2022 LI CorpIssuers

Last Revised: 06/08/2021
MarkMeldrum.com
Level I - Corporate Issuers

Readings Page
Introduction to Corporate Governance and Other ESG Considerations 2
Uses of Capital 18
Sources of Capital 27
Cost of Capital - Foundational Topics 37
Capital Structure 46
Measures of Leverage 61
Reviews 70
This document should be used in conjunction with the corresponding readings in the 2022 Level I CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.
Required disclaimer: CFA Institute does not endorse, promote, or warrant accuracy or quality of the products or services
offered by MarkMeldrum.com. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA
Institute.
© markmeldrum.com. All rights reserved.

Introduction to Corporate Governance and Other ESG Considerations
a. describe corporate governance;
b. describe a company’s stakeholder groups and compare interests of

stakeholder groups;
c. describe principal–agent and other relationships in corporate governance and

the conflicts that may arise in these relationships;
d. describe stakeholder management;
e. describe mechanisms to manage stakeholder relationships and mitigate

associated risks;
f. describe functions and responsibilities of a company’s board of directors and

its committees;
g. describe market and non-market factors that can affect stakeholder

relationships and corporate governance;
h. identify potential risks of poor corporate governance and stakeholder

management and identify benefits from effective corporate governance and
stakeholder management;
i. describe factors relevant to the analysis of corporate governance and

stakeholder management;
j. describe environmental and social considerations in investment analysis;
k. describe how environmental, social, and governance factors may be used in

investment analysis.
Corporate Governance
Page 1
E – environmental
LOS a
S – social - describe
G – governance – the system of internal controls and
procedures by which individual companies are managed
(defines the rights/responsibilities of various groups)
- the arrangement of checks, balances, and incentives a

company needs in order to minimize and manage the
conflicting interests between insiders & external shareowners
Shareholder Theory – the most important responsibility of

mgmt. is to maximize shareholder returns
Stakeholder Theory – broadens focus to also include customers,

suppliers, employees & society
Company Stakeholders
Page 2
Shareholders/ interests focused on growth in
LOS b
profits that maximize value of a company’s equity - describe
vote for BOD
exercise control
vote for specific resolutions
Controlling shareholders – hold a %’age of shares that gives
them sufficient voting power to control the
election of the BOD
· non-controlling shareholders minority shareholders
Creditors/ bondholders & banks (typically)

- exercise control through covenants
Managers & Employees/ senior exec. motivated to maximize

value of their equity-based remuneration
Page 3
Managers & Employees/ lower level employees
LOS b
desire decent wages + job security - describe
- interests of – managers & employees may conflict

- managers & shareholders may conflict
Board of Directors/ elected to protect shareholder interests,

provide strategic direction, monitor company &
mgmt. performance
one-tier – single BOD of executive & non-executive directors
two-tier – 2 separate boards supervisory board

oversees - non-executive directors
management board
- executive directors
Page 4
Customers/ product satisfaction for value paid LOS b
- some may have an interest in the long-term - describe
viability of the company
Suppliers/ primary interest get paid in a timely manner
Governments/Regulators – seek to protect interests of the

general public and ensure the well-being of
the overall economy
Principal-Agent Relationships
Page 5
- created when a principal hires an agent
LOS c
to perform a specific task - describe
- agent is expected to act in the best interests of
the principal
· Shareholder vs. Manager/Director

(principal) (agent)
may seek to maximize personal
benefits to the detriment of shareholders
· risk tolerance – mgmt. may be more risk averse
- protect their positions
· information asymmetry – difficult for shareholders to judge
soundness of strategic decisions
· board composition – too many insiders (executive directors)
Page 6
· Controlling & Minority Shareholders/
LOS c
opinions outweighed by the influence - describe
of the controlling shareholder
- related-party transactions – controlling shareholder has

an interest in a transaction between the
company & a third party supplier (to the detriment
of minority shareholders)
- dual class shares – voting vs. non-voting

typically mgmt.
· Manager & BOD/ · relies on information
· oversight can be compromised if mgmt.
limits information (esp. non-executive directors)
Page 7
· Shareholder vs. Creditor/ - prefer stable LOS c
prefer riskier projects performance & - describe
with higher return lower risk activities

potential · leverage levels low & manageable
· lower levels of shareholder payout
· Other Stakeholder Conflicts/

· Customers vs. shareholders · cutting costs & quality/service
· Customers vs. Suppliers – lenient credit terms to

customers vs. timely payments to suppliers
· Shareholders vs. governments/regulators

- costly regulation
- tax minimization strategies
Shareholder Management
Page 8
LOS d
· effective communication
· identify - describe
· prioritize · active engagement
· understand attempt to balance various interests
· legal infrastructure – rights established

interests of
by law
stakeholder groups
· contractual infrastructure – define &
secure rights through contracts
· organizational infrastructure – internal

systems, governance procedures
· governmental infrastructure
- regulations imposed
Mechanisms of Stakeholder Mgmt.

Page 9
General Meetings/ companies must hold an LOS e
AGM within a specified period of time - describe
after year-end
- vote for directors, special resolutions
- provide performance overview, answer questions
- extraordinary GMs may also be called – M&A, sale of assets
- may require supermajority vote ( - 75%)
· Proxy voting – allows another to vote on your behalf

· cumulative voting – 100 shares, 4 directors 400 votes
Board of Directors/ elected by shareholders to provide broad

oversight of the company (accountable to shareholders)
- BOD appoints top mgmt. of company
Page 10
The Audit Function/ LOS e
· internal audits - describe
· external audits – annual audit of financial records
- provide reasonable & independent
assurance of accuracy & fair representation
Reporting & Transparency/ regulatory disclosures & investor relations

- reduces information asymmetry
- assess performance of directors & mgrs.
- aid in valuation
Policies on Related-Party Transactions/

- procedures for mitigating, managing, and disclosing
such cases
- directors/mgrs. must disclose any material interest
in a transaction
Page 11
Remuneration Policies/ LOS e
- attempt to align mgmt. interests - describe
with shareholder interest (profit sharing, stock options)
- to avoid ‘short-termism’ – use shares instead of options
with longer-term vesting periods
Say on Pay – Shareholders vote on executive pay

- may be a) non-mandatory, non-binding e.g. Canada
b) mandatory, non-binding e.g. U.S., France
c) mandatory, binding e.g. U.K., Netherlands
Contractual Agreements with Creditors/

- indenture – legal contract with bondholders
- covenants – specific terms & conditions
- collateral – specific assets backing the debt
Page 12
Employee Laws & Contracts/ LOS e
- labour laws, unions, employment contracts, - describe
HR policies, ESOPs, Code of Ethics, Standards of
Conduct
Contractual Agreements with customers & suppliers/
Laws & Regulations

- consumers, environment
· Publicly traded companies are generally required to

annually publish corporate governance reports describing
their governance structure and explain any deviation
BOD & Committees

Page 13
Composition of the Board/
LOS f
- a diverse mix of expertise, backgrounds - describe
& competencies (e.g. specialized knowledge, functions)
- some even seek age/gender/cultural diversity
executive – members of senior mgmt.

one tier
non-executive - external
· independent no material relationship with
the company (employment, ownership, remuneration)
supervisory
two tier independent of each other
mgmt.
CEO & Chair position increasingly separated

- if not, use of a lead independent director
Page 14
Staggered Boards/ directors are divided into LOS f
classes that are elected separately in consecutive years - describe
- provides continuity but also entrenchment
Functions/Responsibilities/
duty of care – board members must act on a fully
informed basis, in good faith, with due
diligence and care
duty of loyalty – must act in the interest of the
company & shareholders
- guides/approves strategic direction of company

- appoints CEO – delegates strategic implementation to top mgmt.
- establishes performance criteria
- monitors & reviews performance
Page 15
Functions/Responsibilities/
LOS f
- ensures effectiveness of company’s - describe
audit & control systems
- ensures proper ERM system in place
- reviews all major acquisitions, mergers, divestitures
before they are referred to shareholders
Committees/
a) Audit Committee – oversees the audit & control systems
- monitors financial reporting process
- supervises internal audit function
- recommends external auditor
b) Governance Committee – ensures that the company

adopts good corporate governance procedures
(plus charters of the board & committees, company’s
code of ethics, conflict of interest policy)
Page 16
Committees/ LOS f
- describe
c) Remuneration/Compensation Committee
- develops and proposes remuneration for the
Board & key executives
- may also set performance criteria and evaluate
the performance of managers
d) Nominations Committee – identifies candidates who are

qualified to serve as directors
- recommends their nomination by shareholders
e) Risk Committee – helps determine the risk policy,

profile & appetite of the company
- oversees establishment & implementation of ERM
system
Page 17
Committees/
LOS f
f) Investment Committee - describe
- reviews material investment opportunities

proposed by mgmt. (large projects, acquisitions, expansion)
- establishes the investment policy of the company
· type of committee used may vary by jurisdiction

· composition depends on the scope of the committee
e.g. audit & compensation independent directors
only
or/ external directors of which
a majority should be independent
Factors Affecting Relationships

Page 18
Market Factors/ (capital market related)
LOS g
1) Shareholder engagement – being broadened - describe
beyond the AGM

- builds support for mgmt.’s position
2) Shareholder activism – attempts to compel mgmt. to

act in a desired manner
(proxy battles, shareholder resolutions, raising awareness)
- shareholder derivative lawsuits deemed to be acting
on behalf of the company since the BOD
& mgmt. have failed to do so
3) Competition & Takeovers

- proxy contest – shareholders are persuaded to
vote for a group seeking a controlling position on the BOD
Page 19
Market Factors/
LOS g
3) Competition & Takeovers - describe
· tender offer – shareholders sell their shares
directly to the group seeking control
· hostile takeover – acquire a company without
the consent of mgmt.
Non-market Factors/
1. Legal Environment – common law vs. civil law
superior protection of the

interests of shareholders and
creditors
- creditors generally have an easier time with

legal recourse than do shareholders
Page 20
Non-market Factors/
LOS g
2. The Media – ability to spread info - describe
quickly and shape public opinion
- can spur politicians to introduce regulation or

enforce laws that protect shareholders
- social media – allows information sharing at little to
no cost
3. The Corporate Governance Industry

- external corporate governance services
(governance ratings, proxy advice)
Risks & Benefits

Page 21
risks of poor governance & stakeholder mgmt.
LOS h
1. weak control systems - identify
(poor audit procedures, insufficient scrutiny by the board)
- one stakeholder group may benefit at the expense of
another
2. ineffective decision making
- when mgmt. has information not available to the board
- when remuneration policies encourage mgmt. self-interest
vs. shareholder interest
3. legal, regulatory or reputational risks

- violations of applicable laws
- lawsuits by shareholders, employees, creditors
4. default & bankruptcy risk
Page 22
benefits of effective governance & stakeholder mgmt. LOS h
1. Operational efficiency - identify
- clear delegation of responsibility & reporting

lines across the company
- decisions & activities are properly monitored & controlled
2. improved control
- identify and manage risks at early stages
3. better operating & financial performance

