© CFA Institute. For candidate use only. Not for distribution. CORPORATE FINANCE, EQUITY, AND FIXED INCOME CFA® Program Curriculum 2022 • LEVEL I • VOLUME 4 © CFA Institute. For candidate use only. Not for distribution. © 2021, 2020, 2019, 2018, 2017, 2016, 2015, 2014, 2013, 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute. All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by CFA Institute for this edition only. Further reproductions by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval systems, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trade- marks owned by CFA Institute. To view a list of CFA Institute trademarks and the Guide for Use of CFA Institute Marks, please visit our website at www.cfainstitute.org. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. ISBN 978-1-950157-45-7 (paper) ISBN 978-1-950157-69-3 (ebk) 10 9 8 7 6 5 4 3 2 1 © CFA Institute. For candidate use only. Not for distribution. CONTENTS How to Use the CFA Program Curriculum xi Background on the CBOK xi Organization of the Curriculum xii Features of the Curriculum xii Designing Your Personal Study Program xiii CFA Institute Learning Ecosystem (LES) xiv Prep Providers xv Feedback xvi Corporate Issuers Study Session 10 Corporate Issuers (2) 3 Reading 30 Cost of Capital- Foundational Topics 5 Introduction 5 Cost of Capital 6 Taxes and the Cost of Capital 8 Costs of the Various Sources of Capital 9 Cost of Debt 9 Cost of Preferred Stock 12 Cost of Common Equity 13 Estimating Beta 18 Estimating Beta for Public Companies 18 Estimating Beta for Thinly Traded and Nonpublic Companies 19 Flotation Costs 22 Methods in Use 25 Summary 25 Practice Problems 28 Solutions 34 Reading 31 Capital Structure 39 Introduction 39 Capital Structure and Company Life Cycle 40 Background 40 Start- Ups 42 Growth Businesses 42 Mature Businesses 43 Unique Situations 45 Modigliani–Miller Propositions 47 MM Proposition I without Taxes: Capital Structure Irrelevance 48 MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity 48 MM Propositions with Taxes: Taxes, Cost of Capital, and Value of the Company 51 Costs of Financial Distress 53 indicates an optional segment © CFA Institute. 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Not for distribution. ii Contents Optimal and Target Capital Structure 54 Factors Affecting Capital Structure Decisions 57 Capital Structure Policies and Target Capital Structures 58 Financing Capital Investments 60 Market Conditions 61 Information Asymmetries and Signaling 62 Agency Costs 63 Stakeholder Interests 65 Shareholder vs. Stakeholder Theory 65 Debt vs. Equity Conflict 66 Preferred Shareholders 70 Private Equity Investors/Controlling Shareholders 71 Bank and Private Lenders 72 Other Stakeholders 72 Summary 77 Practice Problems 79 Solutions 83 Reading 32 Measures of Leverage 85 Introduction 85 Leverage 86 Business and Sales Risks 88 Business Risk and Its Components 88 Sales Risk 89 Operating Risk and the Degree of Operating Leverage 90 Financial Risk, the Degree of Financial Leverage and the Leveraging Role of Debt 97 Total Leverage and the Degree of Total Leverage 101 Breakeven Points and Operating Breakeven Points 104 The Risks of Creditors and Owners 107 Summary 108 Practice Problems 110 Solutions 114 Equity Investments Study Session 11 Equity Investments (1) 119 Reading 33 Market Organization and Structure 121 Introduction 122 The Functions of the Financial System 122 Helping People Achieve Their Purposes in Using the Financial System 123 Determining Rates of Return 128 Capital Allocation Efficiency 129 Assets and Contracts 130 Classifications of Assets and Markets 130 Securities 133 Fixed Income 133 Equities 134 indicates an optional segment © CFA Institute. 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Contents iii Pooled Investments 135 Currencies, Commodities, and Real Assets 136 Commodities 136 Real Assets 137 Contracts 139 Forward Contracts 140 Futures Contracts 141 Swap Contracts 143 Option Contracts 143 Other Contracts 144 Financial Intermediaries 145 Brokers, Exchanges, and Alternative Trading Systems 145 Dealers 146 Arbitrageurs 147 Securitizers, Depository Institutions and Insurance Companies 149 Depository Institutions and Other Financial Corporations 150 Insurance Companies 152 Settlement and Custodial Services and Summary 153 Summary 155 Positions and Short Positions 155 Short Positions 157 Leveraged Positions 158 Orders and Execution Instructions 161 Execution Instructions 162 Validity Instructions and Clearing Instructions 