CFA 2024 L1 Corporate Issuers Flashcards
What is a sole trader?
- No separate legal identity
- Owner operated
- Owner has unlimited liability
- Profits taxed as personal income (pass through)
- FInanced by owner’s access to capital
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is a general partnership?
- No separate legal identity
- Partners operated
- Partners have unlimited liability
- Profits taxed as personal income (pass through)
- Financed by partner’s access to capital
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is a limited partnership?
- No separate legal entity
- General partner operated
- GP has unlimited liability (LPs have limited liability)
- Profits taxed as personal income (pass through)
- Financed by partners’ access to capital
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is an LLC?
- Separate legal entity
- Board and management operated
- Owners (shareholders) have limited liability
- Profts taxed as personal income (pass through)
- Unbounded access to capital, unlimited business potential
- There may be legal limits on no. of owners, and require a vote for transfers of ownership
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is a public limited company?
- Should not be confused with a PUBLIC limited liability company
- public limited company is a separate legal entity
- Board and mgmt acess
- Owners ie shareholders still have limited liability
- Big difference is profits taxed at corporate level (dividends also taxed as personal income)
- No restrictions on ownership/transfer
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What are corporate issuers?
- Corporations that raise capital in the financial markets
- When a separate legal entity they are formed thorugh filing articles of incorporation with the relevant reg authority
- Can engage in similar activites as individuals ie hire employees and sign contracts
- Subject to regulation in jurisdictions where it is incorporated, conducts business, or finances itself
- Owner manager separate is where shareholdesr own the business, but not involved in day to day operations
- Shareholders appoint a board of directors, who then appoint the executive management
- Executive management undertake investing, financing, and make operating descisions
- The directors and management bust act in the best interests of shareholders and indrectly, all stakeholders
- If they do not, shareholders can vote to replace the board
- Crucially, this separation allows corporations to obtain financing from a much wider range of sources
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
How is responsibility shared for a limited liability entity?
- Both risk and return are shared proportionally between shareholders
- All shareholders have limited liability
- Liability is limited to the amount invested in the company
- They are not responsible for debt
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is the difference between financial and economic balance sheet?
- Financial inclues assets, obligations (liabillities), and equity
- Economic also includes other intangible or hard to quantify assets and liabilities ie human capital, customer relationshipsetc
- Likewise whereas the financial income statement includes income after fixed obligations have been met (accounting profit)
- the economic income statement only counts returns in excess of an owner’s required return on equity (economic profit)
- Where net income / equity = return on equity
- Economic profit = ROE - required ROE. Equilibrium value is zero
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What sources of finance do limited liability entities have?
- Equity: the sale of shares to investors; or by reinvesting profits
- Returns are dividends
- Debt: taking out loans, issuing bonds, and taking out leases
- The returns are interest and return of principal
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What is the difference between public and private corporate issuers?
- In public (ie listed) company, there is liquidity because the shares are listed on a stock exchange. There is a secondary market for shares
- The percentage of shares actively traded is the free float
- For a given firm the total shares less the value owned by other companies, founders, family etc is the free float
- Listing means price transparency and a clear value derived from market cap
- However it also means quarterly and yearly disclosure and reporting requirements. There are bot financial regulator requirements and stock exchange requirements
- Private companies do not have a ready market for shares, sale requires the buyer and company to agree
- There is no price transparency, because valuation requires a model
- There are fewer disclosure and reporting requirements. This not only means less admin but might also help preserve company secrets & competitive edge
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
How are shares issued?
- For a private company, through private placements
- Company raises capital from accredited investors.
Risks/terms outlined in the private placement memorandum - When a company goes public, there are a few options
- There is an Initial Public Offering (IPO). The firm raises capital from the public.
- Direct listing: no new shares and therefore no capital raised
- SPAC: a shell company raises capital via IPO, then makes an acquisition
- Via acquisition, a company can also become public
- Companies can also issue more shares once public. This is called a secondary offering (secondaries)
- Be careful to distinguish from secondary market, where issued shared are simply traded between market participants
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
How can a company go private?
- All shares acquired and company delisted from exchange
- Price paid is typically a premium to current price
- Commonly financed using debt
- Motivation is to realise value, if you believe the firm is undervalued
- This might be because you can unlock value by restructuring, changing managment, or selling assets
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What are the private v public trends across different kinds of economies?
