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CORPORATE_ISSUERS_CFA1 > CHAPTER 2: INVESTORS & OTHER STAKEHOLDERS > Flashcards

CHAPTER 2: INVESTORS & OTHER STAKEHOLDERS Flashcards

1
Q

Debt Versus Equity

A
  1. Contractual Obligation:

Debt: Has contractual obligation to pay interest and principal.
Equity: No contractual obligation.

  1. Claim on Cash Flows and Assets:

Debt: Debt holders have a PRIOR legal claim on cash flows and assets.
Equity: Equity holders have a RESIDUAL claim on net assets after all stakeholders are paid.

  1. Tax Deductibility:

Debt: Interest payments are typically tax-deductible.
Equity: Dividend payments are not tax-deductible.

  1. Capital Characteristics:

Equity: Permanent source of capital, includes voting rights.
Debt: Cheaper source of capital, finite term, no voting rights.

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2
Q

Debt Versus Equity: Risk and Return

A
  1. Risk Perspective:

Debt: Less risky; debtholders receive predictable coupon payments.
Equity: More risky; payments to shareholders are discretionary.

  1. Return Potential:

Debt: Maximum return is capped at interest and principal repayment.
Equity: Unlimited upside potential due to residual claim on firm value.

  1. Investor Interests:

Debt: Focus on the likelihood of timely debt repayment.
Equity: Focus on maximizing company value, which corresponds to shareholder wealth.

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3
Q

Investor Perspective (Equity vs Debt)

A

Equity:

Tenor: Indefinite
Return Potential: Unlimited
Maximum Loss: Initial investment
Investment Risk: Higher
Desired Outcome: Maximize firm value

Debt:

Tenor: Term (e.g. 10 years)
Return Potential: Capped
Maximum Loss: Initial investment
Investment Risk: Lower
Desired Outcome: Timely repayment

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4
Q

Debt Versus Equity: Risk and Return

A

Issuer Perspective:

Issuing debt is riskier than issuing equity due to potential bankruptcy and liquidation if obligations are unmet.

Despite higher risk, debt cost is lower than equity cost since debtholder returns are capped.

Companies with stable cash flows prefer debt to avoid diluting equity.

Issuing more equity dilutes existing owners’ returns.

Early-stage or unpredictable cash flow companies may prefer equity to avoid default risk.

In default, companies can renegotiate terms or reorganize, potentially turning debtholders into new shareholders.

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5
Q

Issuer Perspective (Debt & Equity)

A

DEBT:

Risk: Higher risk due to potential bankruptcy and liquidation if obligations are not met.

Cost: Lower cost as returns to debtholders are capped.

Preference: Preferred by companies with stable, predictable cash flows.

Downside: Adds leverage risk and potential for default.

Options in Default: Renegotiate terms or liquidate assets; bondholders may become new shareholders.

EQUITY:

Risk: Lower risk for the company since there is no obligation to repay.

Cost: Higher cost as it involves sharing residual value among more owners.

Preference: Preferred by early-stage companies or those with unpredictable cash flows.

Downside: Dilutes existing shareholders’ returns.

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6
Q

Conflicts of Interest among Lenders and Shareholders:

A

Debtholders: Prefer less risky projects with predictable cash flows. Want to be safe.

Equity Holders: Prefer riskier projects with higher return potential. Have unlimited upside, so want to take more risks.

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7
Q

Corporate Stakeholders and Governance Stakeholder Groups:

A
  1. Shareholders and Creditors: Provide capital for financing company activities.
  2. Board of Directors: Serve as the stewards of the company.
  3. Managers: Execute the strategy set by the board and manage day-to-day operations.
  4. Employees: Provide human capital for daily operations.
  5. Customers: Purchase the company’s products and services.
  6. Suppliers: Supply raw materials, goods, and services that are not efficiently produced internally.
  7. Government and Regulators: Establish rules and regulations governing the company.
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8
Q

EXHIBIT 6 (DIAGRAM)

A
  1. Company
    Receives input from suppliers and employees
    Provides value, service, and safety to customers in exchange for a price
    Responsible for financial performance, compliance, and stewardship
  2. External Stakeholders
    Government: Public oversight, sets financial standards
    Investors: Provide capital, expect return on investment (dividends or stock appreciation)
    Creditors: Provide loans, expect repayment with interest
    Suppliers: Provide goods and services, receive financial benefits
    Employees: Perform work, receive remuneration and benefits
    Customers: Receive value, service, and safety at a price
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9
Q

Shareholders versus Stakeholders Theories

A
  1. Shareholder Theory:

Goal: Maximize shareholder returns.

