CFA 2024 L1 Corporate Issuers

Question 1

What is a sole trader?

Answer 1

• 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

Question 2

What is a general partnership?

Answer 2

• 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

Question 3

What is a limited partnership?

Answer 3

• 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

Question 4

What is an LLC?

Answer 4

• 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

Question 5

What is a public limited company?

Answer 5

• 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

Question 6

What are corporate issuers?

Answer 6

• 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

Question 7

How is responsibility shared for a limited liability entity?

Answer 7

• 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

Question 8

What is the difference between financial and economic balance sheet?

Answer 8

• 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

Question 9

What sources of finance do limited liability entities have?

Answer 9

• 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

Question 10

What is the difference between public and private corporate issuers?

Answer 10

• 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

Question 11

How are shares issued?

Answer 11

• 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

Question 12

How can a company go private?

Answer 12

• 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

Question 13

What are the private v public trends across different kinds of economies?

Answer 13

• 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

Question 14

What are the different types of shareholders?

Answer 14

• 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

Question 15

What do debtholders do?

Answer 15

• 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

Question 16

What do equity investors do relative to corporate issuers?

Answer 16

• 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

Question 17

What are the pros and cons of debt v equity financing?

Answer 17

• 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

Question 18

What is the payoff asymmetry for shareholders vs debtholders?

Answer 18

• 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

Question 19

What is the potential conflict of interests for the firm which has both shareholders and bondholders?

Answer 19

• 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

Question 20

What are stakeholder groups?

Answer 20

• 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

Question 21

What are the differences between private and public debtholders?

Answer 21

• 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

Question 22

Who are the board of directors?

Answer 22

• 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

Question 23

Aside from the board of directors who are the primary stakeholder groups?

Answer 23

• 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

Question 24

What are the ESG factors easier to incorporate into the decisionmaking process?

Answer 24

• 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

Question 25

- Why is ESG growing in importance?

Answer 25

- 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 ## Footnote 2024 L1 CI LM2 - Investors and Other Stakeholders

Question 26

How to evaluate ESG risks and opportunities?

Answer 26

- 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 ## Footnote 2024 L1 CI LM2 - Investors and Other Stakeholders

Question 27

What are the corporate stakeholder relationships?

Answer 27

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 28

What are the characterists of diverging interests in corporate governance when it comes to shareholder vs director/management relations?

Answer 28

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 29

Why might shareholder and principal agent (directors/mgmt) interests diverge despite using compensation to align their interests?

Answer 29

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 30

What might be the conflicts between controlling and minority shareholders?

Answer 30

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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Answer 31

## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 32

What is the difference between private and public company reporting?

Answer 32

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 33

What are AGM and EGM for

Answer 33

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 34

What is shareholder activism?

Answer 34

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 35

What is SH litigation?

Answer 35

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 36

What is corp takeover?

Answer 36

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 37

What are anti takeover measures?

Answer 37

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 38

What is bond indenture?

Answer 38

- 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 ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 39

What are creditor committees?

Answer 39

- Established when a company files for bankruptcy, in some jurisdictions - Ad hoc committees may be formed by bondholder groups when a company is struggling ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 40

What is an audit committee?

Answer 40

- 100% independent members - At least one has financial or accounting expertise - Monitor the financial reporting process - Supervise internal audit - Recommends external auditor - Proposes remedial action based on audit reports - May also oversee IT security ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 41

What does the nominating or governance committee?

Answer 41

- In charge of setting up a corp gov structure, a code of ethics, and making sure it's adhered too - Oversees board election process - Sets nomination procedures - Appraises director and manager candidates - Typically independent members

Question 42

What is a compensation committee?

Answer 42

- 100% independent - Develops renumeration policies - Sets performance criteria ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 43

What other committees could be formed within the board of directors?

Answer 43

- Industry specific ones include: - Risk committee, - technology and innovation committee - Specific functions are delegated to committees - No specfic function is delegated to the board sometimes ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 44

What employee mechs can be used to govern principal stakeholder relationship between employees and firm?

Answer 44

- Labour laws: country specific, and define a standard of rights and responsibilities - Unions: employees have the right to form them to advocate for their needs In some countries employees may have dedicated board representation Employee stock ownership plans are used to ensure alignment of interests ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 45

What customer and supplier mechanisms could be used to negotiatae their principal-stakeholder relationship with the firm?

