© CFA Institute. For candidate use only. Not for distribution.

CORPORATE
FINANCE AND
EQUITY

CFA® Program Curriculum
2020 • LEVEL I • VOLUME 4


© CFA Institute. For candidate use only. Not for distribution.

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by CFA Institute. All rights reserved.
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for this edition only. Further reproductions by any means, electronic or mechanical,
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ISBN 978-1-946442-79-6 (paper)

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CONTENTS
How to Use the CFA Program Curriculum  
Background on the CBOK  
Organization of the Curriculum  
Features of the Curriculum  
Designing Your Personal Study Program  
Feedback  

ix
ix
x
x
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xiii

Corporate Finance
Study Session 10

Corporate Finance (1)  

Reading 31

Introduction to Corporate Governance and Other ESG Considerations  
Introduction  

Corporate Governance Overview  
Company Stakeholders  
Stakeholder Groups  
Principal–Agent and Other Relationships in Corporate Governance  
Stakeholder Management  
Overview of Stakeholder Management  
Mechanisms of Stakeholder Management  
Board of Directors and Committees  
Composition of the Board of Directors  
Functions and Responsibilities of the Board  
Board of Directors Committees  
Factors Affecting Stakeholder Relationships and Corporate Governance  
Market Factors  
Non-­
market Factors  
Corporate Governance and Stakeholder Management Risks and Benefits  
Risks of Poor Governance and Stakeholder Management  
Benefits of Effective Governance and Stakeholder Management  
Analyst Considerations in Corporate Governance and Stakeholder
Management  
Economic Ownership and Voting Control  
Board of Directors Representation  
Remuneration and Company Performance  
Investors in the Company  
Strength of Shareholders’ Rights  
Managing Long-­Term Risks  
Summary of Analyst Considerations  
ESG Considerations for Investors  
ESG Terminology  
ESG Implementation Approaches  

Catalysts for ESG Growth  
ESG Market Overview  
ESG Factors in Investment Analysis  
indicates an optional segment

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Contents

Summary  
Practice Problems  
Solutions  

41
44
46

Reading 32

Capital Budgeting  
Introduction  
The Capital Budgeting Process  

Basic Principles of Capital Budgeting  
Investment Decision Criteria  
Net Present Value  
Internal Rate of Return  
Payback Period  
Discounted Payback Period  
Average Accounting Rate of Return  
Profitability Index  
NPV Profile  
Ranking Conflicts between NPV and IRR  
The Multiple IRR Problem and the No IRR Problem  
Corporate Usage of Various Capital Budgeting Methods  
Summary  
Practice Problems  
Solutions  

47
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48
50
52
52
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54
56
57
58
58
60
63

66
67
69
73

Reading 33

Cost of Capital  
Introduction  
Cost of Capital  
Taxes and the Cost of Capital  
Weights of the Weighted Average  
Applying the Cost of Capital to Capital Budgeting and Security
Valuation  
Costs of the Different Sources of Capital  
Cost of Debt  
Cost of Preferred Stock  
Cost of Common Equity  
Topics in Cost of Capital Estimation  
Estimating Beta and Determining a Project Beta  
Country Risk  
Marginal Cost of Capital Schedule  
Flotation Costs  
What Do CFOs Do?  
Summary  
Practice Problems  
Solutions  

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80

indicates an optional segment

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Contents

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iii

Study Session 11


Corporate Finance (2)  

123

Reading 34

Measures of Leverage  
Introduction  
Leverage  
Business Risk and Financial Risk  
Business Risk and Its Components  
Sales Risk  
Operating Risk  
Financial Risk  
Total Leverage  
Breakeven Points and Operating Breakeven Points  
The Risks of Creditors and Owners  
Summary  
Practice Problems  
Solutions  

125
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126
128
128
129
130
137
140

143
145
147
149
153

Reading 35

Working Capital Management  
Introduction  
Managing and Measuring Liquidity  
Defining Liquidity Management  
Measuring Liquidity  
Managing the Cash Position  
Forecasting Short-­Term Cash Flows  
Monitoring Cash Uses and Levels  
Investing Short-­Term Funds  
Short-­Term Investment Instruments  
Strategies  
Evaluating Short-­Term Funds Management  
Managing Accounts Receivable  
Key Elements of the Trade Credit Granting Process  
Managing Customers’ Receipts  
Evaluating Accounts Receivable Management  
Managing Inventory  
Approaches to Managing Levels of Inventory  
Inventory Costs  
Evaluating Inventory Management  
Managing Accounts Payable  
The Economics of Taking a Trade Discount  

