Learning Module 1

Organizational Forms, Corporate Issuer

Features, and Ownership

LOS: Compare the organizational forms of businesses.

LOS: Describe key features of corporate issuers.

LOS: Compare publicly and privately owned corporate issuers.

Organizational Forms of Business

LOS: Compare the organizational forms of businesses.

There are three main types of organizations in most economies: businesses, non-profits, and governments.

Organizational forms of business

Businesses Non-profits Governments

Sole trader or sole

Partnership Limited company
proprietorship

©CFA Institute

The main focus of this reading is businesses, which can be organized as sole proprietorships, partnerships, or
limited companies. These organizational forms are characterized by:

y Legal identity: Whether the business is considered a legal entity separate from its owner(s)
y Owner-manager relationship: The dynamics between the owner(s) and the manager(s) of the business
y Owner liability: Limits on how much an owner is personally liable for the business’s debts and actions
y Taxation: The treatment of business profits (losses) for taxation
y Access to financing: The ability to raise funds and the distribution of risk

Vol 2-51
Learning Module 1

Sole Trader or Proprietorship

Sole proprietorship is the simplest and most common organizational form. The owner personally funds the
business, has complete control over operations, and fully participates in the entity’s risks and returns. Although
this form offers simplicity and flexibility, one drawback is that access to funding is constrained to the owner’s
ability to raise funds.

A small restaurant is an example of a sole proprietorship. The owner opens the restaurant with personal savings
or bank loans and maintains full control of daily operations. All business profits flow to the owner and are taxed
at the owner’s personal income tax rate. Furthermore, the owner is personally responsible for all liabilities.

Partnerships
In a partnership, multiple owners (ie, partners) contribute their resources and collectively share the risks and
returns of the business. Common types of partnerships include general partnerships, limited partnerships, and
limited liability partnerships.

A general partnership has multiple general partners (GPs) who contribute their capital and expertise. The GPs
collectively assume all of the business’s profits and debts. If one partner is unable to satisfy their share of
business debt, then the remaining partners are obligated to satisfy the debt.

In contrast with general partnerships, limited partnerships have multiple limited partners (LPs) and at least
one general partner. LPs have limited liability—their losses are limited to only the amount of their monetary
investment. LPs are primarily responsible for supplying capital and typically do not engage in operating the
business. In contrast, GPs are responsible for operating the business and have unlimited liability, meaning they
are responsible for all business debts. As such, GPs are entitled to a larger share of profits than LPs due to
accepting more responsibilities and more risk.

Limited partnership

Greater management ...Unlimited Less management ...Limited

responsibility liability responsibility liability

General partner Limited partner Limited partner Limited partner

©CFA Institute

In some jurisdictions, businesses can be structured in the form of limited liability partnerships (LLPs). A LLP does
not require a general partner, so all partners are LPs and have limited liability. Typically, one LP is chosen to be
the manager partner.

Compared with sole proprietorships, LPs can generally raise more capital since they have multiple owners.
However, growth is still limited by the partners’ ability to raise capital. Similar to sole proprietorships, partnerships
are pass-through vehicles, meaning profits are taxed at the owners’ individual tax rates.

Limited Companies
Limited companies are similar to LPs but allow for greater access to financing. Private limited companies and
public limited companies are two common forms of limited companies.

In a private limited company, shareholders (ie, owners) own shares in the company and elect a board of directors
to manage the company. Shareholders primarily risk losing their monetary investment. In many jurisdictions,
private limited companies impose limits on the number of shareholders and require votes to transfer share
ownership. Private limited companies are pass-through vehicles, with distributions taxed only at the investor
level. Examples of private limited companies globally include LLCs, S Corps, and GmbH.

Vol 2-52
 Organizational Forms, Corporate Issuer Features, and Ownership

Shareholder Shareholder Shareholder Shareholder

Shareholder Shareholder Shareholder Shareholder

Board of Directors

CEO CFO Other executives

©CFA Institute

In contrast with private limited companies, public limited companies (corporations), have no restrictions on
the number of shareholders. Shares can be transferred freely, and shareholders can sell without corporate
approval. One disadvantage to corporations is that profits are double taxed—meaning company profits are taxed
at the corporate level and distributions of those profits to shareholders (eg, dividend income) are taxed at the
individual level.

Features of Sole Proprietorships, Partnerships, and Corporations

General Limited
Feature Sole Proprietor Corporation
Partnership Partnership

Legal Identity No separate legal No separate legal No separate legal Separate legal
identity; extension identity; extension identity; extension entity
of owner of partner(s) of partner(s)

Owner-Operator Owner operated Partners operated GP operated Board and

Relationship management
operated

Owner Liability Sole unlimited Shared unlimited GP has unlimited Limited liability
liability liability liability; LPs have
limited liability

Taxation Pass-through: Pass-through: Pass-through: Corporation

Profits taxed as Profits taxed as Profits taxed as income taxed;
personal income personal income personal income distributions
(dividends) taxed
as personal
income

Access to Limited by owner Limited by partner Limited by GP/LP Unbounded

Financing access to capital access to capital access to capital access to capital,
unlimited business
potential

©CFA Institute

Vol 2-53
Learning Module 1

Key Features of Corporate Issuers

LOS: Describe key features of corporate issuers.

The rest of the reading primarily focuses on corporations, due to their importance in the capital markets.

Legal Identity
A corporation is a distinct legal entity separate from its owner(s). Just like an individual, a corporation has rights
and responsibilities and can enter into contracts, hire employees, become involved in lawsuits, borrow and lend
money, invest, and pay taxes.

A large corporation is subject to regulation based on where the company is incorporated, where business is
conducted, or where the company’s securities are publicly listed.

Owner-Manager Separation
Company owners (ie, shareholders) are typically separate from operators (ie, board of directors, company
management). Owners primarily fund the business, while operators run it; together they share the business’s
risks and returns.

Owners elect board members to oversee the executive management team (eg, CEO and officers) in charge of
operating the business. Owners can exert control through voting rights from their shares to ensure the business
is operating in alignment with their interests.

Owner-Shareholder Liability
Shareholders share in the risk and return of the company in proportion to their ownership percentage. In theory,
for shareholders, on the upside their potential gains are unlimited, and on the downside their potential losses are
limited to only their invested capital.

External Financing
The separation between ownership and management responsibilities allows corporations to raise more external
financing since investors can invest any amount in the company and not have to worry about getting involved in
daily operations.

This separation allows the mass public to invest in a company without being responsible for operating it.
Although they are the most expensive structure to operate, corporations benefit from having the widest access to
capital (eg, equity or debt) from individuals and institutional investors.

Taxation
Corporate taxation can vary greatly across countries. In many countries, corporate profits are taxed twice, once
at the corporate level and then at the shareholder level. In other countries, shareholders may receive full or
partial tax credit on dividend income tax.

Vol 2-54
 Organizational Forms, Corporate Issuer Features, and Ownership

Publicly versus Privately Owned Corporate Issuers

LOS: Compare publicly and privately owned corporate issuers.

With corporations, public and private refer to whether the company’s equity is listed on a stock exchange. In
addition to the exchange listing, differences between public and private companies relate to:

y the ability to transfer ownership between investors,

y the process of issuing new shares, and
y registration and disclosure requirements.

A publicly listed company has some or all of its traded shares listed on an exchange. The shares that are actively
traded (eg, not held by insiders) are known as free float.

Exchange Listing, Liquidity, and Price Transparency

An exchange allows buyers and sellers to transfer ownership easily through a secondary market. Thus, an
exchange provides visibility into share price based on the supply and demand for a stock.

On the contrary, private company share prices are not readily visible since shares do not trade on an exchange.
As such, the transfer of private shares often occurs between willing parties at a negotiated price.

In spite of worse liquidity and transparency, there are some unique benefits to operating as a private company.
Firstly, controlling owners and management answer to fewer stakeholders. Secondly, many private companies
are in the early stages of their life cycles, which affords shareholders the opportunity to potentially earn high
returns. Finally, private companies have less strict disclosure requirements.

Share Issuance
After an IPO, a publicly listed company can raise additional capital by subsequently issuing more shares to the
public. Once issued, these shares can easily be traded among investors in the secondary market. In contrast,
private companies raise additional capital in much smaller amounts from fewer investors who have longer
holding periods.

Private companies issue additional shares via private placements with details outlined in a private placement
memorandum, a legal document describing the business, the terms of the offering, and the risks. Because
private securities are typically not registered, usually only accredited (or “eligible” or “professional,” depending
on the jurisdiction) investors are allowed to participate. Regulators typically take income and net worth into
consideration when determining if someone is accredited.

Registration and Disclosure Requirements

Public companies are subject to greater compliance and reporting requirements. For example, in the United
States they must disclose certain kinds of financial information on a quarterly basis through the Securities and
Exchange Commission on a system known as EDGAR (Electronic Data Gathering, Analysis, and Retrieval).
Public companies must also disclose stock transactions made by officers and directors. Some rules apply
to both private and public companies (eg, prohibitions against fraud, the obligation to produce a tax return).
Private companies are generally not subject to the same level of regulatory oversight. They can willingly
disclose pertinent information directly to their investors if they hope to raise more capital in the future, but the
requirements to file documents with the regulatory authorities are lower.

Vol 2-55
Learning Module 1

Going from Private to Public

A private company can go public through the following methods: an initial public offering (IPO), direct listing (DL),
or acquisition.

In an IPO, a company hires an investment bank to underwrite new shares to be issued to the public. Proceeds
from the share issuance go to the issuing corporation. To qualify for an IPO, a company must meet specific
listing requirements.

In a direct listing, no new capital is raised for the corporation. Instead, companies list existing shares on a
public exchange at a market-determined price, without involving an investment bank. Direct listings are typically
cheaper than IPOs and are usually undertaken by large, well-established companies.

Private companies can also become public by being acquired by a public company or by a special purpose
acquisition company (SPAC). In an acquisition by a public company, a private company is effectively absorbed
into a public corporation. A less conventional form of acquisition is via a SPAC. A SPAC is a publicly traded
company founded solely for the purpose of acquiring private companies to turn public. SPACs are commonly
referred to as shell companies or blank-check companies. SPACs initially raise funds through an IPO. The funds
are stored in a trust account. Once an opportunity for an acquisition is identified and the SPAC shareholders
approve, a company is acquired. The acquired company then becomes publicly traded since it is a part of the
publicly traded SPAC.

Going from Public to Private

At times, key investors may take a public company private if they believe that they can implement major changes
that greatly increase the company’s value while operating as a private entity. Such changes may include
reshuffling management, divesting assets, restructuring, or reducing costs.

To take a public company private, key investors take on debt to acquire all publicly traded shares at a premium
and delist the company from the exchange. Once they enhance the company’s value, investors may take the
company public again.

The number of public companies compared with private companies can shed light into an economy’s stage of
development. Many developing economies exhibit high growth and tend to experience a surge in the number
of public companies as markets open up to capital flows domestically and internationally. By comparison, many
developed economies exhibit slower growth. This is due to higher volumes of mergers and acquisitions and easy
access to private equity.

