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Study guide · Session 1

Corporate Finance

6-9% of the exam · session 1 · 7 learning modules

Corporate Finance covers how companies are organised and owned, whose interests they serve, how they are governed, and how they manage liquidity, choose investments and finance them. Level I questions test definitions and comparisons, plus calculations of the cash conversion cycle, NPV, IRR, ROIC and WACC.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of this topic's 7 learning modules in the 2027 curriculum, named in our own words.

At a glance

Session 1
6-9%

of the exam, as CFA Institute weights it for 2027

Weight
6-9%
Modules
7
Key terms
10

What this guide covers, module by module

  1. CORP.1Business forms and ownership structures
  2. CORP.2Lenders, shareholders and other stakeholders
  3. CORP.3Governance, agency conflicts and controls
  4. CORP.4Managing working capital and liquidity
  5. CORP.5Choosing investments with NPV, IRR and ROIC
  6. CORP.6Cost of capital and the debt mix
  7. CORP.7How companies create and capture value

CORP.1Business forms and ownership structures

  • A sole proprietorship has one owner with unlimited liability and profits taxed as personal income.
  • A general partnership shares ownership and unlimited liability; a limited partnership has at least one general partner with unlimited liability and limited partners liable only up to their investment.
  • A corporation is a legal entity separate from its owners, with limited liability and easy transfer of shares; profits may be taxed twice (corporate tax, then tax on dividends).
  • Corporations separate ownership from control, which raises agency issues.
  • Public companies list shares on an exchange, giving liquidity and access to capital in exchange for disclosure duties; private companies have fewer owners and less liquidity.
  • Companies move between forms through listings, buyouts, direct listings and special purpose acquisition companies.
  1. The situationA profitable family business considers listing on an exchange.
  2. Step 1Gains: liquid shares, a market price and access to equity capital.
  3. Step 2Costs: listing fees, public disclosure, market scrutiny and a wider shareholder base.
  4. Step 3Control: the family may keep it through a large stake or a dual-class structure.
  5. Where questions turnIn a limited partnership, only the general partner has unlimited liability.
  6. The takeawayGoing public trades privacy and control for liquidity and capital.
Practise CORP.1

CORP.2Lenders, shareholders and other stakeholders

  • Lenders hold a fixed, senior claim: their upside is capped at interest and principal, and they prefer stable cash flows and low risk.
  • Shareholders hold a residual claim: unlimited upside and losses limited to their investment, so they may prefer more risk.
  • Other stakeholders include the board, managers, employees, customers, suppliers and governments, each with its own interest.
  • Shareholder theory puts value for shareholders first; stakeholder theory weighs all groups.
  • ESG factors: environmental (emissions, resources), social (labour, safety, communities, data privacy) and governance (board, pay, rights, controls).
  • ESG issues can affect cash flows, risk and the cost of capital, and so a company's value.
  1. The situationA company owes 100 at maturity; its assets will be worth either 80 or 150.
  2. Step 1If 150: lenders receive 100, shareholders 50.
  3. Step 2If 80: lenders receive 80, shareholders 0.
  4. Step 3A riskier project widening outcomes to 50 or 200 helps shareholders and hurts lenders.
  5. Where questions turnLenders gain nothing from upside beyond full repayment, yet bear losses in a default.
  6. The takeawayPayoff shapes explain why lenders and shareholders view risk differently.
Practise CORP.2

CORP.3Governance, agency conflicts and controls

  • The principal-agent relationship: shareholders (principals) delegate to managers (agents), whose goals may differ.
  • Conflicts include managers versus shareholders (empire building, perks, entrenchment), controlling versus minority shareholders, shareholders versus creditors, and the company versus other stakeholders.
  • Mechanisms: shareholder voting and meetings, independent boards and committees (audit, remuneration, nomination), pay linked to long-term value, debt covenants, laws and regulation.
  • Cumulative voting and proxy access help minority shareholders; dual-class shares and staggered boards entrench control.
  • Risks of weak governance: poor decisions, legal and regulatory action, reputational damage, default.
  • Benefits of good governance: better operating efficiency, stronger controls and a lower cost of capital.
  1. The situationA chief executive is paid on revenue growth and proposes a large, low-return acquisition.
  2. Step 1Identify the conflict: growth raises pay even if value falls.
  3. Step 2Board response: the independent directors test the deal against the cost of capital.
  4. Step 3Longer term: link pay to return on capital and total shareholder return.
  5. Where questions turnEntrenchment devices such as staggered boards protect insiders, not minority shareholders.
  6. The takeawayAligning incentives and independent oversight reduce agency costs.
Practise CORP.3

CORP.4Managing working capital and liquidity

  • Cash conversion cycle = days of inventory on hand + days of sales outstanding - days of payables.
  • A shorter cycle frees cash; a negative one means suppliers finance operations.
  • Primary liquidity sources: cash, short-term investments, operating cash flow, trade credit and bank lines; secondary: selling assets, renegotiating debt, protection from creditors.
  • Liquidity ratios: current, quick and cash ratios; drags (slow collections, obsolete inventory) and pulls (paying suppliers early, credit lines cut) reduce liquidity.
  • Working capital policy can be conservative (more current assets, long-term funding) or aggressive (lean current assets, short-term funding).
  • Cost of forgoing a trade discount = (1 + discount / (1 - discount))^(365 / extra days) - 1.
  1. The situationDays of inventory 60, receivables 40, payables 35.
  2. Step 1Operating cycle = 60 + 40 = 100 days.
  3. Step 2Cash conversion cycle = 100 - 35 = 65 days.
  4. Where questions turnDays of payables are subtracted, not added, in the cash conversion cycle.
  5. The takeawayCash is tied up for 65 days; paying suppliers later or collecting faster shortens it.
Practise CORP.4

