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CFA Lvl 1 > Corporate Issuers > Flashcards

Corporate Issuers Flashcards

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1
Q

Corporate Governance

A

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

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2
Q

Under shareholder theory, what is the primary focus of a system of corporate governance

A

the interests of shareholders

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3
Q

Under stakeholder theory, what is the primary focus of a system of corporate governance

A

consider conflicts between groups that have an interest in the activities and performance in the firm

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4
Q

principal-agent conflict

A

when an agent (management) and the principal (owner of business) have conflicting interests/incentives in running the company

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5
Q

Management of stakeholder relationships based on four types of inrastructure:

A
  • Legal infrastructure (laws relevant to the rights of stakeholders)
  • Contractual infrastructure (contracts between company and stakeholders)
  • Organisational infrastructure (corporate governance procedures)
  • Governmental infrastructure (regulations to which the companies are subject to)
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6
Q

Discussions at an AGM

A
  • audited financial statements for year
  • company performance
  • any significant actions
  • shareholder questions
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7
Q

Ordinary resolutions

A

require a simple majority of the votes cast

e.g. approval of auditor / election of directors

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8
Q

Special resolutions

A

require a supermajority vote for passage (2/3 or 3/4 majority).

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9
Q

Majority and cumulative voting (when electing board members)

A

Majority voting: candidate with most votes for each single board position is elected
Cumulative voting: number of votes * shares owned (more representative)

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10
Q

Two-tier board structure

A

additional supervisory board that excludes executive directors

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11
Q

Activist shareholders

A

Pushing for changes within companies to increase shareholder value.
e.g. shareholder lawsuits, seeking representation on the board of directors, proposing shareholder resolutions

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12
Q

proxy fight

A

Putting pressure on proxies of shareholders to vote in favour of an alternative proposal

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13
Q

tender offer

A

An activist group may make a tender offer for a specific number of shares of a company to gain enough votes to take over the company.

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14
Q

Factors affecting stakeholder relationships

A
  • Market factors
    e. g. pressure from activist shareholders, threat of hostile takeover.
  • Non-market factors
    e. g. legal environment, communication challenges, third-party ratings
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15
Q

Common-law system

A

judicial rulings may become law

Shareholder and creditor interests are considered to be better protected in a common-law system

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16
Q

Civil-law system

A

judges must rule according to enacted laws

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17
Q

agency relationship

A

The relationship between a company’s shareholders and its senior managers

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18
Q

Capital Allocation Process

A

Used to determine and select profitable (or the most profitable) long-term projects:

  1. Generate ideas
  2. Analyse project proposals
  3. Create the capital budget for the firm
  4. Monitor decisions and conduct a post-audit
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19
Q

Type of capital allocation projects

A
  • replacement projects to maintain the business
  • replacement projects for cost reduction
  • expansion projects
  • new products or markets
  • mandatory projects (safety + environmental)
  • others such as pet projects/R+D
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20
Q

Principals of capital allocation

A

 - Decisions are based on after-tax cash flows, not accounting income.

  • Any sunk costs/financing costs not included (reflected in IRR)
  • Cash flows are based on opportunity costs.
  • The timing of cash flows is important.
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21
Q

Independent and mutually exclusive projects

A

Independent projects can be evaluated solely on their own profitability
Mutually exclusive projects: only one project can be profitable.

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22
Q

In the capital allocation process, a post-audit is used to:

A

improve cash flow forecasts and stimulate management to improve operations and bring results into line with forecasts.

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23
Q

cannibalization

A

the reduction of the sales of a company’s own products as a consequence of its introduction of another similar product.

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24
Q

NPV

A

expected change in value of the firm from taking the project.

for independent projects - accept projects with NPV > 0

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25
Q

IRR

A

The expected return on a project.
It is the breakeven discount rate that equates the PV of the project’s cash flows to the initial outlay (makes the NPV =0)

for independent projects - accept projects with IRR > cost of capital (NPV > 0)

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26
Q

Different reinvestment rate assumptions for IRR and NPV

A
  • IRR assumes CF reinvestment at project’s IRR

- NPV assumes CF reinvestment at cost of capital (more conservative)

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27
Q

Return of invested capital (ROIC)

A

net operating profit after tax / average book value of total capital

if ROIC > WACC, management is increasing value of the firm

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28
Q

Issues with using IRR

A

if a project’s cash floes change signs more than once, there may be several or no IRRs that will make the NPV = 0.