Answer 45

- Contracts: specify prices, rights, responsibilities and more - Social media: a virtually cost free method for customers to compete with mgmt and influence public sentiment! - Especially popular when company has been associated with someone problematic or very unpopular ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 46

What mechanisms can be used by govt to negotiate their relationship with firms?

Answer 46

- Laws and regs: protect and enforce property and contract rights - As well as rights of specific groups - Industries more likely to affect public or stakeholder interests are more heavily regulated, e.g. financial services or healthcare - Corporate governance codes: guiding principles for publicly traded companies - Operate a pulicy of comply or explain: comply or give some good reason - Stock exchanges may also have some listing reqs ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 47

What is the benefit of good corp governance?

Answer 47

- Weak corp governance can lead to competitive disadvantage - Could result in adverse performance - Or one stakeholder group benefitting at the expense of others - Management might make decisions solely for their own benefit - Strong corporate governance can increase competitiveness and efficiency - Can help identify, mitigate and control risk factors such as fraud - Allows clear delineation of responsibilities - Helps align interests between mgmt and firm which leads to improved decisionmaking - ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 48

What are the legal, regulatory, and reputational risks and benefits of good corporate governance?

Answer 48

- Benefits: - Stakeholders seek LT relations with firms that have rep for respecting constituent and stakeholder rights - Rep enhances ability to attract talent, secure capital, improve sales - Helps mitigate conflicts of interest and agency problems - Risks: - Govt and regulator investigations for violation of laws - Lawsuits from other stakeholders - Loss of rep due to improperly managed conflicts of interest - Ex: VW falsifying emissons data, fined 37.7bn USD - Problem was that it initially questioned the testing method rather than admitting the falsification ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 49

What are the financial risks and benefits of good corporate governance?

Answer 49

- Benefits: - Increased investor confidence reduces required return, higher valuation - Increased likelihood of credit rating upgrade from speculative to IG - Listed firms with experienced audit committees with financial expertise have shown stronger performance during times of crisis - Board diversity and ind appear to be key factors in firm valuation - Risks: - Weak management of creditor interests can lead to default ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 50

What is working capital?

Answer 50

- Current assets less current liabilities - Every analyst has a different definition though - Key is looking at the operating and cash conversion cycles: how the firm makes money - Take current assets, remove cash and marketable securities (not really part of the cycle) - Take out any debt classed as current - This could be short term debt ie classed as payable within a year - It also includes the amount of a long term loan that is payable this year (amortised over time) - When we talk about WC we talk about having enough assets to pay for short term liabilities ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 51

What is the cash conversion cycle?

Answer 51

1. Start with cash 2. Purchase raw materials 3. Produce finished goods 4. Make sales 5. Collect customer credit 6. Return to cash 7. CCS measures how long this process takes 8. - CCS is time between two cash flows: DOH + DSO - DPO ## Footnote 2024 L1 CI LM3 - Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Question 52

What are DPO, DOH, DSO?

Answer 52

- DPO is days payable outstaning - How long it takes for you to pay your suppliers - DOH is days of inventory on hand. How long is a product in your warehouse before it's sold - DSO is days sales outstanding. How long it takes for you to collect cash from your customers - CCS is time between two cash flows: DOH + DSO - DPO ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 53

Why should we be careful to compare cash conversion cycles across industries?

Answer 53

- Industries are very different - Ie airlines have little inventory (the food that is sold on the plane etc) - Consumers pay for flights upfront - Cash conversion cycle is very short - By contrast pharmaceutical firms are required by law to have certain amount of inventory on hand - Therefore their CCS will be very long - Intra industry differences are more important ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 54

Why is a shorter CCS better?

Answer 54

- Frees up cash to be used elsewhere - Longer CCS has financing costs (or cost of capital) ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 55

How to reduce CCS?

Answer 55

- Reduce DOH: discontinue products, do more frequent ("just in time") deliveries, improve demand forecasts - Reduce DSO: Create prompt-payment discounts, add lateness fees, tighten credit standards, require upfront deposits, hire a 3rd party to collect - Increase DPO: negotiate with suppliers, try to use buying power. However, increasing DPO and paying your suppliers later might mean you lose on discounts - Zara is a good example as it has NEGATIVE CCS. Takes very long time to pay suppliers so suppliers are effectively financing its borrowing - Clothing brands typically have to keep v large inventory to meet quick changes in consumer trends - Zara is famous for bucking that trend. Has extremely fast manufacturing process & gets it on and off the shelves as fast as possible. ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 56

What could be the effect of missing out on fast payment discounts to suppliers?