165 Stop Orders 165 Clearing Instructions 167 Primary Security Markets 167 Public Offerings 167 Private Placements and Other Primary Market Transactions 169 Importance of Secondary Markets to Primary Markets 170 Secondary Security Market and Contract Market Structures 171 Trading Sessions 171 Execution Mechanisms 172 Market Information Systems 175 Well- functioning Financial Systems 175 Market Regulation 178 Summary 181 Practice Problems 184 Solutions 191 Reading 34 Security Market Indexes 195 Introduction 195 Index Definition and Calculations of Value and Returns 196 Calculation of Single- Period Returns 197 Calculation of Index Values over Multiple Time Periods 199 Index Construction 200 Target Market and Security Selection 200 Index Weighting 201 indicates an optional segment © CFA Institute. 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Not for distribution. iv Contents Index Management: Rebalancing and Reconstitution 209 Rebalancing 209 Reconstitution 210 Uses of Market Indexes 211 Gauges of Market Sentiment 212 Proxies for Measuring and Modeling Returns, Systematic Risk, and Risk- Adjusted Performance 212 Proxies for Asset Classes in Asset Allocation Models 212 Benchmarks for Actively Managed Portfolios 212 Model Portfolios for Investment Products 213 Equity indexes 213 Broad Market Indexes 213 Multi- Market Indexes 213 Sector Indexes 215 Style Indexes 215 Fixed- income indexes 216 Construction 216 Types of Fixed- Income Indexes 217 Indexes for Alternative Investments 219 Commodity Indexes 219 Real Estate Investment Trust Indexes 220 Hedge Fund Indexes 221 Summary 223 Practice Problems 225 Solutions 231 Reading 35 Market Efficiency 235 Introduction 235 The Concept of Market Efficiency 237 The Description of Efficient Markets 237 Market Value versus Intrinsic Value 239 Factors Affecting Market Efficiency Including Trading Costs 240 Market Participants 241 Information Availability and Financial Disclosure 242 Limits to Trading 243 Transaction Costs and Information- Acquisition Costs 243 Forms of Market Efficiency 244 Weak Form 245 Semi- Strong Form 246 Strong Form 248 Implications of the Efficient Market Hypothesis 249 Fundamental Analysis 249 Technical Analysis 250 Portfolio Management 250 Market Pricing Anomalies - Time Series and Cross- Sectional 250 Time- Series Anomalies 251 Cross- Sectional Anomalies 254 Other Anomalies, Implications of Market Pricing Anomalies 254 Closed- End Investment Fund Discounts 255 indicates an optional segment © CFA Institute. 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Contents v Earnings Surprise 255 Initial Public Offerings (IPOs) 256 Predictability of Returns Based on Prior Information 257 Implications for Investment Strategies 257 Behavioral Finance 257 Loss Aversion 258 Herding 258 Overconfidence 258 Information Cascades 259 Other Behavioral Biases 260 Behavioral Finance and Investors 260 Behavioral Finance and Efficient Markets 260 Summary 260 Practice Problems 263 Solutions 266 Study Session 12 Equity Investments (2) 269 Reading 36 Overview of Equity Securities 271 Importance of Equity Securities 271 Equity Securities in Global Financial Markets 272 Characteristics of Equity Securities 277 Common Shares 278 Preference Shares 280 Private Versus Public Equity Securities 282 Non- Domestic Equity Securities 285 Direct Investing 286 Depository Receipts 287 Risk and Return Characteristics 290 Return Characteristics of Equity Securities 290 Risk of Equity Securities 291 Equity and Company Value 292 Accounting Return on Equity 293 The Cost of Equity and Investors’ Required Rates of Return 298 Summary 299 Practice Problems 301 Solutions 305 Reading 37 Introduction to Industry and Company Analysis 307 Introduction 308 Uses of Industry Analysis 308 Approaches to Identifying Similar Companies 309 Products and/or Services Supplied 310 Business- Cycle Sensitivities 310 Statistical Similarities 312 Industry Classification Systems 313 Commercial Industry Classification Systems 313 Constructing a Peer Group 318 indicates an optional segment © CFA Institute. 