CFA Level 1: Corporate Issuers

Cash Conversion Cycle (L4)

The timeline for how long inventory, accounts payable, and accounts receivable remain on a balance sheet.

Operating Cycle (L4)

A subset of the Cash conversion cycle that includes purchasing materials, manufacturing inventory, selling finished goods, and collecting cash.

Free Cash Flows (L4)

Cash flows from business operations such as investments and long term assets.

Primary Source of Liquidity (L4)

Borrowing, such as from bank & suppliers, which serves as a temporary source of income. Cash Flow from Business monitored and obtained through business cash flows, and a much more long term source of income.

Secondary Source of Liquidity (L4)

Sale of assets, bankruptcy protection filing, issue of equity, renegotiating contract terms, suspension/discontinuation of dividends, deferring or lowering capital spending.

Drags on Liquidity (L4)

Any slowdown in inflows, that is bad for liquidity such as Obsolete Inventory, borrowing constraints, & uncollected receivables.

Pull on Liquidity (L4)

Any sped up outflows, that is bad for liquidity. Such as making early payments, lowered credit limits, limits on short term lines of credit, & weak liquidity positions.

The conservative approach (L4)

A type of working capital management approach in which there is more reliance on long term equity, with large current assets relative to sale.

Mainly used by start ups due to limited financing, and during rising interest rates.

Advantage: More stability with long term financing, and resilience during much more turbulent markets. Greater certainty of having working capital to acquire inventory.

Disadvantages: Prescence of long term debt may impair flexible business operations, greater dost of debt & equity. 

The Aggressive Approach (L4)

Used to avoid cash drag, and maximize profitability. Prioritizing high-risk, high-return assets like equities to generate significant capital growth. Short term wise they are more reliant on smaller current assets balanced relative to sales.

Used during the event of falling & stable interest rates. Able to forecast sales & cash accurately, easily sell inventory & quickly collect accounts receivables.

Advantage: Lower financing costs with borrowing amounts only as needed, lesser impairment of flexible business operations.  

Disadvantages: Less financial flexibility, less certainty of financing costs due to high fluctuations of short term interest rates.

The Moderate Approach (L4)

Balance relative to sales, balance use of long term & short term debt. 

Used due to the ability to forecast based on cash needs accurately with some uncertainty to variable needs. Desires to lower financing costs and offer a moderate amount of financial flexibility. 

Advantage: Less costly and risky with some flexibility 

Disadvantage: Less certainty of obtaining financing during turbulent markets. 

Modgilani- Miller Model (L6)

A financial theory that states the value of a firm is unaffected by its capital structure, assuming perfect market conditions and no taxes. This suggests that whether a firm finances itself with debt or equity does not impact its overall value.

Modgilani Miller (MMI) No Tax (L6)

A proposition which states that in the absence of taxes, a firm's value is independent of its capital structure. It emphasizes that the way a firm is financed (debt vs equity) does not affect its total market value, and that the value of the firm does not depend on how much debt or equity is used, and the leverage value & unleveraged value are equal. Expressed as Leverage Value (LV) = Unlevered Value (VU).

Modgilani Miller (MMII) No Tax (L6)

A proposition that states the cost of equity rises with leverage, when more debt is added, mainly due to shareholders willing to take in more risk.

Expressed as Re (Cost of Equity) = Ra (Cost of Capital with no debt) + [Ra (Cost of Capital with no debt) - Rd (Cost of Debt) * D (Debt)/ E (Equity)

Modgilani Miller (MMI) With Tax (L6)

More debt increase the firm’s value due to the tax shield.

Expressed as : Vl (Unleveraged Values) = Vu (Unleveraged Values) + Tc (Tax Rate) * D (Debt)

Modgilani Miller (MMII) with Tax (L6)

The tax make debt less risky for shareholders because interest lowers taxable income thus increasing in cost of equity is a bit smaller than the no tax case. 

Re (Cost of Equity) =Ra (Cost of capital with no debt) + [Ra(Cost of capital with no debt) - Rd(Cost of Debt) D(Debt) / E (Equity) * [1 - Tc ( Tax Rate) ]

Early Stage/ Start Up (L6)

The beginning stage of the corporate life cycle with low sales, negative cash flow, high business risk, so financing is largely equity from founders, VCs, & employees, possible through leases & convertible debt.

Growth Stage (L6)

Middle stage of the corporate life cycle with greater demand & revenue growth, so medium business risk & increasing free cash flow; may use structure debt, but mainly equity financing. 

Mature Stage (L6)

Late stage of the corporate life cycle, with slow but stable revenue growth, low risk & high cash flow, mainly use unsecure debt over equity due to being cheap. 

Capital Light Business (L6)

Business that requires low capital needs short cash conversion cycle, there by decreasing WACC. Capital demands may change with expansion plans with the potential increase WACC.