Answer 56

- Let's say you get a 2% discount for paying within 10 days - So buying $100 would cost $98 - Then let's say you average paying in 30 days - The cost is 2.04% for the 20 days of borrowing - 1.0204^(365/20) - 1 = 44.6% - So you borrow at an EAR of 44.6% - If you can borrow at anywhere below this rate to pay early (most lenders)! then you can save money ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 57

Why do we care about working capital?

Answer 57

- Lower WC = more efficient ops - WC to sales ratio allows comp across firms of different sizes - WC levels and CCS length are positively correlated - Reduce one, you'll reduce the other ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 58

What is liquidity?

Answer 58

The nearness to cash or settlement - For assets: cash, then ST investments, then AR, then finally inventory (though some ie aged whisky may be highly illiquid) - For liabilities: accrued payroll, AP, lease payment due in 1 month, short term month - For an issuer liquidity = ability to meet short term liabilities - If ST liabilities > cash issuer requires other sources of liquidity ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 58

What might primary sources of liquidity be (which do not affect ongoing ops)?

Answer 58

- Marketable securities you can sell quick w/o loss of value - Cash - Borrowings (bank, bondholders, supplier credit) - Cash flow from business (though takes time!) ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 59

What are measures of cash flow?

Answer 59

- Cash flow from operations - However some CFO has to be reinvested ie in capital invested - CFO less investment in LT assets = FCF ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 60

What are secondary sources of liqudity?

Answer 60

- May impact firm as could signal deteriorating financial health - Delaying or reducing capex (could lead to missed opportunities) - Suspending/reducing dividends - Issuing equity = dilutes existing shareholders (incl convertible bonds) - Renegotiating contract term (short to long term debt, negotiate rent, leases, w supplier) - Selling assets (will you get good value?) - Filing for bankruptcy - gives protection against creditors + help to restructure debt ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 61

Why does the CCS impact liqudity?

Answer 61

- Lagging cash flows are a drag on liquidty - Accelerated cash outflows are a pull on liquidity (accelerate cash moving out) - Other drags are: uncollected receivables, obsolete inventory, borrowing constraints - Pulls are: early payments, reduced credit limits, limits on short term lines of credit, low liquidity positions ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 62

What ratios can measure liquidity?

Answer 62

- Current ratio: current assets / current liabilities (assumes inventory and receivables are liquid) - Quick ratio: cash + ST marketable securities + receivable / current liabilities (tighter measure) - cash ratio: cash + ST marketable securities / current liabilities (a crisis measure!) ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 63

What is the objective of managing working capital and liquidity?

Answer 63

- A balancing act of firm value v accessible funds - Mantain ready access to runds necessary for day to day ops and obligations - Minimise excess liquidity - Maximise firm value by shortening cash conversion cycle (though biz model dependent). - Ie Starbucks you can prepay for coffee and get a discount (cash in firm BEFORE you buy product) - We need to determine optimal WC level relative to revenue - Then forecast future WC levels (ie based on seasonality and rev forecasts) ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 64

Diff between conservative, moderate and aggressive WC mgmt strats?

Answer 64

- Conservative: large ST asset positions v sales, financed by LT debt and equity - Moderate: aka matched. Moderate ST assets v sales, and match funding: permanent assets financed w LT debt, variable assets financed w ST debt - Aggressive: smaller ST asset position v sales, much greater reliance on ST debt ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 65

Pros and cons of aggressive v conservative WC management?

Answer 65

- - Conservative has greater certainty at higher cost. Typical of growth phase firms with less access to financing, or if rates expected to rise (tie in lower rates now) More established firms may be able to pass higher financing costs onto customers so don't need conservative approach - OTOH has higher interest rates, high cost of equity, permanent financing means not borrowing as needed (supply demand mismatch), LT debtholders typically place restrictions ie covenants on ops so not as much freedom - - Aggressive: higher returns, better for firms with lower profit margins, falling interest rates in future, if future sales and cash can be forecasted precisely, or if they expect to shorten CCC, collect AR quick, liquid inventory. But has higher bankruptcy risk, rariable interest costs, more reliance on trade credit and collecting AR quick (so may use 3rd parties) -- Moderate: can adapt ST debt to seasonal needs, otherwise pros and cons inbetween ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 66

What factors influence ST funding approach?