Consider other stakeholders only if they affect shareholder value.

  1. Stakeholder Theory:

Consider interests of all stakeholders.

Emphasize ESG considerations as an objective for board and management.

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10
Q

Shareholders

A

Own shares in a corporation.

Rights: Receive dividends, vote on corporate issues.

Focus: Growth in corporate profitability and value maximization.

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11
Q

Creditors/Debtholders:

  1. Banks & Private Lenders
  2. Public Debtholders (Bondholders)
A
  1. Banks and Private Lenders:

Hold debt till maturity.

Access to management and insider information.

Can influence company decisions.

Prefer less financial leverage for lower risk.

Vary in approaches: collateral focus, holding debt and equity, equity-like focus, lending with ownership interest if default occurs.

  1. Public Debtholders (Bondholders):

Rely on public information and credit ratings.

Expect periodic interest payments and principal repayment.

No voting rights.

Limited influence on operations.

Prefer stability and minimizing downside risk over higher potential returns.

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12
Q

3.4 Board of Directors

A

Elected by Shareholders: Protect shareholders’ interests, monitor operations, and provide strategic direction.

Responsibilities: Hire the CEO, oversee management performance.

Composition: Includes inside and independent directors.

Inside Directors: Major shareholders, founders, senior managers.

Executive Directors: Maximize returns for EQUITY investors.

Independent Directors: No material relationship with the company; selected for their experience managing/directing other companies. Take care of the interests of DEBT-HOLDERS.

Structure: Varies by company size, structure, complexity.

Corporate Governance Standards: Require diverse expertise, backgrounds, competencies; typically at least one-third independent.

Staggered Board: Directors divided into groups, elected in consecutive years for continuous strategy implementation; limits immediate major changes by shareholders.

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13
Q

3.5 Managers

A

Led by the CEO: Execute board’s strategy, handle day-to-day operations.

Compensation: Base salary, short-term cash bonus, multi-year equity incentive plans (e.g., options, vested shares).

Motivated to maximize total remuneration and protect employment status.

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14
Q

3.6 Employees

A

Lower-Level Employees: Seek fair salary, good working conditions, job security, career development, promotion.

Equity Ownership: Minor part of compensation compared to managers.

More interested in company’s long-term stability, survival, growth.

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15
Q

3.7 Customers

A

Expectations: Good quality products/services for the price, after-sales service/support, guarantee/warranty.

Company Strategy: Strive to keep customers happy for revenue impact.

Concern: Least concerned with company’s overall performance.

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15
Q

Debt vs Equity, who’s cost of capital is higher?

A

EQUITY Ke is higher. Thus, debt is preferred by the issuer.

Equity also creates dilution but maybe the only option when CFs are absent or unpredictable. So, debt is preferred when CFs are predictable & coupons can be paid

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16
Q

3.8 Suppliers

A

Primary Interest: Timely payment for products/services delivered.

Long-Term Relationship: Some aim for ongoing business.

Interest in Stability: Typically prefer company’s long-term stability.

17
Q

3.9 Governments

A

Role: Collect taxes from companies and their employees.

Objective: Protect general public interests, ensure economic well-being.

18
Q

Debt vs Equity: which is more risky for the issuer/company?

A

DEBT is more risky since they’re risking bankruptcy & it adds LEVERAGE risk

19
Q
  1. Corporate ESG Considerations

ESG Definition:

A

Environmental, Social, and Governance (ESG) issues are critical factors in investment analysis.

Historically, governance factors have been more emphasized, while environmental and social factors are gaining importance

20
Q

Catalysts for ESG Growth:

A

Financial Impact: Mismanagement of ESG issues leads to significant investor losses.

Younger Investor Demand: Increased demand for responsible management of inherited wealth and pension funds.

Regulatory Pressure: Governments are prioritizing climate change and social policies, enforcing stricter ESG criteria.

21
Q

Integration of ESG Issues:

A

Traditionally treated as negative externalities, ESG factors are now included in income statements by responsible investors due to heightened stakeholder awareness and regulations.

