CFA 2019 － level 1 schwesernotes book 4

STUDY SESSION 10The topical coverage corresponds with the following CFA Institute assigned reading: 33.. describe the elements that should be covered in a thorough company analysis.page

1 Learning Outcome Statements (LOS)

2 Study Session 10—Corporate Finance (1)

1 Reading 33: Corporate Governance and ESG: An Introduction

1 Exam Focus

2 Module 33.1: Stakeholder Management

3 Module 33.2: Factors Affecting Corporate Governance

4 Key Concepts

5 Answer Key for Module Quizzes

2 Reading 34: Capital Budgeting

1 Exam Focus

2 Module 34.1: Capital Projects, NPV, and IRR

3 Module 34.2: Payback Period, Project Rankings

4 Key Concepts

5 Answer Key for Module Quizzes

3 Reading 35: Cost of Capital

1 Exam Focus

2 Module 35.1: Weighted Average Cost of Capital

3 Module 35.2: Project Cost of Capital

4 Key Concepts

5 Answer Key for Module Quizzes

3 Study Session 11—Corporate Finance (2)

1 Reading 36: Measures of Leverage

1 Exam Focus

2 Module 36.1: Measures of Leverage

3 Key Concepts

4 Answer Key for Module Quiz

2 Reading 37: Working Capital Management

1 Exam Focus

2 Module 37.1: Working Capital Management

3 Key Concepts

4 Answer Key for Module Quiz

4 Topic Assessment: Corporate Finance

5 Topic Assessment Answers: Corporate Finance

6 Study Session 12—Portfolio Management (1)

1 Reading 38: Portfolio Management: An Overview

1 Exam Focus

2 Module 38.1: Portfolio Management Process

3 Module 38.2: Pooled Investments

4 Key Concepts

5 Answer Key for Module Quizzes

2 Reading 39: Portfolio Risk and Return: Part I

1 Exam Focus

2 Module 39.1: Returns Measures

3 Module 39.2: Covariance and Correlation

4 Module 39.3: The Efficient Frontier

5 Key Concepts

6 Answer Key for Module Quizzes

3 Reading 40: Portfolio Risk and Return: Part II

1 Exam Focus

2 Module 40.1: Systematic Risk and Beta

3 Module 40.2: The CAPM and the SML

4 Key Concepts

5 Answer Key for Module Quizzes

7 Study Session 13—Portfolio Management (2)

1 Reading 41: Basics of Portfolio Planning and Construction

1 Exam Focus

2 Module 41.1: Portfolio Planning and Construction

3 Key Concepts

4 Answer Key for Module Quiz

2 Reading 42: Risk Management: An Introduction

1 Exam Focus

2 Module 42.1: Risk Management Introduction

3 Key Concepts

4 Answer Key for Module Quiz

3 Reading 43: Fintech in Investment Management

1 Exam Focus

2 Module 43.1: Fintech in Investment Management

3 Key Concepts

4 Answer Key for Module Quiz

8 Topic Assessment: Portfolio Management

9 Topic Assessment Answers: Portfolio Management

10 Study Session 14—Equity Investments (1)

1 Reading 44: Market Organization and Structure

1 Exam Focus

2 Module 44.1: Markets, Assets, and Intermediaries

3 Module 44.2: Positions and Leverage

4 Module 44.3: Order Execution and Validity

5 Key Concepts

6 Answer Key for Module Quizzes

2 Reading 45: Security Market Indexes

1 Exam Focus

2 Module 45.1: Index Weighting Methods

3 Module 45.2: Uses and Types of Indexes

4 Key Concepts

5 Answer Key for Module Quizzes

3 Reading 46: Market Efficiency

1 Exam Focus

2 Module 46.1: Efficient Markets

3 Key Concepts

4 Answer Key for Module Quiz

11 Study Session 15—Equity Investments (2)

1 Reading 47: Overview of Equity Securities

1 Exam Focus

2 Module 47.1: Types of Equity Investments

3 Module 47.2: Foreign Equities and Equity Risk

4 Key Concepts

5 Answer Key for Module Quizzes

2 Reading 48: Introduction to Industry and Company Analysis

1 Exam Focus

2 Module 48.1: Industry Analysis

3 Module 48.2: Pricing Power and Company Analysis

4 Key Concepts

5 Answer Key for Module Quizzes

3 Reading 49: Equity Valuation: Concepts and Basic Tools

1 Exam Focus

2 Module 49.1: Dividends, Splits, and Repurchases

3 Module 49.2: Dividend Discount Models

4 Module 49.3: Relative Valuation Measures

5 Key Concepts

6 Answer Key for Module Quizzes

12 Topic Assessment: Equity Investments

13 Topic Assessment Answers: Equity Investments

14 Formulas

LEARNING OUTCOME STATEMENTS (LOS)

STUDY SESSION 10

The topical coverage corresponds with the following CFA Institute assigned reading:

33 Corporate Governance and ESG: An Introduction

The candidate should be able to:

a describe corporate governance (page 1)

b describe a company’s stakeholder groups and compare interests of stakeholdergroups (page 2)

c describe principal–agent and other relationships in corporate governance and theconflicts that may arise in these relationships (page 3)

d describe stakeholder management (page 4)

e describe mechanisms to manage stakeholder relationships and mitigate associatedrisks (page 4)

f describe functions and responsibilities of a company’s board of directors and itscommittees (page 5)

g describe market and non-market factors that can affect stakeholder relationshipsand corporate governance (page 8)

h identify potential risks of poor corporate governance and stakeholder managementand identify benefits from effective corporate governance and stakeholder

management (page 10)

i describe factors relevant to the analysis of corporate governance and stakeholdermanagement (page 11)

j describe environmental and social considerations in investment analysis (page 13)

k describe how environmental, social, and governance factors may be used in

investment analysis (page 13)

