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CFA Level II

Contents
ETHICAL AND PROFESSIONAL STANDARDS..........................................................................5
QUANTITATIVE METHODS .........................................................................................................6
Hypothesis Testing ....................................................................................................................6
Test Population Means ..............................................................................................................6
Difference in means test for independent samples Equal Variance..........................................6
Unequal Variance : ....................................................................................................................6
Mean differences test for dependent samples...........................................................................6
Variance Tests............................................................................................................................6
Correlation Coefficient, r ..........................................................................................................7
Multiple Regression ..................................................................................................................7
Regression Analysis Problems ..................................................................................................7
ECONOMICS ...................................................................................................................................8
Growth Accounting Equation....................................................................................................8
Neoclassical Growth Theory.....................................................................................................8
Endogenous Growth Theory .....................................................................................................8
Factors Promoting Economic Growth.......................................................................................8
Purchasing Power Parity ...........................................................................................................8
International Fisher Relation.....................................................................................................8
Uncovered interest Rate Parity..................................................................................................9
Interest Rate Parity....................................................................................................................9
Asset Market Approach.............................................................................................................9
Currency Arbitrage....................................................................................................................9
Real Exchange Rate Risk ..........................................................................................................9
Foreign Currency Risk Premium (FCRP) ...............................................................................10
International CAPM................................................................................................................10
Currency Exposure..................................................................................................................10
Product Life Cycle ..................................................................................................................10
Regression to Mean.................................................................................................................10
PORTFOLIO MANAGEMENT .....................................................................................................11
Measuring Risk .......................................................................................................................11
Portfolio Risk and Return .......................................................................................................11
Efficient Frontier and Optimal Portfolio .................................................................................11
Systematic Risk vs. Unsystematic Risk ..................................................................................11
Capital Market Line(CML) .....................................................................................................12
SML and CAPM .....................................................................................................................12
SML vs. CML .........................................................................................................................12
Arbitrage Pricing Theory(APT) ..............................................................................................12
Testing CAPM.........................................................................................................................12
Multifactor Models .................................................................................................................13
Portfolio management Planning Process.................................................................................13
FINANCIAL STATEMENT ANALYSIS .......................................................................................14
Inventory Analysis ..................................................................................................................14

CFA Level II

Depreciation and Impairment..................................................................................................14


Off-Balance Sheet Debt ..........................................................................................................14
Lease Classification ................................................................................................................14
Effect of Classification on Lessor ...........................................................................................15
Marketable Securities Classification.......................................................................................15
Account for Inter-corporate Investments ................................................................................15
Business Combinations ...........................................................................................................15
Purchase Method: Constructing Consolidated Statements......................................................15
Effect of Pension Plan Assumptions .......................................................................................16
Pension Calculations ...............................................................................................................16
Pension Adjustments ...............................................................................................................16
Multinational Operations ........................................................................................................17
Cash Flow Measures ...............................................................................................................17
Basic and Diluted EPS ............................................................................................................17
Most Critical Ratios ................................................................................................................17
3-component DuPont: .............................................................................................................18
5-component DuPont: .............................................................................................................18
Sustainable Growth Rate.........................................................................................................18
CORPORATE FINANCE ...............................................................................................................19
Weighted Average Cost of Capital ..........................................................................................19
Capital Budgeting Expansion Project .....................................................................................19
Operating Leverage.................................................................................................................19
Financial Leverage..................................................................................................................19
Total Leverage.........................................................................................................................19
Optimal Capital Structure .......................................................................................................19
Dividend Signaling Hypothesis...............................................................................................19
Good Reasons for Mergers......................................................................................................19
Bad Reasons for Mergers ........................................................................................................19
NPV of Merger........................................................................................................................20
Takeover Defense Measures ...................................................................................................20
EQUITY INVESTMENTS .............................................................................................................21
Alpha.......................................................................................................................................21
Taxes and International Investing ...........................................................................................21
Methods to Reduce Execution Costs.......................................................................................21
American Depository Receipts (ADRs)..................................................................................21
Franchise Value and Growth Process ......................................................................................21
Inflation Effects on Valuation .................................................................................................21
Valuation in Emerging Markets...............................................................................................21
Porters Five Forces ................................................................................................................22
Generic Competitive Strategies...............................................................................................22
Industry Analysis.....................................................................................................................22
Discounted Cash Flow (DCF) Methods..................................................................................22
Gordon Growth Model (GGM)...............................................................................................23
Present Value of Growth Opportunities ..................................................................................23

CFA Level II

Two Stage Growth Model ....................................................................................................23


