, 2015,Level,I,Summary,Notes,, ,
,
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4 4 Corporate Finance and Portfolio Management Summary NotesCorporate Finance and Portfolio Management Summary Notes,
R35,Capital,Budgeting .................................................................................................................................. 1
R36,Cost,of,Capital ....................................................................................................................................... 6
R37,Measures,of,Leverage .......................................................................................................................... 14
R38,Dividends,and,Share,Repurchases ....................................................................................................... 17
R39,Working,Capital,Management ............................................................................................................. 20
R40,Corporate,Governance ......................................................................................................................... 26
R41,Portfolio,Management:,An,overview ................................................................................................... 32
R42,Portfolio,Risk,and,Return:,Part,I .......................................................................................................... 35
R43,Portfolio,Risk,and,Return,Part,II .......................................................................................................... 41
R44,Basics,of,portfolio,planning,and,construction ...................................................................................... 46
,
This,document,should,be,read,in,conjunction,with,the,corresponding,reading,in,the,2015,Level,I,CF
A®,Program,curriculum.,Some,of,the,graphs,,charts,,tables,,examples,,and,figures,are,copyright,20
14,,CFA,Institute.,Reproduced,and,republished,with,permission,from,CFA,Institute.,All,rights,reser
ved.,
Required,disclaimer:,,CFA,Institute,does,not,endorse,,promote,,or,warrant,the,accuracy,or,quality,of
,the,products,or,services,offered,by,IFT.,CFA,Institute,,CFA®,,and,Chartered,Financial,Analyst®,ar
e,trademarks,owned,by,CFA,Institute.,
, ,
R35,Capital,Budgeting,,
LO.a:,Describe,the,capital,budgeting,process,,including,the,typical,steps,of,the,process,,and,di
stinguish,among,the,various,categories,of,capital,projects.,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,1,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
Capital,budgeting,is,the,process,that,companies,use,for,decision,making,on,long-
term,projects.,In,simple,terms,,it,is,the,method,used,by,companies,to,decide,which,projects,are,wort
h,pursuing.,
The,steps,in,the,capital,budgeting,process,are,as,follows:,
,
,
,
Following,are,the,categories,of,capital,budgeting,projects,explained,with,examples:,
1. Replacement,projects:,Deciding,whether,an,equipment,should,be,replaced,or,not.,
2. Expansion,projects:,Expanding,a,company‟s,business,operations,such,as,opening,a,new,pl
ant,,or,increasing,the,capacity,of,an,existing,one.,
3. New, products, and, services:, This, involves, identifying, new,
opportunities,
(products/services),to,stay,competitive,and,to,expand,the,customer,base.,
4. Mandatory,projects:,These,are,regulatory,,safety,,and,environmental,projects,that,are,man
dated,by,a,governmental,agency,,an,insurance,company,,or,any,other,external,agency.,
5. Other,projects:,These,may,be,pet/indulgent,projects,of,someone,in,the,company,,or,too,ris
ky,to,be,analyzed,using,the,traditional,methods.,
,
LO.b:,Describe,the,basic,principles,of,capital,budgeting,,including,cash,flow,estimation.,
Capital,budgeting,is,based,on,the,following,principles:,
1. Decisions,are,based,on,incremental,cash,flows:,Investment,decisions,are,based,on,increm
ental,cash,flows,instead,of,accounting,income.,,
2. Timing,of,cash,flows,is,crucial:,The,timing,of,cash,flows,is,important,due,to,the,time,value,
of,money.,
3. Cash,flows,are,based,on,opportunity,cost:,Opportunity,costs,must,be,considered,for,incre