The topical coverage corresponds with the following CFA Institute assigned reading:

34 Capital Budgeting

The candidate should be able to:

a describe the capital budgeting process and distinguish among the various

categories of capital projects (page 19)

b describe the basic principles of capital budgeting (page 21)

c explain how the evaluation and selection of capital projects is affected by mutuallyexclusive projects, project sequencing, and capital rationing (page 22)

d calculate and interpret net present value (NPV), internal rate of return (IRR),

payback period, discounted payback period, and profitability index (PI) of a singlecapital project (page 23)

e explain the NPV profile, compare the NPV and IRR methods when evaluatingindependent and mutually exclusive projects, and describe the problems associatedwith each of the evaluation methods (page 29)

f describe expected relations among an investment’s NPV, company value, and shareprice (page 32)

The topical coverage corresponds with the following CFA Institute assigned reading:

35 Cost of Capital

The candidate should be able to:

a calculate and interpret the weighted average cost of capital (WACC) of a company.(page 39)

b describe how taxes affect the cost of capital from different capital sources

i calculate and interpret the beta and cost of capital for a project (page 48)

j describe uses of country risk premiums in estimating the cost of equity (page 49)

k describe the marginal cost of capital schedule, explain why it may be sloping with respect to additional capital, and calculate and interpret its break-points (page 50)

upward-l explain and demonstrate the correct treatment of flotation costs (page 52)

STUDY SESSION 11

The topical coverage corresponds with the following CFA Institute assigned reading:

36 Measures of Leverage

The candidate should be able to:

a define and explain leverage, business risk, sales risk, operating risk, and financialrisk and classify a risk (page 61)

b calculate and interpret the degree of operating leverage, the degree of financialleverage, and the degree of total leverage (page 62)

c analyze the effect of financial leverage on a company’s net income and return onequity (page 64)

d calculate the breakeven quantity of sales and determine the company’s net income

at various sales levels (page 66)

e calculate and interpret the operating breakeven quantity of sales (page 66)

The topical coverage corresponds with the following CFA Institute assigned reading:

37 Working Capital Management

The candidate should be able to:

a describe primary and secondary sources of liquidity and factors that influence acompany’s liquidity position (page 73)

b compare a company’s liquidity measures with those of peer companies (page 74)

c evaluate working capital effectiveness of a company based on its operating andcash conversion cycles and compare the company’s effectiveness with that of peercompanies (page 76)

d describe how different types of cash flows affect a company’s net daily cashposition (page 77)

e calculate and interpret comparable yields on various securities, compare portfolioreturns against a standard benchmark, and evaluate a company’s short-term

investment policy guidelines (page 77)

f evaluate a company’s management of accounts receivable, inventory, and accountspayable over time and compared to peer companies (page 79)

g evaluate the choices of short-term funding available to a company and recommend

a financing method (page 82)

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STUDY SESSION 12

The topical coverage corresponds with the following CFA Institute assigned reading:

38 Portfolio Management: An Overview

The candidate should be able to:

a describe the portfolio approach to investing (page 95)

b describe types of investors and distinctive characteristics and needs of each

(page 96)

c describe defined contribution and defined benefit pension plans (page 97)

d describe the steps in the portfolio management process (page 98)

e describe mutual funds and compare them with other pooled investment products.(page 100)

The topical coverage corresponds with the following CFA Institute assigned reading:

39 Portfolio Risk and Return: Part I

The candidate should be able to:

a calculate and interpret major return measures and describe their appropriate uses.(page 107)

b describe characteristics of the major asset classes that investors consider in

forming portfolios (page 110)

c calculate and interpret the mean, variance, and covariance (or correlation) of assetreturns based on historical data (page 112)

d explain risk aversion and its implications for portfolio selection (page 114)

e calculate and interpret portfolio standard deviation (page 116)

f describe the effect on a portfolio’s risk of investing in assets that are less thanperfectly correlated (page 117)

g describe and interpret the minimum-variance and efficient frontiers of risky assetsand the global minimum-variance portfolio (page 119)

h explain the selection of an optimal portfolio, given an investor’s utility (or riskaversion) and the capital allocation line (page 119)

The topical coverage corresponds with the following CFA Institute assigned reading:

40 Portfolio Risk and Return: Part II

The candidate should be able to:

a describe the implications of combining a risk-free asset with a portfolio of riskyassets (page 129)

b explain the capital allocation line (CAL) and the capital market line (CML).(page 130)

c explain systematic and nonsystematic risk, including why an investor should notexpect to receive additional return for bearing nonsystematic risk (page 133)

d explain return generating models (including the market model) and their uses.(page 135)

e calculate and interpret beta (page 137)

f explain the capital asset pricing model (CAPM), including its assumptions, and thesecurity market line (SML) (page 139)

g calculate and interpret the expected return of an asset using the CAPM (page 139)

h describe and demonstrate applications of the CAPM and the SML (page 143)

i calculate and interpret the Sharpe ratio, Treynor ratio, M 2, and Jensen’s alpha.(page 145)

STUDY SESSION 13

The topical coverage corresponds with the following CFA Institute assigned reading:

41 Basics of Portfolio Planning and Construction

The candidate should be able to:

a describe the reasons for a written investment policy statement (IPS) (page 153)

b describe the major components of an IPS (page 154)

c describe risk and return objectives and how they may be developed for a client.(page 154)

d distinguish between the willingness and the ability (capacity) to take risk inanalyzing an investor’s financial risk tolerance (page 155)

e describe the investment constraints of liquidity, time horizon, tax concerns, legaland regulatory factors, and unique circumstances and their implications for thechoice of portfolio assets (page 156)

f explain the specification of asset classes in relation to asset allocation (page 157)

g describe the principles of portfolio construction and the role of asset allocation inrelation to the IPS (page 159)

