CFA Level 1 Corporate Finance: Our Cheat Sheet

Sophie Macon ∙ 24 Apr 2021

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Although a relatively small topic weight, CFA Level 1 Corporate Finance is one of those
topics that is highly interlinked with FRA and Quantitative Methods, therefore mastering
this relatively light topic should pay dividends (sorry) for your overall exam.

To help you with your revision, we decided to create our Cheat Sheet series of articles,
which focuses on one specific topic area for each CFA Level.

More Cheat Sheets will be published in the coming weeks, sign up to our member’s list
to be notified first.

By referring to the CFA Learning Outcome Statements (LOS), we prioritize and highlight the
absolute key concepts and formula you need to know for each topic. With some tips at the
end too!

Use the Cheat Sheets during your practice sessions to refresh your memory on important
concepts.

Let’s go – don’t forget to bookmark and come back to this often! 🙂

 Contents

CFA Level 1 Corporate Finance: An Overview

Reading 31: Introduction to Corporate Governance and Other ESG Considerations
Reading 32: Capital Budgeting
Reading 33: Cost of Capital
Reading 34: Measures of Leverage
Reading 35: Working Capital Management
CFA Level 1 Corporate Finance Tips

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CFA Level 1 Corporate Finance: An Overview

Corporate Finance is a central topic across all Level 1 and 2 of the CFA exams, and drops
off in Level 3. Its relatively low topic weighting is deceptive, given how integrated
corporate finance concepts are in finance.
In Level 2, Corporate Finance repeats and tests a lot of the same fundamental concepts,
so if you can gain a solid understanding in Level 1, it will save you time and agony when
you are studying for Level 2. Kinda like Ethics where mastering it earlier generates a high
return in investment for future levels.

CFA Level 1 Corporate Finance’s topic weighting is 8%-12%, which means 14-22
questions of the 180 questions of CFA Level 1 exam is centered around this topic.

It is covered in Study Sessions 10-11 , which includes Reading 31-35.

Here’s a summary of Corporate Finance chapter readings:

Reading
Sub-topic Description
Number

Basically discusses how to set companies up with the right policies.

Introduction to

Corporate
This section has a bit of overlap with Ethics, but the questions are usually less
31 Governance and
subjective.​Put your Ethics hat on and think from the perspective of an investor
Other ESG
when you read the LOS statements; and remember, independence is ALWAYS
Considerations
important.

Covers how will a company budget their capital assets and how will they
decide to invest in certain projects.

You must have a solid understanding of net present value (NPV) as this is the
core of Corporate Finance.​

32 Capital Budgeting

As much as this session focuses on calculations, there is also quite a bit of

theory in understanding various methods and the pros/cons of each, given a
certain situation. Does a project make sense economically, and if so, at what
cost? ​

Looks at general principles of revenue and expense recognition, non-recurring

33 Cost of Capital items and EPS in the income statements that you’ll come across in financial
analysis.
 Reading
Sub-topic Description
Number

Leverage is, essentially, the practice of borrowing money to make more money
faster. This increased return obviously comes at an increased risk so it’s
important to know how to measure leverage.​

Measures of

34
Leverage Candidates must understand and calculate the measures of leverage and the
impact debt can have (both positively and negatively) on a company’s bottom-
line. This section has some calculations that also overlap with Financial
Reporting & Analysis so pay close attention.

Again, FRA is intertwined here.

Working Capital Candidates should have a solid understanding of a company’s working capital,
35
Management which is thoroughly covered in FRA readings. Then, this reading looks at
working capital from a strategic standpoint and explores it from a C-level
executive’s viewpoint.

The topic of Corporate Finance is a relatively interesting reading and I find it does provide
some ‘real life’ practicality compared to other study sessions. It teaches a very big picture
overview of the fundamentals a company will use to evaluate their investing and or
financing decisions.

In essence, the CFA Level 1 Corporate Finance topics teaches you:

– practical fundamentals of finance, e.g. net present value (NPV) concept;

– how to decide which investments to make.

– why working capital management is important.

