2024 L1 CorpIssuers

Last Revised: 06/14/2023
2024 Level 1 - Corporate Issuers

Learning Modules Page
Organizational Forms, Corporate Issuer Features, and Ownership 2
Investors and Other Stakeholders 8
Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits 15
Working Capital and Liquidity 24
Capital Investments and Capital Allocation 37
Capital Structure 50
Business Models 67
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curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.
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1
Organizational Forms, Corporate Issuer Features, and Ownership
a. compare the organizational forms of businesses
b. describe key features of corporate issuers
c. compare publicly and privately owned corporate issuers
2
Forms, Features and Ownership
Organizational Forms
Sole Trader/Proprietorship: No separate legal identity
Owner operated
Owner has unlimited liability
Profits taxed as personal income (pass-through)
Financed by owner’s access to capital
General Partnership: No separate legal identity
Partners operated
Partners have unlimited liability
Financed by partner’s access to capital
Limited Partnership: No separate legal entity
General partner operated
GP has unlimited liability LPs have limited liability
Financed by partners’ access to capital
Organizational Forms
Limited Liability Company: Separate legal entity
Board and Management operated
Owners (shareholders) have limited liability
Limited Company Profits taxed as personal income (pass-through)
Private Public Unbounded access to capital, unlimited business potential
There may be legal limits on number of owners, require a
Privately Publicly
Owned Owned vote for transfer of ownership
[listed]
Public Limited Company: Separate legal entity

(corporation) Board and Management operated
Owners (shareholders) have limited liability
Profits taxed at corporate level (dividends taxed as
personal income)
No restrictions on ownership/transfer
3
Key Features - Corporate Issuers

Corporations that raise capital in the financial markets are known as Corporate Issuers
Separate Legal Entity - Formed through filing articles of incorporation with regulatory authority
- Can engage in similar activities to individuals e.g. hire employees, sign
contracts
- Subject to regulation in jurisdictions where it is - incorporated
- conducts business
- finances itself
Owner-Manager Separation - shareholders own the business, not involved in day-to-day
operations
- sh. appoint board of directors ➞ who appoint executive management
- executive management undertake - investing, financing, operating
decisions
- Responsibility directors & management:
‘Act in the best interests of sh. and, indirectly, all stakeholders’
if they do not, shareholders can vote to replace the board
Separation of ownership and management allows corporation to obtain financing from a

much wider range of sources

Risk/Return shared equally between shareholders (owners), all have limited liability
Liability is limited to the amount invested in the company - minimum share value = 0
- not responsible for debt
Sources of Finance
Equity - The sale of shares to investors Debt - Loans
- Reinvestment of profits - Bonds
- Leases
Returns = Dividends Interest, Return of principal
Equity or debt can be raised via - a private contractual agreement between two parties
or - a standardized instrument that might be tradeable
between investors on a public exchange = a security
4

Financial and Economic Balance Sheet
Financial Balance Sheet - Assets, obligations (liabilities), equity
Economic Balance Sheet - adds other intangible/hard to quantify assets & liabilities:
e.g. Human Capital, Customer Relationships, etc.
Financial and Economic Income Statement

Financial Income Statement - Income after fixed obligations have been met (accounting
profit)
Economic Income Statement - Return in excess of owner’s required return on equity
(economic profit)
Net Income = Return on Equity
Equity
Economic profit = Required return on equity - Return on equity

Taxation
Shareholders may suffer double taxation - corporate tax on profits + personal tax on
dividends
e.g. Pre-Tax Income 838
corporate tax (31.5%) (264) 264 + 172.2
= 52.05%
574 838
Personal Tax Rate 30% (172.2)
Dividend After Tax 401.8
Some jurisdictions offer relief: - Personal tax credits on dividend income

- low/zero corporate tax rates on earnings paid
out as dividends
5
Public v. Private
Public (listed) company: shares listed on a stock exchange:
- liquidity ➞ secondary market for shares
(% shares actively traded = free float)
e.g. L’Oréal S.A. Family owned 33%
Nestlé 23%
Free Float 44%
- price transparency (value = market capitalization = #shares × price)
- extensive disclosure and reporting requirements
Regulator Stock Exchange
Registration Listing Requirements
Disclosures
Private (unlisted) company: - No ready market for shares, sale requires buyer,
company agree?
- No price transparency (valuation requires a model)
- Fewer disclosure and reporting requirements
Public v. Private
Share Issuance
Private Company: Private Placements: Company raises capital from accredited investors
risks/terms outlined in private placement memorandum
Go Public : Initial Public Offering (IPO) : company raises capital from public
(private ➞ public) or direct listing : no new shares (no capital raised)
or SPAC : shell company raises capital via IPO then make an acquisition
[special purpose acquisition company]
or via acquisition
secondary offerings (secondaries) : Company raises capital from public

[secondary market: issued shares trade between market participants]
6
Public v. Private
Go Private : All shares acquired and company delisted from exchange
(Public ➞ Private) Price paid is typically a premium to current price
Commonly financed using debt
Motivation: Realize Value
- Restructure, change mgmt., sell assets etc.
Public v. Private trends : many emerging economics have growing number of public
companies
- high growth
- transition to open market structures
- foreign capital inflows
many developed economies have declining number of public
companies
- mergers & acquisitions
- growing number of private capital sources
- preservation of ownership and control
Public v. Private
Corporate Ownership
Shareholders may include : individual investors, institutional investors, other
corporations, non-profits, governments
governments may create legally separate corporations

and maintain ownership (possibly 100%)
e.g. United States Postal Service (USPS)
common for provision of public goods
may be used to profit from major domestic industries
banks often established as government owned entity in
emerging economies, then transferred to private via IPO
technology may be a catalyst for shift from gov’t. ➞ private
e.g. Telecomms
7
Investors and Other Stakeholders
a. compare the financial claims and motivations of lenders and shareholders
b. describe a company’s stakeholder groups and compare their interests
c. describe environmental, social, and governance factors of corporate issuers

considered by investors
8
Investors and Other Stakeholders
Debt and Equity Claims

Debtholders (Lenders) Equity Investors
Reinvested
Provide capital with a finite Assets Provide permanent capital
maturity Generate
Issuers obligated to make interest Revenue Issuers do not commit to
and principal payments on set dates (COGS) suppliers future dividends or repayments
Debtholders have no decision-making (wages) employees Equity holders have voting
power within the corporation (interest) debtholders rights for key decisions
Debt contract may impose financial (taxes) government Cash distributions are at the
requirements or legal claims on Profit discretion of the board
certain assets
Interest is paid before distributions (Dividend) Retained Equity investors own what is left
to equity investors after all other payments are made
Shareholders
[a priority claim] [a residual claim]
Lower risk for Investor, cheaper for Issuer Higher risk for Investor, costlier for Issuer
Also tax deductible Debt increases risk for equity investors

The impact of debt on equity returns (ROE) and risk:
Assume: Revenue = 100 Expenses = 70 Interest Rate on debt 20% [ignore taxes]
Equity Financed Company Debt and Equity Financed Company
Assets 100 Assets 100
Debt - Debt 75 (Financial Leverage)
Equity 100 Equity 25
ROE = 100 - 70 = 30% ROE = 100 - 70 - (0.2 × 75) = 60%
100 25
Lower ROE Higher ROE
Assume Revenues : Increase by 20% and Decrease by 20% [no change in costs]
Increase: ROE = 120 - 70 = 50% Increase: ROE = 120 - 70 - (0.2 × 75) = 140%
100 25
Decrease: ROE = 80 - 70 = 10% Decrease: ROE = 80 - 70 - (0.2 × 75) = (20%)

100 Lower Risk 25 Higher Risk
9

Conclusion: Debt Financing increases risk
But : Additional share issuance reduces existing shareholders’ fractional ownership
= dilution
Firms can offset the impact of dilution by generating incremental profit
Assume: Previous all equity financed firm is choosing finance for extra 20 of LT assets
ROI on new investment = 30%
Initially: Cash 30
Other 20
LT Assets 50
100
Equity 100
Revenue 100
Expenses (70)
Net Income 30

Payoff Asymmetry
Shareholder Payoff Debtholder Payoff

Shareholder Debtholder
Return Potential
Maximum Loss
Debt Investment Risk
Debt Debt
10

The firm has one set of cash flows that will be split between capital providers with
differing risk and return profiles Potential Conflict
Shareholders - maximize their residual cash flows: unlimited upside Take Risks ➞ Returns
Maximize debt use
Pay dividends
Bondholders - maximize likelihood of timely payments: limited upside No benefit from ↑ risk
No benefit from ↑ leverage
Hence the Contractual

Restrictions
- minimum cash flow
coverage
- maximum leverage
Stakeholder Groups
“Stakeholders depend on the company and the company depends on them”
Any party with a vested interest in a company
Stakeholders may compromise or enhance a company’s ability to maximize shareholder
return
Shareholder Theory of Governance - stakeholders only considered to the extent
that they affect shareholder value
Stakeholder Theory of Governance - corporate governance should consider all
stakeholder interests
- ESG should be an explicit objective of the board
How do you balance multiple objectives?