H-Model..................................................................................................................................23
Solving for Required Return ...................................................................................................23
Strengths of multistage growth models:..................................................................................23
Limitations of multistage models:...........................................................................................24
Free Cash Flow to Firm (FCFF)..............................................................................................24
Free Cash Flow to Eqauity (FCFE).........................................................................................24
Single-Stage FCFF / FCFE Models ........................................................................................24
Two Stage FCFF / FCFF Models .........................................................................................24
Price to Earnings (P/E) Ratio ..................................................................................................24
Justified P/E ............................................................................................................................24
Normalization Methods: .........................................................................................................25
Price to Book (P/B) Ratio .......................................................................................................25
Price to Sales (P/S) Ratio ........................................................................................................25
Price to Cash Flow Ratios.......................................................................................................25
Method of Comparables..........................................................................................................26
Residual Income (RI)Valuation...............................................................................................26
Economic Value Added ...........................................................................................................26
Growth Duration Model..........................................................................................................26
DEBT INVESTMENTS .................................................................................................................27
Credit Analysis........................................................................................................................27
Bond Price Yield Relationship ................................................................................................27
Duration and Convexity ..........................................................................................................28
Yield Curve(Term Structure ) Shifts .......................................................................................28
Theories of the Term Structure................................................................................................28
Key Rate Duration ..................................................................................................................28
Valuing Option Free Bonds.....................................................................................................28
Value Bond with Embedded Option........................................................................................29
Option Adjusted Spread ..........................................................................................................29
Convertible Bonds...................................................................................................................29
MBS Prepayment Risk............................................................................................................29
CMO prepayment Risk ...........................................................................................................30
ABS Prepayment Risk ............................................................................................................30
MBS /ABS spread Analysis ....................................................................................................30
DERIVATIVES ...............................................................................................................................31
Forwards-No Arbitrage Pricing...............................................................................................31
Equity Forward .......................................................................................................................31
Forward on Fixed Income securities .......................................................................................31
Forward Rate Agreements.......................................................................................................31
Currency Forward(Interest Rate Parity ).................................................................................31
Futures Price ...........................................................................................................................31
Futures Arbitrage.....................................................................................................................32
Treasury Bond Futures ............................................................................................................32
Equity Futures .........................................................................................................................32

CFA Level II

Put-Call Parity.........................................................................................................................32
Caps and Floors.......................................................................................................................32
Binomial option Pricing Model...............................................................................................32
Black-Scholes Option Pricing Model......................................................................................32
Delta........................................................................................................................................33
Delta Neutral Hedging ............................................................................................................33
Gamma....................................................................................................................................33
Currency Swaps ......................................................................................................................33
Interest Rate Swaps.................................................................................................................33
Equity Swaps ..........................................................................................................................33
Swap Pricing and Valuation ....................................................................................................33
Swptions..................................................................................................................................34

CFA Level II

ETHICAL AND PROFESSIONAL STANDARDS


I Fundamental Responsibilities
I(A) Comply with laws Code/Standards
I(B) Do noe participate/assits in violations
II Responsibilities to Profession
II (A ) Use of Professional designation
II(B) professional nisconduct
II(C) prohibition against plagiarism
III Responsibilities to Employer
III (A) Inform employer of Code/Standards
III (B) duty to employer
III (C) disclosure of conflicts to employer
III (D)Disclosure of additional compensation
III (E) Responsibilities of supervisors
IV Responsibilities to Clients
IV (A.1) Reasonable basis and represent tations
IV (A.2) Research reports
IV (A.3) Independence and objectivity
IV(B.1) Fiduciary duties
IV(B.2) Portfolio recommendations/actions
IV(B.3) Fair dealing
IV(B.4) Priority of transactions
IV(B.5) Preservation of confidentiality
IV(B.6) Prohibition against misrepresentation
IV(B.7) Disclosure of conflicts to clients
IV(B.8) Disclosure of referral fees
V Responsibilities to Public
V(A) Dont use material nonpublic info
V(B) Performance presentation

CFA Level II

QUANTITATIVE METHODS
Hypothesis Testing
Type I error Rejecting H 0 when true
Type II error Failing to reject H 0 when false
a=probability of Type 1 error
Test Population Means
z=

x 0
x 0
;t =
, n 1, df
s/ n
s/ n
n<30
Z

n30
Z

Normal distribution
Known variance
Normal distribution
t
t or z
Unknown variance
Difference in means test for independent samples Equal Variance

t=

( x1 x2 ) ( 1 2 )
1/ 2

s 2p s 2p
+
n n
2
1

, n1 + n2 2 df

(n1 1) s12 + (n2 1) s22


s =
n1 + n2 2
2
p

Unequal Variance :

t=

( x1 x2 ) ( 1 2 )
1/ 2

s12 s22
+
n1 n2

Mean differences test for dependent samples


t=

d
, n 1 df
sd / n

Variance Tests
Population variance x 2 =

(n 1) s 2

Equality of variances : F =

02

, n 1 df

s12
, n1 1, n2 1 df s12 > s 22
s 22

CFA Level II

Correlation Coefficient, r
Measure of strength of linear relationship (correlation ) between two variables

r1, 2 =

cov(1,2)
s1 s2

Test H 0 :=0:

t stat =

r n2
1 r 2

, n 2 df

Multiple Regression
Yi = bo + (b1 X li ) + (b2 X 2i ) + (b3 X 3i ) + i

Test statistical significance of b:Ho:b=0


t = b / sb , n k 1 df

Confidence Interval: b j t c sbj

SST=SSR+SSE
MSR=SSR/k
MSE=SSE/(n-k-1)
Test statistical significance of regression
F=MSR/MSE with k and n-k-1 df(1-tailed )
Standard error of the estimate (SEE=MSE ) smaller SEE means better fit
Coefficient of determination(R2=SSR/SST).% of variability of Y explained by
Xs ;higher R2 means better fit
Regression Analysis Problems
Heteroskedasticity: Non-constant error variance Detect with Breusch-Paen test
Autocorrelation: Correlation among error terms Detect with Durbin Watson test
positive autocorrelation if DW< d1
Multicollinearity: High correlation among Xs. Detectif F-test significant t-tests
insignificant

