Corporate Issuers Study Notes

LM01 Corporate Structures and Ownership 2023 Level I Notes
LM01 Corporate Structures and Ownership
1. Introduction ...........................................................................................................................................................2
2. Business Structures ............................................................................................................................................2
Sole Proprietorship (Sole Trader)................................................................................................................2
General Partnership...........................................................................................................................................2
Limited Partnership...........................................................................................................................................2
Corporation (Limited Companies) ...............................................................................................................2
3. Public and Private Corporations ....................................................................................................................2
Exchange Listing and Share Ownership Transfer ..................................................................................3
Share Issuance .....................................................................................................................................................3
Going Public from Private — IPO, Direct Listing, Acquisition ...........................................................3
Life Cycle of Corporations ...............................................................................................................................3
4. Lenders and Owners...........................................................................................................................................3
Equity and Debt Risk–Return Profiles ........................................................................................................3
Equity vs. Debt Conflicts of Interest ............................................................................................................3
Summary......................................................................................................................................................................4
This document should be read in conjunction with the corresponding learning module in the 2023
Level I CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are
copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All
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1. Introduction
This reading covers:
 Different forms of business structures – sole proprietorship, general partnerships,
limited partnerships, and corporations.
 Differences between private and public corporations, the process of going public from
private, and the life cycle of corporations.
 Securities issued by corporations – debt and equity, the differences in their risk-return
profiles, and the conflicts of interest between debt and equity.
2. Business Structures
Common forms of business structures include:
 Sole proprietorship
 General partnership
 Limited partnership
 Corporation
To understand the differences between these business structures we will focus on four
areas:
 Legal relationship: the legal relationship between the owners and the business.
 Owner-operator relationship: the relationship between the owners of the business
and those who operate the business.
 Business liability: the extent to which owners are liable for the actions undertaken by
the business.
 Taxation: the tax treatment of profits generated by the business.
Sole Proprietorship (Sole Trader)
A sole proprietorship is the most basic type of business structure. In a sole proprietorship,
the owner personally funds the capital required to operate the business and retains full
control over the business’s operations. The owner also fully participates in the financial
returns and risks of the business. An example of a sole proprietorship is a family-owned
store.
The key features of a sole proprietorship are:
 Legal relationship: It has no legal identity and is considered an extension of the owner.
 Owner-operator relationship: It is an owner operated business and the owner retails
full control of the business.
 Business liability: The owner has unlimited liability. He retains all risk associated with
the business and can be held financially responsible for all debt the business owes.
 Taxation: Profits from the business are taxed as personal income.
Sole proprietorships are preferred for small scale business due to their simplicity and

flexibility. However, their main drawback is that the business is constrained by the owner’s
ability to access capital and assume risk.
General Partnership
A general partnership is similar to a sole proprietorship with the important distinction that
they have two or more owners called ‘partners’. The roles and responsibilities of partners
are outlined in a partnership agreement. As compared to sole proprietorships, this structure
allows for additional resources to be brought into the business. The business risk is also
distributed among a larger group of individuals. Examples of general partnerships include
professional services businesses such as law, accounting, and financial advisory firms.
The key features of a general partnership are:
 Legal relationship: It has no legal identity. The partnership agreement defines the
ownership of the business.
 Owner-operator relationship: The business is operated by partners. Often the partners
bring complementary expertise, such as business development, financial acumen,
operations, or legal/compliance, and share responsibility in running the business.
 Business liability: The partners share all risk and business liability. If one partner is
unable to pay their share of the business’s debts, the remaining partners are fully
liable.
 Taxation: Profits from the business are taxed as personal income of the partners.
Like sole proprietorships, the potential for growth for a general partnership is limited by the
partners’ ability to source capital, their expertise, as well as their collective risk tolerance.
Limited Partnership
A limited partnership is a special type of partnership that has at least one ‘general partner’
(GP) with unlimited liability, who is responsible for managing the business. The remaining
partners are ‘limited partners’ (LPs) with limited liability i.e., they can only lose up to the
amount invested in the business. All partners share profits, with general partners typically
getting a larger share. An example of a limited partnership is a private equity fund.
The key features of a limited partnership are:
 Owner-operator relationship: The GP operates the business. LPs have no control over
the operation of the business. They cannot replace the GP in the event he runs the
business poorly or fails to act in the interest of the LPs.
 Business liability: GP has unlimited liability, while LPs have limited liability.
 Taxation: All partners share profits and the profits are taxed as personal income.
Business growth is limited by the financing capabilities and risk appetite of the partners.

Also, GP’s competence and integrity in running the business affects the business.
Corporation (Limited Companies)
A corporation is an evolved model of the limited partnership. It is also called a limited
liability company (LLC) or limited company in many countries.
Like a limited partnership, owners in a corporation have limited liability; however,
corporations provide greater access to capital and expertise needed to fuel growth.
Examples of corporations are national or multinational conglomerates.
The three main types of corporations are:
 Public for-profit
 Private for-profit
 Nonprofit
Nonprofit corporations are formed to promote a public benefit, religious benefit, or
charitable mission. They do not have shareholders, do not pay dividends, and generally do
not pay taxes. Examples of nonprofits include Harvard university, and the Asian
Development Bank.
Most corporations are for-profit. For-profit corporations can be public or private. The main
difference between the two are the number of shareholders and whether the shares are
listed on a stock exchange. In some countries like the UK, a corporation is categorized as
public if the shareholders are greater than 50. While in many other countries, like the US, a
corporation is categorized as public if the company shares are listed on an exchange.
We will now discuss the key features of for-profit corporations.
Legal relationship:
A corporation is a legal entity separate and distinct from its owners. Corporations have many
of the same rights and responsibilities as an individual. For example, corporations can enter
into contracts, hire employees, borrow and lend money, and pay taxes.
Large corporations frequently conduct business in many different geographic regions and
are subject to regulatory jurisdictions where either:
 the company is incorporated,
 business is conducted, or
 the company’s securities are listed
Owner-operator separation:
A key feature of corporations is the separation between those who own the business – the
shareholders, and those who operate it – the board of directors and company management.
The shareholders elect a board of directors to oversee business operations. The board hires
the CEO and senior management for day-to-day operations of the company. This separation
of operating control from ownership enables corporations to obtain financing from a large

number of investors who are not required to have any expertise in operating the business.
While the board and company management are supposed to act in the best interest of
shareholders, conflicts of interest can occur when management places their own interests, or
the interests of other stakeholders, above those of the shareholders. To prevent such
conflicts and mismanagement of business, corporate governance policies and practices are
put in place. If the board or management does not perform as expected, shareholders have
the ability to enact change through voting rights attached to their shares. This ability to
change things through voting is the key difference between a corporation and a limited
partnership.
Business liability:
Owners of a corporation have limited liability. The maximum amount that they can lose is
what they invested in the company. Owners also have a residual claim on the company’s net
assets after its liabilities have been paid. They can thus participate in the growth of the
company.
Capital financing:
The corporate form of business structure is preferred when capital requirements are greater
than what could be raised through other business structures. Corporations can raise two
types of capital:
 Ownership capital (equity)
 Borrowed capital (debt)
Both equity share holders and debt security holders are referred to as investors in the
corporation’s securities. However, equity shareholders purchase an ownership stake that
entitles them to a residual claim in the corporation. Whereas, bondholders are lenders to the
corporation and do not have any ownership entitlement.
Taxation:
In many jurisdictions, corporate profits are taxed twice (double taxation): once at the
corporate level and again at the individual level when profits are distributed as dividends to
the owners.
Example from the curriculum
The French company Elo (previously known as Auchan Holding) generated operating
income of €838 million and paid corporate taxes of €264 million. Investors in France also
pay a 30% tax on dividends received. If Elo had distributed all of its after-tax income to
investors as a dividend, what would have been the effective tax rate on each euro of
operating earnings?
Solution:
Operating Income €838

Corporate Taxes (31.5%) €264

After-Tax Income (€838 – €264) = €574
Distributed Dividend €574
Investor Dividend Tax (30%) €574 × 0.3 = €172.2
Effective Tax Rate (€264 + €172.2) / €838 = 52.1%
If the remaining after-tax income of €574 million was paid to investors as a dividend,
investors would pay €172.2 million in taxes on the dividends received. Total taxes paid
would be €436.2 million (€264 million at the corporate level plus €172.2 million at the
personal level), resulting in an effective tax rate of 52.1%.
3. Public and Private Corporations
In this section, we will compare public and private companies with respect to:
 Exchange listing and share ownership transfer
 Share issuance
 Registration and disclosure requirements
Exchange Listing and Share Ownership Transfer
Public companies are usually listed on an exchange. This allows ownership to be easily
transferred. New investors can become shareholders in a public company by simply
executing a buy order. Similarly, exiting investors can liquidate their ownership by executing
a sell order. These trades can be executed within a matter of seconds.
Each trade between a buyer and seller can change the share price. We can plot the share
price over time to see how the company’s value changes. We can also see how the company’s
value is impacted by significant news about the company specifically or about the general
state of the economy.
In contrast, private companies are not listed on an exchange, and, therefore have no
observable stock price, which makes their valuation challenging. Transactions between
buyers and sellers have to be privately negotiated and transferring ownership is much more
difficult. Investments in private companies are usually locked up until the company is
acquired by another company, or it goes public.
However, the potential returns in private companies can be much larger than public
companies. This is because investors in private companies usually join early in the
company’s life cycle and they have greater control over management.
Market Capitalization and Enterprise Value
Since the shares of public companies trade on an exchange, we can easily determine what
the company’s equity is worth at any moment in time. The company’s market capitalization
can be calculated as:

Market Capitalization = Current Stock Price × Total Shares Outstanding

While market capitalization represents the market value of a company’s equity, enterprise
value represents the total market value of a company, net of cash held by the company. It is
the amount an acquirer will have to pay to own the company free and clear of all debt.
Enterprise value is calculated as:
Enterprise Value = Market Value of Shares + Market Value of Debt – Cash
Example from the curriculum
8Tera Therapeutics is a hypothetical, public company with 15.2 million shares outstanding,
no short-term debt, and USD200 million of long-term debt. The company also has USD20
million in cash and a recent stock price of USD120 per share.
1. What is 8Tera’s market capitalization?
2. What is 8Tera’s enterprise value?
Solution to 1:
Market Capitalization = Current Stock Price × Total Shares Outstanding
Market Capitalization = (USD120 per share) × (15.2 million shares) = USD1.824 billion
Solution to 2:
Enterprise Value = Market Value of Shares + Market Value of Debt – Cash
EV = USD1.824 billion + USD200 million – USD20 million = USD2.004 billion
Share Issuance
Public companies typically raise very large amounts of capital from many investors through
an IPO and through additional issues after listing. These investors then actively trade shares
among themselves in the secondary market.
In contrast, private companies raise much smaller amounts from far fewer investors who
have much longer holding periods.
Investors in private companies are typically invited to purchase shares in the company
through a private placement. The terms of private placement are outlined in a legal
document called a private placement memorandum (PPM). The PPM describes the business,
the terms of the offering, and the risks involved in investing in the company. Because of the
higher risks, only accredited investors are permitted to invest in private companies.
Accredited investors are those who are sophisticated enough to take greater risks and to
have a reduced need for regulatory oversight and protection. To be considered accredited,
an investor must have a certain level of income or net worth or possess a certain amount of
professional experience or knowledge.
Registration and Disclosure Requirements

Public companies are subject to greater regulatory and disclosure requirements. They are
required to disclose their financial reports as well as other information that may affect stock
price, such as - major changes in the holding of voting rights, any stock transactions made by
officers and directors etc. These documents are made available to the general public, not just
to the company's investors. The primary purpose of this type of disclosure is to make it
easier for investors and analysts to assess the company.
In contrast, private companies are generally not required to make such disclosures and they
are not subject to the same level of regulatory oversight.
Going Public from Private — IPO, Direct Listing, Acquisition
A private company can go public in the following ways -
 IPO: To complete an IPO, a company must meet the specific listing requirements of the
exchange. The IPO is facilitated by investment banks who underwrite (guarantee) the
offering.
 Direct listing (DL): A DL differs from an IPO in two key ways – (1) no underwriter is
involved and (2) no new capital is raised. Instead, the company is simply listed on an
exchange and shares are sold by existing shareholders. As compared to an IPO, a DL is
much faster to execute and involves lower costs.
 Acquisition: Companies can also go public through acquisitions. This may occur
indirectly when a private company is acquired by a larger public company.
Another means of acquisition is through a special purpose acquisition company (SPAC). A
SPAC is a shell company, often called a “blank check” company, because it exists solely for
the purpose of acquiring an unspecified private company sometime in the future.
SPACs raise capital through IPOs and deposit the proceeds in a trust account. They have a
finite time (e.g. 18 months) to complete a deal; otherwise, the proceeds are returned
back to the investors.
Life Cycle of Corporations
The decision to go public or stay private often depends on where the company is in its life
cycle. Companies have a life cycle with four distinct stages: start-up, growth, maturity, and
decline. Exhibit 14 from the curriculum depicts the characteristics and financing needs of
each stage.

Start-Ups: Start-Ups are initially funded by the founders. If more capital is needed, the
founders may reach out to friends and family. At this stage, the company often has very little
revenues and negative cash flows. This makes financing challenging.
As the company grows, the founders may hire an investment banker to raise more capital
from private equity or private debt investors. Early-stage equity investors are also referred
to as venture capitalists, or Series A investors.
Growth: A company needs even more capital to scale in the growth stage. At this stage, the
revenue and cash flows of the company increase rapidly. However, the company may still not
be profitable, so it cannot rely on internally generated earnings to fund growth. The
company may raise capital through a Series B or even a Series C issuance. The company may
also consider going public through an IPO.
Maturity: The external financing needs of a company diminishes as it matures. At this stage,
a company is usually profitable, generates positive and predictable cash flows and can
therefore fund growth internally with retained earnings. If required, the company can also
borrow money at reasonable terms from public or private markets.
Decline: A company may have little need for additional financing in the decline stage. At this
stage, companies may try to reinvent themselves by developing new products/services or by
acquiring other companies. Additional financing may be required to accomplish this, but the
financing cost can be expensive as the company’s financials and cash flows deteriorate.
Public to Private — LBO, MBO
Some public companies may also choose to go private. To accomplish this an investor has to
acquire all of the company’s shares and delist it from the exchange. The process usually
involves borrowing large amounts of money to finance the acquisition (buyout). Buyouts can
be classified as:
 Leveraged buyouts (LBOs): The investors are not affiliated with the company they are
buying.

 Management buyout (MBO): The investors are members of the company’s current
management team.
LBOs and MBOs are initiated when investors believe that the public market is undervaluing
the shares and when financing costs are sufficiently low to make such transactions
attractive.
Trends in Public and Private Companies
The number of public companies is increasing in many emerging economies, while it is
decreasing in many developed economies.
Emerging economies usually have higher growth rates and are transitioning from closed to
open market structures. Therefore, the number of public companies are increasing as these
economies grow larger.
In developed economies, the number of public companies is trending downwards because:
 M&A activities: When a public company is acquired by another private or public
company, one less public company exists.
 LBOs & MBOs: These transactions are structures to take public companies private.
 Many private companies simply choose to remain private: Because of the thriving
venture capital, private equity, and private debt markets, it has become easier for
private companies to access the capital they need without having to go public. This
helps companies avoid regulatory burden and the associated compliance costs of
going public.
4. Lenders and Owners
The key differences between debt and equity financing are:
 Debt represents a contractual obligation on the part of the issuing company. The
company is obligated to make the promised interest and principal payments to
debtholders. Equity does not involve a contractual obligation.
 Debtholders have a prior legal claim on the company’s cash flows and assets. Their
claims have to be fully paid before the company can make distributions to equity
owners. Equity holders have a residual claim on the company’s net asset after all other
stakeholders have been paid.
 Interest payments on debt are typically tax-deductible. Whereas, dividend payments
on equity are not tax deductible.
 Equity represents a more permanent source of capital. It has no finite term and
includes voting rights. In contrast, debt represents a cheaper source of capital. It has a
stated finite term and no voting rights.

Equity and Debt Risk–Return Profiles

Investor’s perspective
From an investor’s perspective, investing in equity is riskier than investing in debt.
Debtholders receive predictable coupon payments, whereas payments to shareholders are at
the company’s discretion.
However, equityholders do have a residual claim, which means they are entitled to whatever
firm value remains after other stakeholders have been paid off, giving them unlimited upside
potential. Therefore, equityholders have an interest in the ongoing maximization of company
value (net assets less liabilities), which directly corresponds to the value of their shareholder
wealth.
On the other hand, no matter how profitable a company becomes, debtholders will never
receive more than their interest and principal repayment. Their maximum return is capped.
They are therefore interested in assessing the likelihood of timely debt repayment and the
risk associated with the company’s ability to meet its debt obligations.
For both equityholders and debtholders, their initial investment represents their maximum
possible loss.
These points are summarized in the table below:
Investor Perspective Equity Debt
Return potential Unlimited Capped
Maximum loss Initial investment Initial investment
Investment risk Higher Lower
Investment interest Max (Net assets – Liabilities) Timely repayment
Issuer Perspective
From the company’s perspective, issuing debt is riskier than issuing equity. If a company
fails to meet its contractual obligations, it may be forced to declare bankruptcy and liquidate.
Although riskier, the cost of debt is lower than the cost of equity (this is because the returns
to debtholders are capped). A company generating stable, predictable cash flows generally
prefers to borrow money rather than issuing additional equity to raise capital. Issuing more
equity also dilutes the upside return for existing equity owners given that residual value
must be shared across more owners. However, early-stage companies or companies with
unpredictable cash flows that find it difficult to borrow may prefer to raise capital through
equity to avoid the risk of default.
In the event of a default, a company does have some options to try and avoid bankruptcy. It
can renegotiate more favorable terms with the debtholders. However, if things don’t
improve, eventually the assets may have to be liquidated to raise as much money as possible

to return to the bondholders. Alternatively, the company may be reorganized, with existing
shareholders getting wiped out and bondholders becoming the new shareholders of the
reorganized company.
These points are summarized in the table below:
Issuer Perspective Equity Debt
Capital cost Higher Lower
Attractiveness Creates dilution, may be only Preferred when issuer cash
option when issuer cash flows are flows are predictable
absent or unpredictable
Investment risk Lower, holders cannot force Higher, adds leverage risk
liquidation
Equity vs. Debt Conflicts of Interest
Potential conflicts of interest can occur between debtholders and equityholders. Debtholders
would prefer that the company invests in less risky projects that generate predictable cash
flows, even if those cash flows are relatively small. Equityholders, on the other hand, would
prefer that the company invests in riskier projects with a much higher return potential.

Summary
LO. Compare business structures and describe key features of corporate issuers.
Common forms of business structures include:
 Sole proprietorship
 General partnership
 Limited partnership
 Corporation
The key features of a sole proprietorship are:
 Legal relationship: It has no legal identity and is considered an extension of the owner.
 Owner-operator relationship: It is an owner operated business and the owner retails
full control of the business.
 Business liability: The owner has unlimited liability.
 Taxation: Profits from the business are taxed as personal income.
The key features of a general partnership are:
 Owner-operator relationship: The business is operated by partners.
 Business liability: The partners share all risk and business liability.
 Taxation: Profits from the business are taxed as personal income of the partners.
The key features of a limited partnership are:
 Owner-operator relationship: The GP operates the business. LPs have no control over
the operation of the business.
 Business liability: GP has unlimited liability, while LPs have limited liability.
 Taxation: All partners share profits and the profits are taxed as personal income.
The key features of a corporation are:
 Legal relationship: It is a legal entity separate and distinct from its owners
 Owner-operator relationship: There is separation between the owners and the
operators. The shareholders elect a board of directors to oversee business operations.
The board hires the CEO and senior management for day-to-day operations of the
company.
 Business liability: Owners have limited liability
 Taxation: Corporate profits are taxed twice once at the corporate level and again at
the individual level when profits are distributed as dividends.
LO. Compare public and private companies.
Public companies are listed on an exchange which allows ownership to be easily transferred.

In contrast, private companies are not listed on an exchange. Transactions between buyers
and sellers are privately negotiated which makes ownership difficult to transfer.
Public companies typically raise very large amounts of capital from many investors through
an IPO and through additional issues after listing. These investors then actively trade shares
among themselves in the secondary market. In contrast, private companies raise much
smaller amounts from far fewer investors who have much longer holding periods.
Public companies are subject to greater regulatory and disclosure requirements. They are
required to disclose their financial reports as well as other information that may affect stock
price, such as - major changes in the holding of voting rights, any stock transactions made by
officers and directors etc. In contrast, private companies are generally not required to make
such disclosures and they are not subject to the same level of regulatory oversight.
LO. Compare the financial claims and motivations of lenders and owners.
Debt represents a contractual obligation on the part of the issuing company. The company is
obligated to make the promised interest and principal payments to debtholders. Equity does
not involve a contractual obligation.
Debtholders have a prior legal claim on the company’s cash flows and assets. Their claims
have to be fully paid before the company can make distributions to equity owners. Equity
holders have a residual claim on the company’s net asset after all other stakeholders have
been paid. This gives them unlimited upside potential.
From an investor’s perspective, investing in equity is riskier than investing in debt.
From the company’s perspective, issuing debt is riskier than issuing equity. If a company
fails to meet its contractual obligations, it may be forced to declare bankruptcy and liquidate.
Potential conflicts of interest can occur between debtholders and equityholders. Debtholders
would prefer that the company invests in less risky projects that generate predictable cash
flows, even if those cash flows are relatively small. Equityholders, on the other hand, would
prefer that the company invests in riskier projects with a much higher return potential.