How do define/measure non-shareholder objectives?
How to compete globally with competitors who don’t have these constraints?
Cost
11
Stakeholder Groups
Primary Stakeholder Groups
Investors : shareholders , debtholders (these we already know)
Private Debtholders Public Debtholders (Bondholders)

often hold debt to maturity tradeable securities
direct access to management and reliance on public information and
non-public information financial statements
critical lenders may have influence little to no influence
wide variation in risk appetite (may have influence if restructuring
may engage in distressed investing debt)
Stakeholder Groups
Board of Directors
Elected by shareholders to advance their interests
Inside Directors - links to the company (includes founders and current, former,
managers)
Independent Directors - no material relationship with the company
- may better represent the interests of minority shareholders
Major stock exchanges require certain corporate governance standards
e.g. London Stock Exchange : 50% directors must be independent
Requirements often include rules re: expertise, diversity, competency
Two-Tier Structure - separate supervisory board oversees board of directors
Independent Directors
Staggered Boards - groups elected separately in consecutive years
Limits the ability of shareholders to effect a major change of control
But, allows for continuity
12
Stakeholder Groups
Managers: Led by CEO, determine and implement strategy and day-to-day operations
Stock based incentive plans align interests with shareholders
Employees: Corporations rely on human capital of employees
May have equity via compensation, form unions to negotiate pay and
conditions
Customers: Require product to satisfy needs at a reasonable price, meet applicable
quality and safety standards
May require ongoing support
Major customers can exert influence
Retail customer satisfaction often correlated with revenue growth
Environmental & social impact of products of growing importance
Suppliers: Primary interest is being paid in a timely manner
Interest in a company’s long-term stability important if specialized products
Government: Governments seek to advance the interests of their constituencies
Regulators have an interest in compliance, govt.’s like tax revenue
ESG
More difficult to incorporate generally well understood

into decision-making process straightforward to evaluate
Growing in importance due to: 1. Financial impact of ESG factors has risen e.g. disasters
2. Interest in E, S, has grown (particularly amongst the young)
3. Increased ESG regulation
Companies being forced to view E, S issues as internal costs not negative externalities
13
ESG
Environmental Factors
Materiality varies across industries (material: significant impact on results or business model)
Natural-resource-intensive industries: direct material effect on operations
Climate Change Considerations
Physical Risks: damage, destruction
Transition Risks: losses related to transition to a lower-carbon economy
e.g. Stranded Assets - emission intensive reserve assets becoming unviable
Social Factors
Practices concerning, and impacts on, employees and human capital, customers, communities
Minimizing social risk can lower costs (higher productivity, lower turnover)
Governance Factors
Analysis usually found in issuer’s proxy statements, annual reports
ESG
Evaluating ESG Risks and Opportunities
Quantify the impact in financial terms and calculate impact on discounted future cash flows
Significant long-term adverse events immediately and disproportionately affect equity
claims
Fixed obligations less affected unless ability to make payments is compromised
Impact is dependent on maturity e.g. 10-year Bond v. 2-year Bond
Analysts should consider ESG by using sensitivity/scenario analysis

e.g. lower discount rates for food company moving to sustainable sources
increase employee turnover assumption (increasing operating costs) in case of bad
publicity surrounding working conditions in a hotel chain
14
Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits
a. describe the principal-agent relationship and conflicts that may arise between
stakeholder groups
b. describe corporate governance and mechanisms to manage stakeholder

relationships and mitigate associated risks
c. describe potential risks of poor corporate governance and stakeholder management

and benefits of effective corporate governance and stakeholder management
15
Corporate Governance
Conflicts
Corporate stakeholder relationships include: Contractual, Principal-Agent, other
one party hires another to perform

a task or service, can be present
with or without a contract
The agent is expected to act in

the principal’s best interest
The agent possesses more information
than the principal (asymmetry)
Conflicts arise when interests diverge
Agency Costs
As information asymmetry increases Direct Indirect
return demanded by shareholders, lenders increases e.g. Monitoring e.g. Foregone
Profits
Conflicts
Shareholder v. Directors, Management
Information asymmetry reduces ability of shareholders to assess performance
increases with lower levels of institutional ownership, free float
Principal tool to align interests: compensation
But, interest may still diverge due to:
Insufficient Effort - Unable, unwilling to make investments, manage costs, make hard decisions
Too little monitoring of employees/controls ➞ Risks and Litigation
Too little time due to outside interests
Inappropriate Risk Appetite - Stock grants, options ➞ excessive risk taking
No stock grants, options ➞ risk-averse decision making
(Stockholder’s diversified portfolios increase risk tolerance)
Empire Building - Compensation tied to business size ➞ too many acquisitions
Entrenchment - Play it safe ➞ copy competitors, avoid risks, avoid speaking out
Self Dealing - Exploit firm resources ➞ perquisites (private planes, memberships etc.)
Smaller stakes, less cost to bear for management
16
Conflicts
Controlling v. Minority Shareholders
Dispersed Ownership: Many shareholders, none with control
Concentrated Ownership: Individual shareholder or group who can exercise control
= Controlling shareholders - can be a family, other companies,
government
Example Conflicts: Controlling shareholder: Founding family seeking diversification

Minority shareholders: Hold diversified portfolios - focus on max s/h value
Controlling shareholder: Long-term shareholder - multi-decade perspective

Minority shareholders: Seeking quicks gains via asset sales, cost cutting
Voting Schemes
Dual-Class Structure: Class A: one vote per share, publicly held and traded
Class B: several votes per share, held by company insiders/founders
Allows one group of shareholders to have disproportionate power: Personal
> Will of
Interest Majority
Conflicts
Which group is most negatively affected

by the increase in leverage?
Welders employed by the company
The company’s dealers
The aluminum suppliers
17
Corporate Reporting and Transparency

External stakeholders rely on corporate reporting for information on performance and
position investors rely on corporate reports to:
Assess company performance and that of its directors/management
Make valuation and investment decisions
Vote on key corporate matters or changes
Ensure compliance with legal commitments in debt contracts (via trustee)
Public Companies: Annual reports, proxy statements, company disclosures, investor relations,
etc.
operations, objectives, audited F/S, governance structure, ownership
structure, remuneration policies, related-party transactions, risk factors
Most jurisdictions, stock exchanges require audited financial statements
Private Companies: Information disclosed to the public to the extent required by regulations
(or voluntarily)
confidential information shared with investors as negotiated (not
standardized)
Most jurisdictions don’t require audits

Shareholder Mechanisms
No global standard set of shareholder rights exists. Quoted are common examples
Shareholder Meetings : Annual General Meeting (AGM)
- discuss board elections, auditor appt., approval of F/S,
dividends, director and auditor compensation, equity based
compensation plans, “say-on-pay” non-binding votes on
compensation plans
Extraordinary General Meetings (EGMs)
- called when resolutions requiring shareholder approval
proposed or by request by a specified minimum number/%
shareholders
e.g. special election, mergers, voluntary liquidation
- shareholders unable to attend vote by proxy
Example: AGM or EGM? Appointment of external auditors
An overview of corporate performance
An amendment to a corporation’s bylaws
18

Shareholder Activism: Investor strategies to compel a company to act in a desired manner
Aim is to rapidly increase shareholder value
or - Social, Political, Environmental Considerations
Hedge Funds are among the predominant shareholder activists
Fees are based on Returns, able to fund large positions with
leverage (unlike ‘Regulated’ investment entities)
e.g. Encourage corporation to focus on what it does well
Encourage restructuring, replacement of management
Shareholder Litigation: Activists may pursue ‘shareholder derivative lawsuits’

s/h acting on behalf of Co. in place of directors/management
who have failed to adequately act for the benefit of the company
Laws restrict s/h taking legal action in some countries
minimum thresholds or prohibition

Corporate Takeovers: Proxy Contest/Fight: Group seeking controlling position persuades
other shareholders to vote for group
Tender Offers: Invitation to existing s/h to sell to group
gain control of board, and hence mgmt.
Hostile Takeover: Attempt to acquire a company without the
consent of its management
Contests for control attract arbitrageurs and takeover specialists
Purchase shares from existing s/h, sell to highest bidder
Anti-Takeover Measures: Preservation of employment should incentivize board to max s/h
wealth
Threat of removal may have a negative impact on governance
Staggered board elections - prevent replacement of entire
board
Poison Pill - shareholder rights plan - one shareholder
purchasing a given percentage of shares
triggers right to buy more shares at a discount
19

Creditor Mechanisms
The rights of creditors are established by law, contracts with the company
Bond Indenture : Legal contract that describes the structure of the bond, the
obligations of the company, the rights of the bondholders
Terms and Conditions may - Require certain actions
- Prohibit certain actions
- Require assets to be pledged
Creditor Committees: Established when company files for bankruptcy (in some countries)
Ad hoc committees may be formed by bondholder groups when
a company is struggling