The topical coverage corresponds with the following CFA Institute assigned reading:

42 Risk Management: An Introduction

The candidate should be able to:

a define risk management (page 165)

b describe features of a risk management framework (page 166)

c define risk governance and describe elements of effective risk governance

(page 166)

d explain how risk tolerance affects risk management (page 167)

e describe risk budgeting and its role in risk governance (page 167)

f identify financial and non-financial sources of risk and describe how they mayinteract (page 168)

g describe methods for measuring and modifying risk exposures and factors toconsider in choosing among the methods (page 169)

The topical coverage corresponds with the following CFA Institute assigned reading:

43 Fintech in Investment Management

The candidate should be able to:

a describe “fintech.” (page 177)

b describe Big Data, artificial intelligence, and machine learning (page 178)

c describe fintech applications to investment management (page 179)

d describe financial applications of distributed ledger technology (page 181)

STUDY SESSION 14

The topical coverage corresponds with the following CFA Institute assigned reading:

44 Market Organization and Structure

The candidate should be able to:

a explain the main functions of the financial system (page 189)

b describe classifications of assets and markets (page 191)

c describe the major types of securities, currencies, contracts, commodities, and realassets that trade in organized markets, including their distinguishing characteristicsand major subtypes (page 192)

d describe types of financial intermediaries and services that they provide

(page 195)

e compare positions an investor can take in an asset (page 198)

f calculate and interpret the leverage ratio, the rate of return on a margin transaction,and the security price at which the investor would receive a margin call

(page 199)

g compare execution, validity, and clearing instructions (page 202)

h compare market orders with limit orders (page 202)

i define primary and secondary markets and explain how secondary markets supportprimary markets (page 205)

j describe how securities, contracts, and currencies are traded in quote-driven, driven, and brokered markets (page 207)

order-k describe characteristics of a well-functioning financial system (page 208)

l describe objectives of market regulation (page 209)

The topical coverage corresponds with the following CFA Institute assigned reading:

45 Security Market Indexes

The candidate should be able to:

a describe a security market index (page 219)

b calculate and interpret the value, price return, and total return of an index

(page 219)

c describe the choices and issues in index construction and management (page 220)

d compare the different weighting methods used in index construction (page 220)

e calculate and analyze the value and return of an index given its weighting method.(page 223)

f describe rebalancing and reconstitution of an index (page 227)

g describe uses of security market indexes (page 227)

h describe types of equity indexes (page 228)

i describe types of fixed-income indexes (page 229)

j describe indexes representing alternative investments (page 229)

k compare types of security market indexes (page 230)

The topical coverage corresponds with the following CFA Institute assigned reading:

46 Market Efficiency

The candidate should be able to:

a describe market efficiency and related concepts, including their importance toinvestment practitioners (page 239)

b distinguish between market value and intrinsic value (page 240)

c explain factors that affect a market’s efficiency (page 240)

d contrast weak-form, semi-strong-form, and strong-form market efficiency.(page 241)

e explain the implications of each form of market efficiency for fundamentalanalysis, technical analysis, and the choice between active and passive portfoliomanagement (page 242)

f describe market anomalies (page 243)

g describe behavioral finance and its potential relevance to understanding marketanomalies (page 246)

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STUDY SESSION 15

The topical coverage corresponds with the following CFA Institute assigned reading:

47 Overview of Equity Securities

The candidate should be able to:

a describe characteristics of types of equity securities (page 253)

b describe differences in voting rights and other ownership characteristics amongdifferent equity classes (page 255)

c distinguish between public and private equity securities (page 255)

d describe methods for investing in non-domestic equity securities (page 256)

e compare the risk and return characteristics of different types of equity securities.(page 258)

f explain the role of equity securities in the financing of a company’s assets

(page 259)

g distinguish between the market value and book value of equity securities

(page 259)

h compare a company’s cost of equity, its (accounting) return on equity, and

investors’ required rates of return (page 260)

The topical coverage corresponds with the following CFA Institute assigned reading:

48 Introduction to Industry and Company Analysis

The candidate should be able to:

a explain uses of industry analysis and the relation of industry analysis to companyanalysis (page 267)

b compare methods by which companies can be grouped, current industry

classification systems, and classify a company, given a description of its activitiesand the classification system (page 268)

c explain the factors that affect the sensitivity of a company to the business cycle andthe uses and limitations of industry and company descriptors such as “growth,”

“defensive,” and “cyclical.” (page 271)

d explain how a company’s industry classification can be used to identify a potential

“peer group” for equity valuation (page 272)

e describe the elements that need to be covered in a thorough industry analysis.(page 272)

f describe the principles of strategic analysis of an industry (page 273)

g explain the effects of barriers to entry, industry concentration, industry capacity,and market share stability on pricing power and price competition (page 275)

h describe industry life cycle models, classify an industry as to life cycle stage, anddescribe limitations of the life-cycle concept in forecasting industry performance.(page 277)

i compare characteristics of representative industries from the various economicsectors (page 279)

j describe macroeconomic, technological, demographic, governmental, and socialinfluences on industry growth, profitability, and risk (page 280)

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k describe the elements that should be covered in a thorough company analysis.(page 281)

The topical coverage corresponds with the following CFA Institute assigned reading:

49 Equity Valuation: Concepts and Basic Tools

The candidate should be able to:

a evaluate whether a security, given its current market price and a value estimate, isovervalued, fairly valued, or undervalued by the market (page 289)

b describe major categories of equity valuation models (page 290)

c describe regular cash dividends, extra dividends, stock dividends, stock splits,reverse stock splits, and share repurchases (page 291)

d describe dividend payment chronology (page 292)

e explain the rationale for using present value models to value equity and describethe dividend discount and free-cash-flow-to-equity models (page 293)

f calculate the intrinsic value of a non-callable, non-convertible preferred stock.(page 296)

g calculate and interpret the intrinsic value of an equity security based on the Gordon(constant) growth dividend discount model or a two-stage dividend discount

model, as appropriate (page 296)

h identify characteristics of companies for which the constant growth or a multistagedividend discount model is appropriate (page 301)

i explain the rationale for using price multiples to value equity, how the price toearnings multiple relates to fundamentals, and the use of multiples based on

comparables (page 302)

j calculate and interpret the following multiples: price to earnings, price to an

estimate of operating cash flow, price to sales, and price to book value (page 303)

k describe enterprise value multiples and their use in estimating equity value

Video covering this content is available online.

The following is a review of the Corporate Finance (1) principles designed to address the learning outcome statements set forth by CFA Institute Cross-Reference to CFA Institute Assigned Reading #33.

READING 33: CORPORATE GOVERNANCE AND ESG: AN INTRODUCTION

Study Session 10

EXAM FOCUS

Candidates should understand the idea of a firm’s stakeholders, how conflicts can arisebetween stakeholders, and how effective corporate governance can mitigate problemsarising from these conflicts Other important points are the election of the board ofdirectors, the board’s duties, and important factors in board composition Finally, therationale for incorporating environmental, social, and governance factors into the

portfolio selection process is presented

MODULE 33.1: STAKEHOLDER MANAGEMENT

LOS 33.a: Describe corporate governance.

CFA ® Program Curriculum, Volume 4, page 6

In the CFA Institute publication, The Corporate Governance of Listed Companies: A Manual for Investors1, corporate governance is described as “the system of internalcontrols and procedures by which individual companies are managed It provides aframework that defines the rights, roles and responsibilities of various groups … within

an organization At its core, corporate governance is the arrangement of checks,

balances, and incentives a company needs in order to minimize and manage the

conflicting interests between insiders and external shareowners.”

Under shareholder theory, the primary focus of a system of corporate governance is

the interests of the firm’s shareholders, which are taken to be the maximization of themarket value of the firm’s common equity Under this theory, corporate governance isprimarily concerned with the conflict of interest between the firm’s managers and itsowners (shareholders)

The focus of corporate governance under stakeholder theory is broader; it considers

conflicts among the several groups that have an interest in the activities and

performance of the firm These groups include shareholders, employees, suppliers, andcustomers, among others

LOS 33.b: Describe a company’s stakeholder groups and compare interests of stakeholder groups.

CFA ® Program Curriculum, Volume 4, page 8

The following have been identified as the primary stakeholders of a corporation.

Shareholders have a residual interest in the corporation in that they have claim to the

net assets of the corporation after all liabilities have been settled Shareholders havevoting rights for the election of the board of directors and for other important corporatematters, which gives them effective control of the firm and its management They have

an interest in the ongoing profitability and growth of the firm, both of which can

increase the value of their ownership shares

The board of directors has a responsibility to protect the interests of shareholders; to

hire, fire, and set the compensation of the firm’s senior managers; to set the strategicdirection of the firm; and to monitor financial performance and other aspects of thefirm’s ongoing activities

Typically, the firm’s executives (most-senior managers) serve on the board of directors,along with directors who are not otherwise employed by the firm In a one-tier boardstructure, both company executives and non-executive board members serve on a singleboard of directors In some countries, boards have a two-tier structure in which the non-executive board members serve on a supervisory board that oversees a managementboard, made up of company executives

Senior managers typically receive compensation (remuneration) that is made up of a

salary, a bonus based on some measure of company performance, and perquisites

(e.g., expense accounts, use of company planes, special retirement benefits, vacationtime off) Their interests can be expected to include continued employment and

maximizing the total value of their compensation Executive bonuses are typically tied

to some measure of firm performance, giving senior managers a strong interest in thefinancial success of the firm

Employees also have an interest in the sustainability and success of the firm They have

an interest in their rate of pay, opportunities for career advancement, training, and

working conditions

Creditors supply debt capital to the firm and are primarily owners of the firm’s

outstanding bonds and banks that have made loans to the firm Providers of debt capital

to the firm do not typically have a vote in firm management and do not participate infirm growth beyond receiving their promised interest and principal payments Theinterests of creditors are protected to varying degrees by covenants in their debt

agreements with the firm

Suppliers of resources to the firm have an interest preserving an ongoing relationship

with the firm, in the profitability of their trade with the firm, and in the growth andongoing stability of the firm As they are typically short-term creditors of the firm, theyalso have an interest in the firm’s solvency and on-going financial strength

LOS 33.c: Describe principal–agent and other relationships in corporate

governance and the conflicts that may arise in these relationships.