Examples: Tech & Service

Capital Intensive Business (L6)

Business that require borrowing of cash to buy assets or lease such assets to reduce cost of capital. Uses assets as a type of collateral to lower the cost of debt. Certain companies may face potential gov’t regulation in order to maintain at least a minimum amount of equity in capital structure. 

WACC (Weighted Average Capital Cost) (L6)

Discount rate that combines the cost of debt & equity for both NPV and IRR computations, other financing costs and weights may be added to calculation. When choosing financing structure chose the option that minimizes WACC.

Expressed as: (Cost of debt * debt weight)(1- tax rate) + (Cost of equity * equity weight) + ( Cost of stock * stock weight)

Capital Structure (L6)

Long term debt & equity financing

Cost of Capital (L6)

The firms required rate of return

Cost of Equity (L6)

More risky source of capital due to being more risky as it is a permanent residual claim so return on equity is higher. Done by issuing equity via selling ownership of a company.

Cost of Debt (L6)

A less risky option of raising capital due to being a priority fixed claim with secure collateral. Done by securing loans from financial intitutions.

Specific Factors Affecting Cost of Capital (L6)

I Sales Risk (Stable)

II Profitability Risks (Operating Leverage) (Future Cashflows)

III Financial Leverage & interest coverage (Debt/Equity Ratio)

IV Collateral / Types of Assets owned (liquid)

Static Trade off Theory (L6)

Firms may find an equilibrium for how much debt they use by balancing debt benefits vs costs. Equity costs is a positive increase, upward sloping.

Capital Structures impact on Agency Cost (L6)

Using more capital structure could could be used to reduce agency cost

Sole Proprietorship (L1)

Legal Identity: None

Taxation: Personal Income

Access to Financing: Limited

Owner Liability: Unlimited

Operator of Business: Owner

General Partnership (L1)

Legal Identity: None

Taxation: Personal Income

Access to Financing: Limited

Owner Liability: Unlimited

Operator of Business: General Partners (2+ Partners) 

Limited Partnership (L1)

Legal Identity: None

Taxation: Personal Income

Access to Financing: Limited for Limited Partners & Unlimited for General Partners

Owner Liability: Unlimited

Operator of Business: General Partners (2+ Owners)

Corporations (L1)

Legal Identity: Separate Legal Identity

Taxation: Double Income

Access to Financing: Unlimited

Owner Liability: Limited

Operator of Business: Board & Management 

Limited Liability Partnership (LLP) (L1)

Legal Identity: Separate legal identity in some jurisdictions, but often treated as a pass-through entity for tax purposes.

Taxation: Personal Income (pass-through entity).Access to Financing: Moderate; generally more than sole proprietorship/general partnership, less than corporations.

Owner Liability: Limited for all partners to their investment

Operator of Business: Partners (can vary, often all partners participate in management, but some may be silent).

Limited Liability Partnership (LLP) (L1)

Legal Identity: Separate legal identity in some jurisdictions, but often treated as a pass-through entity for tax purposes.

Taxation: Personal Income (pass-through entity).

Access to Financing: Moderate; generally more than sole proprietorship/general partnership, less than corporations.

Owner Liability: Limited for all partners to their investment.

Operator of Business: Partners (can vary, often all partners participate in management, but some may be silent).

Asymmetric Information (L6)

When the company has more information about its company that is not publicly disclosed. Managers may use this to generate funds from low information, &use public equity

Pecking Order Theory (L6)

A theory suggesting that companies prefer to finance new investments using internal funds (like retained earnings) first, then debt, and common equity as a last resort. This preference is due to managers having more information than external investors, and wanting to avoid signalling negative information to the market when issuing new equity.

Benefits of Public Listing (L1)

Easy transfer of ownership, liquidity, price transparency, regulatory transparency & disclosure. 

Benefits of Private Listing (L1)

Controlling ownership/managers are accountable to a few shareholders. Potential for investors to earn higher returns, and fewer disclosure requirements.

Initial Public Offering (IPO) (L1)

A method of going public by having investment banks act as intermediaries between companies and investors to go public, by the allowance of buying shares on the stock market.

Direct Listing of Shares (L1)

A method of going public, when a company lists its shares on a stock exchange such as NASDAQ or NYSE. 

Acquisition by Corporation (L1)

A method of going public, when a large public company buys a smaller private company.

Reasons for going Public to Private (L1)

• Investors buying all the shares of a public corporation & delisting the company.

• Restructuring & greater control of company.

• More frequent in developed markets.

• Example is a leverage buyout

Key Features of Corporations (L1)

• Legal identity

• Shareholder Liability

• External Financing

• Owner Manger Section

• Taxation

Debtholder (L2)

Provider of finite capital for a finite period of time. Has a legal claim to the principle & interest, higher priority of claim than equity holders, upside is limited to full repayments, no decision making powers. Low risk source of financing and contains covenants.

Equity Investors / Shareholders (L2)

Provide a permanent source of capital. Have a residual claim to all the assets after all other claims are settled. Have voting rights in decision making and board selection.