- reduces costs associated with weak control systems
4. lower default risk and cost of debt

- help protect creditors rights lower risk
- governance systems a relevant criteria among
credit rating agencies
Analyst Considerations
Page 23
Economic Ownership & Voting Control/ LOS i
- dual-class structures (voting power decoupled - describe
one will have superior from ownership)

voting rights
- typically held by insiders or family members
or/ one class of shares elects a majority of the board
- outside shareholders elect a minority
- tend to trade at discount to peers
Board of Director Representation/

- independence, expertise, experience, tenure, diversity
match the current and future

needs of the company
Page 24
Remuneration & Company Performance/ LOS i
- executive remuneration generally consists of: - describe
1. base salary
2. short-term bonus (cash-based)
3. multiyear incentive plan
(options, time-vested shares and/or
performance-vested shares)
· warning signs
1. plans offering little alignment with shareholders
2. plans exhibiting little variation over multiple years
3. plans with excessive payouts relative to comparable

companies with comparable performance
4. plans based on incentives from an earlier period in the

company’s life
Page 25
Investors in the Company/
LOS i
can shield - cross-shareholdings - describe
a company - sizeable affiliated shareholder (family trust,
from the endowment, individual)
effects of voting by
outside shareholders
- activist shareholders – catalyst for new strategic

directions or short-term arbitrageur?
Strength of Shareholder Rights/
+ look for a history of fines, accidents, regulatory penalties, etc…
ESG Considerations
Page 26
- Exhibit #1 list of some ESG considerations
LOS j, k
ESG Investment Strategies/ - describe
Responsible investing - the practice of considering ESG

approaches in the investment process
- includes: ESG integration - inclusion of material ESG factors

in investment analysis/portfolio construction
Socially Responsible Investing (SRI) - either excluding

undesirable activities (weapons, tobacco) or
including desirable activities
Thematic Investing - investment in themes or assets

specifically related to ESG factors (based on
needs arising from economic or social trends)
e.g. solar, EV.
Page 27
- includes: Impact investing - investments made LOS j, k
with the intention to generate positive, - describe
measurable social & environmental impact alongside
a financial return (e.g. green bonds)
ESG Investment approaches/

value based mitigate material ESG risks
values-based express moral or faith-based investment
objectives
Negative screening - excluding certain sectors or companies
based on ESG criteria (e.g. ex-fossil-fuel)
Positive screening - inclusion of certain sectors or companies

based on specific ESG considerations (e.g. safety)
ESG integration - seek investments in companies that are

properly managing ESG risks/opportunities
Page 28
ESG Investment approaches/ LOS j, k
Thematic investing - themes or assets specifically - describe
related to ESG factors (e.g. clean energy)
Engagement/active ownership - use of shareholder or

bondholder power to influence corporate behavior
through direct corporate engagement
- seeks targeted ESG objectives + financial returns
Impact investing - promote ESG cause + financial return
Catalysts for growth in ESG investing/
1/ ESG issues are having more material financial impacts

on a company’s fair value (micro level)
2/ a greater number of younger investors are increasingly

demanding ESG considerations/ESG material risks (macro level)
Page 29
Catalysts for growth in ESG investing/ LOS j, k
- describe
3/ adoption of more sophisticated views about
sustainable growth and its effect on investment performance
- concept of being ‘universal owners’ - large asset owners

with long investment horizons whose performance
is linked to economic growth and are unavoidably
exposed to negative externalities
ESG factors in investment analysis/
See exhibit 1
Uses of Capital
a. describe the capital allocation process and basic principles of capital

allocation;
b. demonstrate the use of net present value (NPV) and internal rate of return
(IRR) in allocating capital and describe the advantages and disadvantages of
each method;
c. describe expected relations among a company’s investments, company

value, and share price;
d. describe types of real options relevant to capital investments;
e. describe common capital allocation pitfalls

Uses of Capital
LOS a (4p) Capital Allocation Process - describe
LOS b (3.5p) Investment Decision Criteria - describe/demonstrate
LOS c (2p) Usage of Capital Allocation Methods - describe
LOS d (2.5p) Real Options - describe
LOS e (2p) Capital Allocation Pitfalls - describe
Page 1
Capital investments: life > 1 year LOS a
make up long-term asset portion of - describe
balance sheet
Capital allocation process:
Step 1: Idea generation - internal or external opportunity identification

Step 2: Investment analysis - forecast investment’s future
cash flows (timing, duration, volatility, probability)
Step 3: Capital allocation planning - selection of projects that best
fit the company’s strategy given financial and
real resource constraints (the most value enhancing
for the firm’s strategy)
Step 4: Monitoring and post-audit - compare actual results versus
planned
Page 2
Types of Capital Projects/ LOS a
1/ Replacement projects - replace existing assets - describe
- maintains capacity
2/ Expansion projects - increase capacity/size

- greater uncertainty than replacement projects
3/ New Products/services
4/ Regulatory/Safety/Environmental - required by gov’t. or insurance

- may not generate revenues and may be just a cost
- company may be better off exiting a market
5/ Other - mgmt. pet projects, high-risk investments

(AMZN) (TSLA - Bitcoin)
Capital Allocation Assumptions/

1/ Decisions are based on CFs
2/ CFs are not accounting operating or net income
Page 3
Capital Allocation Assumptions/
LOS a
3/ CFs are based on opportunity costs - CFs with - describe
the investment vs. without
4/ CFs are analyzed on an after-tax basis
5/ Timing of CFs are crucial
6/ Financing costs are ignored - they are reflected in the
required rate of return
(opportunity cost of funds, cost of capital)
Definitions/
Sunk costs - already incurred, ignored for capital allocation decisions
- only current and future CFs matter
Opportunity costs - what a resource is worth in its next best use
Incremental cash flow - CF with a decision less CF without the

decision
Page 4
Definitions/ LOS a
Externality - the effect of an investment on things other - describe
than the investment

positive externality - synergies with existing business activities
negative externality - cannibalization - take sales away from
another part of the business
Conventional cash flows - initial cash outflow followed by inflows

$ $ $ $ $ $ $ $ (1 sign change)
or
-$ -$ -$ -$
Non-conventional cash flows - outflows followed by both inflows and

outflows (2 or more sign changes) $ $ $
-$ -$
Project Interactions/
Independent projects - CFs are independent of each other (A and B)
mutually exclusive projects - A or B, but not both (A ∧ B) = 0
Page 5
Project Interactions/ LOS a
Project sequencing - investing in a project creates - describe
the option to invest in future projects
A go B go
no go no go end
Unlimited funds - company can raise all the funds it needs
vs. as long as E(R) > cost of capital
Capital rationing - company has a fixed amount to invest
only and may not be able to pursue all opportunities
Net Present Value LOS b

after-tax cash flow - demonstrate
- describe
=
( + ) - outlay initial outlay
cost of capital
= more generally (when outflows are

( + )
not just at = 0)
Page 6
Net Present Value LOS b
decision criteria if NPV ≥ 0 invest - demonstrate
NPV < 0 do not invest - describe
e.g./ capital project at 50M
= + + + + −
After-tax CF = 16M for 4 yrs. . ( . ) ( . ) ( . ) ( . )
20M in yr. 5 = .
Cost of capital = 10% (N = 5, = 10, PMT = 16, FV = 4, CPT PV) - 50
- company’s wealth increases by 13.136M, ∴ invest
Internal Rate of Return (IRR)
= solve for r (= IRR) n= 5

( + )
PMT = 16
more FV = 4
generally: = solve for r (IRR) PV = -50
( + )
CPT (19.52)
Page 7
Internal Rate of Return (IRR) LOS b
decision criteria if IRR ≥ r invest - demonstrate
IRR < r do not invest - describe
NPV = 0 when IRR = r hurdle rate
- NPV and IRR will usually result in the same decision
since NPV represents the increase in a company’s wealth, for
mutually exclusive projects, select based on max. NPV.
∴ if NPV and IRR rank mutually exclusive projects differently, select

based on highest NPV
mathematically, when you discount a cash flow at a

particular rate, you are implicitly assuming you can reinvest at
that rate
NPV assumes reinvestment at r
IRR assumes reinvestment at IRR - may not be
realistic
Page 8
Internal Rate of Return (IRR) LOS b
IRR issue non-conventional CFs may produce - demonstrate
- describe
multiple IRRs
e.g.: =0 CF = -1000 IRR = 100% and 200%
=1 CF = 5000 - as many
=2 CF = -6000 IRRs as
0
IRR1 IRR2 there are
− + − 300% sign
changes
(-1000 + 2500 - 1500 = 0)
100% 200% 300%

or/ − + −
(-1000 + 1666.67 - 666.67 = 0)
- companies generally select projects based on NPV but report IRR as well
Page 9
ROIC measures the profitability of a company
LOS c
relative to the amount of capital invested - describe
(both debt and equity)
. (debt, preferred, equity)
ROIC vs. CoC (cost of capital)
> increasing firm’s value for shareholders
< destroying value
∴ new projects with NPV > 0 should add to a company’s value

through higher share price (Ex. #1)
Inflation/ - affects forecasts of revenues and expenses differently
- after-tax cash flows could be better or worse as a

result of increased inflation
Page 10
Inflation/ LOS c
=
( + ) - describe
includes expected inflation
if actual inflation > expected, with no change to CFs, real CFs decrease
- if nominal CFs are forecasted, should be discounted at a nominal rate

(real) (real)
Real Options/ a right to take a particular business decision LOS d

- describe
- allow a decision maker to choose the most attractive
alternative after new information has been learned (instead
of making all capital allocation decisions now)
- options tend to be investment specific
1/ Timing options - invest now or delay

or/ - investments are sequenced over time investing in
a project creates the option to make further investment
Page 11
Real Options/ LOS d
1/ Timing options - describe
e.g./ Project A > expectations then invest in Project B else just keep
Project A
2/ Sizing options go/no-go decisions
growth abandonment (if early financial results

(if early financial results are strong) are disappointing)
e.g./ If Project A < expectations then abandon, else grow
3/ Flexibility Options
price setting option - if demand > expectation, raise

price rather than increase output
production-flexibility option - if demand > expectation, use

overtime or add shifts
supply issues change inputs
product issues change outputs
Page 12
Real Options/ LOS d
4/ Fundamental options - whole investment is an option - describe
e.g./ gold mine is a call option on the
price of gold
Analyzing investment projects with real options/
1/ use DCF without considering options

- if NPV > 0, invest since the option only adds value
2/ NPV without options - cost of options + value of options
3/ use decision trees requires a valuation

model
4/ use option pricing models binomial
Ex. #3
BSM
Page 13
- option example:
LOS d
50% 80k 80k 80k 80k
Inv. TV = 0 - describe
40k 40k 40k 40k r = 10%

200k
TV = 0
50%
option to abandon, TV = 150k
. ( )+. ( )
no abandonment NPV = − + =− ,
( . )
option to abandon NPV = − + = ,

( . )
NPV = − + + =− ,
( . ) ( . )
NPV = .5(53,589) + .5(-27,273) = 13,158

Page 14
Common Pitfalls/ LOS e
- describe
not incorporating economic responses into the
investment analysis e.g. competitor response
formulaic approach to budgeting for projects/investments
management pet projects
basing decisions on net income, EPS or ROE - tends to bias

project selection to short-term, fast payback investments
basing decisions on IRR - only useful for independent projects

with conventional cash flows
incorrectly accounting for cash flows - omit, double-count, mishandle

taxes
ignoring overhead costs - mgmt. time, HR, IT support, etc…
Page 15
Common Pitfalls/ LOS e
- describe
not using the correct risk-adjusted required rate
- r should be based on risk, not cost of capital
- if project risk = company risk, r = wacc
over/under spending the capital budget - spending all the

budget when projects don’t support it
failure to consider investment alternatives - lack of creative

thinking about possibilities for projects or states
of the world
not handling sunk costs and opportunity costs correctly
ignore include
Sources of Capital
a. describe types of financing methods and considerations in their selection;
b. describe primary and secondary sources of liquidity and factors that

influence a company’s liquidity position;
c. compare a company’s liquidity position with that of peer companies;
d. evaluate choices of short-term funding.

