CFA Corporate Finance Flashcards

24 sample cards from the Corporate Finance deck

Sampled from the end of the deck, so these are different cards from the ones shown on the syllabus page.

1. State the bond-yield-plus-risk-premium method for estimating the cost of equity.

   $$r_e = r_d + \text{risk premium}$$ The cost of equity is estimated by adding a subjective risk premium (typically 3%–5%) to the firm's before-tax cost of debt (its bond YTM).

2. In the sustainable growth context, how is the growth rate $g$ estimated for the DDM cost of equity?

   $$g = b \times ROE = (1 - \text{payout ratio}) \times ROE$$ where $b$ is the earnings retention rate and $ROE$ is the return on equity.

3. Define beta and its formula.

   Beta measures the systematic (market) risk of an asset—its sensitivity to market returns. $$\beta_i = \frac{\text{Cov}(R_i, R_m)}{\sigma_m^{2}} = \rho_{i,m}\frac{\sigma_i}{\sigma_m}$$ The market beta equals 1.

4. How do you unlever (asset) a beta to remove the effect of financial leverage?

   $$\beta_{asset} = \beta_{equity} \left[\frac{1}{1 + (1 - T)\frac{D}{E}}\right]$$ Unlevering removes the impact of the comparable firm's capital structure, isolating business risk.

5. How do you relever an asset beta to a target firm's capital structure?

   $$\beta_{equity} = \beta_{asset}\left[1 + (1 - T)\frac{D}{E}\right]$$ The asset beta is relevered using the subject firm's tax rate and its target debt-to-equity ratio.

6. Why is the pure-play (comparable company) method used to estimate a project's beta?

   When a project or division has no directly observable beta, analysts take a publicly traded 'pure-play' comparable, unlever its equity beta to get the asset (business-risk) beta, then relever it to the subject firm's capital structure to estimate the appropriate beta.

7. What is the Weighted Average Cost of Capital (WACC) formula?

   $$WACC = w_d\, r_d(1 - T) + w_p\, r_p + w_e\, r_e$$ where $w_d, w_p, w_e$ are the weights of debt, preferred, and equity in the capital structure, and $r_d, r_p, r_e$ are their respective component costs (debt after-tax).

8. What weights should be used to compute WACC, and why?

   Target (or market-value) capital structure weights should be used, not book-value weights. WACC reflects the cost of raising new capital, so weights should represent the proportions the firm intends to finance with going forward at market values.

9. What is the marginal cost of capital (MCC) and the break point?

   The MCC is the cost of the last (next) dollar of new capital raised; it rises as the firm raises more capital. A break point is the amount of new capital at which a component cost changes: $$\text{Break point} = \frac{\text{Amount of capital at which cost changes}}{\text{Weight of that component}}$$

10. Why is WACC the appropriate discount rate for a typical project, and when is it not?

    WACC is the marginal cost of the firm's pooled financing and is the correct discount rate for a project of average risk that does not change the firm's capital structure. It is inappropriate when a project's risk differs materially from the firm's average risk—then a project-specific (risk-adjusted) rate should be used.

11. What is flotation cost and the preferred way to treat it in capital budgeting?

    Flotation costs are fees paid to issue new securities. The preferred approach is to treat them as an additional initial cash outflow in the project's NPV rather than adjusting (inflating) the cost of equity, because flotation is a one-time cost tied to the project.

12. How does a tax rate increase affect the WACC, holding other factors constant?

    A higher tax rate lowers the after-tax cost of debt $r_d(1 - T)$, which lowers WACC (all else equal), because the debt tax shield becomes more valuable.

13. Define corporate governance.

    Corporate governance is the system of internal controls, processes, and procedures by which a company is managed—it defines and balances the rights and responsibilities among the firm's various stakeholders (board, management, shareholders, others) and seeks to minimize and manage conflicting interests.

14. What is the principal–agent problem in corporate governance?

    It is the conflict of interest that arises when an agent (e.g., management) is hired to act on behalf of a principal (e.g., shareholders) but has different incentives, information, and risk preferences, leading the agent to potentially act in its own interest rather than the principal's.

15. Name the primary stakeholder groups in stakeholder management theory.

    Shareholders (equity owners), the board of directors, managers/employees, creditors, suppliers, and customers. (Broader definitions also include governments/regulators and the community.)

16. What is the shareholder theory vs. stakeholder theory of corporate governance?

    Shareholder theory holds that management's primary goal is to maximize shareholder (owner) wealth. Stakeholder theory holds that governance should consider and balance the interests of all stakeholder groups affected by the firm, not just shareholders.

17. Describe the shareholder–manager conflict of interest.

    Managers may pursue their own interests—excessive compensation, empire-building, job security, perquisite consumption, or insufficient risk-taking—rather than maximizing shareholder value. Governance mechanisms (board oversight, incentive alignment) aim to reduce this conflict.

18. Describe the controlling shareholder vs. minority shareholder conflict.

    Controlling (majority) shareholders may take actions that benefit themselves at the expense of minority shareholders, such as related-party transactions or blocking value-enhancing takeovers. Mechanisms like cumulative voting and minority protections mitigate this.

19. Describe the shareholder vs. creditor (bondholder) conflict of interest.

    Shareholders may prefer higher-risk projects or increased leverage/dividends that raise equity value but increase default risk, transferring wealth away from creditors. Creditors protect themselves with covenants restricting such actions.

20. What is a proxy contest (proxy fight)?

    A proxy contest is when shareholders (often dissidents or activists) solicit the voting proxies of other shareholders to vote against management—for example, to replace board members or block a proposal—as a mechanism to influence corporate control.

21. What are the key responsibilities and desirable attributes of an effective board of directors?

    The board oversees strategy, management performance, risk, and controls, and represents shareholder interests. Effective boards are composed of a majority of independent (non-executive) directors, have relevant expertise, separate the chair and CEO roles, and use committees (audit, compensation, nominations).

22. Why are independent (non-executive) board members and separation of chair/CEO roles important?

    Independent directors have no material relationship with the firm that would impair objectivity, improving oversight of management. Separating the board chair from the CEO prevents concentration of power and strengthens the board's monitoring of management.

23. List several mechanisms that help align management's interests with shareholders'.

    Equity-based/performance-linked compensation (stock, options), an independent and engaged board, monitoring by large/institutional shareholders, the market for corporate control (takeover threat), debt covenants and creditor monitoring, and regulatory/legal requirements.

24. What is ESG investing and how does it relate to stakeholder management?

    ESG investing incorporates Environmental, Social, and Governance factors into investment analysis and decisions. It reflects a stakeholder-oriented view: strong governance and management of environmental and social impacts on stakeholders can affect long-term risk, reputation, and firm value.

What this deck covers

Corporate Finance flashcards FAQ