Reading 31: Introduction to Corporate Governance and Other ESG

Considerations
Key areas of corporate governance assessed in investment analysis

Economic ownership and voting control: e.g. dual class structures, power to elect
board members.
Board of directors representation: assess whether the current skillset, expertise
and diversity in board of directors meet the current and future needs of the firm.
Remuneration and company performance: analysts must check if the executive
remuneration are aligned with performance of the company.
Investors in the company: examine the investor structure for cross shareholdings,
affiliated stakeholders and activist shareholders.
Strength of shareholder rights: analysts need to assess the strength of
shareholders’ rights vs other comparable companies
Managing long-term risks: analysts need to form a view of management quality
and their ability to manage long-term risks to the firm.

Reading 32: Capital Budgeting

Basic principles of capital budgeting

Include incremental after-tax cash flows, (positive/negative) externalities and

opportunity costs.
Exclude sunk cost (because already incurred) and financial costs (as already
included in cost of capital) from calculation of operating cash flows.
Timing of cash flows is vital.

Net present value (NPV)

N CFt
NPV = ∑ = – Initia l Outla y
t =1 (1+r)t

For independent projects:

If NPV > 0, accept project;
If NPV < 0, reject project.
For mutually exclusive projects: accept the project with the highest (positive) NPV.

Internal rate of return (IRR)

IRR is the discount rate (r) such that NPV is 0.

 For independent projects:
If IRR > required rate of return, accept project;
If IRR < required rate of return, reject project.
For mutually exclusive projects:
accept the project with the higher IRR, as long as IRR > required rate of return.
use the NPV rule if NPV and IRR rules conflict.

Payback period

Payback period is the number of years required for the cumulative cash flows to equal
initial investment.

However, this metric doesn’t take into account the time value of money, nor considers the
risk of the project.

Discounted payback period (DPB)

Discounted payback period is the number of years required for the cumulative discounted
cash flows to equal initial investment.

However, this metric doesn’t consider any cash flows beyond the payback period is
reached.

Average accounting rate of return (AAR)

Average net income

Average a ccounting ra te o f return =
Average book va lue

The disadvantage of this metric is that it is based on accounting numbers and ignores the
time value of money.

Profitability index (PI)

 PV o f f uture ca sh f lows
Pro f itability index =
Initia l investment
NPV
= 1+
Initia l investment

Invest in project if PI > 1, reject project if PI < 1.

PI > 1 when NPV is positive.

NPV vs IRR methods: Pros and Cons

NPV method IRR method

Pros: It’s a direct

Pros: It shows the return on each $ invested, and allows a direct comparison with the
measure of value
required rate of return.
uplift in the firm.

Cons: It may conflict with NPV analysis, or have multiple IRRs or no IRR for projects
Cons: It doesn’t
with unconventional cash flows. It also incorrectly assumes that intermediate cash
consider project size.
flows are reinvested at IRR rate.

Reading 33: Cost of Capital

Weighted average cost of capital (WACC)

WACC is the cost of each component of capital (debt, preferred stock and common
equity) in the proportion they are used in a company.

WACC = wdrd (1-t) + wprp + were

Cost of preferred stock

Dividend per share o f pre f erred stock

rp =
Current pre f erred stock price per share
Dp
=
Pp

Cost of equity

Capital asset pricing model (CAPM) approach

r e = R F +β i ⎡⎢⎢⎣ E ( R m ) – R F ⎤⎥⎥⎦ → CAPM

= R F +β i ⎡⎢⎢⎣ E ( R m ) – R F +Country risk premium ⎤⎥⎥⎦ → Revised CAPM

Dividend discount model (DDM)

D1
re = +g
P0
where g = susta inable growth ra te
= earnings retention ra tio ×ROE
⎛ D ⎞⎟
= ⎜⎜ 1 – ⎟ ×ROE
⎝ EPS ⎠

Bond yield plus risk premium method

re= rd+ risk premium, where rd is cost of debt

Project beta

Unlevered asset beta for a comparable company

⎡ 1 ⎤
β asset = β equity ⎢
⎛⎜ D ⎞⎟ ⎥
⎢ 1+ ⎜ (1 – t) ⎟ ⎥
⎣ ⎝ E ⎠⎦
Relevered project beta for target company
⎡⎢ ⎤
⎢ ⎛ D ⎞ ⎥⎥
β project = β asset ⎢⎢⎢ 1+ (1 – t) ⎜⎜ ⎟⎟ ⎥⎥⎥
⎢⎣ ⎝ E ⎠ ⎥⎦