Board Mechanisms
Board of Directors
[Specific functions delegated to committees, responsibility is not delegated]
Audit Committee Nominating/Governance Committee Compensation Committee
100% independent members Typically independent members 100% independent
At least one with financial/ Appraises director and manager Develops remuneration
accounting expertise candidates policies
Monitors financial reporting Oversees board election process Sets performance
process Sets nomination procedures criteria
Supervises internal audit Oversees the establishment of
Recommends external auditor corporate policies - e.g. corporate Other Committees
Proposes remedial action governance, code of ethics, ... Often industry specific
based on audit reports e.g. Risk Committee
May oversee I.T. security Technology and
Innovation Committee
20

Employee Mechanisms
Labor Laws : country specific, define standard rights and responsibilities
Unions : employees have right to form unions to advocate
in some countries employees may have board representation
Employee Stock Ownership Plan: alignment of interests
Customer and Supplier Mechanisms
Contracts : specify prices, rights and responsibilities, etc.
Social Media : virtually cost free method to compete with management to
influence public sentiment
Government Mechanisms
Laws and Regulations : Protect and enforce property and contract rights, rights of
specific groups industries more likely to affect public or
stakeholder interests more heavily regulated (e.g. Financial
Services, Health Care)
Corporate Governance Codes: Guiding principles for publicly traded companies ‘comply
or explain’
Stock exchanges may have listing requirements

Examples Ad hoc committee
Which protects creditor’s interests? Poison Pill
Tender offer
Oversight accounting policies

Which is a responsibility of audit committee? Adoption of proper corporate governance
Recommending auditor remuneration level
Activists rarely include hedge funds

Shareholder activism? Regulators play a prominent role
Primary goal is to increase shareholder value
21

Weak corporate governance can lead to competitive disadvantage
Strong corporate governance can increase competitiveness and efficiency
Operational Risks and Benefits
Benefits : Mitigation, identification, control of risk factors such as fraud
Clear delineation of responsibilities
Alignment of interests improved decision making
Risks : Adverse performance
One stakeholder group benefits at the expense of others
Management make decisions solely for their own benefit
e.g. Theranos : Health care company. 2014: valuation USD 10 billion 2018: ceased operations
Board: Very little knowledge of medical technology
Product Testing: No independent expert validation of blood testing product
No peer-reviewed publications by the company
Whistleblowers: Ignored by board, fired by company

Legal, Regulatory, and Reputational Risks and Benefits
Benefits : Stakeholders seek long-term relationships with companies that have a
reputation for respecting constituent and stakeholder rights
Reputation enhances ability to attract talent, secure capital, improve sales, ...
Mitigation of conflicts of interest, agency problems
Risks : Government/regulatory investigation for violation of laws
Lawsuits from other stakeholders
Loss of reputation due to improperly managed conflicts of interest
e.g. Volkswagen AG : 2014 : Diesel vehicles failed emissions testing
VW responds by questioning testing process
2015 : VW admits falsifying emissions data
To Date : USD 37.7 Billion fines
22

Financial Risks and Benefits
Benefits : Increased investor confidence reduces required return, higher valuation
Increased likelihood of credit rating upgrade from speculative to I.G.
Listed Co.s with experienced audit committees with financial expertise
have shown stronger performance during periods or crisis
Board diversity and independence appear to be key factors in firm
valuation
Risks : Weak management of creditor interests can lead to default
23
Working Capital and Liquidity
a. explain the cash conversion cycle and compare issuers’ cash conversion cycles
b. explain liquidity and compare issuers’ liquidity levels
c. describe issuers’ objectives and compare methods for managing working capital
and liquidity
24
Working Capital And Liquidity
What we talk about when we talk about Working Capital and Liquidity
Definition : Working Capital = Current Assets - Current Liabilities

Networking Capital = Current Assets Current Liabilities
- cash - - short-term debt
- marketable securities - current debt
(Issuer) Liquidity = ability to pay short-term liabilities
A Simplistic Balance Sheet: That Same Simplistic Balance Sheet:

Long-Lived Assets 5,000 Long-Lived Assets 5,000
Current Assets 2,000 Working Capital 1,500
Total Assets 7,000 6,500
Current Liabilities 500 Invested Capital 6,500

Long-Term Debt 2,500
Equity 4,000
7,000
Operating Cycle
Most helpful to picture a company that makes and sells physical goods
Collection
Customer Credit Cash
Operating
Cycle
Accounts - Sales Purchases - Accounts
Receivable Payable
- Inventory
Finished Goods Raw Materials
Production
25
Cash Conversion Cycle
Purchase Pay For Sell Collect

Goods Goods Finished Product Cash

(DOH)
Days of Inventory on Hand
(DSO)
(DPO)
Days Sales
Days Payable Outstanding
Outstanding
Cash Conversion Cycle = DOH + DSO - DPO
Airlines
Long cycle may be function of industry
Pharmaceuticals Long cycle v. industry peers may be
problematic
26

Example calculation (many more in FSA LM 11)
Industria de Diseño Textil S.A. (Inditex) [largest brand Zara]
2021
Accounts Receivable 842 DSO: 842 × 365 = 11
Inventories 3,042 27,716
Accounts Payable 6,199 DOH: 3,042 × 365 = 93
11,902
Sales 27,716 DPO: 6,199 × 365 = (190)
Cost of Goods Sold 11,902 11,902
(86)
Shorter (or negative) = Better : Cash freed up to be used elsewhere
To Shorten Cycle:
Reduce DOH: Discontinue products, more frequent (just in time) deliveries, improve demand
forecasts
Reduce DSO: Prompt-Payment discounts, late fees, tighten credit standards, upfront deposits,
3rd party collection
Increase DPO: Negotiate with suppliers! - But, may miss out on discounts ...
Prompt-Payment Discounts
Increasing DPO may mean missing out on prompt-payment discounts
e.g. Discount: Standard payment terms 30 days, 2% discount for payment within 10 days
[notation: 2/10 net 30]
Paying after 30 days = effectively borrowing from supplier for 20 days:
Effective interest rate : e.g. $100 owed. 10 day payment: $100 × (1- 0.02) = $98
30 day payment: = $100
$ cost (20 days) $2
% cost (20 days) 2.04%
𝟑𝟔𝟓
% EAR "𝟏. 𝟎𝟐𝟎𝟒 &𝟐𝟎 ( - 1 44.6%
𝟑𝟔𝟓
Generally: "# 𝟏 + 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭% 1𝐏𝐦𝐭. 𝐏𝐞𝐫𝐢𝐨𝐝 . 𝐃𝐢𝐬𝐜. 𝐏𝐞𝐫𝐢𝐨𝐝
2- 1 MADNESS!
𝟏𝟎𝟎% − 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭%
Borrow at an EAR < 44.6% and
pay early
27
Working Capital
Lower working capital = more efficient operations
Working capital to sales ratio allows comparison across firms of different sizes
calculation:
Cash 40
Marketable Securities 70 Working Capital : 335 - 220 = 115
Accounts Receivable 85
Inventory 130 Net Working Capital: 335 220
Prepaid Accounts 10 (40) (60)
335 (70)
225 - 160 = 65
Accounts Payable 130
Accrued Expenses 30 Working capital levels and the cash conversion cycle
Short-Term Bank Loan 60 are positively correlated
220 Reduce one, you’ll reduce the other
Working Capital
Example calculation (many more in FSA LM 11)
Industria de Diseño Textil S.A. (Inditex) [largest brand Zara]
2021
Accounts Receivable 842 DSO: 842 × 365 = 11
Inventories 3,042 27,716
Accounts Payable 6,199 DOH: 3,042 × 365 = 93
11,902
Sales 27,716 DPO: 6,199 × 365 = (190)
Cost of Goods Sold 11,902 11,902
(86)
Net Working Capital = (842 + 3042) - (6,199) = (2,315)

Net Working Capital to Sales Ratio = (2,315) = - 8.35%
27,716
28
Examples
Impact on CCC?
- Offer larger discounts to customers for prompt payment
- Lower reliance on just-in-time inventory methods
- Negotiate longer payment periods with suppliers
- Tighten credit standards for customers
An issuer is considering borrowing at 15% to take advantage of supplier terms of