Sources of Capital
LOS a (10.5p) Corporate Financing Options - describe
LOS b (4.5p) Managing Liquidity - describe
LOS c (3.5p) Measuring Liquidity - compare
LOS d (3p) Evaluating short-term

financing choices - evaluate
Page 1
Short-term funds without explicit interest rates LOS a
are part of working capital (e.g. Accts. Payable) - describe
Debt and equity are considered part of the firm’s capital structure
Internal/
1/ Operating cash flows - after tax less interest and dividends paid
2/ Accounts payable (trade credit) - sometimes with discounts (2/10,n30)
- extending payables is a source of internal financing as well
Page 2
Internal/ LOS a
3/ Accounts Receivable - amounts owed by customers - describe
- collecting AR faster reduces the need for
other sources of financing
4/ Inventory - holding inventory costs money
- inventory management optimizes inventory to balance
holding costs with lost sales
5/ Marketable Securities - hold extra cash here so as to get
a yield very liquid assets
External/
A) Financial Intermediaries (bank or non-bank lenders)
i) uncommitted lines of credit
- offered by a bank but can be revoked at any time
- least reliable form of financing
- cannot be shown as a financial reserve in a
footnote (since bank will not ‘officially’ acknowledge
these)
- do not require any compensation (interest only)
Page 3
External/ LOS a
A) Financial Intermediaries - describe
ii) committed (regular) lines of credit:
- formal commitment by the bank, supported by
acknowledgment letter to auditor
∴ can be part of a company’s financial reserves
- in effect for 364 days
∴ short-term liability (note payable)
- unsecured, pre-payable without penalty
- involves a commitment fee plus interest accrued
~ .5% money market rate + spread
(depends on creditworthiness)
iii) Revolving credit agreements (revolvers)

- most reliable form of short-term bank borrowing
- basically same as committed LOC but in effect for
multiple years (3-5)
Page 4
External/ LOS a
A) Financial Intermediaries - describe
iii) Revolving credit agreements (revolvers) - used for much larger
amounts than a regular line
iv) secured (asset-based) loans - collateralized loan

- fixed assets or high quality receivables or inventory
assignment of AR
v) Factoring - selling AR to a lender, typically at a discount
assignment company collects AR

factoring lender collects AR
vi) web-based lenders and non-bank lenders

typically small amounts only make loans
to small business
Page 5
External/ LOS a
B) Capital Markets - describe
i) Commercial Paper - short-term, (typically) unsecured
security issued by large and well-rated companies
- can be sold directly to investors or through dealers
- maturity: few days up to 270 days

- issuer often required to have backup lines of credit
ii) Debt vs. Equity (longer-term financing)

Page 6
External/ LOS a
B) Capital Markets - describe
ii) Debt vs. Equity (longer-term financing)
Long-term debt: > 1 yr. (Notes 1-10 yrs., bonds > 10)
- contract governed by trust deed
- can be public or private
Common equity - considered more permanent source of capital

- can be public or private
Preferred equity (hybrid characteristics)

- may be perpetual or term-specific
- dividend may be fixed or floating (or rate-reset)
- may be discretionary or non-discretionary (cumulative if
- may be participating skipped)
Other Hybrid securities - convertible debt & convertible preferred

shares
Page 7
External/ LOS a
C) Other Financing - describe
Leasing FRA, Long-Term Liabilities
Considerations affecting choice of external financing/

1/ Company size:
small large
- internal CFs usually not - internal CFs

sufficient - commercial paper
- must rely on external financing - public markets
- typically equity (private)
2/ Riskiness of assets:
- high volatility of operating CFs rely on equity financing
use little debt
- high degree of business risk low levels of leverage
Page 8
Considerations affecting choice of external financing/ LOS a
3/ Assets for collateral: - describe
real property and equipment lower cost and higher availability
of debt
- unique assets, highly specialized (one use) assets,
and intangible assets less favourable
4/ Public versus private equity smaller companies

higher cost of equity
larger companies
- lowers cost of equity (liquidity lowers required return)
5/ Asset Liability Management - businesses tend to match the maturity

structures of their assets and liabilities
- finance long-term assets with long-term capital

short-term assets with short-term obligations
Page 9
6/ Debt Maturity Structure: if s.t. rates < L.T rates, - describe
less expensive to use s.t. debt and continually refinance
by rolling over the debt
- introduces rollover risk (when rates ↑ or economy ↓)
7/ Currency risks - business revenues and financing (debt) should

be in the same currency
8/ Agency costs - mgmt. decisions that affect bondholder (debt holder)

risk (asset substitution, shareholder distributions, increased
leverage)
- higher agency costs more likely to rely on equity
9/ Bankruptcy costs - costs consumed by 3rd parties (less

for capital providers)
- riskier capital structures raise the cost of capital
Page 10
10/ floatation costs - incurred with new debt or - describe
equity issuance, lower for debt
- can affect the decision of what to issue
general economic considerations:

11/ Taxation - cost of debt < cost of equity
- since interest is an expense, after-tax cost of debt
is even lower
- higher tax rates encourage more use of debt
12/ Inflation - debt does not inflate

- if inflation is expected to be higher, company prefers
to borrow at a fixed rate
(nominal = real + inflation expectation)
13/ Government policy - subsidies, loan guarantees
Page 11
- describe
general economic considerations:
14/ Monetary policy lower rates increase leverage levels
example 1. Need 30M Sources

10M current assets operating CF = 10M + 5M - 4M = 11M
20M long-term assets s.t. financing: AP = 3M
AR loan = 3M
Note = 4M
AP + AR loan + Notes = 10M finances current assets

(s.t. financing) (short-term assets)
Op. CF + new bonds = 11M + 9M finance non-current assets

(L.T. capital sources) (long-term assets)
may typically be raised to meet a target

capital structure
Page 12
Liquidity: the extent to which a company is able to LOS b
meet its short-term obligations using cash flows - describe
and those assets that can be readily transformed to cash
- liquidity of an asset depend on:

type of asset (financial/non-financial)
speed at which the asset can be converted to cash
(sale or financing)
Liquidity Management: the ability to generate cash when and where

it is needed
- the mgmt. of cash balances, borrowing capacity,
and working capital mgmt. (monetize assets, extend liabilities)
in order to keep the business solvent
a) Primary sources of liquidity/
free cash flow = after-tax op. CF - CAPEX

larger for growth companies
Page 13
a) Primary sources of liquidity/ LOS b
- describe
ready cash balances (cash/equivalents)
short-term funds - trade credit, LOCs, s.t. investment portfolio
cash flow management - collections and payments
b) Secondary sources of liquidity/ - use may result in a change in

a company’s financial and operating positions
negotiating debt contracts, relieving pressure from high

interest payments or principal repayments, negotiating
contracts with customers and suppliers
liquidating assets
filing for bankruptcy protection and reorganization

Page 14
Drags on liquidity when receipts lag, creating pressure LOS b
from decreased available funds - describe
uncollected receivables (days outstanding)

obsolete inventory (slow turnover ratios)
tight credit
Pulls on liquidity when disbursements are paid too quickly or trade

credit availability is limited
making payments early

reduced credit limits
limits on short-term LOCs (credit line restrictions)
low liquidity positions (industry or company related)
Page 15
Measuring Liquidity LOS c
- compare
Liquidity ratios Current ratio = CA/CL
- ability to meet ( + . . . .+ )
Quick ratio =
s.t. obligations ( + . . . .)
Cash ratio =
Activity ratios AR Turnover = .

Inv. Turnover = . .
.
1 # days of AR =
. .
2 # days inventory =
.
3 # days payable =
cash conversion cycle (CCC) = 1 + 2 - 3

- ratios should be compared over time for the same company (trend analysis)
and over time versus peers (cross-sectional analysis) (Ex. #4)
Page 16
- major objectives of a short-term borrowing strategy: LOS d
- evaluate
1/ ensure sufficient capacity exists to handle peak
cash needs (e.g. 4th q for retail)
2/ maintain sufficient sources of credit
3/ ensure rates are cost effective
- factors influencing short-term borrowing strategies:

1/ size and creditworthiness - larger size, better credit risk
= lower cost
2/ legal and regulatory considerations - some industries are regulated
e.g. bank restrictions on capital adequacy
3/ sufficient access - diversification of short-term funding sources

- reduce (minimize) reliance on one lender
Page 17
- factors influencing short-term borrowing strategies: LOS d
- evaluate
flexibility of borrowing options - ability to manage
maturities to avoid ‘balloon’ days
- borrowing strategies can be active or passive

one source or type of borrowing
more flexible and reflect with little planning
planning, reliable forecasting, and - often reactive
comparison pricing - involve steady rollovers of
- more proactive, do not fall borrowings
into ‘rollover’ strategies - usually when borrowers have
- matching strategy - timing cash in-flows limited options
with out-flows
Ex. #5/6
Cost of Capital - Foundational Topics
a. calculate and interpret the weighted average cost of capital (WACC) of a

company;
b. describe how taxes affect the cost of capital from different capital sources;
c. calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach;
d. calculate and interpret the cost of noncallable, nonconvertible preferred

stocks;
e. calculate and interpret the cost of equity capital using the capital asset pricing
model approach and the bond-yield-plus risk-premium approach;
f. explain and demonstrate beta estimation for public companies, thinly traded
public companies, and nonpublic companies;
g. explain and demonstrate the correct treatment of flotation costs.