NPV doesn’t have this problem.

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29
Q

Real options

A

Future actions that a firm can take, given that they invest in a project today.

  • Real options have value which need to be included in NPV calculations (always positive values)
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30
Q

Types of real options

A
  • Timing option: delay investment until firm has more information
  • Abandonment option: stop project if PV of doing so > PV of continuing
  • Expansion option: invest in additional projects (similar to call option)
  • Flexibility options:
    > Price-setting: increase product price if demand is high (without increasing production)
    > Production flexibility: inputs (materials, overtime) or variety of product
  • Fundamental option: project payoffs depends on price of an underlying asset
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31
Q

Capital allocation pitfalls

A
  • Failing to incorporate economic responses (e.g. competitors starting similar projects)
  • Using standard templates to evaluate all projects
  • Pet (unnecessary) projects
  • Basing decisions on IRR, EPS or ROE
  • Poor estimates of cash flows (e.g. not considering inflation)
  • Misallocating overhead costs
  • Incorrect discount rate (should use WACC adjusted to level of risk attached to project)
  • Including sunk costs
  • Not considering opportunity costs and externalities
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32
Q

The effects that the acceptance of a project may have on other firm cash flows are best described as:

A

Externalities

Externalities refer to the effects that the acceptance of a project may have on other firm cash flows. Cannibalization is one example of an externality.

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33
Q

Internal sources of financing

A
  • After-tax operating cash flows (NI + depreciation charges - dividends paid)
  • Sell marketable securities
  • Collecting accounts receivables
  • Delaying accounts payable
  • Sell inventory
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34
Q

Capital market sources

A
  • commercial paper
  • debt (public/private)
  • common equity
  • preferred stock
  • leases

Firms decide sources based on availability, cost, risk and flexibility

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35
Q

Liquidity

A

A company’s ability to meet its short-term obligations using its assets that are easily transformed into cash

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36
Q

Primary sources of liquidity (from normal operations)

A
  • Cash, cash equiv., collections and investment income

- Trade credit, bank lines of credit and short-term investment portfolios

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37
Q

Difference between a company’s primary and secondary sources of liquidity

A

Primary sources of liquidity are unlikely to affect normal company operations.
Secondary sources of liquidity lead to a change in a company’s operating/financial position

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38
Q

Secondary sources of liquidity (may significantly impact firm)

A
  • Renegotiation of debt
  • Liquidation of assets
  • Bankruptcy
39
Q

Goals for short-term funding

A
  • sufficient cash for foreseeable needs
  • costs of funding (primary consideration)
  • multiple lenders preferred
  • access to funds to take advantage of business opportunities
40
Q

blanket lien

A

When the bank has claim of all the debtor’s assets in the event of a default

41
Q

Drags on liquidity

A

delays/reduction in cash flows, or increases in borrowing costs e.g. uncollected receivables, bad debt

42
Q

Pulls on liquidity

A

accelerate cash flows e.g. paying vendors sooner, changes in credit terms

43
Q

where is the discount rate derived?

A

= the firm’s WACC

also referred to as the marginal cost of capital (MCC)

44
Q

Weighted average cost of capital?

A

The overall opportunity cost of the firm’s capital is a weighted average of the opportunity costs of capital from debt, preferred equity and common equity.

WACC represents a firm’s cost of capital in which each category of capital is proportionately weighted.

A project should be undertaken only if the return on invested capital is greater than its opportunity cost.