1/14 net 30 (paying on day 14)
Day 14 : Pay $99
Day 30 : Pay $100
Cost (16) $1
%Cost (16) 𝟏 1.01%
𝟗𝟗
Liquidity
Asset/Liability: Liquidity = nearness to cash or settlement
[Assets] [Liabilities]
More Liquid Cash Accrued Payroll
Short Term Investments Accounts Payable
Accounts Receivable Lease Payment due in one month
Less Liquid Inventory Short-Term Debt
Issuer : Liquidity = Ability to meet short-term liabilities

depends on amounts and liquidity of short-term assets/liabilities
depends on business model and cash conversion cycle
If short-term liabilities > cash, issuer requires other sources of liquidity
29
Liquidity
Primary sources of liquidity : most readily accessible cash available:
use unlikely to affect ongoing operations
cash and marketable securities on hand (can be sold quickly without loss of value)
borrowings (banks, bondholders, supplier credit)
cash flow from business (takes time!) Primary long-term source of liquidity
Analysts analyse using statement of cash flows
Measures of Cash Flow
Cash Flow From Operations (CFO) : Free Cash Flow:
Cash Received From Customers X Cash Flow From Operations X
Interest and Dividends Received X Investment in Long-Term Assets (X)
Cash Paid to Suppliers and Employees (X) Free Cash Flow X
Taxes Paid (X)
Interest Paid (X) [more on this in FSA]
CFO X
[Does not account for capital investment required]
Liquidity
Secondary sources of liquidity : use may signal deteriorating financial health
Suspending/Reducing dividends
Delaying/Reducing capital expenditures - may lead to missed opportunities
Issuing equity - dilutes existing shareholders
Renegotiating contract terms - short ➞ long-term debt, rent, leases, suppliers
Selling assets - value?
Filing for bankruptcy - protection, restructure debt
e.g. A theoretical firm in a liquidity crisis is considering selling the following assets:
Fair Value (CADm) Liquidation Cost (%) CAD m Net
Short-Term Marketable Securities 10 0 0 10
Inventories and Receivables 20 10 2 18
Real Estate 50 15 7.5 42.5
Subsidiary 30 20 6 24
110 15.5 94.5
30
Liquidity
The cash conversion cycle has a significant impact on liquidity
Lagging cash inflows = Drag on liquidity Accelerated cash outflows = Pull on Liquidity
Drags Pulls
Uncollected Receivables Early Payments
Obsolete Inventory Reduced Credit Limits
Borrowing Constraints Limits on short-term lines of credit
Low liquidity positions
e.g. A firm experiences three trends:

1. An increase in average days of sales outstanding
2. An increase in days of inventory on hand
3. An increase in credit limits offered by suppliers
Liquidity Ratios
Ability to meet short-term obligations - level of liquidity required differs by
industry ➞ banking
Adequate? Depends on analysis of historical funding needs, access to capital
Current Ratio Current Assets [assumes inventory, recbles liquid]

Current Liabilities
Higher = higher liquidity
Quick Ratio Cash + Short-Term Marketable Investments + Receivables Lower = Reliance on CFO,
Current Liabilities outside financing
Cash Ratio Cash + Short-Term Marketable Investments [crisis measure]

Current Liabilities
31
Liquidity
20X2 20X1
Net Working Capital 65 16
Current Ratio 1.52 1.36

Quick Ratio 0.89 1.00
Cash Ratio 0.50 0.60
Liquidity
32
Working Capital and Liquidity Management

Objective : Balancing Act - Firm Value v. Accessible Funds
Maximize Firm Value Maintain ready access to funds necessary for

day-to-day operations and obligations
Shorten cash conversion cycle Minimize excess liquidity
(business model dependent)
1. Determine optimal working capital level
in relation to revenue
2. Forecast future working capital levels
based on revenue forecasts
Permanent Current Assets Variable Current Assets

Relatively constant levels Seasonal Inventory,
of inventory, recbles etc. staffing requirements

Approaches to working capital management differ in Level of short-term assets
Maturity of finance used
Conservative Moderate (matched) Aggressive
Large short-term asset Moderate short-term asset Smaller short-term asset
Position v. Sales Position v. Sales Position v. Sales
Greater reliance on Match Funding: Greater reliance on

long-term debt and equity Permant Assets Long-Term short-term finance
Variable Assets Short-Term
Permanent Permanent Permanent
Current Assets 100 Current Assets 80 Current Assets 60
Variable Variable Variable
Current Assets 50 Current Assets 40 Current Assets 20
Long-Term Debt/Equity 130 Long-Term Debt/Equity 80 Long-Term Debt/Equity 50
Short-Term Liabilities 20 Short-Term Liabilities 40 Short-Term Liabilities 30
33

Conservative: Largest current assets, most long-term finance = greater certainty at higher cost
Typical for firms in early-growth phase (access to short-term debt limited)
More established companies may be able to pass on higher financing costs to customers
Suitable if expectation is for flat to rising interest rates
Pros: Greater flexibility (but higher cost)

Certainty of working capital needed to purchase the necessary inventory
Reduces need to access capital markets during times of market stress
Financing costs known up front, extended payment term reduces cash required for
debt service
Stable permanent financing avoids rollover risk, gives cash flow stability
Cons: Long-term debt usually involves higher interest rates
High cost of equity
Permanent financing means not borrowing only as needed
Longer lead time required to establish financing position
Long-term debt may place restrictions on operations

Aggressive: Smallest level of current assets, more short-term finance = least flexibility, higher
returns
May be considered for firms with lower profit margins
More suitable when future sales and cash needs can be forecasted with a high degree of
Suitable given an expectation of stable or falling interest rates precision
May be adopted for firms that expect to shorten CCC, can quickly liquidate inventory,
collect AR
Pros: Lower financing cost
Flexibility to borrow only as needed (reduces total interest expense)
Short-term debt typically places fewer restrictions on operations
Flexibility to refinance if rates fall
Cons: Variable interest costs
Higher short-term cash needs to service debt
Rollover risk increases bankruptcy risk
More reliance on trade credit, collecting AR (may use 3rd party collection/AR sale)
34

Moderate: Permanent CA financed with long-term finance, variable CA with short-term
debt
A firm may adopt when a gradual shortening of the CCC is expected
Suitable if permanent CA can be forecast with a high degree of accuracy
Pros Flexibility to increase financing for seasonal needs

Diversified sources of funding
Example: Implications for an issuer of an increase in the line of credit offered to new
customers:
Reduction in inventory levels?
Faster collection, reducing receivables?
Increased need for working capital?
Ability to pay creditors sooner, reducing accounts payable?
No change?

Short-Term Funding
Financial flexibility is maximized by developing and regularly reviewing a short-term
financing strategy
Plan Objectives: - Maintain sufficient, diversified sources of credit to fund ongoing needs
- Secure adequate funding capacity to handle changing cash needs
- Make sure sources chosen have competitive terms
- Understand how rates may change with market conditions
- Include explicit and implicit funding costs in calculation of effective
cost
e.g. Cost of supplier financing
Factors Influencing Approach - Size - larger firms have more credit, sources may have minimum
size
- Creditworthiness - may lead to restrictions
- Legal Considerations - less developed markets ➞ more reliance
on trade credit
- Regulatory Considerations - e.g. banks! capital reqmts, central
bank funds
- Underlying Assets - are they attractive as capital
35
Examples
Short-Term Funding Cost:
Accounts Payable CAD 2 million, Terms 2/10 Net 30
Accounts Receivable CAD 2 million
Marketable Securities CAD 5 million
Payroll Liability CAD 200,000 which source to use to pay it?
Delay Paying Accounts Payable: Cost = 200,000 × 2% = 4,000

Sell Accounts Recble at 10% discount: Cost: 200,000 × 10% = 22,222
Sell Marketable Securities at 0.5% 0.9
Brokerage Cost (ignore tax): Cost: 200,000 × 0.5% = 1,000
Credit Terms: Changed from 1/10 net 30 to 1/15 net 30:

Impact on accounts receivable?
Credit Terms: Extend credit to customers with lower credit rating:
Drag, Pull, or no impact on liquidity?
36
Capital Investments and Capital Allocation
a. describe types of capital investments
b. describe the capital allocation process, calculate net present value (NPV), internal
rate of return (IRR), and return on invested capital (ROIC), and contrast their use
in capital allocation
c. describe principles of capital allocation and common capital allocation pitfalls
d. describe types of real options relevant to capital investments
37
Capital Investments and Capital Allocation
Capital Investments


Equity 4,000
7,000
Capital Investment = Long Term

Capital Investment and Allocation process are key to success:
- Gives insight into quality of management decisions
- How company creates value
Capital Investments
Definition: Investments with of one year or longer ➞ create long-term assets on
balance sheet
Accounting: B/S: Recorded at cost I/S: Periodic expense = depreciation or
amortization
Subsequently reduced by capital spending is smoothed,
depreciation/amortization matched to benefits earned
CFS: Cash outflow in cash flow from investing
e.g. Cost of PPE $120,000 , estimated useful life 3 yrs.:

Recorded at $120,000
𝟏𝟐𝟎, 𝟎𝟎𝟎
Depreciation of $40,000 % * charged to income statement each year
𝟑
End YR 1 B/S: Net PPE $80,000 YR 1 I/S: Depreciation Expense $40,000
End YR 2 B/S: Net PPE $40,000 YR 2 I/S: Depreciation Expense $40,000
End YR 3 B/S: Net PPE $0 YR 3 I/S: Depreciation Expense $40,000
38
Types of Project
Regulatory Compliance
Not discretionary, required to meet Rules and Standards
Typically increase expenses, do not increase revenue
But!
- Avoid fines. Allow business to continue
- May provide a barrier to entry - protect profitability
- Working with regulators helps tailor timing and impact to suit the business
- Early adoption may result in competitive advantage
But!
- High regulatory costs may reduce returns below minimum required level,
- Either pass on costs to customers if possible, or cease operations
Types of Project
Going Concern (Maintenance Capital Expenditures)
Continue the company’s current operations, maintain existing business size
e.g. Asset Replacement, IT hardware/software maintenance, improvements of existing
facilities
Risk : Low, easy to evaluate
e.g. New machine to improve efficiency: upfront cost v. periodic savings
Funding: Match term of new finance with lifespan of new assets

Avoids Rollover Risk, uncertain financing cost/availability during project
life of shorter-term debt
Debt maturing after end of project life may incur higher cost, buyback
cost
Analysis can estimate level of annual maintenance CAPEX using depreciation and
amortization expense - Accuracy depends on whether estimated useful life is correct,
whether historical cost = replacement cost
39
Types of Project
Expansion of Existing Business
Increase in Scale - increase in size of operations e.g. Research into new medications
(pharma)
Scope - extend to adjacent products e.g. Computer hardware ➞ video game
development
Risk: Higher than maintenance, compliance (greater uncertainty, longer, more capital)
e.g. Scale: Unforeseen problems executing project - sourcing inputs, production
bottlenecks
Scope: Complexity of managing multiple lines of business, new competitors
Funding: Firms in early phase - equity

More established firms have more access to debt (lower perceived risk)
Analysts consider competitive position and past performance by peers when analyzing
the likelihood of success
Types of Project
New Lines of Business (and Other)
New Line = Completely outside / minimally related to current business
e.g. Capital invested to explore new technology/business idea (startup-like)
Acquisition of a firm in a different industry/sector - Kirin (beverage)
Fancl. Corp. (cosmetics/
dietary)
Risk: Highest Risk Projects - unforeseen challenges of unfamiliar business

- overpayment (acquisition)
Analysts should review segmental disclosures if available

Access level of expansion expenditure: Total capital expenditure - maintenance
(estimated as depn./amtn.)
40
Types of Project
Example:
Office equipment producer

develops new line of peripherals Compliance
for gamers
Maintenance
Tire producer invests in solar
panel production to benefit from Expansion
government subsidies
New business
Global bank migrates on-site data
storage to cloud to improve efficiency
Property management company installs

new ventilation in all buildings to meet pollution regs.
Capital Allocation
Process used by firm’s management and board to make capital investment and return
decisions
Objective: Earn risk-adjusted returns > investors could earn on similarly risky
investments elsewhere (opportunity cost)
(similar process to portfolio construction but more granular - projects not entire companies
- uses proprietary, non-public info)
Steps: 1. Idea Generation - understand competitive environment, firm’s competitive position
- may be internally generated or via consultants
2. Investment Analysis - forecast amount, timing, duration, volatility of cash flows
3. Planning and Prioritization - most value enhancing on a risk-adjusted return basis
- only choose projects with returns > investor’s opp. cost
- consider interaction with existing operations, finance
- return unused capital to shareholders constraints
4. Monitoring and Post-Investment Review - monitor performance Real Options
- validate assumptions, inc. or dec. investment
41
Capital Allocation Tools

Net Present Value (NPV), Internal Rate of Return (IRR), Return on Invested Capital (ROIC)
Used by management to assess individual projects Aggregate measure used by
analysts
Example: NPV (cash flows equally spaced)

For Your Consideration: $50m investment today, $16m after-tax cash flows for 4 years,
$20m Yr. 5, Required rate of return 10%.
0 1 2 3 4 5
(50) + 16 + 16 + 16 + 16 + 20 = 13.136 Positive

(1.10) 1
(1.10) 2
(1.10) 3
(1.10) 4
(1.10) 5
Calculator: CF0 CO1 FO1 = 4 CO2 I = 10

Excel: = NPV(0.10, 16, 16, 16, 16, 20) - 50
A positive NPV increases value ➞ invest
[assumes 1 cash flow is T1]
st
[NPV ≥ 0 invest, NPV < 0 do not]
necessary, not sufficient

analysts
Example: NPV (cash flows not equally spaced)
0 1 1.5 2 3 4 5
(50) + 10 + -5 + 13 + 16 + 19 + 23 = 4.78 Positive

(1.10) 1.5
(1.10) (1.10)2 (1.10)3 (1.10)4 (1.10)5
𝟏#
Calculator: CF0 CO1 CO2 CO3 CO4 CO5 CO6 CO7 CO8 CO9 C10 I = (𝟏. 𝟏𝟎) 𝟐 -1 =
(50) 0 10 (5) 13 0 16 0 19 0 23 4.88
Excel: XNPV (rate, value, dates) ...
42

analysts
IRR: discount rate that makes the NPV of an investment equal to zero
For Your Consideration: $50m investment today, $16m after-tax cash flows for 4 years,
$20m Yr. 5, Required rate of return 10%.
0 1 2 3 4 5
(50) + 16 + 16 + 16 + 16 + 20 = 13.136
(1.10) 1
(1.10)2
(1.10) 3
(1.10) 4
(1.10) 5
Calculator: CF0 CO1 FO1 = 4 CO2

IRR = 19.52%
Excel: IRR(values, [guess])
= IRR (-50, 16, 16, 16, 16, 20) [assumes 1st cash flow is T0]

analysts
IRR: discount rate that makes the NPV of an investment equal to zero
0 1 2 2.5 3 4 5
Example: I = 10%
(50) 0 1 3 16 20 25
Excel: XIRR(Values, Dates, [guess])

Decision Rule: Invest if IRR ≥ r r = Required Rate of Return = Hurdle Rate
Do not if IRR < r
Note: Investor will only realize the IRR as a (geomtric) rate of return if interim cash
flows are reinvested at the IRR
Limitation: Multiple IRRs may exist when there are multiple changes in cash flow sign (+/-)
e.g. T0 (1,000) T1 5,000 T2 (6,000) IRR = 100% AND 200%
43

analysts
NPV or IRR?
For mutually exclusive investment projects: NPV
indicates increase in wealth
IRR does not account for project size, length
e.g. T0 (500) T1 700 I = 10% NPV 136.36 IRR 40%

T0 (10,000) T1 12,000 I = 10% NPV 909.09 IRR 20%

𝐀𝐟𝐭𝐞𝐫 − 𝐭𝐚𝐱 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐏𝐫𝐨𝐟𝐢𝐭
ROIC: (also known in the curriculum as ROCE) =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐂𝐚𝐩𝐢𝐭𝐚𝐥
= (1 - Tax Rate) × Operating Profit
e.g. Yr. 2 Op. Profit after tax reported as 24,395 Average Total LT Liabilities and Equity
End Yr. 1 End Yr. 2 Avg.
Cash 4,364 6,802
Short-Term Assets 40,529 52,352
Long-Term Assets 287,857 279,769
Total Assets 332,750 338,923
Accounts Payable 35,221 50,766
Short-Term Debt 21,142 5,877
Long-Term Debt 112,257 106,597
Share Capital 15,688 15,688
Retained Earnings 148,442 159,995
Total Liabilities and Equity 332,750 338,923
44

Benefits of ROIC - data to calculate is available to independent investment analysts
(NPV×IRR×)
- ROIC accounts for capital invested (unlike operating profit or op. profit
ROIC = After-Tax operating profit Sales margin)
×
Sales Average Invested Capital
Margin × Capital Turnover
- Aggregate measure for entire firm
- Can be compared to required return (for both debt and equity
investors)
Drawbacks of ROIC - Accounting based figure

- Backward looking
- Aggregation can hide a multitude of sins
- Calculation of operating profit, invested capital open to interpretation
e.g. IC: intangibles, excess cash, deferred tax liabilities may be
excluded
Profit: non-recurring, non-controlling interests may be excluded
Principles and Pitfalls

Principles - use after-tax cash flows
not accounting measures
Consider impact of tax benefits on cash flows e.g. tax allowable depreciation
- use incremental cash flows, ‘examine broadly’

ignore sunk costs impact on other areas of business,
- cost savings, loss of sales
- time value of money!
consider impact on NPV and IRR of a change in timings
45

Pitfalls: Cognitive Errors - internal forecasting errors
- costs, required returns, competitor responses
- ignoring costs of internal financing

- retained earnings are not free ➞ could have been returned
to equity holders
use appropriate risk-adjusted return to evaluate capital
investments
- inconsistent treatment/ignoring inflation

- nominal flows include inflation, real cash flows exclude
discount nominal at nominal rate
discount real at real rate
- actual inflation ≠ expected inflation
- cash flows affected differently