LM02 Introduction to Corporate Governance and ESG 2023 Level I Notes
LM02 Introduction to Corporate Governance and Other ESG

Considerations
1. Introduction ...........................................................................................................................................................3
2. Stakeholder Groups ............................................................................................................................................3
Shareholder vs. Stakeholder Theory ...........................................................................................................4
Shareholders.........................................................................................................................................................4
Creditors/Debtholders .....................................................................................................................................4
Board of Directors ..............................................................................................................................................5
Managers ................................................................................................................................................................5
Employees .............................................................................................................................................................5
Customers ..............................................................................................................................................................6
Suppliers ................................................................................................................................................................6
Governments ........................................................................................................................................................6
3. Principal–Agent and Other Relationships ..................................................................................................6
Shareholder and Manager/Director Relationships ...............................................................................6
Controlling and Minority Shareholder Relationships ..........................................................................7
Manager and Board Relationships ...............................................................................................................8
Shareholder vs. Creditor (Debtholder) Interests ...................................................................................8
4. Corporate Governance and Mechanisms to Manage Stakeholder Risks ........................................8
Shareholder Mechanisms ................................................................................................................................9
Creditor Mechanisms ..................................................................................................................................... 10
Board of Director and Management Mechanisms ............................................................................... 11
Employee Mechanisms .................................................................................................................................. 12
Customer and Supplier Mechanisms........................................................................................................ 12
Government Mechanisms ............................................................................................................................. 12
5. Corporate Governance and Stakeholder Management Risks and Benefits ................................ 13
Risks of Poor Governance and Stakeholder Management ............................................................... 13
Benefits of Effective Governance and Stakeholder Management ................................................. 14
6. ESG Considerations in Investment Analysis........................................................................................... 14
Introduction to Environmental and Social Factors ............................................................................ 15
Evaluating ESG-Related Risks and Opportunities ............................................................................... 15
7. Environmental, Social, and Governance Investment Approaches ................................................. 16
ESG Investment Approaches ....................................................................................................................... 17
ESG Market Overview .................................................................................................................................... 18
Summary................................................................................................................................................................... 19

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1. Introduction
 The various stakeholders of a company and their interests
 The principal-agent and other relationships between stakeholder groups
 Corporate governance mechanisms to manage stakeholder relationships
 The potential risks of poor corporate governance and the benefits from effective
corporate governance
 ESG considerations in investment analysis
 ESG investment approaches
2. Stakeholder Groups
A stakeholder is any individual or group that has a vested interest in a company. The
primary stakeholder groups of a company include:
 Shareholders and creditors: provide capital to finance the company’s activities
 Board of directors: Serves as the steward of the company
 Managers: Execute the strategy set by the board and run day-to-day operations
 Employees: Provide human capital for the day-to-day operations of the company
 Customers: Buy the company’s products and services
 Suppliers: Provide raw materials as well as goods and services that cannot be
produced efficiently internally.
 Government and regulators: Dictate the rules and regulations governing the company.
Exhibit 1 from the curriculum illustrates these relationships.

Shareholder vs. Stakeholder Theory

Traditional corporate governance frameworks were based on the ‘shareholder theory’,
however, many companies are now moving to corporate governance frameworks based on
the ‘stakeholder theory’.
Shareholder theory: The goal of a company is to maximize shareholder returns. The
interests of other stakeholders are considered only to the extent that they affect shareholder
value.
Stakeholder theory: The company should consider the interests of all stakeholders, not just
shareholders. This theory also gives more importance to ESG considerations by making them
an explicit objective for the board of directors and management.
We will now look at each stakeholder group in detail.
Shareholders
Shareholders own shares in a corporation and are entitled to certain rights, such as the right
to receive dividends and to vote on certain corporate issues.
A shareholder’s interests are typically focused on growth in corporate profitability that
maximizes the value of the company.
Creditors/Debtholders
Banks and Private Lenders
 They generally hold a company’s debt till maturity.
 They typically have direct access to company management and insider information
which reduces information asymmetries.
 As compared to public debt holders, banks and private lenders can exert a significant
degree of influence on a company.
 Most banks and private lenders prefer companies to have less financial leverage as it
implies less risk. They may, however, take very different approaches to lending. Some
focus primarily on the collateral supporting their loan; others hold both debt and
equity positions in the same company; some have an equity-like focus on the
company; and some lend to businesses that they would be interested in owning if the
company defaulted.
Public Debtholders (Bondholders)
 They rely on public information and the ratings provided by credit rating agencies to
make their investment decisions.
 In return for the capital provided, they expect to receive periodic interest payments
and repayment of principal at the end of the term.

 Unlike shareholders, they do not have voting rights.

 They have limited influence over a company’s operations.
 They generally seek to minimize downside risk and prefer stability in company’s
operations and performance. This is in contrast to the interests of shareholders, who
are willing to take higher risks for higher potential returns.
Board of Directors
A company’s board of directors is elected by shareholders to protect shareholders’ interests,
monitor the company’s operations, and provide strategic direction. The board is also
responsible for hiring the CEO and overseeing management performance. A board can be
composed on both inside and independent directors.
 Inside directors are major shareholders, founders, and senior managers.
 Independent directors do not have a material relationship with the company in terms
of employment, ownership, or remuneration and are chosen for their experience of
managing or directing other companies.
There is no standard structure or composition for the board of a company. The number of
directors can vary depending on the size, structure, and complexity of operations of the
company. However, most corporate governance standards require that board members have
a diverse range of expertise, backgrounds, and competencies, with at least one-third of the
board being independent.
Staggered board is a commonly followed practice, in which directors are divided into three
groups and elected into office in consecutive years, so that all directors are not replaced at
the same time. The advantage of a staggered board is that it allows for continuous strategy
implementation. The disadvantage is that it limits shareholders' ability to effect an
immediate major change in control of the company.
Managers
Managers, led by the CEO are responsible for executing the strategy set by the board. They
are also in charge of the company’s day to day operations.
Senior managers are typically compensated with a base salary, a short-term cash bonus, and
a multi-year incentive plan that includes one or more forms of equity (such as options, time-
vested shares, and performance-vested shares). As a result, in addition to acting to protect
their employment status, managers may be motivated to maximize the value of their total
remuneration.
Employees
Lower-level employees seek fair salary, good working conditions, job security, career
development opportunities, promotion, etc.
As compared to managers, equity ownership is a minor part of their compensation.

Therefore, they are more interested in the company’s long-term stability, survival and
growth.
Customers
Customers expect to receive products and services of good quality for the price paid. They
also expect after-sales service, support, and guarantee/warranty for the period promised. In
return, companies strive to keep their customers happy as this has a direct effect on its
revenues. Of all the stakeholders, customers are least concerned about a company’s
performance.
Suppliers
The primary interest of a supplier is to be paid on time for the products and services
delivered to the company. Some suppliers are keen to maintain a good long-term
relationship with companies as it is recurring business. Like customers, suppliers typically
have an interest in the company’s long-term stability.
Governments
Government is a stakeholder as it collects taxes from companies and their employees.
Governments seek to protect the interests of the general public and ensure the well-being of
their nations’ economies.
3. Principal–Agent and Other Relationships
A principal-agent relationship arises when a principal hires an agent to carry out a task or a
service (e.g. shareholders and managers/directors). An agent is obliged to act in the best
interests of the principal and should not have a conflict of interest in performing a task.
However, in reality, there are several conflicts of interest that arise in a principal-agent
relationship, for example: information asymmetry.
Information asymmetry: Managers have greater access to information about a company’s
performance and prospects as compared to outsiders such as shareholders and creditors.
This information asymmetry reduces shareholders' ability to assess managers' true
performance and vote out poor performers. Investors demand higher risk premiums and
returns from companies that have greater information asymmetry.
In this section we will discuss a few examples of conflicts between principal-agents and
other relationships.
Shareholder and Manager/Director Relationships
In this relationship, shareholders are the principals and managers/directors are the agents.
Compensation is the main tool used to align the interest of managers/directors with those of
the shareholders. In theory, stock grants/options offered as part of management
compensation are intended to motivate managers to maximize shareholder value. However,

in practice, the alignment of interests is rarely perfect. Three common examples of conflict of
interests are:
 Entrenchment: If the overall level of manager/director compensation is excessive,
they may try to avoid risk so as to not jeopardize the compensation they have been
receiving.
 Empire building: If manager/director compensation is tied to the size of the
company, it can lead to ‘growth for growth’s sake’; managers may pursue acquisitions
and expansions that do not increase shareholder value.
 Excessive risk taking: Because option holders only participate in stock up moves, a
compensation package that relies too heavily on stock grants/options may encourage
excessive risk taking by management. Similarly, a compensation package with too
little or no stock grants/options can have the opposite effect.
Agency costs: Agency costs arise due to conflicts of interest when an agent makes decisions
for a principal. All public companies and large private companies are usually managed by
non-owners. Therefore, an agency cost in the context of a corporation is a consequence of a
conflict of interest between managers and owners. Since outside shareholders are aware of
this conflict, they will take steps that incur costs such as:
 Costs borne by owners to monitor the management of the company, e.g., expenses of
the annual report, board of director expenses, etc.
 Costs borne by management to assure owners that they are maximizing the company
value, e.g., the implicit cost of noncompete employment contracts and the explicit cost
of insurance to guarantee performance.
The better a company is governed, the lower the agency costs.
Controlling and Minority Shareholder Relationships
Corporate ownership structures can be classified as:
 Dispersed: Many shareholders exist and none of them have the ability to individually
exercise control over the company.
 Concentrated: An individual shareholder or a group has the ability to exercise control
over the company.
 Hybrid: A combination of the above two types.
Share ownership alone may not necessarily reflect whether the control of a company is
dispersed or concentrated. Controlling shareholders may be either majority shareholders or
minority shareholders.
 Majority shareholders: Own more than 50% of a company’s shares.
 Minority shareholders: Own less than 50% of a company’s shares.
In companies with concentrated ownership, conflict of interest may arise between the

controlling and minority (without control) shareholders. For example,

 Electing board of directors: Controlling shareholders have greater representation and
influence in electing the board of directors that use straight voting. As a result,
minority shareholders do not have much representation on the board.
 Takeover transactions: Corporate decisions taken by controlling shareholders impact
the performance of a company, and consequently, shareholders’ wealth. Controlling
shareholders exercise their influence on significant decisions such as takeover
transactions.
Dual-Share Classes
An equity structure with multiple share classes tends to assign superior voting powers to
one class and limited voting rights to other classes. The multiple-class structure allows
controlling shareholders avoid dilution of their voting power when new shares are issued
and to retain control of board elections, strategic decisions, and all other significant voting
matters for an extended period of time — even if their ownership level falls below 50%.
Manager and Board Relationships
The management of the company is primarily responsible for the operations of a company
and has access to all information about the company. Since the board relies on the
management for information, its powers and monitoring ability is impacted if information is
withheld by the management or only selective information is provided.
Shareholder vs. Creditor (Debtholder) Interests
There is a conflict of interest between the two suppliers of capital to a company under the
following circumstances:
 Distribution of dividends: Creditors are concerned if a company pays excess dividends
to shareholders that may impair its ability to service debt.
 Risk tolerance: Shareholders have a higher risk tolerance and prefer a company takes
on more risk to generate higher returns. The better the performance of a company, the
higher is the return shareholders can expect. Creditors are conservative and prefer a
stable operating cash flow over higher returns as they do not have a claim to residual
income.
 Increased borrowing: When a company increases its borrowing and fails to generate
returns to service the debt, then the default risk faced by the creditors increases.
4. Corporate Governance and Mechanisms to Manage Stakeholder Risks

Corporate governance practices differ from country to country, and even within a country
several governance systems may be practiced. There is no single universally accepted
definition of corporate governance.
The curriculum defines corporate governance as the arrangement of checks, balances, and

incentives that exists to manage conflicting interests among a company’s management,

board, shareholders, creditors, and other stakeholders.
Stakeholder management involves identifying, prioritizing, and understanding the
interests of stakeholder groups and managing the company’s relationships with
stakeholders.
Shareholder Mechanisms
Mechanisms to mitigate shareholder risks include company reporting and transparency,
general meetings, investor activism, derivative lawsuits, and corporate takeovers.
Corporate Reporting and Transparency
Shareholders have access to financial and non-financial information about the company from
annual reports, proxy statements, disclosures on the company's website, the investor
relations department, and other channels. Such information helps shareholders to:
 reduce the extent of information asymmetry between shareholders and managers;
 assess the performance of the company and that of its directors and managers;
 make informed decisions in valuing the company and deciding to purchase, sell, or
transfer shares; and
 vote on key corporate matters or changes.
Shareholder Meetings
General meetings provide an opportunity to shareholders to exercise their vote on major
corporate issues. There are typically two types of general meetings:
 Annual general meetings: These are usually held once a year. During an AGM, a
company’s annual performance is presented and discussed, and shareholders’
questions are answered.
 Extraordinary general meetings: These can be called anytime during the year, either by
the company or shareholders, whenever a major resolution has to be passed such as
an amendment to a company’s bylaws, mergers or acquisitions, or the sale of
businesses.
Number of votes required may be one of the following two types based on the type of
resolution to be passed:
 For simple decisions, a simple majority of votes is sufficient.
 For material decisions, a supermajority vote is required, i.e., 75% of the votes must be
in favor of a resolution to be passed.
Proxy voting allows shareholders to authorize another individual to vote on their behalf at
the AGM. In cumulative voting, shareholders may accumulate their votes to vote for one
candidate in an election that involves more than one director.
Shareholder Activism

Shareholder activism refers to strategies used by shareholders to attempt to compel a

company to act in a desired manner. The primary motivation of activist shareholders is to
increase shareholder value. Hedge funds are amongst the most predominant shareholder
activists.
Shareholder Derivative Lawsuits
Shareholder derivative lawsuits are legal proceedings initiated by one or more shareholders
against board directors, management, and/or controlling shareholders of the company.
However, in many countries, the law prohibits shareholders from taking legal action through
the court system.
Corporate Takeovers
Shareholders prefer corporate takeover if the management of a company underperforms.
The commonly used methods for corporate takeovers are as follows:
 Proxy contest: A group attempting to take a controlling position on a company’s board
influences shareholders to vote for them.
 Tender offer: An offer by a group seeking to gain control to purchase a shareholder’s
shares.
 Hostile takeover: One company tries to acquire another company by bypassing the
management and directly going to the company’s shareholders.
Creditor Mechanisms
Mechanisms to mitigate creditor risks include bond indenture(s), company reporting and
transparency, and committee participation.
Bond Indenture
 A bond indenture is a legal contract that describes the structure of a bond, the
obligations of the company, and the rights of the bondholders.
 Covenants are terms in a bond indenture that specify what a bond issuer may and may
not do. The goal is to reduce bondholders' exposure to risk. Affirmative covenants,
also known as positive covenants, require the company to take specific actions or
meet certain requirements, such as maintaining adequate levels of insurance.
Restrictive covenants, also known as negative covenants, require bond issuers to not
perform certain actions, such as allowing the company's liquidity level to fall below a
minimum coverage ratio.
 Collaterals are pledged assets or financial guarantees that may be used to repay
bondholders if an issuer defaults on periodic payments.
Corporate Reporting and Transparency
Creditors require the company to provide periodic financial information to monitor the risk

exposure and to ensure covenants are not violated.

Creditor Committees
In some countries, official creditor committees are formed once a company files for
bankruptcy. Such committees are expected to represent bondholders throughout the
bankruptcy proceedings and protect bondholder interests in any restructuring or
liquidation.
Board of Director and Management Mechanisms
The board of directors delegates specific functions to individual committees that, in turn,
report to the board on a regular basis. The most commonly established board committees
are:
Audit Committee
The key functions of the audit committee include:
 monitoring the financial reporting process;
 supervising the internal audit function, annual audit plan, and annual review; and
 appointing and interacting with an external auditor as well as implementing
remediation per that auditor.
Governance Committee
The key functions of the governance committee include:
 developing and monitoring corporate governance policies and practices,
 ensuring organizational compliance and remediation with applicable laws and
regulations, and
 aligning organizational structure with governance principles.
Remuneration or Compensation Committee
The key functions of the remuneration committee include:
 developing director and executive remuneration policies,
 overseeing performance policy management and evaluation, and
 setting human resources (HR) policies relating to employee compensation.
Nomination Committee
The key functions of the nomination committee include:
• overseeing the director nomination and board election process,
• identifying senior leadership candidates, and
• maintaining board composition and independence.
Risk Committee
The key functions of the risk committee include:

 determining company risk profile,

 ensuring appropriate enterprise risk management, and
 aligning corporate activities with risk appetite.
Investment Committee
The key functions of the investment committee include:
 assessing of major investment opportunities, and
 evaluating board investment recommendations.
Employee Mechanisms
Labor Laws
Standard rights of employees in any country such as hours of work, pension and retirement
plans, vacation and leave, are defined in labor laws. Employees can form unions in many
countries to collectively influence the management on issues they may face.
Employment Contracts
Individual employee contracts define an employee’s rights and responsibilities,
remunerations, and other benefits such as ESOPs.
Customer and Supplier Mechanisms
Companies enter into contracts with both customers and suppliers that define the products,
services, any guarantee, after-sales support, payment terms, etc. It also defines the course of
action in case one party violates the contract.
Government Mechanisms
Regulations
Governments and regulatory agencies pass laws to protect the interests of consumers or
specific stakeholders. Sensitive industries such as banks, health care, and food
manufacturing companies have to comply with a rigorous regulatory framework.
Corporate Governance Codes
Many regulatory authorities have also adopted corporate governance codes, which are
guiding principles for publicly traded companies. These codes require companies to disclose
whether they have implemented recommended corporate governance practices or explain
why they have not done so.
Common Law vs. Civil Law Systems
The rights of stakeholders depend on the law of the country the company operates in. There
are primarily two law systems.
 Common law system: This is considered to offer better protection for stakeholders as

laws can be created both by legislature and judges. This system is found in the United
Kingdom, United States, India, etc.
 Civil law system: This is considered restrictive for stakeholders as laws can be created
only by passing legislation.
Creditors are more successful in winning legal battles when the terms of indenture are
violated. In contrast, shareholders find it difficult to prove in court that a manager/director
has not acted in their best interests.
5. Corporate Governance and Stakeholder Management Risks and

Benefits
Risks of Poor Governance and Stakeholder Management
In this section, we analyze the risks a company faces due to a poor governance structure.
Weak Control Systems
Weak control systems and poor monitoring can affect a company’s performance and value.
One example is that of Enron where auditors failed to uncover fraudulent reporting that
ultimately affected many stakeholders.
Ineffective Decision-Making
Poor decisions include managers avoiding good investment opportunities to maintain a low-
risk profile or taking on excessive risk without properly evaluating potential investments.
Both decisions are not in the interests of shareholders. Such decisions may result from
information asymmetry, when managers have access to more information than the
board/shareholders.
Legal, Regulatory, and Reputational Risks
Improper implementation and monitoring of corporate governance procedures may result in
the following risks:
• Legal: Stakeholders such as shareholders, creditors and employees may file lawsuits
against the company if their rights are violated.
• Regulatory: Government/regulator may choose to take action if the applicable laws
are violated.
• Reputational: A company may be subjected to negative publicity by
investors/analysts if there is an improperly managed conflict of interest.
Default and Bankruptcy Risks
Poor corporate governance may affect the company’s performance, which in turn may affect
the company’s ability to service its debt. If creditors’ rights are violated and they choose to
take legal action on defaulting debt, the company may be forced to file for bankruptcy.

Benefits of Effective Governance and Stakeholder Management

The benefits of good corporate governance and stakeholder management are as follows:
• Operational efficiency: A good governance structure ensures that all employees of a
company have a clear understanding of their responsibilities and reporting structures.
The operational efficiency of a company is improved when good governance structure
is combined with strong internal control mechanisms.
• Improved control: Good governance implies improved control at all levels to help a
company manage its risk efficiently. Control can be improved with a good audit
committee, complying with laws and regulations, and introducing procedures to
handle related-party transactions.
• Better operating and financial performance: A company’s operating and financial
performance can be improved with good governance practices. Proper remuneration
for management, mitigation of lawsuits against the company, and improving the
decision-making of its managers to make the right investments are ways that will help
in improving the performance of a company.
• Lower default risk and cost of debt: A company’s cost of debt and default risk can be
reduced by protecting creditors’ rights, ensuring proper audits are conducted, and
that there is no information gap between the company and its creditors.
6. ESG Considerations in Investment Analysis

ESG is an acronym for environmental, social and governance issues. The importance of good
corporate governance has long been understood by analysts and shareholders. Therefore,
the practice of considering governance factors in investment analysis has evolved
considerably. However, the practice of considering environmental and social factors in
investment analysis has evolved more slowly.
The two main catalysts for growth in ESG investing are:
1. ESG issues are having more financial impacts. Many investors incurred significant
losses when the companies they invested in mismanaged ESG issues.
2. A greater number of younger investors are increasingly demanding that their
inherited wealth or pension contributions be managed responsibly.
Historically, environmental and social issues, such as climate change, air pollution, and
societal impacts of a company’s products and services, have been treated as negative
externalities. However, increased stakeholder awareness and strengthening regulations
have led to inclusion of environmental and societal costs in the company’s income statement
by responsible investors.

Introduction to Environmental and Social Factors

Corporate governance considerations are reasonably consistent across most companies and
industries. However, environmental and social considerations differ greatly across
industries. For example, environmental and social concerns for the energy sector will be
very different from the concerns for the banking sector.
While evaluating ESG factors, analysts first need to evaluate if a factor is material. An ESG
factor is considered to be material when that factor is believed to have an impact on a
company’s long-term business model.
Some environmental and social factors considered in investment analysis are listed below:
Environmental factors
 Natural resource management.
 Pollution prevention.
 Water conservation.
 Energy efficiency and reduced emissions.
 Existence of carbon assets.
 Compliance with environmental and safety standards.
Social factors
 Human rights and welfare concerns in the workplace
 Data privacy and security
 Access to affordable health care products
 Community impact
Stranded assets: A specific concern among investors of energy companies is the existence of
“stranded assets” — carbon-intensive assets that are at risk of no longer being economically
viable because of changes in regulation or investor sentiment.
Evaluating ESG-Related Risks and Opportunities
Some examples of ESG factors are presented in Exhibit 7 from the curriculum.

Environmental Issues Social Issues Governance Issues

• Climate change and carbon • Human rights • Bribery and corruption
emissions • Labor standards • Shareholder rights
• Air and water pollution • Data security and privacy • Board composition
• Biodiversity • Occupational health & safety (independence & diversity)
• Deforestation • Customer satisfaction & • Audit committee structure
• Energy efficiency product responsibility • Executive compensation
• Waste management • Treatment of workers • Lobbying & political
• Water scarcity • Gender equity and diversity contributions
• Community relations & • Whistleblower schemes
charitable activities
Typically, a smaller set of factors are material for each company depending on the business
segments and geography it operates in.
Equity vs. Fixed-Income Security Analysis
ESG integration refers to the implementation of qualitative and quantitative ESG factors in
traditional security and industry analysis. The process of identifying ESG factors is similar
for both equity as well as fixed-income analysts. However, ESG integration differs
significantly between equities and fixed income with respect to valuation.
Equity analysis: ESG integration is used to both identify potential opportunities and
mitigate downside risk. ESG-related factors are often analyzed in the context of forecasting
financial metrics and ratios, adjusting valuation model variables (e.g., discount rate), or using
sensitivity and/or scenario analysis.
Fixed-income analysis: ESG integration is generally focused on mitigating downside risk.
Analysts usually do not focus on potential opportunities. Measures such as relative value,
spread, duration, sensitivity/scenario analysis are used.
The credit assessment may vary depending on maturity. For example, some factors may have
an impact in the long term but have no impact in the short term. Such factors are not
relevant while evaluating short term bonds.
7. Environmental, Social, and Governance Investment Approaches
There is a lack of consensus on ESG related terms used in the investment community. The
curriculum defines ESG investing terminology as follows:
Responsible investing is the broadest definition used to describe investment strategies that
incorporate ESG factors with the objective of mitigating risk and protecting asset value while
avoiding negative environmental or social consequences.
Sustainable investing selects assets and companies based on their perceived ability to

deliver value by advancing economic, environmental, and social sustainability.