Varieties of Corporate Owners

Shareholders of corporations can be individuals, institutional investors, other corporations, governments, and/
or non-profits. Often, government-owned (ie, public sector) corporations, such as post offices, railways, and
airports, are formed to benefit the public. In some developing economies, state-run enterprises often dominate
basic commodity sectors. As developing economies expand, such state-run enterprises may transfer ownership
to the private sector due to deregulation or access to additional capital.

Vol 2-56
Learning Module 2
Investors and Other Stakeholders

LOS: Compare the financial claims and motivations of lenders and shareholders.

LOS: Describe a company’s stakeholder groups and compare their interests.

LOS: Describe environmental, social, and governance factors of corporate issuers considered by
investors.

Financial Claims of Lenders and Shareholders

LOS: Compare the financial claims and motivations of lenders and shareholders.

Debt versus Equity

Debtholders (ie, lenders) loan funds with finite maturities to debt issuers (ie, borrowers) in exchange for promised
timely interest and principal payments. Compared with shareholders, lenders have priority claims against assets
and receive interest payments before shareholders can receive dividends. Although lenders lack direct decision-
making authority over the corporation, they can impose covenants with their debt and have legal claims against
assets to protect against default.

Equity investors (ie, shareholders) provide funds to issuers of shares of stock, but the shares are issued without
maturity and do not obligate the company to make specific payments. Shareholders have a residual claim on
cash flows, meaning they only receive distributions after the company has paid suppliers, employees, taxes,
and lenders. In the event of a liquidation, shareholders are last in line to receive any potential leftover proceeds.
To their benefit, shareholders have ongoing claims to future profits and may potentially enjoy unlimited capital
appreciation. Compared with lenders, shareholders have greater influence over a company due to voting rights
from shares.

Vol 2-57
Learning Module 2

Exhibit 1 Perspectives of equity and debt investors

Attribute Equity Debt

Tenor Indefinite Term (e.g., 3 months, 10 years)

Return potential Unlimited Capped

Maximum loss Initial investment Initial investment

Investment risk Higher Lower

Desired outcome Maximize firm value Timely repayment

© CFA Institute

Debt versus Equity: Risk and Return

The cost of issuing debt is less than the cost of issuing equity, for two reasons:

y Lenders have priority of claim on assets and cash flows, so lenders require a lower rate of return due to
lower risk.
y Unlike dividends, interest is tax-deductible for corporations, providing a tax shield from debt.

For issuers, debt is less expensive but riskier than equity due to contractual payments and covenant restrictions.
Additionally, more debt (ie, financial leverage) in an issuer’s capital structure increases its financial risk and may
potentially lead to bankruptcy. Conversely, equity financing requires no contractual payments, and more equity
does not necessarily increase the firm’s financial risks, although it does reduce each shareholder’s proportional
ownership through dilution. Firms with less stable cash flows (eg, early-stage companies) typically issue equity,
whereas firms with more stable and positive cash flows (eg, mature companies) may issue debt.

For investors, equity is riskier than debt but offers much greater potential returns. Although shareholders
have only residual claims, once the value of the firm exceeds the value of debt, the upside on equity value is
theoretically unlimited. In contrast, debt investors take on less risk, but the value of debt is limited.

Exhibit 2 Shareholder payoff vs. debtholder payoff

Shareholder
payoff

Debt(D)

Debtholder
payoff

Firm value (V)

0
Insolvent Solvent

Vol 2-58
 Investors and Other Stakeholders

Conflicts of Interest among Lenders and Shareholders

At times, shareholders and lenders may have conflicts of interest. Shareholders aim to maximize residual cash
flows. Since shareholders face limited downside and potentially unlimited upside, they prefer firms to pursue riskier
projects heavily financed with debt. Aside from this preference, shareholders may also have their firms borrow to
fund dividend distributions, which puts lenders further at risk. In contrast, bondholders are concerned with receiving
timely interest and principal payments. Thus, they prefer less risky projects that produce stable and certain
cash flows. As such, covenants are often put in place to restrict firms from indulging in overly risky activities. For
example, a covenant clause may restrict a firm’s debt-to-EBITDA ratio to 3x to limit financial leverage.

Corporate Stakeholders and Governance

LOS: Describe a company’s stakeholder groups and compare their interests.

A stakeholder is any person or group that has a vested interest in a company. Broad stakeholder categories are
shown in Exhibit 3:

Exhibit 3 Stakeholder groups

Stakeholder
groups

Managers/ executives Board of Governments/

Shareholders Creditors Customers Suppliers
and employees directors regulators

Shareholders versus Stakeholders

Good corporate governance seeks to properly balance the various interests among different stakeholder groups.
According to the traditional shareholder theory of corporate governance, the interests of all stakeholder groups
are considered only in relation to maximizing shareholder value.

By comparison, the stakeholder theory of corporate governance considers the collective interests of all
stakeholder groups in relation to each other. As an example, stakeholder theory considers how environmental,
social, and governance (ESG) practices impact the broader community.

We will examine the various stakeholder groups in more detail below.

Investors
Investors consist of shareholders and debtholders (ie, lenders). Shareholders are concerned with maximizing
share price and can vote on important matters such as board member selection, mergers, and dividends.
Debtholders are concerned with timely repayment of principal and interest. Debtholders impose covenants to
discourage borrowers from engaging in overly risky activities. Debtholders can further be divided into private
debtholders and public debtholders.

Private debtholders, such as banks and credit unions, offer loans and credit facilities that are not publicly traded.
For example, a bank may loan a corporation $10 million repayable in 5 years. Due to their critical importance in
financing, many private lenders can exert significant influence over a company by controlling covenant terms.
Furthermore, creditors often have direct access to a company’s nonpublic information (eg, monthly financials).

Vol 2-59
Learning Module 2

Public debtholders (eg, institutional investors, asset managers) typically invest in debt that can be publicly
traded (eg, bonds). Bondholders have less influence over the borrower (except when a borrower undergoes
restructuring) since most of the covenant terms are drafted by the borrower at inception.

Board of Directors
Shareholders elect the board of directors to represent shareholder interests. The board is responsible for hiring
executive management and monitoring their performance. Board members typically include inside directors
(eg, company employees or individuals with company ties) and independent directors (eg, nonemployees
or individuals without company ties). Many major stock exchanges require significant independent director
representation on boards.

In some countries (eg, Germany), a two-tiered board structure exists in which a separate supervisory board
comprised of independent directors oversees the board of directors.

To further vary board composition, some companies have staggered boards in which board members are divided
into different cohorts that begin and end their terms at different times. This mechanism limits the ability of any
powerful shareholder (or group of shareholders) from selecting an entire board team to their favor, all at once.

Managers
Management, led by the CEO, is responsible for executing strategy, under board supervision. To incentivize
company performance, executive compensation typically includes a stock-based component.

Employees
A corporation owes its employees fair compensation, promotion opportunities, job security, and healthy work
conditions in exchange for their labor and skills. In some scenarios, employees are incentivized with some form
of equity-based compensation to perform well.

Customers
Customers expect to obtain quality products and services from a company at a fair price. It is crucial for
companies to maintain good relationships with large customers who can boost revenue and profits in the long
run. Recently, the growing importance of ESG considerations among customers has pressured companies to
adopt better ESG practices.

Suppliers
Company suppliers have a goal of being paid for their services and materials on a timely basis. Similar to
creditors, suppliers prefer companies to be financially stable on an ongoing basis.

Governments
Governments care about a country’s economic well-being. Because businesses impact economic output, capital
flows, employment, social welfare, and the environment, governments are concerned with properly regulating
industries. Furthermore, businesses provide an important source of tax revenue.

Vol 2-60
 Investors and Other Stakeholders

Corporate ESG Considerations

LOS: Describe environmental, social, and governance factors of corporate issuers considered by
investors.

Although ESG factors may impact a company’s performance in the long run, they are often difficult to quantify.
Exhibit 4 shows a list of common corporate ESG considerations:

Exhibit 4 Corporate ESG considerations

Environmental Social Governance

Conservation of the Consideration of Standards for

natural world people and relationships running a company

y Climate change y Customer satisfaction y Board compostion

y Air and water pollution
y Biodiversity
y Deforestation
y Energy efficiency
y Waste management
y Water scarcity
y Data protection and privacy
y Gender and diversity
y Employee engagement
y Community relations
y Human rights
y Labor standards
y Audit committee structure
y Bribery and corruption
y Executive compensation
y Lobbying
y Political contributions
y Whistleblower schemes

©CFA Institute

Historically, environmental and social issues such as climate change, pollution, and societal impact have been
regarded as negative externalities, or costs passed on to society at large. However, ESG considerations are
increasingly and more directly important to corporations, given the trend of increases to:

y the material financial impact of environmental and social disasters,

y customer concern and interest, and
y government oversight and regulation.

Environmental Factors
Material environmental factors include climate change, pollution and waste, resources and land use, ecological
footprint, and biodiversity. Climate change considerations can relate to physical risk or transition risk. Physical
risks are more immediate (eg, direct damage from a storm), whereas transition risks manifest over long time
frames (eg, oil industry revenues decline in the long run due to transition to alternative energy sources).
Transition risk includes the risk of stranded assets that suffer from forced obsolescence.

Vol 2-61
Learning Module 2

Social Factors
Social factors pertain to a firm’s practices concerning employees and human capital, customers, and
communities. Factors include compensation, retention, worker health, training and safety, morale, diversity,
customer confidentiality, and community relations. Properly managing social risk can boost productivity, improve
retention, reduce litigation risk, and enhance reputation.

Governance Factors
Corporate governance and stakeholder management address ownership and voting structure, board member
selection, executive compensation, shareholder rights, and long-term risk management. Many of these topics
are addressed in a company’s proxy statements, annual reports, and sustainability reports.

Evaluating ESG-Related Risks and Opportunities

When evaluating ESG impact, analysts should first quantify the impact on future cash flows and then determine
the impact on debt and equity. Often, ESG factors have more significant impacts over the long run and therefore
expose shareholders to more risk than debtholders and expose long-term debtholders to more risk than short-
term debtholders.

Vol 2-62
Learning Module 3
Corporate Governance: Conflicts,
Mechanisms, Risks, and Benefits

LOS: Describe the principal-agent relationship and conflicts that may arise between stakeholder
groups.

LOS: Describe corporate governance and mechanisms to manage stakeholder relationships and
mitigate associated risks.

LOS: Describe potential risks of poor corporate governance and stakeholder management and
benefits of effective corporate governance and stakeholder management.

Corporate governance describes the system of guidelines and practices for managing the relationships between
various stakeholders. In this learning module, we will examine the relationships among different stakeholders,
how potential conflicts may arise, mechanisms around handling these conflicts, and the benefits of effective
corporate governance.

Stakeholder Conflicts and Management

LOS: Describe the principal-agent relationship and conflicts that may arise between stakeholder
groups.

When a principal hires an agent to act on its behalf, a principal-agent relationship is created. Embedded in the
relationship are characteristics involving trust, an expectation of loyalty, and other agent obligations to act in the
principal’s best interest. However, conflicts may arise between the principal and agent when their interests do not
fully align, and these conflicts can create agency costs.