mental,cash,flows.,Suppose,you,started,a,business,in,a,building,that,you,inherited,from,your,
father.,Net,cash,flow,from,the,business,is,$2000/month.,Instead,of,using,the,building,for,bus
iness,purposes,,you,could,have,rented,the,building,for,$3000/month.,In,this,scenario,,rentin
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,2,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
g,out,the,building,seems,like,an,obvious,choice,as,it,earns,more,than,the,business,does,curre
ntly.,
4. Cash,flows,are,analyzed,on,an,after-
tax,basis:,The,effect,of,taxes,must,be,considered,when,analyzing,projects.,
5. Financial,costs,are,ignored:,Since,the,required,rate,of,return,includes,financing,costs,,they,
should,not,be,deducted,from,the,cash,flows;,otherwise,,it,would,lead,to,doublecounting,of,th
e,financing,costs.,
,
LO.c:,Explain,how,the,evaluation,and,selection,of,capital,projects,is,affected,by,mutually,excl
usive,projects,,project,sequencing,,and,capital,rationing.,
• Independent,projects,versus,mutually,exclusive,projects:,If,projects,are,independent,,th
ey,can,all,be,undertaken,,provided,that,they,individually,satisfy,the,decision,rules.,In,the,cas
e,of,mutually,exclusive,projects,,the,projects,compete,with,each,other.,If,projects,A,and,B,ar
e,mutually,exclusive,,it,means,that,either,A,or,B,can,be,undertaken,,but,not,both.,
• Project,Sequencing:,Projects,are,sequenced,through,time.,That,is,,completion,of,one,proje
ct,creates,an,opportunity,to,invest,in,another,project,later,,based,on,the,financial,results,of,th
e,earlier,project.,,
• Unlimited,funds,versus,capital,rationing:,Under,unlimited,funds,,funding,is,not,a,constrai
nt,,so,a,company,may,invest,in,all,profitable,projects.,However,,if,the,company,has,limited,f
unds,for,investment,,then,the,company,must,allocate,funds,such,that,they,maximize,shareho
lder,value.,,
,
LO.d:,Calculate,and,interpret,the,results,using,each,of,the,following,methods,to,evaluate,a,sin
gle,capital,project:,net,present,value,(NPV),,internal,rate,of,return,(IRR),,payback,period,,dis
counted,payback,period,,and,profitability,index,(PI).,
Net,present,value,(NPV),is,the,present,value,of,the,future,after,tax,cash,flows,,minus,the,investmen
t,outlay,(cost,of,the,project).,For,independent,projects-
,accept,all,projects,with,positive,NPV.,For,mutually,exclusive,projects-
,accept,the,project,with,the,higher,NPV.,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,3,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
Consider,the,following,two,projects:,
Cost,of,Capital,=,10%,
, , ,
Expected,net,cash,flows,
, , ,
Year, 0, 1, 2, 3, 4,
Project,A, $1000, $500, $400, $300, $100,
Project,B, $1000, $100, $300, $400, $600,
,
NPV,of,the,projects,can,be,calculated,by,plugging,the,cash,flows,and,IRR,=,10%.,You,will,get,NPV
A,=,78.82,and,NPVB,=,49.18.,If,these,two,projects,are,independent,then,both,of,them,should,be,acce
pted.,If,these,are,mutually,exclusive,,only,project,A,must,be,accepted.,,
Internal,rate,of,return,(IRR),is,the,discount,rate,which,makes,NPV,equal,to,0.,For,independent,pr
ojects,,if,IRR,is,greater,than,opportunity,cost,(required,rate,of,return),,accept,the,project;,otherwise,r
eject,the,project.,For,mutually,exclusive,projects,,accept,the,project,with,the,higher,IRR,as,long,as,t
he,IRR,is,greater,than,the,opportunity,cost.,The,IRR,of,Projects,A,and,B,can,be,computed,by,pluggi
ng,cash,flows,on,calculators.,You,will,get,IRRA,=,14.49%,and,IRRB,=,11.79%,
Payback,period,is,the,number,of,years,it,takes,to,recover,the,initial,investment.,,
Discounted,payback,period,is,the,number,of,years,it,takes,for,the,present,value,of,the,estimated,ca
sh,flows,to,equal,the,initial,investment.,Both,concepts,are,explained,in,the,following,example:,
Year, 0, 1, 2, 3, 4,
Cash,flows, -800, 340, 340, 340, 340,
Cumulative,Cash,flow, -800, -460, -120, 220, 560,
Discounted,Cash,flows, -800, 309.1, 280.99, 255.45, 232.22,
Cumulative,Discounted,Cash,flows, -800, -490.9, -209.91, 45.54, 277.76,
The,payback,and,discounted,payback,periods,are:,
,
,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,4,