Answer 66

- Size: larger firms have more credit - Creditworthiness: may lead to restrictions - Legal considerations; less dev markets req more reliance on trade credit - Reg considerations: banks have capital reqmts but OTOH have access to CB funding unlike retailers - Underlying assets: are they attractive as capital? ## Footnote 2024 L1 CI LM4 - Working Capital and Liquidity

Question 67

What are capital investments?

Answer 67

Investments of one year of longer - They create long term assets on balance shet - You match the cost to the revenues, smoothing the capital spending to match it to the benefits earned - This is depreciation or amortisation, a periodic expense derived from the capitla investment - It is recorded on the income statement - On the balance thing it is initially recorded at cost, - and the balance is subsequently REDUCED by depreciation or amortisation - - on the CFS the initial expense is recorded as a cash outflow - It sits in the Cash Flow from Investing section ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 68

What types of project might involve capital investments?

Answer 68

1. Reg compliance project. Required to do and usually won't earn returns. But still have to do it. This could reduce profitability even to negative. However benefit is may provide an economic moat if compliance is very expensive 2. Going concern: continuing the firm's current ops and maintain existing biz size. Ie asset replacement, IT hard/software maintenance, imp of existing facilities. Risks are low and easy to evaluate because can judge upfront cost against periodic savings. Funding should match the lifespan of the new asset, which avoids rollover risk (uncertain financing of asset during project life of shorter term debt. 3. Expansion of existing biz: increase in scale of ops, or scope of product offering. Higher risk than maintenance or compliance as greater uncertainty and reqs more capital. Complex execution for increases in scope. Funding for firms in early phase should be equity; older firms canaccess debt. Analysts should consider competitive position and past performance by peers when determining chance of success 4. New lines of biz: highest risk, minimally related to current biz. ie R&D in new technology. Startup like. Could also refer to acquisition outside of business industry. Analysts should review segmental disclosures to determine what's going on. You can assess level of expansion expenditure by lessing maintenance form total capex. ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 69

What is the capital allocation process?

Answer 69

- Process used by firm's mgmt and baord to make cap investments and return decision - Aim is to earn risk adjusted returns greater than elsewhere - Since have to consider opportunity costs - Steps involve: idea generation, investment analysis, planning and priioritisation, monitoring and post inv review ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 70

What are the exact steps of the capital allocation process?

Answer 70

1. Idea gen: understand competitive env, firm's competitive position. May be internally generated by consultants 2. Investment analysis: forecast amount, timing, duration, volatility of cash flows 3. Planning and prioritisation: most value enhancing plan on a risk adjsuted return basis. Only choose projects with returns greater than opportunity costs. Consider interactions with existing ops, plus finance constraints. Return unused capital to shareholders. 4. Monitoring and post investment review: monitor performance. Validate assumptions, increase or decrease investment ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 71

What principles should we use when making capital allocation decisions?

Answer 71

1. Use aftrer tax cash flows 2. Use incremental cash flows. Ignore things you have already spent on (ie sunk costs: consultant example), and "examine broadly" the impact across other areas of the biz like cost savings or loss of sales 3. Time Value of Money: consider impact on NPV and IRR of a change in timings ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 72

What are the pitfalls of capital allocation?

Answer 72

- Cognitive errors: ie retained earnings still have an opportunity cost (not free cash!) - Internal forecasting errors about costs, required returns, and competitor responses - Inconsistent treatment or ignoring inflation: nominal flows include inflation, real cash flows exclude. Actual inflation /= expected inflation. Different cash flows affected differently (ie being able to pass on costs to consumers for different products) - Behavioural bias: pet projects, inertia causing less rigorous processes, failure to considera alternatives (breakeven, scenario, simulation analyses ignored), use of accounting measures like EPS destroying long term profitability ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 73

What are real options?

Answer 73

- In practice firms have choices after inception of project and don't have to maintain one course of action throughout project's life - Real options are the right but not obligation to take action in the future - They will be exercised only if value enhancing - Real options can alter the value of a capital investment - The option value depends on future events - For example I might build a project with conservative growth projections but lay the foundations for a potential expansion if the market is great - I can then choose to allocate more capital easily and expand ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 74

What kinds of real options are there?