CFA ® Program Curriculum, Volume 4, page 11

The principal-agent conflict arises because an agent is hired to act in the interest of the

principal, but an agent’s interests may not coincide exactly with those of the principal.Consider an insurance agent who is paid a commission on policies written It would be

in the agent’s interest to write insurance policies on people or property that are not goodrisks, in order to maximize commission income The principal (the owners of the

insurance company) does not want to issue policies that are bad risks as that is a losing proposition Insurance companies mitigate this conflict by imposing underwritingstandards for the policies they will issue and by continuing to work only with agentswho consistently act in the company’s best interest

money-Conflicts of interest between shareholders and managers

or directors

In the context of a corporation, shareholders are the principals (owners), and firm

management and board members (directors) are their agents Managers and directorsmay choose a lower level of business risk than shareholders would This conflict canarise because the risk of company managers and directors is more dependent of firmperformance compared to the risk of shareholders, who hold diversified portfolios ofstocks and are not dependent on the firm for employment

Conflicts may also arise when directors who are also managers favor managementinterests at the expense of shareholders or when directors favor one group of

shareholders at the expense of another

There is also an information asymmetry between shareholders and managers because

managers have more and better information about the functioning of the firm and itsstrategic direction than shareholders do This decreases the ability of shareholders ornon-executive directors to monitor and evaluate whether managers are acting in the bestinterests of shareholders

Conflicts between groups of shareholders

A single shareholder or group of shareholders may hold a majority of the votes and actagainst the interests of the minority shareholders Some firms have different classes ofcommon stock outstanding, some with more voting power than others A group ofshareholders may have effective control of the company although they have a claim toless than 50% of the earnings and assets of the company

In the event of an acquisition of the company, controlling shareholders may be in aposition to get better terms for themselves relative to the terms forced on minority

shareholders Majority shareholders may cause the company to enter into related party

transactions, agreements or specific transactions that benefit entities in which they

have a financial interest, to the detriment of minority shareholders

Conflicts of interest between creditors and shareholders

Shareholders may prefer more business risk than creditors do because creditors have alimited upside from good results compared to shareholders Equity owners could alsoact against the interests of creditors by issuing new debt that increases the default riskfaced by existing debt holders, or by the company paying greater dividends to equityholders, thereby increasing creditors’ risk of default

Conflicts of interest between shareholders and other

Conflicts of interest between shareholders and other

stakeholders

The company may decide to raise prices or reduce product quality in order to increaseprofits to the detriment of customers The company may employ strategies that

significantly reduce the taxes they pay to the government

LOS 33.d: Describe stakeholder management.

LOS 33.e: Describe mechanisms to manage stakeholder relationships and mitigate associated risks.

CFA ® Program Curriculum, Volume 4, page 14

Stakeholder management refers to the management of company relations with

stakeholders and is based on having a good understanding of stakeholder interests andmaintaining effective communication with stakeholders The management of

stakeholder relationships is based on four types of infrastructures:

1 The legal infrastructure identifies the laws relevant to and the legal recourse of

stakeholders when their rights are violated

2 The contractual infrastructure refers to the contracts between the company and

its stakeholders that spell out the rights and responsibilities of the company andthe stakeholders

3 The organizational infrastructure refers to a company’s corporate governance

procedures, including its internal systems and practices that address how it

manages its stakeholder relationships

4 Governmental infrastructure comprises the regulations to which companies are

subject

With respect to the company’s relationship with shareholders, there are standard

practices These practices are required by corporate laws and similar in many

jurisdictions, although there are some differences across countries

Corporations typically hold an annual general meeting after the end of the firm’s fiscal

year At the general meeting, company management provides shareholders with theaudited financial statements for the year, addresses the company’s performance andsignificant actions over the period, and answers shareholder questions

Corporate laws dictate when the annual general meeting may occur and how the

meeting must be communicated to shareholders Typically, anyone owning shares ispermitted to attend the annual general meeting, to speak or ask questions, and to votetheir shares A shareholder who does not attend the annual general meeting can vote her

shares by proxy, meaning she assigns her right to vote to another who will attend the

meeting, often a director, member of management, or the shareholder’s investmentadvisor A proxy may specify the shareholder’s vote on specific issues or leave the vote

to the discretion of the person to whom the proxy is assigned

Ordinary resolutions, such as approval of auditor and the election of directors, require asimple majority of the votes cast Other resolutions, such as those regarding a merger or

takeover, or that require amendment of corporate bylaws, are termed special

resolutions and may require a supermajority vote for passage, typically two-thirds or

three-fourths of the votes cast Such special resolutions can also be addressed at

extraordinary general meetings, which can be called anytime there is a resolution

about a matter that requires a vote of the shareholders

When there are multiple board member elections at one meeting, some companies use

majority voting and some use cumulative voting With majority voting, the candidate with the most votes for each single board position is elected With cumulative voting,

shareholders can cast all their votes (shares times number of board position elections)for a single board candidate or divide them among board candidates Cumulative votingcan result in greater minority shareholder representation on the board compared tomajority voting

Minority shareholders may have special rights by law when the company is acquired byanother company

LOS 33.f: Describe functions and responsibilities of a company’s board of

directors and its committees.

CFA ® Program Curriculum, Volume 4, page 21

Board structure

A company may have any number of directors on its board Companies often havedirectors with expertise in specific areas of the firm’s business, such as risk

management, finance, or industry strategy In a one-tier board, there is a single board

of directors that includes both internal and external directors Internal directors (alsocalled executive directors) are typically senior managers employed by the firm Externalboard members (also called non-executive directors) are those who are not companymanagement Non-executive directors who have no other relationship with the company

are termed independent directors Employee board representatives may be a

significant portion of the non-executive directors

In a two-tier board structure, there is a supervisory board that typically excludes

executive directors The supervisory board and the management board (made up ofexecutive directors) operate independently The management board is typically led bythe company’s CEO

With a one-tier board, the chairman of the board is sometimes the company CEO Whilethis was common practice in the United States historically, separation of the CEO andchairman of the board functions has become more common in recent years When a

lead independent director is appointed, he has the ability to call meetings of the

independent directors, separate from meetings of the full board

Currently, the general practice is for all board member elections to be held at the same

meeting and each election to be for multiple years With a staggered board, elections

for some board positions are held each year This structure limits the ability of

shareholders to replace board members in any one year and is used less now than it hasbeen historically

Board responsibilities

The board of directors is elected by shareholders to act in their interest Board membersare typically mandated by corporate law to be fully informed and to use due diligenceand their expertise in fulfilling their obligation to act in the interests of the company andits shareholders.