Exhibit 1 The principal-agent relationship

Self-interest
Hires for task or service

Principal Agent

Performs task or service

Self-interest

Vol 2-63
Learning Module 3

Shareholder, Board Director, and Manager Relationships

Exhibit 2 Board of directors, shareholders, and managers

Board of directors

Represents Oversees

Shareholders Managers

Within a corporation, shareholders (as principals) elect board directors (as agents) to represent shareholders’
best interests. The board hires managers, who also serve as agents, to transact business in a manner that
maximizes value for shareholders. Due to their closer involvement in the business, board directors and
managers have more visibility into performance, risks, and opportunities than shareholders do.

This information asymmetry may affect shareholders’ ability to evaluate whether board members and
management executives are truly running operations to maximize long-term shareholder value. At times, agents
may lack sufficient effort, differ in risk appetite, engage in unprofitable acquisitions, and/or pursue activities that
benefit themselves at the expense of shareholders, such as empire building, becoming entrenched, and/or
indulging in executive perks.

Controlling and Minority Shareholder Relationships

Shareholders may fall into many heterogenous groups with different interests. Often a corporation may have
controlling shareholders (ie, individuals or groups with significant influence) and minority shareholders. Greater
voting power affords controlling stakeholders more authority on critical matters such as board elections, strategic
decisions, and merger and acquisition opportunities.

Often times corporations have a dual class share structure that grants disproportionate voting power to certain
categories of shareholders. For example, a corporation may have Class A shares held by the general public and
Class B shares held by the founding family (ie, insider shares). Class A shares allow 1 vote per share, whereas
Class B shares allow more than 1 vote per share, such that, although they hold a minority of shares, Class B
shareholders have a majority of votes.

As a guideline, issuers are recommended to disclose dual-class share arrangements to investors.

Vol 2-64
 Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Exhibit 3 Dual-class structure

Share class types

Class A share Class B share

Number of votes: 1 Number of votes: Greater than 1

Held by: Outsiders (eg, general investors) Held by: Insiders (eg, founder or family)

Implication for shareholders

Company ownership Voting control

(holding number of common shares) (holding number of votes)

Class A
Class B
Class A
Class B

Class B shareholders own less than half the company but control majority of the votes

Shareholder versus Creditor Interests

The relationship between shareholders and creditors can create conflicts of interest due to the risk tolerance and
expected return of each: typically, a shareholder takes additional risk for greater return, while a creditor looks for
stability and lower risk. Increasing leverage can increase shareholders’ return, but also increases creditors’ risk.

Corporate Governance Mechanisms

LOS: Describe corporate governance and mechanisms to manage stakeholder relationships and
mitigate associated risks.

Corporate Reporting and Transparency

Corporate reporting and transparency give investors visibility into company performance and position. For
publicly traded corporations, reporting is mandatory and regulated. Investors can access financial and
nonfinancial information through sources such as annual reports, proxy statements, company disclosures, and
investor relations materials.

Shareholder Mechanisms
Shareholders can utilize several control mechanisms to exert influence over a company so that their interests
are served.

Vol 2-65
Learning Module 3

Shareholder Meetings
In annual general meetings, shareholders can discuss and vote on important matters such as board member
elections, independent auditor selection, dividends, and various compensation topics. Shareholders who are
unable to attend may authorize another party to vote on their behalf in a proxy voting process.

Outside of regularly scheduled annual general meetings, shareholders may also put together extraordinary
general meetings to vote on important matters as they arise, such as takeover opportunities, capital increases,
and amendments to bylaws.

Shareholder Activism
Shareholder activism involves a group of shareholders implementing strategies to influence a company to
act in a certain way. Such tactics include initiating proxy fights, proposing shareholder resolutions, proposing
alternative board members, and publicizing issues of contention. Hedge funds are popular examples of
shareholder activists.

Shareholder Litigation
Shareholder activists may sue the board, management, and/or controlling shareholders when they believe a
party is not acting in the best interest of the company.

Corporate Takeovers
When shareholders believe the company’s performance is not acceptable, they may pursue a more aggressive
stance and a corporate takeover attempt may ensue, which could be a proxy contest, a tender offer, or a hostile
takeover.

y In a proxy contest (or proxy fight), shareholders are persuaded to vote for a group seeking to take
positions that will control the company’s board of directors.
y With a tender offer, activist shareholders attempt to persuade other shareholders to sell their shares to the
group seeking to gain control.
y A hostile takeover results when an entity acquires a company without the consent of company
management.

Takeover attempts can be countered with anti-takeover measures such as a poison pill.

Creditor Mechanisms
Creditors such as banks and bondholders have various mechanisms for safeguarding their interests. For
bondholders, a bond indenture legally specifies the obligations of the issuer and the rights of the bondholders.
For bank lenders, covenants within the lending agreement require the company to perform certain actions or
prohibit the company from taking certain actions. Furthermore, many loan agreements require the borrower to
pledge collateral.

In some countries, various ad hoc committees can be formed to protect creditors when a company is in distress
or is undergoing bankruptcy, restructuring, or liquidation.

Vol 2-66
 Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Board and Management Mechanisms

A board typically has several functional committees that oversee different areas of the company.

Exhibit 4 Core board committees and key oversight functions

Governance

• Ensure adoption of best corporate governance practices
• Oversee implementation of corporate governance code
• Oversee charters of the board and its committees
• Oversee code of ethics and conflict of interest policy
• Oversee annual board evaluation
• Review regulatory changes and
developments, ensure compliance
with laws, and recommend actions
for breaches

Audit

• Monitor financial reporting • Present annual audit to board • Oversee audit and
process and ensure financial • Recommend external auditors control systems
accuracy

Remuneration

• Develop remuneration policies • Handle employment contracts • Set human

for directors and executives of managers and directors resource policies

Nomination

• Identify candidate positions on • Establish nomination procedures • Ensure director

board of directors and policies independence

Risk

• Establish enterprise risk • Supervise risk management • Establish risk policy

management plans and functions in the company and risk profile
monitor implementation

Investment

• Review investment opportunities • Establish and revise investment • Monitor investment

(eg, mergers and acquisitions, strategy performance
capital projects, divestitures)

Vol 2-67
Learning Module 3

Audit Committee
The audit committee monitors the financial reporting process to ensure that financial statements are prepared
accurately and in accordance with proper accounting standards and regulations. Furthermore, the audit
committee supervises the internal audit function to ensure independence. Lastly, this committee recommends,
appoints, and interacts with external auditors.

Nominating/Governance Committee
The nominating, or governance, committee creates nomination policies and procedures for identifying and
placing new board members. The committee also oversees the creation and enforcement of the corporate
governance code and code of ethics. Furthermore, it ensures that the firm implements policies, complies with
regulations, and pursues appropriate action if any policies are violated.

Compensation/Remuneration Committee
The compensation, or remuneration, committee develops and proposes remuneration policies for directors
and key executives, sets performance criteria and evaluates manager performance, and properly structures
executive compensation to align with long-term company performance.

Employee Mechanisms
Firms can greatly benefit from keeping employees satisfied. Managing employee relationships and respecting
employee rights help firms reduce reputational risks, as well as attract and retain top talent. Many countries allow
employees to join unions to advocate for employee compensation and work conditions. Some companies even
offer employee ownership plans (ESOP) that grant employees partial ownership of the company based on tenure.

Customers and Supplier Mechanisms

Customers and suppliers have contractual agreements with firms that dictate the terms and conditions of
their transactions. These contracts typically outline actions and recourse in the event of breach of contract.
Additionally, parties can utilize social media to publicize their degree of satisfaction.

Government Mechanisms
Governments and regulators seek to protect the public by developing and enforcing laws and regulations. Many
regulatory authorities have also adopted governance codes that consist of guiding principles for publicly traded
companies. These codes require companies to disclose their adoption of recommended corporate governance
practices or explain why they have elected not to do so.

Vol 2-68
 Corporate Governance: Conflicts, Mechanisms, Risks, and Benefits

Corporate Governance Risks and Benefits

LOS: Describe potential risks of poor corporate governance and stakeholder management and
benefits of effective corporate governance and stakeholder management.

Corporate governance is strongly correlated to a company’s success. Weak corporate governance exposes a
firm to risk and places it at a competitive disadvantage to its peers. Conversely, strong corporate governance can
increase competitiveness, improve operational efficiency and profitability, and mitigate risk.

Operational Risks and Benefits

Weak corporate control procedures can allow one group of stakeholders to benefit at the expense of the firm
or another group of stakeholders. For example, weak corporate control allowed Enron managers to divert the
company’s resources to investments in overly risky activities that ultimately harmed shareholders and creditors.
Conversely, strong corporate governance involves proper scrutiny and control at all corporate levels. These
checks can detect potential conflicts of interest and other risks early and benefit the firm’s operational results in
the long run.

Legal, Regulatory, and Reputational Risks and Benefits

Weak compliance practices may expose a company’s legal, regulatory, or reputational risks, which may result in
government fines and stakeholder lawsuits. In contrast, strong compliance practices can shield a company from
such risks and enhance the company’s reputation. A healthy reputation enhances a firm’s ability to attract and
retain employees and do business.

Financial Risks and Benefits

Weak governance and management of creditors’ interest can increase a company’s risk of default, which can
harm its credit rating or even bankrupt the company. This ultimately harms all the company’s stakeholders.

Strong corporate governance can benefit stakeholders in a number of ways; more specifically, studies have
shown that good corporate governance can:

y increase the probability of a credit rating upgrade, which may in turn lower the cost of debt,
y improve market performance during a crisis, and
y contribute positively to firm valuation.

Vol 2-69
Learning Module 3

Vol 2-70
Learning Module 4
Working Capital and Liquidity

LOS: Explain the cash conversion cycle and compare issuers’ cash conversion cycles.

LOS: Explain liquidity and compare issuers’ liquidity levels.

LOS: Describe issuers’ objectives and compare methods of managing working capital and liquidity.

This module focuses on the management of short-term assets and liabilities (ie, working capital) and how it
impacts liquidity. We will examine how changes in working capital levels impact the timing of cash flow, what
metrics can be used to measure liquidity, and the various approaches to managing working capital and liquidity.

Cash Conversion Cycle

LOS: Explain the cash conversion cycle and compare issuers’ cash conversion cycles.

Exhibit 1 Cash conversion cycle

1. Company purchases Inventory 2. Company sells

inventory from suppliers inventory to customers
on credit; amount owed on credit, generating AR
recorded as AP

Accounts payable Accounts receivable

Days
(AP) (AR)

4. Company uses cash to 3. Company collects AR,

pay suppliers, decreasing receiving cash
AP balance Cash

The cash conversion cycle (ie, net operating cycle) captures the average time it takes for a company to convert
its inventory into cash to pay its suppliers. The full process entails the company:

y purchasing inventory from suppliers on credit,

y selling the inventory to customers on credit,

Vol 2-71
Learning Module 4

y collecting cash from customers, and

y paying suppliers for the inventory purchased.