Socially responsible investing (SRI) incorporates environmental and social factors into the
investment decision-making process, selecting those investments and companies with
favorable profiles or attributes based on the investor’s social, moral, or faith-based beliefs.
ESG investing can be value-based or values-based.
• The goal of value-based investing is to incorporate important ESG factors and
traditional financial metrics into investment analysis while mitigating risk.
• The goal of values-based investing is to choose investments that express or align with
an investor's moral or faith-based beliefs.
ESG Investment Approaches
The six main ESG investment approaches are:
 Negative screening: This involves exclusion of certain sectors or companies or
practices from a fund or portfolio on the basis of specific ESG criteria. For example,
companies engaged in fossil fuel extraction or garment companies employing child
labor.
 Positive screening: Positive screening strategy involves inclusion of certain sectors,
companies, or practices in a fund or portfolio on the basis of specific ESG criteria. For
instance, these companies may have policies focused on the well-being and safety of
its employees, and strive towards protecting employee rights.
 ESG integration: Refers to the practice of including material ESG factors in the
investment process. Traditional financial analysis metrics such as cash flow forecasts,
credit/default risk forecasts, and/or cost of capital estimates are adjusted to account
for the ESG factors.
 Thematic investing: This strategy picks investments based on a theme or single
factor, such as energy efficiency or climate change. An increasing trend world over is
the increasing demand for energy and water. Companies that provide solutions to
these socio-economic problems make for attractive investments.
 Engagement/active ownership: This strategy involves achieving targeted social or
environmental objectives along with measurable financial returns by using
shareholder power to influence corporate behavior. Examples include: venture capital
investing and green bonds.
 Impact investing: Investments made with the intention to generate positive,
measurable social and environmental impact alongside a financial return. For
example, investments that help achieve one of the United Nations sustainable

development goals such as SDG6: Clean Water and Sanitation.

Green finance: It is a responsible investing approach that uses financial instruments to
support a green economy. For example, green bonds are bonds where the proceeds are used
by the issuer to fund environmental-related projects.
ESG Market Overview
The amount of global assets under management (AUM) dedicated to ESG investments has
increased substantially. This has led to increased corporate disclosures of ESG issues, as well
as a growing number of firms that collect and analyze ESG data. Also, several organizations
have been formed to monitor and advance the mission of sustainable investing.

Summary
LO. Describe a company’s stakeholder groups and compare their interests.
The primary stakeholders of a company include:
 Shareholders
 Creditors
 Managers and employees
 Board of Directors
 Customers
 Suppliers
 Government/Regulators
LO. Describe the principal-agent relationship and conflicts that may arise between
stakeholder groups.
A principal-agent relationship arises when a principal hires an agent to carry out a task or a
service. An agent is obliged to act in the best interests of the principal and should not have a
conflict of interest in performing a task. However, such relationships often lead to conflicts
among stakeholders in a corporate structure. Examples of relationships that lead to such
conflicts include:
 shareholder and manager/director.
 controlling and minority shareholder.
 manager and board.
 shareholder and creditor.
LO. Describe corporate governance and mechanisms to manage stakeholder
relationships and mitigate associated risks.
Corporate governance can be defined as the arrangement of checks, balances, and incentives
that exists to manage conflicting interests among a company’s management, board,
shareholders, creditors, and other stakeholders.
Mechanisms to mitigate shareholder risks include company reporting and transparency,
general meetings, investor activism, derivative lawsuits, and corporate takeovers.
Mechanisms to mitigate creditor risks include bond indenture(s), company reporting and
transparency, and committee participation.
Mechanisms to mitigate board risks include board/management meetings and board
committees.
Mechanisms to mitigate risks for other stakeholder (employees, customers, suppliers, and
regulators) include policies, laws, regulations, and codes.
LO. Describe both the potential risks of poor corporate governance and stakeholder

management and the benefits from effective corporate governance and stakeholder
management.
The risks of poor corporate governance include weak control systems; ineffective decision-
making; legal, regulatory, and reputational risks; and default and bankruptcy risks. Benefits
include operational efficiency, improved control, better operating and financial performance,
and lower default risk and cost of debt.
LO. Describe environmental, social, and governance considerations in investment
analysis.
Materiality and Investment Horizon: While evaluating ESG factors, analysts first need to
evaluate if an information is material. Materiality typically refers to ESG related issues that
can affect a company’s operation, its financial performance, and the valuation of its
securities.
Analysts also consider their investment horizon when deciding which ESG factors to
consider in their analysis. Some factors may affect a company’s performance in the short
term, whereas other issues may be more long term in nature.
Some examples of ESG factors are presented in Exhibit 7 from the curriculum.
Environmental Issues Social Issues Governance Issues

• Climate change and carbon • Human rights • Bribery and corruption
emissions • Labor standards • Shareholder rights
• Air and water pollution • Data security and privacy • Board composition
• Biodiversity • Occupational health & safety (independence & diversity)
• Deforestation • Customer satisfaction & • Audit committee structure
• Energy efficiency product responsibility • Executive compensation
• Waste management • Treatment of workers • Lobbying & political
• Water scarcity • Gender equity and diversity contributions
• Community relations & • Whistleblower schemes
charitable activities
Equity vs. Fixed-Income Security Analysis:

 Equity analysis: ESG integration is used to both identify potential opportunities and
mitigate downside risk. Analysts adjust financial model variables such as cost of
capital to reflect ESG factors.
 Fixed-income analysis: ESG integration is generally focused on mitigating downside
risk. Analysts usually do not focus on potential opportunities. The credit assessment
may vary depending on maturity.

LO. Describe environmental, social, and governance investment approaches.

The six main investment approaches are:
ESG Investment Style Description
Negative screening Excluding certain sectors or companies or practices from a fund

or portfolio on the basis of specific ESG criteria.
Positive screening Including certain sectors, companies, or practices in a fund or

portfolio on the basis of specific ESG criteria.
ESG integration Refers to the practice of including material ESG factors in the
investment process.
Thematic investing This strategy picks investments based on a theme or single factor,
such as energy efficiency or climate change.
Engagement/ active This strategy involves achieving targeted social or environmental

ownership objectives along with measurable financial returns by using
shareholder power to influence corporate behavior.
Impact investing Investments made with the intention to generate positive,

measurable social and environmental impact alongside a
financial return.

LM03 Business Models & Risks 2023 Level I Notes
LM03 Business Models & Risks

1. Introductory Context/Motivation .................................................................................................................3
2. What is a Business Model? ...............................................................................................................................3
Business Model Features .................................................................................................................................4
Customers, Market: Who .................................................................................................................................5
Firm Offering: What ...........................................................................................................................................5
Channels: Where .................................................................................................................................................6
Pricing: How Much .............................................................................................................................................7
Value Proposition (Who + What + Where + How Much) ....................................................................9
Business Organization, Capabilities: How.............................................................................................. 10
Profitability and Unit Economics ............................................................................................................... 10
3. Business Model Types..................................................................................................................................... 11
Business Model Innovation.......................................................................................................................... 12
Business Model Variations ........................................................................................................................... 12
E-Commerce Business Models .................................................................................................................... 13
Network Effects and Platform Business Models .................................................................................. 13
Crowdsourcing Business Models ............................................................................................................... 13
Hybrid Business Models................................................................................................................................ 14
4. Business Models: Financial Implications................................................................................................. 14
External Factors ............................................................................................................................................... 14
Firm-Specific Factors ..................................................................................................................................... 15
5. Business Risks .................................................................................................................................................... 15
6. Macro Risk, Business Risk, And Financial Risk ..................................................................................... 15
Risk Impacts Are Cumulative ...................................................................................................................... 16
7. Business Risk: A Closer Look ....................................................................................................................... 16
Industry Risks ................................................................................................................................................... 16
Industry Definition .......................................................................................................................................... 17
Company-Specific Risks ................................................................................................................................ 17
8. Financial Risk ..................................................................................................................................................... 18
Measuring Operating and Financial Leverage ...................................................................................... 18
Summary................................................................................................................................................................... 20
rights reserved.

Version 1.0

1. Introductory Context/Motivation
 What is a business model
 The types of business models
 The financial implications of business models
 Risks faced by companies – Macro risk, business risk, and financial risk
A well-defined business model helps analysts in understanding a company's operations,
strategy, target customers, key partners, prospects, risks, and financial profile. Many
companies have conventional business models that are easily understood, such as
manufacturer, wholesaler, retailer, restaurant chain etc.
However , the advent of digital technology has changed the way most businesses operate,
and enabled disruption of existing business models. Many companies now have business
models that are complex, specialized, or new.
2. What is a Business Model?

A business model describes how a business is organized to deliver value to its customers:
 who its customers are,
 how the business serves them,
 key assets and suppliers, and
 the supporting business logic.
A business model explains what the company does, how it operates, and how it generates
revenue and profits, as well as how it differs from competitors. It provides enough detail to
understand the basic relationships between these key elements, however, it does not
provide a full description. For a full description (such as detailed financial forecasts) we
would have to refer to a business plan.
A business model should have a value proposition and a value chain.
 The firm’s “value proposition” refers to the product or service attributes valued by a
firm’s target customer that lead those customers to prefer a firm’s offering over those
of its competitors, given relative pricing.
 The firm’s “value chain” refers to how the firm is structured to deliver that value. It
refers to the systems and processes within a firm that create value for its customers.
This is illustrated in Exhibit 1 from the curriculum.

Business Model Features

The key features of a public company’s business model are often provided in annual reports
or other disclosure documents. As an example, the curriculum presents the ‘business
description’ from Tesla’s annual report.
“We design, develop, manufacture, sell and lease high-performance fully electric vehicles
and energy generation and storage systems, and offer services related to our products.
We are the world’s first vertically integrated sustainable energy company, offering end-
to-end clean energy products, including generation, storage and consumption. We
generally sell our products directly to customers, including through our website and retail
locations. We also continue to grow our customer-facing infrastructure through a global
network of vehicle service centers, Mobile Service technicians, body shops, Supercharger
stations and Destination Chargers to accelerate the widespread adoption of our products.
We emphasize performance, attractive styling and the safety of our users and workforce
in the design and manufacture of our products, and are continuing to develop full self-
driving technology for improved safety. We also strive to lower the cost of ownership for
our customers through continuous efforts to reduce manufacturing costs and by offering
financial services tailored to our vehicles. Our sustainable energy products, engineering
expertise, intense focus to accelerate the world’s transition to sustainable energy and
achieve the benefits of autonomous driving, and business model differentiate us from
other companies.”
In this paragraph, Tesla describes many features, including its products and their attributes,

key channels, and its emphasis on innovation and vertical integration. Let's take a closer look
at the features.
Customers, Market: Who
A business model should identify the firm’s target customers:

 What geographies will be served?
 What market segments will be served? (e.g., high income suburban families)
 What customer segments will be served? Is this a business (B2B) or consumer (B2C)
market?
In the Tesla example, the business description does not specify which customer segments
are being targeted. This is most likely because Tesla’s target market is shifting over time
toward the mass market, as costs and prices decline.
Firm Offering: What
A business model should define:

 What products and services are being offered?
 What differentiates these offerings from competitors?
 How are the needs of its target customers being met?
In the Tesla example, instead of using a broad description such as “electric car” to describe
its product offering; Tesla has used a more precise description that is useful to analysts -
“high-performance fully electric vehicles and energy generation and storage systems”.

Channels: Where
A firm’s channel strategy refers to “where” the firm is selling its offering and how it is
reaching its customers. Channel strategy typically involves two main functions:
 Selling the firm’s products and services
 Delivering them to customers
When evaluating a firm’s channel strategy, it is important to distinguish the functions
performed, from the assets that might be involved, and different firms that might be involved
in performing those functions or owning those facilities. Exhibit 2 from the curriculum,
illustrates this concept.
Many “product” businesses, employ a traditional channel strategy, that reflects the flow of
finished goods (e.g., from manufacturer to wholesaler, retailer, and end customer). However,
some manufacturers may employ a direct sales strategy, selling directly to the end
customer. This strategy bypasses (or disintermediates) the distributor and retailer.
Typically, direct sales involved the use of the company’s own sales force and was very
expensive. However, with e-commerce, direct sales have now become a cost-effective
strategy. Exhibit 3 from the curriculum compares the two strategies.

When an intermediary is involved, that intermediary may work on an agency basis, earning
commissions, rather than taking ownership of the goods (e.g., auctioneers such as Sotheby’s
that deal in fine art).
The drop shipping model in e-commerce allows an online marketer to have goods delivered
directly from the manufacturer to the end customer without taking the goods into inventory.
Companies often use several channels in tandem. With an omnichannel strategy, both
digital and physical channels are used to complete a sale. For example, a customer might
order an item online and pick it up in a store (“click and collect”).
It is important to understand how a firm’s channel strategy differs from those of its
competitors. For example, Tesla mentions its direct sales strategy, which differs from the
franchised dealer model used by most automakers.
Pricing: How Much
A business model should answer the following questions related to pricing:

 Does the firm price at a premium, parity, or discount relative to competitors?
 How is the firm’s pricing justified in its business model?
Based on pricing power companies can be classified into:
 Price takers – Companies with little differentiation are "commodity" producers who
must accept market prices dictated to them. Such companies focus on other sources of
value such as employing a discounting strategy to build scale and a cost advantage

(e.g., Walmart).
 Price setters – Companies with high differentiation can command premium pricing
and face significantly less pricing risk from competitors.
Most firms try to differentiate their offerings in some way to achieve some degree of pricing
power. For example, Tesla focuses on the “total cost of ownership” which factors in
government subsidies and lower operating costs for electric vehicles as an offset to higher
purchase prices.
Pricing and Revenue Models
Pricing approaches are typically value based or cost based.
 Value-based pricing attempts to set pricing based on the value received by the
customer. For example, Tesla can command a premium price because they have low
operating costs, which is a source of value for their customers.
 Cost-based pricing attempts to set pricing based on costs incurred. For example, an
environmental law firm may charge clients by the hour because it is difficult to predict
how many hours (cost) will be required and how much value the client will receive.
Price Discrimination
Price discrimination refers to situations where firms charge different prices to different
customers. The objective of price discrimination is to maximize revenues in a situation
where different customers have different willingness to pay. Common pricing strategies in
this category include:
 Tiered pricing charges different prices to different buyers, most commonly based on
purchase volume.
 Dynamic pricing charges different prices at different times. For example, off-peak
pricing offered by hotel rooms and airlines, and movie tickets; and surge pricing
offered by ride sharing companies.
 Auction/reverse auction models establish prices through bidding.
Pricing for Multiple Products
Firms selling multiple products frequently use the following pricing models:
 Bundling refers to combining multiple products or services so that customers are
incentivized, or required, to buy them together. For example, cable TV and internet
services, prepackaged set of kitchen utensils.
 Razors-and-blades pricing combines a low price on a piece of equipment and high-
margin pricing on repeat-purchase consumables. For example, razors and blades,

printers and refill cartridges.

 Optional product pricing applies when a customer buys additional services or product
features, either at the time of purchase or afterward. For example, deluxe interior for a
car, a side order with a restaurant meal.
Pricing for Rapid Growth
 Penetration pricing: A firm willingly sacrifices margins in order to build scale and
market share. For example, Netflix subscriptions, Amazon e-readers.
 Freemium pricing: Allows customers a certain level of usage or functionality at no
charge. For example, mobile games, software applications.
 Hidden revenue business models: Provide free services to users while generating
revenue elsewhere. For example, media sector which provides free content and paid
advertising.
Alternatives to Ownership
Some business models create value by offering an alternative to purchasing an asset or
product, such as:
 Recurring revenue/subscription pricing: Enables customers to rent a product or service
for as long as they need it. For example, TV channels, telecommunication services.
 Fractionalization: Creates value by selling an asset in smaller units or through the use
of an asset at different times. For example, web hosting which allows sharing of server
capacity, Office sub-leasing/co-working.
 Leasing: Involves shifting the ownership of an asset from the firm using it to an entity
that has lower costs for capital and maintenance. For example, real estate, aircrafts.
 Licensing: Gives a firm access to intangible assets (e.g., brand name, song, patented
formula) in return for royalty payments.
 Franchising: It is a more comprehensive form of licensing, in which the franchisor
typically gives the franchisee the right to sell or distribute its product or service in a
specified territory and to receive marketing and other support.
Value Proposition (Who + What + Where + How Much)
A firm’s value proposition refers to the product or service attributes valued by a firm’s target
customer that lead those customers to prefer a firm’s offering over those of its competitors,
given relative pricing.
Value propositions can arise from:
 The product itself – e.g., performance, features style etc.

 Service and support – e.g. access to repairs, spare parts etc.

 The sale process – e.g., purchasing convenience, no-hassle return
 Pricing relative to competitors
In the Tesla example, its electric car value proposition highlights the advantages of its
electric propulsion system: zero emissions and high performance (strong and silent
acceleration) and technological sophistication (e.g., self-driving capabilities, frequent
enhancements via software upgrades).
Business Organization, Capabilities: How
In addition to specifying a firm’s value proposition, a business model should also specify
“how” the firm is structured to deliver that value. It should address the following questions:
 What assets and capabilities (e.g., skilled personnel, technologies) does the firm
require to execute on its business model?
 Will these be owned/insourced or rented/outsourced?
Value Chain
The “how” aspect of a business model is also referred to as a firm’s value chain. It refers to
the systems and processes within a firm that create value for its customers.
A value chain includes only those functions performed by a single firm. Some of these
functions may be valued by customers but may not involve physical transformation or
handling the product.
A firm’s value chain is different from a supply chain. A supply chain refers to the sequence of
processes involved in the creation of a product, both within and external to a firm. It includes
all steps involved in producing and delivering a product, regardless of whether those steps
are performed by a single firm.
Value chain analysis provides a link between the firm’s value proposition for customers and
its profitability. It involves:
 identifying the specific activities carried out by the firm,
 estimating the value added and costs associated with each activity, and
 identifying opportunities for competitive advantage.
Profitability and Unit Economics
A business model should specify how the firm expects to generate its profits. To understand
the profitability of a business, the analyst should examine margins, break-even points and
unit economics (which is expressing revenues and costs on a per-unit basis).
The curriculum provides the following examples for unit economics:
Example:

A producer of bottle caps might sell its product at 2.5 cents per unit, with direct costs for
material and labor of 2.0 cents per unit and a contribution margin (selling price per unit
minus variable cost per unit) of 0.5 cents per unit. If the firm has fixed costs of USD500,000
per year, what is its unit break-even point?
Solution:
Break-even point (unit) = Fixed costs/Contribution margin
= USD500,000/0.5 cents
= 100 million units.
Example:
A restaurant chain might have an average order of EUR50, with ingredient costs equal to
50% of sales. If fixed costs are EUR250,000 annually per outlet, what is the firm’s unit break-
even point and operating margin at 20,000 orders per year?
Solution:
Break-even point (order) = Fixed costs/Contribution margin
= EUR250,000/EUR25
= 10,000 orders/year.
Operating margin = 20,000 orders × EUR50
= EUR1,000,000 revenues – EUR500,000 ingredient costs (50% of sales) – EUR250,000 fixed
costs
= EUR250,000 operating profit, or
= EUR250,000/EUR1,000,000 = 25%.
Tesla's business model is based on declining unit revenues and costs over time as volume
increases and technology improves. This is expected to result in a virtuous circle: Lower
prices allow Tesla to expand its addressable market and market share, while lower costs
allow profits to rise and create a competitive barrier.
3. Business Model Types

Each industry tends to has its own set of established business models. Firms in the goods-
producing sectors are generally easy to classify based on how they fit into the supply chain.
For example, manufactures, wholesalers, retailers, suppliers etc.
However, service businesses are more diverse. For example, the financial services sector has
many established business models, as shown in Exhibit 5.

Some firms combine these models together (e.g. universal banks) while some specialize in a
particular model (e.g. discount brokers).
Business Model Innovation
Digital technology has transformed the “where” and “how” elements of business models in
established markets, by drastically reducing the cost of communicating, exchanging
information, and transacting between businesses.
 Location matters less: customers can easily buy from firms having no local physical
presence.
 Outsourcing is easier: for similar reasons.
 Digital marketing: makes it easy and cost-effective to reach very specific groups of
customers, regardless of location.
 Network effects: (discussed later) have become more powerful and accessible to firms.
Business Model Variations
There are many business model variations such as:
 Private label or “contract” manufacturers that produce goods to be marketed by others.
 Licensing arrangements in which a company will produce a product using someone
else’s brand name in return for a royalty. For example, toys and apparel based on
famous film characters.