Answer 74

- Timing: delay investment and hope for improved information; sequence projects - Sizing: abandonment (if present value of future cash flows is less than cost now) or grwoth: additional investment when performance is strong - Flexibility: price setting (increase prive to benefit from strong demand), production flexibility: alter production levels in line with demand Fundamental: the entire investment is an option, e.g. value of oil well contingent on oil price. R&D projects. ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 75

How to evaluate real options?

Answer 75

1. Positive NPV without option, then do it anyway (option can only add value) 2. Calculate NPV with option (NPV without - option cost + option value) 3. Decision trees and option pricing models ie decision tree = calculate probabilities of different outcomes and returns for each. May be multi stage ## Footnote 2024 L1 CI LM5 - Capital Investments and Capital Allocation

Question 76

Why are WACC calcs based on book value more stable?

Answer 76

- Equity value changes all the time when you use market value - Book value changes much much more slowly - Don't need to constantly keep recalculating WACC - WACC accounts for cost of financing debt and equity (usually debt has a discount of 1- tax rate) and proportions in the firm. ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 77

What factors affect capital structure?

Answer 77

- Amount and type of financing need - Depends on business model (utilities, transport, real estate are highly capital intensive) and stage in life cycle - You can manage a capital intense business effectively through franchising, contracting, leasing - Leasing is cheap because the asset itself can act as collateral - In regulated industries like banks and utilities govts might require minimim % of equity to increase resilience - Capital light (tech, service) have high fixed asset turnover, low capex to sales. They may be operating networks for others (uber, airbnb). They take upfront payments and comissions so could even have neg CCC & therefore no need to finance WC - Can use stock for employee comp, reducing need for cash - If profitable at early stage there is minimal need for external financing until want a major expansion ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 78

What kind of debt do startup, growth and mature comps take?

Answer 78

- Startup: convertible, if any (and will cost you via dilution - Growth: secured - Mature: unsecured ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 79

What top down factors affect what capital structure a firm pursues?

Answer 79

- Debt investors require risk free rate + spread - Macro and country factors can increase RFR and spread (real growth, MP, FX rates) ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 80

What issuer specific factors affect their capital structure?

Answer 80

- Operating leverage (higher proportion of costs are fixed costs, meaning higher risk) - Sales risk (stable predictable growing revs are lower risk) - If issuer has a lot of strong and liquid collateral that can easily generate cash (real estate, aircraft, receivables) this improves borrowing ability and decreases rates ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 81

What are the objs of capital structure decisions?

Answer 81

1. Minimise WACC, and therefore 2. Maximise value of the firm 3. Modigliani Miller (1958) said under certain assumptions choice of capital structure is irrelevant in determining the value of a firm ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 81

What are the Modigliani Miller assumptions?

Answer 81

1. Homogeneous expectations: investors agree on future cash flows investments will generate 2. Perfrect capital markets: no transaction costs, taxes, bankruptcy costs, and everyone has the same information 3. RFR exists: and everyone can borrow and lend at that RFR 4. NO agency costs: managers always act to maximise shareholder wealth 5. Independent decisions: financing and investment decisions are independent of each other Extremely restrictive: as these assumptions are relaxed, factors that impact value are revealed ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 81

Why does the introduction of taxes to Modigliani Miller assumptions NOT mean firms should have 100% debt capital structure?

Answer 81

- There are costs to financial distress: suppliers not winning to supply, cost of bankruptcy proceedings - You want the additional tax shielding of using debt rather than equity to equal the losses from bankruptcy - It's an optimisation problem! ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 82

What is the difference in evaluating optimal and target vs real capital structures?

Answer 82

- As an analyst you may choose to use target structures as in the long run the firm might converge to this - Analysts can also look at capital structures of comparable companies if the company of interest does not disclose theirs ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 83

What does a D:E ratio of 0.7 mean?

Answer 83

- for every 70 dollars of debt there are 100 dollars of equity - you can calculate the amount of debt as 70 / (100 +70) - So debt = 0.41 = 41% ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 84

What are the potential agency benefits of a highly levered company according to Jensen's free cash flow hypothesis?

Answer 84

- Agency costs are incremental costs resulting from conflicts of interest - Increased use of debt may reduce agency costs of equity - If a firm has increased financial leverage this forces the company to be run more efficiently by management - Therefore improving the quality of the firm ## Footnote 2024 L1 CI LM6 - Capital Structure

Question 85

What is the definition of a business model?