A shorter cash conversion cycle means that the company generates cash from operations faster. This efficiency
helps the company have better liquidity and rely less on external financing. The cash conversion cycle can be
broken down into subcomponents.

Exhibit 2 Operating cycle (OC) and cash conversion cycle (CCC)

OC

CCC = DOH + DSO − DPO

Days of inventory on hand (number of days of inventory)

Days of sales outstanding (number of days of receivables)
Days of payables outstanding (number of days of payables)

Days of inventory on hand (DOH) is the average time it takes to turn inventory into sales.

Days of sales outstanding (DSO) is the average time it takes to turn accounts receivable into cash.

Days of payables outstanding (DPO) is the average time it takes to pay suppliers.

y The operating cycle (OC) measures the time it takes for the firm to turn its inventory into cash (ie, a source
of cash).
y The net operating cycle or cash conversion cycle (CCC) nets out payments to suppliers (ie, a use of cash)
from the operating cash.

Example 1 Cash conversion cycle

An analyst gathers the following information about three companies:

Company X Company Y Company Z

Days of inventory on hand 70 72 68

Days of sales outstanding 35 37 35
Days of payables outstanding 27 13 22

Which company has the shortest cash conversion cycle?

Company X Company Y Company Z

DOH 70 72 68
+ DSO 35 37 35
− DPO 27 13 22
CCC 78 96 81

Company X has the shortest cash conversion cycle.

Vol 2-72
 Working Capital and Liquidity

A firm can shorten its CCC by:

y Reducing DOH by improving sales techniques, inventory management, and demand forecasting
y Reducing DSO by offering early payment discounts to customers, imposing late payment penalties, and
encouraging cash sales and/or deposits
y Increasing DPO by negotiating better payment terms with suppliers

Although extending DPO can shorten the cash conversion cycle, suppliers often provide a discount for paying
earlier. For example, a supplier may offer a 2% discount if an invoice that’s due in 30 days is paid on the 10th
day or earlier (ie, 2/10, net 30). For companies that forego this trade discount, there’s an implicit cost. A model
for calculating trade credit is shown in Exhibit 3.

Exhibit 3 Cost of trade credit

365
Discount Days beyond discount period
Cost of trade credit (%) = 1 + −1
1 − Discount

Example 2 Cash conversion cycle

Company M cost of trade credit

Company M recently purchased materials on credit with the terms 1/10, net 30. If the company pays the
invoice on the 30th day, what is the effective cost of foregoing the discount on the 10th day?

365
20
0.01
Cost of trade credit (%) = 1 + − 1 = 20.1%
1 − 0.01

Under a 1/10 net 30 term, Company M could have effectively earned an annual savings of 20.1% on its
purchases had it paid on the 10th day.

It may not be helpful to compare CCC across industries, given their differences in operations. For example,
a restaurant will have a much lower CCC than a clothing retailer as restaurants turn over their inventory very
quickly. Analysts should compare a firm’s CCC with those of its peers at any one time or with itself over time.
A company that has lengthened its CCC over time or has longer CCC days relative to its peers may not be
managing its operations as well as it might.

Another important measure of liquidity compares working capital levels to sales. Often, a company that can
generate more sales with less working capital exhibits greater efficiency.

Vol 2-73
Learning Module 4

Liquidity

LOS: Explain liquidity and compare issuers’ liquidity levels.

Liquidity for an individual asset or liability describes how quickly and easily that asset (liability) can be turned into
(ie, settled with) cash. Current assets and liabilities are expected to turn into cash or be settled with cash within a
year. Exhibit 4 shows the relative liquidity of current assets and liabilities.

Exhibit 4 Relative liquidity of short-term assets and liabilities

Accrued
More liquid Cash
payroll

Short-term Accounts
investments payable

Accounts Lease payment

receivable next month

Short-term
Less liquid Inventory
debt
©CFA Institute

Liquidity for a company describes how well the company can satisfy its short-term liabilities. An analyst can
gauge a company’s liquidity by comparing its levels of current assets to current liabilities (ie, liquidity ratios) or by
assessing the length of its cash conversion cycle.

Primary Liquidity Sources

A company’s most readily available sources of cash are its primary sources, which involve strategies to increase
liquidity by generating more cash or increasing the sources of cash:

y Cash and marketable securities, including bank cash balances and very liquid securities (eg, money
market instruments)
y Borrowing, including funding from banks, bondholders, or suppliers. Although borrowed funds can be used
to settle current obligations, they create additional future obligations.
y Cash flows generated from the business, which include cash flow from operating activities and free cash
flow. Although generating cash from operations may be a lengthy process (ie, going through the cash
conversion cycle), it is the most important and sustainable source of primary liquidity in the long run.

Vol 2-74
 Working Capital and Liquidity

Exhibit 5 Cash from operating activities example

Indirect format Direct format

Cash from operating activities (USD millions) Cash from operating activities (USD millions)

Net income 24 Cash received from customers 198

Adjustments to reconcile net income Cash paid to suppliers (83)
to cash from operating activities Cash paid to employees (69)
Depreciation 10 Cash paid for interest (5)
Loss on sale of equipment 1 Cash paid for taxes (9)
Change in current assets and liabilities
Cash from operating activities 32
Accounts receivable (2)
Inventory (1)
Accounts payable (2)
Wages payable 1
Interest payable –
Taxes payable 1
Cash from operating activities 32

Companies prefer to use cash from primary sources to meet current obligations since primary sources are
more sustainable and less likely to negatively affect a firm’s operations. However, when primary sources are
exhausted, companies may turn to secondary sources of liquidity.

Secondary Liquidity Sources

Secondary sources are strategies that involve increasing liquidity by decreasing the use of cash. Secondary
sources include:

y Cutting back on dividend payments, which can be a negative signal to shareholders

y Holding back on capital expenditures, which may limit the firm’s growth opportunities
y Issuing equity, which may dilute existing share value
y Renegotiating contracts, which involves refinancing debt, seeking concessions on loan payments,
restricting covenants, and renegotiating terms with customers and suppliers. These actions can affect
relationships with such stakeholders
y Selling assets, which depends on how liquid the assets are
y Filing for bankruptcy protection and reorganization to either close the business or restructure it

These sources can signal a firm’s worsening financial position, increase the firm’s cost of capital, threaten future
funding, and ultimately affect operations.

Factors Affecting Liquidity: Drags and Pulls

Businesses manage liquidity by controlling cash inflows and outflows in the near term. Various activities
drain liquidity through drags and pulls, which reduce a company’s available cash balance. A drag on liquidity
represents a slowdown in cash inflows. A pull on liquidity represents an acceleration in cash outflows.

Major sources of drags on liquidity include:

y Uncollected accounts receivables: The longer a customer’s invoices are past due, the greater the chances
the invoices will not be paid at all.
y Obsolete inventory: Aging inventory may lead to obsolescence or write-downs.
y Borrowing constraints: Challenging economic conditions can lead to a tightening of short-term credit.

Vol 2-75
Learning Module 4

Major sources of pulls on liquidity include:

y Early payments to suppliers. By paying vendors and creditors early, a company reduces its funds available
for other uses.
y Reduced credit limits. A track record of late payments may cause suppliers and creditors to impose lower
credit limits and worsen credit terms.
y Low liquidity position. Some companies just have chronically low liquidity, often due to industry and or
competitive dynamics.

Measuring and Evaluating Liquidity

Exhibit 6 Liquidity ratios

Current assets
Current ratio
Current liabilities

Cash + Marketable securities + Accounts receivable

Quick ratio
Current liabilities

Cash + Marketable securities

Cash ratio
Current liabilities

The current ratio, quick ratio, and cash ratio are common liquidity metrics. Analysts can use these ratios to
measure a company’s performance over time or relative to its peers. The cash ratio is the most conservative of
the three since it only includes cash in the numerator. The current ratio is the least conservative as it includes all
current assets, including inventory, which is the least liquid current asset.

Managing Working Capital and Liquidity

LOS: Describe issuers’ objectives and compare methods for managing working capital and liquidity.

Working Capital Management

The goal of working capital management is to maximize firm value while maintaining sufficient liquidity. Firms
typically forecast working capital levels in relation to revenues and their business cycle. Businesses usually
maintain a constant base level of inventory plus additional, variable levels that fluctuate with seasonal sales
demand. Firms forecast accounts receivables levels relative to sales using certain DSO assumptions.

To support sales, firms vary in their approach to maintaining current assets and financing.

y Under a conservative approach, a firm will maintain a high level of current assets relative to sales, funded
with long-term financing.
y Under a moderate approach, a firm will maintain a moderate level of current assets relative to sales,
funded with a mixture of short-term and long-term financing.
y Under an aggressive approach, a firm will maintain a low level of current assets relative to sales, funded
with short-term financing.

Vol 2-76
 Working Capital and Liquidity

Exhibit 7 Working capital management and funding approaches

Moderate
Conservative "Matched" Aggressive

Larger short-term asset Moderate short-term asset Smaller short-term asset

position versus sales position versus sales position versus sales

Greater reliance on long-term Match funding: Greater reliance on

debt and equity Fund permanent assets long-term short-term liabilities
Fund variable assets short-term

Permanent Long-term debt Permanent Long-term debt Permanent Long-term debt

current assets and equity current assets and equity current assets and equity

Variable current Short-term Variable current Short-term Variable current Short-term

assets liabilities assets liabilities assets liabilities

©CFA Institute

The three approaches attempt to balance the cost of having liquidity and the risk of not having liquidity.

A conservative approach provides the most flexibility for supporting sales since inventory is readily available
in stock and financing is already secured. However, it is also the costliest approach as it can be expensive to
hold high levels of working capital: high inventory levels increase storage costs and the risk of obsolescence.
Additionally, interest rates on long-term financing are typically higher than for short-term financing. Firms that
adopt a conservative approach to working capital management are often firms with higher margins that can
afford to pursue this strategy.

A moderate approach attempts to strike a balance between long-term funding and short-term funding sources
to support current asset needs. Long-term funding is used to fund permanent current assets while short-term
funding is used to fund variable current assets. Under this approach, a firm will hold a moderate level of both
permanent and variable inventory.

An aggressive approach involves carrying low levels of current assets relative to sales, with significant reliance
on short-term financing to support variable levels of inventory when needed. This approach provides the least
amount of flexibility for supporting sales as it increases the risk of an inventory stock out, which threatens sales,
and as rates on short-term financing tend to fluctuate. However, it is also the least costly approach as it does not
require holding high levels of working capital and interest rates are lower on short-term financing, although firms
may experience rollover risk during periods of rising interest rates. Often, firms with low margins or high current
asset turnover choose to adopt this strategy.

Liquidity and Short-Term Funding

Having access to short-term financing can greatly benefit a firm’s liquidity position. A prudent short-term financing
strategy entails having access to multiple lenders who can provide competitive rates. Often, the amount and rate
of the loan will depend on the firm’s size, creditworthiness, and underlying assets. Access to short-term financing
is also impacted by a country’s legal systems and regulatory considerations.

