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LM02 Investors and Other Stakeholders 2025 Level I Notes © IFT. All rights reserved 1 LM02 Investors and Other Stakeholders 1. Introduction ........................................................................................................................................................... 2 2. Financial Claims of Lenders and Shareholders ........................................................................................ 2 3. Corporate Stakeholders and Governance .................................................................................................. 4 4. Corporate ESG Considerations ....................................................................................................................... 7 Summary ...................................................................................................................................................................10 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM02 Investors and Other Stakeholders 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  Securities issued by corporations – debt and equity, the differences in their risk-return profiles, and the conflicts of interest between debt and equity.  The various stakeholders of a company and their interests.  ESG considerations in investment analysis 2. Financial Claims of Lenders and Shareholders Debt Versus Equity The key differences between debt and equity financing are:  Debt represents a contractual obligation on the part of the issuing company. The company is obligated to make the promised interest and principal payments to debtholders. Equity does not involve a contractual obligation.  Debtholders have a prior legal claim on the company’s cash flows and assets. Their claims have to be fully paid before the company can make distributions to equity owners. Equity holders have a residual claim on the company’s net asset after all other stakeholders have been paid.  Interest payments on debt are typically tax-deductible. Whereas, dividend payments on equity are not tax deductible.  Equity represents a more permanent source of capital. It has no finite term and includes voting rights. In contrast, debt represents a cheaper source of capital. It has a stated finite term and no voting rights. Debt Versus Equity: Risk and Return Investor’s perspective: From an investor’s perspective, investing in equity is riskier than investing in debt. Debtholders receive predictable coupon payments, whereas payments to shareholders are at the company’s discretion. However, equityholders do have a residual claim, which means they are entitled to whatever firm value remains after other stakeholders have been paid off, giving them unlimited upside potential. Therefore, equityholders have an interest in the ongoing maximization of company value (net assets less liabilities), which directly corresponds to the value of their shareholder wealth. On the other hand, no matter how profitable a company becomes, debtholders will never receive more than their interest and principal repayment. Their maximum return is capped. They are therefore interested in assessing the likelihood of timely debt repayment and the
LM02 Investors and Other Stakeholders 2025 Level I Notes © IFT. All rights reserved 3 risk associated with the company’s ability to meet its debt obligations. For both equityholders and debtholders, their initial investment represents their maximum possible loss. These points are summarized in the table below: Investor Perspective Equity Debt Tenor Indefinite Term (e.g. 10 years) Return potential Unlimited Capped Maximum loss Initial investment Initial investment Investment risk Higher Lower Desired outcome Maximize firm value Timely repayment Issuer Perspective: From the company’s perspective, issuing debt is riskier than issuing equity. If a company fails to meet its contractual obligations, it may be forced to declare bankruptcy and liquidate. Although riskier, the cost of debt is lower than the cost of equity (this is because the returns to debtholders are capped). A company generating stable, predictable cash flows generally prefers to borrow money rather than issuing additional equity to raise capital. Issuing more equity also dilutes the upside return for existing equity owners given that residual value must be shared across more owners. However, early-stage companies or companies with unpredictable cash flows that find it difficult to borrow may prefer to raise capital through equity to avoid the risk of default. In the event of a default, a company does have some options to try and avoid bankruptcy. It can renegotiate more favorable terms with the debtholders. However, if things don’t improve, eventually the assets may have to be liquidated to raise as much money as possible to return to the bondholders. Alternatively, the company may be reorganized, with existing shareholders getting wiped out and bondholders becoming the new shareholders of the reorganized company. These points are summarized in the table below: Issuer Perspective Equity Debt Capital cost Higher Lower Attractiveness Creates dilution, may be only option when issuer cash flows are absent or unpredictable Preferred when issuer cash flows are predictable Investment risk Lower, holders cannot force liquidation Higher, adds leverage risk Conflicts of Interest among Lenders and Shareholders
LM02 Investors and Other Stakeholders 2025 Level I Notes © IFT. All rights reserved 4 Potential conflicts of interest can occur between debtholders and equityholders. Debtholders would prefer that the company invests in less risky projects that generate predictable cash flows, even if those cash flows are relatively small. Equityholders, on the other hand, would prefer that the company invests in riskier projects with a much higher return potential. 3. Corporate Stakeholders and Governance A stakeholder is any individual or group that has a vested interest in a company. The primary stakeholder groups of a company include:  Shareholders and creditors: provide capital to finance the company’s activities  Board of directors: Serves as the steward of the company  Managers: Execute the strategy set by the board and run day-to-day operations  Employees: Provide human capital for the day-to-day operations of the company  Customers: Buy the company’s products and services  Suppliers: Provide raw materials as well as goods and services that cannot be produced efficiently internally.  Government and regulators: Dictate the rules and regulations governing the company. Exhibit 6 from the curriculum illustrates these relationships. Shareholders versus Stakeholders Traditional corporate governance frameworks were based on the ‘shareholder theory’, however, many companies are now moving to corporate governance frameworks based on the ‘stakeholder theory’.