Course Content
Organizational Forms, Corporate Issuer Features, and Ownership
This is Reading 22 of CFA Level 1, Corporate Issuers, 2024 course. This reading consists of three LOSs, i.e.,: a. compare the organizational forms of businesses b. describe key features of corporate issuers c. compare publicly and privately owned corporate issuers
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LOS A: Compare the organizational forms of businesses.
LOS B: Describe key features of corporate issuers
LOS C: Compare publicly and privately owned corporate issuers
INTRODUCTION TO CORPORATE GOVERNANCE AND OTHER ESG CONSIDERATIONS
This chapter is covered under study session 10, reading 31 of the study materials as provided by the CFA Institute.
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Introduction
LOS A: Describe corporate governance
00:00
LOS B: Company’s Stakeholders
08:17
LOS C: Principal-Agent Relationship
08:13
LOS D: Stakeholder’s Management
02:39
LOS E: Mechanisms of Stakeholders Management
09:25
LOS F: Board of Directors and Committees
06:57
LOS G: Factors Affecting Stakeholders Relationship and Corporate Governance
04:43
LOS H: Risks of Poor Corporate Governance & Benefits of Corporate Governance
03:14
LOS I: Analysts’ Consideration
04:32
Factors Affecting Company & ESG Implementation Methods
05:00
USES OF CAPITAL
This chapter is covered under study session 9, reading 28 of the study materials as provided by the CFA Institute. After reading this chapter, the candidate should be able to: a. a describe the capital allocation process and basic principles of capital allocation; b. demonstrate the use of net present value (NPV) and internal rate of return (IRR) in allocating capital and describe the advantages and disadvantages of each method; c. describe expected relations among a company’s investments, company value, and share price; d. describe types of real options relevant to capital investment; e. describe common capital allocation pitfalls.
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Introduction
LOS A: Capital Budgeting Process
20:19
LOS B: NPV and IRR
19:58
LOS C: Company’s Investment, Value, and Share Price
06:42
LOS D: Real options
08:54
LOS E: Capital Allocation Pitfalls
05:42
Sources of Capital
This topic is covered under LOS 29 of study session 9. After reading this chapter, you should be able to: a. describe types of financing methods and considerations in their selection; b. describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position; c. compare a company’s liquidity position with that of peer companies; d. evaluate choices of short-term funding.
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Corporate Financing Options
24:21
Sources and Factors That Influence Liquidity
10:28
Comparing Liquidity Position
08:23
Short Term Funding
06:59
Cost of Capital
This chapter is covered under study session 10, reading 30 of the study material as provided by the CFA institute. After reading this chapter, the candidate should be able to: a) calculate and interpret the weighted average cost of capital (WACC) of a company; b) describe how taxes affect the cost of capital from different capital sources; c) calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach; d) calculate and interpret the cost of noncallable, nonconvertible preferred stock; e) calculate and interpret the cost of equity capital using the capital asset pricing model approach and the bond yield plus risk premium approach; f) explain and demonstrate beta estimation for public companies, thinly traded public companies, and nonpublic companies; g) explain and demonstrate the correct treatment of flotation costs.
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Introduction
LOS A: Weighted Average Cost of Capital
12:25
LOS B: The Effect of Taxes on Capital Budgeting Decision
08:33
LOS C: Calculating Cost of Debt
08:27
LOS D: Calculating Cost of Preferred Stock
04:01
LOS E: Calculating Cost of Common Equity
12:40
LOS F: Estimating Company & Project β (Beta)
11:16
LOS J: Country Risk
LOS K: Marginal Cost of Capital Schedule
LOS L: Floatation Cost
Measures of Leverage
This chapter is covered under study session 11, reading 34 of the study material as provided by the CFA institute. After reading this chapter, the candidate should be able to: a. Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk, given a description. b. Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage. c. Analyze the effect of financial leverage on a company’s net income and return on equity. d. Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels. e. Calculate and interpret the operating breakeven quantity of sales.
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Introduction
LOS A: Risk and Components of Risk
LOS B and C: Degree of Leverage
LOS D: Break-Even Points
Impact of Leverage on Bankruptcy
Working Capital Management
This chapter is covered under study session 11, reading 35 of the study material as provided by the CFA institute. After reading this chapter, the candidate should be able to: a. describe primary and secondary sources of liquidity and factors that influence a company’s liquidity position; b. compare a company’s liquidity measures with those of peer companies; c. evaluate the working capital effectiveness of a company based on its operating and cash conversion cycles, and compare the company’s effectiveness with that of peer companies; d. describe how different types of cash flows affect a company’s net daily cash position; e. calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines; f. evaluate a company’s management of accounts receivable, inventory, and accounts payable over time and compared to peer companies; g. evaluate the choices of short-term funding available to a company and recommend a financing method. 
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Introduction
LOS A: Liquidity Management
LOS C: Cash Conversion Cycle
LOS D: Impact of Cash Flow on Net Daily Cash Position
LOS E: Yield, Returns, and Policies
LOS F: Accounts Receivables, Inventories & Accounts Payable
LOS G: Short Term Funding
Corporate Issuers

Calculating cost of equity, capm, bond yield plus risk premium approach

LOS E requires us to:

calculate and interpret the cost of equity capital using the capital asset pricing model approach and the bond yield plus risk premium approach

 

There are many methods of calculating and estimating the cost of common equity, the most prominent of them being: the Capital Asset Pricing Model (CAPM), Dividend Discount Model (DDM), and Bond Yield plus Risk Premium Approach.