The board of directors is not involved in the day-to-day management of the company;that responsibility rests with senior management The duties of the board include

A board of directors typically has committees made up of board members with

particular expertise These committees report to the board, which retains the overallresponsibility for the various board functions The following are examples of typicalboard committees

An audit committee is responsible for:

Oversight of the financial reporting function and implementation of accountingpolicies

Effectiveness of the company’s internal controls and the internal audit function.Recommending an external auditor and its compensation

Proposing remedies based on their review of internal and external audits

A governance committee is responsible for:

Oversight of the company’s corporate governance code

Implementing the company’s code of ethics and policies regarding conflicts ofinterest

Monitoring changes in relevant laws and regulations

Ensuring that the company is in compliance with all applicable laws and

regulations, as well as with the company’s governance policies

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A nominations committee proposes qualified candidates for election to the board,

manages the search process, and attempts to align the board’s composition with thecompany’s corporate governance policies

A compensation committee or remuneration committee recommends to the board the

amounts and types of compensation to be paid to directors and senior managers Thiscommittee may also be responsible for oversight of employee benefit plans and

evaluation of senior managers

A risk committee informs the board about appropriate risk policy and risk tolerance of

the organization, and oversees the enterprise-wide risk management processes of theorganization

An investment committee reviews and reports to the board on management proposals

for large acquisitions or projects, sale or other disposal of company assets or segments,and the performance of acquired assets and other large capital expenditures

The number and size of board committees will depend on the size, complexity, andnature of the business Regulations often require that firms have audit committees.Financial services firms are often required to have a risk committee as well Somecompanies combine two functions into one committee The composition of a boardcommittee is often based on its function, with audit committees, compensation

committees, and governance committees often made up of only non-executive or

independent directors

MODULE QUIZ 33.1

To best evaluate your performance, enter your quiz answers online.

1 The theory that deals with conflicts of interest between a company’s owners and

its creditors is most appropriately called:

A Suppliers and employees.

B Employees and managers.

C Managers and shareholders.

3 The least likely item to be a requirement for good stakeholder management is:

A maintaining effective communication with other stakeholders.

B an understanding of the interests of several stakeholder groups.

C the ability to put aside the interests of one’s stakeholder group.

4 An agreement between a company and a labor union that represents most of its

employees would be most appropriately considered part of a company’s:

A legal infrastructure.

B contractual infrastructure.

C organizational infrastructure.

5 The type of voting that is most likely to allow minority stockholders a greater

representation on the board of directors is:

A majority voting.

B staggered voting.

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C cumulative voting.

6 The type of resolution most likely to require a supermajority of shareholder votes

for passage is a resolution to:

A acquire a company.

B choose a board member.

C approve the choice of an auditor.

7 The board of directors committee most likely to be responsible for monitoring the

performance of a project that requires a large capital expenditure is:

A the risk committee.

B the audit committee.

C the investment committee.

MODULE 33.2: FACTORS AFFECTING

CORPORATE GOVERNANCE

LOS 33.g: Describe market and non-market factors that can affect

stakeholder relationships and corporate governance.

CFA ® Program Curriculum, Volume 4, page 25

Several capital market factors can affect corporate governance and stakeholder

relationships Companies that work to have more communication and contact withshareholders, in addition to annual meetings and analyst meetings, have improved

relations with shareholders who may be more likely to support management proposalsand positions in the event of negative comments or pressure for change from dissidentshareholder groups

Activist shareholders pressure companies in which they hold a significant number of

shares for changes, often changes they believe will increase shareholder value Theymay bring pressure for change by initiating shareholder lawsuits or by seeking

representation on the board of directors Other activist tactics include proposing

shareholder resolutions for a vote and raising their issues to all shareholders or thepublic to gain wider support Hedge funds have, more and more, engaged in shareholderactivism to increase the market values of firms in which they hold significant stakes

A group may initiate a proxy fight, in which they seek the proxies of shareholders to

vote in favor of their alternative proposals and policies An activist group may make a

tender offer for a specific number of shares of a company to gain enough votes to take

over the company

Both senior managers and boards of directors can be replaced by shareholders if theybelieve company performance is poor and would be improved by a change The threat

of a hostile takeover, one not supported by the company’s management, can act as an

incentive to influence company managements and boards to pursue policies more inalignment with the interests of shareholders and oriented toward increasing shareholdervalue

Issues of corporate governance and conflicts of interest arise when company

management proposes and the board passes anti-takeover measures to protect their jobs.Staggered board elections make a hostile takeover more costly and difficult

An important non-market factor that can affect stakeholder relationships is the legalenvironment within which the company operates Shareholders’ and creditors’ interests

are considered to be better protected in countries with a common-law system under which judges’ rulings become law in some instances In a civil law system, judges are

bound to rule based only on specifically enacted laws In general, the rights of creditorsare more clearly defined than those of shareholders and, therefore, are not as difficult toenforce through the courts

In the past, corporate boards and managements have had an advantage in

communicating through the media to influence shareholders or to shape public opinion.Advances in communications, especially through internet outlets and social media sites,have levelled the playing fields to a significant degree It has become much easier fordissident shareholders to bring issues to the attention of other shareholders and to

influence public opinion about certain issues Among senior managers and board

members, concern about their professional reputations has increased as a result Mediaexposure can act as an important incentive for management to pursue policies that areconsistent with the interests of shareholders and avoid egregious related-party

transactions

In 2003, the U.S SEC mandated that U.S.-registered mutual funds institute policies andprocedures to ensure that the proxies they hold for investors in their funds are voted inthe best interests of fund investors Prior to this, many funds that held shares for

investors failed to devote resources to fulfill their responsibility to vote proxies U.S.funds are also required to disclose their proxy voting records

Overall, the increased focus on the importance of good corporate governance has givenrise to a new industry focused on corporate governance, which includes firms that

advise funds on proxy voting and corporate governance matters Firms that provideratings of companies’ corporate governance practices offer another avenue to influencemanagements to better address the interests of shareholders

LOS 33.h: Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and

stakeholder management.