CFA Level II

ECONOMICS
Growth Accounting Equation
Total economic output growth=(labor share labor input growth)+(growth of total
factor productivity ) (a,k,a technological progress )
(Percapita economic output growth)=( capital share)(capital-labor ratio
growth )+(growth of total factor productivity )
Neoclassical Growth Theory
z Assumes diminishing marginal product of capital (MPC) and curved savings
function Predicts that an increase in savings rate will
Increase the level of per capita output
Not change long-run growth in total output which equals population growth
in long-run
Not change growth rate in per capita output withch equals technological
progress in long-run
Endogenous Growth Theory
z Assumes constant MPC to society and a straight line savings curve but
diminishing MPC to individual firms
Predicts that an increase in savings rate will increase long run growth in per
capita output
Factors Promoting Economic Growth
z High savings/capital investment
z Human capital development
z Balanced budgets tight monetary policy
z Free trade
z Adequate legal system
z Low population growth
z Technological advancement and sharing
Purchasing Power Parity
Law of one price a single clearly comparable good should have same real price in all
countries Relative PPP Countries with high inflation rates should see their currencies
depredate

s1 1 + iFC
=
, Sin FC / DC
s0 1 + iDC
International Fisher Relation
Assumes real interest rates are equal across borders so interest differential equals
inflation differential

CFA Level II

1 + rFC 1 + E (iFC )
=
1 + rDC 1 + E (iDC )
rFC rDC E (iFC ) E (iDC )

Uncovered interest Rate Parity


Countries with high minimal interest rates should see their currencies depreciate

E ( s1 ) 1 + rFC
, S _ in FC / DC
=
s0
1 + rDC
%S rFC rDC

Interest Rate Parity


Countries with high minimal interest rates will have their currencies sell at forward
discount to prevent arbitrage

F 1 + rFC
=
, Sand F in FC / DC
S 0 1 + rDC
F S0
rFC rDC
S0
Asset Market Approach
Money supply increase will cause:
z Short-run DC depreciation form inflation Increase and rate decrease.
z Long-run DC appreciation to PPP level.
z Overall, DC depreciates from initial level PPP level.
Currency Arbitrage
2-currency arbitrage
bid-ask midpoint range =

1
1
1

2
S f S f (1 TC )
S f

Triangular arbitrage opportunity if :

FC1

DC bid

DC


FC
2 bid

FC2
1

FC
1 bid

Real Exchange Rate Risk


Real exchange rate (X) is:

P
X = S FC
PDC

, S in DC/FC

CFA Level II

Real exchange rate is possibility of nominal exchange rate changes not explained by
inflation differentials.

Foreign Currency Risk Premium (FCRP)


Expected foreign currency appreciation less interest rate differential:
FCRP = E (%S ) (rDC rFC ) , S in

DC/FC

International CAPM
DC return =FC interest rate +FC appreciation = DC interest rate + FCRP.
E ( R ) = RF + ( G MRPG ) + ( 1 FCRP1 ) + ( 2 FCRP2 )

= FC + 1
Currency Exposure
Exporters are hurt ad importers are helped by domestic currency appreciation.
Traditional model predicts domestic currency depreciation will improve
competitiveness and increase equity prices (negative currency exposure).
Money demand model predicts positive currency exposure; decreased LR economic
activity causes currency depreciation and lower equity prices.
Product Life Cycle
Development
Expansion

Maturity

Decline

Regression to Mean
Industry competition drives margins to long-run normal level; economic profit = 0.

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CFA Level II

PORTFOLIO MANAGEMENT
Measuring Risk
From expectation data
N

variance= 2 = [ri E(r)] Pi


i=1

s tan dard deviation = = 2

Portfolio Risk and Return


E (rp ) = wa E (ra ) + Wb E (rb )
2
ab
= ( wa2 a2 ) + ( wb2 b2 ) + (2wa wb pab a b )

The lower the correlation the greater the benefits of diversification


Efficient Frontier and Optimal Portfolio
Efficient portfolios have highest return for given level of risk or lowest risk for given
level of return
Optimal portfolio is intersection of efficient frontier with I curves
E(RP)

Risk P

Systematic Risk vs. Unsystematic Risk


Systematic risk cannot be diversified away ;relevant risk for security measured with
beta

i =

cov(stock , market )
var(market )

Unsystematic risk can be diversified away

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CFA Level II

Capital Market Line(CML)


E (rM ) rf

E (rp ) = rf + p

Capital market line

E(RP)
Efficient Frontier
Market Portfolio
Risk P

SML and CAPM

E (ri ) = rf + { i [ E (rm ) r f ]}
Security market line

E(RP)