 Value added resellers that not only distribute a product but also handle more complex
aspects of product installation, customization, service, or support. For example,
heating/air conditioning systems resellers.
 Franchise models in which distributers or retailers have a tightly defined and often
exclusive relationship with the parent company.
E-Commerce Business Models
E-commerce is a broad category that includes a wide range of internet-based direct sales
models. A few key variations of e-commerce business models include:
 Affiliate marketing generates commission revenue from sales made on other people's
websites. E.g., CJ Affiliate.
 Marketplace businesses create networks of buyers and sellers without taking
ownership of the goods during the process. E.g., eBay.
 Aggregators are similar to marketplaces, but they re-markets products and services
under their own brand. E.g., Uber.
Network Effects and Platform Business Models
The term "network effects" refers to the increase in value of a network to its users as more
people join. Many internet-based businesses are built on network effects. For example, social
media, ride-sharing services, online classified etc. Network effects are also applicable to
older, non-internet businesses such as telephone services, credit cards etc.
Network effects can be described as:
 Multi-sided: applicable to two or more groups of users. For example, buyers and sellers
on an online marketplace.
 One-sided: Users are a single, homogeneous group.
A platform business is defined as a business based on network effects—that is, where the
value of its service or product is enhanced by the addition of customers or users. They are
different from traditional or linear businesses. With a linear business, value is added by the
firm; with a platform business, value is created in the network, outside the firm.
Crowdsourcing Business Models
Crowdsourcing business models enable users to contribute directly to a product, service, or
online content. For example, Wikipedia, Google Maps, Tripadvisor.
Hybrid Business Models
Some companies employ hybrid models that combine platform and traditional “linear”
businesses. For example, Tesla sells cars via a linear model, but its customers benefit from an

expanding network of charging stations.
4. Business Models: Financial Implications

Businesses have very different financing needs and risk profiles depending on both external
and firm specific factors. These factors influence the firm's ability to raise capital.
External Factors
External factors include:
 Economic conditions: They affect almost all businesses. Important macroeconomic
variables to consider are GDP growth, exchange rates, interest rates, the credit
environment, unemployment, and inflation. Some businesses are more sensitive to
certain factors than others; for example, a wind farm business is likely to be more
sensitive to interest rates than to the overall GDP growth.
 Demographics trends: They influence the overall economy. Most mature, urbanized
economies have aging, declining populations and labor shortages. While most emerging
markets have high population growth and high labor availability. As compared to
economic forecasting, demographic forecasting can be done with higher accuracy
because the underlying drivers (birth, death, and immigration rates) change very slowly.
 Sector demand: These characteristics vary by industry. Some industries, such as
consumer staples, have very stable and predictable demand, while others, such as
industrial machinery, are more cyclical. The business cycle has less of an impact on the
demand for non-discretionary and immediate consumption products than it does on
demand for long-lived products. For example, toothpastes versus cars.
 Industry cost characteristics: Some industries, such as hotels, utilities, and airlines, are
inherently capital intensive, whereas others, such as many internet-based and service
businesses, require very little capital.
 Political, legal, and regulatory environment: This includes the institutions, laws,
regulations, and policies that affect the business. Some regulations may affect all
businesses, while others may affect specific industries or firms.
 Social and political trends: Changes in public opinion and taste can signal changes in
consumer buying behavior and the political/legal environment. For example, green
products, renewable energy etc.
Firm-Specific Factors
Firm-specific factors include:
 Firm maturity or stage of development: A startup typically requires more external capital
and has more business risk than a mature business.

 Competitive position: All else equal, a company with strong barriers to competition
(referred to as a “wide moat”), will have lower business and financial risk than a
company that does not have strong barriers. Similarly, a market leader will enjoy brand
and scale benefits over smaller competitors.
 Business model: A company’s business model influences its decisions about which assets
to “own” and which assets to “rent”. In this context, commonly observed business models
are:
o Asset-light business models: The ownership of high-cost assets is shifted to other
firms. For example, hotels, restaurants that use the franchisee model; the assets are
owned by the franchisee rather than the parent company.
o Lean startups: This model extends the logic of the ‘asset-light’ model to human
resources. The company outsources as many functions as possible. For example,
technology companies often adopt this approach.
o Pay-in-advance: Companies generate cash from sales before paying suppliers. This
model reduces or eliminates the need for working capital. For example, Amazon.
5. Business Risks
Financial analyst and investors must consider risk factors that can cause investment returns
to be different from expectations. Risk can be categorized into:
 Macro risk: Arises from the economic environment in which the business operates
 Business risk: Arises from the business itself
 Financial risk: Arises from the way in which the business is financed
6. Macro Risk, Business Risk, And Financial Risk
Macro risk refers to the risk from political, economic, legal, and other institutional risk
factors that impact all businesses in an economy, a country, or a region. The primary macro
risk affecting most businesses is the potential slowdown or decline in economic activity.
Depending on its geographic location, other country risk factors such as exchange rates,
political instability, or gaps in the legal framework may also be important for a business.
Some business such as consumer staples are less sensitive to economic activity, whereas,
others such as capital goods are more sensitive.
Business risk is the risk that the firm’s operating results will be different from expectations,
independently of how the business is financed. In accounting terms, we can say that business
risk reflects the risk at the operating profit (EBIT) level. EBIT can be lower than expected
due to lower revenues and/or higher than expected costs.
Financial risk refers to the risk arising from a company’s capital structure, specifically from

the level of debt and debt-like obligations (such as leases and pension obligations) involving
fixed contractual payments. Debt(financial leverage) causes net profit to vary more than
operating profit, on both the upside and downside.
Risk Impacts Are Cumulative
The impact of risks on a business are cumulative. A company’s operating results are affected
by both macro risks and business risks. Likewise, a company’s net earnings reflect the
combined impacts of macro risks, business risks and financial leverage.
7. Business Risk: A Closer Look

Industry Risks
Industry risks apply to all companies in the same industry and include risk factors that are
likely to affect the industry’s overall level of demand, pricing, and profitability.
 Cyclicality: Many industries such as discretionary goods, housing, durable goods (e.g.,
autos and appliances) and capital equipment exhibit cyclicality. These products are
generally long lived, which gives the buyer the flexibility to decide when to replace them.
Firms try to reduce the impact of cyclicality in different ways:
o Some enter into long-term customer or hedging contracts
o Some try to minimize fixed operating costs (e.g., through outsourcing)
Cyclical firms tend to have more conservative capital structure policies, with little debt as
compared to less cyclical firms.
 Industry structure: Industry structure can impact the overall risk of an industry. Lower
concentration (the presence of many small competitors) generally results in a high
degree of competitive intensity.
The Herfindahl–Hirschman Index (HHI) is frequently used to measure industry
concentration. It is calculated by squaring the market share of each firm competing in a
market and then summing the resulting numbers. High numbers indicate high
concentration and vice-versa.
 Competitive intensity: High competitive intensity can reduce overall industry
profitability. Analysts usually track return on invested capital (ROIC) and operating
profit margin (EBIT/revenue) to determine how the industry profitability is changing
over time.
 Competitive dynamics within the value chain: Analysts use Michael Porter’s “five
forces” model to identify and analyze five competitive forces that shape every industry
and to determine the impact on an industry’s profitability. The five forces are:
o Competition in the industry

o Threat of new entrants

o Bargaining power of suppliers
o Bargaining power of customers
o Threat of substitute products
 Long-term growth and demand outlook: Long-term growth can contribute to an
industry's long-term profitability; however, sudden and unexpected declines in growth
can result in excess capacity and aggressive competition. Long-term growth trends are
determined by the level of innovation, the dominating business models, and the
age/maturity of the industry.
 Other industry risks: This includes regulatory and other potential external risks.
Industry Definition
It is important to define the industry appropriately. If an analyst defines an industry too
broadly, then conclusions drawn from the industry analysis may be too broad to be useful.
In general, a narrower industry definition is preferable. However, defining the industry too
narrowly can make it difficult to obtain accurate data on demand and competition and to
draw conclusions about risk factors affecting the industry as a whole.
Company-Specific Risks
Company-specific risk vary based on the nature, scale and maturity of the business. They can
be categorized into:
 Competitive risk: It is the risk of loss of market share or pricing power to competitors. It
reflects a lack of competitive advantage. Typically, companies with strong competitive
advantage tend to have higher margins and lower business risk.
The typical sources of competitive advantage are:
o Cost advantages which can be based on scale, a superior production process,
proprietary technology, or other factors.
o Product or service differentiation which creates value for customers.
o Network effects which make the products or service more useful when they are
widely adopted.
o Switching barriers which make it more difficult or more costly to switch suppliers.
The larger and more durable these advantages, the lower the level of competitive risk.
Competitive risk can also arise from “disruption”, where new competitors use new
technology or business models to take market share from existing firms.
 Product market risk: It is the risk that the market for a new product or service will fall

short of expectations. This risk is generally more relevant for early-stage firms than for
mature, well-established firms.
 Execution risk: Refers to the possibility that management may not be able to do what is
needed to deliver the expected results. Typically, early-stage firms have less room for
management error and therefore have higher execution risk.
 Capital investment risk: Refers to the potential for sub-optimal investment by a firm.
This risk is generally more relevant for mature businesses that generate substantial cash
flows but lack natural reinvestment opportunities in their current business.
 ESG risk: Refers to risks arising from environmental, social and governance factors.
Instructor’s Note: This topic is covered in detail in a separate reading.
 Operating leverage: Refers to the sensitivity of a firm’s operating profit to changes in
revenue. Firms with high fixed costs and low variable costs have high operating leverage.
High operating leverage can be good for successful, growing businesses; but problematic
for struggling, declining businesses.
8. Financial Risk
fixed contractual payments. Debt(financial leverage) causes net profit to vary more than
operating profit, on both the upside and downside.
High financial leverage increases the probability that the firm will be unable to secure
needed financing (financing risk) or that it will fail to meet its financial obligations (default
risk).
Financial risk reflects the cumulative impact of macro and business risk.
Different businesses can support different levels of financial leverage. Businesses with stable
and predictable cash flows can generally support a high level of financial leverage. For
example, an electric utility company.
Measuring Operating and Financial Leverage
Leverage is the use of fixed costs in a company’s cost structure. It has two components:
 Operating leverage: Fixed operating costs such as depreciation and rent create
operating leverage.
 Financial leverage: Fixed financial costs such as interest expense create financial
leverage.
For highly leveraged firms, i.e., firms with a high proportion of fixed costs relative to total
costs, a small change in sales will have a big impact on earnings.

Operating leverage captures the sensitivity of operating profit (EBIT) to changes in revenue.
It can be calculated as:
Operating leverage = Contribution/EBIT
where: Contribution = Sales – Variable costs
Financial leverage captures the sensitivity of net profit to a change in operating profit.
Earnings before taxes (EBT) are frequently used instead of net profit, because taxes
fluctuate. Therefore, financial leverage can be calculated as:
Financial leverage = EBIT/EBT
The total leverage of the company can be expressed as:
Total leverage = Operating leverage × Financial leverage

Summary
LO. Describe key features and types of business models.
A business model describes how a business is organized to deliver value to its customers:
 who its customers are,
 how the business serves them,
 key assets and suppliers, and
 the supporting business logic.
A business model should have a value proposition and a value chain.
 The firm’s “value proposition” refers to the product or service attributes valued by a
firm’s target customer that lead those customers to prefer a firm’s offering over those
of its competitors, given relative pricing.
 The firm’s “value chain” refers to how the firm is structured to deliver that value. It
refers to the systems and processes within a firm that create value for its customers.
A firm’s channel strategy refers to “where” the firm is selling its offering and how it is
reaching its customers. Firms may employ a traditional channel strategy - using wholesalers
and retailers or a direct sales strategy – selling directly to end customers. An omnichannel
strategy refers to using both digital and physical channels to complete a sale.
Pricing is a key element of business models. Based on pricing power companies can be
classified into price takers and price setters. Pricing approaches are typically value based or
cost based.
To understand the profitability of a business, the analyst should examine margins, break-
even points and unit economics (which is expressing revenues and costs on a per-unit basis).
Business models types: Each industry tends to has its own set of established business
models. Firms in the goods-producing sectors are generally easy to classify based on how
they fit into the supply chain. However, service businesses are more diverse.
Digital technology has enabled significant business model innovation, often based on
network effects.
LO. Describe expected relations between a company’s external environment, business
model, and financing needs.
Businesses have very different financing needs and risk profiles depending on both external
and firm specific factors. These factors influence the firm's ability to raise capital.
External factors include:
 Economic conditions
 Demographic trends
 Sector demand

 Industry cost characteristics

 Political, legal, and regulatory environment
 Social and political trends
Firm-specific factors include:
 Firm maturity and stage of development
 Competitive position
 Business model
LO. Explain and classify types of business and financial risks for a company.
Macro risk refers to the risk from political, economic, legal, and other institutional risk
factors that impact all businesses in an economy, a country, or a region.
Business risk is the risk that the firm’s operating results will be different from expectations,
independently of how the business is financed.
fixed contractual payments.
Business risk includes both industry risk and company specific risk
The main industry risk factors include:
 Cyclicality
 Industry structure
 Competitive intensity
 Competitive dynamics within the value chain
 Long-term growth and demand outlook
The main company-specific risk factors include:
 Competitive risk
 Product market risk
 Execution risk
 Capital investment risk
 ESG risk
 Operating leverage
A firm’s use of leverage can be calculated as:
Operating leverage = Contribution/EBIT
Financial leverage = EBIT/EBT
Total leverage = Operating leverage × Financial leverage


LM04 Capital Investments 2023 Level I Notes
LM04 Capital Investments

1. Introduction ...........................................................................................................................................................2
2. Types of Capital Investments ..........................................................................................................................2
Business Maintenance ......................................................................................................................................3
Business Growth .................................................................................................................................................3
3. The Capital Allocation Process .......................................................................................................................4
4. Investment Decision Criteria ..........................................................................................................................6
Net Present Value ...............................................................................................................................................6
Internal Rate of Return .....................................................................................................................................7
5. Common Capital Allocation Pitfalls ..............................................................................................................9
6. Corporate Use of Capital Allocation........................................................................................................... 10
7. Real Options ........................................................................................................................................................ 11
Summary................................................................................................................................................................... 13
rights reserved.
Version 1.0

1. Introduction
Capital investments are investments with a life of one year or more. Companies make capital
investments to generate value for their shareholders.
Capital allocation is the process by which companies make capital investment decisions.
Capital allocation is important because it impacts a company’s future.
 Types of capital investments – going concern, regulatory/compliance, expansion, and
other projects
 A typical capital allocation process – steps and principles
 Basic investment decision criteria – NPV and IRR
 Common capital allocation pitfalls
 Corporate use of capital allocation – ROIC
 Real options – timing, sizing, flexibility, and fundamental options
2. Types of Capital Investments
Companies invest for two primary reasons – to maintain their existing business and to grow
it.
Projects undertaken by companies to maintain the business include:
 Going concern projects: Projects necessary to continue current operations and
maintain existing size of the business or to improve business efficiencies.
Example: machine replacement, infrastructure improvement
 Regulatory/Compliance projects: Projects typically required by a third party, such
as the government regulatory body, to meet specified safety and compliance
standards.
Example: factory pollution control installation, performance bond posting to
guarantee satisfactory project completion
Projects undertaken by companies to expand the business include:
 Expansion projects: Projects that expand business size and typically involve greater
degrees of risk and uncertainty than going concern projects.
Example: new product or service development, merger, acquisition
 Other projects: Projects, which include high-risk investments and new growth
initiatives, that are outside the company’s conventional business lines.
Example: exploration investment into a new innovation, business model, or idea
(These definitions and examples are taken from Exhibit 1 of the curriculum.)

Business Maintenance
Going Concern Projects
 Projects necessary to continue current operations and maintain existing size of the
business or to improve business efficiencies.
 Most common going concern projects are replacing assets that have reached the end of
their useful life, and maintaining IT hardware and software.
 Typically, these projects do not increase revenues but they could help a company save
costs.
 They are fairly easy to evaluate as compared to the other projects.
 To fund these projects, managers often try to match the financing with the life-span of
the asset. For example, issuing a 20-year bond to fund an asset with an expected life of
20-years.
o If a company finances long-term assets with short-term financing, it faces rollover risk
– the short-term financing costs could go up.
o If a company finances short-term assets with long-term financing, it faces the risk of
overpaying in financing costs.
 To estimate the amount of capital spending on going concern projects, analysts often look
at the depreciation and amortization expense reported on the income statement.
Regulatory/Compliance Projects
 Projects typically required by a third party, such as the government regulatory body, to
meet specified safety and compliance standards.
 These projects are unlikely to increase revenue; in fact, they may increase compliance
costs. However, regulatory/compliance costs can act as barriers to entry and protect the
industry's profitability.
 While evaluating these projects, management must determine whether the business will
still be profitable after considering the additional compliance costs.
o In most cases, companies will accept these projects and pass on the additional cost to
customers.
o However, sometimes the cost may be too high and the company may decide that it is
better off ceasing operations or shutting down the part of the business that is subject
to the new regulation.
o “Stranded-assets” refers to assets that are at risk of no longer being economically
viable due to regulatory changes. For example, carbon-intensive assets such as coal
power plants.
Business Growth
Expansion Projects
 Projects that expand business size and typically involve greater degrees of risk and

uncertainty than going concern projects.

 Some industries such as pharmaceuticals and oil and gas spend heavily (over 10% of
revenues) on expansion projects.
 If internal opportunities for expansion are limited, managers may pursue acquisitions.
However, the two main risks in acquisitions are the risk of overpaying and the difficulty
in integrating the acquirer’s business operations.
Other Projects
 Projects, which include high-risk investments and new growth initiatives, that are
outside the company’s conventional business lines.
 These projects are often observed in privately held companies or public companies
under the control of a founding owner/significant shareholder.
 These projects tend to have a venture capital element to them. There will probably be a
complete loss of investment, but if successful the project could be highly profitable.
3. The Capital Allocation Process

Capital allocation is the process used by an issuer’s management to make capital investment
decisions.
Steps in Capital Allocation Process
The steps in the capital allocation process are as follows:
Step 1 – Idea generation: Most important step in the process. Investment ideas can come
from anywhere within the organization, or outside (customers, vendors, etc.). What projects
can add value to the company in the long term?
Step 2 – Investment analysis: Gathering information to forecast cash flows for each project
and then computing the project’s profitability. Output of this step: A list of profitable
projects.
Step 3 – Capital allocation planning: Do the profitable projects fit in with the company’s long-
term strategy? Is the timing appropriate? Some projects may be profitable in isolation but
not so much when considered along with the other projects. Scheduling and prioritizing of
projects are important.
Step 4 - Monitoring and post-audit: Post-audit helps in assessing how effective the capital
budgeting process was. How do the actual revenues, expenses, and cash flows compare
against the predictions? Post-auditing is useful in three ways:
 If the predictions were optimistic or too conservative, then it becomes evident here.
 Helps improve business operations. Puts the focus on out-of-line sales and costs.
 Helps in identifying profitable areas for fresh investments in the future, or scale down
in non-profitable ones.

Capital Allocation Principles

The following are the six key principles of capital allocation:
1. Decisions are based on cash flows: Decisions are not based on an accounting/accrual
basis (net income or operating income) which subtract non-cash charges such as
depreciation.
2. Measure incremental cash flows: What incremental cash flows occur with the investment
as compared to without it?
3. Timing of cash flows is crucial: Due to the time value of money, cash flows received
earlier are more valuable than cash flows received later.
4. Cash flows are analyzed on an after-tax basis: Shareholder value increases only on the
cash that they have earned. Hence, any tax expenses must be deducted from the cash
flows.
5. Cash flows are not accounting net income or operating income: Cash flows should not
reflect non-cash charges. Economic income (cash inflows plus change in company’s
market value),unlike accounting income, does not reflect non-cash charges.)
6. Financial costs are ignored: Financial costs are already included in the cost of capital
(discount rates) used to discount cash flows to arrive at the present value. Hence, to
avoid double counting, they must not be deducted from the cash flows.
Other important points to consider:
 Exclude sunk costs: A sunk cost is one that has already been incurred and cannot be
changed. For example, already incurred costs like preliminary consulting fees should not
be included in the analysis.
 Use incremental cash flows: Cash flow with the decision minus the cash flow without the
decision.
 Include externalities: Both positive/negative externalities should be considered in the
analysis. Cannibalization is an example of a negative externality. For example, negative
impact of a new diet soda product launch on the sales of existing soda products.
 Conventional cash flow pattern vs. nonconventional cash flow pattern: A project has
conventional cash flows if the sign of cash flows changes only once during the life of the
project, while an unconventional cash flow project has more than one sign change.
Independent projects vs. mutually exclusive projects: Independent projects are
unrelated projects that can be analyzed separately, while mutually exclusive projects
compete with each other. Two independent projects can both be executed if they
individually meet the criteria. If two projects are mutually exclusive, then either of the two
can be undertaken, not both.
Project sequencing: Certain projects are linked through time, i.e., completion of one project

creates an opportunity to invest in another project later based on its profitability.