22
Q

Examples of ESG Factors:

A
  1. Environmental Issues: Climate change, air and water pollution, biodiversity, energy efficiency, waste management, etc.
  2. Social Issues: Customer satisfaction, data protection, diversity, employee engagement, human rights, etc.
  3. Governance Issues: Board composition, executive compensation, shareholder rights, bribery, lobbying, etc.

After ENRON scandal (Arthur Anderson)= SARBANES OXLEY ACT in the USA= SOX Act

23
Q

4.1 Governance Factors

A

Corporate Governance Factors:

  1. Ownership and Voting Structure: Influence on decision-making and control.
  2. Board Skills and Experience: Expertise relevant to company needs.
  3. Management Compensation: Alignment with company performance.
  4. Shareholder Rights: Strength compared to industry peers.
  5. Risk Management: Effectiveness in managing long-term risks and sustainability.
24
Q

Consistency and Variability:

A

Corporate governance factors are generally consistent across industries.

Environmental and social considerations vary significantly based on industry specifics (e.g., energy vs. banking sectors).

25
Q

Materiality in ESG Evaluation:

A

Analysts prioritize material ESG factors that impact a company’s long-term business model.

Materiality assessment crucial in determining which ESG factors are most relevant for each company.

Understanding and integrating ESG considerations is crucial for modern corporate governance and investment analysis, reflecting evolving investor priorities and regulatory landscapes.

26
Q

LO. Describe a company’s stakeholder groups and compare their interests

A

The primary stakeholders of a company include:

  1. Shareholders
  2. Creditors
  3. Managers and employees
  4. Board of Directors
  5. Customers
  6. Suppliers
  7. Government/Regulators
27
Q

4.2 Environmental Factors

What are Stranded Assets?

A

Stranded Assets: Refers to carbon-intensive assets within energy companies that may become economically unviable due to regulatory changes or shifts in investor sentiment towards sustainability.

eg: In Oil refineries: Hydro-Skinning (old assets & old process) vs Deep-Conversion (newest)

Risk: These assets may lose economic value or become obsolete as environmental regulations tighten or societal preferences shift towards cleaner energy sources.

Carbon-intensive assets that may get stranded & lose Economic Value due to ESG guidelines or societal preferences.

27
Q

4.4 Evaluating ESG-Related Risks and Opportunities

A

Similarity in Analysis:

  • Equity and Debt Perspectives: Both equity and debt analyses involve identifying and evaluating ESG factors.
  • Material Impact Quantification: Crucial step involves quantifying the material impact of ESG factors on future cash flows of the company.
28
Q

Impact on Equity vs. Debt:

A
  1. Equity Impact: Significant adverse ESG events can immediately and severely impact equity, leading to sharp declines in share prices.
  2. Debt Impact: While debt is also affected by ESG factors, it tends to be less volatile compared to equity unless the company’s ability to meet interest and principal payments is compromised.
  3. Maturity Dependency: Impact on debt varies with maturity; factors that affect long-term sustainability may not immediately impact short-term debt evaluations.
29
Q

LO. Compare the financial claims and motivations of lenders and shareholders

A

Debt vs. Equity: Key Differences and Implications

  1. Contractual Obligations:

Debt: Represents a contractual obligation where the issuing company must make promised interest and principal payments to debtholders.

Equity: Does not involve a contractual obligation; equity holders participate in the company’s profits but do not have guaranteed payments.

  1. Priority of Claims:

Debt: Debtholders have a prior legal claim on the company’s cash flows and assets. They must be fully paid before equity owners can receive distributions.

Equity: Equity holders have a residual claim on the company’s assets, receiving what remains after all other obligations, including debt payments, are met. This gives them unlimited upside potential if the company performs well.

  1. Risk Perspective:

Investor’s View: Investing in equity is generally riskier than investing in debt due to the lack of guaranteed payments and the higher volatility associated with equity returns.

Company’s View: Issuing debt is riskier than issuing equity because failure to meet debt obligations can lead to bankruptcy and potentially liquidation of the company.

  1. Conflicts of Interest:

Debtholders vs. Equityholders:

Debtholders prefer lower-risk projects that generate steady cash flows to ensure timely repayment of their debt, even if the returns are modest.

Equity holders, however, may prefer riskier projects with higher potential returns, despite the higher risk of failure or volatility.

30
Q

LO. Describe environmental, social, and governance factors of corporate issuers considered by investors

A
  1. While evaluating ESG factors, analysts first need to evaluate if an information is material.