Vol 2-77
Learning Module 4

Vol 2-78
Learning Module 5
Capital Investments and Capital Allocation

LOS: Describe types of capital investments.

LOS: Describe the capital allocation process, calculate net present value (NPV), internal rate of return
(IRR), and return on invested capital (ROIC), and contrast their use in capital allocation.

LOS: Describe principles of capital allocation and common capital allocation pitfalls.

LOS: Describe types of real options relevant to capital investments.

Capital Investments

LOS: Describe types of capital investments.

Capital projects (ie, capital investments) have a life of one year or more and are reported on the balance sheet
as long-term assets, net of depreciation. The investment cash outflows are included in capital expenditures (ie,
CAPEX) on the cash flow statement. These investments can reveal how well management has historically added
value to the firm and can provide insights into future investment opportunities. Capital projects can be tangible
(eg, solar plant) or intangible (eg, artificial intelligence program). There are four categories of capital investments,
as shown in Exhibit 1.

Exhibit 1 Types of capital projects

Maintain Business Grow Business

Going Concern (Maintenance) Expansion of Existing Business

y Continue current operations y Expand business size

y Improve efficiency y Expand business scope
y Risk management y Research and evelopment and
acquisitions within core business
y Low to moderate risk

Regulatory / Compliance New Lines of Business and Other

y Usually imposed by a third party, laws, etc. y Research and development, investments, and
acquisitions outside the firm's current business
y Needed to meet safety, compliance,
regulatory or supervisory standards y Often high risk

© CFA Institute

Vol 2-79
Learning Module 5

Going Concern Projects

Going concern projects (ie, maintenance CAPEX) are essential for continuing operations and maintaining the
business. These projects generally can improve efficiency (eg, reduce costs) but do not necessarily increase
revenue. Common investments include replacing worn-out assets, maintaining IT hardware and software, and
improving existing facilities.

Management can easily estimate maintenance project costs due to the existence of data from similar historical
projects. The duration of funding typically matches the lifespan of the asset.

Regulatory/Compliance Projects
Firms take on regulatory/compliance projects to comply with government regulation. These projects do
not add revenue or improve efficiency but are mandatory to avoid fines and to legally continue operations.
Although compliance can be cumbersome, it may at times protect incumbents by establishing a barrier to entry
for new firms.

Firms should assess the long-term costs and benefits of implementing these projects. If a project is extremely
costly and the firm is unable to pass the cost to customers, then the firm might need to change its business
model or cease operations.

Expansion of Existing Business

Expansion projects seek to grow a business’s scale and scope. Examples include a tire manufacturer investing
in more equipment to increase its production capacity or a snack company starting a new flavor of chips.
These projects often involve more future cash flow uncertainty, driven by risks surrounding execution, sourcing
new inputs, production and distribution, and customer acquisition. Typically, more established firms invest in
expansion projects to stay ahead of competition.

New Lines of Business and Other Projects

A company may invest in an activity completely outside its business based on unique growth opportunities.
These projects exhibit characteristics of startups and tend to be highly risky. An example would be if a traditional
car manufacturer decided to start producing airplanes.

Capital Allocation

LOS: Describe the capital allocation process, calculate net present value (NPV), internal rate of return
(IRR), and return on invested capital (ROIC), and contrast their use in capital allocation.

Capital allocation involves investment and return decisions. Management seeks to add value by investing in
projects that earn risk-adjusted returns exceeding the cost of capital. In the long run, investors can determine if
management has made prudent capital allocation decisions based on the increase in company value.

Vol 2-80
 Capital Investments and Capital Allocation

Exhibit 2 Steps in the capital allocation process

Step 1:
Idea generation
• Identify investment projects

Step 2:
Investment analysis
• Forecast cash flows
• Evaluate profitability

Step 3:
Capital allocation planning
• Schedule outlays
• Prioritize investments

Step 4:
Monitoring and post audit
• Compare actual and predicted results

The capital allocation process involves four steps:

y Idea generation: Ideas can come from anywhere, internal or external to the organization.
y Investment analysis: After forming ideas, management forecasts the amount, timing, duration, and
volatility of cash flows and assesses the overall profitability of the investment to evaluate feasibility.
y Planning and prioritization: Management ranks and selects profitable opportunities that produce the
most value on a risk-adjusted basis. Only projects with positive risk-adjusted values should be considered.
Furthermore, any individual project should be considered in the context of how well it will perform together
with existing operations and whether the project falls within budget.
y Monitoring and post-investment review: Management monitors the project’s actual cash flows and will
adjust ongoing investment levels if necessary.

Some of the most popular metrics for investment analysis include net present value (NPV), internal rate of return
(IRR), and return on invested capital (ROIC).

Vol 2-81
Learning Module 5

Net Present Value

NPV is a key measure used to evaluate capital projects. It is the present value of the project’s cash inflows
minus the present value of outflow(s). Essentially, NPV measures the project’s value added.

Net present value (NPV)

Initial investment After-tax cash flow

CF1 CF2 CFn

NPV = CF0 + + +...+
(1 + r ) 1 (1 + r)2 (1 + r)n

Discount rate Time period

A project should be selected if NPV > 0 and should not be selected if NPV < 0. NPV should be considered
together with other factors when making the capital allocation decision.

Example 1 Maar Corporation NPV

Assume that Maar Corporation is considering a capital investment of EUR 120 million that will return after-
tax cash flows of EUR 28.4 million per year for the next 5 years (at the end of each year), with an additional
EUR 35.5 million at the end of year 5. If the required rate of return is 8.9%, what is the associated NPV of
this investment?

Solution

After-tax cash flows

100

63.9

50
28.4 28.4 28.4 28.4

0
0 1 2 3 4 5

−50

−100

−120

−150

NPV = 28.4 / 1.089 + 28.4 / (1.089)2 + 28.4 / (1.089)3 + 28.4 / (1.089)4 + 63.9 / (1.089)5 − 120 = 13.93

Vol 2-82
 Capital Investments and Capital Allocation

TI BA II Plus key strokes

Key Strokes Display

[CF] 120 [+|-] [ENTER] CF0 = −120

[↓] 28.4 [ENTER] [↓] 4 [ENTER] F01 = 4

[↓] 63.9 [ENTER] [NPV] 8.9 [ENTER] [↓] [CPT] NPV = 13.932

This investment decision increases the company’s value by approximately EUR 13.93 million.

Internal Rate of Return

CF1 CF2 CFn
NPV = 0 = CF0 + + + ... +
(1 + IRR) (1 + IRR)2 (1 + IRR)n

The internal rate of return (IRR) is the discount rate that equates NPV to zero. The IRR decision rule is to invest
in a project if the IRR exceeds the required rate of return (r) and to not invest in the project if IRR is less than r.
The required rate of return is also commonly referred to as the hurdle rate.

One bold assumption of IRR is that interim cash flows will be reinvested at the IRR, which is often unrealistic.
Reinvesting interim cash flows at r is often a more realistic assumption because the required rate of return is the
firm’s cost of capital.

Example 2 IRR calculation

For a project with the following cash flows, what is the IRR?

Year 0 Year 1 Year 2 Year 3

−39,000 15,500 16,500 170,000

Solution

Key Strokes Display

[CF] 39000 [+|−] [ENTER] CF0 = −39,000

[↓] 15,500 [ENTER] CF1 = 15,500

[↓] [↓] 16,500 [ENTER] CF2 = 16,500

[↓] [↓] 17,000 [ENTER] CF3 = 17,000

[IRR] [CPT] IRR = 12.1369

Vol 2-83
Learning Module 5

Note that there is a drawback to using IRR when calculating return for projects with cash flows that change sign
(positive to negative to positive, etc.) more than once in the cash flow stream since multiple IRRs will satisfy that
relationship.

When IRR and NPV conflict among projects, choose the project with the higher NPV since it is a measure
of increase in shareholder wealth, whereas the IRR indicates only a measure of return. For example, when
comparing hypothetical Projects A and B, if A has a higher NPV but B has a higher IRR, choose A.

Return on Invested Capital

Return on invested capital (ROIC) is after-tax operating profit as a percentage of average invested capital
(ie, long-term liabilities and equity). Since most investors and analysts do not know project-level financial
performance, they calculate capital returns either at a segment level or company level.

After-tax operating profitt (1 − Tax rate) × Operating profitt

ROIC = =
Average invested capital Average total LT liabilities and equityt−1,t

Example 3 ROIC calculation

An analyst gathers the following information for a company. What is the company’s return on invested
capital in 20X6?

Operating profit (20X5) 61,973

Tax rate 15%

Assets 20X6 20X5

Cash 12,438 11,597

Short-term assets 80,438 81,564
Long-term assets 497,465 490,456
Total assets 590,341 583,617

Liabilities and equity 20X6 20X5

Accounts payable 60,732 59,345

Short-term debt 10,000 11,000
Long-term debt 168,700 168,700
Shareholders’ equity 350,909 344,572
Total liabilities and equity 590,341 583,617
Solution

(1 − 0.15) × 61,973
ROIC =
0.5[(168,700 + 350,909) + (168,700) 344,572)]

ROIC = 10.2%

Compared with NPV and IRR, which are measures at the project level of the business-segment level, ROIC is
an aggregate company-level measure. This is important for investors because they invest at the company level.
ROIC can be compared to investors’ overall required rate of return since total invested capital encompasses both
debt and equity.

Vol 2-84
 Capital Investments and Capital Allocation

The drawbacks to using ROIC are that operating profit is an accounting measure, so ROIC is based on historical
(ie, backward-looking) data, and also that ROIC does not provide insight into return at the project level or
business-segment level.

Capital Allocation Principles and Pitfalls

LOS: Describe principles of capital allocation and common capital allocation pitfalls.

Capital Allocation Principles

Key principles should be followed when using the analytical tools of the capital allocation process:

y After-tax cash flows: managers should analyze projects using after-tax cash flows (which include tax
benefits from depreciation), rather than using accounting profit measures.
y Incremental cash flows: managers should only consider incremental cash flows, including cost savings and
losses that result from taking on the project. Sunk costs, or expenses that have already been incurred prior
to the project, should be ignored.
y Timing of cash flows: forecasted timing, duration, volatility, and directional change of the expected cash
flows should be factored in.

Capital Allocation Pitfalls

Correctly applying capital allocation analysis may be challenging for management due to certain cognitive errors
and behavioral biases.

Cognitive Errors in Capital Allocation

y Internal forecasting errors: Management forecasts may contain errors regarding costs and required rates of
return. Furthermore, forecasts may exclude external impacts from competition.
y Ignoring costs of internal financing: Management may underestimate the cost of capital if they ignore
financing costs associated with free cash flow. Although free cash flow is internally generated by the firm,
it is not truly “free” for shareholders. There is an opportunity cost associated with not distributing free cash
flow as dividends to shareholders.
y Inconsistent treatment of, or ignoring, inflation: Management should apply the correct type of discount rate
based on whether the cash forecasts are real or nominal. At times, management may mismatch the two.