Managing Cash Disbursements  
Evaluating Accounts Payable Management  
Managing Short-­Term Financing  
Sources of Short-­Term Financing  
Short-­Term Borrowing Approaches  
Asset-­
Based Loans  
Computing the Costs of Borrowing  
Summary  
Practice Problems  
Solutions  

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indicates an optional segment


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Contents

Equity Investments
Study Session 12

Equity Investments (1)  

Reading 36


Market Organization and Structure  
207
Introduction  
208
The Functions of the Financial System  
208
Helping People Achieve Their Purposes in Using the Financial System  209
Determining Rates of Return  
214
Capital Allocation Efficiency  
215
Assets and Contracts  
216
Classifications of Assets and Markets  
216
Securities  
218
Currencies  
221
Contracts  
222
Commodities  
227
Real Assets  
228
Financial Intermediaries  
230
Brokers, Exchanges, and Alternative Trading Systems  
230

Dealers  
232
Securitizers  
233
Depository Institutions and Other Financial Corporations  
234
Insurance Companies  
235
Arbitrageurs  
236
Settlement and Custodial Services  
238
Summary   
240
Positions  
240
Short Positions  
242
Leveraged Positions  
243
Orders  
246
Execution Instructions  
246
Validity Instructions  
250
Clearing Instructions  
251
Primary Security Markets  
252

Public Offerings  
252
Private Placements and Other Primary Market Transactions  
254
Importance of Secondary Markets to Primary Markets  
255
Secondary Security Market and Contract Market Structures  
255
Trading Sessions  
256
Execution Mechanisms  
256
Market Information Systems  
260
Well-­Functioning Financial Systems  
260
Market Regulation  
262
Summary  
265
Practice Problems  
268
Solutions  
275

indicates an optional segment

205



Contents

Reading 37

Reading 38

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v

Security Market Indexes  
Introduction  
Index Definition and Calculations of Value and Returns  
Calculation of Single-­Period Returns  
Calculation of Index Values over Multiple Time Periods  
Index Construction and Management  
Target Market and Security Selection  
Index Weighting  
Index Management: Rebalancing and Reconstitution  
Uses of Market Indexes  
Gauges of Market Sentiment  
Proxies for Measuring and Modeling Returns, Systematic Risk, and
Risk-­
Adjusted Performance  
Proxies for Asset Classes in Asset Allocation Models  
Benchmarks for Actively Managed Portfolios  
Model Portfolios for Investment Products  
Equity Indexes  
Broad Market Indexes  
Multi-­

Market Indexes  
Sector Indexes  
Style Indexes  
Fixed-­
Income Indexes  
Construction  
Types of Fixed-­Income Indexes  
Indexes for Alternative Investments  
Commodity Indexes  
Real Estate Investment Trust Indexes  
Hedge Fund Indexes  
Summary  
Practice Problems  
Solutions  

279
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283
284
284
285
293
295
295

Market Efficiency  
Introduction  
The Concept of Market Efficiency  

The Description of Efficient Markets  
Market Value versus Intrinsic Value  
Factors Contributing to and Impeding a Market’s Efficiency  
Transaction Costs and Information-­Acquisition Costs  
Forms of Market Efficiency  
Weak Form  
Semi-­
Strong Form  
Strong Form  
Implications of the Efficient Market Hypothesis  
Market Pricing Anomalies  
Time-­
Series Anomalies  
Cross-­
Sectional Anomalies  
Other Anomalies  
Implications for Investment Strategies  

317
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325
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338

indicates an optional segment

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Contents

Behavioral Finance  
Loss Aversion  
Herding  
Overconfidence  
Information Cascades  
Other Behavioral Biases  
Behavioral Finance and Investors  
Behavioral Finance and Efficient Markets  
Summary  
Practice Problems  
Solutions  

338
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340
340
341
341
341
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347

Study Session 13


Equity Investments (2)  

349

Reading 39

Overview of Equity Securities  
Introduction  
Equity Securities in Global Financial Markets  
Types and Characteristics of Equity Securities  
Common Shares  
Preference Shares  
Private versus Public Equity Securities  
Investing in Non-­Domestic Equity Securities  
Direct Investing  
Depository Receipts  
Risk and Return Characteristics of Equity Securities  
Return Characteristics of Equity Securities  
Risk of Equity Securities  
Equity Securities and Company Value  
Accounting Return on Equity  
The Cost of Equity and Investors’ Required Rates of Return  
Summary  
Practice Problems  
Solutions  

351
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352

357
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365
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385

Reading 40

Introduction to Industry and Company Analysis  
Introduction  
Uses of Industry Analysis  
Approaches to Identifying Similar Companies  
Products and/or Services Supplied  
Business-­
Cycle Sensitivities  
Statistical Similarities  
Industry Classification Systems  
Commercial Industry Classification Systems  
Governmental Industry Classification Systems  

