CFA Level 1 – Corporate Finance

Study Session 12: Corporate Finance (1)
Reading 31 Introduction to Corporate Governance and Other ESG Considerations
11 LOSs | 3 Quizzes
Describe corporate governance
Describe a company’s stakeholder groups and compare interests of stakeholder groups
Describe principal–agent and other relationships in corporate governance and the conflicts that may arise in these relationships
Describe stakeholder management
Describe mechanisms to manage stakeholder relationships and mitigate associated risks
Describe functions and responsibilities of a company’s board of directors and its committees
Describe market and non-market factors that can affect stakeholder relationships and corporate governance
Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management
Describe factors relevant to the analysis of corporate governance and stakeholder management
Describe environmental and social considerations in investment analysis
Describe how environmental, social, and governance factors may be used in investment analysis
Reading 31 Introduction to Corporate Governance and Other ESG Considerations – Quiz 1
Reading 31 Introduction to Corporate Governance and Other ESG Considerations – Quiz 2
Reading 31 Introduction to Corporate Governance and Other ESG Considerations – Quiz 3
Reading 32 Capital Budgeting
 7 LOSs | 3 Quizzes
Describe the capital budgeting process and distinguish among the various categories of capital projects
Describe the basic principles of capital budgeting
Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing
Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project
Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods
Contrast the NPV decision rule to the IRR decision rule and identify problems associated with the IRR rule
Describe expected relations among an investment’s NPV, company value, and share price
Reading 32 Capital Budgeting – Quiz 1
Reading 32 Capital Budgeting – Quiz 2
Reading 32 Capital Budgeting – Quiz 3
Reading 33 Cost of Capital
 12 LOSs | 3 Quizzes
Calculate and interpret the weighted average cost of capital (WACC) of a company
Describe how taxes affect the cost of capital from different capital sources
Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined
Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget
Explain the marginal cost of capital’s role in determining the net present value of a project
Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach
Calculate and interpret the cost of noncallable, nonconvertible preferred stock
Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yieldplus risk-premium approach
Calculate and interpret the beta and cost of capital for a project
Describe uses of country risk premiums in estimating the cost of equity
Describe the marginal cost of capital schedule, explain why it may be upward sloping with respect to additional capital, and calculate and interpret its break-points
Explain and demonstrate the correct treatment of flotation costs
Reading 33 Cost of Capital – Quiz 1
Reading 33 Cost of Capital – Quiz 2
Reading 33 Cost of Capital – Quiz 3
Study Session 11: Corporate Finance (2)
Reading 34 Measures of Leverage
 5 LOSs | 2 Quizzes
Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk
Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage
Analyze the effect of financial leverage on a company’s net income and return on equity
Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels
Calculate and interpret the operating breakeven quantity of sales
Reading 34 Measures of Leverage – Quiz 1
Reading 34 Measures of Leverage – Quiz 2
Reading 35 Working Capital Management
 7 LOSs | 3 Quizzes
Describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position;
Compare a company’s liquidity measures with those of peer companies
Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company’s effectiveness with that of peer companies
Describe how different types of cash flows affect a company’s net daily cash position
Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines
Evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies
Evaluate the choices of short-term funding available to a company and recommend a financing method
Reading 35 Working Capital Management – Quiz 1
Reading 35 Working Capital Management – Quiz 2
Reading 35 Working Capital Management – Quiz 3
Corporate Finance – Exam
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Describe how environmental, social, and governance factors may be used in investment analysis

CFA Level 1 – Corporate Finance Reading 31 Introduction to Corporate Governance and Other ESG Considerations Describe how environmental, social, and governance factors may be used in investment analysis

At one end, value-based investing adds ESG consideration on top of traditional security analysis, while on the other hand, values-based investing screen/filter companies based an investor’s values/beliefs. In between these exist the specific implementations of ESG such as: 

  • Negative screening (also called exclusionary screening or norms-based screening) excludes companies which do not meet the ethical/ESG standards of an investor.
  • Positive screening, typically implemented using ESG scoring approach, selects investments if they have minimum required ESG scores. Best-in-class screening selects investments with the best ESG score in each sector weighted in accordance with some benchmark.
  • Full integration, explicit inclusion of ESG factors into traditional security analysis.
  • Overlay/portfolio tilt involves use of certain strategies to achieve particular ESG characteristics for a portfolio. Risk factor/risk premium investing includes ESG information in determination of systematic risk. 
  • Thematic investing focuses on investing in a specific sector or theme such as energy efficiency.
  • Engagement/active ownership attempts to achieve targeted social/environmental objectives along with measurable financial return, often through active/direct investment. Examples include green finance, green bonds, etc.

Catalysts for ESG growth include (a) significant losses incurred by some companies due to their ESG lapses, such as BP Plc for environmental concerns due to Deepwater Horizon, Walmart for HR policies, Volkswagen for unlawful emissions; and (b) focus of long-term institutional investors, called universal owners, on long-term sustainable growth due to their seemingly perpetual time horizon.

There has been a significant growth in assets under management (AUM) dedicated to consideration of ESG factors. Different organizations such as Global Sustainable Investing Alliance (GSIA) collect information about assets subject to ESG consideration. There is also an increased focus on additional ESG disclosure, for example Global Reporting Initiative (GRI) prepares a sustainability reporting framework, Sustainability Accounting Standards Board (SASB) prepares sustainability accounting standards.

ESG factors in investment analysis

Not all ESG considerations are equally important for all companies. For example, environmental factors such as emissions and water usage are more significant for utilities or mining companies, yet inconsequential for financial institutions.

Environmental factors include natural resource management, pollution prevention, water conservation, energy efficiency and reduced emissions, the existence of carbon assets, and adherence to environmental safety and regulatory standards. Stranded assets, carbon-intensive assets which are no longer economically viable, are of particular concern for energy companies because if not managed properly they may result in huge liabilities for energy companies. However, such an assessment is not easy because it is difficult to assess political and regulatory risks. 

Social factors relate to worker rights, human rights, welfare concerns in the workplace, and community impact. Quality of human capital can affect a company’s competitive advantage because it affects employee turnover, training, safety, diversity, etc. Further, lower social risks mean lower costs, higher productivity and lower reputational risk.

Governance factors have long been recognized in investment analysis. Many performance indicators can help evaluate risks arising from governance issues such as ownership structure, board independence and composition, and compensation. 

But there is a question, whether the consideration of ESG factors is consistent with fiduciary duty, such as in the case of pension funds. For example, whether a pension fund should accept lower return in fulfilling its ESG consideration while it is required by law to protect the interest of pension fund participants. However, recent court judgements have upheld that certain ESG factors do not violate fiduciary duty, such as addition of ESG factors in investment policy statements, integration of ESG in determining risk and return, and in the case of investments which are economically equivalent, using ESG considerations should be the determining factor.

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