Wednesday, April 18, 2012

Clayman et al., Corporate Finance

This second edition of Corporate Finance: A Practical Approach, part of the CFA Institute Investment Series (Wiley, 2012), was edited by Michelle R. Clayman, Martin S. Fridson, and George H. Troughton. In more than 500 pages its contributors cover corporate governance, capital budgeting, cost of capital, measures of leverage, capital structure, dividends and share repurchases, working capital management, financial statement analysis, and mergers and acquisitions.

The book is assembled from texts used in the CFA Program curriculum, a global graduate-level self-study program for those aspiring to become chartered financial analysts. Each chapter concludes with a set of problems. An accompanying workbook, which I haven’t seen, is also available.

I’m going to focus on a single concept for this post, leverage, since it is understood somewhat differently in the corporate context than it is in the trading context. First, the definition: “Leverage is the use of fixed costs in a company’s cost structure. The fixed costs that are operating costs (such as depreciation or rent) create operating leverage. Fixed costs that are financial costs (such as interest expense) create financial leverage.” (p. 171)

Leverage is a key component in assessing a company’s risk and return characteristics. “Leverage increases the volatility of a company’s earnings and cash flows and increases the risk of lending to or owning a company.” (p. 172)

Assume that two companies have the same net income, produce the same number of units, and sell each unit for the same price but have significantly different cost structures. Company A has a much lower variable cost per unit and a much higher fixed operating cost per unit than does company B. If unit sales drop, A will be harder hit than B; if sales rise, A will turn a higher profit than B. In brief, “The greater the fixed operating costs relative to variable operating costs, the greater the operating risk.” (p. 174)

Without going into the nitty-gritty of calculating the degree of operating leverage (in the simplest of terms it’s the percentage change in operating income divided by the percentage change in units sold), let’s skip to a general conclusion. “Industries that tend to have high operating leverage are those that invest up front to produce a product but spend relatively little on making and distributing it. Software developers and pharmaceutical companies fit this description. Alternatively, retailers have low operating leverage because much of the cost of goods sold is variable.” (p. 180)

Business risk is comprised of operating risk and sales risk (“the uncertainty with respect to the price and quantity of goods and services”). But investors also have to worry about financial risk, associated with how the company finances its operations. “If a company finances with debt, it is legally obligated to pay the amounts that make up its debts when due. By taking on fixed obligations, such as debt and long-term leases, the company increases its financial risk. If a company finances its business with common equity, generated either from operations (retained earnings) or from issuing new common shares, it does not incur fixed obligations. The more fixed-cost financial obligations (e.g., debt) incurred by the company, the greater its financial risk.” (p. 182)

Trust me, you couldn’t correctly answer questions about leverage on the CFA exam based on my summary. But I think it will give you some idea of the way topics are covered (sans math) in this very thorough book. It is valuable reading not only for grad students and CFA wannabes but also for sophisticated investors and professional managers who want to understand what corporate finance is all about.

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