,
,
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4 4 Corporate Finance and Portfolio Management Summary NotesCorporate Finance and Portfolio Management Summary Notes,
R35,Capital,Budgeting .................................................................................................................................. 1
R36,Cost,of,Capital ....................................................................................................................................... 6
R37,Measures,of,Leverage .......................................................................................................................... 14
R38,Dividends,and,Share,Repurchases ....................................................................................................... 17
R39,Working,Capital,Management ............................................................................................................. 20
R40,Corporate,Governance ......................................................................................................................... 26
R41,Portfolio,Management:,An,overview ................................................................................................... 32
R42,Portfolio,Risk,and,Return:,Part,I .......................................................................................................... 35
R43,Portfolio,Risk,and,Return,Part,II .......................................................................................................... 41
R44,Basics,of,portfolio,planning,and,construction ...................................................................................... 46
,
This,document,should,be,read,in,conjunction,with,the,corresponding,reading,in,the,2015,Level,I,CF
A®,Program,curriculum.,Some,of,the,graphs,,charts,,tables,,examples,,and,figures,are,copyright,20
14,,CFA,Institute.,Reproduced,and,republished,with,permission,from,CFA,Institute.,All,rights,reser
ved.,
Required,disclaimer:,,CFA,Institute,does,not,endorse,,promote,,or,warrant,the,accuracy,or,quality,of
,the,products,or,services,offered,by,IFT.,CFA,Institute,,CFA®,,and,Chartered,Financial,Analyst®,ar
e,trademarks,owned,by,CFA,Institute.,
, ,
R35,Capital,Budgeting,,
LO.a:,Describe,the,capital,budgeting,process,,including,the,typical,steps,of,the,process,,and,di
stinguish,among,the,various,categories,of,capital,projects.,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,1,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
Capital,budgeting,is,the,process,that,companies,use,for,decision,making,on,long-
term,projects.,In,simple,terms,,it,is,the,method,used,by,companies,to,decide,which,projects,are,wort
h,pursuing.,
The,steps,in,the,capital,budgeting,process,are,as,follows:,
,
,
,
Following,are,the,categories,of,capital,budgeting,projects,explained,with,examples:,
1. Replacement,projects:,Deciding,whether,an,equipment,should,be,replaced,or,not.,
2. Expansion,projects:,Expanding,a,company‟s,business,operations,such,as,opening,a,new,pl
ant,,or,increasing,the,capacity,of,an,existing,one.,
3. New, products, and, services:, This, involves, identifying, new,
opportunities,
(products/services),to,stay,competitive,and,to,expand,the,customer,base.,
4. Mandatory,projects:,These,are,regulatory,,safety,,and,environmental,projects,that,are,man
dated,by,a,governmental,agency,,an,insurance,company,,or,any,other,external,agency.,
5. Other,projects:,These,may,be,pet/indulgent,projects,of,someone,in,the,company,,or,too,ris
ky,to,be,analyzed,using,the,traditional,methods.,
,
LO.b:,Describe,the,basic,principles,of,capital,budgeting,,including,cash,flow,estimation.,
Capital,budgeting,is,based,on,the,following,principles:,
1. Decisions,are,based,on,incremental,cash,flows:,Investment,decisions,are,based,on,increm
ental,cash,flows,instead,of,accounting,income.,,
2. Timing,of,cash,flows,is,crucial:,The,timing,of,cash,flows,is,important,due,to,the,time,value,
of,money.,
3. Cash,flows,are,based,on,opportunity,cost:,Opportunity,costs,must,be,considered,for,incre