Materiality typically refers to ESG related issues that can affect a company’s operation, its financial performance, and the valuation of its securities.

Analysts also consider their investment horizon when deciding which ESG factors to consider in their analysis.

Some factors may affect a company’s performance in the short term, whereas other issues may be more long term in nature.

31
Q

LO. Describe environmental, social, and governance factors of corporate issuers considered by investors

A
  1. Environmental Issues:

Climate change
Air and water pollution
Biodiversity
Deforestation
Energy efficiency
Waste management
Water scarcity

  1. Social Issues:

Customer satisfaction
Data protection and privacy
Gender and diversity
Employee engagement
Community relations
Human rights
Labor standards

  1. Governance Issues:

Board composition
Audit committee structure
Bribery and corruption
Executive compensation
Lobbying
Political contributions
Whistleblower schemes

32
Q

Which of the following payments are most likely tax deductible?

A Interest payments only.
B Dividend payments only.
C Both interest and dividend payments only.

A

A is correct. Interest payments on debt are typically tax-deductible whereas dividend payments on equity are not.

33
Q

Which of the following statements is most accurate from issuer’s perspective?

A equity is preferred when cash flows are predictable.
B cost of debt is higher.
C debt increases leverage risk.

A

C= correct

A= equity is preferred when CFs are unpredictable
B= ke is higher

33
Q

Which of the following statements is least accurate?

A Equity does not involve a contractual obligation.
B Debt holders have a residual claim on the company’s net assets.
C Debt has a stated finite term and no voting rights.

A

B.

Debt holders have PRIOR claim, not residual claim (equity)

A= correct
C= correct

34
Q

Which stakeholder most likely serves as the steward of the company?

A Board of Directors
B Managers
C Shareholders

A

A

A is correct. The board of directors serves as the steward of the company.

B is not correct because the managers execute the strategy set by the board and run day-to-day operations.

C is not correct because the shareholders and creditors provide the capital and financial resources to finance the company’s activities.

35
Q

Which stakeholders would be most affected by a decrease in the market value of a company?

A Private lenders
B Shareholders
C Employees

A

B is correct. Shareholders own shares in a corporation and are directly affected by the market value of the company.

A is not correct because private lenders are usually not entitled to any additional cash flows (beyond interest and debt repayment) if the company’s value increases.

C is not correct because, as compared to managers, equity ownership is a minor part of compensation of lower-level employees. Therefore, they are more interested in the company’s long-term stability, survival and growth.

36
Q

ESG considerations in investment analysis have most likely gained importance due to which of the following factors?

A Many investors incurred significant losses when the companies they invested in mismanaged ESG issues.
B A greater number of older investors are increasingly demanding that their wealth be managed responsibly.
C Environmental and social issues are being treated as negative externalities.

A

A is correct. ESG issues are having more financial impacts. Many investors incurred significant losses when the companies they invested in mismanaged ESG issues.

B is not correct because a greater number of younger investors are increasingly demanding that their inherited wealth or pension contributions be managed responsibly.

C is not correct. Unlike the past, environmental and social issues are no longer being treated as negative externalities. Increased stakeholder awareness and strengthening regulations have led to inclusion of environmental and societal costs in the company’s income statement by responsible investors.

37
Q

Which of the following statements is least accurate about ‘stranded assets’?

A They are carbon intensive assets.
B Investors in energy companies are concerned about the existence of these assets.
C They are typically at risk of being obsolete due to technological changes.

A

C is correct. Stranded assets are at risk of no longer being economically viable because of changes in regulation or investor sentiment.

A and B are correct statements about stranded assets.

38
Q

FINANCIAL BS VS ECONOMIC BS

A

FINANCIAL BS:

ASSETS: Cash, ST Claims & Assets, LT Assets
LIABILITIES: ST Obligations, LT Obligations, Equity

ECONOMIC BS:

CLAIMS: Suppliers, Customers, Employees, Community, Internal & External Governance
OBLIGATIONS: Suppliers, Customers, Employees, Community, Internal & External Governance

39
Q

FINANCIAL VS ECONOMIC INCOME STATEMENT

A

ECONOMIC PROFIT is return in excess of owners’ required rate of return

NET INCOME/EQUITY > Required Rate of Equity Return

CORPORATE_ISSUERS_CFA1 (7 decks)

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