Behavioral Biases in Capital Allocation

y Inertia: Many companies anchor capital expenditure at the business-unit level to the prior year’s
expenditure. This bias effectively allocates capital based on high-level business unit growth guidance
instead of actual profitable opportunities.
y Basing investment decisions on accounting measures, such as net income: most accounting measures do
not reflect actual project cash flows and do not capture long-term performance.
y Pet project bias: Management may apply selective personal favoritism to suboptimal pet projects.
y Failure to consider investment alternatives or alternative scenarios: Management may overlook many
feasible ideas in the idea-generation phase. Management also sometimes fails to capture all the potential
outcomes to a project.

Vol 2-85
Learning Module 5

Real Options

LOS: Describe types of real options relevant to capital investments.

Often, firms can alter their expenditures on existing projects by exercising real options. A real option gives a firm
the right, but not obligation, to take a subsequent action that can increase the project’s value. Examples of real
options include:

y Timing option: A timing option allows a firm to delay an investment decision until more information is
available surrounding current investments.
y Sizing option: Sizing options include abandonment and growth options.
○ An abandonment option allows a company to abandon a project based on unfavorable results.
○ A growth option allows a company to make additional investments based on favorable results.

y Flexibility option: Compared with a sizing option, a flexibility option allows a firm to make less drastic
changes, such as altering product pricing or adjusting production volumes, instead of fully expanding or
abandoning the project.
y Fundamental option: A fundamental option allows a firm to pursue an action based on an external
outcome. It’s very common in commodity industries; for example, an oil company may choose whether to
drill in an oil well based on the price of oil.

Firms can use several approaches to evaluating capital investments in relation to the real options available:

y Calculate NPV without considering real options: Firms can choose whether to invest in a project based on
the NPV. The real options are simply additional value on top of the NPV.
y Calculate NPV with real options: Firms can include the net value of the options in the calculation of NPV.
Firms will then choose whether to invest in a project based on the all-inclusive NPV value.

Project NPV = NPV (without options) − Option cost + Option value

y Calculate NPV from a decision tree and option pricing model. This is the most complex out of the three
methods and involves different probabilities with different values at each node.

Example 4 Decision tree NPV calculation with new spa

A holding company is opening a new spa location that requires an up-front investment of $300,000. The cost
of capital is 10%.

If the new location meets operational metrics in the first year, then the company will further invest in facility
upgrades at the end of the first year and at the end of the second year will sell the spa to a strategic or
financial buyer.

If the new location fails to meet operational metrics in the first year, then the company will sell the spa to
recoup the up-front costs.

Vol 2-86
 Capital Investments and Capital Allocation

The probabilities and expected after-tax cash flows are shown in the decision tree.

t=0 t=1 t=2

Sell to strategic buyer

(50%)
Meets operating CF2 = 900,000
metrics,
make facility upgrades
(80%) Sell to financial buyer
CF1 = 100,000 (50%)
Open spa CF2 = 700,000
CF0 = −300,000
Does not meets
operating metrics,
r = 10%
sell spa
(20%)
CF1 = 300,000

What is the NPV of the new spa, based on the decision tree?

Solution

CF1 CF2
NPV = CF0 + +
(1 + r) (1 + r)2
−100,000 × 0.8 + 300,000 × 0.2 900,000 × 0.5 + 700,000 × 0.5
= −300,000 + +
1.1 1.12
= 342,972

Vol 2-87
Learning Module 5

Vol 2-88
Learning Module 6
Capital Structure

LOS: Calculate and interpret the weighted average cost of capital for a company.

LOS: Explain factors affecting capital structure and the weighted average cost of capital.

LOS: Explain the Modigliani-Miller propositions regarding capital structure.

LOS: Describe optimal and target capital structures.

The Cost of Capital

LOS: Calculate and interpret the weighted average cost of capital for a company.

Cost of capital (also known as the required rate of return) refers to the rate of return investors require for
providing capital to a firm. It is logical to expect that investors will invest capital only if a company can meet or
exceed this rate; otherwise the investors’ funds are better deployed elsewhere.

A company’s weighted average cost of capital (WACC) is the weighted average of the costs of its different kinds
of capital, which are primarily either debt or equity, based on the sources. WACC is also the discount rate used
for calculating a firm’s value.

Exhibit 1 Weighted average cost of capital (WACC)

Weight of debt Weight of equity

WACC = (w d ) (r d ) (1 − t ) + (w e ) (r e )

Pretax cost Corporate Cost of

of debt tax rate equity

The component weights for debt and equity may be based on target values or current market values. The cost of
debt reflects the creditors’ required rate of return. Since interest expense provides tax savings (also known as a
tax shield) by reducing the issuer’s taxable income, the effective cost of debt is calculated net of tax savings. The
cost of equity reflects the shareholders’ required rate of return for investing in the company’s shares.

Vol 2-89
Learning Module 6

Example 1 WACC calculation

A company has a capital structure of 80% equity and 20% debt. The cost of equity is 14% and the cost of
debt, before the tax savings from interest, is 8%. If the corporate tax rate is 15%, the company’s WACC is
calculated as follows:

WACC = (0.20)(0.08)(1 − 0.15) + (0.80)(0.14) = 12.56%

Factors Affecting Capital Structure

LOS: Explain factors affecting capital structure and the weighted average cost of capital.

Companies strive for a capital structure that minimizes WACC and appropriately matches the duration of the
company’s assets. Internal factors, which affect the amounts and types of financing that can be obtained, include
the company’s:

y Business model
y Current life cycle stage
y Ability to generate cash flows and profits
y Types of owned assets

External factors, such as the macro market environment and issuer-specific factors, determine the costs of
debt and equity.

Determinants of the Amount and Type of Capital Needed

Capital-Intensive Businesses
Capital-intensive businesses, such as manufacturers and natural resource extractors, require large amounts of
assets and therefore large amounts of external financing. Assets are often financed through noncurrent forms
of debt such as long-term leases (eg, equipment lease) or asset-backed loans (eg, commercial real estate loan
backed by the underlying property).

Capital-Light Businesses
Capital-light businesses, such as technology firms or service-based companies, generally require fewer and/
or cheaper long-term assets and thus have low capital needs outside of occasional growth capital. Their assets
are typically comprised of excess cash and intangibles. An example of a capital-light business is Airbnb, which
operates through a website and earns revenue by facilitating the use of other people’s assets.

For capital-light businesses, maintaining short cash conversion cycles, paying employees with large stock
options, and generating recurring subscription revenue are some factors that may reduce the need for
substantial external financing to sustain operations at current levels.

Corporate Life Cycle

A company’s stage in its life cycle will heavily determine the type of financing it can raise. In early stages of the
cycle, companies often lack the cash flows to adequately service debt financing and are therefore limited to
equity financing, which is more costly. As a company grows, it gradually gains more access to debt, and once the
company has reached maturity, it is able to maximize that access.

Vol 2-90
 Capital Structure

Early Stage/Startup

Early-stage companies require funding to develop and introduce their products or services to market. Due to the
uncertainty of revenue and free cash flow (FCF) for most startups, they are primarily restricted to equity funding.
However, despite this lack of access to traditional debt, the companies can issue convertible notes, which will
allow investors to convert their debt investment into equity in the future on predefined terms.

Growth

Companies in the growth phase experience accelerated revenue driven by rising product demand. Further
investments of growth capital are needed to support this demand and scale the company. FCF typically remains
negative as this phase begins, due to the company’s reinvestment activities, and turns positive over time, making
the company more attractive to lenders. Even after gaining interest from lenders, most growth-stage companies
continue financing primarily through equity to preserve operational flexibility (ie, avoid debt covenants) and
minimize financial risk.

Mature Phase

Mature companies tend to have slow but predictable revenue growth, with an established customer base and
stable positive FCF. Healthy FCF levels enable mature firms to issue more debt strategically and at favorable
costs and terms, so they maintain high levels of debt in their capital structure while preserving investment-grade
ratings and financial flexibility. Due to their slower market growth and limited investment opportunities, mature
businesses return significant amounts of FCF to shareholders in the form of dividends or share repurchases.

Determinants of the Costs of Debt and Equity

Various top-down and issuer-specific factors affect capital costs.

Top-Down Factors
Financial market and industry conditions are top-down factors that have an impact on a firm’s cost of capital.
Economic conditions affect the expected returns for debt and equity investors. Investors can invest in
government debt (eg, treasury notes) and earn a near risk-free rate of return, depending on real economic
growth, inflation, monetary policy, and exchange rate movements. So, when they choose to invest in riskier
assets (eg, corporate bonds, stock), investors demand a premium for accepting the greater risk.

When the probability of a recession is high, cash flow projections for corporations are weakened, which
increases the investment risk for both debt and equity providers. Thus, the cost of debt and equity will be greater
due to higher risk premiums. Conversely, during times of expansion, stronger company cash flow forecasts result
in lower risk premiums.

Industry conditions also influence the cost of capital across different sectors. For example, when steel prices are
higher, steel producers benefit from increased revenues and cash flows that lower their cost of capital. However,
rising steel prices increase input costs for construction companies, so their revenues and cash flows decline; this
raises their cost of capital.

Issuer-Specific Factors
Investors consider issuer-specific risk and return factors, such as:

y Sales risk: Predictable, growing, and/or recurring revenue lowers sales risk, thus lowering the
cost of capital.
y Profitability risk: Aside from profit margins, investors also pay close attention to operating leverage (ie,
fixed costs relative to variable costs). Higher levels of operating leverage lead to more volatile operating
earnings, which can increase the cost of capital.
y Financial leverage and interest coverage: Greater financial leverage and low interest coverage increase
the risk of a firm not being able to service its debt. This, in turn, increases the cost of capital.
y Collateral: High-quality liquid collateral can reduce a company’s cost of debt.

Vol 2-91
Learning Module 6

Modigliani-Miller Capital Structure Propositions

LOS: Explain the Modigliani-Miller propositions regarding capital structure.

Nobel Prize winners Franco Modigliani and Merton Miller famously published their views on how a firm’s
value relates to its capital structure. In the Modigliani-Miller propositions, they asserted that under one set
of assumptions, capital structure has no impact on a firm’s value—while under another set of assumptions,
debt can increase a firm’s value up to a point before being offset by financial distress costs. Regardless of the
assumptions, future cash flows are still the key determinant of a company’s value.

Exhibit 2 Modigliani-Miller (MM) assumptions

1. 2. 3. 4. 5.
Homogeneous Perfect capital Risk-free No agency Independent
expectations markets rate costs decisions

Investors agree No transaction Investors can Managers Financing and

on a given costs, no taxes, no borrow and always act to investment
investment's bankruptcy costs. lend at the maximize decisions are
expected cash Everyone has the risk-free rate. shareholder independent
flow. same information. wealth. of each other.

© CFA Institute

Capital Structure Irrelevance (MM Proposition I without Taxes)

Under Proposition I without taxes (ie, perfect markets with no inefficiencies), capital structure does not impact
firm value or WACC. An investor who wishes to alter the capital structure of their investment in a firm can simply
borrow or lend at the risk-free rate in addition to owning shares.