Strengths and Weaknesses of Current Systems  
Constructing a Peer Group  
Describing and Analyzing an Industry  
Principles of Strategic Analysis  
External Influences on Industry Growth, Profitability, and Risk  

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422

indicates an optional segment


Contents

Reading 41

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vii

Company Analysis  
Elements That Should be Covered in a Company Analysis  
Spreadsheet Modeling  
Summary  
Practice Problems  
Solutions  

429
430
433
434
438
442

Equity Valuation: Concepts and Basic Tools  
Introduction  
Estimated Value and Market Price  
Major Categories of Equity Valuation Models  
Present Value Models: The Dividend Discount Model  
Dividends: Background for the Dividend Discount Model  
The Dividend Discount Model: Description  
Preferred Stock Valuation  
The Gordon Growth Model  
Multistage Dividend Discount Models  
Multiplier Models  
Relationships among Price Multiples, Present Value Models, and
Fundamentals  

The Method of Comparables  
Illustration of a Valuation Based on Price Multiples  
Enterprise Value  
Asset-­
Based Valuation  
Summary  
Practice Problems  
Solutions  

445
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447
448
450
450
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456
459
463
468
469
472
475
477
479
483
486
492

GlossaryG-1


indicates an optional segment


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How to Use the CFA
Program Curriculum
Congratulations on your decision to enter the Chartered Financial Analyst (CFA®)

Program. This exciting and rewarding program of study reflects your desire to become
a serious investment professional. You are embarking on a program noted for its high
ethical standards and the breadth of knowledge, skills, and abilities (competencies)
it develops. Your commitment to the CFA Program should be educationally and
professionally rewarding.
The credential you seek is respected around the world as a mark of accomplishment and dedication. Each level of the program represents a distinct achievement in
professional development. Successful completion of the program is rewarded with
membership in a prestigious global community of investment professionals. CFA
charterholders are dedicated to life-­long learning and maintaining currency with the
ever-­changing dynamics of a challenging profession. The CFA Program represents the
first step toward a career-­long commitment to professional education.
The CFA examination measures your mastery of the core knowledge, skills, and
abilities required to succeed as an investment professional. These core competencies
are the basis for the Candidate Body of Knowledge (CBOK™). The CBOK consists of
four components:
■■


A broad outline that lists the major topic areas covered in the CFA Program
( />
■■

Topic area weights that indicate the relative exam weightings of the top-­level
topic areas ( />
■■

Learning outcome statements (LOS) that advise candidates about the specific
knowledge, skills, and abilities they should acquire from readings covering a
topic area (LOS are provided in candidate study sessions and at the beginning
of each reading); and

■■

The CFA Program curriculum that candidates receive upon examination
registration.

Therefore, the key to your success on the CFA examinations is studying and understanding the CBOK. The following sections provide background on the CBOK, the
organization of the curriculum, features of the curriculum, and tips for designing an
effective personal study program.

BACKGROUND ON THE CBOK
The CFA Program is grounded in the practice of the investment profession. Beginning
with the Global Body of Investment Knowledge (GBIK), CFA Institute performs a
continuous practice analysis with investment professionals around the world to determine the competencies that are relevant to the profession. Regional expert panels and
targeted surveys are conducted annually to verify and reinforce the continuous feedback about the GBIK. The practice analysis process ultimately defines the CBOK. The

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ix


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How to Use the CFA Program Curriculum

CBOK reflects the competencies that are generally accepted and applied by investment
professionals. These competencies are used in practice in a generalist context and are
expected to be demonstrated by a recently qualified CFA charterholder.
The CFA Institute staff, in conjunction with the Education Advisory Committee
and Curriculum Level Advisors, who consist of practicing CFA charterholders,
designs the CFA Program curriculum in order to deliver the CBOK to candidates.
The examinations, also written by CFA charterholders, are designed to allow you to
demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum.
As you structure your personal study program, you should emphasize mastery of the
CBOK and the practical application of that knowledge. For more information on the
practice analysis, CBOK, and development of the CFA Program curriculum, please
visit www.cfainstitute.org.

