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
About Lesson

LOS A requires us to:

describe types of financing methods and considerations in their selection

 

In this section, we will be discussing various sources of financing such as internal financing, external financing, and other sources of financing. We will also be discussing various considerations affecting financing choices.

1. Sources of Financing

1.1.  Internal Financing

Companies can generate short-term financing and liquidity through internal financing. Some of the ways of generating finance in the form of internal financing are:

1.1.1.  Increase the amount of after-tax operating cash flows.

Operating cash flow is a measure of the amount of cash generated by a company’s normal business operations. It can be calculated by adding depreciation and reducing dividend payments from the net income, i.e.:

Operating Cash Flow = Net Income + Depreciation – Dividend Payments

A company can increase the amount of its internal financing by increasing the amount of after-tax operating cash flows.

1.1.2. Working on working capital efficiency.

Working capital is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entities.
One can increase working capital efficiency in many ways, like:

1.1.2.1.  Extending company’s accounts payables period.

And while doing so consider these two countering forces.

i.  Paying too early can prove to be costly unless there are enough discounts as incentives.

ii.  Too late payments or stretching the accounts payable may impact the creditworthiness of the company.

One needs to carefully analyze all the options.

1.1.2.2.  Reducing Receivables Period.

The receivables period can be reduced by altering the credit period that we provide to the debtors. But these credit terms also impact the number of sales. So, one needs to carefully examine the costs and benefits of extending and reducing the receivables period.

1.1.2.3.  Shortening the asset conversion cycle.

The asset conversion cycle is the process by which cash is used to create goods and services, deliver them to customers, and then collect the resulting receivables and convert them back into cash. If we can reduce the size of this cycle in terms of the number of days, we can increase the amount of operating cash available to the company, thus raising the available internal finance.
Managing the inventory properly and efficiently can also reduce the asset conversion cycle. Because maintaining inventory for longer involves huge costs. One can also introduce JIT (or just-in-time) approach to manage the inventory efficiently.

1.1.3.  Liquidating liquid assets.

Another way of raising short-term finance is through converting short-term assets such as receivables, inventories, and marketable securities into cash. These can be sold quickly in times when there is a need for cash.

1.2.  External Financing Through Financial Intermediaries

Financial intermediaries such as banks and non-bank lenders may provide financing by the following means:

1.2.1.  Line of Credits

a. A line of credit is a credit facility extended by a bank or other financial institution to a government, business, or individual customer that enables the customer to draw on the facility when the customer needs funds.

b. It is usually in form of a letter of credit provided by the bank, in return for a fee, guaranteeing the investor that the company’s obligations will be paid.

c. The line of credits may be of two types, uncommitted line of credit and committed (regular) line of credit.

1.2.2.  Uncommitted Lines of credit

The uncommitted line of credit is provided by the bank for an extended period of time. But here, the bank reserves the right to refuse to honor any request for the use of line.

1.2.3.  Committed Lines of Credit

a. The committed (regular) lines of credit are a much reliable source of short-term financing, which is usually less than 365 days. And it is the bank’s formal commitment.

b. These are usually unsecured and have an option of prepayment without penalties.

c. Banks receive a commitment fee along with interest as compensation for providing sure credit.

d.  The details about the committed credit can be found mentioned in the footnotes of a company’s annual report.

1.2.2.  Revolving Credit Agreement

a.  Revolving credit is an agreement that permits an account holder to borrow money repeatedly up to a set dollar limit while repaying a portion of the current balance due in regular payments.

b. Each payment, minus the interest and fees charged, replenishes the amount available to the account holder.

c. A revolving credit agreement is in effect for multiple periods and involves a larger amount.

1.2.3.  Secured ‘Asset-Based’ Loans

a. These are the loans in which the lender requires the company to pledge collateral in the form of an asset.

b. These assets could either be any fixed asset that the company owns or some high-quality receivables and inventory.

c. In the assignment of accounts receivable, the borrower pays interest, a service charge on the loan, and the assigned receivables serve as collateral.

1.2.4.  Factoring Arrangement

a. Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable to a third party at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs.

b. A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less a discount for commission and fees.

c. In the process of factoring, the company shifts the credit granting and collection process to a factor or the lender.

d. If in a factoring arrangement, the factor takes on the risk of bad debt, it is called non-recourse factoring.

1.2.5.  Web-based Lenders & Non-bank Lenders

Web-based, non-bank, or peer-to-peer lending is a recent innovation in the lending industry and is not very popular with larger companies.

1.3.     Capital Market Financing

1.3.1.  Commercial Paper

a. Commercial paper is a common form of unsecured, short-term debt issued by a corporation. Commercial paper is typically issued for the financing of payroll, accounts payable, inventories, and meeting other short-term liabilities.

b. Commercial papers are generally issued by large and well-rated companies.

c. Commercial papers are usually cheaper than the short-term business loans taken from commercial banks.

d. The maturity period of commercial paper generally ranges between a few days to up to 270 days.

e. The dealers of commercial papers (usually large financial firms) or paper dealers require a line of credit to ensure that the commercial paper is paid off.