Suppose that a company is financed with 50% debt and 50% equity. An investor who desires a capital structure
of 60% debt and 40% equity can borrow additional funds and structure the purchase to synthetically derive a
60/40 capital structure for the investment. This is known as “homemade leverage.” Since investors can create
such leverage, they may be indifferent to a company’s capital structure decisions.

Modigliani and Miller also argued that, if two firms have differing capital structures but are identical in all other
aspects, both firms should have the same value. Otherwise, arbitrage could occur. For example, suppose Firms
L and U are identical, except that Firm L has debt and Firm U has no debt. If the two firms’ values are unequal,
an investor might sell their shares of the overvalued firm and use the proceeds to buy shares of the undervalued
firm, thus earning a riskless profit.

Higher Financial Leverage Raises Cost of Equity

(MM Proposition II without Taxes)
Under Proposition II without taxes, capital structure does not impact firm value or WACC. The cost of debt is less
than the cost of equity since bondholders have a higher priority claim. However, as companies increase debt,
the risk to equity holders grows alongside higher chances of bankruptcy, so the cost of equity increases. MM
Proposition II states that as a company adds more debt (and if the cost of debt is constant), its cost of equity
rises in a linear fashion, exactly offsetting the benefit of using a greater proportion of cheaper debt; thus, the
firm’s WACC remains unchanged.

Vol 2-92
 Capital Structure

Exhibit 3 Equity cost as a function of the debt-to-equity ratio

re

D
r0 + (r0 − rd)
E

re
D
E
r0 r WACC

0
D
E

© CFA Institute

Example 2 MM Proposition II without taxes

A firm has zero debt and annual expected cash flows of AUD 10 million into perpetuity. The firm’s cost of
equity when it has no debt (r0) is 10%. Suppose the board wishes to recapitalize the firm to 20% debt and
80% equity by issuing debt and using the proceeds to repurchase shares. The cost of debt is 8%.

Solution

1. Find the value of the all-equity firm.

CFe 10M
V= = = 100M
r0 0.10

2. Determine the new cost of equity (re) of the firm under a 20% debt and 80% equity capital structure.
D
re = r0 + (r0 − rd)
E
20
= 0.10 + (0.10 − 0.08) = 10.5%
80
Note that re has increased linearly from 10% to 10.5% in response to adding debt to the capital structure.

Vol 2-93
Learning Module 6

3. Calculate WACC under the new capital structure.

WACC =(wd)(rd)(1−t) + (we)(re)

=(0.20)(0.08)(1−0) + (0.80))(0.105) = 10%

This MM proposition assumes no taxes. Note that the WACC of 10% under the new 20/80 capital
structure remains unchanged from the WACC under the initial all-equity structure.

4. To verify that the firm’s value is unchanged at AUD 100 million, divide the cash flow that’s available to all
capital providers (ie, AUD 10 million) by the WACC of 10%.

CF 10M
V= = = 100M
WACC 0.10

Firm Value with Taxes (MM Proposition II with Taxes)

VL = VU + tD

Under Proposition II with taxes, in an environment without financial distress costs or bankruptcy, the value of
the levered company Firm L equals the value of the unlevered company Firm U plus the debt tax shield. In most
jurisdictions, interest from debt reduces a company’s taxable income, thereby creating a tax shield that increases
firm value for profitable companies. In this equation, t is the marginal tax rate and tD is the present value (PV) of
the debt tax shield. The higher the tax rate, the more value added by the tax shield.

Exhibit 4 Firm value with corporate taxes and debt

Value of firm
(V )
VL = VU + tD

PV of tax
shield on debt
VU (no debt)

0
Debt (D)

© CFA Institute

As a firm’s amount of debt increases, its overall WACC decreases since the incremental tax savings from debt
outweigh the increase in the cost of equity. In theory, at a capital structure of 100% debt, WACC is minimized
and firm value is maximized. However, in the real world, increased debt levels may lead to financial distress and
bankruptcy, thus reducing firm value.

Vol 2-94
 Capital Structure

Cost of Capital with Taxes (MM Proposition II with Taxes

Example 3 MM Proposition II with taxes but no financial distress costs

A firm has no debt and annual expected cash flows of $10 million into perpetuity. The firm’s cost of equity
when it has no debt (r0) is 10%. The corporate tax rate is 25%. Suppose the board wishes to recapitalize the
firm to 20% debt and 80% equity by issuing debt and using the debt proceeds to repurchase shares. The cost
of debt is 8%. Let us look at what happens to the cost of equity, WACC, and firm value.

Solution

1. Find the value of the all-equity firm.

CFe $10M × (1 − 0.25)

V= = = $75M
r0 0.10

Note that, unlike the Example 2 scenario, we are assuming a world where corporate taxes do exist.
Therefore, the cash flow in the numerator is adjusted by the corporate tax rate to represent after-
tax cash flows.

2. Determine the new cost of equity (re) of the firm under a 20% debt and 80% equity capital structure.

D
re = r0 + ( r0 − rd)(1 − t)
E
20
= 0.1 + (0.10 − 0.08)(1 − 0.25) ≈ 10.38%
80

3. Next, calculate WACC under the new capital structure.

WACC = (wd)(rd)(1 − t) + (we)(re)

= (0.20)(0.08)(1−0.25) + (0.8)(0.1038) = 9.5%

This MM proposition assumes taxes. Note that WACC of 9.5% under the new 20/80 capital structure is
smaller than the initial WACC of 10% when the firm was all-equity financed. Even though re had increased
to 10.38%, the tax benefits from debt reduced the overall WACC to 9.5%.

4. To calculate the new firm value, divide the after-tax cash flow that’s available to all capital providers (ie,
free cash flow to the firm) by the new WACC.

CF $10M (1 − 0.25)
V= = ≈ $78.95M
WACC 0.095

Note that the firm value has increased due to benefits from financial leverage in an environment with taxes
but absent financial distress costs.

Costs of Financial Distress

Financial distress refers to the increased risk of a company not being able to meet its debt obligations due
to inadequate earnings or excessive financial leverage. If unmitigated, financial distress can ultimately result
in bankruptcy.

Vol 2-95
Learning Module 6

There are direct costs and indirect costs associated with financial distress. The direct costs include legal and
administrative fees; the indirect costs include lost business and investment opportunities, reputational risk, and
conflict of interest. Even prior to bankruptcy, signs of financial distress may cause companies to lose customers,
creditors, suppliers, and employees.

The costs of financial distress are typically less for firms that can easily liquidate their assets in a
secondary market.

Optimal Capital Structure

LOS: Describe optimal and target capital structures.

The static trade-off theory of capital structure states that as a firm takes on more debt, the benefit from the tax
shield is eventually offset by financial distress costs, thus decreasing firm value. Theoretically, there is an optimal
level of debt (denoted on the horizontal axis in Exhibit 5) that maximizes the firm’s value.

Exhibit 5 Static trade-off theory of capital structure

Firm's market
value Value of levered firm net of
benefits and costs

Value of levered firm before

any benefits or costs
Cost of
bankruptcy

Benefits from
interest tax shield

Value of
unlevered firm

Optimal Debt-to-equity
debt-to-equity ratio
ratio

As debt levels increase on the horizontal axis, the firm’s value increases provided the tax shield benefits
outweigh financial distress costs. Beyond the optimal point of maximum value, the firm’s value starts to decline
since the financial distress costs now outweigh tax shield benefits.

Vol 2-96
 Capital Structure

Managers cannot exactly pinpoint this optimal capital structure, so they establish a target capital structure range
based on the trade-offs of adding debt. In practice, a company’s actual capital structure may differ from its target
capital structure due to advantageous short-term financing opportunities (eg, favorable interest rates).

The proportions of different sources of capital (ie, the weights of each kind of capital) are critical components
when calculating WACC. WACC is typically calculated using market value weights for debt and equity, but target
capital structure is often expressed using book value weights since:

y Market values (especially equity) can fluctuate substantially and seldom impact the appropriate level of
borrowing. For example, a significant increase in share price may entice a company to tactically issue large
amounts of new equity, which will diminish the debt-to-equity ratio.
y Management’s primary concern is the amount and types of capital invested by the company, not in the
company. This means that managers focus on the actual amount the company has invested in capital
projects, which is related more closely to the book value of the individual projects’ assets than to the market
value of the overall company.
y Capital structure policy is aligned to measures used by third parties. When calculating metrics, creditors
and rating agencies generally focus on the book value of debt and equity.

Although the curriculum emphasizes such reasons for using book values to calculate target capital structure,
managers are generally also aware of current market values, which more closely approximate the amounts of
new capital that can be issued.

If target weights are unavailable, analysts can substitute current market values, infer target capital structure from
company trends or management discussions, or utilize the capital weightings of peers or competitors.

Pecking Order Theory and Agency Costs

Information asymmetry arises from the fact that managers know more about their company and its prospects
than the company’s investors do. The greater this asymmetry, the greater the returns investors demand for the
lack of visibility. Management should take investor skepticism into account and carefully consider how investors
will interpret the firm’s capital structure decisions.

Exhibit 8 Pecking order theory

Source of funds preferences based on amount of information disclosure

More Internally generated • Funds already possessed by company

preferred funds • No disclosures required before using funds

Debt • Investors/lenders able to demand information

(bonds or loans) • Extensive disclosures, though less so than for equities

Less Equity • Requires extensive disclosures

preferred (common and preferred) • Public equity offerings subject to greatest scrutiny

The pecking order theory suggests that managers prefer to raise capital using methods that require the least
amount of disclosure (ie, providing investors with only the information necessary to make an investment
decision). According to this theory, management’s first choice is to fund the business with internally generated
funds, followed in order of preference by private debt, public debt, and lastly public equity, which requires the
most disclosure and draws the greatest scrutiny.

Vol 2-97
Learning Module 6

Investors have two common negative interpretations of companies issuing additional equity:

y The company’s prospects must be discouraging. If prospects were better, the managers and existing
owners would not share their ownership eagerly.
y Managers would be reluctant to issue stock if they thought it was undervalued, so the issue indicates that
the stock is overvalued.

If a company were to issue new equity and both interpretations proved to be true, the company’s stock value
would decrease and its cost of equity would increase.

Debt issuance can be interpreted by investors as a positive signal that suggests the firm’s future performance
will be strong enough to repay interest and principal. Leverage may also incentivize management to run the
company more efficiently in order to service debt. Although managers prefer issuing debt over equity, lenders
still require a high degree of financial disclosure. Furthermore, increased financial leverage increases the risk to
shareholders as residual claimants.

Given investors’ interpretations of issuing debt and equity, managers prefer to finance operations with internally
generated cash flows, which require no public disclosure and do not increase financial leverage.

Vol 2-98
Learning Module 7
Business Models

LOS: Describe key features of business models.

LOS: Describe various types of business models.

Defining the Business Model

LOS: Describe key features of business models.

A business model refers broadly to how a firm creates and delivers value for customers. The model should
address the following areas:

y Customers: Who does the firm sell to?

y Products and services: What does the firm sell?
y Sales channels: Where does the firm sell (eg, physical store versus online marketplace) and how do
products and services get delivered to customers (eg, through intermediaries versus direct sales)?
y Pricing strategy: How much does the firm charge for its products and services relative to competitors?
y Key assets, partners, and suppliers: How does the firm produce and distribute its goods and services?