ORGANIZATION OF THE CURRICULUM
The Level I CFA Program curriculum is organized into 10 topic areas. Each topic area
begins with a brief statement of the material and the depth of knowledge expected. It
is then divided into one or more study sessions. These study sessions—19 sessions in
the Level I curriculum—should form the basic structure of your reading and preparation. Each study session includes a statement of its structure and objective and is
further divided into assigned readings. An outline illustrating the organization of
these 19 study sessions can be found at the front of each volume of the curriculum.
The readings are commissioned by CFA Institute and written by content experts,
including investment professionals and university professors. Each reading includes

LOS and the core material to be studied, often a combination of text, exhibits, and
in-­text examples and questions. A reading typically ends with practice problems followed by solutions to these problems to help you understand and master the material.
The LOS indicate what you should be able to accomplish after studying the material.
The LOS, the core material, and the practice problems are dependent on each other,
with the core material and the practice problems providing context for understanding
the scope of the LOS and enabling you to apply a principle or concept in a variety
of scenarios.
The entire readings, including the practice problems at the end of the readings, are
the basis for all examination questions and are selected or developed specifically to
teach the knowledge, skills, and abilities reflected in the CBOK.
You should use the LOS to guide and focus your study because each examination
question is based on one or more LOS and the core material and practice problems
associated with the LOS. As a candidate, you are responsible for the entirety of the
required material in a study session.
We encourage you to review the information about the LOS on our website (www.
cfainstitute.org/programs/cfa/curriculum/study-­sessions), including the descriptions
of LOS “command words” on the candidate resources page at www.cfainstitute.org.

FEATURES OF THE CURRICULUM
OPTIONAL
SEGMENT

Required vs. Optional Segments  You should read all of an assigned reading. In some
cases, though, we have reprinted an entire publication and marked certain parts of the
reading as “optional.” The CFA examination is based only on the required segments,
and the optional segments are included only when it is determined that they might


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How to Use the CFA Program Curriculum


help you to better understand the required segments (by seeing the required material
in its full context). When an optional segment begins, you will see an icon and a dashed
vertical bar in the outside margin that will continue until the optional segment ends,
accompanied by another icon. Unless the material is specifically marked as optional,
you should assume it is required. You should rely on the required segments and the
reading-­specific LOS in preparing for the examination.
Practice Problems/Solutions  All practice problems at the end of the readings as well as
their solutions are part of the curriculum and are required material for the examination.
In addition to the in-­text examples and questions, these practice problems should help
demonstrate practical applications and reinforce your understanding of the concepts
presented. Some of these practice problems are adapted from past CFA examinations
and/or may serve as a basis for examination questions.
Glossary   For your convenience, each volume includes a comprehensive glossary.
Throughout the curriculum, a bolded word in a reading denotes a term defined in
the glossary.
Note that the digital curriculum that is included in your examination registration
fee is searchable for key words, including glossary terms.
LOS Self-­Check  We have inserted checkboxes next to each LOS that you can use to
track your progress in mastering the concepts in each reading.
Source Material  The CFA Institute curriculum cites textbooks, journal articles, and
other publications that provide additional context or information about topics covered
in the readings. As a candidate, you are not responsible for familiarity with the original
source materials cited in the curriculum.
Note that some readings may contain a web address or URL. The referenced sites
were live at the time the reading was written or updated but may have been deactivated since then.
 
Some readings in the curriculum cite articles published in the Financial Analysts Journal®,
which is the flagship publication of CFA Institute. Since its launch in 1945, the Financial
Analysts Journal has established itself as the leading practitioner-­oriented journal in the

investment management community. Over the years, it has advanced the knowledge and
understanding of the practice of investment management through the publication of
peer-­reviewed practitioner-­relevant research from leading academics and practitioners.
It has also featured thought-­provoking opinion pieces that advance the common level of
discourse within the investment management profession. Some of the most influential
research in the area of investment management has appeared in the pages of the Financial
Analysts Journal, and several Nobel laureates have contributed articles.
Candidates are not responsible for familiarity with Financial Analysts Journal articles
that are cited in the curriculum. But, as your time and studies allow, we strongly encourage you to begin supplementing your understanding of key investment management
issues by reading this practice-­oriented publication. Candidates have full online access
to the Financial Analysts Journal and associated resources. All you need is to log in on
www.cfapubs.org using your candidate credentials.

Errata  The curriculum development process is rigorous and includes multiple rounds
of reviews by content experts. Despite our efforts to produce a curriculum that is free
of errors, there are times when we must make corrections. Curriculum errata are periodically updated and posted on the candidate resources page at www.cfainstitute.org.

xi

END OPTIONAL
SEGMENT


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How to Use the CFA Program Curriculum