1.3.2.  Long-Term Debt

a. Long-term debt is a debt with a maturity of more than one year.

b. Long-term debt could either be either private or public.

i.  The public debt is in the form of negotiable instruments that can be traded in the open markets.

ii. Private debt, on the other hand, could also be negotiable but is not traded in the open market.

c. Long-term debt could be taken in the form of bank loans, notes, bonds, debentures, etc.

d. While notes have a maturity ranging from one to ten years; bonds and debentures have maturities of at least ten years.

e. Higher the term of maturity of bonds, the greater the risk (in the form of credit risk) and hence a higher interest rate.

1.3.3.  Common Equity

a. Common equity is the total amount of all investments in a company made by common equity investors, including the total value of all shares of common stock, plus retained earnings and additional paid-in capital.

b. Common equity represents the ownership in a company and is a more permanent source of capital.

c. The owners of the common shares or the shareholders receive dividends distributed by the company.

d. The shareholders hold the right to elect the directors of the company.

e. The equity of a private company and private equity are not required to register with SEC and are not traded in open markets.

1.3.4.  Preferred Equity

Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument.

1.3.5.  Other Hybrid Securities

a. There are various convertibles issued by a company that can be considered as hybrid security, such as convertible debentures or convertible preferred equity.

b. These instruments can be converted into a fixed number of pre-specified common stock of the company after a specified date.

1.4. Other Financing

1.4.1. Lease

a. A lease is a contract outlining the terms under which one party agrees to rent an asset owned by another party.

b.  It guarantees the lessee, also known as the tenant, use of the property and guarantees the lessor—the owner of the asset—regular payments for a specified period in exchange.

c. There are generally formal contracts for a lease. And these contracts specify the length of time for which the lessee can use the asset. The contract also specifies the terms of the lease, such as the amount of rent payable, the maintenance obligation of the asset (whether the lessee is responsible for maintenance or lessor), buying option (at the end of lease and the price at which it can be bought), etc.

2. Considerations Affecting Financing Choices

There could be two types of considerations i.e., firm-specific considerations and general economic considerations that could affect the financing decisions by a company.

2.1.  Firm-Specific Considerations Affecting Financing Decisions

2.1.1.  Size of the company

The size of the company impacts both the costs at which it can raise the capital and the sources through which it can raise the capital. The larger the size of the company more options it has and the lower the cost.

2.1.2.  Riskiness of Assets

There is a higher risk involved with the borrowed funds as compared to the owner’s funds, but they also provide leveraging benefits. The risk and benefits must be analyzed judiciously before making any decision.

2.1.3.  Requirements for Collaterals

Often, when the companies are raising funds through debt, they are required to pledge certain assets as collateral. It is important to look at the terms of such contracts about any restrictions on the use of such assets.

2.1.4. Public Vs. Private Equity

With public equities, there is a risk of losing control over the affairs of the company. Whereas with the private company, the shares are held by a few people from within the group, so there is little or no diversion of control.

2.1.5.  Asset-Liability Management

Asset/liability management is the process of managing the use of assets and cash flows to reduce the firm’s risk of loss from not paying a liability on time. Well-managed assets and liabilities increase business profits. It is a long-term strategy and an important consideration in financial decision-making.

2.1.6. Debt Maturity Structure

Debt maturity is the time at which each item of the debt (both long-term and short-term) falls due for repayment. The debt maturity is usually structured in such a way that each time one item falls due for repayment, there are enough funds at the disposal of the company to clear the same. Therefore, maturity and terms of debt is also an important consideration in financial decisions of the company.

2.1.7.  Currency Risk

While making international investments or taking foreign currency loans, currency risk is an important factor to be considered. A decrease in the value of the domestic currency at the time of repayment of a loan or an increase at the time of selling foreign assets may jeopardize the financial position of the company.

2.1.8. Agency Cost

a.  Agency cost is the cost of disagreement in case of a conflict between the managers and the shareholders of the company. The conflict arises because the owners want managers to make a decision that benefits them.

b.  The conflict could be between:

i.  the managers and the owners

ii.  the majority and minority shareholders

iii.  owners and other stakeholders.

c. The agency cost could be in form of agency cost of debt, which arises when debt suppliers add restrictive covenants to the terms of debt.

d. And agency cost on equity rises when the managers diverge from the interest of shareowners.

2.2. General Economic Considerations

2.2.1. Taxation

Generally, the debt-servicing cost is deductible from the income for taxation purposes thus providing tax benefits to the companies (or leveraging benefits). Similarly, there could be other tax benefits in form of conversion of the instrument instead of other forms of redemption at maturity. These factors need to be taken into consideration before making any financial decision.

2.2.2. Inflation

Inflation is yet another important factor in financial decisions. If inflations levels are unnaturally high then the value of a currency is low and it is a good time to sell foreign investments or raise debt finance, etc.

2.2.3. Government Policy

Certain government policies are sometimes in favor of certain types of investment. They provide benefits in terms of tax concessions or subsidies. These may make these investments more profitable in comparison to others.

There may be other policies as well such as taxation policies, monetary and fiscal policies, etc. These may impact the rate at which a source of finance is available to the businesses.

2.2.4. Monetary Policy

The monetary policies of the government directly impact the rate at which the debt finance can be raised. This is done through the reserve requirements, money supply, etc. And, this indirectly also impacts the cost of equity as well.

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