Reading 34: Measures of Leverage

Degree of operating leverage (DOL)

% change in opera ting income

DOL =
% change in units sold
Q (P – V)
=
Q (P – V) – F

Degree of financial leverage (DFL)

% change in net income

DFL =
% change in opera ting income
Q (F – V) – F
=
Q (F – V) – F – C

Degree of total leverage (DTL)

 % change in net income
DTL =
% change in units sold
= DOL ×DFL
Q (P – V)
=
Q (P – V) – F – C

Breakeven

Breakeven point is the number of units produced and sold at which net income is zero,
where revenue equals cost.

F+C
QBE = Operating breakeven point is the number of units produced and sold at which
P–V
operating income is zero.

F
QOBE =
P –V

where Q = quantity, P = price, V = variable cost per unit, F = fixed operating cost, C = fixed
financial cost.

Reading 35: Working Capital Management

Liquidity management
 Primary sources of liquidity: sources of cash from day-to-day operations, e.g. cash
balances, short term funding, collections/payments management.
Secondary sources of liquidity: sources of cash that may negatively impact the
company’s financial position, e.g. negotiating debt agreements, filing for
bankruptcy, liquidating assets.
Drags on liquidity means delayed/reduced cash inflows, e.g. bad debt,
late/uncollected receivable payments.
Pulls on liquidity means accelerated cash outflows, e.g. earlier debt repayment.

Measures of liquidity (in addition to the ones in FRA)

Operating cycle

Operating cycle = Number of days of inventory + Number of days of receivables

Net operating cycle

Net operating cycle = Number of days of inventory + Number of days of receivables –

Number of days payables

Yield on short-term investments (covered in Quant Methods)

Discount basis yield

F–P 360
Discount ba sis yield = × where F = face value, P = purchase price, T = number of days
F T
to maturity.

Money market yield

F–P 360
Money market yield = ×
P T
360
= Holding period yield ×
T

Bond equivalent yield

 F–P 365
Bond equiva lent yield = ×
P T
365
= Holding period yield ×
T

Cost of trade credit (CTC)

Trade discounts (for example, “3/10 net 30” means that 3% discount is available if paid
within 10 days, else the balance must be paid within 30 days).

The cost of trade credit (CTC) is the annualized cost of not taking the early repayment
trade discount.

365
⎛ % discount ⎞⎟ # d ays post discount period
Cost o f trade credit = ⎜⎜ 1+ ⎟ –1
⎝ 1 – % discount ⎠

CFA Level 1 Corporate Finance Tips

Practice using your calculator

In comparison to some of the more difficult study sessions such as Derivatives,
or subjective sessions like Ethics – Corporate Finance should be a relatively
easy section to pick-up some points and time on exam day.
There are not a lot of ways a calculation question can be modified for this
section, so if you have a solid understanding of the fundamentals – you should
be set.
 Practice using your calculator and get familiar with how to solve for various NPV
questions as that is guaranteed to show up and be tested.
Check out our BA II Plus guide or HP 12C calculator guide for relatively unknown
tips and techniques when using your CFA calculator.

Lots of formulae, but don’t just memorize

Although this section at first glance may appear to be heavily formula based, do
not skim over the basic theoretical concepts that the LOS mentions.
These can often be where the CFA Institute tries to deliver a trickier question
versus a typical punch and crunch calculation.
A helpful tip that I find is to go through the LOS one by one and hand-write all the
formulas that are described as “calculate” or “evaluate” as this will give you an
overview of things you can quickly start to memorize, without getting lost in all
the detail.

More Cheat Sheet articles will be published over the coming weeks. Get ahead of other
CFA candidates by signing up to our member’s list to get notified.

Meanwhile, here are other related articles that may be of interest: 3H

CFA Level 1 Cheat Sheets series: Quant Methods | Economics | FRA | Derivatives |

Fixed Income | Equity Investments | Ethics | Alt Investments | Portfolio
Management
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