CFA ® Program Curriculum, Volume 4, page 28

Risks of poor governance and stakeholder management

When corporate governance is weak, the control functions of audits and board oversightmay be weak as well The risk is that some stakeholders can gain an advantage, to thedisadvantage of other stakeholders Accounting fraud, or simply poor recordkeeping,will have negative implications for company performance and value

When governance is weak and managers are not monitored, they may choose than-optimal risk, reducing company value Without proper monitoring and oversight,management may have incentive compensation that causes them to pursue their ownbenefit rather than the company’s benefit If they are allowed to engage in related-partytransactions that benefit their friends or family, this will decrease company value

lower-Poor compliance procedures with respect to regulation and reporting can easily lead tolegal and reputational risks Violating stakeholder rights can lead to stakeholder

lawsuits A company’s reputation can be damaged by failure to comply with

governmental regulations Failure to manage creditors’ rights can lead to debt defaultand bankruptcy

Benefits of effective governance and stakeholder

Formal policies regarding conflicts of interest and related party transactions can alsolead to better operating results Proper governance with respect to the interests of

creditors can reduce the risk of debt default or bankruptcy, thereby reducing the cost ofdebt financing Alignment of management interests with those of shareholders leads tobetter financial performance and greater company value

LOS 33.i: Describe factors relevant to the analysis of corporate governance and stakeholder management.

CFA ® Program Curriculum, Volume 4, page 31

In recent years, both analysts and markets have had an increased focus on effectivecorporate governance as an important factor in operational and financial performance.Elements of corporate governance that analysts have focused on include ownership andvoting structures, board composition, management remuneration, the composition ofshareholders, strength of shareholder rights, and management of long-term risks

Company ownership and voting structure

Voting control of companies is typically proportional to share ownership because each

share entitles its holder to one vote In a dual class structure, one class of shares may

be entitled to several votes per share, while another class of shares is entitled to one voteper share This structure is often used to ensure that founding shareholders (and, later,their heirs) can maintain control of the board of directors even when their economicownership is significantly less than 50% Companies with a dual-class share structurehave traded, on average, at a discount to comparable companies with a single class ofshares

Clearly, the interests of the owners of shares with multiple votes will take precedenceover the interests of shareholders in general Analysts will consider what the interests ofthe controlling shareholders are and how the ownership of the controlling shares isexpected to change over time

Composition of a company’s board

Analysts may want to consider carefully the make-up of a company’s board of directors.Important considerations are whether directors:

Are executive, non-executive, or independent directors

Are involved in related-party transactions with the company

Have the diversity of expertise that suits the company’s current strategy andchallenges

Have served for many years and may have become too close to the company’smanagement

Overall, an analyst must decide if the board is responsive to shareholder interests or hasconflicts of interest, and if the board has the mix of expertise that is needed to deal withchallenges and pursue the best strategy for the company

Management incentives and remuneration

In addition to salary, senior corporate managers often receive cash bonuses based onshort-term performance metrics and bonuses based on longer-term equity performance,such as company shares or options to be awarded at future dates While such plans aretypically described as being a mechanism to align the interests of management andshareholders more closely, in many cases they may not do that well Analysts may beconcerned if:

The remuneration plan seems to offer greater incentives, paid in cash, to achieveshort-term performance goals at the expense of building long-term company valuethrough equity-based incentives

Performance-based incentive pay is fairly stable over time, indicating that theperformance targets are possibly easy to achieve

Management remuneration is very high relative to that of comparable companies

potential hostile takeovers and activist shareholders

Activist shareholders and investors who buy shares in an attempt to profit from theiractivism can cause changes in the composition of a firm’s shareholders, its board

membership, and its corporate strategy in a relatively short period of time

Relative strength of shareholders’ rights

If the rights of shareholders are weak, perceived increases in shareholder returns frombeing acquired or from significant changes in corporate strategy may be difficult orimpossible to realize Examples of weak shareholders’ rights are the existence of anti-takeover provisions in the corporate charter or bylaws, staggered boards, and a class ofsuper voting shares, which all restrict the rights of shareholders to effect change

Management of long-term risks

Analysts should be concerned if a company does not manage the risks of stakeholderconflicts well over time A failure to manage stakeholder issues well or a failure tomanage other long-term risks to the company’s sustainability can have disastrous

consequences for shareholders and others with interests tied to company results

LOS 33.j: Describe environmental and social considerations in investment analysis.

CFA ® Program Curriculum, Volume 4, page 36

While the quality of corporate governance has long been a consideration in investmentanalysis, the consideration of environmental and social factors is a more recent

development The use of environmental, social, and governance factors in making

investment decisions is referred to as ESG investing Many issues can be considered in

this context, including harm or potential harm to the environment, risk of loss due toenvironmental accidents, the changing demographics of the workforce, and reputationalrisks from corrupt practices or human rights abuses

ESG investing is also termed sustainable investing or responsible investing and

sometimes socially responsible investing, although that term can be somewhat

ambiguous because it previously referred to investing that integrated ethical or moralconcerns into the portfolio selection process

Conflict may occur when integrating ESG considerations into portfolio constructionwhen the manager has a fiduciary responsibility to act in the best financial interests ofthe account owner or beneficiaries Choosing to construct a portfolio based on an

environmental, social, or governance concern at the expense of investor returns wouldviolate the manager’s fiduciary duty In the United States, the Employee RetirementIncome Security Act (ERISA) describes the fiduciary duty of pension fund managers.Recently, the U.S Department of Labor addressed this potential conflict, stating thatusing ESG factors in determining the risk and expected return of securities is not aviolation of the manager’s fiduciary responsibilities Additionally, it was determinedthat for two investments that have the same relevant financial characteristics, using ESGfactors to choose one over the other is not a violation of the fiduciary duty imposed byERISA

LOS 33.k: Describe how environmental, social, and governance factors may be used in investment analysis.