CORP.5Choosing investments with NPV, IRR and ROIC

  • Capital investments include going concern projects (maintenance, efficiency), regulatory and compliance projects, expansion and new lines of business.
  • Process: generate ideas, analyse proposals, plan the budget, monitor and conduct post-audits.
  • NPV = sum of discounted future cash flows - initial investment; accept if NPV > 0.
  • IRR is the rate that makes NPV zero; accept if IRR exceeds the required return; for mutually exclusive projects that conflict, prefer NPV.
  • ROIC = after-tax operating profit / average invested capital; value is created when ROIC exceeds the cost of capital.
  • Principles: use incremental after-tax cash flows, ignore sunk costs, include opportunity costs, discount at the project's risk-adjusted rate.
  • Real options (timing, expansion, abandonment, flexibility) can add value beyond the static NPV.
  1. The situationA project costs 500 and returns 200 a year for 3 years; the required return is 8%.
  2. Step 1PV = 200 x (1 - 1.08^-3) / 0.08 = 515.42.
  3. Step 2NPV = 515.42 - 500 = 15.42, so accept.
  4. Step 3IRR is about 9.7%, above 8%, consistent with a positive NPV.
  5. Where questions turnSunk costs already spent do not belong in the analysis, while forgone opportunities do.
  6. The takeawayFor a single conventional project, NPV and IRR give the same accept or reject decision.
Practise CORP.5

CORP.6Cost of capital and the debt mix

  • WACC = wE x rE + wP x rP + wD x rD x (1 - t), using target or market-value weights.
  • Factors: business risk, tax rates, the stage of the company's life cycle, asset tangibility and market conditions.
  • MM without taxes: firm value and WACC do not depend on capital structure; the cost of equity rises with leverage.
  • MM with taxes: the interest tax shield makes value rise with debt, and WACC fall.
  • Static trade-off: the tax benefit is balanced against expected costs of financial distress; the optimum minimises WACC and maximises value.
  • Pecking order: managers prefer internal funds, then debt, then new equity, because of information asymmetry.
  1. The situationTarget weights 70% equity and 30% debt; cost of equity 10%, pre-tax cost of debt 5%, tax rate 20%.
  2. Step 1After-tax cost of debt = 5% x 0.8 = 4%.
  3. Step 2WACC = 0.7 x 10% + 0.3 x 4% = 7% + 1.2% = 8.2%.
  4. Where questions turnUnder MM without taxes, cheaper debt does not lower WACC because the cost of equity rises to offset it.
  5. The takeawayThe tax deductibility of interest lowers the effective cost of debt.
Practise CORP.6

CORP.7How companies create and capture value

  • A business model describes who the customers are, what value is offered, how it is delivered and how the company earns money.
  • Pricing approaches include value-based and cost-plus pricing, tiered and subscription pricing, and bundling.
  • Razor-and-blades: a low-priced base product with profitable repeat purchases.
  • Platforms and marketplaces rely on network effects, where value grows with the number of users.
  • Asset-light models such as franchising and licensing earn fees without owning the operating assets.
  • The value chain and the configuration (vertical integration or outsourcing) shape margins and risk.
  1. The situationA ride-hailing app connects riders and drivers and takes a fee on each trip.
  2. Step 1Customers: riders and drivers, two sides of one platform.
  3. Step 2Value: shorter waits for riders and more fares for drivers as both sides grow.
  4. Step 3Earnings: a percentage fee per trip, with few owned assets.
  5. Where questions turnEconomies of scope (shared costs across products) are not the same as network effects (value from more users).
  6. The takeawayNetwork effects can build a lasting advantage once the platform reaches scale.
Practise CORP.7

Key terms

Limited liability
An owner can lose no more than the amount invested.
Residual claim
Shareholders' right to what remains after all other claims are paid.
Agency cost
The loss and monitoring cost from agents not acting in principals' interests.
Cash conversion cycle
Days from paying suppliers to collecting from customers.
Net present value
Present value of future cash flows less the initial investment.
Internal rate of return
The discount rate at which a project's NPV is zero.
Return on invested capital
After-tax operating profit divided by average invested capital.
Weighted average cost of capital
The blended required return of all capital providers, net of the interest tax saving.
Real option
A right, not an obligation, to change a project as information arrives.
Network effect
Value to each user rises as more users join.

After this guide: You should be able to compare business forms and stakeholder claims, describe governance mechanisms, and compute the cash conversion cycle, NPV, IRR, ROIC and WACC.

Practise Corporate Finance

Built to the topics and weights CFA Institute publishes for the 2027 Level I curriculum. The module names, explanations, worked examples and traps are ExamDragon's own. Every source this path is built on.