4. Investment Decision Criteria
Net Present Value
Net present value is the present value of the future after tax cash flows minus the investment
outlay.
CF1 CF2 CF3
NPV = CF0 + [ ] + [ ] + [ ]
(1 + r)1 (1 + r)2 (1 + r)3
Decision rule:
For independent projects:
If NPV > 0, accept.
If NPV < 0, reject.
For mutually exclusive projects:
Accept the project with higher and positive NPV.
Example
Compute NPV for projects A and B given the following data:
Cost of capital = 10%
Expected Net after Tax cash flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
500 400 300 100
NPV = -1000 + 1.1
+ 1.12 + 1.13 + 1.14 = 78.82
On the exam, you can save time by using the calculator to solve for NPV instead of using the
above formula. The key strokes are given below:
Key strokes Display
nd
[CF][2 ][CLR WORK] CF0 = 0
1000 [+|-] [ENTER] CF0 = -1000
[↓] 500 [ENTER] C01 = 500
[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1

[↓] 100 [ENTER] C04 = 100

[↓] F04 = 1
[NPV] 10 [ENTER] I = 10
[↓] CPT NPV = 78.82
Project B:
100 300 400 600
NPV = -1000 + 1.1
+ 1.12 + 1.13 + 1.14 = 49.18
Microsoft Excel functions can also be used to solve for the NPV. The two functions available
are:
 NPV or =NPV(rate, values) and
 XNPV or =XNPV(rate, values, dates),
where “rate” is the discount rate, “values” are the cash flows, and “dates” are the dates of
each of the cash flows.
Internal Rate of Return
IRR is the discount rate that makes the present value of future cash flows equal to the
investment outlay. We can also say that IRR is the discount rate which makes NPV equal to 0.
Decision rule:
For independent projects:
If IRR > required rate of return (usually firms cost of capital adjusted for projects
riskiness), accept the project.
If IRR < required rate of return, reject the project.
The required rate of return is also called hurdle rate.
For mutually exclusive projects:
Accept the project with higher IRR (as long as IRR > cost of capital).
Example
Compute IRR for projects A and B given the following data.
Cost of Capital = 10%; Expected Net After Tax Cash Flows
Year Project A (in $) Project B (in $)
0 -1,000 -1,000
1 500 100
2 400 300
3 300 400
4 100 600
Solution:
Project A:
A very tedious method is to set up the equation below and solve for r using trial and error.
500 400 300 100
1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 14.49%

A much faster method is to use the calculator:
Key strokes Display

[CF][2nd][CLR WORK] CF0 = 0
1000[+|-] [ENTER] CF0 = -1000
[↓] 500 [ENTER] C01 = 500
[↓] F01 = 1
[↓] 400 [ENTER] C02 = 400
[↓] F02 = 1
[↓] 300 [ENTER] C03 = 300
[↓] F03 = 1
[↓] 100 [ENTER] C04 = 100
[↓] F04 = 1
[IRR][CPT] 14.49
Project B:
100 300 400 600
1000 = 1 + r + (1 + r)2 + (1 + r)3 + (1 + r)4 r = 11.79%
Microsoft Excel functions can also be used to solve for the IRR. The two functions available
are:
 IRR or =IRR(values, guess)
 XIRR or =XIRR(values, dates, guess)
where “values” are the cash flows, “guess” is an optional user-specified guess that defaults
to 10%, and “dates” are the dates of each cash flow.
Ranking conflicts between NPV and IRR
For single and independent projects with conventional cash flows, there is no conflict
between NPV and IRR decision rules. However, for mutually exclusive projects the two
criteria may give conflicting results. The reason for conflict is due to differences in cash flow
patterns and differences in project scale.
For example, consider two projects one with an initial outlay of $1 million and another
project with an initial outlay of $1 billion. It is possible that the smaller project has a higher
IRR, but the increase in firm value (NPV) is small as compared to the increase in firm value
(NPV) of the larger project.
In case of a conflict, we should always go with the NPV criterion because:
 The NPV is a direct measure of expected increase in value of the firm.
 The NPV assumes reinvestment of cash flows at the required rate of return (more
realistic), whereas the IRR assumes reinvestment of cash flows at the IRR rate (less
realistic).
 IRR is not useful for projects with non-conventional cash flows as such projects can

have multiple IRRs , i.e., there are more than one discount rates that will produce an
NPV equal to zero.
Comparison between NPV and IRR
NPV IRR
Advantages Advantages
Direct measure of expected increase Shows the return on each dollar invested.
in value of the firm.
Theoretically the best method. Allows us to compare return with the required rate.
Disadvantages Disadvantages
Does not consider project size. Incorrectly assumes that cash flows are reinvested at
IRR rate. The correct assumption is that
intermediate cash flows are reinvested at the
required rate.
Might conflict with NPV analysis.
Possibility of multiple IRRs.
5. Common Capital Allocation Pitfalls
Common mistakes that companies make when analyzing capital allocation projects are:
 Inertia: The amount of capital investment in a business segment/unit for a year is highly
correlated to the amount spent in the previous year. Ideally, the amount should vary
based on the number and scale of opportunities available each year.
 Source of capital bias: Many managers consider internally generated capital to be "free"
and allocate it according to a budget that is heavily correlated with prior period amounts.
Externally raised capital, on the other hand, is regarded as "expensive" and is used
sparingly, typically only for large investments. Ideally, managers should view all capital
as having an opportunity cost, regardless of source.
 Failing to consider investment alternatives or alternative states: During the ‘idea
generation’ step, many good alternatives are never even considered at some companies.
Many companies also fail to consider differing states of the world, which should ideally
be incorporated through breakeven, scenario, and simulation analyses.
 Pushing “pet” projects: Pet projects are projects backed by senior management. They
may contain overly optimistic projections that overstate the project’s profitability.
 Basing investment decisions on EPS, net income, or return on equity: The
compensation of managers is sometimes tied to EPS, net income, or ROE. They may
therefore reject even strong positive NPV projects that reduce these accounting numbers
in the short run.
 Internal forecasting errors: Companies may make errors in their internal forecasts.

The errors could be related to incorrect costs or discount rate inputs. For example,
overhead costs such as management time, IT support, and financial systems can be
difficult to estimate. Also, companies may incorrectly treat sunk costs and missed
opportunity costs; and incorrectly use the company’s overall cost of capital, cost of debt,
or cost of equity rather than the investment’s required rate of return in their analysis.
6. Corporate Use of Capital Allocation

Analysts and corporate managers should understand the logic and practicalities of different
capital allocation methods.
If a company can invest in a project that earns more than its opportunity costs of funds, then
the investment creates value and will increase shareholder wealth. Conversely, if the project
earns less than the company’s opportunity cost of funds, then the investment decreases
value and will reduce shareholder wealth. The return on invested capital (ROIC) is a
measure that is often used to make these comparisons.
ROIC = After-Tax Operating Profit/Average Book Value of Invested Capital
ROIC reflects how effectively a company’s management is able to convert capital into after-
tax operating profits. Note that the numerator excludes interest expense because it
represents a source of return to providers of debt capital, and the denominator includes
sources of capital from all providers.
If the ROIC measure is higher than the cost of capital (COC), the company is generating a
higher return for investors compared with the required return, thereby increasing the firm’s
value. We can also say that projects with positive NPV will have a ROIC that is greater than
the COC.
Relationship between NPV and Stock Price
 The value of a company can be measured as the existing value plus the present value of
its future investments. NPV is a direct measure of the expected change in the firm’s value
from undertaking a capital project.
 Theoretically, a positive NPV project should cause a proportionate increase in a
company’s stock price. But, if the project’s profitability is less than expectations, then the
stock price may be negatively impacted.
 However, in reality, there are many other factors that can affect the stock price, and the
relationship between NPV and stock price is not perfect.
Example
A company is undertaking a project with an NPV of $500 million. The company currently has
100 million shares outstanding and each share has a price of $50. What is the likely impact of
the project on the stock price?
Solution:

NPV of the project = $500 million. The overall value of company should increase by $500
million because of the project. Since there are 100 million shares outstanding, each share
should go up by 500/100 = $5. The share price should increase from $50 to $55.
Effects of Inflation on Capital Allocation process
Capital allocation analysis can be done either in ‘nominal’ terms or ‘real’ terms. Nominal cash
flows include the effects of inflation. Whereas, real cash flows are adjusted downward to
remove the effect of inflation. Nominal cash flows should be discounted at a nominal
discount rate, and real cash flows should be discounted at a real rate. In general, the
relationship between real and nominal rates is:
(1 + Nominal rate) = (1 + Real rate) (1 + Inflation rate).
Inflation reduces the value of depreciation tax savings. This is because the depreciation
charge is based on the asset’s original purchase price and it is not adjusted to match the
current inflated price. Higher-than-expected inflation increases the corporation’s real taxes
and shifts wealth from the corporation to the government.
Inflation does not affect all revenues and costs uniformly. The company’s after-tax cash flows
will be better or worse than expected depending on how particular sales outputs or cost
inputs are affected.
Inflation complicates the capital allocation process.
7. Real Options
Real options are options that allow managers to make decisions in the future that change the
value of capital investment decisions made today. As with financial options, real options are
contingent on future events. The difference is that real options deal with real assets.
Types of real options include:
 Timing options: A company can delay investing until it has better information.
 Sizing options: If a company can invest in a project and then abandon it if its financial
results are weak, it has an abandonment option. Conversely, if the company can make
additional investments when financial results are strong, it has a growth option.
 Flexibility options: Once an investment is made, operational flexibilities such as
changing the price (price setting option), or increasing production (production
flexibility option) may be available.
 Fundamental options: In this case, the whole investment is an option. For example,
the value of an oil well or refinery depends on the price of oil. If oil prices are low, a
company may not drill a well. If oil prices are high, the company may pursue drilling.
There are several approaches to evaluating capital allocation projects with real options.
1. Use DCF analysis without considering options. If the NPV of the project without

considering options is positive, then we can go ahead and make the investment. The
presence of real options will simply add even more value. Therefore, it is not
necessary to determine the value of the options separately.
2. If NPV is negative without considering options, then calculate project NPV as: Project
NPV = NPV (based on DCF alone) – Cost of options + Value of options. Check if the
project NPV turns positive after the options are considered.
3. Use decision trees and option pricing models. They can help in many sequential
decision-making problems.
Example: Production-flexibility option
(This is Example 7 from the curriculum.)
Auvergne AquaFarms has estimated the NPV of the expected cash flows from a new
processing plant to be –EUR0.40 million. Auvergne is evaluating an incremental investment
of EUR0.30 million that would give management the flexibility to switch between coal,
natural gas, and oil as an energy source. The original plant relied only on coal. The option to
switch to cheaper sources of energy when they are available has an estimated value of
EUR1.20 million. What is the value of the new processing plant including this real option to
use alternative energy sources?
Solution:
NPV, including the real option = NPV based on DCF alone – Cost of options + Value of options
= -0.40 million – 0.30 million + 1.20 million = 0.50 million.
Without the flexibility offered by the real option, the plant is unprofitable. The real option to
adapt to cheaper energy sources adds enough to the value of this investment to give it a
positive NPV.

Summary
LO. Describe types of capital investments made by companies.
Companies invest for two primary reasons – to maintain their existing business and to grow
it.
Projects undertaken by companies to maintain the business include:
 going concern projects
 regulatory/compliance projects
Projects undertaken by companies to expand the business include:
 expansion projects
 other projects
LO. Describe the capital allocation process and basic principles of capital allocation.
Capital allocation is the process used by an issuer’s management to make capital investment
decisions.
The typical steps companies take in the capital allocation process are:
1. idea generation
2. investment analysis,
3. capital allocation planning
4. post-audit/monitoring
The six key capital allocation principles are:
1. Decisions are based on cash flows
2. Measure incremental cash flows
3. Timing of cash flows is crucial
4. Cash flows are analyzed on an after-tax basis
5. Cash flows are not accounting net income or operating income
6. Financial costs are ignored
LO. Demonstrate the use of net present value (NPV) and internal rate of return (IRR)
in allocating capital and describe the advantages and disadvantages of each method.
Net present value (NPV) is the present value of the future after-tax cash flows, minus the
investment outlay (cost of the project). For independent projects, accept all projects with
positive NPV. For mutually exclusive projects, accept the project with the higher NPV.
Internal rate of return (IRR) is the discount rate which makes NPV equal to 0. For
independent projects, if IRR is greater than opportunity cost (required rate of return), accept
the project, otherwise reject the project. For mutually exclusive projects, accept the project
with the higher IRR as long as the IRR is greater than the opportunity cost.

Comparison between NPV and IRR:

NPV IRR
Advantages Advantages
Direct measure of expected increase Shows the return on each dollar invested.
in value of the firm.
Theoretically the best method. Allows us to compare return with the required rate.
Disadvantages Disadvantages
Does not consider project size. Incorrectly assumes that cash flows are reinvested at
IRR rate. The correct assumption is that
intermediate cash flows are reinvested at the
required rate.
Might conflict with NPV analysis.
Possibility of multiple IRRs.
LO. Describe common capital allocation pitfalls.
Common mistakes that companies make when analyzing capital allocation projects are:
 Inertia
 Source of capital bias
 Failing to consider investment alternatives or alternative states
 Pushing pet projects
 Basing investment decisions on EPS, net income, or return on equity
 Internal forecasting errors
LO. Describe expected relations among a company’s investments, company value, and
share price.
NPV is a direct measure of the expected change in the firm’s value from undertaking a capital
project. A positive NPV project should cause a proportionate increase in a company’s stock
price. But if the project’s profitability is less than expectations, then the stock price might be
negatively impacted.
LO. Describe types of real options relevant to capital investment.
The types of real options include:
1. Timing options
2. Sizing options - abandonment options or growth options
3. Flexibility options - price-setting options or production-flexibility options
4. Fundamental options
If NPV is positive without considering options, go ahead and make the investment.
If NPV is negative without considering options, calculate NPV (based on DCF alone) – Cost of

options + Value of options.

LM05 Working Capital & Liquidity 2023 Level I Notes
LM05 Working Capital & Liquidity

1. Introduction ...........................................................................................................................................................2
2. Financing Options ................................................................................................................................................2
Internal Financing ..............................................................................................................................................3
External Financing: Financial Intermediaries .........................................................................................4
External Financing: Capital Markets ...........................................................................................................4
3. Working Capital, Liquidity, and Short-Term Funding Needs .............................................................6
4. Liquidity And Short-Term Funding ..............................................................................................................8
Primary Sources of Liquidity .........................................................................................................................9
Secondary Sources of Liquidity .....................................................................................................................9
Drags and Pulls on Liquidity ....................................................................................................................... 10
5. Measuring Liquidity......................................................................................................................................... 10
6. Evaluating Short-Term Financing Choices ............................................................................................. 11
Summary................................................................................................................................................................... 14
rights reserved.
Version 1.0

1. Introduction
Working capital (also called net working capital) is defined as current assets minus current
liabilities.
Working capital = Current assets – Current liabilities
Working capital includes both operating assets and liabilities (such as accounts receivable,
accounts payable, inventory etc.) as well as financial assets and liabilities (such as short-
term investments and short-term debt).
The goal of effective working capital management is to ensure that a company has adequate
ready access to the funds necessary for day-to-day operating expenses, while avoiding
excess reserves that can reduce a business’s profitability.
 Internal and external sources of working capital
 Working capital approaches and their impact on the funding needs of a company
 Primary and secondary sources of liquidity
 Evaluating a company’s liquidity position
 Evaluating the short-term financing choices available to a company
2. Financing Options
Exhibit 1 from the curriculum shows the main internal and external sources of capital for a
company.
External
Internal
Financial Intermediaries Capital markets
 After-tax operating  Uncommitted lines of  Commercial
cash flows credit paper
 Accounts payable  Committed lines of
Short-term  Accounts receivable credit
 Inventory  Revolving credit
 Marketable securities  Secured loans
 Factoring
 Long-term debt
Long-term  Equity
We will discuss each of these sources in detail.

Internal Financing
Companies can generate internal financing from short-term operating activities in many
ways such as:
 Generating more after-tax operating cash flows.
 Increasing working capital efficiency, e.g., by shortening its cash conversion cycle.
 Converting liquid assets to cash, e.g., by selling inventories.
Some important terms related to internal financing are:
 Operating cash flows: Calculated as ‘net income + depreciation – dividends.’ This is
the cash available for investment after interest, tax, and dividend payments are made.
Companies with high, relatively stable after-tax operating cash flows have a greater
ability to use internal financing.
 Accounts payable: Represents amounts due to suppliers of goods and services. They
often have associated trade credit terms. For example, the terms ‘2/10 net 30’, mean
that if the payment is made within 10 days, the company will get a 2 percent discount
else the entire payment must be made within 30 days.
 Accounts receivables: Represents amounts owed by customers. They can be thought
of as being the opposite of accounts payables. The sooner the company can collect its
accounts receivables, the lesser the need to use other sources to finance operations.
 Inventory: Represents goods waiting to be sold. Since holding inventory costs money,
efficient companies try to hold as little inventory as necessary and sell it as quickly as
possible.
 Marketable securities: Represents financial instruments such as stocks and bonds,
that can be sold quickly and converted to cash. Companies invest in marketable
securities to earn a higher rate of return as compared to simply holding cash.
Example: Internal Financing Decision
(This is based on Example 1 from the curriculum.)
A company is evaluating two options to fund its working capital needs:
 Option1: Forgo the 2% discount offered by its supplier. The standard trade terms are
2/10 net 30.
 Option 2: Borrow through its external line of credit. The effective annual rate for the line
of credit is 7.7%.
Which option should the company prefer?
Solution:
The effective annual rate on the forgone trade credit can be calculated as:
[(1+(2/98))^(365/20)] – 1 = 44.6%

This is significantly higher than the 7.7% rate on the external credit line. Therefore, the
company should prefer the credit line.
External Financing: Financial Intermediaries
Financial intermediaries can include both bank or non-bank lenders. The main type of
financing options available through these sources are:
 Uncommitted lines of credit – They are the least reliable form of bank borrowing.
The bank can refuse to honor the request to use the line. An uncommitted line is
therefore not reliable.
 Committed lines of credit – Also called regular lines of credit, they are more reliable
than uncommitted lines. The bank makes a formal commitment to honor the line of
credit. The interest rate charged is usually the bank’s prime rate or a money market
rate plus a spread that depends on the borrower’s creditworthiness. These lines are
usually in effect for 364 days. They are unsecured and prepayable without penalty.
Unlike uncommitted lines, regular lines require compensation. Banks typically charge
a commitment fee e.g., 0.50% of the full amount or the unused amount of the line.
 Revolving credit agreements (Revolvers): They are the most reliable form of short-
term bank borrowing. They involve formal agreements similar to those used for
regular lines of credit. Revolvers differ from regular lines in two ways (1) they are in
effect for multiple years and (2) they are often used for much larger amounts.
 Secured (“asset-based”) loans: The options discussed above are unsecured loans.
Secured loans are loans in which the lender requires the company to provide collateral
in the form of assets. For example, a company can use its accounts receivables as a
collateral to generate cash flows through the ‘assignment of accounts receivable’.
A company can also sell its accounts receivables to a lender (called a factor), typically
at a substantial discount. This is called a factoring arrangement. In an assignment
arrangement, the company retains the collection responsibilities, whereas in a
factoring arrangement, the company shifts the collection responsibilities to the lender
(factor).
Web-based lenders and non-bank lenders are recent innovations that operate primarily
on the internet. They typically offer loans in relatively small amounts to small businesses in
need of cash.
External Financing: Capital Markets
Short-Term Commercial Paper
It is a short-term, unsecured instrument typically issued by large, well-rated companies. It
has maturities typically ranging from a few days to 270 days. Issuers of commercial paper
are often required to have a backup line of credit. The short duration, high creditworthiness

of the issuing company, and the backup line of credit generally makes commercial paper a
low-risk investment for investors.
Long-Term Debt
It has a maturity of at least one year. Due to their long maturities, bonds are riskier than
shorter-term notes or money market instruments from an interest rate and credit risk
perspective. Therefore, to reduce risk, bonds often contain covenants that are detailed
contracts specifying the rights of the lender and restrictions on the borrower.
Public debt is negotiable (a negotiable instrument is a written document describing the
promise to pay that is transferable and can be sold to another party) and more liquid as it
trades on open markets. Private debt can also be negotiable, but it is less liquid and difficult
to sell as it does not trade on open markets. Some private debt instruments, such as savings
bond and certificates of deposit are not negotiable.
Common Equity
Common equity represents ownership in a company. It is considered a more permanent
source of capital. Shareholders have a residual claim on the company’s profits after its
obligations and other contractual claims are satisfied.
Example: External Financing Decision
A company is planning its financing for a substantial investment of C$30 million next year.
Specific details are as follows:
 The total investment of C$30 million will be distributed as follows: C$5 million in
receivables, C$5 million in inventory, and fixed capital investments of C$20 million,
including C$5 million to replace depreciated equipment and C$15 million of net new
investments.
 Projections include a net income of C$10 million, depreciation charges of C$5 million, and
dividend payments of C$4 million.
 Short-term financing from accounts payable of C$3 million is expected. The company will
use receivables as collateral for another C$3 million loan. The company will also issue a
C$4 million short-term note to a commercial bank.
 Any additional external financing needed can be raised from an increase in long-term
bonds. If additional financing is not needed, any excess funds will be used to repurchase
common shares.
How much, if any, does the company need to issue in long-term bonds?
Solution:
Total amount receivable from different sources of capital for the company can be calculated

as:
Source Amount
Operating cash flow (Net income + depreciation - dividends) 11
Accounts payable 3
Bank loan against receivables 3
Short-term note 4
Total 21
Since, the company requires C$30 million of financing and the planned sources total C$21
million, the company will need to issue C$9 million of new bonds.
3. Working Capital, Liquidity, and Short-Term Funding Needs

To determine their required working capital investment, companies first identify their
optimal levels of inventory, receivables and payables as a function of sales. They then project
these assumptions forward into the future.
After determining its working capital requirements, a firm then identifies the optimal mix of
short-and long-term financing necessary to fund these requirements. Companies may take
different approaches to working capital management:
 Conservative approach: In a conservative approach, the firm holds a larger position
in current assets (cash, receivables, and inventories). This provides financial flexibility
to respond to unforeseen events, but it results in a lower return on equity.
Instructor’s Note: Current assets can be divided into ‘permanent current assets’ and
‘variable current assets.’ Permanent current assets remain relatively constant
throughout the year. Variable current assets vary based on the seasonality of the
business, increasing during peak production periods.
In a conservative approach, the firm finances a majority of its current assets (both
permanent and variable) with long-term debt or equity financing.
 Aggressive approach: In an aggressive approach, the firm holds a substantially
smaller position in current assets. This reduces financial flexibility, but it results in a
higher return on equity.
Also, the firm finances a majority of its current assets (both permanent and variable)
with short-term debt or payables.
 Moderate approach: In a moderate approach, the firm holds a position in current
assets that is somewhere between the two approaches.
Also, the firm attempts to match the duration of the current assets with the liabilities.
It would finance its permanent current assets with long-term debt and equity; and

finance its variable current assets with short-term debt and payables.
Example 3 from the curriculum presents the pros and cons of each approach. Excerpts from
this example are presented below:
Conservative approach
Pros Cons
Stable, more permanent financing that does Higher debt financing cost with an upward-
not require regular refinancing; reduced sloping yield curve
rollover risk
Financing costs are known upfront High cost of equity
Certainty of working capital needed to Permanent financing dismisses the
purchase the necessary inventory opportunity to borrow only as needed
(increasing ongoing financing costs)
Extended payment term reduces short-term A longer lead time is required to establish
cash needs for debt service the financing position
Improved flexibility during times of stress, Long-term debt may require more
with excess liquidity in marketable covenants that restrict business operations
securities
Aggressive approach
Pros Cons
Short-term lines of credit provide the Higher levels of short-term cash may be
flexibility to access financing only when needed to meet short-term debt maturities
needed—particularly appropriate for
seasonality—reducing overall interest
expense
Short-term loans involve less rigorous Potential difficulty in rolling the short-term
credit analysis, as the lender has greater loans, thus increasing bankruptcy risk,
clarity as to the short-term operations of particularly during times of stress
the firm
Flexibility to refinance if rates decline Greater reliance on trade credit (expensive
financing) may be necessary if the business
is unable to refinance at favorable terms
Tighter customer credit standards may be
required, thereby reducing sales, if the
business is unable to access the necessary
financing to support credit terms to its
customers

Moderate approach
Pros Cons
Lower cost of financing than conservative Access to short-term capital may be
approach restricted when needed for inventory build
Flexibility to increase financing for seasonal Potential difficulty in rolling the short-term
spikes while maintaining a base level for loans, thus increasing bankruptcy risk,
ongoing needs particularly during times of stress
Diversifying sources of funding with a more Greater reliance on trade credit (expensive
disciplined approach to balance sheet financing) may be necessary if the business
management is unable to refinance at favorable terms
Tighter customer credit standards may be
required, thereby reducing sales, if the
business is unable to access the necessary
financing to support credit terms to its
customers
Exhibit 2 from the curriculum summarizes the relationship between financing requirements,
costs, risks, and return on equity based on funding approach.
4. Liquidity And Short-Term Funding