1.  Capital Asset Pricing Model (CAPM)

a.  The CAPM developed by William F Sharpe, John Lintener, and Jan Mossin is one of the major developments in financial theory. The CAPM establishes a linear relationship between the required rate of return of a security and its systematic or undiversifiable risk or beta.

CAPM can be mathematically represented as:

Re = Rf + βj (km – Rf)

Where,

Re = expected or required rate of return on security j.

Rf = risk – free rate of return.

βj  = beta coefficient of security j

km= return on market portfolio.

b.  The selection of a risk-free rate of return is usually guided by the duration of the project’s cash flow. So, if the duration of the project’s cash flow is expected to be around 10 years, then the risk-free rate on the government bonds, etc. of a similar duration should be considered.

c.  Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. It should be estimated relative to the market index.

d.  The term ‘km – Rf’ is the expected market risk premium, also referred to as Equity Risk Premium (ERP).

e.  Here, as per the CAPM, we use βj to estimate the risk associated with the project. This beta may not be able to capture all the risks. In such cases, we could use the multi-factor models with multiple betas.
The equation for such a model is:

Re = Rf + βj1 (Factor Risk Premium) + βj2 (Factor Risk Premium) + …… + βjn (Factor Risk Premium)

1.1.  Estimating Equity Risk Premium (ERP)

ERP can be estimated using one of the following methods:

Historical Equity Risk Premium Approach.

a.  The two main components of ERP are market return and the risk-free rate. The historical approach makes use of historical data to find out an average market return and the risk-free rate of return.

b.  While using this approach, analysts must consider different time periods to average the rates (i.e. 1-year period, 5-year period, 10-year period, etc.). They may also consider overlapping vs. non-overlapping time periods.

c.  For averaging the returns, the analyst may use arithmetic or geometric means. A geometric mean may be used to measure the profitability of an investment over a multi-period horizon.

d.  Some of the limitations of using such an approach are:

i.  The levels of risks of an index can change over time,

ii.  The levels of risk aversions can also change,

iii.  Estimates are sensitive to the methodologies of choosing that we use, etc.

Dividend Discount Model or Implied Risk Premium Approach.

a.  This approach is implemented using the Gordon Growth Model. According to this approach, the market returns are reflected in the long-run trends in growth rates.

b.  Assuming a constant rate of growth of dividends, the following equation shows how the price is calculated using this approach:

Po =  D1 / ( re – g)

Where,

D1           = Dividends expected in the next period,

Po           = Current Market Value of Equity Market Index,

re            = Required rate of return on the market, and

g             = Expected growth rates of dividends

Solving this equation for the value of re, we get the value of the required rate of return on the market index:

re = ( D1 / Po ) + g

Where,

D1              = Dividends expected in the next period,

Po              = Current Market Value of Equity Market Index,

re                = Required rate of return on market, and

g                = Expected growth rates of dividends

This value of re is considered as a market return and is reduced from the risk-free rate to get the value of ERP.

Survey Approach.

According to this approach, a panel of experts is asked for their opinion as to what should be the market rate of return. The average of all the responses is considered as the market rate of return on equity. This is reduced from the risk-free rate (which may also be suggested by the experts), to arrive at the figure of ERP.

2.  Dividend Discount Model Approach

Instead of using this approach to find the value of equity risk premium (as done above), we can also use this approach to find the value or cost of equity.

According to this method:

Vo  =  D1 / ( re – g )

Where,

D1           = Dividends expected in the next period,

Vo           = Current Market Value of Equity,

re            = Required rate of return on the market, and

g             = Expected growth rates of dividends

If we let the value of equity be the current market price of equity, we can find the value of re i.e. required return on equity, as follows:

re = ( D1 / Po ) + g

Where,

D1              = Dividends expected in the next period,

Po              = Current Market Value of Equity Market Index,

re                = Required rate of return on market, and

g                = Expected growth rates of dividends

NOTE:

i.  The term in the above equation is nothing but the forward annual dividend yield.

ii. Re-arranging the above equation, we get:

g=(1-D/EPS)×ROE

Where (D/EPS) represents the assumed stable dividend payout ratio and ROE is the historical return on equity.

iii. The term 1 – (D/EPS) represents the company’s earnings retention rate. Thus, the growth rate of a company equals its earnings retention rate times its return on equity.

3.  Bond Yield Plus Risk Premium Approach

a.  As per this approach, the cost of equity to a company equals the corporate bond yield plus some premium i.e. a spread representing premium against risk on investing in equity over the bonds.

Re = Rd + Risk Premium

b.  The risk premium is usually estimated from historical spreads between stocks and bonds.

 

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