CFA ® Program Curriculum, Volume 4, page 39

There are several approaches to integrating ESG factors into the portfolio managementprocess The following are some important examples.

Negative screening (sometimes called exclusionary screening or norms-based

screening) refers to excluding companies in specific industries from consideration for

the portfolio based on their practices regarding human rights, environmental concerns,

or corruption Examples of industries where ESG factors might lead to exclusion aremining, oil extraction and transport, and tobacco Specific companies that might beexcluded are those with poor records on corruption and human rights (labor) practices.Company scores based on a range of ESG concerns are often used in negative screening

to identify companies that should be excluded

Under the positive screening approach, investors attempt to identify companies that

have positive ESG practices For example, a portfolio manager may focus on

environmental sustainability, employee rights and safety, and overall governance

practices Often a scoring system across a set of ESG factors is used to identify

companies for inclusion in portfolios A related approach, the best-in-class approach,

seeks to identify companies within each industry group with the best ESG practices Byconstructing portfolios of these companies, a manager can preserve the index sectorweightings in the portfolio while still taking advantage of opportunities to profit frompositive ESG practices

The terms ESG integration and ESG incorporation refer broadly to integrating

qualitative and quantitative characteristics associated with good ESG managementpractices

Impact investing refers to investing to promote specific social or environmental goals

while still making profitable investments Investments made can be in specific

companies or projects, including venture capital investments in companies focused onincreasing sustainability or providing environmental improvements Another approach

to impact investing is green finance Green finance refers to producing economic

growth achieved in a more sustainable way by reducing emissions and better managing

natural resource use An important part of green finance is the issuance of green bonds,

bonds for which the funds raised are used for projects with a positive environmentalimpact

Thematic investing refers to investing in an industry or sector based on a single goal,

such as the development of sustainable energy sources, clean water resources, or climatechange

MODULE QUIZ 33.2

To best evaluate your performance, enter your quiz answers online.

1 Which of the following statements concerning corporate takeovers is most

accurate?

A Staggered board elections are considered an anti-takeover measure.

B A proxy fight refers to a move by management to take away voting rights from an activist shareholder.

C A takeover not supported by management is termed hostile, while a takeover supported by management is termed a tender offer.

2 Benefits of effective corporate governance and stakeholder management most

2 Benefits of effective corporate governance and stakeholder management most likely include:

A reduced risk of default.

B more efficient related-party transactions.

C greater control exercised by the most-interested stakeholders.

3 Executive compensation and bonuses are most likely consistent with the interests

of shareholders if they are:

A stable over time.

B aligned with the company’s strategy.

C sufficiently high relative to the company’s competitors.

4 The method of ESG integration that does not exclude any sectors but seeks to invest in the companies with the best practices regarding employee rights and environmental sustainability is:

A impact investing.

B positive screening.

C negative screening.

KEY CONCEPTS

LOS 33.a

Corporate governance refers to the internal controls and procedures of a company thatdelineate the rights and responsibilities of various groups and how conflicts of interestamong the various groups are to be resolved

LOS 33.b

The primary stakeholders of a corporation include shareholders, the board of directors,senior management, employees, creditors, and suppliers

LOS 33.c

The principal-agent relationship refers to owners employing agents to act in their

interests Conflicts can arise because the agent’s incentives may not align with those ofthe owner or, more generally, because the interests of one group within a corporationare not the same as those of other groups

LOS 33.d

Stakeholder management refers to the management of the company relations with

stakeholders and is based on having a good understanding of stakeholder interests andmaintaining effective communication with stakeholders

LOS 33.e

The management of stakeholder relationships is based on a company’s legal,

contractual, organizational, and government infrastructures

LOS 33.f

The duties of a board of directors include:

Selecting senior management, setting their compensation, and evaluating theirperformance

Setting the strategic direction for the company

Approving capital structure changes, significant acquisitions, and large investmentexpenditures

Reviewing company performance and implementing any necessary correctivesteps

Planning for continuity of management and the succession of the CEO

Establishing, monitoring, and overseeing the firm’s internal controls and riskmanagement

Ensuring the quality of the firm’s financial reporting and internal audit

LOS 33.g

Factors that can affect stakeholder relationships and corporate governance include:Communication and engagement with shareholders.

Shareholder activism

Threat of hostile takeover and existence of anti-takeover provisions

Company’s legal environment

Growth of firms that advise funds on proxy voting and rate companies’ corporategovernance

Elements of corporate governance that analysts have found to be relevant include

ownership and voting structures, board composition, management remuneration, thecomposition of shareholders, strength of shareholder rights, and management of long-term risks

LOS 33.j

The use of environmental, social, and governance (ESG) factors in making investmentdecisions is referred to as ESG investing Many issues can be considered in this context,including harm or potential harm to the environment, risk of loss due to environmentalaccidents, the changing demographics of the workforce, and reputational risks fromcorrupt practices or human rights abuses

LOS 33.k

Methods of integrating ESG concerns into portfolio construction are negative screening,positive screening, best-in-class investing, impact investing, and thematic investing