LOS a (2p) Cost of Capital - calculate/interpret
LOS b (1p) Taxes and Cost of Capital - describe
LOS c (3p) Cost of Debt - calculate/interpret
LOS d (1.5p) Cost of Preferred Stock - calculate/interpret
LOS e (4.5p) Cost of Common Equity - calculate/interpret
LOS f (4.5p) Estimating Beta - explain/demonstrate
LOS g (3p) Floatation Costs - explain/demonstrate
Page 1
Debt LOS a
Capital Preferred components of - calculate
Equity
Common capital - interpret
each component has its
own cost
- new investments (i.e. capital projects) will require new capital

- the cost of that capital is the cost of raising additional capital
of the same type the ‘marginal’ cost of capital
cost
cost of capital (CoC) = required rate of

mcc return
mcc gaps up
Company CoC required return for the
low high ‘average’ risk investment/project
for a company
Page 2
- companies use a variety of financing for each investment LOS a
- calculate
∴ the weighted average CoC (wacc) is used - interpret
(also called the ‘marginal cost of capital’ - MCC)
wacc = wdrd(1 - ) + wprp + w ere w = weightings

r = cost of: d - debt
p - preferred
weights = the proportion of e - equity
various sources of capital of the company’s
‘target’ capital structure not the current capital structure
ex. #1. 30% D rd = 8% = 40%

10% Pr. rp = 10%
60% Eq. re = 15% wacc = .3(.08)(.6) + .1(.1) + .6(.15)
= .0144 + .01 + .09
= 11.44%
Page 3
- if interest expense is tax deductible (typically), the LOS b
after-tax cost of debt = rd(1 - ) - describe
- if not, or if limits on deductibility apply, cost of debt just equals rd
ex. #2/ rd = 4% re = 6% After-tax rd after-tax re

= 30% .04(.7) = 2.8% 6%
= 48% .04(.52) = 2.08% 6%
Cost of Debt/ LOS c

1/ YTM approach - the annual yield an investor holds on - calculate
- interpret
a bond if held-to-maturity
m = periodicity
= + n = # of years
( + ⁄ ) ( + ⁄ )
PMT = coupon/m
then
or/ FV = $, PMT = , N = # yrs. × periodicity PV = -P0 CPT [× m = YTM]
Page 4
Cost of Debt/ LOS c
ex. 3A/ 10-yr., $1000, 5% semi. @ 1025
1/ YTM approach - calculate
= 35% - interpret
PV = -1025, PMT = = 25 N = 10 x 2 = 20 FV = 1000 CPT = 2.342
x 2
∴ rd(1 - ) = 4.684%(65%) = 3.045% 4.684%
2/ Debt Rating approach - when reliable current market prices for

the company’s debt is not available
- based on the company’s debt-rating (of the debt issue itself),
use the yield on comparatively-rated bonds for maturities
that closely match the company’s existing debt
(typically arrived at using
ex. 3B/ Avg. mat. = 15 yrs. matrix pricing Fix. Inc.)
rated A1 comparable yields = 6.1%
= 18%
may be higher or lower depending on the
characteristics of the bond issue (sec./unsec., callable/straight)
Page 5
Issues in estimating the cost of debt/ LOS c
1/ fixed vs. floating rate unknown cost, depends on - calculate
fixed cost future yields - interpret
∴ determination of r is easy
d
∴ estimated cost only
2/ Debt with optionlike features (calls, puts, conversions)

raise yields lower yields
- if a company has existing debt with similar features, use that YTM
- if new debt will add or subtract features, adjustments must be
made to existing YTMs
3/ Non-rated debt company may not have any debt yet or have
unrated debt
- a ‘synthetic’ rating can be approximated based on
financial ratios (not accurate)
Page 6
Issues in estimating the cost of debt/ LOS c
4/ Leases - if used, cost of lease (implied rate) should - calculate
be included in the CoC - interpret
Cost of Preferred Equity LOS d

- calculate
fixed-rate, perpetual: = - interpret
- no tax adjustment since preferred

dividends are not tax-deductible
- adjustments must be made from here for features
e.g. callable, cumulative, participating and/or adjustable rate divs.,
conversion
e.g./ $3.75/yr. cumulative dividend

= . = . %
P0 = 80
Page 7
Cost of common equity/ - equity includes new issuances LOS e
- calculate
and retained earnings
- interpret
1/ CAPM:
( )= + [ ( )− ]
consistent with ERP equity risk premium or market risk

the life of the investment premium
e.g./ E(Rm) - Rf = 7% Rf = 5% = 1.5
E(Re) = 5% + 1.5(7%) = 15.5%
e.g./ Rm - Rf Rf Rf + (Rm - Rf)
Exxon .9 4.4% 2.8% 6.76%

BP .78 5.5% 2.0% 6.29%
Mobil .71 5.9% 1.7% 5.89%
Page 8
Cost of common equity/ LOS e
1/ CAPM: a single factor model - calculate
- interpret
- can also use a multi-factor model to incorporate
risks not captured by the market portfolio alone
- other factors would be ‘priced’ risk (or rewarded factors)

(e.g. inflation, interest rates, fx-rates, business cycle risk)
E(re) = Rf + RP1 + RP2 + … + RPn RP = risk premium
Estimating ERP:
a) historical equity risk premium approach
G
- average rate of return on
A
1/ country’s market portfolio (Rm)
3 mos.
2/ government s.t. or L.T rate (Rf)
20 yr.
Page 9
Estimating Rm: LOS e
a) historical equity risk premium approach - calculate
- interpret
Dimson et all (2018)
Rm
ERPG ERPA
s.t. T-Bills 5.6% 7.5% T-Bond
L.T. T-Bonds 4.4% 6.5% T-Bill
ERPA
ERPG
(1 + ERPg)t (1+r1)(1+r2)(1+r3)(1+r4)
√ r
ERPG ERPA - unbiased estimate of E(re) for

- better reflects growth rates a single period
over many periods
Page 10
Limitations of CAPM/ LOS e
a) level of risk of the stock index may change - calculate
ERP is not over time (i.e. vol. may ↑ or ↓) - interpret
static b) risk aversion of investors may change over time

(i.e. require ↑ E(re) to invest, or lower)
c) estimates are sensitive to the method of estimation
and the historical period covered
b) Survey method - ask a panel of finance experts and take the mean
Once E(re) is estimated, it should be adjusted for specific systematic risk

of any particular investment/project
2/ Bond yield plus risk premium approach/ for companies with

publicly-traded debt
re = rd + risk premium
additional risk of company’s stock over its bonds
rf + spread
- typically 3%-5% in developed countries
Page 11
Summary/ · YTM
· Debt rating CAPM: re = Rf + (Rm - Rf)
wacc = wdrd(1 - ) + wprp + were · historical

· survey method
target capital Bond yield + Risk premium

structure re = rd + RP
Rf + spread
LOS f
A/ Estimating for public companies
- explain
- regress return of stock on a return on the market series - demonstrate
unadjusted or ‘raw’ historical
= +
estimate of influenced by:
a) choice of index to represent the market portfolio
b) length of data period and frequency of obs.
(most common: 5 yrs. of monthly data 60 obs.)
Page 12
A/ Estimating for public companies LOS f
- explain
s tend to regress towards one (1) - demonstrate
- use of Blume adjustment
adjusted beta = (unadjusted beta) + (1)
e.g./ = 1.3 adj. = (1.3) + = 1.20
- financial data vendors typically provide both adjusted/unadjusted
B/ Estimating for thinly-traded and non-public companies
- OLS won’t work - no, or unreliable, return series (re)
will tend to underestimate
- find a peer/comparable company (one with similar business risk)

- use GICS to identify peers
Page 13
B/ Estimating for thinly-traded and non-public companies LOS f
- explain
- if the peer company has a substantially different
- demonstrate
capital structure, which is typically the case, unlever
and relever the
(asset ) = MV of peer assumes debt is IG

+( − ) (HY will not have D = 0)
peer peer marginal tax rate
= +( − ) MV of target Re
premium
target’s marginal tax rate for
financial
risk
- if target’s > peer , premium for
Rf business risk
> peer
Debt
ex. #8/9
Page 14
Floatation costs LOS g
- the cost to raise additional capital - explain
- demonstrate
- higher for equity (debt/preferred very low, < 1%,
often ignored in estimating CoC)
- higher for smaller issues
Method 1/ directly incorporate floatation costs into CoC
= + or = + (GGM to
( − ) ( − )
estimate re)
$ %
e.g./ D0 = $2
retained earnings reinvested share issuance with f = 4%
P0 = $40 ( . ) ( . )
g = 5% = +. = . % =
(. )
+. = .
issue - f/F happens only once − ≠

( . ) ( . )
Page 15
Floatation costs LOS g
Method 2/ - reduce NPV by F (i.e. F is a cash outflow - explain
at = 0) - demonstrate
10k 10k 10k = 40%, rd = 5%, re = 10%, wd = 40%

-60,000 = 10 we = 60%
24k Debt rd(1 - ) = .05(.6) = 3%

60,000
36k Equity re = 10%
wacc = .40(.03) + .60(.10) = 7.2% N = 10, PMT = 10,000, FV = 0, = 7.2%
CPT PV = 69591
- 60,000
Let f = 5% or F = 1800 NPV = 9591
NPV = 9591 - 1800 = 7791
Note: adjusting re for f changes
or NPV = 9591 - 1800(.6) = 8511
wacc to 7.3579, NPV = 9089
if F is tax deductible 9591 - 9089 ≠ 1800
Capital Structure
a. describe how a company’s capital structure may change over its life cycle;
b. explain the Modigliani-Miller propositions regarding capital structure;
c. describe the use of target capital structure in estimating WACC, and calculate
and interpret target capital structure weights;
d. explain factor affecting capital structure decisions;
e. describe competing stakeholder interests in capital structure decisions.

Capital Structure
LOS a (6.5p) Capital Structure and Company Life Cycle - describe
LOS b (8p) Modigliani-Miller Propositions - explain
LOS c (3p) Optimal & Target Capital Structure - describe, calculate

interpret
LOS d (7p) Factors Affecting Capital Structure - explain
LOS e (12p) Stakeholder Interests - describe
Page 1
- Capital structure - the mix of debt and equity used to LOS a
finance a company’s assets - describe
Life-cycle stage - principal

factor in determining
(net CAPEX) capital structure
1/ Start-ups:
uncertain cash flows
∴ main reliance is on
(private) equity
(VCs, angels, FFF)

Page 2
2/Growth Businesses: LOS a
revenue growth, cash flow negative but improving - describe
predictability improving, cost of debt ↓ and availability ↑

assets may be available to secure debt
- still, debt is used conservatively
- some are ‘capital light’ or ‘asset light’, requiring little
reinvestment to support growth
3/ Mature Businesses:
- slowing revenue growth, strong positive cash flow
- lower levels of CAPEX
- access to unsecured debt
- IG rating ensures low cost + maximum flexibility
- may use debt to ‘optimize’ the capital structure
capital structure that maximizes

company value
Page 3
3/ Mature Businesses: LOS a
- very mature businesses will de-lever over time - describe
explicitly or implicitly
pay down debt as ↑, = ↓
to maintain ‘optimal’ capital structure, the company will

conduct share buybacks
Unique situations/
1/ Capital intensive businesses with marketable assets
- real estate, shipping, airlines
- assets can support secured debt, regardless of life stage
2/ Cyclical industries - mining, materials

- tend to have less debt than non-cyclicals
3/ ‘Capital light’ businesses - software