E(RM)
Market Portfolio
Rf
Risk P
1

SML vs. CML


Risk measure for CML is total risk only market portfolio and risk-free asset plot on
CML
Risk measure for SML is beta all properly priced securities and portfolios plot on
SML
Arbitrage Pricing Theory(APT)
Main advantage over CAPM is that APT requires fewer assumptions to derive APT
may be a more general model Specifically APT does not require the following
(historic ) assumptions that are requited by CAPM
Investors have quadratic utility functions
Security returns are normally distributed
All investors hold market portfolio
Testing CAPM
security betas are unstable portfolio betas are stable
Rolls Critique CAPM not testable because cannot observe market portfolio
Benchmark error problem cannot identify market portfolio empirical SML is too flat
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CFA Level II

Multifactor Models
Macroeconomic factors Unexpected changes in inflation real GDP consumer
confidence yield curve
Microeconomic factors (Fama-French model ) Excess market returns large-cap minus
small cap returns value ninus growth returns stock return momentum
Portfolio management Planning Process
z Analyze risk constraints liquidity time horizon legal and regulatory taxes unique
circumstances
z Develop IPS client description purpose duties objectives and constraints
performance review schedule modification policy rebalancing guidelines
z Determine investment strategy passive active semi-active
z Select strategic asset allocation asset class weightings based on capital market
expectations

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CFA Level II

FINANCIAL STATEMENT ANALYSIS


Inventory Analysis
z INVEND=INVBGN + Pur-COGS
z IF Price
LIFO COGSothers(taxes, net income, inventory balances,
NWC)so determine the relevant ratios.
FIFO COGSothers(taxes, net income, inventory balances,
NWC)so determine the relevant ratios.
FIFO
COGs

LIFO
COGS

Depreciation and Impairment


z accelerated SL depreciation: depreciationfuture net income, ROA,
ROE.
z Asset Impairment Obligation (AIO) :
todays assets, shareholders equity, net income, ROA, and ROE;
increases todays debt/equity
future depreciation expense, debt/equity; future net income, ROA ,
ROE , and asset turnover.
Off-Balance Sheet Debt
z Sale of A/R with recourse and take-or-pay contracts
parent assets, liabilities.
Lease Classification
Lease is capital lease to lessee if one holds:
z Title is transferred to lessee at end
z Bargain purchase option
z Lease period 75% of assets life.
z PV of payments > 90% of FV.
Lease is capital lease to lessor if all hold:
z If lessee regards the lease as Capital Lease
z Predictable collectability of the A/R.
z Cost can be determnined.
Sales-type (capital) lease:;
Direct financing :.

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CFA Level II

Effect of Classification on Lessor


z Sales-type
lessor is equipment dealer
Will report profits and has higher assets at the beginning; earlier profits, same
total CF, CFO(Because of Less interest revenue).
z Direct Financing
if the lessor is not the equipment dealer
Will reports no profits, no change in assets at the beginning; later profits,
same total CF, and more CFO(Because of More interest revenue)
Marketable Securities Classification
z Held to-maturity
B/S: Cost ; I/S : interest, realized gains/losses
z Available for sale
B/S: FMV, unrealized gains/losses; I/S: interest, realized gains/losses,
dividends
z Trading
B/S: FMV; I/S: interest, realized gains/losses, dividends, realized and
unrealized gains/losses
Account for Inter-corporate Investments
z Cost/market

Equity ratio <20%; no influence.


z Equity
20% Equity ratio 50%; significant influence.
z Consolidation

Equity ratio >50%; control.


Business Combinations
Under IASB GAAP pooling method:
z No identification of acquirer and acquired.
z B/S values consolidated at historical cost.
z Prior operating results restated.
Under IASB and U.S. GAAP purchase methods:
z Acquirer and acquired identified.
z Acquired firm B/S restated to FMV.
z Prior results disclosed, not restated.
z Goodwill

U.S- annual impairment test; IASB annual amortization.


z In-process R&D

U.S expense immediately; IASB capitalize and amortize.


Purchase Method: Constructing Consolidated Statements
z Revalue all tangible assets/liability of acquired to FMV.
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CFA Level II

z
z
z

Recognize intangible assets/liabilities of acquired firm.


Allocate remaining purchase price to goodwill (net of assumed liabilities).
Eliminate common equity of acquired firm; replace with MV of shares issued.

Effect of Pension Plan Assumptions


z Higher discount rate
PBO, ABO, service cost, pension expense;
funded status; interest cost.
z Lower compensation growth rate
PBO, service cost, interest cost, pension expense;
funded status.
z Higher expected return
pension expense.
z Lower healthcare cost inflation rate
decrease APBO & post-retirement benefit expense.
Pension Calculations
FV of plan assets (beginning)
+
actual ROA
+
contributions
+/- other factors
benefits paid
=
FV of plan assets (ending)
PBOt-1
+ service cost
+ interest cost
+/- actuarial losses/gains and amendments
+/- other factors
- benefits paid
PBOt
Funded status = FV of plan assets PBO funded status
+/- unrecognized actuarial losses (gains)
+ unrecognized prior service cost
+/- unrecognized prior transfer obligation (asset )
+/- amortization of actuarial losses/gains
= net pension asset (liability)

Pension Adjustments
z Adjust pension liability/asset to reflect funded status.
z Recurring cost = Service cost + Interest cost
z Gross pension cost = Recurring cost + actuarial losses + Plan amendments
z Non-smoothed cost (credit) = Gross pension cost Actual ROA
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CFA Level II

Multinational Operations
z All-current method: condition
Local currency functional currency
z Method
assets/liabilities: current rate.
common stock: historical rate .
I/S : average rate.
z

Temporal method.
Local currency Reporting currency
Functional currency Reporting currency
sub in inflationary environment, parent currency is functional currency.
Method
B/S monetary assets/liabilities: current rate.
B/S non-monetary assets/liabilities: historical rate.
I/S sales, SG&A : average rate.
COGS& depreciation: historical rate.