45
Q

how to calculate a company’s cost of preferred stock? Kps

A

preferred dividend / market price of preferred stock

46
Q

how to calculate a company’s cost of common equity? Kce

A
  1. CAPM method (E(R))

2. bond market yield + risk premium (based on judgement)

47
Q

how to calculate a company’s cost of debt? Kd

A
  • market rate of interest (YTM)
  • yield based on comparable bonds (bonds with similar debt rating and maturity of existing debt) (if YTM is unknown)

NB - tax rate is applied for the ‘after-tax’ cost of debt used in the WACC calculation

48
Q

Raw/unadjusted beta estimation for public companies

A

Estimated as a slope of regression of stock returns (dep. variable) on market returns (indep. variable)

49
Q

Why is an adjusted beta calculated?

A

Equity betas tend to move towards 1 over time. the adjusted beta accounts for this

50
Q

Adjusted beta

A

(2/3*unadjusted beta) + 1/3

51
Q

Estimating beta for non-public company

A
  • Calculate beta for comparable company.
  • Unlever it using the comparable company’s D/E ratio and tax rate to calculate the ASSET BETA
  • Relever the asset beta to reflect the D/E ratio and tax rate of the the nonpublic company to calculate the TARGET BETA
  • Adjust the target beta
  • Use the adjusted target beta to calculate the cost of equity for the nonpublic company
52
Q

Asset beta

A

β comparable * ( 1 / ( 1 + ( D/E (1-t) ))

53
Q

Target beta

A

β asset * ( 1 + ( D/E (1-t ))

54
Q

Flotation costs

A

fees charged by investment bankers when a company raises external equity capital (usual range: 2-7%)

These costs are captured by adjusting the initial cash outflow when computing NPV

55
Q

What is the optimal capital structure a company will choose?

A

One that minimises its weighted average cost of capital (WACC)

56
Q

In the context of the capital structure, where are the values for debt and equity derived?

A

market values for D and E are used

as opposed to balance sheet values

57
Q

The proportions of a firm’s capital structure are influenced by:
(5)

A
  • revenue growth/stability
  • cash flow growth/predictability
  • business risk (volatility of EBIT (sales, op. leverage))
  • liquidity of assets
  • cost and availability of debt financing
58
Q

Capital structure of company life cycle (start-up, growth, mature stage):

A

Start-up: equity financing only (high-risk, little collateral to back debt and expensive rates)

Growth: revenue/cash-flows increasing, mostly equity (<20% debt), often collaterized with assets

Mature: risk: less risk, both unsecured and secured debt (debt>20% and may increase). Equity may then increase as company prospers

59
Q

MM I

A

The value of the firm is unaffected by its capital structure (the mix of debt and equity)

60
Q

Assumptions of MM I and MM II (5)

A
  • no taxes, transaction costs, bankruptcy costs
  • homogenous transactions
  • borrowing/lending at risk-free rate
  • no agency costs
  • investment decisions unaffected by financing decisions
61
Q

MM II

A

WACC is unaffected by a firm’s capital structure

  • cost of debt cheaper than equity. As the level of debt increases, the cost of equity increases to offset the increase in debt (as cash flows to debtholders are less risky) and WACC stays constant
62
Q

MM theories WITH TAXES

A

Debt financing creates a tax shield (reduces taxable income as interest is tax deductible (ie not taxed but taken from gross income)) that increases company values
- value is maximised at 100% debt

63
Q

Costs of financial distress:

why companies are not 100% levered

A
  • legal/admin fees from bankruptcy
  • loss of trust / foregone investment opportunities
  • agency costs of debt: managers represent equity owners
64
Q

Static Trade-off Theory

A

A firm’s optimal capital structure: when the value of the tax shield from additional borrowing offsets the increase in the costs of financial distress

65
Q

In practice, why does a firm’s capital structure fluctuate around its target?

A
  • Exploiting market opportunities e.g. issuing more equity following a rise in the stock price
  • Market values of debt and equity fluctuating (as D/E based on market values in this context)
66
Q

In calculating a firm’s WACC, what weightings of debt/equity in the capital structure should be used?

A

That of the target capital structure

67
Q

In the absence of a target capital structure, what weightings of debt/equity in the capital structure should be used to calculate WACC?