DESIGNING YOUR PERSONAL STUDY PROGRAM
Create a Schedule  An orderly, systematic approach to examination preparation is

critical. You should dedicate a consistent block of time every week to reading and
studying. Complete all assigned readings and the associated problems and solutions
in each study session. Review the LOS both before and after you study each reading
to ensure that you have mastered the applicable content and can demonstrate the
knowledge, skills, and abilities described by the LOS and the assigned reading. Use the
LOS self-­check to track your progress and highlight areas of weakness for later review.
Successful candidates report an average of more than 300 hours preparing for
each examination. Your preparation time will vary based on your prior education and
experience, and you will probably spend more time on some study sessions than on
others. As the Level I curriculum includes 19 study sessions, a good plan is to devote
15−20 hours per week for 19 weeks to studying the material and use the final four to
six weeks before the examination to review what you have learned and practice with
practice questions and mock examinations. This recommendation, however, may
underestimate the hours needed for appropriate examination preparation depending
on your individual circumstances, relevant experience, and academic background.
You will undoubtedly adjust your study time to conform to your own strengths and
weaknesses and to your educational and professional background.
You should allow ample time for both in-­depth study of all topic areas and additional concentration on those topic areas for which you feel the least prepared.
As part of the supplemental study tools that are included in your examination
registration fee, you have access to a study planner to help you plan your study time.
The study planner calculates your study progress and pace based on the time remaining
until examination. For more information on the study planner and other supplemental
study tools, please visit www.cfainstitute.org.
As you prepare for your examination, we will e-­mail you important examination
updates, testing policies, and study tips. Be sure to read these carefully.
CFA Institute Practice Questions  Your examination registration fee includes digital
access to hundreds of practice questions that are additional to the practice problems
at the end of the readings. These practice questions are intended to help you assess
your mastery of individual topic areas as you progress through your studies. After each
practice question, you will be able to receive immediate feedback noting the correct

responses and indicating the relevant assigned reading so you can identify areas of
weakness for further study. For more information on the practice questions, please
visit www.cfainstitute.org.
CFA Institute Mock Examinations  Your examination registration fee also includes
digital access to three-­hour mock examinations that simulate the morning and afternoon sessions of the actual CFA examination. These mock examinations are intended
to be taken after you complete your study of the full curriculum and take practice
questions so you can test your understanding of the curriculum and your readiness
for the examination. You will receive feedback at the end of the mock examination,
noting the correct responses and indicating the relevant assigned readings so you can
assess areas of weakness for further study during your review period. We recommend
that you take mock examinations during the final stages of your preparation for the
actual CFA examination. For more information on the mock examinations, please visit
www.cfainstitute.org.


© CFA Institute. For candidate use only. Not for distribution.
How to Use the CFA Program Curriculum

Preparatory Providers  After you enroll in the CFA Program, you may receive numerous solicitations for preparatory courses and review materials. When considering a
preparatory course, make sure the provider belongs to the CFA Institute Approved Prep
Provider Program. Approved Prep Providers have committed to follow CFA Institute
guidelines and high standards in their offerings and communications with candidates.
For more information on the Approved Prep Providers, please visit www.cfainstitute.
org/programs/cfa/exam/prep-­providers.
Remember, however, that there are no shortcuts to success on the CFA examinations; reading and studying the CFA curriculum is the key to success on the examination. The CFA examinations reference only the CFA Institute assigned curriculum—no
preparatory course or review course materials are consulted or referenced.
SUMMARY
Every question on the CFA examination is based on the content contained in the required
readings and on one or more LOS. Frequently, an examination question is based on a
specific example highlighted within a reading or on a specific practice problem and its

solution. To make effective use of the CFA Program curriculum, please remember these
key points:

1 All pages of the curriculum are required reading for the examination except for
occasional sections marked as optional. You may read optional pages as background, but you will not be tested on them.

2 All questions, problems, and their solutions—found at the end of readings—are
part of the curriculum and are required study material for the examination.

3 You should make appropriate use of the practice questions and mock examinations as well as other supplemental study tools and candidate resources available
at www.cfainstitute.org.

4 Create a schedule and commit sufficient study time to cover the 19 study sessions,
using the study planner. You should also plan to review the materials and take
practice questions and mock examinations.

5 Some of the concepts in the study sessions may be superseded by updated
rulings and/or pronouncements issued after a reading was published. Candidates
are expected to be familiar with the overall analytical framework contained in the
assigned readings. Candidates are not responsible for changes that occur after the
material was written.

