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Ethical and Professional
Standards
Study Session 1 – 2
Weighting 10%
2
Overview of Level II Ethics
Code of
Ethics
Standards of
Professional
Conduct
CFA Institute
Research
Objectivity
Standards
Study Session 1
Ethics Cases:
 Glenarm
Company
 Preston Partners
 Super Selection
Other topics:
 Fair dealing & disclosure
 Changing investment objectives
 Prudence in Perspective
Study Session 2
CFA Institute
Soft Dollar
Standards
3
Overview of the Code and Standards
Code of Ethics
• Act in an ethical
manner
Integrity is
paramount and
clients always
come first
• Use reasonable
care and be
independent
• Be a credit to the
investment
profession
• Uphold capital
market rules and
regulations
• Be competent
Standards of Professional Conduct
I: Professionalism
A.Knowledge of the Law
B.Independence and Objectivity
C.Misrepresentation
D.Misconduct
II: Integrity of Capital Markets
A.Material Nonpublic Information
B.Market Manipulation
III: Duties to Clients
A.Loyalty, Prudence, and Care
B.Fair Dealing
C.Suitability
D.Performance Presentation
E.Preservation of Confidentiality
IV: Duties to Employers
A.Loyalty
B.Additional Compensation
Arrangements
C.Responsibilities of Supervisors
V: Investment Analysis,
Recommendations, and
Actions
A. Diligence and Reasonable Basis
B. Communications with Clients and
Prospective Clients
C. Record Retention
VI: Conflicts of Interest
A. Disclosure of Conflicts
B. Priority of Transactions
C. Referral Fees
VII: Responsibilities as a CFA
Institute Member or CFA
Candidate
A. Conduct as Members and
Candidates in the CFA Program
B. Reference to CFA Institute, the
CFA Designation, and the CFA
Program
4
Standards of Professional Conduct
Standard I: Professionalism
I(A): Knowledge of the Law
• Understand and comply with all laws, rules,
regulations (including Code & Standards)
governing professional activities
• Comply with more strict law, rule, regulation
• Do not knowingly assist in violation, otherwise
dissociate from activity
Guidance
• Most strict
• First – notify supervisor or
compliance
• May confront wrongdoer directly
• Dissociate if necessary
• Inaction may be construed as
participation
• No requirement to report violations
to governmental authorities, but this
may be appropriate in certain cases
I(B): Independence and Objectivity
• Use reasonable care, judgment to
achieve, maintain independence in
professional activities
• Do not offer, solicit, accept any
compensation that could compromise
independence, objectivity
Guidance
• Modest gifts OK
• Distinguish between gifts from clients and gifts
from entities trying to influence
• May accept gift from clients – must disclose to
employer – must get permission if gift is for
future performance
• Investment banking relationships – do not bow
to pressure to issue favorable research
• For issuerpaid research, flat fee structure is
preferred
5
Standards of Professional Conduct
Standard I: Professionalism
I(C): Misrepresentation
• Do not make misrepresentations
relating to investment analysis,
recommendations, actions or other
professional activities
Guidance
• Standard covers oral, written, or
electronic communications
• Do not misrepresent qualifications,
services of self or firm, or performance
record, characteristics of an investment
• Do not guarantee a certain return
• No plagiarism – written or oral
communications
I(D): Misconduct
• Do not engage in any professional
conduct involving dishonesty, fraud,
deceit, or commit any act that reflects
adversely on professional reputation,
integrity, or competence
Guidance
This Standard covers conduct
that may not be illegal, but
could adversely affect a
member’s ability to perform
duties
6
Standards of Professional Conduct
Standard II: Integrity of
Capital Markets
II(A): Material Nonpublic Information
• Members in possession of nonpublic
information that could affect an
investment’s value must not act or
cause someone else to act on the
information
II(B): Market Manipulation
• Do not engage in practices that
distort prices or artificially inflate
trading volume with intent to
mislead market participants
Guidance
• “Material” – if disclosure of information would
impact a security’s price or if reasonable
investors would want the information before
making an investment decision
• Information is “nonpublic” until it has been
made available to the marketplace
• Information made available to “analysts” is
considered nonpublic until it is made available
to investors in general
• Mosaic Theory
Guidance
• Do not engage in transaction
based manipulation – give false
impression of activity / price
movement; gain dominant
position in an asset to manipulate