A
  • current capital structure
  • the most consistent capital structure historically
  • average capital structure for industry
68
Q

Factors affecting capital structure decisions

A
  • debt ratings (rating ↓ IR ↑)
  • market conditions
  • asymmetric information between managers and shareholders/creditors
  • agency costs of equity (conflicts of interest between owners and managers) -> actions undertaken by managers that don’t maximise shareholder values (net agency of equity
  • pecking order theory
69
Q

Valuation implications of a stock offering

A

stock price overvalued (negative signal)

70
Q

Valuation implications of a debt offering

A

ability to meet fixed payments (positive signal)

71
Q

Net agency costs of equity

essentially mitigating the principal agent problem

A
  • monitoring costs (e.g. better corporate governance)
  • bonding costs (e.g. non-complete agreement)
  • residual losses (can’t eliminate)

financial leverage ↑ agency costs ↓

72
Q

Pecking order theory

A

managers rank financing choices based on information content (to investors):

  • internally generated funds (most favoured)
  • debt
  • new equity (least favoured)

Capital structure determined by financing choices over time

73
Q

Interests of public debtholders and preferred shareholders in capital structure decisions:

A

debt issuance ↓, financial distress ↓

74
Q

Interests of private equity holders and controlling shareholders in capital structure decisions:

A

equity issuance ↓, to avoid dilution of existing holders

75
Q

Interests of customers and suppliers in capital structure decisions:

A

that the firm maintains stability

76
Q

Interests of employees in capital structure decisions:

A

that the firm maintains stability -> job stability ↑

  • some employees may own equity in the business - job more important generally
  • employees with specialised skills prefer less risk than employees with easily transferrable skills
77
Q

Interests of managers and directors in capital structure decisions:

A

level of risk ↑, stock value ↑, compensation ↑

  • they may prefer a lower level of risk if focus is own continued employment
78
Q

Interests of regulators and government in capital structure decisions:

A

maintain minimum proportions of equity financing - restricting ability to issue debt or pay cash dividends.

79
Q

Leverage

A

A firm’s fixed costs (operating leverage + financial leverage)

  • fixed operating expenses (e.g. building/equip. leases)
  • fixed financing costs (e.g. interest payments on debt)
80
Q

Business risk

A

Variability in EBIT - affected by operating leverage

Business risk is the uncertainty regarding the operating income of a company

81
Q

Financial risk

A

Variability in EPS - affected by financial leverage

Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

82
Q

Degree of Operating Leverage (DOL)

A

= %Δ EBIT / %Δ Sales

= (Sales - TVC) / (Sales - TVC - TFC)

when TFC=0, DOL=1 and there is no operating leverage (%Δ EBIT = %Δ Sales)

83
Q

Degree of Financial Leverage (DFL)

A

= %Δ EPS / %Δ EBIT

= EBIT / (EBIT-interest)

when TFC=0, DFL=1 and there is no financial leverage (%Δ EPS = %Δ EBIT)

84
Q

Degree of Total Leverage

A

DOL * DFL

= %Δ EPS / %Δ Sales

= (Sales - TVC) / (Sales - TVC - TFC - Interest)

85
Q

Three rules of leverage

A
  1. High fixed costs = high operating leverage
  2. High debt ratio = high financial leverage
  3. High fixed costs + high debt ratio = high total leverage
86
Q

Breakeven quantity

A

The level of sales at which a firm’s net income is zero.

Q(BE) = TFC / (P -variable cost per unit)

87
Q

Net income calculation (at various sales levels)

A

NI = Q(P-V) - fixed costs - interests

88
Q

Operating breakeven quantity

A

The level of sales that just covers a firm’s fixed operating costs.

Q(OBE) = fixed operating costs / (P-variable cost per unit)

89
Q

Business risk is the combination of:

A

operating risk and sales risk

Business risk is the uncertainty regarding the operating income of a company

90
Q

Uncommitted line of credit

A

A bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change (less reliable)

91
Q

Committed line of credit

A

A bank extends an offer of credit that it “commits to” for some period of time, usually less than a year (more reliable)

92
Q

Revolving line of credit

A

contractual, long-term borrowing (most reliable)

93
Q

factoring

A

sell receivables to a third-party at a discount

CFA Lvl 1 (10 decks)

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