Answer 85

- Trick question: no precise generally accepted definition! ## Footnote 2024 L1 CI LM7 - Business Models

Question 86

# ``` ``` What are the key features of a business model?

Answer 86

- Exactly what you do - Who you do it for: local, national, international customers; B2B or B2C, segmented by geography. demographics, seasonal, life stage, behaviour - Why: what need is being filled. How big are the addressable markets, are they growing or shrinking, what are the opportunities (who else might buy it?), what are the risks (technology that might catch up)? - What assets will be required? Warehouses, retailers, delivery fleets, sales agents, after sales service. - How much: if you have low pricing power demand is elastic, if high (ie monopoly or highly differentiated product) demand is inelastic. - ## Footnote 2024 L1 CI LM7 - Business Models

Question 87

What is the traditional sales strategy and the pros and cons?

Answer 87

- Manufacturer > wholesaler > retailer > end customer - Direct sales strategy means you skip all this margin erosion - You become customer facing ie can respond more readily to demand - Problem is you need a sales team ## Footnote 2024 L1 CI LM7 - Business Models

Question 88

What kinds of price discrimination are there?

Answer 88

- Net prices: after specific discounts/ promos / bundles - Tiered pricing: based on vol or product features (base model plus add ons) - Dynamic pricing: based on time of purchase; supply and demand (ie Uber on NYE) - Value based pricing: based on value received by customer (pharma v expensive) - Auction/reverse auction models: bidding process (ebay innovated this) ## Footnote 2024 L1 CI LM7 - Business Models

Question 89

What multiple or complex product pricing and revenue models are there?

Answer 89

- Bundling: combining multiple products. Useful for prods with high marketing cost ie insurance, high incremental profit margins - Razors and blades: low initial price, high margin repeat purchases. Need to prevent generic substitutes (also nespresso - although there are subs now!) - Add on pricing when you have captive customers (ie flight addons, games) ## Footnote 2024 L1 CI LM7 - Business Models

Question 90

What pricing strategies can help growth?

Answer 90

- Penetration pricing: build scale and market share, sacrifice margin. Effectively a marketing expense! - Freemium biz model: basic usage for free or maybe plus ads. Common in digital servs and when you have network effects - Hidden revenue business model: no charge for service, re eleswhere (ie pay extra for the data! or social media and marketing data) ## Footnote 2024 L1 CI LM7 - Business Models

Question 91

What are the key alternatives to asset ownership?

Answer 91

- Subscription models ie software - Lease tangible assest - License out intangible assets - Franchise your brand ## Footnote 2024 L1 CI LM7 - Business Models

Question 92

What are value chain and supply chain?

Answer 92

- Value chain: activities carried out by the firm that add value to the customers. If you can't add value you probably shouldn't be involved in that part of the value chain (maybe contract it out!) - Supply chain: sequence of processes involved in the production and delivery of a product. Is likely to involve multiple firms. ## Footnote 2024 L1 CI LM7 - Business Models

Question 93

What are the variations of biz model?

Answer 93

1. Contract manufacturers ie private label. Produce goods marketed by others (ie apple doesn't manufacture!) 2. Vallue added resellers: distribute and handle complex aspects of installation, service etc 3. Licensing arrangements: produce under a recognised brand name, pay royalty (pop myth that Beatles invented royalties by selling wallpaper. They really milked their brand at the height of their fame!) 4. Franchise models: franchisor earns royalty and is responsible for advertising and product dev ## Footnote 2024 L1 CI LM7 - Business Models

Question 94

What are the innovations that can be added to biz models (esp dig tech)?

Answer 94

- Location matters less - Outsourcing easier (do in cheapest country) - Digital marketing is cost effective at finding right customer - Network effects ## Footnote 2024 L1 CI LM7 - Business Models

Question 95

What are the networks effects of different biz models?

Answer 95

- Increase in value of a network to its users as more users join - eg messaging platforms, payment platforms, social media, payment systems, stock exchanges - One sided: there is one type of user valuable to other users ie Venmo - Two sided: two or more types of users ie credit card networks - Crowdsourcing: users contribute to the product, and the bsuiness facilitates "communities" ## Footnote 2024 L1 CI LM7 - Business Models