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Cfa1 5 Corporate Finance Notes

Finance Notes > CFA Level 1 Notes

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CFA Level 1

Corporate Finance

Capital Budgeting
Capital Budgeting Process
Generate investment ideas
Analyze individual proposals
Plan the capital budget
Monitor and post-audit the project
Categories of Capital Budgeting Process
Replacement project
Expansion project
New products / services
Regulatory / Safety / Environmental project
Basic Principles of Capital Budgeting
Decisions are based on cash flows
Timing of cash flows is crucial
Cash flows are based on opportunity costs
Cash flows are analyzed on an after-tax basis
Financing costs are ignored (NPV based on the required rate of return)
Capital Budgeting cash flows are not accounting net income (e.g. no depreciation)
Important Capital Budgeting Concepts
Sunk Cost
Cost that has already incurred
Opportunity Cost
Benefit foregone by selecting one alternative over another
Incremental Cash Flow
Difference between cash flows with and without the project
Effect of an investment on other things besides the investment itself
Occur when investment takes customers and sales away from another part of the firm
Conventional Cash Flow 1 CFA Level 1

Corporate Finance

Patten of cash flow with an initial outflow followed by a series of inflows
Unconventional Cash Flow
Patten of cash flow different from conventional cash flow
Projects Obscuring Incremental Cash Flow Analysis
Independent Projects
Mutually Exclusive Projects
Project Sequencing
Projects with Unlimited Funds
Capital Rational Projects

Investment Decision Criteria
Net Present Value (NPV)
Invest if NPV > 0
Not invest if NPV < 0
The project with a higher NPV should be chosen
Initial Outlay (IO)
NPV = CF0 + CF1 / (1 + R)1 + CF2 / (1 + R)2 + … + CFN / (1 + R)N - IO
Internal Rate of Return (IRR) (Set NPV = 0)
Accept the project: IRR > Opportunity Cost of Capital (Hurdle Rate)
Reject the project: IRR < Opportunity Cost of Capital (Hurdle Rate)
The project with a higher IRR should be chosen 0 = CF0 + CF1 / (1 + IRR)1 + CF2 / (1 + IRR)2 +… + CFN / (1 + IRR)N - IO
Undiscounted Payback Period
No. of years required to recover the initial outlay
Discounted Payback Period
No. of years needed for cumulative discounted CFs of a project to equal IO
Average Accounting Rate of Return (AAR)
AAR = Average Net Income / Average Book Value
Average Book Value = (Initial Outlay - Residual Value) / 2
Profitability Index (PI)
Present value of a project's future cash flows divided by IO
2 CFA Level 1

Corporate Finance

Invest if PI > 1
Not Invest if PI < 1
PI = PV of Future Cash Flows / IO
PI = 1 + NPV / IO
Cost of Capital
Rate of return that the suppliers of capital (e.g. bondholders and owners) require as compensation for their contribution of capital
Marginal Cost of Capital (MCC)
Amount that would be cost to raise additional funds for an investment project
Weighted Average Cost of Capital (WACC)
Weight average of the proportions of the various sources of capital that the company uses to support its investment program
Marginal Tax Rate (T)
Additional tax rate results from an increase in income
Weight of Debt Financing (Long-term Debt) (D)
Weight of Equity Financing (Ordinary Shares) (E)
Weight of Preferred Equity Financing (Preferred Shares) (P)
Marginal Cost of Debt (before Tax) (RD)
Marginal Cost of Common Stock (RE)
Marginal Cost of Preferred Stock (RP)
WACC = D RD (1 - T) + E RE + P RP
Preferred Stock
Can be viewed as long-term debt or equity depending on accounting principles
Converting D/E Ratio into Weights
D = D / (D + E)
E = E / (D + E)
MMC Schedule
Represents the cost of capital faced by the firm
Cost of Capital (Y-axis), Required Capital (X-axis)
Investment Opportunity Schedule (IOS)
Represents the projects that are available to the firm
Rate of Return (Y-axis), Required Capital (X-axis)
3 CFA Level 1