- minimal fixed investment or working capital needs
- little debt and substantial net cash
Page 4
Modigliani-Miller - under certain assumptions, a company’s LOS b
choice of capital structure does not affect its value - explain
(it is a theoretical argument intended to identify the variables

that do matter
Assumptions/
Page 5
Proposition 1 (without taxes): Capital Structure Irrelevance
LOS b
The MVcompany is not affected by the capital structure - explain
of the company
525 Debt
- proof: 50% 1400
50% Debt (5%) 875 Equity
good
50% Equity $1000
bad
525 Debt
50% 900
375 Equity
Returns
Str. Wk. Str. Wk. E(R)
D 500 525 525 5% 5% 5%
wacc = .5(.05) + .5(.25)
EL 500 875 375 75% -25% 25% = .15
EU 1000 1400 900 40% -10% 15% wacc = 0(.05) + 1(.15)

= .15
Page 6
Proposition 1 (without taxes): Capital Structure Irrelevance LOS b
- explain
- wacc is unaffected by capital structure
- managers cannot create value by changing the company’s
capital structure
- value of a company is determined solely by its cash flows
adding leverage increases risk to equity holders

∴ equity holders will demand a higher E(R)
Proposition 2 (without Taxes): Higher financial leverage raises the cost
of equity
- increases in the cost of equity are exactly offset
by the greater use of lower cost debt
- the cost of equity is a linear function of the company’s ratio
= +( − ) where r0 = cost of 100% equity
Page 7
Proposition 2 (without Taxes) LOS b
wacc = wdrd + were if wd = 0, wacc = wdre = r0 - explain
∴ = + e.g./ CFe = $5,000/yr. 100% E

re = 10% ∴ wacc = 10%
= − = =
=
.
= −
× issue 15k D at 5% to buy back 15k E
( + ) re = .10 + (.10 - .05) = 12.143%
V = E +D = −
= + = , −( , ×. )
+
= + − . .
= 35k + 15k = 50k
= + −
wacc = . + . = %
= +( − )
Page 8
Proposition 2 (without Taxes) LOS b
- explain
= +( − ) implies = +( − )
equity asset debt (= 0 for IG debt)

(≠ 0 for HY)
e.g./ D = 0, then = +( − ) =
D = 50%
= +( − )( ) = + =
E = 50%
- under MM Prop. I/II, leverage does not affect the value of a firm
or wacc, but does cause the risk of equity to
increase and therefore re ex. #6
Page 9
MM Propositions with Taxes/ - debt provides a tax shield LOS b
- result in savings that enhance the value of - explain
the firm (this value increases with increasing debt)
- recall: after-tax cost of debt = rd(1 - )
VL = Vu + D D = 1000 @ 5% perpetual, = 40%

debt tax shield MVd = . = 1000, savings = . = 400
( ↑ as ↑ and/or ↑) =
- for this to hold, wacc must decrease as debt increases
wacc = ( − )+ re = r0 + (r0 - rd)(1 - )
(since + = +( − ) )
Prop. 1 (with taxes) MV of levered company = MV of unlevered company

plus debt.
Prop. 2 (with taxes) re is a linear function function of adjusted by
(1 - )
Page 10
MM Propositions with Taxes/ LOS b
example revisited: CF = 5,000/yr. 100% E re = 10% = 25% - explain
= = , ( −. )
= , Note: taxes will reduce
. the value of the firm
issue 15k of D at 5%, buyback 15k of E

Note: D = (. )
=
VL = Vu + D = 37,500 + .25(15,000) = 41,250 .
= = +( − )( − ) =. + (. −. )(. ) =.
.
VL = VU + D = ( − )( − . )
+ = , + , = ,
. .
- finally, wacc = wdrd(1 - ) + were = . (. )+
.
.
. .
= 9.0909% (lower than 10%)
Page 11
LOS b
Summary/
Without Taxes With Taxes - explain
Proposition 1 VL = Vu VL = Vu + D
Proposition 2 re = r0 + (r0 - rd) re = r0 + (r0 - rd)(1 - )
Cost of Capital - no taxes Cost of Capital - taxes
m = r0 - rd
m = (r0 - rd)(1 - )
wacc
wacc
rd rd
- cost of capital does not - cost of capital does

depend on capital structure depend on capital structure
Page 12
- at the extreme, optimal capital structure = 100% Debt LOS b
wacc = rd(1 - ) - explain
- counterpoint personal taxes

- since interest is taxed higher than dividends or
capital gains, investors will begin to demand a
higher pre-tax return to debt (as equity availability
declines)
Costs of Financial Distress (more likely)
- operating/financial leverage magnifies losses
- financial distress adds costs implicit and explicit
lost customers bankruptcy costs
employees
suppliers
agency costs of debt
- greater probability of default raises costs of debt
rd ↑, re ↑, wacc ↑
Page 13
- Optimal Capital Structure - theoretical point at which the LOS c
value of the company is maximized - describe
- calculate
- balances ‘value-enhancing’ effects of leverage - interpret
with ‘value-reducing’ effects of financial distress
tax-shield vs. financial distress:

VL = Vu + D - PV(fin. distress costs)
- referred to as the
‘static trade-off theory
of capital structure’
optimal capital structure will

be < 100% Debt
- will depend on business risk, tax

situation, corporate governance,
actg. position, etc.
Page 14
- Optimal Capital Structure LOS c
CoC optimal D/E may be - describe
cost of equity company’s target capital - calculate
structure - interpret
wacc
after-tax - actual D/E may differ:

cost of debt
S.t. opportunities in one financing
optimal
source
optimal range market price fluctuations will
continuously affect MVd/MVe ratio
- if a project will use specific floatation costs make it impractical
capital components, use those for wacc to target a specific
- else, use the target weights:
current MVd/MVe
could mgmt. statement of target ex. #8
be or company trend /
Note: =
avg. of comparables +
Page 15
Factors affecting capital structure decisions/ LOS d
- explain
1/ Capital structure policies and target capital structures
- since re and PV(FD) are difficult to estimate, policy tends

to focus on reasonable limits to borrowing
e.g. max , . < 2, or D < 50% TC
typically driven by debt covenants or rating agency thresholds

as leverage rises, rating agencies tend to lower the ratings of a company’s
debt
- lower ratings signal higher risk to both equity and debt
providers (demand higher returns)
- cost of capital ∴ tied to bond ratings

- some companies target a specific rating
- rd ↑ dramatically if bond ratings ↓ from IG to HY

Page 16
- explain
1/ Capital structure policies and target capital structures
- higher rated: industries with stable CFs, greater profitability,
shorter asset conversion cycles and/or more liquid assets
- stable and defensive sectors (Utilities, Cons., Staples)
- Policy will typically use BVd/BVe rather than MVs
MVs fluctuate substantially and seldom impact the

appropriate level of borrowing
e.g. MVe ↑ ↓, but better to issue equity at high

prices
its more about capital invested by the company,
not what has been invested in the company
lenders, debt investors, rating agencies generally focus on BV
Page 17
2/ Financing capital investments - key financing decisions - explain
typically tied to a specific investment or acquisition

- nature of the investment may be well or poorly suited to leverage
- well suited marketable, cash-generative, considered strong

collateral
- asset/liability mgmt. - short-term projects should
use short-term financing (ret. earn, s.t. debt)
- foreign investments typically financed substantially with debt

- hedges currency risk by borrowing in the same currency
as revenues earned
3/ Market conditions - financings are often opportunistic

- borrow when rates are low, sell equity when share
prices are elevated
Page 18
- explain
3/ Market conditions - manage debt or equity issuance
to meet index requirements (e.g. min. debt issue size)
- lower credit spreads lower the cost of debt

(issuer and economy dependent)
interest rates, inflation, credit cycle
- well developed legal systems lower borrowing costs

- companies in emerging markets make more use of
equity
4/ Information asymmetries and signaling
- the more asymmetry (managers vs. investors) the higher rd & re
e.g. companies with complex products, little transparency

in fin. actg. info., lower levels of institutional
ownership
Page 19
4/ Information asymmetries and signaling - explain
pecking order theory

Investors financing - mgmt. selects methods of financing
- potential insider activities according to a hierarchy that gives
opinions about first preference to methods with the
company prospects? least potential information content and
lowest preference to the form with the
greatest information content
as a result, mgmt. RE Debt Equity

can ‘signal’ to the market
tend to issue stock when
their confidence in the company’s
they believe shares are
prospects through the issuance of
overvalued
debt (called debt signalling)
Page 20
4/ Information asymmetries and signaling - explain
- issuing equity seen as a negative signal

- mgmt. believes shares are overvalued or they
had no other alternative
Agency costs/ - costs arising from conflicts of interest when an agent

makes a decision for a principal (mgrs. vs. bondholders/
shareholders)
- the smaller the stake mgmt. has, the greater the
potential agency costs of equity
- the better a company is governed, lower the agency costs

- higher shareholder value
- higher the use of debt - lower the net agency costs of equity
- more leverage, less freedom on mgmt. to unwisely spend
Page 21
Agency costs/ ‘Jensen’s free cash flow hypothesis’ LOS d
- higher debt levels discipline managers - explain
to operate more efficiently
- reduction in FCF reduces opportunities for misuse
LOS e
Shareholder vs. Stakeholder theory/
- describe
company is run
in the interests broader
of shareholders group
considered
(more prominence
to ESG considerations
by making them an
explicit objective
for the BoD/mgmt.)
Page 22
Shareholder vs. Stakeholder theory/ LOS e
- capital structure decisions impact stakeholder groups - describe
differently e.g. higher leverage increases risk for all
stakeholders (higher financial risk) but benefits
accrue almost entirely to shareholders/mgmt.
A/ Debt vs. Equity conflict:

- debtholders prefer decisions that reduce a company’s leverage
and financial risk
- common shareholders prefer higher leverage levels that offer
them greater return potential
Bondholders Shareholders
upside return of principal multiples of - higher leverage
original investment adds to sh.
downside 100% loss 100% loss upside only
Ex. #11
Page 23
A/ Debt vs. Equity conflict: - describe
Distressed debt the potential upside of high risk debt

can be substantial if the company does not default
∴ return profile and perspective of bondholders becomes
closer to that of equity investors
- other debt considerations:

i) seniority and security
secured/senior lenders can better tolerate actions
by mgmt. that increase POD
ii) long-term vs. short-term
potential conflicts are greater with LTD
iii) safeguards for debtholders
debt covenants may limit debt levels
company desire to maintain easy access to credit
company desire (mgmt./sh.) to avoid FD costs
Page 24
B/ Preferred Shareholders: - describe
- long-term capital provider, lack covenant protection
- vulnerable to decisions that increase financial leverage and risk
C/ Private equity investors/Controlling Shareholders:

- issuance/retirement of shares may affect voting control
- majority shareholder may have objectives that are at
odds with minority shareholders
e.g. dual-class shares, one voting, other not
- may issue more non-voting shares
majority shareholder selling stake may take short-term
view on capital structure decisions
D/ Banks and Private Lenders - hold debt to maturity

- generally have more direct access to information
versus public debtholders - reduces info. asymmetry
Page 25
D/ Banks and Private Lenders - describe
- also may be a critical source of credit for a
company, so the lender will have a degree of influence
on the company
E/ Other Stakeholders
i) customers/suppliers - financial stability important for
extension of credit and for some vendor selection decisions
ii) employees - employment prospects + any share-based
compensation
iii) Management & Directors
- maximize shareholder value
- interests aligned through equity-based compensation
Issues a) excessive compensation - leads to entrenchment

- avoiding risk or ‘going along’ so as
not to lose one’s position
Page 26
E/ Other Stakeholders - describe
iii) Management & Directors
Issues b) when compensation is tied to the size of the business

- can lead to ‘empire building’ M&A that increases
size but not shareholder value
c) reliance on stock options can motivate
risk-taking behavior (only participate in the upside)
iv) Regulators/Government
- capital structure may be a regulatory issue
- capital structure may be influenced by global tax
rates
Measures of Leverage
a. define and explain leverage, business risk, sales risk, operating risk, and
financial risk and classify a risk;
b. calculate and interpret the degree of operating leverage, the degree of

financial leverage, and the degree of total leverage;
c. analyze the effect of financial leverage on a company’s net income and return
on equity;
d. calculate the breakeven quantity of sales and determine the company’s net
income at various sales levels;
e. calculate and interpret the operating breakeven quantity of sales.

