Level I Review Corporate Finance

The good news is that Corporate Finance is almost all conceptual material and anyone with undergraduate-level coursework in Finance will have seen much of it. As with much of the material at Level 1, you need a good base of understanding because you will be expected to know it in the other two exams.

The readings here are good, “what-if,” material as in what if you want to transition into management or corporate finance from investment management but neglected this really core information.
Capital Budgeting
Remember that only incremental cash flows are to be considered in budgeting. These are the additional inflow directly associated with the project. Sunk costs, like spending on impact or research, are not to be included because they are already spent. Financing costs are also not included because they are already factored into the discount rate.
Understand the difference between independent and mutually exclusive projects. Most questions on the exams will be about mutually exclusive projects, only able to go with one project. This is capital rationing in contrast to unlimited funds.
The biggest part of the reading is remembering all the measures: NPV, IRR, Payback & Discounted Payback, AAR, and PI. While NPV and IRR are the most important and will be seen many times in the curriculum, the others are pretty basic and easily remembered. Along with the calculations, you should know advantages/limitations of each method and the decision rule.
Remember, IRR is less subjective and widely accepted but based on the assumption of reinvested cash flows (not always realistic). The method will give multiple IRRs with un-conventional cash flows so the NPV method may be preferable.
NPV directly measures the increase in value to the firm and assumes reinvestment at the opportunity cost of capital, r.
Cost of Capital
Remember the preference continuum for estimating capital structure: target capital structure > current capital structure (weighted by market value) > trends in capital structure and management statements  >  averages of comparable companies’ capital structure
The various methods of estimating cost of debt and equity are probably the most important material in the reading.
Yield to Maturity or Debt-Rating for debt – YTM can be found using your calculator (N, PMT, FV, PVà compute i/Y) but remember to multiply the rate by number of coupons per year. Debt-rating is pretty easy using the yield on comparably rated bonds. ** The cost of debt is NOT the coupon rate.
Cost of equity: Dividend discount, bond yield plus risk, CAPM
Remember, estimated growth equals the retention rate times ROE.
Measures of Leverage
Understand the difference between operating leverage and financial leverage. Operating leverage refers to the fixed costs in operating while financial leverage refers to the debt costs in the capital structure. Remember that the higher the leverage, the higher the volatility and risk in net income.
Be able to calculate DOL, DFL and DTL using income statement items (changes in operating income, units sold, EBIT, Sales) or by the per unit inputs (quantity, price, variable operating cost per unit, fixed operating cost).
Companies with a high degree of financial leverage may be able to exit bankruptcy through restructuring (going concern) while those with high operating leverage have less flexibility and may be liquidated.
Dividends and Share Repurchases
Types of dividends: cash, stock, stock split, and liquidating dividend.
Remember the chronology for dividends: declaration dateàex-dividend dateàrecord date(typically two days after ex-div)àpayment date.
Share repurchase methods: open market, tender offer, dutch auction, and repurchase through direct negotiation.
Remember the advantages/disadvantages of each form of dividend or repurchase plan and how each impacts shareholder wealth.
Working Capital Management
There is some really good corporate finance material here but the specific measures are probably most important for the CFA exams. You’ll see these again in the equity investment material.
Liquidity measures: current and quick ratio (know the difference)
Turnover ratios: accounts receivable, inventory turnover, number of days receivables, number of days payable, number of days inventory (be able to calculate the operating and net operating cycle)
Remember the difference between money market yields, discount basis yield and the bond equivalent yield. You use 360 days for money market and discount yield and 365 days to calculate the BEY.
The cost of trade credit is a very testable formula. Put it on a flash card and learn it.
Corporate Governance
Remember the best-practices information here:

  • A majority of board members should be independent
  • Nominating, compensation, and audit committees should be completely independent members
  • Board should have resources to hire external consultants
  • Annual elections allow quick action by shareholders
  • Independent members of the board should meet regularly without management
  • Board should conduct an annual self-assessment
  • Company should adopt a code of ethics
  • Compensation and the incentive structure should align management-shareholder interests

‘til next time, happy studyin’
Joseph Hogue, CFA

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