2024 CFA L1: Lecture Notes

Corporate Issuers
LM 2: Investors and Other Stakeholders
LEARNING OUTCOME STATEMENTS

• Compare the financial claims and

motivations of lenders and shareholders.

• Describe a company's stakeholder groups

and compare their interests.

• Describe environmental, social, and

governance factors of corporate issuers
considered by investors.
Debtholders vs Shareholders

Debtholders (lenders) – Provide capital with a finite maturity

• Borrowers agree to make promised interest payments and to repay principal on
pre-specified dates
• Lenders have no decision-making power within the corporation
• May impose financial requirements and legal claims if debt is not repaid
• Interest payments must be paid before distributions to equity investors and are
a priority claim against a firm's cash flow and assets
Shareholders (equity) - A residual claim against earnings remaining after
expenses, investments, and debt payments; considered to be permanent capital
• Cash distributions are decided by the board of directors
• Shareholders may vote on choosing the board of directors, which appoints and
oversees management, and other important matters
Practice Question

Which of the following is most likely to be a feature of debt obligations?

A. Finite term.
B. Voting rights.
C. Discretionary payments voted by the board.
Practice Question

Which of the following is most likely to be a feature of debt obligations?

A. Finite term.
B. Voting rights.
C. Discretionary payments voted by the board.
Answer: A
Debt obligations usually have a finite term while equity investment is considered
permanent capital. While shareholders may sell or buy additional interest, the
capital paid in through shares stays with the company rather unless decided to be
returned. Voting rights and discretionary payments voted by the board are
features of equity rather than debt.
Debt vs. Equity: Risk and Return

Financial Leverage – Using debt rather than equity to finance firm operations.

Firms with predictable cash flows may

borrow using debt rather than increase
capital by issuing more shares. Cash
• Dilution - Issuing shares spreads Debt
profit among more shareholders. 75%
• Issuing debt makes sense when Other S-T
rD(1 – t) < ROA; ROE increases. Assets
Leverage also increases the probability
of insolvency, bankruptcy, and potential Equity Long-Term
liquidation to satisfy debtholder claims. 25% Assets
Firm Value and Shareholder Payoff

Value to equity holders equals firm

value (V) less debt (D). Potential
gain to equity holders is unlimited. Insolvent: Solvent:
V<D V>D
Solvent: V > D. Lender returns will
be the interest and principal
Region of
payments. shareholder gain
Debt
Insolvent: V < D. Debtholders will
recover their capital from remaining
assets.
Region of
lender gain

VD Firm Value
Practice Question

Corporate equity and debt holders share the same investor perspective with
respect to:
A. maximum loss.
B. investment risk.
C. return potential.
Practice Question

Corporate equity and debt holders share the same investor perspective with
respect to:
A. maximum loss.
B. investment risk.
C. return potential.
Answer: A
Initial investment represents the maximum possible loss for both equity investors
and debtholders. Equity have greater investment risk, because they only hold a
residual claim on cash flows lower in priority to the debtholders’ claims. The return
potential is unlimited for equity holders; it is capped at the value of interest
payments for debtholders.
Interests of Shareholders and Debt Holders

Equity investors have a different goal than debt investors:

• Equity investors seek to maximize firm profits and residual cash flow.
• Debt investors seek to maximize the probability of receiving timely interest and
principal payments
The differing perspectives and goals provides an opportunity for conflicts of
interest, where one group (equity holders) may decide to pursue a goal that harms
another group (bond holders).
Shareholder-Stakeholder Conflicts

Shareholder theory – The board and management exist to enhance shareholder

value. Creditors, employees, customers, and society are considered only to the
extent that they affect shareholder value.
Stakeholder theory – Corporate governance should consider all stakeholder
interests.
Stakeholder theory gives rise to additional conflicts of interest:
• Direct costs of adhering to ESG standards
• Competing globally with firms not subject to the same constraints
• defining, measuring, and balancing non-shareholder objectives
Key Corporate Stakeholders

BOARD OF DIRECTORS CUSTOMERS

Stewardship; financial Value, service, safety;
and reputational benefits price

SUPPLIERS GOVERNMENTS
COMPANY,
Financial benefits from Compliance, tax
EMPLOYEES,
sales; input to revenues; public
SHAREHOLDERS
operations oversight, standards