price of the asset or a related
derivative
• Do not distribute false, misleading
information
7
Standards of Professional Conduct
Standard III: Duties to Clients
III(A): Loyalty, Prudence, and Care
• Act with reasonable care and exercise
prudent judgment
• Act for benefit of clients and place their
interests before employer’s or own interests
• Determine and comply with any applicable
fiduciary duty
III(B): Fair Dealing
Deal fairly, objectively with all clients
when:
• Providing investment analysis
• Making investment recommendations
• Taking investment action
• Engaging in other professional activities
Guidance
• Take investment actions in client’s best interests
• Exercise prudence, care, skill, and diligence
• Follow applicable fiduciary duty
• Manage pools of client assets according to terms
of governing documents
• Make investment decisions in context of total
portfolio
• Vote proxies responsibly and disclose proxy
voting policies to clients
• “Soft dollars” must benefit client
Guidance
• Different levels of service okay as
long as disclosed, and does not
disadvantage any clients
• Investment recommendations:
all clients must have fair chance
to act on every recommendation
• Investment actions: treat all
clients fairly – consider
investment objectives,
circumstances
8
Standards of Professional Conduct
Standard III: Duties to Clients
III(C): Suitability
• Know client’s risk and return
objectives, and financial constraints
• Update information regularly
• Make investment recommendations or
take investment actions that are
consistent with the stated objectives
and constraints
• Look at suitability in a portfolio context
III(D): Performance Presentation
• When communicating investment
performance information, ensure
that information is fair, accurate,
and complete
Guidance
• When in advisory relationship, gather
client information at the outset and
prepare IPS
• Update IPS at least annually
• Consider whether leverage (derivatives)
is suitable for client
• If managing a fund to an index or other
mandate, invest according to mandate
Guidance
• Do not misstate performance or
mislead clients about investment
performance
• Do not state or imply ability to
achieve returns similar to those
achieved in the past
9
Standards of Professional Conduct
Standard III: Duties to Clients
III(E): Preservation of Confidentiality
Keep current and prospective client information confidential, unless:
• Illegal activities are suspected
• Disclosure is required by law
• Client or prospect allows disclosure of the information
Guidance
• In some cases it may be required by law to report activities
to relevant authorities
• This Standard extends to former clients
• Exception: May provide confidential information to CFA
Institute for an investigation under Professional Conduct
Program
10
Standards of Professional Conduct
Standard IV: Duties to
Employers
IV(A): Loyalty
• Must act for the benefit of their employer
Guidance
Loyalty – Independent practice:
• If planning to engage in independent practice, notify employer of services provided,
expected duration, and compensation
• Do not proceed without consent from employer
Loyalty – Leaving an employer:
• If seeking new employment, act in best interest of employer until resignation is effective
• Do not take records or files without permission
• Simple knowledge of names of former clients is OK
• No prohibition on use of experience or knowledge gained at former employer
Loyalty – Whistleblowing:
• Permitted only if it protects client or integrity of capital markets
• Not permitted for personal gain
11
Standards of Professional Conduct
Standard IV: Duties to
Employers
IV(C): Responsibilities of
Supervisors
• Must make reasonable efforts to
detect and prevent violations
IV(B): Additional Compensation Arrangements
Do not accept gifts, benefits, compensation,
consideration that competes with, or creates a
conflict of interest with, employer’s interest unless
written consent is obtain from all parties involved
Guidance
• Compensation and benefits covers
direct compensation by the client
and other benefits received from
third parties
• For written consent from “all parties
involved,” email is acceptable
Guidance
• Supervisors must take steps to
prevent employees from violating
laws, rules, regulations, or the
Code and Standards
• Supervisors must make
reasonable efforts to detect
violations
12
Standards of Professional Conduct
Standard V: Investment Analysis, Recommendations, and Actions
V(A): Diligence and Reasonable Basis
• Exercise diligence, independence, and
thoroughness
• Have a reasonable and adequate basis,
supported by appropriate research, for
any investment analysis,
recommendation, or action.