Cash Flow Measures


z Traditional cash flow = net income + depreciation + change in deferred taxes.
z Cash flow from operations (CFO) = traditional cash flow net changes in non-cash
current assets and liabilities.
Basic and Diluted EPS
NI Pr ef div
Basic EPS=
WA common sharesO / S

Diluted EPS=

Adj NI available for common shares


WA common shares + potential connom shares O/S

Most Critical Ratios


Internal liquidity:
z Current ratio = current assets / current liabilities.
z Quick ratio = (current assets - inventory) / current liabilities.
z Receivables turnover = sales / average accounts receivable
z Average collection period = 365/ receivables turnover.
z Inventory turnover = COGS / average inventory..
z Payables turnover = COGS / average trade payables.
z Payables payment period = 365 / payables turnover.
Evaluating operating efficiency:
z Total asset turnover = sales / average total assets.
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CFA Level II

z
z
z
z
z
z

Fixed asset turnover = sales / average fixed assets.


Gross profit margin = gross profit / sales.
Operating profit margin = EBIT / sales.
Net profit margin =net income / sales.
Return on total assets (ROA) = net income/ average total assets.
Return on total equity (ROE) = net income / average total equity.

Evaluate business and financial risk:


z Debt-equity ratio = total long term debt/ total equity.
z Long term debt to total capital = long term debt / long term capital.
Note: long term capital = long term debt+ preferred stock + equity.
z Debt to assets = total debt / total assets.
Note: also called debt to total capital.
z Interest coverage = EBIT / interest expense.

3-component DuPont:
netincome sales assets

ROE =


sales assets equity

5-component DuPont:
assets
EBIT sales int erest exp ense
(1 t )
ROE =

]
assets

sales assets
equity

Sustainable Growth Rate


g = ROERR, RR=Retention Ratio.

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CFA Level II

CORPORATE FINANCE
Weighted Average Cost of Capital
WACC = (wd)[kd(1-t)]+(wps)(kps)+(wce)(ks), weighted by the market value.
Capital Budgeting Expansion Project
z Initial investment : Cost , changes in NWC
z Operating cash flows = (R-C) (1-t)+(Dt), D is Depreciation.
z Terminal cash flows:
after-tax salvage
return of NWC
Operating cash flows at the last period
Operating Leverage
Variable vs. fixed cost tradeoff.
DOL = (EBIT/EBIT) / (Q/Q)
DOLQ=Q(P-V) / [Q(P-V)-F]
DOLS= (S-VC)/ (S-VC-F)
Financial Leverage
Use of fixed incomes in capital structure
DFL =(EPS /EPS) / (EBIT/EBIT)
DFL = EBIT / [EBIT I]
Total Leverage
DTL = DOLDFL=(EPS /EPS) / (Q/Q)
Optimal Capital Structure
Tradeoff between tax shelter benefit from more debt and higher expected bankruptcy
costs from higher leverage.
Dividend Signaling Hypothesis
Unexpected dividend cut is bad news; dividend increase is good news.
Good Reasons for Mergers
z Economies of scale.
z Vertical integration.
z Complementary resources.
z Surplus cash.
z Eliminating operating inefficiencies.
Bad Reasons for Mergers
z Diversification.
z Lower financing costs.
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CFA Level II

Bootstrapping

NPV of Merger
NPV (cash merger)=gain cost
=VBT-(cash price VT)
Cost of stock merger = (NPBT)-VT
Takeover Defense Measures
z Staggered boards.
z Supermajority.
z Fair price amendment
z Restricted voting rights
z Waiting period.
z Poison pill
z Litigation.
z Asset or liability restructuring .

20

CFA Level II

EQUITY INVESTMENTS
Alpha
ex ante = expected return required return from CAPM or APT
ex post = holding period return - return on similar assets.
Taxes and International Investing
Three forms of tax: transaction, capital gain, income.
Methods to Reduce Execution Costs
Program trading, Internal / external crossing, Principal trades, agency trades, futures
contract.
American Depository Receipts (ADRs)
Advantage: Reduce administration / duty costs on each transaction.
Disadvantage: Do not eliminate inherent currency / economic risks.
Franchise Value and Growth Process
Tangible P/E =1/r
Franchise P/E = franchise factor growth factor = FFG
1
1
FF =
r ROE
G=

g
rg

IF ROE>r, firm has sustainable competitive advantage, Franchise Factor>0.


If FF>0, higher retention ratio implies higher GF, higher franchise P/E.

Inflation Effects on Valuation


Higher flow-through rate implies higher P/ E, all else equal.
If inflation flow-through <100%, higher inflation implies lower P/E, all else equal.

P0
1
=
, k is the required rate of return, I is the inflation rate, is the
E1 k + (1 ) I
inflation flow-through rate.