FEEDBACK
At CFA Institute, we are committed to delivering a comprehensive and rigorous curriculum for the development of competent, ethically grounded investment professionals.
We rely on candidate and investment professional comments and feedback as we
work to improve the curriculum, supplemental study tools, and candidate resources.
Please send any comments or feedback to You can be
assured that we will review your suggestions carefully. Ongoing improvements in the
curriculum will help you prepare for success on the upcoming examinations and for
a lifetime of learning as a serious investment professional.


xiii


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Corporate Finance

STUDY SESSION
Study Session 10
Study Session 11

Corporate Finance (1)
Corporate Finance (2)

TOPIC LEVEL LEARNING OUTCOME
The candidate should be able to evaluate a company’s corporate governance; to analyze a capital budgeting problem; to estimate a company’s cost of capital; to evaluate
a company’s operating and financial leverage and its working capital management.
Some academic studies have shown that well governed companies may perform
better in financial terms. Increasingly, investment approaches that consider environmental, social, and governance factors, known as ESG, are being adopted. In
addition to good governance practices, management decisions regarding investment
and financing also play a central role in corporate profitability and performance. To
remain in business as a going concern and to increase shareholder value over time,
management must consistently identify and invest in profitable long-­term capital
projects relative to cost of capital (financing) and make optimal use of leverage and
working capital in day to day operations.


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© CFA Institute. For candidate use only. Not for distribution.


© CFA Institute. For candidate use only. Not for distribution.

C o r po r ate F inance

10

STUDY SESSION

Corporate Finance (1)

This study session provides an introduction to corporate governance and investing

and financing decisions. An overview of corporate governance is presented along with
a framework for understanding and analyzing corporate governance and stakeholder
management. The growing impact of environmental and social considerations in investing is also highlighted. Capital budgeting and the assessment of capital investments
are covered next. The session ends with practical techniques to estimate a company’s
or project’s cost of capital.

READING ASSIGNMENTS
Reading 31

Introduction to Corporate Governance and Other
ESG Considerations
by Assem Safieddine, PhD, Young Lee, CFA, Donna F.

Anderson, CFA, and Deborah Kidd, CFA

Reading 32

Capital Budgeting
by John D. Stowe, PhD, CFA, and Jacques R. Gagné,
FSA, CFA, CIPM

Reading 33

Cost of Capital
by Yves Courtois, CMT, MRICS, CFA, Gene C. Lai,
PhD, and Pamela Peterson Drake, PhD, CFA

© 2019 CFA Institute. All rights reserved.


© CFA Institute. For candidate use only. Not for distribution.


© CFA Institute. For candidate use only. Not for distribution.

READING

31

Introduction to Corporate Governance
and Other ESG Considerations
by Assem Safieddine, PhD, Young Lee, CFA, Donna F. Anderson, CFA, and
Deborah S. Kidd, CFA

Assem Safieddine, PhD, is at Suliman Olayan Business School, American University of
Beirut (Lebanon). Young Lee, CFA, is at MacKay Shields LLC (USA) and MacKay Shields
UK LLP (United Kingdom). Donna F. Anderson, CFA (USA). Deborah S. Kidd, CFA (USA).

LEARNING OUTCOMES
Mastery

The candidate should be able to:
a. describe corporate governance;
b. describe a company’s stakeholder groups and compare interests of
stakeholder groups;
c. describe principal–agent and other relationships in corporate
governance and the conflicts that may arise in these relationships;
d. describe stakeholder management;

e. describe mechanisms to manage stakeholder relationships and
mitigate associated risks;

f. describe functions and responsibilities of a company’s board of
directors and its committees;
g. describe market and non-­market factors that can affect
stakeholder relationships and corporate governance;

h. identify potential risks of poor corporate governance and
stakeholder management and identify benefits from effective
corporate governance and stakeholder management;

i. describe factors relevant to the analysis of corporate governance
and stakeholder management;
j. describe environmental and social considerations in investment

analysis;

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

© 2019 CFA Institute. All rights reserved.


© CFA Institute. For candidate use only. Not for distribution.
Reading 31 ■ Introduction to Corporate Governance and Other ESG Considerations

6

1

2

INTRODUCTION
Weak corporate governance is a common thread found in many company failures. A
lack of proper oversight by the board of directors, inadequate protection for minority
shareholders, and incentives at companies that promote excessive risk taking are
just a few of the examples that can be problematic for a company. Poor corporate
governance practices resulted in several high-­profile accounting scandals and corporate bankruptcies over the past several decades and have been cited as significantly
contributing to the 2008–2009 global financial crisis.
In response to these company failures, regulations have been introduced to
promote stronger governance practices and protect financial markets and investors.
Academics, policy makers, and other groups have published numerous works discussing the benefits of good corporate governance and identifying core corporate
governance principles believed to be essential to ensuring sound capital markets and
the stability of the financial system.
The investment community has also demonstrated a greater appreciation for the

importance of good corporate governance. The assessment of a company’s corporate
governance system, including consideration of conflicts of interest and transparency
of operations, has increasingly become an essential factor in the investment decision-­
making process. Additionally, investors have become more attentive to environment
and social issues related to a company’s operations. Collectively, these areas often are
referred to as environmental, social, and governance (ESG).
Section 2 of this reading provides an overview of corporate governance, including
its underlying principles and theories. Section 3 discusses the various stakeholders of
a company and conflicts of interest that exist among stakeholder groups. Section 4
describes stakeholder management, reflecting how companies manage their relationships with stakeholders. Section 5 focuses on the role of the board of directors and its
committees as overseers of the company. Section 6 explores certain key factors that
affect corporate governance. Section 7 highlights the risks and benefits that underlie
a corporate governance structure. Section 8 provides an overview of corporate governance issues relevant for investment professionals. Finally, Section 9 discusses the
growing effect of environmental and social considerations in the investment process.