V(B): Communication with Clients and
Prospective Clients
• Disclose the basic format and general principles
of investment processes and promptly disclose
any changes that might affect those processes
materially
• Identify important factors and include them in
communications with clients/prospective clients
• Distinguish between fact and opinion in the
presentation of investment analysis and
recommendations
Guidance
• Make reasonable efforts to cover
all relevant issues when arriving at
an investment recommendation
• Determine soundness when using
secondary or thirdparty research
• Group research and decision
making: As long as there is
reasonable basis for opinion,
member does not necessarily have
to agree with the opinion
Guidance
• Distinguish between facts and opinions
• Include basic characteristics of the security
• Inform clients of any change in investment
processes
• Suitability of investment – portfolio context
• All communication covered, not just reports
13
Standards of Professional Conduct
Standard V: Investment Analysis, Recommendations, and Actions
V(C): Record Retention
• Develop and maintain appropriate records to support
their investment analysis, recommendations, actions,
and other investmentrelated communications
Guidance
• Maintain records to support research, and the
rationale for conclusions and actions
• Records are firm’s property and cannot be
taken when member leaves without firm’s
consent
• If no regulatory requirement, CFA Institute
recommends retention period of 7 years
14
Standards of Professional Conduct
Standard VI: Conflicts of Interest
VI(A): Disclosure of Conflicts
• Must make full and fair disclosure to clients, prospects or employer of all
matters that could reasonably be expected to impair their independence
and objectivity or interfere with respective duties
Guidance
Disclose to clients:
• All matters that could impair objectivity – allow clients to judge motives, biases
• For example, between member or firm and issuer, investment banking relations,
broker/dealer marketmaking activities, significant stock ownership, board
service
Disclose to employers:
• Conflicts of interest – ownership of stock analyzed/recommended, board
participation, financial and other pressures that may influence decisions
• Also covers conflicts that could be damaging to employer’s business
15
Standards of Professional Conduct
Standard VI: Conflicts of Interest
VI(C): Referral Fees
• Must disclose to
employer, clients, and
prospective clients
VI(B): Priority of Transactions
• Investment transactions for clients and
employers must have priority over investment
transactions in which a Member or Candidate
is the beneficial owner
Guidance
• “Beneficial owner” – has direct /
indirect personal interest in the
securities
• Client, employer transactions take
priority over personal transactions
(including beneficial ownership)
• Family member accounts that are
client accounts must be treated as
other client accounts
Guidance
• Disclosure allows clients and
employers to evaluate full cost of
service and any potential biases
• Disclosure is to be made prior to
entering into any formal agreement
for services
• Disclose the nature of the
consideration
16
Standards of Professional Conduct
Standard VII: Responsibilities as a CFA
Institute Member or CFA Candidate
VII(A): Conduct as Members and Candidates in the CFA Program
• Must not engage in any conduct that compromises the reputation or
integrity of CFA Institute or the CFA designation or the integrity, validity,
or security of the CFA examinations.
Guidance
Conduct includes:
• Cheating on the exam
• Disregarding rules and policies or security measures related to
exam administration
• Giving confidential information to candidates or public
• Improper use of CFA designation to further personal and
professional objectives
• Misrepresenting the CFA Institute Professional Development
Program or the Professional Conduct Statement
17
Standards of Professional Conduct
Standard VII: Responsibilities as a CFA
Institute Member or CFA Candidate
VII(B): Reference to CFA Institute, the CFA Designation, and the CFA Program
• Must not misrepresent or exaggerate the meaning or implications of membership in
CFA Institute, holding the CFA designation, or candidacy in the CFA program
Guidance
CFA Institute membership:
• Complete PCS annually
• Pay membership dues annually
Using the CFA designation:
• Don’t misrepresent or exaggerate the meaning of holding the CFA designation
Reference to the CFA program:
• May reference participation but no partial designation
• OK to say “passed all levels on first attempt,” but do not imply superior ability
Improper use of the CFA marks:
• The “Chartered Financial Analyst” and “CFA” marks must always be used either
after a charterholder’s name or as adjectives, not as nouns
Failure to comply with results in an inactive
member status
18
Definitions
I. General
III. Selection of
brokers
Soft Dollar Standards
II.Relationship
with clients
VI. Disclosure
IV. Evaluation of
research
CFA Institute Soft Dollar Standards
VII. Record keeping
Appendix: Permissible
research guidance
V. Clientdirected
brokerage
General
Principles
19
Relationship with clients
• Disclose involvement in soft dollar
