suppliers
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7
Q

principal-agent conflict

A

arise because an agent is hired to act in the interests of the principal, but an agent’s interests may not coincide exactly with those of the principal.
* Conflicts of Interest Between Shareholders and Managers or Directors (information asymmetry)
* Conflicts Between Groups of Shareholders (related party transactions)
* Conflicts of Interest Between Creditors and Shareholders
* Conflicts of Interest Between Shareholders and Other Stakeholders

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8
Q

Corporate governance

A

the system of internal controls and procedures by which individual companies are managed

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9
Q

Stakeholder management

A

management of company relations with stakeholders and is based on having a good understanding of stakeholder interests and maintaining effective communication with stakeholders.

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10
Q

Shareholder mechanisms

A

AGM, proxy, special resolutions

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11
Q

Majority voting vs cumulative voting

A

cumulative supports minority shareholders

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12
Q

Activist shareholders

A

pressure companies in which they hold a significant number of shares for changes, often changes they believe will increase shareholder value

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13
Q

proxy fight

A

in which they seek the proxies of shareholders to vote in favor of their alternative proposals. An activist group may make a tender offer for a specific number of shares of a company to gain enough votes to control the company.

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14
Q

hostile takeover

A

can act as an incentive for company managements and boards to pursue policies better aligned with the interests of shareholders

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15
Q

bond indenture

A

specifies the rights of bondholders and the company’s obligations in a legal document

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16
Q

Board of directors committees include:

A
  • Audit committee
  • Governance committee
  • Nominations committee
  • Compensation or remuneration committee
  • Risk committee
  • Investment committee
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17
Q

Common law vs Civil law

A

Shareholders’ and creditors’ interests are considered to be better protected in countries with a common-law system

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18
Q

Risks of Poor Governance and Stakeholder Management:

A
  • Decrease in company value
  • Weak controls
  • Poor fraudulent accounting
  • Lax oversight (poor risk levels)
  • Legal and reputational risks
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19
Q

Negative screening

A

excluding specific companies or industries from consideration for the portfolio based on their practices regarding human rights, environmental concerns, or corruption

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20
Q

positive screening

A

investors attempt to identify companies that have positive ESG practices

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21
Q

relative/best-in-class

A

approach, seeks to identify companies within each industry group with the best ESG practice

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22
Q

Full integration

A

refers to the inclusion of ESG factors or ESG scores in traditional fundamental analysis

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23
Q

Thematic investing

A

refers to investing in sectors or companies in an attempt to promote specific ESG-related goals

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24
Q

Management/active ownership

A

Investing refers to using ownership of company shares or other securities as a platform to promote improved ESG practices

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25
Q

green finance

A

An important part of green finance is the issuance of green bonds, bonds for which the funds raised are used for projects with a positive environmental impact.

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26
Q

business model

A

offers some detail about how a company proposes to make money
* Identify the firm’s potential customers
* Describe the firm’s product or service
* Explain how the firm will sell its product or service

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27
Q

financial plan

A

which has detailed financial projections for revenue and expenses, as well as plans for financing the business

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28
Q

channel strategy

A

how to deliver goods to customers

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29
Q

omnichannel strategy

A

both digital and physical

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30
Q

Options for who firms sell too

A

B2B (business to business)
B2C (business to consumer)

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31
Q

Value-based pricing

A

setting prices based on the value received (or perceived) by the buyer

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32
Q

Cost-based pricing

A

setting prices based on the costs of producing the firm’s good or service (plus a profit).

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33
Q

Price discrimination

A

to setting different prices for different customers or identifiable groups of customers.

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34
Q

tiered pricing

A

based on volume of purchases

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35
Q

dynamic pricing

A

depending on the time of day or day of the week

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36
Q

Pricing Strategy - Bundling

A

Where multiple products are complementary (e.g., a furnished apartment), bundling the products may be a profitable strategy.

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37
Q

Pricing Strategy - Penetration pricing

A

A company offers a product at low margins or even at a loss for a period of time to grow market share and achieve greater scale of operations. Netflix has followed this strategy to grow its subscriber base rapidly.

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38
Q

Pricing Strategy - Freemium pricing

A

Offer a product with basic functionality at no cost, but sell/unlock other functionality for a fee. Video game makers have used this strategy to encourage wide usage and then profit on sales of greater functionality (e.g., weapons).