Pitfalls: Behavioral Bias - inertia
McKinsey (2012): correlation between capital
investmentt, t-1 = 0.92
- use of accounting measures
e.g. EPS - managers may be incentivized on EPS, high NPV
projects may initially reduce these measures
- Pet Projects
- selected without rigorous analysis, forecasts optimistic
- Failure to consider alternatives

Breakeven, scenario, simulation analyses ignored
May result from lack of experience, or lack of failure
lack of failure over time may indicate too little
risk taking
46

Examples: If a project is funded using internally generated cash flows should it be
evaluated using a lower required rate of return?
If an analyst uses real cash flows and a real discount rate, a project’s
NPV will be unaffected by future inflation. True or False?
What’s the problem here:

Examples : Forecasted Gross Cash Flows Time: 0 1 2 3
(7.5) 4.5 4.5 6.0
Forecasted Depreciation 0.0 (1.0) (1.0) (1.0)
Required Rate of Return = 6%

Tax Rate = 18%
Depreciation is not deductible for taxes
After-Tax Cashflows (7.5) 3.69 3.69 4.92
NPV = 3.396
47
Real Options
So far, presumption has been - all capital investment decisions are taken at inception
- one course of action is maintained throughout project’s
life
In practice, firms have alternatives - decisions can be taken in the future based on
future economic events
The right (but not obligation) to take action in the future is a real option
exercise only if value enhancing
Real options can alter the value of a capital investment - the option value depends on
future events
Real Options
Types of Real Options:
Timing - Delay investment and hope for improved information, sequence projects
Sizing - Abandonment: CF abandoning > PV future flows, exercise

- Growth: additional investment when performance is strong
Flexibility - Price-Setting: increase price to benefit from strong demand

Production-Flexibility: alter production levels in line with demand
Fundamental - The entire investment is an option e.g. Value of oil well contingent on oil
price research and development projects
Evaluation Approaches: 1. Positive NPV without option, do it anyway (option can only add
value)
2. Calculate NPV with option: NPV(without) - option cost + option
value
3. Decision trees and option pricing models - sounds fun...
48
Real Options
Decision Tree Example:
Initial outlay $500m to produce a new product, 10% required return
Probability of success 60%, $750m at T1
Probability of failure 40% in which case: 30% probability an alternative launch returns
$600m at T2
30% probability asset sold realizing $400m at
T2
40% probability assets abandoned realizing $0
T0 T1 T2
60% 750 NPV without options: (0.6 × 750) + (0.4×0) - 500
[success] 1.10 = (90.9)
(500) 30% 600 options: (600 × 0.4 × 0.3) + (400 × 0.4 × 0.3) = 99.17
[outlay] 1.102
30%
40% 0 400
[failure] NPV with options 8.27
40% 0
Real Options
A company is considering expanding, but new environmental regulation may provide
tax incentives that would increase cash flows:
- waiting for the new legislation before expanding will incur a cost of $1.8m
- the NPV if the company waits has been estimated at $9.7m, compared to
$8.9m if work starts immediately
- What is the option value?
49
Capital Structure
a. calculate and interpret the weighted-average cost of capital for a company
b. explain factors affecting capital structure and the weighted-average cost of capital
c. explain the Modigliani-Miller propositions regarding capital structure
d. describe optimal and target capital structures
50
Capital Structure


Equity 4,000
7,000
Weighted Average Cost of Capital (WACC)

Issuer’s required rate of return is derived from its investor’s required rates of return
[cost of capital] adjusted for risk of project
Excess capital remaining after all positive NPV projects have been undertaken should be
Investors can get their required rate
returned
of return elsewhere
Sources of Capital: Debt Equity
less risky for investors more risky for investors
- Priority claim - Residual claim
- may be secured
lower required rate of return higher required rate of return
Thefore For Issuers: Cost of Debt < Cost of Equity
𝐫𝐝 𝐫𝐞
The weighted average cost of capital (WACC) = weighted average of 𝐫𝐝 and 𝐫𝐞
51

WACC = (Cost of debt × Weighting of debt) + (Cost of equity × Weighting of equity)
Interest rate on existing debt Equity investors’ required rate

But - should be forward looking of return
Consider cost of recent borrowing No historical interest rate to observe
for comparable companies Starting Point = Historical returns on
If interest is tax deductible, cost equity in general (e.g. market index)
of debt = 𝐫𝐝 (1 - 𝐭) Distributions (dividends) not deductible
Weightings: Based on either 1. Market Values - investors’ opportunity costs are based
on market values
2. Target Values - less common, targets typically based on
book values
Other Sources of Finance : e.g. Preferred Stock, non-controlling interests
- should be included in WACC

e.g. Corporation Financed : $40m debt $60m equity
Interest is tax deductible
New funds will be raised using current capital structure
Debt investors’ required rate of return (pre-tax) is 4%
Equity investors’ required rate of return is 10%
Marginal tax rate is 23%
WACC = (𝐫𝐝 (1 - 𝐭) × 𝐖𝐝 ) + (𝐫𝐞 × 𝐖𝐞 )
= (4% (1 - 0.23) × 0.4) + (10% × 0.6)
= 7.23%
52

e.g. Issuer Balance Sheet: Bonds 400,000
Common Stock (40,000 shares) 600,000
Total Liabilities and Equity 1,000,000
Current Stock Price: $20 per share
Required Return on Debt (pre-tax) 5%
Required Return on Equity 10%
Marginal Tax Rate 20%
Weightings ? Book Value Market Value
D: 400,000 D: 400,000
E: 600,000 E: 800,000
Total: 1,000,000 Total: 1,200,000
If stock price increases to $25, WACC?

Flashback to LM5: Positive NPV projects create value
NPV is Positive if Return > Required Return
Two ways to maximize NPV: Maximize Return Minimize Required Return
not easy
Objectives for management in capital structure decisions:
1. minimize WACC
2. match liquidity/time horizon with that of capital investments
e.g. 30% debt 70% equity , interest tax deductible , 𝐫𝐝 (pre-tax) 6%. 𝐫𝐞 12%
If tax rate rises from 20% to 25% :
Initial WACC: (6%(1-0.2) × 0.3) + (12% × 0.7) After Change: (6%(1-0.25) × 0.3) + (12% × 0.7)
= 9.84% = 9.75%
Decrease in WACC of 0.09%
53
Factors Affecting Capital Structure and WACC

Amount and Type of Financing Needed: Business Model
Stage in Life Cycle
Costs of Debt and Equity : Financial Markets (top down factors)
Issuer Specific Factors
Business Model: Capital Intensive (e.g. utilities, transportation, real estate,)

(Amount and Type) Require high levels of capital
low asset turnover, high CAPEX to sales ratio, high wcapital to sales
ratio
Capital needs can be reduced by franchising/contracting
Assets often leased - cheaper implicit rate than borrowing
leased asset acts as collateral
Regulated Industries (e.g. banks, utilities)
Government/regulator may dictate capital structure
e.g. minimum % equity (generally increases WACC)
Business Model: Capital Light (e.g. technology, service)

(Amount and Type) Low capital needs
High Fixed Asset turnover, low CAPEX to sales ratios
Operate networks for others e.g. Uber, Airbnb
Upfront payments/commissions ➞ negative cash conversion cycle

no need to finance working
capital
Employee compensation primarily stock, reduced need for cash
If profitable from an early stage, minimal need for external

financing until large expansion
54
Stage in Life Cycle:

(Amount and Type)
Top Down Factors : Debt Investors’ Required Return = Risk-Free + spread

(Cost of Debt and Equity) return on sovereign government debt
compensation for issuer-specific
Cost Debt < Cost Equity risks
influenced by same Macroeconomic, country-specific factors can increase 𝐑 𝐅 and

spread
risk factors [real growth, inflation, monetary policy, ex rates]
move together ➞ claims
on same cash flows Increase in recession risk increase in spreads increase 𝐫𝐝
bigger impact on cyclical sectors
lower stock prices increase 𝐫𝐞
Industry factors significant: e.g. oil price oil producer
airline
55
Issuer Specific Factors : Sales Risks

stable, predictable, growing revenues = lower risk ➞ lower cost
financing
larger customer base, subscription based e.g. Telecoms v.
Construction
Profitability Risks
Stability of profit margins is affected by a company’s mix of
fixed and variable costs = operating leverage
Higher Proportion of Fixed Costs
= higher operating leverage
= higher risk

Operating leverage example: Two all equity financed firms with 100 total equity
Firm (FC+) : Revenue 100 Firm (FC-) : Revenue 100
Fixed Costs (50) Fixed Costs (20)
Variable Costs 20% (20) Variable Costs 50% (50)
Profit 30 30
ROE 30% ROE 30%
Net Profit Margin 30 Net Profit Margin 30
If both firms experience a 25% change in sales:
-25% +25% -25% +25%
Firm (FC+) : Revenue 75 125 Firm (FC-) : Revenue 75 125
Fixed Costs (50) (50) Fixed Costs (20) (20)
Variable Costs 20% (15) (25) Variable Costs 50% (37.5) (62.5)
Profit 10 50 17.5 42.5
ROE 10% 50% ROE 18% 43%
Net Profit Margin 13.3% 40% Net Profit Margin 23.3% 34%
56
Issuer Specific Factors : Financial Leverage and Interest Coverage