Liquidity is the extent to which a company is able to meet its short-term obligations using
cash flows and those assets that can be readily transformed into cash.
The liquidity of an asset can be evaluated along two dimensions:
 The type of the asset
 The speed at which the asset can be converted into cash (by sale or financing)
Liquidity management refers to the company’s ability to generate cash when needed, at the
lowest possible cost.
Two sources of liquidity for a company are:

 primary sources of liquidity, such as cash balances

 secondary sources of liquidity, such as selling assets
The main difference between the two is that using primary sources has no effect on the
operations of a company while using secondary sources may negatively impact a company’s
financial position.
Primary Sources of Liquidity
They represent the most readily accessible resources available to the company. Primary
sources include:
 Free cash flow: The firm’s after-tax operating cash flow less planned short- and long-
term investments.
 Ready cash balances: Cash available in bank accounts.
 Short-term funds: Include items such as trade credit, bank lines of credit, and short-
term investment portfolios.
 Cash management: Refers to the company’s effectiveness in its cash management
system and practices, and the degree of decentralization of the collections/payments
processes. The higher the degree of decentralization, the more the cash tied up in the
system.
Secondary Sources of Liquidity
Secondary sources include:
 negotiating debt contracts
 liquidating assets
 filing for bankruptcy protection and reorganization
Example: Estimating Costs of Liquidity
A company facing a liquidity crisis has the following options to raise funds. The estimated
fair value and liquidation costs for each source of funds is listed below:
Source of Funds Fair Value (C$, Liquidation
millions) Costs (%)
Sell short-term marketable securities 10 0
Sell select inventories and receivables 20 10
Sell excess real estate property 50 15
Sell a subsidiary of the firm 30 20
Net of liquidation costs, how much liquidity can the company raise if all four sources of funds
are used?
Solution:
The costs and net funds raised are summarized in this table:

Source of Funds Fair Value Liquidation Liquidation Net Proceeds

(C$, Costs (%) Costs (C$, (C$, millions)
millions) millions)
Marketable securities 10 0 0 10
Inventories and receivables 20 10 2 18
Real estate property 50 15 7.5 42.5
Subsidiary of the firm 30 20 6 24
Total 15.5 94.5
Drags and Pulls on Liquidity
A company’s liquidity position is affected by cash receipts and the amount of cash it has to
pay.
Drags on liquidity reduce cash inflows. For example, uncollected receivables, obsolete
inventory, tight credit etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues,
reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.
5. Measuring Liquidity
Liquidity contributes to a company’s credit-worthiness. Credit-worthiness is the perceived
ability of the borrower to pay what is owed in a timely manner, despite adverse conditions.
High credit-worthiness allows a company to:
 Obtain lower borrowing costs.
 Obtain better terms for trade credit.
 Have greater flexibility.
 Exploit profitable opportunities, as the company can raise money relatively quickly to
invest in profitable projects.
Ratios used for assessing a company’s liquidity
Financial ratios can be used to assess a company’s liquidity as well as its management of
assets over time. The commonly used ratios are:
Liquidity Ratios
Ratio Formula Interpretation
Current Current assets ÷ Current liabilities The greater the current ratio the
ratio higher the company’s liquidity
Quick ratio (Cash + Marketable securities + The higher the quick ratio the higher
Receivables) ÷ Current liabilities the company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ The higher the cash ratio the higher
Current liabilities the company’s liquidity
Activity Ratios

Receivable Credit Sales ÷ Average receivables It is a measure of how many times, on

turnover average, accounts receivable are
created by credit sales and collected
on during the fiscal period.
Number of 365 or days in period ÷ Receivable It tells the number of days on average
days of turnover the company takes to collect on the
receivables credit accounts
Inventory Cost of goods sold ÷ Average It is a measure of how many times, on
turnover inventory average, inventory is created or
acquired and sold during the fiscal
period
Number of 365 or days in the period ÷ Inventory It is the length of time, on average,
days of turnover that the inventory remains within the
inventory company
Payables Average day’s purchases ÷ Average It is a measure of how long it takes
turnover trade payables the company to pay its own suppliers
Number of 365 or days in the period ÷ Payables It tells the number of days on average
days of turnover the company takes to make payments
payables to its suppliers.
Cash Days of inventory + Days of It measures the time from paying
conversion receivables – Days of payables suppliers for raw materials to
cycle collecting cash from customers. The
shorter the cycle, the better is the
cash-generating ability of a company
Liquidity ratios are used to measure a company’s ability to meet its short-term obligations.
Activity ratios measure how well key current assets and working capital is managed over
time.
The levels of these ratios, and their trends, or changes over time, in addition to comparisons
with competitors or the industry, are used to judge a firm’s liquidity position.
6. Evaluating Short-Term Financing Choices
Since many short-term financing alternatives are available, a company should evaluate these
options and create a planned borrowing strategy that will maximize its cost savings.
Companies seek to implement a short-term financing strategy that will help achieve the
following objectives:
 Ensure sufficient capacity to handle peak cash needs.
 Maintain sufficient and diversified sources of credit.
 Ensure rates are cost-effective.

 Ensure both implicit and explicit funding costs are considered.

Factors that will influence a company’s short-term borrowing strategies are:
 Size and creditworthiness: Larger companies have additional and cheaper options as
compared to smaller companies. The borrower’s creditworthiness determines the
access to and the cost of borrowing.
 Legal and regulatory considerations: Legal and regulatory constraints on specific
industries can restrict how much a company can borrow and under what terms.
 Asset nature: Depending on their business model, some companies may have assets
that are considered attractive as collateral for secured loans.
 Flexibility of financing options: Flexibility allows a company to better manage its debt
maturities. Cash budgeting exercises can help businesses avoid issues when credit
markets are tight and a company's ability to roll a particular maturity is limited.
Example: Meeting Short-Term Financing Need
Keown Corp. has accounts payable of C$2 million with terms of 2/10, net 30. Accounts
receivable also stands at C$2 million. In addition, the company has C$5 million in marketable
securities. Keown has a short-term need of C$200,000 to meet payroll. Which of the
following options makes the most sense for raising the C$200,000?
A. The company should issue long-term debt.
B. The company should issue common stock.
C. The company should delay paying accounts payable and forgo the 2% discount.
D. The company should sell some of its accounts receivable to a factor at a 10% discount.
E. The company should sell some of its marketable securities at a 0.5% brokerage cost.
Solution
A and B would not be appropriate for raising C$200,000 for a short-term need. These
options take time to arrange, and they are more appropriate for long-term capital needs and
for much larger financing amounts.
C, D, and E are all appropriate options for meeting short-term financing needs. However, C
and D are costly.
The options for raising C$200,000 are summarized in this table:
Liquidation Costs
Source of Funds Action % C$
C. Accounts payable (2/10, Delay C$200,000 in payment and 2.0 4,000
net 30) forgo 2% discount

D. Accounts receivable Sell C$222,222 in value at 10% 10.0 22,222

discount to raise CA$200,000
E. Marketable securities Sell C$200,000 in value 0.5 1,000
Choosing C means forgoing a 2% discount, which on C$ 200,000 amounts to a cost of
C$4,000. To net C$200,000 using option D, the company would have to sell C$222,222 of
accounts receivable to a factor, representing a cost of C$22,222. E appears to be the best
choice. Marketable securities are liquid and can be easily sold for market value, less the
relatively minor brokerage cost of C$1,000.

Summary
LO. Compare methods to finance working capital.
The main internal and external sources of capital for a company.
External
Internal
Financial Intermediaries Capital markets
 After-tax operating  Uncommitted lines of  Commercial
cash flows credit paper
 Accounts payable  Committed lines of
Short-term  Accounts receivable credit
 Inventory  Revolving credit
 Marketable securities  Secured loans
 Factoring
 Long-term debt
Long-term  Equity
LO. Explain expected relations between working capital, liquidity, and short-term
funding needs.
Exhibit 2 from the curriculum summarizes the relationship between financing requirements,
costs, risks, and return on equity based on funding approach.
LO. Describe sources of primary and secondary liquidity and factors affecting a
company’s liquidity position.
Liquidity is the extent to which a company is able to meet its short-term obligations using
cash flows and those assets that can be readily transformed into cash.
Liquidity management refers to the company’s ability to generate cash when needed, at the
lowest possible cost.

Two sources of liquidity for a company are:

 Primary sources of liquidity, such as free cash flow, ready cash balances, short-term
funds, cash management.
 Secondary sources of liquidity, such as negotiating debt contracts, liquidating assets,
filing for bankruptcy protection.
The main difference between the two is that using primary sources has no effect on the
operations of a company while using secondary sources may negatively impact a company’s
financial position.
A company’s liquidity position is affected by cash receipts and the amount of cash it has to
pay.
Drags on liquidity reduce cash inflows. For example, uncollected receivables, obsolete
inventory, tight credit etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues,
reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.
LO. Compare a company’s liquidity position with that of peers.
Financial ratios can be used to assess a company’s liquidity as well as its management of
assets over time. The commonly used ratios are:
Liquidity Ratios
Ratio Formula Interpretation
Current Current assets ÷ Current liabilities The greater the current ratio the
ratio higher the company’s liquidity
Quick ratio (Cash + Marketable securities + The higher the quick ratio the higher
Receivables) ÷ Current liabilities the company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ The higher the cash ratio the higher
Current liabilities the company’s liquidity
Activity Ratios
Receivable Credit Sales ÷ Average receivables It is a measure of how many times, on
turnover average, accounts receivable are
created by credit sales and collected
on during the fiscal period.
Number of 365 or days in period ÷ Receivable It tells the number of days on average
days of turnover the company takes to collect on the
receivables credit accounts
Inventory Cost of goods sold ÷ Average It is a measure of how many times, on
turnover inventory average, inventory is created or
acquired and sold during the fiscal
period

Number of 365 or days in the period ÷ Inventory It is the length of time, on average,
days of turnover that the inventory remains within the
inventory company
Payables Average day’s purchases ÷ Average It is a measure of how long it takes
turnover trade payables the company to pay its own suppliers
Number of 365 or days in the period ÷ Payables It tells the number of days on average
days of turnover the company takes to make payments
payables to its suppliers.
Cash Days of inventory + Days of It measures the time from paying
conversion receivables – Days of payables suppliers for raw materials to
cycle collecting cash from customers. The
shorter the cycle, the better is the
cash-generating ability of a company
LO. Evaluate short-term funding choices available to a company.
Companies seek to implement a short-term financing strategy that will help achieve the
following objectives:
 Ensure sufficient capacity to handle peak cash needs.
 Maintain sufficient and diversified sources of credit.
 Ensure rates are cost-effective.
 Ensure both implicit and explicit funding costs are considered.
Factors that will influence a company’s short-term borrowing strategies are:
 Size and creditworthiness
 Legal and regulatory considerations
 Asset nature
 Flexibility of financing options

LM06 Cost of Capital - Foundational Topics 2023 Level I Notes
LM06 Cost of Capital - Foundational Topics
1 Introduction ............................................................................................................................................................2
2. Cost of Capital .......................................................................................................................................................2
Taxes and the Cost of Capital .........................................................................................................................3
3. Costs of the Various Sources of Capital .......................................................................................................4
Cost of Debt ...........................................................................................................................................................4
Cost of Preferred Stock .....................................................................................................................................5
Cost of Common Equity ....................................................................................................................................6
4. Estimating Beta ....................................................................................................................................................7
Estimating Beta for Public Companies .......................................................................................................7
Estimating Beta for Thinly Traded and Nonpublic Companies ........................................................8
5. Flotation Costs ......................................................................................................................................................9
6. Methods in Use .................................................................................................................................................. 10
Summary................................................................................................................................................................... 11
This document should be read in conjunction with the corresponding reading in the 2023 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.
Version 1.0

1. Introduction
This reading defines what is cost of capital, methods to estimate the cost of capital, and why
estimating the cost of capital accurately is important, both for decision-making by a
company’s management and for valuation by investors. Estimating the cost of capital is a
complex process which requires many assumptions.
 Introduction to the cost of capital and its basic computation
 Methods for estimating the costs of the various sources of capital: debt, preferred
stock, and common equity
 Beta estimation for public and non-public companies
 Correct treatment of floatation costs
 Methods used in practice by companies
2. Cost of Capital
Cost of capital is the rate of return that the suppliers of capital require as compensation for
their contribution of capital. Assume a company decides to build a steel plant and needs
money or capital for it. Investors such as bondholders or equity holders will lend this capital
to the company. Suppliers of capital will be motivated to part with their money for a certain
period of time if the money invested can earn a greater return than it would earn elsewhere.
In short, investors will invest if the return (IRR) is greater than the cost of capital.
A company has access to several sources of capital such as issuing equity, debt, or
instruments that share characteristics of both debt and equity. Each source becomes a
component of the company’s funding and has a specific cost associated with it called the
component cost of capital.
The cost of capital is the rate of return expected by investors for average-risk investment in a
company. Investors will demand a higher rate of return for higher-than-average-risk
investments. Similarly, investors will demand a lower rate of return for lower-than-average-
risk investments.
One way of calculating this cost is to determine the weighted average cost of capital
(WACC), which is also called the marginal cost of capital. It is called marginal because it is
the additional or incremental cost a company incurs to issue additional debt or equity.
Three common sources of capital are common shares, preferred shares, and debt. WACC is
the cost of each component of capital in the proportion they are used in the company.
WACC = wd rd (1 − t) + wp rp + we re
where:
wd = proportion of debt that the company uses when it raises new funds
rd = before-tax marginal cost of debt
t = company’s marginal tax rate

wp = proportion of preferred stock the company uses when it raises new funds
rp = marginal cost of preferred stock
we = proportion of equity that the company uses when it raises new funds
re = the marginal cost of equity
The weights are the proportions of the various sources of capital that the company uses. The
weights should represent the company’s target capital structure and not the current
capital structure. For example, suppose that current capital structure of a company is 33.3%
debt, 33.3% preferred stock and 33.3% common stock. To fund a new project, the company
plans to issue more debt and its capital structure will change to 50% debt, 25% preferred
stock, and 25% common stock. WACC calculations should be based on these new weights,
i.e., the target weights.
Example
IFT has the following capital structure: 30 percent debt, 10 percent preferred stock, and 60
percent equity. IFT wants to maintain these weights as it raises additional capital. Interest
expense is tax deductible. The before-tax cost of debt is 8 percent, cost of preferred stock is
10 percent, and cost of equity is 15 percent. If the marginal tax rate is 40 percent, what is the
WACC?
Solution:
WACC = (0.3) (0.08) (1 - 0.4) + (0.1) (0.1) + (0.6) (0.15) = 11.44 percent
Note: Before-tax cost of debt is given. Do not forget to calculate the after-tax cost.
Example
Machiavelli Co. has an after-tax cost of debt capital of 4 percent, a cost of preferred stock of 8
percent, a cost of equity capital of 10 percent, and a weighted average cost of capital of 7
percent. Machiavelli Co. intends to maintain its current capital structure as it raises
additional capital. In making its capital budgeting decisions for the average risk project, what
is the relevant cost of capital?
Solution:
The relevant cost of capital is 7%. The WACC using weights derived from the current capital
structure is the best estimate of the cost of capital for the average risk project of a company.
Taxes and the Cost of Capital
Notice that in the equation for WACC, we consider taxes only for debt. This is because
payments to equity shareholders in the form of dividends are not tax-deductible. On the
other hand, interest costs are tax-deductible in some jurisdictions; they pass through the
income statement and provide a tax shield. If interest expense is not tax deductible, then the
tax rate applied is zero and effective marginal cost of debt is equal to cost of debt (rd). Let us

see the effect on net income in the example below.

A company pays 10% interest on capital raised. On the left-hand side of the table below, you
see that the interest is tax deductible. On the right-hand side, the interest is not tax
deductible. So, the tax expense on the LHS is 16, which is 4 less than that on the RHS. The
savings on taxes consequently reflect in the net income as well. The actual cost of debt is 6%
when it is tax-deductible instead of 10%.
Calculation of net income assuming Calculation of net income assuming
interest is tax-deductible interest is not tax-deductible
Revenue 100 Revenue 100
Operating Expenses 50 Operating Expenses 50
Interest 10 EBT 50
EBT 40 Tax expense (40%) 20
Tax Expense (40%) 16 Interest Expense 10
Net Income 24 Net Income 20
After-tax cost of debt = Before-tax cost of debt x (1 - tax rate)
3. Costs of the Various Sources of Capital
Each source of capital has a different cost because of differences in seniority, contractual
commitments, and potential value as a tax shield. Three primary sources of capital are:
 Debt
 Preferred equity
 Common equity
Cost of Debt
Cost of debt is the cost of financing to a company using debt instruments such as taking a
bank loan or issuing a bond. In simpler terms, it is the effective interest rate a company pays
on its current debt. Two methods to estimate the before-tax cost of debt are:
 The yield to maturity (YTM) approach
 Debt-rating approach
Yield to Maturity Approach
YTM is the annual return an investor earns if the bond is purchased today and held until
maturity. It is the rate at which the present value of all future cash flows equals the market
price of the bond.
PMTt FV
P0 = ∑nt=1 [ r t
]+ r n
(1 + d ) (1 + d )
2 2
where:
P0 = the current market price of the bond
PMTt = interest payment in period t

rd = the yield to maturity

n = number of periods remaining to maturity
FV = maturity value of the bond
Example
A company issues a 10-year, 8% semi-annual coupon bond. Upon issuance, the bond sells for
$980. If the marginal tax rate is 30%, what is the after-tax cost of debt?
Solution:
First, calculate the before-tax cost of debt by entering the following values:
N = 20 because it is a semi-annual coupon bond, so there are 10 x 2 = 20 periods.
PV = -980; the price at which the bond is current selling
FV = 1000; the face value of the bond that will be repaid at maturity (the face value of the
bond is not explicitly given but assume it is the nearest round figure.)
PMT = (0.08/2) * 1000 = 40 (Coupons are always paid on the face value)
Compute I/Y = 4.15 %
Annual I/Y = 4.15 x 2 = 8.30 = before-tax cost of debt
After-tax cost of debt = 8.30 (1 - 0.3) = 5.8%
Debt Rating Approach
This method is used when the company’s debt doesn’t have an YTM as it is not publicly
traded. In such case, the approach is as follows:
 Determine the current market rates for comparable bonds with similar ratings and
maturities (using matrix pricing).
 Analyze the company characteristics like covenants, seniority, etc. to get before-tax
cost of debt.
 Apply the marginal tax rate to arrive at the after-tax cost of debt.
Example
A company’s capital structure includes debt with an average maturity of 10 years. The
company’s rating is AA, and it has a marginal tax rate of 30%. The yield on comparable AA
bonds with similar maturity is 5%. Compute the company’s after-tax cost of debt.
Solution:
The company’s after-tax cost of debt is:
rd(1 – t) = 5%(1 – 0.3) = 3.5%
Cost of Preferred Stock
The cost of preferred stock is the cost that a company has committed to pay to preferred
stockholders in the form of preferred dividend. Preferred stock has the characteristics of
both debt and equity. Unlike common dividend which is variable, preferred dividend is

usually fixed and paid before common shareholders. The cost of preferred stock can be
computed as:
Dp
Pp =
rp
where:
Pp = the current preferred stock price per share
Dp = the preferred stock dividend per share
rp = the cost of preferred stock
Example
A company issues preferred stock with par value $100 that is currently valued at $125 per
share. The preferred dividend is $5 per share. The marginal tax rate is 33 percent. What is
the cost of preferred stock?
Solution:
Cost of preferred stock = 5/125 = 4%
Note: We ignore taxes, because unlike interest payments, dividends are not tax deductible.
Cost of Common Equity
Cost of common equity, or cost of equity, is the rate of return required by a company’s
common shareholders. It is the return expected by investors for the risk they undertake.
Unlike debt and preferred stock, estimating the cost of equity is challenging because of the
uncertain nature of future cash flows.
Two commonly used methods to estimate the cost of equity are:
 Capital asset pricing model
 Bond yield plus risk premium method
Capital Asset Pricing Model (CAPM) Approach
According to this method, the cost of equity is equal to the risk-free rate plus a premium for
bearing the security’s market risk. The premium is the beta for the security multiplied by the
equity risk premium.
re = RFR + β [E(R mkt ) – RFR]
where:
re = the cost of equity
RFR = risk-free rate of an asset
β = the sensitivity of a stock’s return to changes in market return
E(R mkt ) = expected return on the market
[E(R mkt ) – RFR] is also called the equity risk premium because it is the premium that
investors expect for investing in the market relative to the risk-free rate.

Example
In a developing market, the risk-free rate is 10% and the equity risk premium is 6%. The
equity beta for a given company is 2. What is the cost of equity using the CAPM approach?
Solution:
re = 0.1 + 2 [0.06] = 22%
To estimate the risk-free rate, we use the yields on long-term government bonds with
maturity close to the useful life of the project. To estimate the equity risk premium, we use
historical returns. Historical equity risk premium is a good indicator of expected equity risk
premium.
Bond Yield plus Risk Premium Method
The bond yield plus risk premium method is commonly used for companies with publicly
traded debt. It provides a quick estimate of the cost of equity for such companies.
In this method, we add a risk premium to the yield on the firm’s long-term debt. The
assumption here is that the return on a company's equity will be greater than the return on
the company's bond, as equity is riskier than the bond.
re = bond yield + risk premium
Example
A company’s interest rate on long-term debt is 8%. The risk premium of equity is estimated
to be 5%. What is the cost of equity?
Solution:
re = 8% + 5% = 13 %
4. Estimating Beta
A firm’s beta is used to estimate its required return on equity. Beta is a measure of the
company’s systematic or market related risk. Riskier firms will have higher betas, whereas
less risker firms will have lower betas.
Estimating Beta for Public Companies
For a public company, beta is computed by regressing the return on the stock with the
return on the market. The regression equation is: R i = αi + βi ∗ R M . The return on market is
plotted on the x-axis as an independent variable. The return on stock is plotted on the y-axis
as a dependent variable. The slope of the best-fit line through this data is the regression beta.
Regression beta is also called an unadjusted or raw historical beta. Such a beta estimate is
influenced by:
 The choice of index used to represent the market. For US equities, indexes such as the
S&P 500 and NYSE are used.