Valuation in Emerging Markets


Adjust cash flows rather than discount rate:
z Country risks are diversifiable.
z Differing response to country risk.
z Country risk is one- sided.
z ID cash flow aids in risk management.

21

CFA Level II

Porters Five Forces


1. Entry barriers(or threat of new entrants)
z function of economies of scale, product differentials, brand identity, capital
requirements, access to distribution channels, government policy, cost
advantages,
2. Threat of substitutes
z function of relative price performance of substitutes, buyer propensity to
substitute, switching cost.
3. Bargaining power of buyers
z function of bargaining leverage / price sensitivity.
4. Bargaining power of suppliers
z determined by differentiation of inputs, presence of substitute inputs, supplier
concentration, importance of volume to supplier, threat of forward
integration.
5. Rivalry among existing competitors:
z function of industry growth, fixed costs, value added, product differences,
brand identity, diversity of competitors, exit barriers, informational
complexity.
Generic Competitive Strategies
z Cost leadership
Try to be low- cost producer.
z Differentiation.
Try to set products apart from competitors products.
z Cost focus

Cost leader in industry segment.


z Differentiation focus.
Differentiate in industry segment.
Industry Analysis
z Industry life cycle:
Pioneer
Growth
Mature
Decline
z External factors: Technology, government, social change, demography, foreign
influences.
Discounted Cash Flow (DCF) Methods
Use dividend discount models (DDM) when:
z Firm has dividend history.
z Dividend policy related to earnings.
z Minority shareholder perspective.
Use free cash flow (FCF) models when:
z Firm lacks stable dividend policy.
z Dividend policy not related to earnings.
z FCF is related to profitability.
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CFA Level II

z Controlling shareholder perspective.


Use residual income (RI) when:
z Firm lacks dividend history.
z FCF is negative.
Three ways to determine cost of equity:
z CAPM: r=rf+(rm-rf).
z Multifactor APT.
z Add equity risk premium to firms LT bond yield.
Gordon Growth Model (GGM)
Assumes perpetual dividend growth rate
V0 =

D1
rg

Most appropriate for mature, stable firms. Limitations are:


z Very sensitive to estimates of r and g,
z Difficult with non-dividend stocks.
z Difficult with unpredictable growth patterns (use multi-stage model).
Present Value of Growth Opportunities
E
Vo = 1 + PVGO
r

Two Stage Growth Model


Step 1: Calculate dividends in high-growth period.
Step 2: Use GGM for terminal value at end of high-growth period.
Step 3: Discount interim dividends and terminal value to time zero to find stock value.
H-Model

Vo =
H=

[D0 (1 + g L )] + [D0 H ( g s g L )]
r gL
t
2

Solving for Required Return


For Gordon (or stable growth) model, solving for return yields:

r=

D1
+g
P0

Strengths of multistage growth models:


z Flexibility.
z Use in forward or reverse.
z Relationship between assumptions and value estimates.
23

CFA Level II

Easy with spreadsheet software.

Limitations of multistage models:


z Garbage-in, garbage-out.
z Cant determine effects of assumptions unless model is clearly understood.
z Value estimates sensitive to assumptions of growth and required return.
z Difficult to ID data / input errors.
Free Cash Flow to Firm (FCFF)
Assuming DEPreciation is only NCC:
z FCFF= NI+Dep+[Int(1-tax rate)]-FCInv-WCInv.
z FCFF = [EBIT](1-tax rate)]+Dep-FCInv WCInv.
z FCFF = [EBITDA(1-tax rate)]+(Deptax rate)-FCInv-WCInv.
z FCFF = CFO + [Int(1-tax rate)]-FCInv.
Free Cash Flow to Eqauity (FCFE)
z FCFE = FCFF [Int(1-tax rate)]+Net borrowing.
z FCFE = NI + Dep FCInv-WCInv+Net borrowing.
z FCFE = NI-[(1-DR)(FCInv-Dep)]-[(1-DR)WCInv].
z
Single-Stage FCFF / FCFE Models
z

For FCFF valuation: Vo =

FCFF1
WACC g

For FCFF valuation: Vo =

FCFF1
rg

Two Stage FCFF / FCFF Models


Step 1: Calculate FCF in high-growth period.
Step 2: Use single-stage FCF model for terminal value at end of high-growth period.
Step 3: Discount interim FCF and terminal value to time zero to find stock value; use
WACC for FCFF, r for FCFE.
Price to Earnings (P/E) Ratio
Problems with P/E.
z If earnings <0, P/E meaningless.
z Volatile, transitory portion of earnings makes interpretation difficult.
z Management discretion over accounting choices affects reported earnings.
Justified P/E
Leading P / E1 =

1 b
rg

24

CFA Level II

Trailing P / E0 =

(1 b)(1 + g )
rg

Normalization Methods:
z Historical average EPS.
z Average ROE.
Price to Book (P/B) Ratio
Advantages:
z BV almost always>0,
z BV more stable than EPS.
z Measures NAV of financial institutions.
Disadvantages:
z Size differences cause misleading comparisons.
z Influenced by accounting choices.
z BVMV due to inflation/ technology.
Justified = P / B =

ROE g
rg

Price to Sales (P/S) Ratio


Advantages:
z Meaningful even for distressed firms.
z Sales revenue not easily manipulated.
z Not as volatile as P/E ratios.
z Useful in valuing mature, cyclical, and start-up firms.
Disadvantages:
z High sales do not imply high profits and cash flows.
z Does not capture cost structure differences.
z Revenue recognition practices still distort sales.
Justified P / S =

PM 0 (1 b)(1 + g )
rg

Price to Cash Flow Ratios


Advantages:
z Cash flow harder to manipulate than EPS.
z More stable than P/E
z Mitigates earnings quality concerns.
Disadvantages:
z Difficult to estimate true CFO
z FCFE better but more volatile.