Higher levels of debt = higher financial leverage = higher risk
Limits capacity to service more debt
Increases risk of cash flows for equity holders
Measures = debt levels v. profit or equity

Interest Coverage : Profit before interest and taxes
Interest expense

Financial leverage example: Two companies: Assets 100, Revenue 100, operating expenses 70
Firm A: equity 80 debt 20 interest 2
Firm B: equity 40 debt 60 interest 9
Calculate profit, interest coverage and ROE for current operating expenses and a change
of +/- 25%
Firm A +25% -25% Firm B +25% -25%
Revenue 100 Revenue 100
Operating Expenses (70) Operating Expenses (70)
Operating Income 30 37.5 22.5 Operating Income 30 37.5 22.5
Interest Expense (2) (2) (2) Interest Expense (9) (9) (9)
Profit 28 35.5 20.5 Profit 21 28.5 13.5
Interest Coverage Interest Coverage
Return on Equity Return on Equity
57
Issuer Specific Factors : Collateral/Asset type

Assets that support greater use of debt: - strong collateral
- generate cash
- fungible or liquid
e.g. Real estate, aircraft, receivables
Examples: Types of debt
Life cycle: Start up
Growth
Mature
Cost of capital highest with: Revenue is stable

High operating leverage
High interest coverage
1. Likeliest source of finance for Newtech?

Unsecured debt, IPO, founders/employees
2. Given Jayman’s forecast which company

will experience a greater change in cash
flow and profitability?
3. Oldtech’s business model?

Capital light
Capital intensive
Contractual relationships
58
Modigliani and Miller

Recap: Objective of Capital Structure Decisions: 1. minimize WACC
maximize value of firm
Enter Modigliani and Miller (1958):
Under certain assumptions a company’s choice of capital structure is irrelevant in
determining its value
Have we been wasting our time?

Recap: Objective of Capital Structure Decisions: 1. minimize WACC
maximize value of firm
Enter Modigliani and Miller (1958):
Under certain assumptions a company’s choice of capital structure is irrelevant in
determining its value
Have we been wasting our time? Happily, no!

The key is in the assumptions :
1. Homogenous Expectations - Investors agree on future cash flows investments will generate
2. Perfect Capital Markets - No transaction costs, no taxes, no bankruptcy costs, everyone
has the same information
3. Risk-Free Rates Exits - And everybody can borrow and lend at that risk-free rate
4. No Agency Costs - Managers always act to maximize shareholder wealth
5. Independent Decisions - Financing and investment decisions are independent of each other
Extremely restrictive - as these assumptions are relaxed, factors that impact value are revealed
59

MM Proposition I without taxes: Capital Structure irrelevance
The value of a firm is not affected by changes in capital structure
1. The value of the levered company (𝐕𝐋 ) is equal to the value of the unlevered
company (𝐕𝐮 )
if this wasn’t true, the overvalued firm will be sold, undervalued bought to make
arbitrage profits and drive prices back to equality
2. The value of a company is determined solely by its expected future cash flows
(not debt/equity mix)
if shareholders desire leverage they can achieve it themselves by borrowing
or lending
e.g. Co. A: Equity $100 Co. B: Equity $50 Shareholders with an ROE of 20% in Co. A:
Debt - Debt (10%) $50 Buy $50 shares
Return $20 Return $15 Borrow to buy another $50 shares (10%)
ROE 20% ROE 30% ROI: $20 - $5 = 30%
$50
3. The WACC is unaffected by capital structure - Risk increases, cost equity increases,
but debt offsets

MM Proposition II without taxes: Higher Financial Leverage Raises the Cost of Equity
As cheaper debt is added to the capital structure, financial risk increases and
the cost of equity increases
Lower-cost debt capital is perfectly offset by the increase in the cost of equity
no change in WACC
Cost of Equity at any given leverage (𝐫𝐞 ):
𝐫𝐞 = 𝐫𝐨 + (𝐫𝐨 - 𝐫𝐝 ) 𝐃
𝐄
Cost of equity for all equity Debt to equity ratio
Financed company (zero debt)
Spread between 𝐫𝐨
cost of debt
60

Side Quest! - This ‘𝐫𝐞 ’ formula is in the midst of an explain LOS
- It does not need deriving
- It is worth knowing, we’ll work a numerical example which
helps to ‘explain’ how the WACC remains constant
- But in case you’re interested, here’s where it came from

Example: All equity financed company has a WACC = 10%, perpetual cash flow of EUR 5,000
- it then decides to issue EUR 15,000 debt at a cost of 5% and use the
proceeds to buy back shares
Initial Valuation : 5,000 = EUR 50,000 (𝐕𝐮 )

10% Proposition I
Post Buyback Valuation = EUR 50,000 (𝐕𝐋 )
Proposition II : 𝐫𝐞 = 𝐫𝐨 + (𝐫𝐨 - 𝐫𝐝 ) 𝐃 = 10% + (10% - 5%) 15,000 = 12.143%

𝐄 35,000
61

MM Proposition I with taxes: The value of a levered company is greater than that
of an unlevered company
𝐕𝐋 = 𝐕𝐮 + 𝐭𝐃
Value levered Value of debt
Value unlevered Tax rate
Interest in most jurisdictions is tax deductible ➞ saves cash

Value of the saving = tax rate × value of debt (𝐭𝐃)
MM Proposition II with taxes: The WACC decreases as more debt is introduced
𝐫𝐞 = 𝐫𝐨 + (𝐫𝐨 - 𝐫𝐝 )(1 - 𝐭) 𝐃
𝐄
Cost of equity increases at a slower rate
‘Optimal’ capital structure to minimize WACC/maximize firm value? 100% debt?
- ignores cost of financial distress - indirect e.g. Loss of suppliers, customers
- direct e.g. Bankruptcy costs

Example: All equity financed company has a WACC = 10%, perpetual cash flow of EUR 5,000
- it then decides to issue EUR 15,000 debt at a cost of 5% and use the
proceeds to buy back shares, corporate tax rate is 25%
𝐕𝐮 = 5,000(1 - 0.25) = 37,500
0.10
after buyback: 𝐕𝐋 = 𝐕𝐮 + 𝐭𝐃 = 37,500 + (0.25 × 15,000) = 41,250
debt 15,000 equity 26,250
𝐫𝐞 = 10% + (10% - 5%)(1 - 0.25) 15,000 = 12.1429%
26,250
WACC = 15,000 × 5%(1 - 0.25) + 26,250 × 12.1429% = 9.091%

41,250 41,250
62

Examples :
‘Debt financing is highly advantageous and the optimal capital structure is 100% debt’
Consistent with?
‘MM made it clear that the primary driver of firm value is capital structure’
Truth? Or simply a falsehood?
A company has: unlevered WACC 10%, cost debt 5.5%, debt-to-equity ratio 0.75,
corporate tax rate 25%.
Cost of Equity without tax Cost of Equity with taxes
Optimal and Target Capital Structures

Recap: MM no taxes : capital structure would not matter
no bankruptcy costs
MM with taxes: optimal capital structure 100% debt
Adjusting for the presence of costs of financial distress:

𝐕𝐮 = 𝐕𝐋 + 𝐭𝐃 - PV(costs of financial distress)
Value of Firm Static Trade Off Theory At low levels of debt:

𝐕𝐋 = 𝐕𝐮 + 𝐭𝐃 tax benefit of > increase in costs
increasing debt financial distress
Actual Value of Firm

At high levels of debt:
𝐕𝐮 (no debt) increase in costs tax benefit of
>
financial distress increasing debt
Debt (D)
Optimal Debt (D*) D* = optimal level of debt
63

Optimal level of debt (D*) maximizes firm value, minimizes WACC
Finding D* requires estimations of - value of tax shield
- PV costs of financial distress
The target capital structure is likely to be based on other factors, with the likely
range of D* a consideration
Actual v. Target Capital Structure

Reasons the two may differ:
- short-term opportunities - management take advantage of attractive rates
- changing market values - a change in the value of debt/share price will change the
capital structure when weightings are based on market
values
- transaction costs/minimum sizes - make it impractical to constantly aim for a
specific number
target is likely to be a range

Target capital structures often expressed by management in terms of book values
- often because management feel that market values fluctuate substantially
and “seldom impact the appropriate level of borrowing”
- primary concern is the amount and types of capital invested by the company
not in the company
- capital structure policy is aligned to measures used by third parties
Analysts may choose to use the target capital structure to compute WACC if
disclosed. If not disclosed, can be estimated using:
1. The current market values
2. Capital structure trends, management statements
3. Average of comparables
64

Example :
Market Value Debt Market Value Equity
Company G 50M 60M
Competitor A 25M 50M
Competitor B 101M 190M
Competitor C 40M 60M
Weightings using current capital structure: Debt Equity
using competitors
using debt-to-equity ratio of 0.7
Pecking Order Theory and Agency Costs