 The length of data and frequency of observation. Often, five years of monthly data are
used.
Adjusted beta: In the long-term, beta has been observed to have a mean-reverting value of 1.
Beta for high-risk stocks is more than 1 but it gradually drifts towards 1. Similarly, beta for
low-risk stocks is less than 1 but it gradually drifts towards 1. Therefore, some analysts
adjust the raw beta using the ‘Blume method’ as shown below:
2 1
Adjusted beta = 3 ∗ unadjusted beta + 3 ∗ 1.0
Example: If the beta from a regression of an asset’s returns on the market return is 1.20,
calculate its adjusted beta.
Solution:
Adjusted beta = (2/3)(1.20) + (1/3)(1.0) = 1.13.
Estimating Beta for Thinly Traded and Nonpublic Companies
For companies that are thinly traded or private companies, beta cannot be determined
through regression, as market price information is not readily available. So, betas of publicly
traded comparable companies are used as a proxy. A four-step process is followed to make
adjustments:
Step 1: Select the benchmark public company
Step 2: Estimate benchmark’s beta
Step 3: Unlever the benchmark’s beta, i.e., estimate the beta without the impact of debt (or
leverage). The formula for unlevering beta is:
1
βU = βE [ D]
1 + (1 − t) E
where:
βU = unlevered beta
D = debt of benchmark company
E = equity of benchmark company
βE = beta of benchmark company
Step 4: Lever the beta to reflect the subject company’s financial leverage. The formula for
calculating the beta of the subject company is:
D′
β′E = βU [1 + (1 − t) ′ ]
E
where:
β′E = beta of subject company
D′ = debt of subject company
E ′ = equity of subject company

βU = unlevered beta (benchmark)

Example
AA Corp. is a large conglomerate and wants to determine the equity beta of its food division.
This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable publicly traded food
company has an equity beta of 1.2 and a D/E ratio of 0.5. What is the equity beta of AA’s food
division?
Solution:
We can calculate the equity beta of AA’s food division as:
1
1. Unlevered beta of publicly traded food company = 1.2 * 1 + 0.6 (0.5) = 0.923
2. Levered equity beta of AA’s food division = 0.923 [1 + 0.6 x 0.7] = 1.31
Inference: Since AA’s food division has more debt than the publicly traded company, it is
riskier and has a higher beta value.
5. Flotation Costs
Flotation costs are the fees charged by investment bankers when a company raises external
capital. There are two approaches to deal with floatation costs:
Approach 1: Incorporate flotation costs into the cost of capital. This will increase the cost of
capital.
Di
re = +g
(P0 − F)
For example, consider a company that has a current dividend of $5 per share, a current price
of $100 per share and an expected growth rate of 10%. The cost of equity without
considering floatation costs would be:
$5 × 1.1
re = + 0.1 = 0.155 or 15.5%
$100
If the floatation costs are 3% of the issuance, the cost of equity considering the floatation
costs would be:
$5 × 1.1
re = + 0.1 = 0.1567 or 15.67%
$100 − $3
However, the problem with this approach is that floatation costs are not an ongoing expense;
they are a cost that the firm incurs at the start of the project. Hence, we should not be
discounting all future cash flows at a higher cost of capital. The correct way to treat
floatation costs is to use approach 2.
Approach 2: We adjust the initial cash flow by the amount of floatation costs. We do not
adjust the discount rate.

Let’s say in the above example, the company raised $100,000 for a project by issuing new
shares. The floatation costs would be 3% of $100,000 i.e. $3,000. In this approach we
increase the initial cash outlay of the project to $103,000. The cost of equity, however,
remains unchanged at 15.5%.
6. Methods in Use
In this reading, we saw several methods to estimate the cost of capital for a company or
project. A survey of a large number of company CFOs to understand the methods they use to
estimate the cost of capital revealed the following:
 The capital asset pricing model is the commonly used model. The single-factor capital
asset pricing model is the most popular one.
 Few companies use the dividend cash flow model.
 Publicly traded companies were more likely to use the capital asset pricing model
than private companies.
 Most companies used a single cost of capital across projects, while some used risk
adjustments for individual projects.

Summary
LO: Calculate and interpret the weighted average cost of capital (WACC) of a company.
WACC = wd rd (1 − t) + wp rp + we re
WACC represents the overall cost of capital for the firm and is the appropriate discount rate
to use for projects having a similar risk profile as that of the firm.
LO: Describe how taxes affect the cost of capital from different capital sources.
In most jurisdictions, interest paid to debt holders are tax deductible, whereas dividends
paid to preferred and common stockholders are not tax deductible. To arrive at the after-tax
cost of capital, we multiply only the cost of debt by (1-t).
LO: Calculate and interpret the cost of debt capital using the yield-to-maturity
approach and the debt-rating approach.
Cost of debt is the cost of financing a company using debt instruments. Two methods of
estimating the cost of debt are:
YTM approach: It is the annual return that an investor earns if he purchases the bond today
and holds it till maturity.
Debt rating approach is used if the market YTM is not available. First estimate the before-tax
cost of debt based on comparable bonds with similar ratings and similar maturities. Analyze
rated firms with similar financial/valuation characteristics, debt seniority, and security. The
company’s marginal tax rate is then used to compute the after-tax cost of debt.
LO: Calculate and interpret the cost of noncallable, nonconvertible preferred stock.
preferred dividend
Cost of preferred stock =
current stock price
LO: Calculate and interpret the cost of equity capital using the capital asset pricing
model approach and the bond yield plus risk premium approach.
CAPM:
re = RFR + β [E (R mkt ) − RFR]
Bond yield plus risk premium:
re = bond yield + risk premium
LO: Explain and demonstrate beta estimation for public companies, thinly traded
public companies, and nonpublic companies.
Beta for a public company is estimated by regressing market returns on stock returns. This is
the unadjusted beta. The beta is then adjusted for its mean-reverting value using

2 1
Adjusted beta = ∗ unadjusted beta + ∗ 1.0
3 3
Beta for thinly traded public companies and nonpublic companies is estimated using a
comparable company’s beta. It is a four-step process that involves:
 Selecting a benchmark company
 Estimating the benchmark’s beta
 Unlevering the benchmark’s beta
1
βU = βE [ D]
1 + (1 − t) E
 Re-levering the beta to reflect the subject company’s leverage.

D′
β′E = βU [1 + (1 − t) ]
E′
LO: Explain and demonstrate the correct treatment of flotation costs.
Flotation costs are the fees incurred by a company when it raises new capital such as issuing
new equity or debt. The correct method to account for flotation costs is to increase a
project’s initial cash outflow by the flotation cost attributable to the project.

LM07 Capital Structure 2023 Level I Notes
LM07 Capital Structure

1. Introduction ...........................................................................................................................................................2
2. Factors Affecting Capital Structure ...............................................................................................................2
Internal Factors Affecting Capital Structure ............................................................................................2
Existing leverage .................................................................................................................................................4
External Factors Affecting Capital Structure ...........................................................................................5
3. Capital Structure and Company Life Cycle .................................................................................................6
Background ...........................................................................................................................................................6
Start-Ups ................................................................................................................................................................7
Growth Businesses .............................................................................................................................................7
Mature Businesses .............................................................................................................................................8
Unique Situations................................................................................................................................................8
4. Modigliani–Miller Propositions .....................................................................................................................8
MM Proposition I without Taxes: Capital Structure Irrelevance .....................................................9
MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity.... 10
MM Propositions with Taxes: Firm Value .............................................................................................. 11
MM Propositions with Taxes: Cost of Capital ....................................................................................... 12
Costs of Financial Distress............................................................................................................................ 13
5. Optimal and Target Capital Structures..................................................................................................... 13
Market Value vs. Book Value ....................................................................................................................... 15
Target Weights and WACC ........................................................................................................................... 15
Pecking Order Theory and Agency Costs ............................................................................................... 16
6. Stakeholder Interests ...................................................................................................................................... 17
Debt vs. Equity Conflict ................................................................................................................................. 18
Preferred Shareholders ................................................................................................................................. 19
Management and Directors ......................................................................................................................... 19
Summary................................................................................................................................................................... 20
rights reserved.

Version 1.0

1. Introduction
Capital structure refers to the specific mix of debt and equity a company uses to finance its
assets and operations.
 Factors affecting capital structure
 How a company’s capital structure may change over its life cycle
 Modigliani–Miller propositions regarding capital structure
 Optimal and target capital structure
 Competing stakeholder interests in capital structure decisions
2. Factors Affecting Capital Structure
Exhibit 1 from the curriculum shows the primary internal and external factors that affect a
company’s capital structure.
We will discuss each of these in detail.

Internal Factors Affecting Capital Structure
Business model characteristics
A company’s business model can greatly impact its capital structure by influencing its ability
to service debt. Key factors that differ among business models include:
 Revenue, earnings, and cash flow sensitivity
 Asset type
 Asset ownership
Revenue, earnings, and cash flow sensitivity:
Some companies like Vodafone in the telecom industry, have very stable revenue streams
because a large proportion of their revenues are subscription-like, recurring revenues. This
is generally viewed as a positive for its ability to support debt, because their revenues are
less affected by fluctuations in the business cycle.
In contrast, companies in cyclical industries, such as Toyota in the automobile industry, have

more volatile revenue streams that are highly sensitive to fluctuations in the business cycle.
This is viewed as a negative for the company’s ability to support debt.
Also, companies with pay-per-use business models, rather than subscription-based models,
are likely to have a lower degree of revenue predictability. This reduces their ability to
support debt.
Generally, stable revenue streams should result in stable earnings and cash flow streams.
But the company’s cost structure (the proportion of fixed and variable costs) also plays a
role. Companies with higher operating leverage (operating leverage = fixed costs / variable
costs) have high earnings and cash flow volatility as compared to firms with low operating
leverage. Thus, high operating leverage reduces a company’s ability to support debt.
Exhibit 2 from the curriculum summarizes these relationships:
Business Model Factor Ability to Support Debt
High (low) revenue, cash flow volatility Reduced (increased)
High (low) earnings predictability Increased (reduced)
High (low) operating leverage Reduced (increased)
Asset Type:
A company’s assets can be broadly classified as:
 Tangible or intangible: Tangible assets are identifiable, physical assets like property,
plant and equipment, inventory, cash etc. In contrast, intangible assets do not exist in
physical form, such as goodwill, patents, property rights.
 Fungible or non-fungible: Fungible assets are those that can be interchanged or
substituted for another asset of similar identity, eg money. In contrast, non-fungible
assets are unique assets such as art pieces that are not mutually interchangeable or
substitutable.
 Liquid or illiquid: Liquidity refers to the ability to convert an asset into cash without
losing a substantial amount of its value. Some assets like marketable securities are very
liquid. In contrast, some assets like real estate, property plant and equipment are illiquid.
From a creditor’s perspective, tangible assets are considered safer than intangible assets as
they can better serve as debt collateral. So companies with mostly tangible assets (e.g. oil
and gas, and real estate industries) can operate with a higher proportion of debt as
compared to companies with mostly intangible assets (e.g. software industry).
Similarly, creditors prefer fungible liquid assets over non-fungible, illiquid assets.
Therefore, companies with greater fungible, tangible, liquid assets can support a higher level
of debt.
Asset Ownership:

Some ‘asset-light’ companies may choose not to own assets but instead ‘out-source’ asset
ownership to other parties. For example, Uber and Airbnb. This strategy, reduces the amount
of assets on the balance sheet, reduces operating leverage, and allows companies to
maximize their flexibility and ability to scale quickly.
The effect of this strategy on the ability to support debt is mixed, On one hand, the lower
operating leverage can support higher debt levels. On the other hand, a lower proportion of
tangible assets on the balance sheet reduces the ability to support debt.
Existing leverage
The existing financial leverage of a firm influences its capital structure decisions. Highly
leveraged firms face a higher risk of default and, as a result, have less capacity to service
additional debt. Underleveraged firms, on the other hand, can support additional debt
relatively easily.
The following ratios are commonly used to determine a company's ability to support
additional debt (Exhibit 4 from the curriculum):
Exhibit 5 presents the relationship between the above ratios and the ability to support debt.
Financial Ratio Type Ability to Support Debt
Higher (lower) liquidity Increased (reduced)
Higher (lower) profitability Increased (reduced)
Higher (lower) leverage Reduced (increased)
Higher (lower) interest coverage Increased (reduced)

Corporate Tax Rate

In many countries, interest expense is a tax-deductible expense. As a result of the tax
savings, a company's after-tax cost of debt will be lower than the actual cost. The higher
(lower) the firm’s marginal income tax rate, the greater (lower) the tax benefit of using debt
in the firm’s capital structure.
Capital Structure Policies/Guidelines
Many companies establish capital structure polices that define the acceptable levels of debt
in the capital structure. For example,
 debt/equity less than 0.5 times
 debt to operating cash flow less than 2.0 times
 debt as a maximum of X% of total capital
To come up with these thresholds, companies may start with debt covenants or rating
agency thresholds and add a cushion or ‘margin of safety’ to ensure that the actual
thresholds are not breached.
Another important consideration is whether their debt or equity issuance meets index
provider requirements. Inclusion in a benchmark index can significantly affect the demand
for these securities.
Third-Party Debt Ratings
Debt ratings are independent, third-party assessments of the quality and safety of a
company’s debt. They are based on the analysis of the company’s ability to pay the promised
cash flows. Debt ratings are an important factor in the practical management of leverage.
Since borrowing costs are closely tied to the bond ratings, maintaining the company’s rating
at a certain level can also be an explicit goal for management.
As leverage rises, rating agencies tend to lower the ratings of the company’s debt. This is
done to reflect the higher credit risk resulting from the increasing leverage. Lower ratings
signify higher risk to both equity and debt capital providers, who in turn demand higher
returns.
External Factors Affecting Capital Structure
Market Conditions/Business Cycle
A company’s cost of debt is equal to a benchmark risk-free rate plus a credit spread specific
to the company. Market conditions/ business cycle affect both the benchmark rates and the
credit spreads. The credit spreads tend to widen during recessions and tighten during
expansions.
Companies may increase their use of debt when borrowing is less expensive due to low
benchmark interest rates and/or tight credit spreads, and vice versa.

Cyclical industries: The revenues and cash flows of companies in cyclical industries (e.g.,
mining) fluctuate widely with the business cycle. Therefore, such companies tend to use less
debt in their capital structure as compared to other companies in less cyclical industries.
Regulatory Constraints
The capital structures of some firms are regulated by government or other regulators. For
example, financial institutions are required to maintain certain levels of solvency or capital
adequacy, as defined by regulators.
Industry/Peer Firm Leverage
Companies in the same industry tend to have fairly similar capital structures. This is because
they are likely to have similar assets and business model characteristics. For example,
companies in the automobile industry tend to own large proportions of tangible, non-
fungible fixed assets in the form of property, plant, and equipment, with significant
proportions of debt in their capital structures.
3. Capital Structure and Company Life Cycle
In this section we will look at the typical changes in a company’s capital structure as it
evolves from a start-up, to a growth business, to a mature business.
Background
A company’s life cycle stage influences its cash flow characteristics, its ability to support
debt; and is therefore a primary factor in determining capital structure. Any capital that is
not sourced through borrowing must come from equity.
As companies mature and move from start-up, through growth, to maturity, their business
risk typically declines, and their operating cash flows turn positive and become more
predictable. This allows for greater use of leverage at more attractive terms. This is
illustrated in Exhibit 7 from the curriculum.

Start-Ups
 In this stage a company’s revenues are close to zero and a lot of investment is required to
move from the prototype stage to commercial production.
 Therefore, cash flow is usually negative.
 The risk of business failure is high.
 The company typically raises capital through equity rather than debt.
 Equity is generally sourced through private markets (venture capital) rather than public
markets.
 Debt is generally not available or is very expensive. It is usually a negligible component of
the capital structure.
Growth Businesses
 In this stage a company typically experiences high revenue growth but investment is
needed to achieve this growth.
 Therefore, cash flow may be negative but it is likely to be improving and becoming more
predictable.
 The risk of business failure decreases.

 As the business becomes more attractive to lenders, debt financing may be available at
reasonable terms. The company may also have assets that it can use to secure debt.
 However, most companies use debt conservatively to retain their operational and
financial flexibility.
 Equity is generally the main source of capital.
Mature Businesses
 In this stage a company typically experiences a slowdown in revenue growth; and
growth-related investment spending decreases.
 Cash flow is usually positive and predictable.
 The risk of business failure is low.
 Debt financing is available at attractive terms often on an unsecured basis.
 To take advantage of the cheaper debt (as compared to equity) companies typically use
significant leverage.
 Over time a company may experience de-leveraging due to continuous positive cash flow
generation and share price appreciation.
 To offset this de-leveraging companies typically buy back shares and reduce the
proportion of equity in the capital structure.
 Share buy backs are preferred over cash dividends as they are more tax-efficient and do
not set future expectations.
 Investors generally respond favorably to share buy back announcement, which may lead
to an increase in share price.
Unique Situations
In the preceding sections we established a general relationship between company maturity
and capital structure. However, there are two important exceptions:
 Capital intensive businesses with marketable assets: Business such as real estate,
utilities, shipping, airline etc. are highly capital intensive. Also, the underlying assets
can be bought and sold fairly easily and make for a good collateral. Such businesses
tend to use high levels of leverage irrespective of their maturity stage.
 “Capital-light” businesses: Some businesses such as software can scale easily and do
not require substantial investments in fixed or working capital to support growth.
They are typically cash flow positive from an early stage and never need to raise large
amounts of capital. Therefore, they tend to use very little debt in their capital
structure.
4. Modigliani–Miller Propositions
Economists Modigliani and Miller claimed that given certain assumptions, a company’s

choice of capital structure does not affect its value.

The assumptions made were:
1. Homogeneous expectations: All investors have the same expectations with respect to the
cash flows from an investment in bonds or stock.
2. Perfect capital markets: There are no transaction costs, no taxes, no bankruptcy costs,
and everyone has the same information.
3. Risk-free rate: Investors can borrow and lend at the 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. Operating income is unaffected by changes in the capital structure.
Modigliani and Miller’s work provides us a starting point and allows us to examine what
happens when the assumptions are relaxed to reflect real-world considerations.
MM Proposition I without Taxes: Capital Structure Irrelevance
MM Proposition I: The market value of the company is not affected by the capital structure
of the company. This is because individual investors can create any capital structure they
prefer for the company by borrowing and lending in their own accounts in addition to
holding shares in the company.
VL = VU
where:
VL = value of the levered firm
Vu = value of the unlevered firm
In other words, the value of a company is determined solely by its cash flows, not by the
relative reliance on debt and equity capital.
The weighted average cost of capital (WACC) is unaffected by the capital structure.
where: WACC = wd rd + wprp + were
We can explain MM’s capital structure irrelevance proposition in terms of a pie. Suppose the
total value of a company is represented by a pie. Slices represents how much of the total
capital is contributed by debt and equity. Depending on the capital structure, the pie can be
split in any number of ways, but the size of the pie will remain the same. This is illustrated in
the figures below.

MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity
MM Proposition II: The cost of equity is a linear function of the company’s debt-to-equity
ratio.
D
re = r0 + (r0 − rd )
E
where:
r0 is the cost of capital for a company financed only by equity and has zero debt
rd is the cost of debt
re is the cost of equity
D/E = debt-to-equity ratio
As D/E rises, i.e. the company increases the use of debt, the cost of equity (re) rises. We
know from MM Proposition I that the value of a company is unaffected by changes in D/E
and the WACC remains constant. Proposition II then implies that the cost of equity increases
in such a manner as to exactly offset the increased use of cheaper debt in order to maintain a
constant WACC. Under this proposition, WACC is determined by the business risk of the
company, and not by the capital structure.
MM Proposition II is illustrated in the figure below.

As leverage increases, the cost of equity increases, but WACC and the cost of debt remain
constant.
Systematic Risk
The systematic risk or beta of a company’s assets is a weighted average of the systematic
risks of its source of capital.
D E
βa = ( ) βd + ( ) βe
V V
where:
βa = asset beta
βd = debt beta
βe = equity beta
According to MM, as the use of debt rises the risk borne by equity holders rises, and
therefore the equity beta rises.
D
βe = βa + (βa − βd ) ( )
E
Example: Effect of Leverage on Equity Beta
A company is financed with 10% debt and 90% equity.
1. If the asset beta is 0.8 what is the equity beta.
2. How does the equity beta change if management increases leverage to 30% debt?
Solution to 1:
Prior to the change in capital structure, the equity beta is
βe = 0.8 + (0.8 − 0.2)(10/90) = 0.87.
Solution to 2:
After the capital structure change, the equity beta is higher because more debt increases the
risk to equityholders. The new equity beta is
βe = 0.8 + (0.8 − 0.2)(30/70) = 1.06.
MM Propositions with Taxes: Firm Value
The discussion so far has ignored taxes. Now, we will present MM propositions I and II with
taxes. As interest paid is tax deductible, the use of debt provides a tax shield that increases
the value of a company. If we ignore the costs of financial distress and bankruptcy, the value
of the company increases as we take on more debt.
MM Proposition I with taxes: The value of a levered company is equal to the value of an
unlevered company plus the value of the debt tax shield.

VL = VU + tD
where:
VL = value of the levered firm
Vu = value of the unlevered firm
t = marginal tax rate
D = value of debt in the capital structure
The term tD is often referred to as the debt tax shield
MM Propositions with Taxes: Cost of Capital
MM Proposition II with taxes: The cost of equity is a linear function of the company’s debt-
to-equity ratio with an adjustment for the tax rate.
The cost of equity increases as the company increases the amount of debt in its capital
structure, but the cost of equity does not rise as fast as it does in the no tax case.
D
re = r0 + (r0 − rd )(1 − t)
E
WACC for a leveraged company falls as debt increases, and therefore the overall company
value increases. This is illustrated in the figure below:
This proposition implies that in the presence of taxes (but no financial distress or
bankruptcy costs), the use of debt is value enhancing and, at the extreme, 100% debt is
optimal.
The table below provides a summary of MM propositions.

Without Taxes With Taxes

Proposition I VL = VU VL = VU + tD
Proposition II re = r0 + (r0 − rd ) D⁄E re = r0 + (r0 − rd )(1 − t) D⁄E
Costs of Financial Distress

The disadvantage of operating and financial leverage is that earnings are magnified
downward during economic slowdown. Lower or negative earnings put companies under
stress, and this financial distress adds costs to a company.
The costs of financial distress can be classified into direct and indirect costs. Direct costs
include the actual cash expenses associated with the bankruptcy process, such as legal and
administrative fees. Indirect costs include forgone investment opportunities, impaired
ability to conduct business, and agency costs associated with the debt during periods in
which the company is near or in bankruptcy.
The costs of financial distress are lower for companies whose assets have a ready secondary
market. For example, airlines, shipping companies etc.
The probability of financial distress and bankruptcy increases as the degree of leverage
increases. The probability of bankruptcy depends, in part, on the company’s business risk.
Other factors that affect the likelihood of bankruptcy include the company’s corporate
governance structure and the management of the company.
5. Optimal and Target Capital Structures
So far in our discussion of the MM propositions, we have only relaxed the assumption of no
corporate taxes. We now consider a scenario that includes both corporate taxes and the
costs of bankruptcy/financial distress.
The optimal capital structure is the one at which the value of the company is maximized. The
static trade-off theory is based on balancing the expected costs from financial distress
against the tax benefits of debt service payments. Considering both the tax shield provided
by debt and the costs of financial distress, the expression for the value of a leveraged
company becomes:
VL = VU + tD − PV(Costs of financial distress)
This equation represents the static trade-off theory of capital structure. It results in an
optimal capital structure where debt is less than 100%. At low levels of debt, the tax
benefits of debt outweigh the PV of financial distress, and the firm’s value increases.
However, as more debt is added, the PV of financial distress begins to rise. At the optimal
debt/equity ratio point, the PV of financial distress is equal to the tax benefit of debt, and the
firm value is maximum. If more debt is added beyond this point, the PV of financial distress
outweigh the tax benefits of debt, and the firm’s value decreases.
These concepts are illustrated in Exhibit 10 from the curriculum.