Corporate Finance

Optimal Capital Budget
Intersection of MMC Schedule with IOS
Cost of Debt
Incurred when a firm issued bonds for debt financing
Calculating the Cost of Debt
Yield-to-Maturity Approach
Current Market Price of Bond (P0) (PV)
Interest Payment per Period (PMT)
Yield to Maturity (RD)
No. of Periods (N)
Maturity Value of Bond (FV)
PV = PMT / (1 + RD) + PMT / (1 + RD)2 + … + (PMT + FV) / (1 + RD)N
Before-tax Cost of Debt = RD
After-tax Cost of Debt = RD (1 - T)
Debt-Rating Approach
Used when PV is not available
RD is based on the credit rating of the firm
RD = Yield on debt of other firms with the same credit rating and similar maturity
After-tax Cost of Debt = RD (1 - T)
Things Affecting the Cost of Debt
Fixed-Rate Debt vs Floating-Rate Debt
Debt with Optionlike Features
Nonrated Debt
Financing Lease (Long-term Borrowing)
Cost of Preferred Stock
Incurred when a firm issues preferred stock and pay preferred dividends
No maturity date and at a fixed rate (e.g. perpetuity)
Not tax-deductible
Current Preferred Stock Price per Share (PP)
Preferred stock dividend per Share (DP)
Cost of Preferred Stock (RP)
P P = D P / RP
4 CFA Level 1

Corporate Finance

RP = DP / PP
Things Affecting Cost of Preferred Stock
Cumulative Dividends
Participating Dividends
Adjustable-rate Dividends
Cost of Equity (Common Stock)
Rate of return required by common shareholders
Capital Asset Pricing Model (Single-factor Model) (CAPM)
RD = RF -  (RM - RF)
Risk-free Rate of Return (RF)
Sensitivity to Market Risk ()
Expected Market Return (RM)
Market Risk Premium or Equity Risk Premium (RM - RF)
Multifactor CAPM
RD = RF - 1 (R1 - RF) + 1 (R2 - RF) + … + N (RN - RF)
Expected Return of Bearing Factor Risk 1 (R1)
Expected Return of Bearing Factor Risk 2 (R2)
Expected Return of Bearing Factor Risk N (RJ)
Sensitivity to Factor Risk 1 (1)
Sensitivity to Factor Risk 2 (2)
Sensitivity to Factor Risk N (N)
Dividend Discount Model Approach
Current Market Price per Share of Common Equity (P0)
Estimated Dividend in Next Period (D1)
Current Dividend (D0)
Expected Growth Rate of Dividend (G)
P0 = D1 / (RE - G)
RE = (D1 / P0) + G
RE = [D0 (1 + G)] / P0) + G
Computing Growth Rate
Dividend Payout Ratio (D / EPS)
Historical Return on Equity (ROE) = Net Income / Common Equity 5 CFA Level 1

Corporate Finance

Retention Rate = 1 - (D / EPS)
G = (1 - D / EPS)  ROE
Bond Yield plus Risk Premium Approach
RE = RD + Risk Premium
Things Affecting Cost of Equity
Uncertain future cash flow
Potential Share Dilution
Uncertain Dividend Payout

Estimating Beta
Regression Model for Estimating Beta
Expected Rate of Return of Stock (E(R))
Estimated Intercept (a)
Estimated Slope ()
R = a +  (RM)
Factors Affecting Estimation
Estimation Period
Periodicity of the Return Interval
Selection of an Appropriate Market Index
Use of a Smoothing Technique
Adjustments for Small-capitalization Stocks
Components of Beta
Business Risk (Operating Risk, Sales Risk)
Financial Risk
Pure-play Method for Estimation of Beta
Use a comparable publicly traded company's beta and adjust it for financial leverage difference
(debt financing)
Steps in Using Pure-Play Method
Select the comparable
Estimate comparable's beta
Unlever the comparable's beta 6

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