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39
Q

Pricing Strategy - Hidden revenue

A

Online content may be “free” but generate revenue through ads. For example, internet search is free to the user with revenue coming from the sale of user data.

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40
Q

Pricing Strategy - Razors-and-blades

A

A company may find it profitable to sell a piece of equipment for a relatively low price (low margins) and make profits by selling a consumable used with the equipment. Printers and ink cartridges and an e-reader and e-books are common examples.

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41
Q

Pricing Strategy - Optional products

A

Options or add-ons priced with high margins are added to the product after the purchase decision has been made. An example is the many pricey options that may be offered after a customer has decided to purchase an automobile.

42
Q

Pricing Strategy - Subscription model

A

Microsoft’s model for software has changed from selling the software to a subscription (paying monthly for access) to their Office suite of software.

43
Q

Pricing Strategy - Fractional ownership

A

Time share companies sell condominium ownership by the week; use of private jets is sold for specific amounts of time.

44
Q

Pricing Strategy - Licensing

A

For a biotech company that has developed a new and effective drug, it may be most profitable to license the production of the drug to an established drug maker with a large sales force and established distribution channels, rather than developing those resources itself for the single drug.

45
Q

Pricing Strategy - Franchising

A

Similar to licensing, but a franchisee typically is permitted to sell in a specific area and pays a percentage of sales to the franchisor, which provides some level of product and marketing support.

46
Q

firm’s value proposition

A

how customers will value the characteristics of the product or service, given the competing products and their prices

47
Q

value chain

A

w the firm executes its value proposition

48
Q

external factors that can affect business risk

A
  • Changes in economic conditions
  • Changing demographics
  • The winds of political, legal, and regulatory change
49
Q

Firm-specific risk factors include:

A
  • Competitive risks include the erosion of an existing competitive advantage over time or the introduction of innovative business models that disrupt the industry. ((switching costs & execution risk)
  • Product market risk: For firms early in their life cycles, expectations of growth in demand may decrease over time, consumer preferences may change, products may become obsolescent, and patents may expire
  • Capital investment risk refers to investing firm assets in opportunities that do not produce returns above the firm’s cost of capital.
  • ESG risk measures often focus on corporate governance risk, but the risk of running afoul of current expectations for environmentally and socially progressive company policies can damage a company’s reputation and bottom line
  • Business risk is increased by higher operating leverage that results from higher percentages of fixed costs, relative to variable costs, in a firm’s cost structure
  • Financial risk increases with higher levels of debt in a firm’s capital structure, which increases, the risk of financial distress, default, or even insolvency.
50
Q

Macro risk

A

risk (to operating profit) arising from economic, political, and legal risk factors

51
Q

Business risk

A

Variability of operating income (EBIT) that arises from both firm-specific risk factors and industry risk factors

52
Q

Capital investments may be divided into the categories of

A

business maintenance and business growth.

53
Q

Business maintenance investments

A

going concern projects and regulatory/compliance projects:
* Going concern projects may be needed to maintain the business or reduce costs. Projects that maintain the business are normally made without detailed analysis.
* Regulatory/compliance projects may be required by a governmental agency or insurance company and often involve safety-related or environmental concerns. These projects typically generate little to no revenue.

54
Q

Business growth investments

A
  • Companies take on expansion projects to grow the business and involve a complex decision-making process because they require an explicit forecast of future demand. A very detailed analysis is required.
  • Other projects, such as new investments outside a company’s existing lines of business, also entail a complex decision-making process that require a detailed analysis due to the large amount of uncertainty involved.
55
Q

The capital allocation process has four administrative steps

A
  1. Idea generation
  2. Analysing project proposals
  3. Create the firm-wide capital budget
  4. Monitoring decisions and conducting a post-audit
56
Q

Principles of Capital Allocation

A
  • Decisions are based on cash flows, not accounting income (incremental cash flows)
  • Cash flows are based on opportunity costs.
  • The timing of cash flows is important
  • Cash flows are analysed on an after-tax basis
  • Financing costs are reflected in the project’s required rate of return.
57
Q

Externalities

A

effects the acceptance of a project may have on other firm cash flows. The primary one is a negative externality called cannibalization, which occurs when a new project takes sales from an existing product.

