2022 CFA Program Curriculum Level I Corporate Finance, Equity, And Fixed Income

666 Pages·2021·6.197 MB·English

by  CFA Institute

© 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.
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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
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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
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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
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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
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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
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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
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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
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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
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