Risks
LOS a, d, e
elasticity of - define
demand - explain
Sales - calculate
cyclicality Risk - interpret
(Q×P)
industry Business
β Financial level
structure Risk
Risk of
Operating
MIX of debt
Risk
VC vs. FC Financial
Operating Leverage Leverage
use of FC in company’s use of debt in
cost structure the company’s capital
structure
increases the volatility of
earnings and cash flows
increases risk, which increases & , which increases WACC
LOS a, d, e
e.g./ A B - define
Q 100,000 100,000 - explain
SP/U $10 $10 - calculate
- interpret
VC/U 2 6
CM/U 8 4
FC/
,
Op. Exp. 500k 150k BEP(A) = = = ,
/
Int. Exp. 100k - 50k -
Sales $1M 1M ,
Operating BEP = = ,
- VC .2 .6
= CM 800k 400k BEP(B) = =
,
= ,
- Op Ex 500k 150k /
= Op Pr = Ø 300k 250k
,
- INT 100k 50k Operating BEP = = ,
= NI 200k ø 200k ø
LOS a, d, e
e.g./ A B
- define
Q 100,000 100,000 - explain
SP/U $10 $10 - calculate
VC/U 2 6 $ - interpret
CM/U 8 4
FC/
Op. Exp. 500k 150k A
400k -
Int. Exp. 100k 50k B
Sales $1M 1M 200k -
•
- VC .2 .6 Q
-
= CM 800k 400k -200k -
50k 75k 100k
- Op Ex 500k 150k
-400k - NI = -200,000 + 4Q
= Op Pr 300k 250k
- INT 100k 50k -600k -
NI = -600,000 + 8Q
= NI 200k 200k
CVP - Graph
LOS a
Business Sales P industry structure - define

- explain
Risk Risk × elasticity of demand
G cyclicality - macro
Operating
FC
all companies in Risk - higher FC, higher operating
vs.
the same line on risk, higher business risk
VC
business face the
somewhat dependent on the industry
same sales risk
structure but more discretionary than
Sale Risk
Debt
Financial - Level of - fixed financing charges
Risk Debt Pref.
Degree of Leverage
P Recall: from microeconomics LOS b, c, d

- calculate
- interpret
%∆
elastic · elasticity is - analyze
%∆
unit elastic at a particular Q
• inelastic
D
Q same concept
Degree of Operating Leverage (DOL) - calculated at a

particular Q
%∆ . .
= %∆ . .= (%∆ ) ~
%∆
× /
=
. . ( × / )−
LOS b, c, d
A B - calculate
Sales $1M 1M - interpret
- VC 200k 600k ( )= = = .
- analyze
= CM 800k 400k . .
- Op Ex 500k 150k
= Op Pr 300k 250k × / , ×
( )= = =
( × / )− ( , )
× −
= .
for a 1% change in Q;
up
A %∆ . .= (%∆ ) = . ( )= . %
given
down
Q = 100k
( ) up
B %∆ . .= (%∆ ) = . %
down
80,000 Q 100,000 Q 120,000 Q LOS b, c, d

- calculate
A B A B A B - interpret
Sales $1M 1M - analyze
- VC 200k 600k
= CM 640k 320k 800k 400k 960k 480k
- Op Ex 500k 150k 500k 150k 500k 150k
= Op Pr 140k 170k 300k 250k 460k 330k
−
− = %
= . ↓%
DOL(A) = 2.67
DOL(B) = 1.6
20 ↓ Q 20% ↑ Q
%ΔOp.Pr. = 2.67(20) = 53.4% %ΔOp.Pr. = 1.6(20) = 32%
80,000 Q 100,000 Q 120,000 Q LOS b, c, d

- calculate
A B A B A B - interpret
Sales $1M 1M - analyze
- VC 200k 600k
= CM 640k 320k 800k 400k 960k 480k
- Op Ex 500k 150k 500k 150k 500k 150k
= Op Pr 140k 170k 300k 250k 460k 330k
At Q = 80,000 25% ↑ Q At Q = 120,000

DOL(A) = = = . DOL(A) = = .
.
DOL(B) = = . DOL(B) = = .
%ΔOp.Pr. = DOL(%ΔQ)
=1.88(25%)
= 47.06 −
= . %
/ × LOS b, c, d
Operating BEP(A) = - calculate
DOL ( / × )−
- interpret
× , - analyze
= = =∅
( × , )−
40 -
30 -
20 - if FC = 0
10 -
= =
−
-
-
-10 -
62,500 units
-20 -
DOL (80k) = 4.57 as Q↑
DOL (100k) = 2.66 DOL → 1
-30 -
DOL (120k) = 2.09
DOL (500k) = 1.14
LOS b, c, d
units - calculate
- interpret
- analyze
- 62,500
DOL
-
30 20 10 -10 -20 -30

LOS b, c, d
Degree of %∆
· calculated at - calculate
Financial =
%∆ . .
a particular level of - interpret
Leverage - analyze
Op.Pr.
re-arranging %ΔNI = DFL(%ΔOp.Pr.)
− c – fixed financing
( − )− costs
if Op.Pr. ↑ 20%
. .
e.g./ Op. Pr. 300,000 = = . ,
- Int. Exp. 100,000 ,
(EBT) NI 200,000 1.5(20%) = 30% ,
−
= %
LOS b, c, d
e.g./ C = 150,000
- calculate
- interpret
Op. Pr. 300,000 + 20% 360,000
- analyze
Int. 150,000 × 2 150,000
−
NI 150,000 = 40% 210,000 = %
= =
- Capital structure choice by mgmt.
· If is high, capacity for higher DFL
· if revenues have below-average business-cycle

sensitivity, capacity for higher DFL
e.g./ DFL & ROE, $2M assets LOS b, c, d

(-40%) (+40%) - calculate
- interpret
EBIT 500,000 300,000 700,000
- analyze
I ø ø ø
EBT 500,000 300,000 700,000
T 150,000 90,000 210,000
NI 350,000 210,000 490,000
ROE = 17.5% 10.5% 24.5%
$1M Equity $1M Debt @ 5%

(-40%) (+40%)
EBIT 500,000 300,000 700,000
I 50,000 50,000 50,000
EBT 450,000 250,000 650,000
T 135,000 75,000 195,000
NI 315,000 175,000 455,000
ROE = 31.5% 17.5% 45.5%
LOS b, c, d
%∆ . . %∆ %∆ - calculate
= × = - interpret
%∆ %∆ . . %∆
- analyze
DOL × DFL
− DOL
− − − TL
DFL
= =
− −
∴ %∆ = (%∆ )
(1)
LOS b, c, d
e.g./ Q 100,000 - calculate
SP/U $10 = = = . - interpret
. . - analyze
VC/U 2
CM/U 8 . .
= = = .
FC/ Op.Exp. 500k
Int 100k = × = . × . = .
Sales $1M if Q ↑ 10%,

- VC 200k NI ↑ 40% @ 110,000 units
= CM 800k
CM 880,000
- Op. Ex. 500k
- OpEx 500,000
= Op. Pr. 300k 380,000
- Int 100k −
- Int 100,000
( ) = %↑
= EBT 200k
280,000
- T% 60k − - T 84,000
( ) = %↑
= NI 140k
NI 196,000
LOS b, c, d
DOL - calculate
- interpret
TL
- analyze
- bankruptcy
reorganization (11)
- less likely to be
successful if high DOL
if the cause of distress
DOL
DFL liquidation (7)
Q
Corporate Governance
Review - 1
E – environmental
S – social checks, balances
G – governance internal controls incentives
rights, responsibilities
Shareholder Theory – mgmt. should max shareholder return

shareholders
Stakeholder Theory – mgmt. should max value for customers, suppliers
employees
1. Shareholders – exercise control (equity owners)
(controlling & non-controlling)
2. Creditors – bondholders/banks (debt holders)
3. Managers/Employees – max. sh. return vs. decent wages
4. Board of Directors – protect shareholder interests, elected
one-tier – single BoD
supervisory board (non-executives)
two-tier
management board (executives)
Review - 2
- Stakeholders (con’t.)
5. Customers – value for payment
6. Suppliers – get paid
7. Government/Regulators – protect interest of general public
must manage potential/real conflicts between stakeholder
- Principal-Agent Relationships
a) Shareholder vs. Manager
(principal) (agent) - expected to act in best
interest of principal
- potential agent issues/
- max. personal benefits
- too risk averse – protect position
- information asymmetry – mgmt. knows more
- board composition – too many insiders
b) Controlling vs. Minority Shareholders
potential issues - related party transactions
- dual class shares
Review - 3
- Principal-Agent Relationships
c) Manager & BoD
- potential issues · lack of info. for BoD
d) Shareholder vs. Creditor (risky projects vs. stability)
e) Customers vs. Shareholders (higher quality vs. lower costs)
f) Customers vs. Suppliers (give me credit vs. you pay now!)
g) Shareholders vs. Government/Regulators (taxes/regulation)
identify
Management/ interests of stakeholder groups
prioritize
(attempt to balance various interests)
understand
legal
must work within existing
contractual
infrastructure
organization
governmental
- Mechanisms of Stakeholder Management
1) General Meetings – AGM once a year (min.)
- vote for BoD, performance overview, resolutions
- proxy voting (others vote your shares) cumulative voting (100 sh., 4 directors = 400 votes)
Review - 4
- Mechanisms of Stakeholder Management
2) BoD – provides oversight (accountable to
- appoints top mgmt. shareholders)
3) Audit Function – internal/external
4) Reporting & Transparency – regulatory disclosures
- reduces information asymmetry
5) Policies on Related–Party Transactions – process for
mitigating, managing & disclosing such cases
6) Remuneration Policies – profit sharing, stock options
7) Say on Pay – sh. vote on executive pay
- may be 1) non-mandatory, non-binding 2) mandatory, non-binding
3) mandatory, binding indenture
8) Contractual Agreements with Creditors covenants
9) Employee Laws/Contracts collateral
10) Contractual Agreements with customers/suppliers
11) Laws & Regulations
Review - 5
executive
Composition of the Board/ one-tier
non-executive
independent
supervisory
two-tier mgmt.
- diverse mix of expertise, backgrounds, competencies
- CEO & Chair position increasingly separated
· Staggered Boards - of Board up for election each yr. (3 yr. terms)