- In EMDEs there are a growing no. of public companies
- This is because these economies there is high growth
- They are transitioning to open market structures
- There are also often new foreign capital inflows
- In developed economies, there is often a declining number of public companies
- This is because of M&A
- Also a growing no. of private capital sources
- There is greater preservation (and enhancement) of ownership and control when private
- When companies are public there is investor pressure to deliver short term returns. Some companies may feel they may deliver better long term returns if they shy away from the scrutiny afforded by public listing. However CFA module says evidence that going private to achieve better long term returns works is “thin at best”.
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What are the different types of shareholders?
- Individuals
- Institutional investors
- Other corporations
- Non profits
- Governments
- Governments may create legally separate corps and maintain ownership (possibly 100%, ie US Postal Service)
- This is common when provisioning public goods
- May also be used to profit from major domestic industries
- Banks often start as govt run then IPO
- Technology advancement may also cause shift from govt to listed, ie telecoms advancement
2024 L1 CI LM1 - Organizational Forms, Corporate Issuer Features, and Ownership
What do debtholders do?
- Provide capital with a finite maturity
- Issuers obligated to make interst and pricnipal payments on set dates
- Debtholdesr have no decision-making power within the corporation
- Debt contract may impose financial reqs or legal claims on certain assets
- Interest is paid befpre distributions to equity investors (a priority claim)
- Debt is therefore lower risk for the investor, and cheaper for the issuer.
- It’s also tax deductible
2024 L1 CI LM2 - Investors and Other Stakeholders
What do equity investors do relative to corporate issuers?
- Provide permanent capital
- Issuers do not commit to future dividends or repayments
- Equity holders have voting rights for key decisions
- Cash distributions are at the discretion of the board
- Equity investors own what is left after all other payments are made (a residual claim)
- Ie when a company earns revenue first it plays COGS to suppliers, then wages to employees, then interest to debtholders, then taxes to govt, then profit, and finally pays out some of that profit to equity holders (and retaining some of the earnings too)
- Equity is higher risk for investors, and costlier for the issuer
2024 L1 CI LM2 - Investors and Other Stakeholders
What are the pros and cons of debt v equity financing?
- Partial debt financing is financial leverage and boosts returns
- It also boosts volatility and therefore increases risk
- Extra fixed payment you have to debt holders is what causes that discrepancy
- Holding only equity is complicated because if you issue more you dilute existing shareholders’ fractional ownership.
- Firms can offset the impact of dilution by generating incremental profit. If Return on Investment is higher than cost of debt you increase income
- However cash on hands gives biggest boost to ROE versus issuing shares or borrowing
2024 L1 CI LM2 - Investors and Other Stakeholders
What is the payoff asymmetry for shareholders vs debtholders?
- Until the value of the firm is enough to cover existing debt you get zero, because the company is insolvent
- However, every dollar after debt has a payoff, with no limit. The maximum value is infinite
- Any time firm is above the value of debt they get their money back, but get no more
- Anything below and debtholders get a proportional fraction of the value of the firm
- Equity has unlimited upside, so the goal is maximise value.
- Debtholders just want you to pay your debts: timely repayment
2024 L1 CI LM2 - Investors and Other Stakeholders
What is the potential conflict of interests for the firm which has both shareholders and bondholders?
- Given that the firm has one set of cashflows it has to split between bondholders and dividends,
- Their incentive to provision for shareholders is to maximise for cashflows
- Therefore to rake risks and earn more returns,
- Therefore also to increase leverage by maximising debt use
- By contrast, bondholders want the firm to maximise the likelihood of financial payments, since they have limited upside
- There is no benefit for them from additional risk, and no benefit from higher leverage
- Hence bondholdesr involve contractual restictions: stipulating minimum cash flow coverage and maximum leverage
2024 L1 CI LM2 - Investors and Other Stakeholders
What are stakeholder groups?
- Stakeholders depend on the company and the company depens on them
- Astakeholders are any party with a vested interest in a company
- They may compromise or enhance firm abiltiy to maximise shareholder returns
- Shareholder theory of governance is that stakeholders are only considered to the extent that they affect shareholder value
- Stakeholder theory of governance is that corporate governance should consider all stakeholder interests. Thus for example ESG should be an explicit objective of the board
- Questions arise over how you should balance multiple objectives, how to define and measure non shareholder ojectives, how to compete globally with competitors who do not have these constraints, and cost
2024 L1 CI LM2 - Investors and Other Stakeholders
What are the differences between private and public debtholders?