25

CFA Level II

Method of Comparables
z Firm multiple > benchmark implies overvalued
z Firm multiple < benchmark implies undervalued.
z Fundamentals that affect multiple should be similar between firm and benchmark.
Residual Income (RI)Valuation
z RIt=Et-(rBt-1)
z Firm value = adjusted BV0+ PV of expected future RI.
z

Single-stage residual income model: V0 = B0 +

PV of continuous residual income in T-1:

ROE r
B0
rg

RI T
, is the persistence factor,
1+ r

between 0 and 1.

Economic Value Added


EVA = NOPAT - $WACC; NOPAT = EBIT(1-t)
$WACC = WACCInvested capital; Invested capital = NWC + Net PP&E
Ways to increase EVA : Increase revenues, reduce expenses, less invested capital ,
find + NPV projects, reduce WACC.
Growth Duration Model
1 + gH + dH
High, Growh, P / E

ln
= T ln
Cons tan tGrowthP / E
1 + gC + dC

26

CFA Level II

DEBT INVESTMENTS
Credit Analysis
Liquidity sources
z Working capital
z Cash flow.
z Back-up facilities
z Third-party guarantees.
High-yield debt
z Issuer has senior, short-term, floating bank debt.
Asset-backed debt
z Quality of collateral.
z Servicer quality
z Payment structure.
z Legal structure (VIE, SPV)
Municipal bonds
z Tax-backed: repaid with tax revenue
z Revenue: repaid with project CF.
Sovereign debt
z Local vs. foreign currency rating.
z Economic risk; ability to pay.
z Political risk: willingness to pay.
Bond Price Yield Relationship
Option free bond exhibits
positive convexity.

Callable bond exhibits


negative convexity.
price

price

Strike price

yield

yield

27

CFA Level II

Duration and Convexity

ED =

(BVY BV+Y )
2 BVO Y

%BV (from duration)-EDy


Convx =

BV y BV+ y (2 BVo )
2 BVo y 2

%BV (from convx)Convxy

Yield Curve(Term Structure ) Shifts


Parallel shift
Nonparallel shift slope changes
Butterfly twist change in humped shape
Theories of the Term Structure
z Pure (unbiased) expectations Forward rates (F) function of expected future spot
rates E(S)
If up sloping, spot rates rise
If down sloping , spot rates fall
If flat, spot rates constant
z Liquidity theory
F rates reflect expectation of E(S) plus liquidity premium
z Preferred habitat theory
Imbalance between fund supply demand at maturity range induces lenders to
shift from preferred habitats to one with opposite imbalance
z Market segmentation theory
Imbalance between fund supply demand at maturity range induces lenders to
shift from preferred habitats to one with opposite imbalance
z Market segmentation theory
Yield curve shape determined by supply demand for securities at each
maturity
Key Rate Duration
% value from 100 bps in key rate
Have several key rates (5-yr, 10-yr )
Estimate effect of non-parallel yield curve shift on bond portfolio value
Valuing Option Free Bonds
To value option free bond with the binomial tree start at end and discount back though
the tree (backwards induction method ) Value 2-year option free bond
step1: Find the time one up node value

28

CFA Level II

Nodal value 1,U =

1 nodal _ value2UU

2
1 + i1,U

nodal _ value2UD
+

1 + i1,U

Step 2 Find time one down-node value


nodal value 1,D =

1 nodalvalue2, DD

2
1 + i1, D

nodalvalue2,UD
+

1 + i1, D

Step 3: Find time zero value :


nodal value 0 =

1 nodal _ value1,U

2
1 + i0

nodalvalue1, D
+

1 + i0

Value Bond with Embedded Option


For bonds with embedded options assess whether option will be exercised at each
node New Step 3 is
Step 3 (callable bond ) Find time 0 value assuming year 1 down node calculated
value> than call price
nodal value 0 =

1 nodal _ value1,U

2
1 + i0

nodal _ value1,D
+

+
1
i
0

Call=noncallable bond callable bond

Option Adjusted Spread


Option-removed spread.
Compensation for liquidity and credit risk
Spread that forces model price =marker price
z-spread =OAS+option cost
Convertible Bonds
Conversion value =stucco price x conversion ratio
Minimum value =min(straight value conversion value )
Market conversion premium=conversion price market price
Callable convertible bond=straight bond - call on stock call on bond
MBS Prepayment Risk
z Prepayment speed factors
Spread of current vs original mortgage rates.
Mortgage rate path (refinancing burnout )
Level of mortgage rates
Underlying mortgage rates
Seasonal factors
z Contraction risk occurs as rates fall prepayments rise average life falls
z Extension risk occurs as rates rise prepayments fall slow average life rises