- provides continuity, but also entrenchment
· Functions/Responsibilities fully informed basis

· duty of care good faith must act
due diligence
· duty of loyalty – interests of shareholders
· guides/approves strategic direction
· appoints CEO
· monitors/reviews performance
· ensures effectiveness of audit procedures
· reviews all major M&A
Review - 6
- Board Committees/
a) Audit Committee – supervises internal audit system, appoints
external auditor (external directors only/mostly)
b) Governance Committee – ensures good governance procedures
c) Remuneration/Compensation Committee
d) Nominations Committee – for the Board
e) Risk Committee - determine risk profile/appetite of the company
f) Investment Committee – reviews material investment
opportunities proposed by mgmt.
Factors Affecting Relationships/

· Market Factors (capital market related)
1) Shareholder engagement – build support for mgmt. position
2) Shareholder activism – attempts to compel mgmt. to act in
a desired manner
i.e. shareholder derivative lawsuits
Review - 7
Factors Affecting Relationships/
· Market Factors (capital market related)
3) Competition & Takeovers proxy contest
tender offer
hostile takeover
· Non-Market Factors/
1) Legal Environment – offers protection of the interests
of stakeholders
2) Media/Social Media – shape public opinion
3) Corporate Governance Industry – external governance services
Risks of poor governance Benefits of good governance

a) operational efficiency
a) weak control systems b) improved control
b) ineffective decision making c) better operating/financial
c) legal, regulatory or performance
reputational risks d) lower default risk and cost
d) default & bankruptcy risk of debt
Review - 8
- Analyst Considerations/
· economic ownership & voting control
voting
· dual class structure?
non-voting/restricted
· BoD representation
- independence, expertise, experience, tenure, diversity
· Remuneration & Company Performance

base salary + short-term bonus + multiyear incentive plan
- should align interests with shareholders
cross shareholdings
· Investors in the Company
sizeable affiliated shareholder
activist investors
· Strength of Shareholder Rights
ESG Considerations
Review - 9
Responsible investing - considering ESG approaches
ESG integration - inclusion of material ESG risks

Socially responsible investing (SRI) - excluding undesirable or
including desirable activities
Thematic investing - themes/assets related to ESG factors
Impact investing - intent to generate positive ESG impact
Investment approaches/
value based avoid material ESG risk
versus values-based lean in to moral/faith-based objectives
negative screening - exclude sectors/companies on ESG criteria

positive screening - include sectors/companies on ESG criteria
ESG integration Thematic investing Impact investing
Engagement/activism - shareholder/bondholder power to influence
corporate behavior
Review - 10
Catalysts for growth in ESG investing
micro level company risk exposures affecting FV.
macro level demand from investors
Universal owners - large global asset base, perpetual lives

- negative externalities today are tomorrow’s
risk factors
Uses of Capital
Review - 1
LOS a - describe/
- capital allocation process:
Step 1: Idea generation - internal/external opportunities
2: Investment analysis - forecast cash flows
3: Capital allocation planning - what project fit
4: Monitoring/post-audit - actual vs. planned
- types of capital projects:

1/ Replacement projects - maintain capacity
2/ Expansion projects - expand capacity
3/ New products/services - expand product line
4/ Regulatory/Safety/Environmental - required by gov’t./insurance
5/ Other - pet/risky projects
Review - 2
LOS a - describe/
- capital allocation assumptions
1/ Decisions are based on CFs
2/ CFs are not accounting operating or net income
3/ CFs are based on opportunity costs
4/ CFs are after-tax
5/ timing of CFs matter
6/ financing costs ignored (in the required rate of return)
- Definitions
- sunk costs - money already spent, ignored, only current and future CF
matter
- opportunity costs - next best use, what is given up
- incremental cash flow - CF with project less CF without project
- externality positive - synergies effect of an investment

negative - cannibalization on other things
Review - 3
LOS a - describe/
- Definitions
- conventional CFs - 1 sign change (outflow inflows)
- non-conventional CFs - > 1 sign change (outflows inflows outflows
etc.)
- Project interactions:
Independent A and B (A ∧ B = 0)
Mutually-exclusive A or B, but not both
project sequencing A - go B - go C
no-go no-go - end
unlimited funds - invest in all projects if E(R) > r
capital rationing - fixed capital budget
LOS b - demonstrate/describe/
= = - outlay
( + ) ( + )
all types of CFs outlay at = 0
Review - 4
LOS b - demonstrate/describe/
- if NPV ≥ 0, invest, else don’t
IRR - internal rate of return (mwrr)
= outlay or = solver for r

( + ) ( + )
- if IRR > r invest, else don’t
- if NPV & IRR rank mutually exclusive projects differently, select on

NPV
- for independent projects with conventional CFs, NPV and IRR
will agree with each other
- IRR with non-conventional CFs - as many IRRs as there are sign

changes
LOS c describe/
ROIC > CoC - value producing
=
. (debt, preferred, common) < CoC - value destroying
Review - 5
LOS c describe/
- new projects with NPV > 0 should increase share price
Inflation will affect revenues and costs differently

( + )
includes expected inflation
- if real CFs are forecasted, should be discounted with real r
LOS d describe/
Real Options - the right to take a particular business decision
1/ Timing options - invest now or delay

or - investments are sequenced over time
2/ Sizing options go/no-go decisions
growth abandonment
3/ Flexibility options - price setting option
- production-flexibility option (supply or output)
Review - 6
LOS d describe/
4/ Fundamental options - the whole project is an option (e.g. gold mine)
analyzing projects with real options:
1/ DCF without option, if NPV > 0, invest

2/ DCF without option - cost of option + value of option
3/ Decision trees requires a valuation
4/ Option pricing model model
LOS e describe/
not incorporating economic responses (i.e. competitors)

formulaic approach to budgeting
mgmt. pet projects
basing decisions on accounting criteria
basing decisions on IRR
incorrectly accounting for CFs
Review - 7
LOS e describe/
ignoring overhead costs

not using the correct discount rate (i.e. project specific)
over/under spending the capital budget
failure to consider investment alternatives
not handling sunk costs or opportunity costs correctly
ignore include
Sources of Capital
Review - 1
LOS a - describe/
working capital - short-term funds without an explicit interest rate
Debt + equity - firm’s capital structure
Sources: Internal
Operating cash-flows (after tax)
Accounts payable (delaying)
Accounts receivable (collecting faster)
Inventory (optimizing levels)
Marketable securities
External: A) Financial Intermediaries
uncommitted lines of credit (interest only)

committed lines of credit (up to 364 days) - unsecured, pre-payable
- commitment fee + interest
revolving credit agreements - multi-year line of credit
secured (asset-based loans) - assets or AR pledged
assignment of AR
Review - 2
LOS a - describe/
External: A) Financial Intermediaries
factoring - selling AR at a discount

web-based and non-bank lenders
B) Capital markets
commercial paper - unsecured, up to 270 days

Debt vs. Equity
legal agreement, set maturity, prior claim on CFs/assets, lower
cost
- long term debt, common equity, preferred equity, hybrids
C) Leasing convertible debt or

preferreds
- Considerations affecting choice of external financing/
small, typically equity
Size
large - internal CFs, CP, public markets
Review - 3
LOS a - describe/
Riskiness of assets - high vol. CFs or high degree of business
risk more use of equity, less leverage
Assets for collateral - real property, equipment debt

- unique assets, highly specialized, intangible equity
Public vs. Private equity smaller companies, higher cost

larger companies, lower cost
Asset Liability Management - finance long-term assets with

long-term sources of capital (and
short-term assets with short-term sources)
Debt Maturity Structure (Term structure of rates) - borrow at

lower s.t. rates and continually roll over
Currency risk - cash inflows/outflows should be in the same currency
Review - 4
LOS a - describe/
Agency costs - higher more reliance on equity
Bankruptcy costs - riskier capital structures raise the cost of capital
Floatation costs - higher for equity
Taxation - higher rates encourage more use of debt
Inflation - debt does not inflate, borrow at a fixed rate if

inflation is expected to be higher than consensus
Government policy - subsidies, loan guarantees
Monetary policy - lower rates increase leverage levels
LOS b - describe
Liquidity - the ability to meet s.t. obligations
- liquidity of an asset depends on type (fin./non-fin.) and speed

at which it can be monetized (sold/financed)
Review - 5
LOS b - describe
Primary sources of liquidity:

free cash flow - after-tax - CAPEX
ready cash balances - cash/equiv.
short-term funds - AP, LOCs
cash flow mgmt. - collections/payments
Secondary sources of liquidity:
negotiating favourable terms with liquidity providers

(lenders, suppliers, customers)
liquidating assets
bankruptcy protection
Drags on liquidity uncollected receivables, obsolete inventory, tight credit
Pulls on liquidity making payments early, reduced credit limits, limits on s.t.
LOCs
Review - 6
LOS c - compare/
Liquidity ratios Current ratio = CA/CL
- ability to meet Quick ratio = (Cash + s.t. mkbl. sec. + AR)/CL
s.t. obligations
Cash ratio = (Cash + s.t. mkbl. sec.)/CL
Activity ratios AR Turnover = .

