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

Externality

Effect of an investment on other things besides the investment itself

Cannibalization

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

Tax-deductible

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

Convertibility

Callability

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

Lever the beta for the project's financial risk 6

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