A business model should include just enough information so that the basics of the company can be understood
without getting too deep into the details, which can be found in a business plan.

Exhibit 1 Business model

What is the firm's value proposition to its target customer(s)? What is the firm's value chain?

Who are the firm's What product(s), Where is the firm How much is How is Does the
target customers? services(s), and selling? How offer pricing the firm firm have
How does the firm experience(s) does it reach its relative to organized competitive
keep its customers? does the firm offer? customer(s)? competitors? to execute? capabilities?

What impact does the firm’s business model have on its:

Revenue model?
What is
the firm’s
Cost structure? profitability?

Asset profile? Financial structure?

© CFA Institute

Vol 2-99
Learning Module 7

Business Model Features

Business model descriptions are often found in companies’ annual reports, presentations, and websites.

The Customers and the Market (Who)

A business model should specify its target customers by answering the following questions:

y What are the specific types, or segments, of customers served?

y Are the customers businesses (B2B), individual consumers (B2C), or both?
y In what geographical regions are the targeted customers located?

Customers can be segmented into many groups: by geography, demographics, behavior, age, wealth, etc. Below
are the customers and markets targeted by three different companies.

Exhibit 2 Customer and the market examples

B2B (Business to
Business) or Geographical
Customer
Company location of
Segmentation B2C (Business to customers
Consumer)

Primarily United
Beyond Meat States, Austria,
Primarily vegans
(Plant-based meat Primarily B2B Switzerland,
and vegetarians
manufacturer) Netherlands,
Canada, China

Primarily United
Lululemon High-income States, Canada,
sports and Western Europe,
(Athletic wear Primarily B2C
athleisure Singapore, Hong
clothing company) enthusiasts Kong, Japan,
South Korea

Chewy

(Online retailer for pet Pet owners Primarily B2B United States
food, medication, and
other supplies)

Product or Service Offering (What and Often Why)

The business model should describe what products or services the firm provides to address its customers’
needs, and often, how its offerings differ from those of the competition. Understanding such factors can help
analysts estimate the product’s addressable market and understand the related opportunities and threats.

Channels (Where)
Channel strategy refers to where a firm sells (ie, sales channels) and how its offerings reach customers (ie,
distribution channels).

When developing channel strategy, firms should evaluate what functions can be performed internally versus
outsourcing them to external providers. For example, accounting software providers (eg, Sage Intaact, NetSuite)
often use third-party consultants to implement software for end users.
Vol 2-100
 Business Models

Exhibit 3 Traditional channel strategy vs. direct sales strategy

From
manufacturer

Finished good
To wholesaler
Direct sales
Traditional strategy
channel Finished good
To retailer
strategy

Finished good To end

customer

© CFA Institute

Businesses that produce physical goods often sell the products to multiple intermediaries who resell them to end
customers. This describes the traditional channel strategy. Typically, different physical storage facilities are used
in each stage of the channel.

In contrast, some firms avoid intermediaries and sell products directly to end customers through the direct sales
strategy. This strategy is normally used for very expensive, complex products sold in niche markets, such as
medical devices, industrial equipment, and luxury goods. Direct selling of such products often requires investing
in a large internal sales force. However, more common products can be sold directly through a website.

Some companies implement an omnichannel strategy, which is a hybrid of the traditional channel and direct
sales strategies. For example, many health supplement manufacturers sell their products through both physical
and online retailers.

When evaluating a company, analysts should understand how the company’s channel strategy impacts its
revenues and profits. For example, a direct sales strategy may help build strong relationships with customers but
also incur high fixed costs.

Pricing (How Much)

A business model needs to address certain aspects of pricing:
What are the prices relative to competitors’ prices?

y How do the prices compare to costs?

y Are the firm’s prices justified by its business model?

Firms that sell products in markets with many competitors or minimal product differentiation are called price
takers because their prices are externally set by the market forces of supply and demand. These companies are
often commodity producers. A commodity producer can pursue a cost-leadership strategy (eg, being the lowest-
cost producer) in order to beat its competition.

In contrast, companies selling in markets with few competitors or high product differentiation enjoy more pricing
power. Such companies sell products that are more price inelastic, which allows them the flexibility to charge
premium prices without severely impacting demand. Often, companies use product benefits and strong branding
to justify premium pricing.

Pricing and Revenue Models

Pricing models are used to determine how a firm establishes its unit pricing.Price discrimination refers to
charging different unit prices to customers in different situations in order to maximize profit. Price discrimination

Vol 2-101
Learning Module 7

is effective when customers have varying demand elasticities—that is, they value the same product differently at
different times or under different circumstances. Price discrimination can occur through several common models:

y Tiered pricing: Prices vary based on volume or features. For example, Tier 1 monthly pricing for a 500-
user package of an enterprise software might be $20 per user while Tier 2 monthly pricing for a 1,000-user
package is $15 per user.
y Dynamic pricing: Prices vary based on levels of demand at different times. For example, airfare tends to
be more expensive during peak travel seasons.
y Value-based pricing: Prices vary based on customers’ perceived value. For example, two individuals may
differ in their perceived value of the same piece of art. The art dealer can sell the painting for a much higher
price to the customer who values it more.
y Auction/reverse auction: Prices can be established through bids. For example, a seller may auction a
soccer jersey online for the highest price.

Pricing models may also be different for multiple products or complex products:

y Bundling refers to incentivizing consumers to purchase multiple, complementary products or services

together in one packaged bundle. For example, a large telecommunications provider may bundle cable,
internet, and phone services as a part of a monthly subscription package. Bundling allows companies to
efficiently spread sales and marketing expenses across multiple products.
y Razor-razorblade pricing combines a low-price initial equipment purchase with subsequent, recurring
purchases of accessory, high-margin items. For example, an office printer with low margin can be sold
alongside recurring ink cartridge subscriptions with high margin.
y Add-on pricing refers to offering optional add-on features with a product or service. For example,
Tesla buyers have the option to add on features such as full self-drive, long-range drive, music services
subscription, etc.

At times, firms strategically implement penetration pricing, which involves deeply discounting prices and
sacrificing short-term profits to aggressively scale and grow their market share. For digital businesses (eg, online
dating apps), acquiring a large user base is critical. A digital business with a large free user base can recover
fixed costs by converting more users to paid subscribers. Two common pricing strategies for doing this are:

y Freemium business models, which give users free access up to a certain level of usage. Once a
customer seeks to unlock further usage, there is a fee. For example, many dating apps offer free usage
based on a limited number of swipes per day. Users who want more daily swipes can upgrade their
subscription for a fee.
y Hidden revenue business models, which provide free services to users while deriving revenue
elsewhere. For example, most online search engines are free to users but generate advertising revenue
from businesses bidding on keywords.

Some business models allow customers to enjoy benefits without having to directly own the good or service:

y In a subscription model, users gain access to a good or service in exchange for paying periodic
subscription dues. Common examples include application software, cloud computing, utilities, and
digital media.
y Leasing, licensing, and franchising models are similar to subscriptions.
○ Leasing transfers property or equipment to another entity for a specified period in exchange for periodic
lease payments.
○ Licensing gives a licensee access to intellectual property in exchange for royalty payments.
○ Franchising is a form of licensing in which the franchisor gives the franchisee the right to sell and
distribute products and services.

Vol 2-102
 Business Models

The Value Proposition (Who + What + Where + How Much)

Value proposition refers to attributes that lead customers to select one firm’s products or services over those of
its competitors. Such attributes include:

y A product’s capabilities, performance, features, and style

y Customer service and support after purchase
y Sales process—before and during the purchase, and post-sales follow-up
y Competitive pricing

Business Organization and Capabilities

Business organization and capabilities refer to how a firm is structured to deliver its value proposition. Analysts
should consider a firm’s means and resources for delivering its business model and whether they are internal (ie,
provided within) or external to the firm.

For example, Apple invests heavily in internal R&D to develop new products and software. The firm collaborates
externally with suppliers and manufacturers to acquire materials and assembly services for its semiconductor
chips and digital displays. After outsourcing the production, Apple distributes the finished goods via authorized
retailers (ie, physical and online stores).

A firm’s value chain consists of the systems and processes it uses to create value for its customers. The value
chain involves only functions performed by the firm itself. Analysts should identify the specific activities of each
component in the chain and the net value added by that component.

Exhibit 4 Support and primary activities of value chain components

Firm infrastructure

Human resource management

Support
activities Technology development

Procurement

Inbound Outbound Marketing

Operations Service
logistics logistics and sales

Primary activities
© CFA Institute

The supply chain refers to the process of creating a product and delivering it to customers, regardless of whether
all steps in the process are performed by a single firm. As such, the supply chain may include capabilities and
resources across several firms, including partners and suppliers.

In addition to describing a firm’s value chain and supply chain, a business model should show how the firm
makes a profit: how margins, breakeven points, scale, and unit economics (ie, revenue and costs per unit)
impact the firm’s profitability over time.

Vol 2-103
Learning Module 7

In summary, the business model should answer these questions:

What is the firm selling?

y Who are the firm’s customers and how does it reach them?
y How does the firm price its products?
y How will the firm execute the model?
y How much will the model cost, and how will the costs behave as scale and conditions change?

Business Model Types

LOS: Describe various types of business models.

Business Model Variations

The curriculum lists natural resource producers, manufacturers, distributors, retailers, brokers, banks, service
providers, and software companies as firms that operate conventional business models. In addition, the
curriculum lists the following industry-specific business model variations:

y Private labels and contract manufacturers that produce goods for customers who later sell those goods
under their own brand.
y Value-added resellers, who complement product distribution with complex activities such as installation,
customization, and support services.
y Licensing arrangements, in which one company produces a product using someone else’s brand name
in exchange for paying royalty fees.
y Franchises, where a franchisee operating under a specific brand pays fees to the franchisor. In return, the
franchisor provides operational and administrative support to the franchisee. Franchise restaurants are a
common example of this model.

Business Model Innovations

Technological advancements have made the world more interactive by facilitating rapid information exchange.
As a result, location matters less, outsourcing is more easily available, digital marketing is widespread, and more
firms are adopting network effects. Technology has helped create many business model innovations that are
used, for example, in ride sharing, content streaming, and social media advertising.

Network Effects and Platform Business Models

The network effect is a network’s increase in value as more users—or more types of users—are added to it. For
example, Venmo has a one-sided network that facilitates money transfers between users of one type (ie, friends
and family members). In contrast, a multi-sided network has more than one user type, such as the hosts and
guests in Airbnb’s online short-term rental network; the network effect accelerates as more Airbnb hosts attract
more guests who then attract more hosts in a cycle that exponentially expands the network.

Another networking business model is crowdsourcing, where users contribute content, services, or financial
contributions to help produce goods or services. TikTok, Instagram, Yelp, and TripAdvisor are examples of social
media platform models in which user communities generate the content with little oversight from the company.

Vol 2-104
Financial Statement
Analysis, Part I