Chartered Financial Analyst (CFA) Corporate Issuers Flashcards

24 sample cards from the Corporate Issuers deck

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

1. 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 $w$ are target weights and $r$ are component costs of debt, preferred, and equity; $t$ is the marginal tax rate applied to debt.

2. Why is the after-tax cost of debt used in WACC?

   Because interest expense is tax-deductible, the effective cost to the firm is reduced by the tax shield: $$r_d (1-t)$$ Dividends on preferred and common are not tax-deductible, so no such adjustment applies.

3. How is the cost of equity estimated using the CAPM?

   $$r_e = R_f + \beta [E(R_m) - R_f]$$ where $R_f$ is the risk-free rate, $\beta$ is the stock's systematic risk, and $[E(R_m) - R_f]$ is the equity risk premium.

4. State the dividend discount (Gordon growth) model for the cost of equity.

   $$r_e = \frac{D_1}{P_0} + g$$ where $D_1$ is next year's dividend, $P_0$ the current price, and $g$ the constant dividend growth rate. Sustainable $g = \text{retention ratio} \times ROE$.

5. What are marginal costs and target weights in WACC, and why are they used?

   WACC should use the marginal cost of each new source of capital and target (optimal, often market-value-based) capital structure weights, because the WACC is used to evaluate new investments financed at the margin—not historical book values.

6. What is a beta, and how do you unlever and relever it (Hamada)?

   Beta measures systematic risk. Unlevered (asset) beta: $$\beta_U = \frac{\beta_L}{1 + (1-t)\frac{D}{E}}$$ Relevered: $$\beta_L = \beta_U \left[1 + (1-t)\frac{D}{E}\right]$$ Used to estimate beta for a project or private firm using comparable companies (pure-play method).

7. What is the country risk premium (CRP) and how is it added to the cost of equity?

   A premium added to the equity risk premium to reflect added risk of investing in a developing market: $$r_e = R_f + \beta[\,ERP_{mature} + CRP\,]$$ CRP is often estimated as the sovereign yield spread scaled by relative equity/bond volatility.

8. State the Modigliani-Miller Proposition I without taxes.

   In a perfect market with no taxes, capital structure is irrelevant: firm value is unaffected by the debt-equity mix. $$V_L = V_U$$

9. State MM Proposition II without taxes and its implication.

   $$r_e = r_0 + (r_0 - r_d)\frac{D}{E}$$ The cost of equity rises linearly with leverage, exactly offsetting the benefit of cheaper debt, so WACC remains constant.

10. How does MM Proposition I change with corporate taxes?

    With taxes, the interest tax shield adds value: $$V_L = V_U + t \cdot D$$ implying firm value is maximized at 100% debt (before considering financial distress costs).

11. What is the static trade-off theory of capital structure?

    The optimal capital structure balances the marginal benefit of the debt tax shield against the marginal cost of financial distress (bankruptcy) and agency costs. Optimal leverage minimizes WACC and maximizes firm value: $$V_L = V_U + tD - PV(\text{costs of financial distress})$$

12. What is the pecking order theory of financing?

    Due to asymmetric information, managers prefer financing in order: internal funds first, then debt, then external equity last. Issuing equity signals overvaluation, so it is least preferred.

13. What does the degree of operating leverage (DOL) measure, and its formula?

    Sensitivity of operating income (EBIT) to changes in units sold (operating risk). $$DOL = \frac{\% \Delta EBIT}{\% \Delta Q} = \frac{Q(P - V)}{Q(P - V) - F}$$

14. What does the degree of financial leverage (DFL) measure, and its formula?

    Sensitivity of net income (or EPS) to changes in operating income, due to fixed financing costs. $$DFL = \frac{\% \Delta EPS}{\% \Delta EBIT} = \frac{EBIT}{EBIT - I}$$

15. What is the degree of total leverage (DTL) and how does it combine DOL and DFL?

    $$DTL = DOL \times DFL = \frac{\% \Delta EPS}{\% \Delta Q} = \frac{Q(P-V)}{Q(P-V) - F - I}$$ It measures the sensitivity of EPS to a change in units sold.

16. State the breakeven and operating breakeven quantity formulas.

    Breakeven (net income = 0): $$Q_{BE} = \frac{F + I}{P - V}$$ Operating breakeven (EBIT = 0): $$Q_{OBE} = \frac{F}{P - V}$$ where $P$ = price, $V$ = variable cost per unit, $F$ = fixed operating costs, $I$ = fixed financing costs.

17. List the four key dates in the dividend chronology.

    Declaration date, ex-dividend date (buy before to receive the dividend), record (holder-of-record) date, and payment date. The ex-date is typically one business day before the record date.

18. Compare the major dividend policy theories.

    Dividend irrelevance (MM): policy doesn't affect value. Bird-in-hand: investors prefer certain dividends, lowering required return. Tax-aversion: investors prefer capital gains/buybacks if dividends are taxed more heavily. Clientele effects: investors self-select into firms matching their preferences.

19. Why is a share repurchase economically equivalent to a cash dividend (under certain conditions)?

    With equal pre-tax amounts, no taxes, and informational neutrality, a buyback and a cash dividend deliver the same total shareholder wealth—the buyback raises per-share value (fewer shares) while the dividend pays cash directly.

20. How does a share repurchase affect EPS, and when is it accretive?

    A buyback reduces shares outstanding. It is accretive (raises EPS) when the after-tax cost of funds used (e.g., the earnings yield on cash or after-tax borrowing rate) is less than the company's earnings yield $\frac{E}{P}$; otherwise it is dilutive.

21. What are the main merger classifications by form and by relationship?

    By relationship: horizontal (same industry), vertical (supplier-customer chain), and conglomerate (unrelated). By form/payment: statutory, subsidiary, or consolidation mergers, and stock vs. cash acquisitions.

22. Distinguish a tender offer, a proxy fight, and a leveraged buyout (LBO) as merger mechanisms.

    A tender offer appeals directly to target shareholders to sell shares; a proxy fight seeks shareholder votes to replace management/board; an LBO acquires a company primarily with borrowed funds, often taking it private.

23. Name common pre-offer and post-offer takeover defenses.

    Pre-offer: poison pills, staggered boards, supermajority and fair-price provisions, golden parachutes, restricted voting rights. Post-offer: 'just say no,' litigation, greenmail, the crown jewel defense, the Pac-Man defense, and finding a white knight or white squire.

24. What three valuation approaches are used to value a target company in M&A and restructuring?

    Discounted cash flow analysis (e.g., FCFF/FCFE), comparable company analysis (trading multiples plus a takeover premium), and comparable transaction analysis (multiples from prior acquisitions, premium already embedded).

What this deck covers

Corporate Issuers flashcards FAQ