WACC is minimum at the point where the firm value is maximized.
When a company identifies its most appropriate capital structure, it may adopt this as its
target capital structure. However, a company’s capital structure may vary from its target
because management may try to take advantage of short-term opportunities in alternate
financing sources. Market value variations also continuously affect the company’s capital
structure. Sometimes, it may be impractical and expensive for a company to maintain its

target structure.
In practice, it is difficult to precisely determine the optimal capital structure, because of the
difficulty in estimating some costs, such as the costs of financial distress. Therefore,
managers often use an optical capital structure range instead of a precise ratio. For example,
instead of saying exactly 40% debt is optimal, managers can say debt should be in the range
of 30% to 50%.
Market Value vs. Book Value
The optimal capital structure should be calculated using the market value of equity and debt.
However, company capital structure targets often use book values instead because:
 Market values can fluctuate a lot and they do not necessarily impact the appropriate
level of borrowing. For example, a company that has seen a rapid share price increase
may decide to take advantage of this situation and issue even more equity instead of
debt.
 The management is primarily concerned with the amount and types of capital
invested ‘by’ the company and not ‘in’ the company. Their perspective is different from
investors who have purchased securities at the prevailing market price.
 Lenders and rating agencies typically focus on the book value of debt and equity for
their calculation measures.
Financing decisions are often opportunistic. Managers consider the share price of their
company as well as market interest rates for their debt when deciding when, how much, and
what type of capital to raise.
Target Weights and WACC
When conducting an analysis if we know the company’s target capital structure, then we
should use it in our analysis. However, analysts typically do not know a company’s target
capital structure. It can be estimated using one of these methods:
1. Assume the company’s current capital structure, at market value weights for the
components, represents the company’s target capital structure.
2. Examine trends in the company’s capital structure or statements by management
regarding capital structure policy to infer the target capital structure.
3. Use averages of comparable companies’ capital structures as the target capital
structure.
Example: Estimating the Proportions of Capital
The following information is provided for a company:
Market value of debt: EUR50 million
Market value of equity: EUR60 million

Primary competitors and their capital structures (in millions):

Competitor Market Value of Debt Market Value of Equity
A EUR25 EUR50
B EUR101 EUR190
C GBP40 GBP60
Calculate the proportions of debt and equity, if the target capital structure is calculated
based on:
1. The current capital structure
2. Competitor’s capital structure
3. The company’s announcement that a debt-to-equity ratio of 0.7 reflects its target capital
structure.
Solution to 1:
50
wd = = 0.4545
50 + 60
60
we = = 0.5454
50 + 60
Solution to 2:
25 101 40
(25+50) + (101+190) + (40+60)
wd = = 0.3601
3
50 190 60
(25+50) + (101+190) + (40+60)
we = = 0.6399
3
Solution to 3:
A debt-to-equity ratio of 0.7 represents a weight on debt of 0.7/1.7 = 0.4118, so wd = 0.4118
and we = 1 − 0.4118 = 0.5882.
Pecking Order Theory and Agency Costs
Managers have more information about a company’s performance and prospects than
outsiders, such as owners and investors. This is referred to as information asymmetry.
Investors demand higher returns when asymmetry of information is high because this
increases the probability of agency costs.
Investors closely watch manager’s decision for insights into the company’s future prospects.
Managers may provide information to investors ("signaling") through their choice of
financing method. Fixed payment commitments, for example, can indicate management's
confidence in the company's future prospects.
Being aware of this, managers take into account how their actions might be interpreted by

outsiders.
Pecking Order Theory: This theory suggests that managers choose methods of financing
that send the least signal to outsiders. The preferred hierarchy for financing is:
 First preference: internal financing (retained earnings)
 Second preference: debt financing
 Third preference: equity financing
Agency Costs: Agency costs are incremental costs that arise from conflicts of interest
between managers, shareholders, and bondholders. Agency theory predicts that as the use of
debt increases, agency costs to equity will decrease. The more financially leveraged a
company is, the less freedom managers have to incur additional debt or waste cash in
inefficient ways. This also serves as the basis for the 'free cash flow hypothesis.'
Free Cash Flow Hypothesis: As per this hypothesis, high debt levels discipline managers by
forcing them to manage the company efficiently so that the company can make its interest
and principal payments. Thus, by reducing the company’s free cash flows, managers have
fewer opportunities to misuse cash.
6. Stakeholder Interests
Exhibit 11 from the curriculum shows the key stakeholder groups for a company.

Capital structure decisions impact stakeholder groups differently. Higher financial leverage
usually increases the risk for all stakeholders. However, the benefits of increased leverage,
accrue almost entirely to shareholders (including senior management and the board). As a
result, shareholders and managers acting on their behalf may prefer to increase financial
leverage, whereas other stakeholders will not.
Debt vs. Equity Conflict
 In exchange for the capital provided, debtholders expect periodic coupon payments and
principal repayment at maturity.
 Unlike equity shareholders, they do not directly benefit from a company's strong
performance and prefer cash flow stability.
 As a result, debt holders will almost always prefer decisions that reduce the leverage and
financial risk of a company. Common shareholders, on the other hand, often prefer higher
leverage levels that provide them with greater return potential.
 The debt-equity conflict increases as leverage increases.
 While evaluating projects, management is likely to make the investment when
equityholders are expected to benefit, even if the impact on debtholders is negative,
resulting in a debt-equity conflict. However, management is unlikely to make the
investment when the impact on equityholders is negative, even if the impact on
bondholders and the project’s NPV is positive.
Distressed Debt: If the value of the outstanding debt exceeds the value of the enterprise, the
company has negative equity. In such scenarios, it is difficult to raise new equity capital and
a financial restructuring may be required. By exchanging debt for equity, the company’s
capital structure can be repaired, new investments can be financed, and the company can
avoid liquidation.
The holders of distressed debt have an equityholder like perspective. The potential upside
can be substantial if the company does not default. This makes their risk-return profile
similar to that of an equity holder.
Other debt considerations:
Seniority and security:
In the event of a default, secured lenders are likely to recover more of their principal than
unsecured lenders. Similarly, senior debt is likely to recover more than subordinated debt.
Safeguards for debtholders:
Debtholders typically impose debt covenants to protect their interests. Positive covenants
specify what the borrower must do, such as keep financial ratios within certain limits.
Negative covenants specify what the borrower must not do, such as additional secured
borrowing or dividend payments.

Companies have an incentive to maintain or improve their creditworthiness since they may
need to borrow in the future at favorable terms.
The costs of financial distress can be substantial. Therefore, management will generally take
actions to keep the probability of default at very low levels.
Preferred Shareholders
Preferred shares are frequently referred to as “hybrid” securities because they possess both
debt-like and equity-like characteristics. Failure to pay a preferred dividend is not a default
event for a company. Thus, preferred equity creates less risk for a company as compared to
debt.
Preferred shareholders are vulnerable to decisions that increase financial leverage and risk
over the long term, as this may gradually erode the company's ability to pay preferred
dividends.
Management and Directors
Compensation is the primary tool used to align the interests of management, directors, and
shareholders. Equity compensation can account for a sizable portion of their total
compensation. However, the alignment of managers' and shareholders' interests is never
perfect. For example, the use of management stock options can encourage excessive risk-
taking behavior.

Summary
LO. Explain factors affecting capital structure.
Exhibit 1 from the curriculum shows the primary internal and external factors that affect a
company’s capital structure.
LO. Describe how a company’s capital structure may change over its life cycle.
A company’s life cycle stage influences its cash flow characteristics, its ability to support
debt; and is therefore a primary factor in determining capital structure. Any capital that is
not sourced through borrowing must come from equity.
As a company matures and progresses from start-up to growth to maturity, its business risk
typically decreases, and its operating cash flows turn positive and more predictable. This
enables greater use of leverage at more favorable terms.
LO. Explain the Modigliani–Miller propositions regarding capital structure.
Without Taxes With Taxes
Proposition I VL = VU VL = VU + tD
Proposition II re = r0 + (r0 − rd ) D⁄E re = r0 + (r0 − rd )(1 − t) D⁄E
LO. Describe the use of target capital structure in estimating WACC, and calculate and
interpret target capital structure weights.
When conducting an analysis if we know the company’s target capital structure, then we
should use it in our analysis. However, analysts typically do not know a company’s target
capital structure. It can be estimated using one of these methods:
1. Assume the company’s current capital structure, at market value weights for the
components, represents the company’s target capital structure.
2. Examine trends in the company’s capital structure or statements by management
regarding capital structure policy to infer the target capital structure.
3. Use averages of comparable companies’ capital structures as the target capital
structure.

LO. Describe competing stakeholder interests in capital structure decisions.

Management's capital structure decisions have varying effects on various stakeholder
groups. In seeking to maximize shareholder wealth, managers may create conflicts of
interest in which one or more groups are favored at the expense of others, e.g. debt-equity
conflict.

LM08 Measures of Leverage 2023 Level I Notes
LM08 Measures of Leverage
1. Introduction ...........................................................................................................................................................2
2. Leverage ..................................................................................................................................................................2
3. Business and Sales Risks...................................................................................................................................3
Business Risk and Its Components ..............................................................................................................3
Sales Risk ...............................................................................................................................................................4
4. Operating Risk and the Degree of Operating Leverage.........................................................................4
5. Financial Risk, the Degree of Financial Leverage and the Leveraging Role of Debt ..................5
6. Total Leverage and the Degree of Total Leverage ..................................................................................6
7. Breakeven Points and Operating Breakeven Points ..............................................................................7
Summary......................................................................................................................................................................9
This document should be read in conjunction with the corresponding reading in the 2023 Level I
CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
reserved.
Version 1.0

1. Introduction
The total costs of a company can be broken down into two parts: fixed costs and variable
costs. Fixed costs do not vary with output (the number of units produced and sold), whereas
variable costs vary with output.
Leverage is the use of fixed costs in a company’s cost structure. It has two components:
 Operating leverage: Fixed operating costs such as depreciation and rent create
operating leverage.
 Financial leverage: Fixed financial costs such as interest expense create financial
leverage.
For highly leveraged firms, that is firms with a high proportion of fixed costs relative to total
costs, a small change in sales will have a big impact on earnings.
2. Leverage
Let’s look at an example to understand the impact of leverage.
Example
Consider two companies, HL (high leverage) and LL (low leverage), with the same revenue
and net income but a different cost structure.
Operating Performance Income Statement
HL LL HL LL
No. of units sold 100 100 Revenue 100 100
Sales price per unit 1 1 Operating costs 70 75
Variable cost per unit 0.2 0.6 Operating Income 30 25
Fixed operating cost 50 15 Financing Expense 10 5
Fixed financing cost 10 5 Net Income 20 20
How is the cost structure different?
What is the impact on net income if sales numbers change?
Solution:
Net income for different units of sold
HL LL HL LL HL LL
No. of units sold 100 100 0 0 120 120
Fixed operating costs 50 15 50 15 50 15
Variable costs 20 60 0 0 24 72
Operating costs 70 75 50 15 74 87
Operating Income 30 25 -50 -15 46 33
Interest expense 10 5 10 5 10 5
Net Income 20 20 -60 -20 36 28
Let us plot the net income for different levels of sales (units sold) for HL and LL.

Net Income for different no. of units sold

60
40
20
Net Income
0
0 20 40 60 80 100 120 HL
-20
LL
-40
-60
-80
Number of units sold
As you can see, the loss is magnified when revenue is zero and the profit is also magnified
when revenue increases by a marginal amount for HL relative to LL. When 100 units are
sold, the net income is the same for both the companies. The effect of both loss and profit is
higher for a high leverage firm.
Leverage increases volatility of a company’s earnings and cash flows and also increases the
risk of lending to or owning a company. The valuation of a company and its equity is affected
by the degree of leverage. The higher a company’s leverage, the higher is its risk, which
requires a higher discount rate to be applied in valuation.
3. Business and Sales Risks

Business Risk and Its Components
Business risk is the risk associated with operating earnings. All firms face the risk that
revenues will decline, which will, in turn, affect operating earnings. Business risk consists of
two components: sales risk and operating risk.
Business risk and its two components are depicted in the picture below:

Sales Risk
Sales risk is the variability in profits due to uncertainty of sales price and volume (product
demand and revenue uncertainty).
4. Operating Risk and the Degree of Operating Leverage
Operating risk is the risk due to operating cost structure. It is greater when fixed operating
costs are higher relative to variable operating costs.
Degree of operating leverage is a quantitative measure of operating risk. It is the ratio of
the percentage change in operating income to the percentage change in units sold. It
measures how sensitive a company’s operating income is to changes in sales. For example, a
DOL of 2 means that a 1 percent change in units sold results in a 2 percent change in
operating income.
Percentage change in operating income
DOL = Percentage change in units sold
Q(P−V)
It can be shown that DOL = Q(P−V)–F
where:
Q = number of units
P = price per unit
V = variable operating cost per unit
F = fixed operating cost
P - V = per unit contribution margin
Q (P - V) = contribution margin
Example
Given the following data, compute DOL for HL and LL.
HL LL
Number of units sold 100 100
Sales price per unit 1 1
Variable cost per unit 0.2 0.6
Fixed operating cost 50 15
Fixed financing cost 10 5
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50
100 ∗ 0.8
DOL for HL: 100 ∗ 0.8 − 50 = 2.67
For LL:
Q = 100; P = 1; V = 0.6; F = 15

100 ∗ 0.4
DOL for LL: = 1.6
100 ∗ 0.4 − 15
5. Financial Risk, the Degree of Financial Leverage and the Leveraging

Role of Debt
Financial risk is the risk associated with how a company finances its operations. A company
may choose to finance using debt or equity. The greater the use of debt, the greater is the
company’s financial risk. This is because the company takes on fixed expenses in the form of
interest payments.
Degree of financial leverage is a quantitative measure of financial risk. For example, if DFL
is 2, then a 5 percent increase in operating income will most likely result in a 10 percent
increase in net income.
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐧𝐞𝐭 𝐢𝐧𝐜𝐨𝐦𝐞
DFL = 𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐨𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐢𝐧𝐜𝐨𝐦𝐞
Q(P−V)−F
It can be shown that DFL = Q(P−V)–F−C
where
Q = number of units
P = price per unit
C = fixed financial cost
P-V = per unit contribution margin
Example
Given the following data, compute DFL for HL and LL.
HL LL
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50; C = 10
100 ∗ 0.8−50
DFL for HL: 100 ∗ 0.8 − 50 − 10 = 1.5
For LL:
Q = 100; P = 1; V = 0.6; F = 15; C = 5

100 ∗ 0.4 − 15
DFL for LL: = 1.25
100 ∗ 0.4 − 15 − 5
Effect of Financial Leverage on NI and ROE

Higher leverage leads to higher ROE volatility and potentially higher ROE levels. This is
illustrated through a simple example. Consider two firms with the same operating income
(EBIT), but different capital structures. While Firm 1 has no debt, the capital structure of
Firm 2 comprises 50% debt and 50% equity. The table below computes ROE for different
levels of EBIT.
ROE = NI / equity
Firm 1: Assets = 200; Equity = 200 Firm 2: Assets = 200; Equity =
Debt = 0; Tax = 0% 100; Debt = 100, Interest = 10%
EBIT NI ROE NI ROE
0 0 0 -10 -10%
20 20 10% 10 10%
40 40 20% 30 30%
60 60 30% 50 50%
80 80 40% 70 70%
Some inferences about the effect of financial leverage on NI and ROE:
 For lower levels of EBIT, NI and ROE are negative for the high leverage firm.
 Higher EBIT leads to potentially higher ROE levels, as seen in Firm 2 (high leverage
firm).
 ROE of firm 2 (high leverage firm) has a higher volatility and variability (-10% to
70%) relative to firm 1 (0 to 40%).
6. Total Leverage and the Degree of Total Leverage
Total leverage gives us the combined effect of both operating leverage and financial leverage.
Degree of total leverage (DTL) measures the sensitivity of net income to changes in the
number of units produced and sold.
Percentage change in net income
DTL =
Percentage change in units sold
Q(P−V)
It can be shown that DTL = DOL * DFL = Q(P−V)–F−C
where
Q = number of units
P = price per unit
P-V = per unit contribution margin

Example
Given the following data, compute DTL for HL and LL.
HL LL
Solution:
For HL:
Q = 100; P = 1; V = 0.2; F = 50; C = 10
100 ∗ 0.8
DTL for HL: 100 ∗ 0.8 − 50 − 10 = 4
For LL:
Q = 100; P = 1; V = 0.6; F = 15; C = 5
100 ∗ 0.4
DTL for LL: 100 ∗ 0.4 − 15 − 5 = 2
7. Breakeven Points and Operating Breakeven Points

Breakeven point
Breakeven point is the number of units produced and sold at which net income is zero, the
point at which revenues are equal to costs.
F+C
Breakeven point QBE = P−V
where:
F = fixed operating costs
V = variable cost per unit
P = the price per unit
Operating breakeven point
Operating breakeven point is the number of units produced and sold at which operating
income is zero.
F
Operating breakeven point QOBE = P−V
All else equal companies that have high operating and financial leverage will have high break
even points as compared to companies with low leverage. This is demonstrated in the

following example.
The further away unit sales are from the breakeven point for high leverage companies, the
greater the magnifying effect of this leverage.
Example
Given the following data, compute the breakeven and operating breakeven points for HL
(high leverage) and LL (low leverage) companies.
HL LL
Solution:
For HL:
F = 50; C = 10; P = 1; V = 0.2
F+C 50 + 10
QBE = P − V = 1 − 0.2
= 75
F
QOBE = P−V = 50/0.8 = 62.5
For LL:
F = 15; C = 5; P = 1; V = 0.6
F+C 15 + 5
QBE = P − V = 1 − 0.6 = 50
F
QOBE = P − V = 15/0.4 = 37.5
Instructor’s Note: Section 8 ‘The Risks of Creditors and Owners’ is not testable and hence
not covered.

Summary
LO: Define and explain leverage, business risk, sales risk, operating risk, and financial
risk, and classify a risk, given a description.
Leverage is the use of fixed costs in a company’s cost structure. Leverage has two
components: operating leverage and financial leverage. Fixed operating costs such as
depreciation and rent create operating leverage. Fixed financial costs such as interest
expense create financial leverage.
Business risk is the risk associated with operating earnings. All firms face the risk that
revenues will decline, which in turn will affect operating earnings. Business risk consists of
two components: Sales risk and operating risk.
Sales risk is the variability in profits due to uncertainty of sales price and volume.
Operating risk is the risk due to the operating cost structure. Operating risk is greater when
fixed operating costs are higher relative to variable operating costs.
Financial risk is the risk due to debt financing.
LO: Calculate and interpret the degree of operating leverage, the degree of financial
leverage, and the degree of total leverage.
Degree of operating leverage (DOL) is a measure of operating risk. It is the ratio of the
percentage change in operating income to the percentage change in units sold. It can be
calculated using the following formula:
Q(P − V)
DOL =
Q(P − V) − F
Degree of financial leverage (DFL) is a quantitative measure of financial risk. It is the ratio of
percentage change in net income to percentage change in operating income.
Q(P − V) − F
DFL =
Q(P − V) − F − C
Degree of total leverage (DTL) measures the sensitivity of net income to changes in the
number of units produced and sold. It is the ratio of percentage change in the net income to
the percentage change in the number of units sold.
Q(P − V)
DTL = = DOL ∗ DFL
Q(P − V) − F − C
Where Q is the number of units, P is the price per unit, V is the variable cost per unit, F is the
fixed operating cost, and C is the fixed financial cost.
LO: Describe the effect of financial leverage on a company’s net income and return on
equity.

Higher leverage leads to higher ROE volatility and potentially higher ROE levels:
 For lower levels of EBIT, NI and ROE are negative for the firm with the higher
leverage.
 Higher EBIT leads to potentially higher ROE levels.
 ROE of a high leverage firm has higher volatility and variability.
LO: Calculate the breakeven quantity of sales and determine the company's net
income at various sales levels.
Breakeven quantity of sales is the quantity of units sold to earn revenue equal to the fixed
and variable costs, i.e., for net income to be 0.
F+C
Q(BE) =
P−V
Where F is the fixed cost, C is the financial cost, V is the variable cost per unit, and P is the
price per unit.
LO: Calculate and interpret the operating breakeven quantity of sales.
Operating breakeven quantity of sales ignores the fixed financing costs, i.e., quantity sold for
operating income to be 0.
F
Q(OBE) =
P−V
Where F is the fixed cost, V is the variable cost per unit, and P is the price per unit.

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LM01 Corporate Structures and Ownership 2023 Level I Notes

LM01 Corporate Structures and Ownership

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Corporate Taxes (31.5%) €264

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Market Capitalization = Current Stock Price × Total Shares Outstanding

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Equity and Debt Risk–Return Profiles

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LM02 Introduction to Corporate Governance and Other ESG

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Shareholder vs. Stakeholder Theory

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 Unlike shareholders, they do not have voting rights.

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controlling and minority (without control) shareholders. For example,

4. Corporate Governance and Mechanisms to Manage Stakeholder Risks

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incentives that exists to manage conflicting interests among a company’s management,

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Shareholder activism refers to strategies used by shareholders to attempt to compel a

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exposure and to ensure covenants are not violated.

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 determining company risk profile,

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5. Corporate Governance and Stakeholder Management Risks and

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Benefits of Effective Governance and Stakeholder Management

6. ESG Considerations in Investment Analysis

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Introduction to Environmental and Social Factors

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Environmental Issues Social Issues Governance Issues

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deliver value by advancing economic, environmental, and social sustainability.

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development goals such as SDG6: Clean Water and Sanitation.

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Environmental Issues Social Issues Governance Issues

Equity vs. Fixed-Income Security Analysis:

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LO. Describe environmental, social, and governance investment approaches.

Negative screening Excluding certain sectors or companies or practices from a fund