CREDITORS SHAREHOLDERS
Supply capital; receive Supply capital; receive
interest income, capital dividends and capital
protection, desire gain, have control
safeguards
The Board of Directors

• Elected by shareholders:
• Define the company’s “risk appetite”
• Provide strategic direction
• Protect shareholder interests
Inside (Internal) directors – Major shareholders, founders, and senior managers
Independent (External) directors:
• No material relationship with the company regarding employment, ownership,
or remuneration
• Chosen for management experience and strategic leadership
Staggered Boards

Staggered boards – Different groups of members are elected separately in

consecutive years. It takes several years to replace a full staggered board
• Limits the ability of shareholders to effect a major change of control at the
company.
• Allow for continuity without constant reassessment of strategy and oversight by
new board members, which may introduce short-termism into company
strategy.
Practice Question

Which of the following would most likely be considered the primary benefit of
external (independent) directors?
A. No allegiance to other board members or executives.
B. Limit "short-termism" in compensation structures and strategy.
C. Allow for continuity without constant reassessment of strategy and
oversight.
Practice Question

Which of the following would most likely be considered the primary benefit of
external (independent) directors?
A. No allegiance to other board members or executives.
B. Limit "short-termism" in compensation structures and strategy.
C. Allow for continuity without constant reassessment of strategy and
oversight.
Answer: A
External directors should theoretically make decisions independent of past
relationships that could present a conflict of interest. Limiting short-termism
should also result from adding independent directors except that they may be
compensated based on short-term results. That and allowing for continuity are
benefits of staggered boards rather than external board members.
ESG Examples

Environmental Social Governance

• Climate change and • Human rights • Bribery and
carbon emissions • Labor standards corruption
• Air and water pollution • Data security / privacy • Shareholder rights
• Biodiversity • Customer satisfaction • Board independence
• Deforestation / product responsibility and diversity
• Energy efficiency • Treatment of workers • Audit committee
• Waste management • Equity and diversity structure
• Water scarcity • Community relation • Executive
• Workplace health and compensation
safety • Political contributions
• Whistleblower
schemes
Negative Externalities

Negative externalities – Costs not borne by a company and its investors.

Stronger regulations and increased stakeholder activism are forcing companies to
reflect environmental and societal costs in their financial statements.
ESG considerations are of increasing importance for three reasons:
• Shareholders and debtholders have suffered substantial losses due to
environmental disasters, social controversies, and governance deficiencies.
• Increasing demands that wealth be managed with ESG considerations in
mind.
• Revised regulations are forcing corporate issuers to adapt their business
practices to meet more stringent ESG criteria.
Climate Change Risks

Material - Having a significant impact on a company’s results or business model.

Climate Change Risks – Material physical or transitional risks resulting from
perceived climate change issues.
• Physical risks – Potential damage to or destruction of assets by severe
weather
o expected with increasing frequency as the climate changes.
o can often be insured against or diversified.

• Transition risks - Potential losses caused by transition to a lower-carbon

economy
o May result from regulations or shifting consumer demand.
o Stranded assets - Emission-intensive assets at risk of losing viability as
the economy becomes more "eco sensitive"
Social Risk

Social risk – Risks related to a firm’s practices concerning its employees and
human capital, customers, and communities in which it operates. Addressing
social risk can reduce risks to employee productivity, employee turnover, litigation
potential, and reputational risk.
Practice Question

Which theory of corporate governance is most likely to include ESG

considerations?
A. Shareholder theory
B. Stakeholder theory
C. Principal-Agent theory
Practice Question

Which theory of corporate governance is most likely to include ESG

considerations?
A. Shareholder theory
B. Stakeholder theory
C. Principal-Agent theory
Answer: B
Stakeholder theory includes ESG considerations because it seeks to balance
shareholder interests with those of a broader group. Shareholder theory, in
contrast, includes a narrower group of parties interested in the company's
success. Principal-agent theory describes pitfalls that can arise when an “agent,”
represents a “principal.” Agents may have the problem of different desired
outcomes from principals, much like the problems arising among stakeholders.