- Private debtholders negotiate directly with the firm and have a much closer relationshio
- Public debtholders buy bonds
- Private debtholders often hold debt to maturity, have direct access to mgmt and non public information, solving transparency issues which is a major issue for capital providers ie something is going on in the firm
- Critical lenders may even have influence over the board
- There is wide variation in risk appetite for private debtholders
- Private debtholders may also engage in distressed investing
- By contrast, the public debtholders rely on public information and financial statements
- ## They have little to no influence unless restructuring the debt
2024 L1 CI LM2 - Investors and Other Stakeholders
Who are the board of directors?
- Board of directors: elected by shareholders to advance their interests
- Inside directors have links to the company ie may be founders or current former managers
- Independent directors have no material relationship with the company
- They may better represent the interests of minotiry shareholders
- Some stock exchanges ie LSE require 50% independent directors, others require staggered appointments by 2 years so board composition evolves slowly & creates knowledge continuity (though decreases ability of shareholders to effect major change on the board)
- There may also be rules on expertise, diversity, competency of board members
- ## There is also sometimes a two tier structure, where a supervisory board of independent directors oversees the board of internal directors
2024 L1 CI LM2 - Investors and Other Stakeholders
Aside from the board of directors who are the primary stakeholder groups?
- Managers: led by CEO, determine and implement strategy and day to day ops
- Stock based incentive plants ai m to align manager interests with shareholder interests
- Employees: corporations fundamentally rely on the human capital ofn employees. They may have equity via compensation, but also form unions to negotiate pay and conditions
- Customers: require the product to satisfy their needs at a reasonable price, as well as meet applicable safety and quality standards. They may require ongiong support, major customers can exert influence, retail customer satisfaction is often correlated with revenue growth, and ESG impact of products is of growing importance
- Suppliers: their main interest is being paid on time, so their focus is a company’s long term stability
- Governments: want to advance the interest of their constituencies. So regs have an interest in compliance, and govts want tax revenue
2024 L1 CI LM2 - Investors and Other Stakeholders
What are the ESG factors easier to incorporate into the decisionmaking process?
- Governance factors inclulde board ocmpositon, bribery and graft, exec comp, lobbying, political contributions and whistleblower schemes
- Social factors involve gender, diversity, employee engagement, community relations, human rights, labour standards, customer satisfaction
- Environmental factors inlcude climate and environmental effects
- Governance factors are well understood and straightforward to currently evaluate
- E and S factors are more difficult to incorporate into the decisionmaking process
2024 L1 CI LM2 - Investors and Other Stakeholders
- Why is ESG growing in importance?
- Financial impact of esg factors like disasters has risen
- general interest in E and S factors has risen esp in younger generation
- Increased regulation
- MM course says companies are being forced to view E and S as INTERNAL COSTS rather than negative externalities. ie that solving these issues will boost company financials etc
2024 L1 CI LM2 - Investors and Other Stakeholders
How to evaluate ESG risks and opportunities?
- Quantify the impact in financial terms [double materiality] and calculated impact on discounted future cash flows
- Significant long term adverse events immediately and disproportionately affect equity claims
- Fixed obligations less affected unless abiltiy to make payments is compromised
- Impact is dependent on maturity: 10yr bond holders may care more than 2yr bond holders
- Analysts should consider ESG by using sensitivity/scenario analysis
- eg lower discount rates for food company moving to sustainable sources (lower risk)
- Ther emay be an increase in employee turnover, increasing op costs if there is bad publicity over S element
2024 L1 CI LM2 - Investors and Other Stakeholders
What are the corporate stakeholder relationships?
- Contractual, Principal-Agent, and Other
- Principal agent is where one party hires another to perform a task or service
- This relationship acn be present WITH or WITHOUT a contract
- The agent is expected to act in the prinicpal’s best interests
- The agent possesses more information than the principal (asymmetry)
- Conflicts arise when interests diverge
- Agency costs arise from these interests divergences. They can be direct or indirect
- Direct costs might be monitoring ie listed companies spend money on reporting. indirect could include sth more abstract like foregone profits
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What are the characterists of diverging interests in corporate governance when it comes to shareholder vs director/management relations?
- Information asymmetry reduces ability of shareholders to assess performance
- It increases with lower levels of institutional ownership ie lower % free float shares
- Principal tool to align their interests is compensation ie executives and employees get compensated for better share performance
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
Why might shareholder and principal agent (directors/mgmt) interests diverge despite using compensation to align their interests?