CORPORATE GOVERNANCE OVERVIEW
Corporate governance can be defined as “the system of internal controls and procedures by which individual companies are managed. It provides a framework 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.”1
Corporate governance practices differ among countries and jurisdictions, and even
within countries different corporate governance systems may co-­exist. The corporate
governance systems adopted in most of the world typically reflect the influences of
either shareholder theory or stakeholder theory to a varying extent, as well as historical,
cultural, legal, political, and other influences specific to a region.

1  CFA Institute Centre for Financial Market Integrity, The Corporate Governance of Listed Companies: A
Manual for Investors, 2nd ed. (Charlottesville, VA: CFA Institute, 2009).



© CFA Institute. For candidate use only. Not for distribution.
Corporate Governance Overview

Shareholder theory takes the view that the most important responsibility of a
company’s managers is to maximize shareholder returns. Stakeholder theory broadens a company’s focus beyond the interests of only its shareholders to its customers,
suppliers, employees, and others who have an interest in the company. The approach
to corporate governance in a given country typically places greater emphasis on one
of the two theories but can also exhibit a combination of the two. Notwithstanding the
system of corporate governance used, nearly all companies depend on contributions
from a number of stakeholders for their long-­term success. The company’s strategy
is set by the board of directors, which also oversees management; in turn, the company’s strategy is executed by its managers; financial capital to fund the company’s
activities and operations is supplied by shareholders, creditors, and suppliers; human
capital is provided by employees; and demand for goods and services comes from
customers. Other stakeholders include governments and regulators, which seek to
protect the interests and well-­being of their citizens. Certain external forces, such as
the legal environment and competition, affect the way a company operates and the
relationships among its stakeholders.
Two reports issued during the 1990s, the Cadbury Report and the Principles of
Corporate Governance, were particularly influential in shaping the global corporate
governance landscape. In 1991, the Committee on the Financial Aspects of Corporate
Governance was established in the United Kingdom by the Financial Reporting
Council, the London Stock Exchange, and the accountancy profession to examine
corporate governance. In the following year, the report of the committee—commonly
referred to as the Cadbury Report, after its chairman—defined corporate governance
simply as “the system by which companies are directed and controlled.” The report
focused on the responsibilities of a company’s board of directors, shareholders, and
auditors, with shareholders implicitly identified as the primary stakeholder. In 1999,
the Organisation for Economic Co-­operation and Development (OECD) produced
the Principles of Corporate Governance, which expanded the scope of corporate

governance to consider the interests of other stakeholders—notably employees, creditors, and suppliers. According to the OECD, “Corporate governance includes a set
of relationships between a company’s management, its board, its shareholders, and
other stakeholders.” The Principles of Corporate Governance, which was revised in
2004 and again in 2015, also discusses potential positive outcomes of good corporate
governance practices (including financial market stability and economic growth) and
includes standards and guidelines designed to evaluate and improve the corporate
governance framework throughout the world.
There is evidence that some movement toward global convergence of corporate
governance systems is underway. One trend is the increased acceptance and adoption
of corporate governance regulations with similar principles from one jurisdiction
to another. For example, a number of countries implemented regulations similar to
those of the US Sarbanes–Oxley Act of 2002 (SOX) in response to corporate and
accounting scandals of the early 2000s. Although these regulations are not identical,
they share the same objective of improving internal controls and restoring investor
confidence in financial disclosures. Another trend is initiatives by international agencies to build greater consensus on important corporate governance principles. The
Principles of Corporate Governance, for example, has been ratified by more than 30
member countries, representing a broad range of corporate governance models. The
Principles of Corporate Governance do not mandate, or even promote, the adoption
of a single corporate governance regime; rather, the principles were designed to serve
as a framework that can be adopted by any number of corporate governance systems.

7


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Reading 31 ■ Introduction to Corporate Governance and Other ESG Considerations

8

EXAMPLE 1 


Corporate Governance Overview
Which statement regarding corporate governance is most accurate?
A Most countries have similar corporate governance regulations.
B A single definition of corporate governance is widely accepted in practice.
C Both shareholder theory and stakeholder theory consider the needs of a
company’s shareholders.