Inv. Turnover = . .
.
1 # days of AR =
. .
2 # days inventory =
.
3 # days payable =
cash conversion cycle (CCC) = 1 + 2 - 3

- ratios should be compared over time for the same company (trend analysis)
and over time versus peers (cross-sectional analysis)
Review - 7
LOS d - evaluate/
ensure sufficient borrowing capacity exists
objectives:
maintain sufficient sources of credit
ensure rates are cost effective
- factors influencing s.t. borrowing strategy:
1/ Size and creditworthiness

2/ legal/regulatory considerations
3/ sufficient access - diversification of sources
4/ flexibility in setting maturities
Active strategies proactive, reflects planning, matching strategy
Passive strategies reactive, single source, steady rollovers


Review - 1
LOS a - calculate/interpret/
Debt
- components of capital preferred
Equity
common
marginal costs
- weighted average cost of capital (wacc) = wdrd(1 - ) + wprp + were
- represents the CoC for a company’s weights based on the

‘average’ risk project ‘target’ capital structure
LOS b - describe
- since interest is (typically) tax deductible,
the after-tax cost of debt is used rd(1 - )
LOS c - calculate/interpret
Cost of Debt 1/ YTM approach yield of debt if held to
maturity
when reliable 2/ Debt rating approach based on the debt issue
market prices for the - use yields on comparable-rated bonds for
company’s debt is not closely matched maturities
available
LOS c - calculate/interpret Review - 2
Issues 1/ floating rate coupons - unknown cost

2/ Debt with optionlike features - interest rate contingent costs
3/ Non-rated debt - synthetic ratings not reliable
4/ Leases - cost of lease must be included in CoC
LOS d - calculate/interpret/ = no tax adjustment
LOS e - calculate/interpret/ new issuances and/or retained earnings

1/ CAPM: E(re) = Rf + ERP single factor model
E(re) = Rf + RP1 + RP2 + … + RPn - multi-factor

model
Estimating ERP: a) historical EPR approach
- average (G/A) historical premium ( − )
b) survey method - avg. of a panel of experts

Review - 3
LOS e - calculate/interpret/
limitations: market risk is not stable over time ERP is not

risk aversion may change over time static
estimates are sensitive to the method of estimation
and the historical period covered
2/ Bond yield plus risk premium approach: (companies with

publicly-traded debt)
re = rd + risk premium
risk of company’s stock over its debt
rf + spread ~ 3% - 5% in developed countries
· YTM
· Debt Rating
CAPM: re = Rf + · ERP
· historical
wacc = wdrd(1 - ) + wprp + were
· survey
Bond yield + risk premium
target capital
re = rd + RP & rd = Rf + spread
structure
Review - 4
LOS f - explain/demonstrate/
A/ for public companies: OLS = +
- estimate of influenced by a) choice of market index
b) time period and
- since tends to regress to 1: frequency of obs.
use Blume adjustment
- adjusted = ( )+ ( )
B/ for thinly traded or private companies

- OLS won’t work
- find a peer company and:
D peer’s
1/ unlever its =
+( − ) E
2/ relever = +( − ) D target’s
E
Review - 5
LOS f - explain/demonstrate/
B/ for thinly traded or private companies
- if target’s > peer’s , target’s > peer’s
LOS g - explain/demonstrate/
Floatation costs cost to raise additional financing
Method 1 incorrect directly incorporate into CoC
re = + or re = +
− ( − )
$ %
Method 2 correct reduce NPV by F or F(1 - )
- F is treated as an additional outflow at = 0

Capital Structure
Review - 1
LOS a - describe/
capital structure - the mix of debt and equity used to finance
a company’s assets
Start-up Growth Maturity

Debt availability very limited Limited/improving high
Cost high medium low
% in cap. st. close to 0% 0 - 20% 20% +
(secured) (unsecured) - debt being
used to optimize Cap. Str.
Unique situations:
1/ Capital intensive businesses with marketable assets
- assets can secure debt
2/ Cyclical industries - lower leverage
3/ Capital light businesses - little debt
Review - 2
LOS b - explain/
Assumptions: homogenous expectations - expected cash flows
perfect capital markets - no transaction costs, no
taxes, no bankruptcy costs (symmetric info.)
risk free lending/borrowing
no agency costs
Independent decisions - financing vs. investment
Proposition 1: Capital Structure Irrelevance VL = Vu (no taxes)
- MVcompany not affected by capital structure decisions in

the absence of taxes
- wacc is unaffected wacc = wdrd + wprp + werr
Proposition 2: higher fin. leverage raises the cost of equity
= +( − ) implies = +( − )
- no taxes
Review - 3
LOS b - explain/
- with taxes Prop. 1: VL = Vu + D
Debt tax shield
wacc = wdrd(1 - ) + wprp + were

- wacc decreases as D↑
Prop. 2: re = r0 + (r0 - rd)(1 - )

CoC no tax CoC taxes
m = (r0 - rd)
m = (r0 - rd)(1 - )
wacc
wacc
rd rd
- cost of capital does not - cost of capital does depend

depend on capital structure on capital structure
Review - 4
LOS b - explain/
implicit
Cost of financial distress
explicit
- raises both rd and re , and thus wacc
LOS c - describe/calculate/interpret/
Optimal Capital Structure at which wacc is minimized
and firm value is maximized
- balances D with PV(FD)
CoC
VL = Vu + D - PV(FD)
re
Static trade-off theory of capital structure
wacc
- actual may differ from optimal
after-tax rd
opportunistic financing
optimal
market price fluctuations
optimal range floatation costs
Review - 5
LOS d - explain/
1/ Capital structure policies - policy may focus on reasonable
levels of debt (vs. D & PV(FD))
- typically driven by debt covenants or preferred credit
rating
- policy will use BVd/BVe (not MV)
more stable, used by lenders/rating agencies
2/ Financing and investment interdependence

- nature of the investment may dictate type of financing
e.g./ s.t. projects with s.t. financing

foreign investments with foreign debt (hedges fx risk)
3/ Market conditions - opportunistic - borrow when rates/spreads are

low, sell equity when prices are
high
- financing may be done to meet
index requirements
Review - 6
LOS d - explain/
3/ Market conditions well-developed legal systems lower borrowing
costs
4/ Information asymmetries and signalling
- the more asymmetry, the higher rd and re
- investors watch company financing decisions for

insider opinions about company prospects
- pecking order theory - mgmt. selects financing methods

from lowest info. content upwards
RE - Debt - Equity
signals signals that
use of debt
that debt & equity shares are
signals confidence
were too expensive overvalued
in company
(debt signalling)
Review - 7
LOS d - explain/
Agency costs - cost arising from conflicts when an agent makes
a decision for a principal
- smaller mgmt. equity stake - higher the cost

- higher use of debt ‘Jensen’s free cash flow hypothesis’
- higher debt levels discipline mgmt.
- lower FCF reduces opportunities for misuse
LOS e - describe/
A/ Debt vs. Equity conflict
- bondholders prefer cap. st. decisions that reduce risk over time
- equity holders prefer higher levels of leverage higher levels
of expected return
- upside for bondholders always limited to
return of capital
- Distressed debt potential upside, perspective becomes more

like equity holders
Review - 8
LOS e - describe/
A/ Debt vs. Equity conflict
- senior/secured debt less sensitive to conflict
- long-term debt - potential conflicts greater
- safeguards for bondholders - covenants
- company desire to keep rating
- company desire to avoid FD costs
B/ Preferred Shareholders - lack covenant protection, behind debt on

claims
C/ Private equity/Controlling shareholders
- issuance/retirement may affect voting control
e.g./ - dual-class shares may issue more non-voting shares
- majority shareholder may favour debt when equity would
be better
D/ Banks/Private Lenders - access to more direct info.
- may be a critical funding source - more collaborative
and more influence on the company
Review - 9
LOS e - describe/
E/ Other Stakeholders
customers/suppliers
employees
mgmt. & directors - interests aligned with shareholders
through share-based compensation
issues excessive compensation leads to entrenchment

compensation tied to company size leads to
empire building
reliance on stock options motivates risk
regulators/government taxes may have an affect

on cap. st. domestically
cap. st. may be internationally
a regulatory issue
Measures of Leverage
Review - 1
- Operating leverage - mix of FC vs. VC
- use of FC in company’s cost structure
- financial leverage - level of debt - use of debt in company’s
capital structure
- both increase the volatility of earnings & cash flow
=
/ /
- operating BEP = - removes effect of financial
/ leverage
$ -
cup - NI = -FC + (CM/U Q)
graph -
Q if Q = 0
- NI = -FC
-
-
p - industry structure Review - 2

Business Risk Sales Risk
(not much x elasticity of demand
discretion) Q - cyclicality
Operating Risk - FC - higher FC, higher
(discretionary to vs. operating risk, higher
some extent) VC business risk
Debt
Financial Risk - level of debt - fixed financing charges
Preferred
(far more discretionary)
- the % . . for a
Degree of Leverage/ % . .
= given % (typically
- calculated at a %
1% a 1% )
particular Q
% . .= % 1%
e.g./ if DOL = 1.9
then % . .: % × /
gross
= 1.9% . .
=
( × / )−
% . .: %
= 9.5%
DOL Review - 3
DOL drops as Q ↑
+
lowest value of DOL = 1

% = % . .
-
Operating BEP
- no operating leverage
- low operating leverage companies
- defensive
- - high operating leverage companies
- cyclical
- Degree of Financial Leverage/ DFL
%∆ %∆ = % . .
=
%∆ . . C - fixed
- calculated at a particular − financing
level of Op.Pr. ( − )− costs
. .
- if DFL = 1.5 & Op.Pr. ↑ 20% , % NI = 30%
Review - 4
· if is high, capacity for higher DFL
(assets to back debt)
· if revenues have below average business cycle sensitivity,
capacity for higher DFL
% . . % %
= =
% % . . %
× TL
−
×
− − − DOL
= DFL
− −
=
Q

2022 LI CorpIssuers

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2022 LI CorpIssuers

Uploaded by

Copyright:

Available Formats

Last Revised: 06/08/2021

Level I - Corporate Issuers

Introduction to Corporate Governance and Other ESG Considerations 2

Cost of Capital - Foundational Topics 37

© markmeldrum.com. All rights reserved.

Introduction to Corporate Governance and Other ESG Considerations

a. describe corporate governance;

b. describe a company’s stakeholder groups and compare interests of

c. describe principal–agent and other relationships in corporate governance and

d. describe stakeholder management;

e. describe mechanisms to manage stakeholder relationships and mitigate

f. describe functions and responsibilities of a company’s board of directors and

g. describe market and non-market factors that can affect stakeholder

h. identify potential risks of poor corporate governance and stakeholder

i. describe factors relevant to the analysis of corporate governance and

j. describe environmental and social considerations in investment analysis;

k. describe how environmental, social, and governance factors may be used in

- the arrangement of checks, balances, and incentives a

Shareholder Theory – the most important responsibility of

Stakeholder Theory – broadens focus to also include customers,

Creditors/ bondholders & banks (typically)

Managers & Employees/ senior exec. motivated to maximize

- interests of – managers & employees may conflict

Board of Directors/ elected to protect shareholder interests,

one-tier – single BOD of executive & non-executive directors

two-tier – 2 separate boards supervisory board

Suppliers/ primary interest get paid in a timely manner

Governments/Regulators – seek to protect interests of the

· Shareholder vs. Manager/Director

- related-party transactions – controlling shareholder has

- dual class shares – voting vs. non-voting

prefer riskier projects performance & - describe

with higher return lower risk activities

· Other Stakeholder Conflicts/

· Customers vs. Suppliers – lenient credit terms to

· Shareholders vs. governments/regulators

· legal infrastructure – rights established

· organizational infrastructure – internal

Mechanisms of Stakeholder Mgmt.

· Proxy voting – allows another to vote on your behalf

Board of Directors/ elected by shareholders to provide broad

Reporting & Transparency/ regulatory disclosures & investor relations

Policies on Related-Party Transactions/

Say on Pay – Shareholders vote on executive pay

Contractual Agreements with Creditors/

Contractual Agreements with customers & suppliers/

Laws & Regulations

· Publicly traded companies are generally required to

BOD & Committees

- some even seek age/gender/cultural diversity

executive – members of senior mgmt.

CEO & Chair position increasingly separated

- guides/approves strategic direction of company

b) Governance Committee – ensures that the company

d) Nominations Committee – identifies candidates who are

e) Risk Committee – helps determine the risk policy,

- reviews material investment opportunities

· type of committee used may vary by jurisdiction

Factors Affecting Relationships

beyond the AGM

2) Shareholder activism – attempts to compel mgmt. to

3) Competition & Takeovers

superior protection of the