- Insufficient effort: unable, unwilling to make investments, manage costs, make hard decisions. Too little monitoring of employees or controls could lead to risks and litigation. There might be too little time invested by directors/mgmt due to outside interests
- Inappropriate risk appetite: stock grants, options could lead to excessive risk taking. If no stock grants or options could lead to risk averse decision making
- Empire building: if compensation tied to business size there might be excessive acquisitions
- Entrenchment: playing it safe might mean copying competitors, avoiding risks, avoiding speaking out. This could lead to a slowdown in long term growth
- Self dealing: exploiting firm resources could occur, ie private planes and club memberships. If you are not exposed to firm equity then it doesn’t cost you at all to use those firm resources
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What might be the conflicts between controlling and minority shareholders?
Dispersed ownership would be where there are many shareholders, none with control
- Concentrated ownership is where an indv shareholder or group can exercise control (govt, founding family, other companies)
- Controlling shareholder might be a founding family seeking diversification, whereas minority shareholders may already hold diversified portfolios and want to focus on maximising value
- Or, a controlling shareholder might be a long term share owner with a mullti decade perspective, whereas minority shareholders seek quick gains via asset sales and cost cutting
- Voting schemes might affect this too: class B shares with disproportionate number of votes per share may be held by company insiders /founders. This may allow one group of SHs to have disproportionate power and personal interest overpowers will of majority
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What is the difference between private and public company reporting?
- Public companies publish annual reports, proxy statements, company disclosures, investor relations
- These show ops, objectives, audited FS, governance structure, ownership structure, renumeration policies, related party transactions, and risk factors
- Most juristictions and stock exchanges required audited FS
- Private companies disclose information often only to the extent reqd by regs
- Confidential information shared with investors as negotiated (it’s not standardised)
- Most jurisdictions don’t require audits
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What are AGM and EGM for
- No global standard of how to asset SH rights exists
- AGM and EGM are common mechs
- AGM: discuss board elections, auditor appointment, approval of FS, dividends, director and auditor comp, equity based compy plans, non binding votes on comp (“say on pay”)
- EGM: called when resolutions requiring SH approval are proposed OR by requested by a specified no. or % of SH
- Eg special election, mergers, voluntary liquidation
- Appointment of external auditors = AGM
- Overview of corp performance = AGM
- Amendment to a corp’s bylaws = EGM
- Anything recurring or run of the mill is AGM
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What is shareholder activism?
- Investor strats to compel a company to act in a desired manner
- Aim is to rapidly increase SH value
- or social, political, env considerations
- HFs among main SH activists. Fees are based on returns and able to finance large positions via leverage, unlike more regulated investment entities
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What is SH litigation?
- SH activists may purshue shareholder derivative lawsuits
- This is when SH act on behalf of comp in place of directors/mgmt who have FAILED to adequately act for benefit of firm
- Laws RESTRICT SHs taking action in some countries, ie min thresholds or prohibition
- Newby vs Enron, 2005, $7.2bn is one of the most sig cases
- Also sees Wells Fargo, $3bn, 2020
- And VW, Theranos
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What is corp takeover?
- SH believes MGMT not extracting value they should be
- Hostile takeover gets quite interesting (when you don’t have consent of mgmt)
- Proxy contest/fight: group seeking controlling position persuades other shareholdesr to vote gfor group
- Tender offer is invitation to existing SH to sell to group. This would enable group to gain board control and hence mgmt control
- Key example is MNG vs Gannett. MNG publishes newspapers but backed by HF with rep for hostile takeover etc. Gannett publishes USA today.
- Seen as battle between evil HF and hardworking journalists
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What are anti takeover measures?
- Try to protect against SHs
- Threat of removal can have neg impact on governance
- Preservation of employment should incentivise board to max SH wealth
- Staggered board elections may be used to prevent replacement of entire board
- Poison pill could be used via SH rights plan: one SH purchasing a given % of shares triggesr right to buy more shares at a discount
- Makes takeover much more expensive
- Netflix v Carl Icahn who owned 10%. Netflix responded by instituting a poison pill ie SH rights plan
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What is bond indenture?
- A creditor mechanism to ensure creditor rights
- RIghts of creditors are established by law + contracts with the firm
- Bond indenture is where there is a legal contract that describes the structure of the bond, the obls of the company, the rights of the bondholders.
- Terms and conditions may require certain actions, prohibit certain conditions, requires assets to be pledged
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
What are creditor committees?
- Established when a company files for bankruptcy, in some jurisdictions
- Ad hoc committees may be formed by bondholder groups when a company is struggling
2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