Solution:
C is correct. Both shareholder and stakeholder theories consider the needs of
shareholders, with the latter extending to a broader group of stakeholders. A
is incorrect because corporate governance regulations differ across countries,
although there is a trend toward convergence. B is incorrect because a universally
accepted definition of corporate governance remains elusive.

3

COMPANY STAKEHOLDERS
A corporate governance system is likely to be influenced by several stakeholder groups.
These groups do not necessarily share similar goals or needs; in fact, the interests of any
one group may conflict with the interests of another group. The varying influences of
these groups are important considerations for investment professionals when analyzing
a corporate governance system. This section provides an overview of a corporation’s
primary stakeholder groups, followed by a discussion of principal–agent considerations
and the conflicts that may arise among the groups.

3.1  Stakeholder Groups
The primary stakeholder groups of a corporation consist of shareholders, creditors,
managers (or executives), other employees, board of directors, customers, suppliers,
and governments/regulators (and, by extension, affected individuals and community

groups). The interests of each of these groups are discussed in the following sections.
3.1.1  Shareholders
Shareholders own shares of stock in a corporation and are entitled to certain rights,
such as the right to receive dividends and to vote on certain corporate issues.2 In terms
of capital structure, shareholders are the most junior class of capital providers; in
case of a company bankruptcy, shareholders receive proceeds only after all creditors’
claims are paid. Shareholder interests are, therefore, typically focused on growth in
corporate profitability that maximizes the value of a company’s equity.
As a company grows in size and its operations and structure become more complex, most individual shareholders have little involvement in the company’s activities.
Shareholders maintain control over the company through their power to elect the board
of directors and vote for specified resolutions. The board of directors is expected to
represent shareholders—protecting their interests, appointing senior management,
providing strategic direction, and monitoring company and management performance.

2  />

© CFA Institute. For candidate use only. Not for distribution.
Company Stakeholders

In publicly traded companies that have dispersed ownership, the voting power in
general meetings is distributed among a large number of shareholders. But in some
companies, a particular shareholder or block of shareholders may hold a percentage
of shares that gives them sufficient voting power to control the election of the board
of directors and to influence the approval or blockage of a company resolution; these
shareholders are known as controlling shareholders. In contrast, non-­controlling
shareholders (minority shareholders) hold a much smaller proportion of a company’s
outstanding shares, resulting in a more limited ability to exercise control in voting
activities.
3.1.2  Creditors
Creditors, most commonly bondholders and banks, are a company’s lenders and the

providers of debt financing. Creditors do not hold voting power (unlike common
shareholders) and typically have limited influence over a company’s operations.
Creditors may protect themselves and exert some control over a company by using
covenants, which restrict activities of the borrower. In return for capital provided,
creditors expect to receive interest and principal payments. These payments are
pre-­determined from the terms of a debt contract and are typically not contingent
on the company’s performance. Creditors usually do not participate in a company’s
superior performance beyond receiving promised interest and principal payments.
The company’s ability to generate cash flows, mainly through its operations, is the
primary source of payments for creditors. Consequently, creditors generally prefer
stability in company operations and performance, which contrasts with the interests
of shareholders, who generally are inclined to tolerate higher risks in return for higher
return potential from strong company performance.
3.1.3  Managers and Employees
Senior executives and other high-­level managers are normally compensated through
salary, bonuses, equity-­based remuneration (or compensation),3 and certain perquisites. As a result, managers may be motivated to maximize the value of their total
remuneration while also protecting their employment positions. Lower-­level employees normally seek fair remuneration, good working conditions, access to promotions,
career development opportunities, training and development, job security, and a safe
and healthy work environment.
As with shareholders and creditors, managers and employees have a significant
interest in the company’s viability. Managers and employees tend to benefit if the
company performs well and are among the most adversely affected stakeholders if
a company’s financial position weakens. Despite some similarities, the interests of
managers and employees and other stakeholders can conflict. For example, a company
may be presented with a takeover offer that is attractive to shareholders but would
jeopardize the interests of managers in preserving their employment at the company.
3.1.4  Board of Directors
A company’s board of directors is elected by shareholders to protect shareholders’
interests, provide strategic direction, and monitor company and management performance. A board is typically structured as either one-­tier or two-­tier.
A one-­tier structure consists of a single board of directors, composed of executive

and non-­executive directors. Executive (sometimes called “internal”) directors are
employees, typically senior managers, of the company. Non-­executive (sometimes

3  The terms “remuneration” and “compensation” are typically interchangeable, with compensation generally
used in North America and remuneration generally used outside North America. In this reading, unless
specifically identified with North America, we primarily use “remuneration”.

9