58
Q

conventional cash flow

A

sign on the cash flows changes only once

59
Q

unconventional cash flow

A

pattern has more than one sign change

60
Q

Independent projects

A

evaluated solely on their own profitability

61
Q

mutually exclusive

A

only one of them can be accepted so that profitability must be evaluated among the projects

62
Q

hurdle rate

A

minimum IRR, above which a project will be accepted

63
Q

A key advantage of NPV

A

is that it is a direct measure of the expected increase in the value of the firm. NPV is theoretically the best method. Its main weakness is that it does not include any consideration of the size of the project.

64
Q

A key advantage of IRR

A

is that it measures profitability as a percentage, showing the return on each dollar invested

65
Q

Common mistakes managers make when evaluating capital projects include the following:

A
  • Failing to incorporate economic responses into the analysis
  • Misusing standardized templates.
  • Pet projects of senior management.
  • Basing investment decisions on EPS or ROE
  • Using the IRR criterion for project decisions
  • Poor cash flow estimation
  • Misestimating overhead costs
  • Using the incorrect discount rate
  • Politics involved with spending the entire capital budget.
  • Failure to generate alternative investment ideas
  • Improper handling of sunk and opportunity costs.
66
Q

A company’s return on invested capital (ROIC), or simply return on capital, is defined as its net operating profit after tax (NOPAT), or simply after-tax net profit, over a period, divided by the average book value of its total capital over the period.

A

ROIC > WACC = good

67
Q

Real options

A

future actions that a firm can take, given that they invest in a project today.
* Timing options
* Abandonment options
* Expansion options
* Flexibility options
o Price setting
o Production flexibility
* Fundamental options

68
Q

Financing working capital

A

Internal methods
Financial intermediaries
Capital market sourced funds

69
Q

Internal methods

A
  • Accounts receivable
  • Accounts payable
  • Selling inventory
  • Selling marketable securities
70
Q

Financial Intermediaries:

A
  • Lines of credit
    o Uncommitted line of credit
    o Committed (regular) line of credit
    o Revolving line of credit
  • Secured (asset-backed) loans are backed by collateral, for example, fixed assets, receivables, or inventory. Factoring refers to the actual sale of receivables at a discount from their face value
  • Web-based and non-bank lenders typically lend to medium-to-small-size firms and typically charge fees in addition to interest charges.
71
Q

Capital Markets Sources of Funds

A
  • Companies can issue public debt (trades on public markets) or private debt (provided by private entities and not actively traded
72
Q

commercial paper

A

Large, creditworthy companies often issue short-term debt securities

73
Q

backup line of credit

A

unsecured debt if markets for commercial paper are disrupted.

74
Q

Long-term debt

A

often carries a fixed interest rate through maturity, which may be decades after issuance

75
Q

Strategies for working capital

A

Conservative strategy – high working capital as a percentage of sales, finance with equity or long term debt, Lower ROA
Aggressive strategies low working capital as a percentage of sales , Finance with short term debt, Higher ROA

76
Q

primary sources of liquidity

A

Sources of cash it uses in its normal day-to-day operations

77
Q

Secondary sources of liquidity

A

liquidity include liquidating short-term or long-lived assets, renegotiating debt agreements, or filing for bankruptcy and reorganizing the company

78
Q

Drags on liquidity

A

delay or reduce cash inflows, or increase borrowing costs

79
Q

Pulls on liquidity

A

Accelerate cash outflows. Examples include paying vendors sooner and changes in credit terms that accelerate the required payment of outstanding balances

80
Q

Adjusted Beta

A

= 2/3(unadjusted Beta) + 1/3

81
Q

Asset Beta

A

= Equity Beta ( 1 / ( 1 + ((1-t) x (D/E))))

just flip to solve for equity Beta

82
Q

Flotation costs

A

include flotation costs are cashflows at t = 0

83
Q

Capital structure determinants:

A
  • Companies in non-cyclical industries are better able to support high proportions of debt than companies in cyclical industries.
  • Companies with low fixed operating costs as a proportion of total costs (i.e., low operating leverage) are better able to support high proportions of debt than companies with high fixed costs.
  • Companies with subscription-based revenue models are better able to support high proportions of debt than companies with pay-per-use revenue models.
84
Q

Bad signs regarding capital structure

A
  • Debt to EBITDA > 3
  • Interest coverage ratio < 2
85
Q

Company characteristics that influence the proportion of debt in a company’s capital structure include the following:

A
  • Growth and stability of revenue. High growth of revenue or stability of significant revenue suggest continuing ability to service debt.
  • Growth and predictability of cash flow. Growing cash flow increases the ability to service debt. Significant and stable cash flows indicate continuing ability to service debt.
  • Amount of business risk. More business risk (operational risk and demand risk) means greater variability of earnings and cash flows, which decreases the ability to service debt.
  • Amount and liquidity of company assets. Assets can be pledged as collateral to make a company’s debt more attractive. When assets are more liquid (easier to turn into cash, values more stable), they can be pledged more readily.
  • Cost and availability of debt financing. Companies find debt relatively more attractive when the cost of debt is lower and investors are more willing to lend to the company. Both of these are greater when the above characteristics support the issuance of debt.
86
Q

Stages of growth capital structures

A
  • Start-up stage – almost all equity
  • Growth stage – equity 80% - 20% debt
  • Mature stage – more than 20% debt – less equity
87
Q

MM Proposition I (No Taxes): Capital Structure Irrelevance

A

Capital structure doesn’t matter because returns will be equal across equity and debt

88
Q

MM Proposition II: Cost of Equity and Leverage

A

MM’s second proposition (MM II) is framed in terms of a firm’s cost of capital, rather than firm value. Based on the same assumptions as MM I, MM II states that the cost of equity increases linearly as a company increases its proportion of debt financing

Cost of equity = cost of equity with no debt + (D/E)(cost of equity with no debt – cost of debt)

89
Q

MM With Taxes: Value Is Maximized at 100% Debt

A

This differential tax treatment encourages firms to use debt financing because debt provides a tax shield that adds value to the company.

Cost of equity = cost of equity with no debt + (D/E)(cost of equity with no debt – Cost of debt)(1-tax)

90
Q

Reasons why not fully debt structured

A
  • Costs of financial distress and bankruptcy (Agency costs of debt)
  • Probability of financial distress is related to the firm’s use of operating and financial leverage
91
Q

Static Trade-Off Theory

A

The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. Optimal Capital Structure is where gains from tax shield and cost of financial distress are optimised. (Minimise WACC)

92
Q

Target capital structure

A

is the capital structure that a firm seeks to achieve on average over time to maximize firm value. That is, it reflects management’s beliefs about its optimal capital structure.
In practice, a firm’s actual capital structure tends to fluctuate around the target capital structure for two reasons:
*  Management may choose to exploit opportunities in a specific financing source. For example, a temporary rise in the firm’s stock price may create a good opportunity to issue additional equity, which would result in a higher percentage of equity than the target.
*  Market values of a firm’s equity and debt fluctuate. Because capital structure weights are based on market values, market fluctuations (especially the market value of firm equity) may cause the firm’s capital structure to vary from the target.

93
Q

Costs of asymmetric information

A

arise from the fact that managers typically have more information about a company’s prospects and future performance than owners or creditors.
* Stock offering = negative signal
* Debt offering = positive signal

94
Q

Net agency costs of equity

A

related to conflicts of interest between managers and owners
* Monitoring costs (better corporate governance, lower agency costs)
* Bonding costs (noncomplete agreement, stock options, etc)
* Residual losses (can’t eliminate)
Greater financial leverage reduces agency costs

95
Q

Pecking order theory

A

Sends the least signal to shareholders
* Internally generated funds (most favoured)
* Debt
* New equity (least favoured)

96
Q

Business risk

A

refers to the risk associated with a firm’s operating income and is the result of uncertainty about a firm’s revenues and the expenditures necessary to produce those revenues. Business risk is the combination of sales risk and operating risk.
* Sales risk is the uncertainty about the firm’s sales.
* Operating risk refers to the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm’s operating risk.

97
Q

Leverage

A

in the sense we use it here, refers to the amount of fixed costs a firm has. These fixed costs may be fixed operating expenses, such as building or equipment leases, or fixed financing costs, such as interest payments on debt.

98
Q

Financial risk

A

refers to the additional risk that the firm’s common stockholders must bear when a firm uses fixed cost (debt) financing.

99
Q

degree of operating leverage (DOL)

A

Quantity (price - variable costs) / Quantity (price - variable costs) + fixed cost

100
Q

degree of financial leverage (DFL)

A

EBIT / (EBIT - interest)

101
Q

degree of total leverage (DTL)

A

DOL x DFL

CFA Level 1 (9 decks)

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