Issuer’s management have more information that investors = Asymmetric information
The greater the informational asymmetry, the higher the return demanded by investors
Risk that management will issue shares when overvalued, repurchase when
undervalued, issue debt in advance of credit deterioration
Implication is that investors look for indications of company’s prospects in management
Management consider what signals their actions send to outsiders behavior
Pecking Order Theory - management has a preference for financing methods with the
least potential information content:
Least Content Internal Financing
Private Debt
Public Debt
Most Content Equity Issue
65
Pecking Order Theory and Agency Costs

Possible Interpretations of Financing Choices
Equity Issuance - Management believe shares are overvalued Negative Signal
- Results in an increase in the cost of capital,
mgmt. needed to raise capital despite cost Negative Signal
Debt Issuance - Confident in taking on obligation to pay interest Positive Signal
Agency Costs
Recap: Incremental costs resulting from conflicts of interest e.g. Management and
- Increased use of debt may reduce agency costs of equity Shareholders
- Free Cash Flow Hypothesis - increased financial leverage forces management to run
the company more efficiently
Asymmetric Information and Signalling
66
Business Models
a. describe key features of business models
b. describe various types of business models
67
Business Models
Key Features
Business Model - “No precise generally accepted definition”
- we do have required elements
[Value to be delivered to customers] [How will it be delivered]
Value Proposition Value Chain
Who What Where How Organizational Competitive

Target Literally Channels ... much Structure Capabilities
Market What = Price How is the firm structured Does it have them
Analysts: Understand the business model and its impact on - Revenue Model
- Cost Structure Profitability
- Asset Profile
- Financial Structure
Starting Point: Annual Reports and Presentations
[see Equity LM on Company Analysis]
Key Features
Who : Customers and Markets
Geography : Local, National, International
B2B or B2C : B2B - Customers are other businesses ➞ tailor product to their needs
B2C - Consumers ➞ Target types/segments served
Segmenting : Geography, demographics, seasonal or life-cycle timing, behavior
As far as postcode Age: Cruise When do we Our relationship Early adopter?

Lines? spend and with the product Like being seen
on what with a new
product?
68
Key Features
What (and often why) : Product or Service
How is it different: If it is
What needs does it address: Why does customers buy it, what job are customers hiring
the product or service to fulfill
Allows identification of : Addressable markets - how big are they

Key opportunities - who else might buy it
Key risks - is there a high risk of substitution
The what may (should?) change: New technology, new delivery methods, new markets
Key Features
Where : Channels
How to Reach Customers : How is the product/service sold , how is it delivered
[sales and marketing] [distribution]
Which functions will the firm perform: e.g. selling/display, physical distribution, after-sales
service
What assets will be required : warehouse/store delivery fleet sales force
Which firms will be partners/suppliers: wholesalers/ haulage agents
retailers firm
Franchisees
Traditional Channel Strategy: Manufacturer Wholesaler Retailer End Customer

Direct Sales Strategy:
Complex products, high-margin products e.g. medical devices, industrial equipment
Historically required a salesforce Now complemented/substituted with digital
sales capability
Combination = Omnichannel strategy : order online Pick up in store
69
Key Features
Channels Impact : Revenues
Cost Behavior
Sensitivity to internal and external risk factors
e.g. Direct Sales : - Close relationship with customers

Do not compete with substitutes in stores
But : Imposes significant costs including fixed salaries
How (much) : Pricing

Pricing Relative to Competitors : Premium , Parity , Discount
Pricing Power: High competition, low differentiation ➞ Low Pricing Power = Price Takers
= Commodity Producers
Likely to adopt a cost leadership model
Key Features
Pricing and Revenue Models
Price discrimination : different channels, customers, different prices
maximizes profits when customers have different willingness
Net Prices - Prices after specific discounts/promotions/bundles to pay
Tiered Pricing - Based on volume or product features

‘base’ model plus add-ons
Dynamic Pricing - Based on time of purchase, supply and demand
try and get an Uber home on New Year’s eve
Value-Based Pricing - Price based on value received by customer
must estimate opportunity cost for buyer e.g. drugs (Legal)
Auction/Reverse Auction Models - Bidding process
digital technology enabled automation
70
Key Features
Pricing and Revenue Models
Price Multiple/Complex Products
Bundling - Combining Multiple Products - useful for products with high marketing costs,
high incremental profit margin
Razor, Razorblade - Low initial price, high margin repeat purchases
need to prevent generic substitutes
Add-On Pricing - Captive customers
Pricing To Help Growth

Penetration Pricing - Building scale and market share, sacrificing margin
effectively a marketing expense
Freemium Business Model - Basic usage for free/ads
common in digital services with network effects
Hidden Revenue Business Model - No charge for service, revenue elsewhere
data
Key Features
Alternatives to ownership - subscription models e.g. software
- leasing tangible assets
- licensing intangible assets
- franchising comprehensive form of licensing
Summary
Value Proposition Value Chain
Who What Where How much How is the What are its
(Price) firm organized competitive advantages
Done Business organization and capabilities
71
Key Features
Business Organization and Capabilities
Value Chain - Activities carried out by the firm that add value to customers
Supply Chain - Sequence of processes involved in the production and delivery of a
is likely to involve multiple firms product
A firm’s value chain should include activities in which it has a competitive advantage
Primary
Inbound Operations Outbound Marketing and Service
Logistics Logistics Sales
For each activity: Firm Infrastructure Identify opportunities

- estimate value added Human Resources for competitive advantage
- estimate costs Technology
Procurement outsource those activities where
Value Proposition Support the firm has no competitive
advantage
Conventional Business Models
72
Types of Business Model

Business Model Variations
Contract Manufacturers (private label) : Produce goods marketed by others
Value Added Resellers: Distribute and handle complex aspects of installation, service, etc.
Licensing Arrangements : Produce under a recognized brand name, pay royalty
Franchise Models: Franchisor earns a royalty and is responsible for advertising and product
development
Business Model Innovation (digital technology)
Location matters less
Outsourcing is easier
Digital marketing can target specific customers cost effectively
Network effects ...
2
Types of Business Model
Network Effects
The increase in value of a network to its users as more users join
e.g. messaging platforms, payment platforms, social media, payment systems, stock
exchanges
One sided : there is one type of user that is valuable to other users e.g. Venmo
Two sided : two (or more) types of users e.g. credit card networks
Crowdsourcing : users contribute to the product, the business facilities ‘communities’
73

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Last Revised: 06/14/2023

2024 Level 1 - Corporate Issuers

Organizational Forms, Corporate Issuer Features, and Ownership 2

Investors and Other Stakeholders 8

Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits 15

Working Capital and Liquidity 24

Capital Investments and Capital Allocation 37

© 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved.

Organizational Forms, Corporate Issuer Features, and Ownership

a. compare the organizational forms of businesses

b. describe key features of corporate issuers

c. compare publicly and privately owned corporate issuers

Forms, Features and Ownership

Public Limited Company: Separate legal entity

Key Features - Corporate Issuers

Separation of ownership and management allows corporation to obtain financing from a

Key Features - Corporate Issuers

Returns = Dividends Interest, Return of principal

Key Features - Corporate Issuers

Financial and Economic Income Statement

Economic profit = Required return on equity - Return on equity

Key Features - Corporate Issuers

Some jurisdictions offer relief: - Personal tax credits on dividend income

secondary offerings (secondaries) : Company raises capital from public

governments may create legally separate corporations

Investors and Other Stakeholders

a. compare the financial claims and motivations of lenders and shareholders

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

c. describe environmental, social, and governance factors of corporate issuers

Investors and Other Stakeholders

Debt and Equity Claims

Debt and Equity Claims

Decrease: ROE = 80 - 70 = 10% Decrease: ROE = 80 - 70 - (0.2 × 75) = (20%)

Debt and Equity Claims

Debt and Equity Claims

Shareholder Payoff Debtholder Payoff

Debt Investment Risk

Debt and Equity Claims

Hence the Contractual

How do you balance multiple objectives?

Private Debtholders Public Debtholders (Bondholders)

More difficult to incorporate generally well understood

Impact is dependent on maturity e.g. 10-year Bond v. 2-year Bond

Analysts should consider ESG by using sensitivity/scenario analysis

Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

b. describe corporate governance and mechanisms to manage stakeholder

c. describe potential risks of poor corporate governance and stakeholder management

one party hires another to perform

The agent is expected to act in

Example Conflicts: Controlling shareholder: Founding family seeking diversification

Controlling shareholder: Long-term shareholder - multi-decade perspective

Which group is most negatively affected

Welders employed by the company

The company’s dealers

The aluminum suppliers

Corporate Reporting and Transparency

Corporate Reporting and Transparency

Corporate Reporting and Transparency

Shareholder Litigation: Activists may pursue ‘shareholder derivative lawsuits’