• OK to use brokerage from agency trades to obtain research – client should receive
some benefit
• OK to use client brokerage obtained from principal trades to benefit other client
accounts, as long as disclosed
Selection of brokers
• Consider trade execution capabilities
CFA Institute Soft Dollar Standards
General
• Soft dollar practices must benefit client, whose interests always come first
• Allocation of client brokerage – must not be based on amount of client referrals
investment manager receives from broker
Two fundamental principles
• Client property
• Duty to minimize transaction costs, obtain best execution & use client brokerage to
benefit clients
Soft dollar practices
• The use of client brokerage by investment manager to obtain products/services to aid
manager in investment decision making process
20
Evaluation of research
• Meet definition of Standard
• Benefit client
• Documentation of basis
• Disclosure and consent obtained if benefit other clients
• Investment manager pays for research if doesn’t meet criteria
• Mixeduse research – allocate
Clientdirected brokerage
• Cannot use brokerage from another client to pay
• Manager: Disclose duty of best execution
• Disclose to client that client’s selection may adversely affect execution and adequacy
of research
CFA Institute Soft Dollar Standards34
Disclosure
• Disclose types of thirdparty research received
• To comply with Soft Dollar Standards, send client statement of practices annually
• On client request, provide description of product / service obtained through client
brokerage generated by client’s account
• Provide total amount of brokerage paid from all accounts (where manager has
discretion)
21
Record keeping
Manager must maintain records
• Document arrangements obligating manager to generate specific dollar amount of
brokerage
• Document client arrangements re: client brokerage
• Document brokerage arrangements
• Document basis for allocations – mixed use brokerage
• Show how products / services obtained assist in investment process
• Show compliance with CFAI Soft Dollar Standards, responsible party
• Include copies of disclosures / authorizations from clients
CFA Institute Soft Dollar Standards
Permissible research: 3 level analysis
• Level I: define the product or service
• Level II: determine usage
• Level III: mixeduse analysis – investment manager makes proper allocation
22
Objectives
Research
objectivity
policy
Reasonable
and adequate
basis
Procedures for
compliance
Public
appearances
Relationships
with subject
companies
Investment
banking
CFAI Research Objectivity Standards
Personal
investments
and trading
Timeliness of research
reports and
recommendations
Compliance
and
enforcement
Disclosure
Rating system
Research
analyst
compensation
23
Objectives of the Standards
• Prepare research, recommendations, investment action – clients always first
• Full, fair, meaningful disclosures of conflicts
• Promote effective policies/procedures – minimize conflicts affecting
independence/objectivity
• Support selfregulation – adhere to specific, measurable standards, promoting
independence, objectivity
• Provide ethical work environment
CFAI Research Objectivity Standards
Required Compliance Procedures
Research objectivity policy
• Provide written policy on research independence and objectivity
• Have supervisory procedures that ensure compliance
• Have a senior officer who attests to the firm’s implementation and adherence
Public appearances
• Require covered employees to disclose both personal and firm conflicts of interest to
the interviewer/host and, if possible, to the audience
24
Required Compliance Procedures
Reasonable and adequate basis
• Appoint a supervisory analyst or a review committee to evaluate and approve
research report recommendations
Investment banking
• Separate research analysts from the investment banking division
• Research analysts are not supervised by or report to the investment banking
• Investment banking or corporate finance divisions are unable to modify, review,
approve or reject research recommendations and reports
Research analyst compensation
• Compensation should reflect the quality and accuracy of the recommendations made
• Compensation should be not be connected to the analyst’s involvement with
investment banking or corporate finance activities
Relationships with subject companies
Research analysts are not allowed to:
• Share research report with a subject company prior to the publication of the research
report
• Promise a favorable report or a certain price target to a subject company or corporate
issuer
CFAI Research Objectivity Standards
25
Required Compliance Procedures
Personal investments and trading
• Firm should have policies to ensure covered employees’ personal investment
dealings are properly managed
Timeliness of research reports and recommendations
• Reports should be issued on a timely and regular basis
Compliance and enforcement
• Effective compliance procedures should be in place
• The compliance procedures should be supervised and audited & maintain internal
audit records
Disclosure
• Firm to provide full disclose of conflicts of interest
Rating system
• Rating system should be helpful to investors in their decisionmaking process
CFAI Research Objectivity Standards
26
26