29

CFA Level II

CMO prepayment Risk


z PAC I tranches: low contraction and extension risk (due to PAC collar)
z PAC II tranches: somewhat higher contraction and extension risk
z Support tranches: higher contraction and extension risk
z IO strips: value positively related to interest rates at low current rates
z PO strips: negative convexity at low rates high interest rate sensitivity
ABS Prepayment Risk
z External credit enhancement corporate guarantees leers of credit bond insurance
z Internal credit enhancement reserve funds over-collateralization senior sub
structure
z Auto loan low prepayment risk small balances high depreciation
z Credit card receivable low prepayment (lockout period no prepayments on crddit
cards )
MBS /ABS spread Analysis
z Plain vanilla corporate: Z-spread
z Callable corporate: OAS (binomial model )
z MBS: OAS (Monte Carlo model )
z Credit card auto ABS: Z-spread
z High quality home equity ABS: OAS (Monte Carlo model )

30

CFA Level II

DERIVATIVES
Forwards-No Arbitrage Pricing
FP = S 0 (1 + R f ) T
Vlong = S t

FP
(1 + R f )T t

Equity Forward
FP (equity ) = ( S 0 PVD ) (1 + R f )T
Vlong = S t PVDt

FP
(1 + R f )T t

Forward on Fixed Income securities


FP ( fixedincome) = ( S 0 PVD ) (1 + R f )T
Vlong = S t PVC

FP
(1 + R f )T t

Forward Rate Agreements


Long position in FRA is party that would borrow If LIBOR at end is above forward
rate in FRA long in effect has right to borrow at below market rates and receives a
payment
FRAPriceis forward rate implied by current sport rates
j+k

1 + L(1+ k ) 360
360
1
FR ( j , k ) =

1 + L( j ) ( j )
k
360

Currency Forward(Interest Rate Parity )


FP (currency ) = S 0

T
(
1 + Rdomestic )

(1 + R foreign ) T

F and S in DC/FC
Vlong =

St
(1 + R foreign )

T t

FP
(1 + Rdomestic )T t

Futures Price
FP = S 0 (1 + R f ) T

Futures> forward when rates and asset values positively correlated


Futures< forward when rates and asset values negatively correlated
31

CFA Level II

Futures Arbitrage
Cash and carry: Borrow, buy spot, sell futures today deliver asset, repay loan at end
Reverse cash and carry: short spot, invest, buy futures today; collect loan, buy asset
under futures contract, deliver to cover short sale .
Treasury Bond Futures
FP = bond price (1 + R f )T FVC

Equity Futures
FP( stock ) = S 0 (1 + R f ) T FVD

FP(index) = S 0 e ( R )T
Put-Call Parity
Call+Risk-free Bond=Put+Underlying
Co +

X
= P0 + S 0
(1 + r )T

Caps and Floors


Cap=portfolio of calls on LIBOR
Floor=portfolio of puts on LIBOR
Collar=buy cap and sell floor or sell cap and buy floor
Binomial option Pricing Model
Step 1: Calculate option payoffs at end in all stares
Step 2:Calculate expected value using probabilities

1+ R D
U D
Step 3: Discount to today at risk free rate

up =

Black-Scholes Option Pricing Model

Ct = [ S t N (d1 )] [ X e r (T t ) N (d )]

S
ln t + r + (0.5 2 ) (T t )
X
d1 =
T t

d 2 = d1 ( T t )
Pt = Ct St + (e r (T t ) X )
Effect of each variable on a call option Asset price positively related
32

CFA Level II

z
z
z
z
z

Asset price: positively related


Volatility of asset price: positively related
Risk free rate: positively related
Time to expiration: positively related
Exercise price: Negatively related

Delta
Estimates the change in value of option for a one-unit change in stock price
Call delta between o and 1 increases as stock price increases
Call delta close to 0for far out of the money calls close to 1 for fan in the money
calls
Put delta between I and 0 increases from 1 to 0 as stock price increases
Put delta =call delta -1 (all else equal )
Delta close to 0 for far out of the money puts close to -1 for fan in the money puts
Delta Neutral Hedging
#Calls for delta hedge =

# shares of stock
delta of call option

Delta neutral position only holds for very small changes in value of underlying stock
Delta neutral portfolio must be frequently (continuously) rebalanced to maintain
hedge called a dynamic hedge

Gamma
Measures rate of change in delta as underlying stock price changes largest when
option is at the money
Currency Swaps
Parties swap payments in two currencies at fixed or floating rates
Interest Rate Swaps
Plain vanilla interest rate swap trading fixed interest rate payments for floating rate
payments
Equity Swaps
Return on stock portfolio or stock index is paid each period by one party in return for
a fixed payment Return can be capital appreciation or total return including dividends
on the stock or portfolio
Swap Pricing and Valuation
Swap rate is set so PV of floating rate payments PV of fixed rte payments swap
value is zero to both parties

CN =

1 BN
B1 + B2 + L + BN
33

CFA Level II

Bn = PV of 1 on n th date

Value to fixed pay side =PV of floating PV of fixed


Value to floating pay side=PV of fixed PV of floating
Swptions
Payer swaption value increases as rates rise
Receiver swaption value increases as rates fall

34