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Not for distribution. vi Contents Describing and Analyzing an Industry and Principles of Strategic Analysis 321 Principles of Strategic Analysis 323 Barriers to Entry 324 Industry Concentration 326 Industry Capacity 328 Market Share Stability 330 Price Competition 331 Industry Life Cycle 332 External Influences on Industry 336 Macroeconomic Influences 337 Technological Influences 337 Demographic Influences 338 Governmental Influences 339 Social Influences 340 Environmental Influences 340 Industry Comparison 343 Company Analysis 346 Elements That Should Be Covered in a Company Analysis 347 Spreadsheet Modeling 349 Summary 350 Practice Problems 354 Solutions 358 Reading 38 Equity Valuation: Concepts and Basic Tools 361 Introduction 362 Estimated Value and Market Price 363 Categories of Equity Valuation Models 364 Background for the Dividend Discount Model 366 Dividends: Background for the Dividend Discount Model 366 Dividend Discount Model (DDM) and Free- Cash- Flow- to- Equity Model (FCFE) 369 Preferred Stock Valuation 373 The Gordon Growth Model 375 Multistage Dividend Discount Models 380 Multipler Models and Relationship Among Price Multiples, Present Value Models, and Fundamentals 385 Relationships among Price Multiples, Present Value Models, and Fundamentals 386 Method of Comparables and Valuation Based on Price Multiples 389 Illustration of a Valuation Based on Price Multiples 392 Enterprise Value 394 Asset- Based Valuation 397 Summary 401 Practice Problems 403 Solutions 409 indicates an optional segment © CFA Institute. 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Contents vii Fixed Income Study Session 13 Fixed Income (1) 415 Reading 39 Fixed- Income Securities: Defining Elements 417 Introduction and Overview of a Fixed- Income Security 417 Overview of a Fixed- Income Security 418 Bond Indenture 424 Bond Indenture 424 Legal, Regulatory, and Tax Considerations 432 Tax Considerations 435 Principal Repayment Structures 437 Principal Repayment Structures 437 Coupon Payment Structures 441 Floating- Rate Notes 442 Step- Up Coupon Bonds 442 Credit- Linked Coupon Bonds 443 Payment- in-K ind Coupon Bonds 443 Deferred Coupon Bonds 444 Index- Linked Bonds 444 Callable and Putable Bonds 448 Callable Bonds 448 Putable Bonds 450 Convertible Bonds 451 Summary 454 Practice Problems 457 Solutions 461 Reading 40 Fixed- Income Markets: Issuance, Trading, and Funding 465 Introduction 465 Classification of Fixed- Income Markets 466 Classification of Fixed- Income Markets 466 Fixed- Income Indexes 473 Investors in Fixed- Income Securities 474 Primary Bond Markets 475 Primary Bond Markets 475 Secondary Bond Markets 480 Sovereign Bonds 483 Characteristics of Sovereign Bonds 483 Credit Quality of Sovereign Bonds 484 Types of Sovereign Bonds 485 Non- Sovereign, Quasi- Government, and Supranational Bonds 487 Non- Sovereign Bonds 487 Quasi- Government Bonds 488 Supranational Bonds 488 Corporate Debt: Bank Loans, Syndicated Loans, and Commercial Paper 489 Bank Loans and Syndicated Loans 489 Commercial Paper 490 indicates an optional segment © CFA Institute. 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Not for distribution. viii Contents Corporate Debt: Notes and Bonds 493 Maturities 493 Coupon Payment Structures 493 Principal Repayment Structures 494 Asset or Collateral Backing 494 Contingency Provisions 495 Issuance, Trading, and Settlement 495 Structured Financial Instruments 497 Capital Protected Instruments 497 Yield Enhancement Instruments 498 Participation Instruments 498 Leveraged Instruments 499 Short- Term Bank Funding Alternatives 500 Retail Deposits 500 Short- Term Wholesale Funds 501 Repurchase and Reverse Repurchase Agreements 502 Structure of Repurchase and Reverse Repurchase Agreements 503 Credit Risk Associated with Repurchase Agreements 504 Summary 506 Practice Problems 509 Solutions 513 Reading 41 Introduction to Fixed- Income Valuation 517 Introduction 517 Bond Prices and the Time Value of Money 518 Bond Pricing with a Market Discount Rate 518 Yield-t o- Maturity 522 Relationships between the Bond Price and Bond Characteristics 523 Pricing Bonds Using Spot Rates 527 Prices and Yields: Conventions For Quotes and Calculations 529 Flat Price, Accrued Interest, and the Full Price 529 Matrix Pricing 533 Annual Yields for Varying Compounding Periods in the Year 536 Yield Measures for Fixed- Rate Bonds 539 Yield Measures for Floating- Rate Notes 542 Yield Measures for Money Market Instruments 546 The Maturity Structure of Interest Rates 550 Yield Spreads 558 Yield Spreads over Benchmark Rates 558 Yield Spreads over the Benchmark Yield Curve 560 Summary 563 Practice Problems 566 Solutions 575 Reading 42 Introduction to Asset- Backed Securities 589 Introduction: Benefits of Securitization 589 Benefits of Securitization for Economies and Financial Markets 590 How Securitization Works 591 An Example of a Securitization 592 indicates an optional segment