mental,cash,flows.,Suppose,you,started,a,business,in,a,building,that,you,inherited,from,your,
father.,Net,cash,flow,from,the,business,is,$2000/month.,Instead,of,using,the,building,for,bus
iness,purposes,,you,could,have,rented,the,building,for,$3000/month.,In,this,scenario,,rentin
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,2,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
g,out,the,building,seems,like,an,obvious,choice,as,it,earns,more,than,the,business,does,curre
ntly.,
4. Cash,flows,are,analyzed,on,an,after-
tax,basis:,The,effect,of,taxes,must,be,considered,when,analyzing,projects.,
5. Financial,costs,are,ignored:,Since,the,required,rate,of,return,includes,financing,costs,,they,
should,not,be,deducted,from,the,cash,flows;,otherwise,,it,would,lead,to,doublecounting,of,th
e,financing,costs.,
,
LO.c:,Explain,how,the,evaluation,and,selection,of,capital,projects,is,affected,by,mutually,excl
usive,projects,,project,sequencing,,and,capital,rationing.,
• Independent,projects,versus,mutually,exclusive,projects:,If,projects,are,independent,,th
ey,can,all,be,undertaken,,provided,that,they,individually,satisfy,the,decision,rules.,In,the,cas
e,of,mutually,exclusive,projects,,the,projects,compete,with,each,other.,If,projects,A,and,B,ar
e,mutually,exclusive,,it,means,that,either,A,or,B,can,be,undertaken,,but,not,both.,
• Project,Sequencing:,Projects,are,sequenced,through,time.,That,is,,completion,of,one,proje
ct,creates,an,opportunity,to,invest,in,another,project,later,,based,on,the,financial,results,of,th
e,earlier,project.,,
• Unlimited,funds,versus,capital,rationing:,Under,unlimited,funds,,funding,is,not,a,constrai
nt,,so,a,company,may,invest,in,all,profitable,projects.,However,,if,the,company,has,limited,f
unds,for,investment,,then,the,company,must,allocate,funds,such,that,they,maximize,shareho
lder,value.,,
,
LO.d:,Calculate,and,interpret,the,results,using,each,of,the,following,methods,to,evaluate,a,sin
gle,capital,project:,net,present,value,(NPV),,internal,rate,of,return,(IRR),,payback,period,,dis
counted,payback,period,,and,profitability,index,(PI).,
Net,present,value,(NPV),is,the,present,value,of,the,future,after,tax,cash,flows,,minus,the,investmen
t,outlay,(cost,of,the,project).,For,independent,projects-
,accept,all,projects,with,positive,NPV.,For,mutually,exclusive,projects-
,accept,the,project,with,the,higher,NPV.,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,3,
,
, , 2015,Level,I,Summary,Notes,, ,
,
,
Consider,the,following,two,projects:,
Cost,of,Capital,=,10%,
, , ,
Expected,net,cash,flows,
, , ,
Year, 0, 1, 2, 3, 4,
Project,A, $1000, $500, $400, $300, $100,
Project,B, $1000, $100, $300, $400, $600,
,
NPV,of,the,projects,can,be,calculated,by,plugging,the,cash,flows,and,IRR,=,10%.,You,will,get,NPV
A,=,78.82,and,NPVB,=,49.18.,If,these,two,projects,are,independent,then,both,of,them,should,be,acce
pted.,If,these,are,mutually,exclusive,,only,project,A,must,be,accepted.,,
Internal,rate,of,return,(IRR),is,the,discount,rate,which,makes,NPV,equal,to,0.,For,independent,pr
ojects,,if,IRR,is,greater,than,opportunity,cost,(required,rate,of,return),,accept,the,project;,otherwise,r
eject,the,project.,For,mutually,exclusive,projects,,accept,the,project,with,the,higher,IRR,as,long,as,t
he,IRR,is,greater,than,the,opportunity,cost.,The,IRR,of,Projects,A,and,B,can,be,computed,by,pluggi
ng,cash,flows,on,calculators.,You,will,get,IRRA,=,14.49%,and,IRRB,=,11.79%,
Payback,period,is,the,number,of,years,it,takes,to,recover,the,initial,investment.,,
Discounted,payback,period,is,the,number,of,years,it,takes,for,the,present,value,of,the,estimated,ca
sh,flows,to,equal,the,initial,investment.,Both,concepts,are,explained,in,the,following,example:,
Year, 0, 1, 2, 3, 4,
Cash,flows, -800, 340, 340, 340, 340,
Cumulative,Cash,flow, -800, -460, -120, 220, 560,
Discounted,Cash,flows, -800, 309.1, 280.99, 255.45, 232.22,
Cumulative,Discounted,Cash,flows, -800, -490.9, -209.91, 45.54, 277.76,
The,payback,and,discounted,payback,periods,are:,
,
,
Copyright,©,IFT.,All,rights,reserved, www.ift.world, , Page,4,
,