Recommended Procedures for Compliance
Research objectivity policy
• Identify and describe covered employees
• Covered employees to be trained regularly and indicate in writing their adherence to the
policy annually
• Disclose conflict of interest that covered employees face
• Identify factors on which research analysts’ compensation is based
• Disclose the terms for the purchase of research reports by clients
Public appearances
• Ensure that the audience of a presentation has enough information to make informed
judgments
• Be prepared to disclose conflicts of interest
• Firm should require research analysts that are participating in public appearances to
disclose investment banking relationship with the subject company and whether the
analyst has participated in marketing activities for the subject company
• Research reports on the companies discussed should be provided to the audience for a
reasonable fee
CFAI Research Objectivity Standards
27
27
Recommended Procedures for Compliance
Reasonable and adequate basis
• Develop written guidance for judging what constitutes reasonable and adequate basis
• Provide or offer to provide supporting information, and disclose current price of the
security
Investment banking
• Prohibit research analysts from communicating with the investment banking or corporate
finance department prior to the publication of a research report
• Investment banking or corporate finance personnel may review reports for factual
accuracies or to identify possible conflicts
• Implement quiet periods for IPOs and secondary offerings
• Analysts not be allowed to participate in marketing roadshows for IPOs and secondary
offerings
Research analyst compensation
• Compensation should be based on measurable criteria
• Direct link of analysts’ compensation with investment banking and corporate finance
activities is not allowed but firm should disclose to what extent analysts’ compensation
depends on investment banking revenues
CFAI Research Objectivity Standards
28
28
Recommended Procedures for Compliance
Relationships with subject companies
• Implement policies that govern analysts relationship with subject companies
• Implement guidelines that only those sections of the report related to factual information
that could be verified by the subject company is shared before publication
• Compliance and legal departments get a copy of the draft report before it is shared with
the subject company
Personal investments and trading
• Approval required prior to trading in securities in the industries assigned to the analyst
• Should have procedures to prevent employees from trading ahead of investing client
trades
Restricted period of at least 30 days prior and 5 days after a report is issued
• Analysts permitted to sell contrary to their recommendation when in extreme financial
hardship
• Covered employees to provide a list of personal investments
• Establish policies to prevent shortterm trading of securities
CFAI Research Objectivity Standards
29
29
Recommended Procedures for Compliance
Timeliness of research reports and recommendations
• Reports and recommendations should be issued at least quarterly
• If the coverage of a firm is discontinued, a “final” research report should be issued
Compliance and enforcement
• Distribute a list of activities that constitute violations and the disciplinary sanctions
Disclosure
• Disclose investment banking or other corporate finance relationships & conflicts of
interests
• Provide information on their recommendations and ratings
• Disclose the valuation methods used to determine price targets, including risk factors
Rating system
• Rating systems should include recommendation and rating categories, time horizon
categories, and risk categories
• Absolute or relative recommendations are allowed
• Employees should be prohibited from communicating a recommendation contrary to
the current published one
CFAI Research Objectivity Standards
30
Study Session 2 topics
The Glenarm
Company
Applications
of Standards
Preston
Partners
Super
Selection
Case Studies
Trade Allocation: Fair
Dealing and
Disclosure
Changing Investment
Objectives
Prudence in
Perspective
Ethics and Professional Standards
31
Quantitative Methods
Study Session 3
Weighting 5 – 10%
32
Study Session 3
TimeSeries
Analysis
Multiple
Regression
Correlation and
Linear Regression
Overview of Level II Quant
33
Covariance & Correlation
Covariance
• may range from +ve to –ve infinity
• units are squared hence less meaningful
( )( )
=
÷ ÷
=
÷
¯
n
t,1 1 t,2 2
t 1
1,2
R R R R
cov
n 1
Correlation
• standardised measure of relationship
• bounded by 1 and +1
• the closer to absolute 1, the stronger the
relationship
o o
=
1,2
1,2
1 2
Cov
r
Significance of correlation coefficient
H
0
: ²= 0 H
a
: ²Į0
Twotailed test
Degrees of freedom are n – 2
Limitations to correlation analysis
•outliers affect the coefficient
•spurious correlation: linear relationship
but no economic explanation
•a nonlinear relationship exists which
cannot be captured by correlation
2
r n 2
t =
1 r
÷
÷
34
Linear Regression
x
x
x
x
x
x
x
x
x
x x
x
x
x
x
x
x
x
x
Y, dependent
variable
X
i
c
i
error term
or residual
i i
X b b Y
1 0
ˆ ˆ ˆ
+ =
X, independent
variable
Y
i
i
Y
ˆ
Basic idea: a linear relationship between two variables, X and Y. Note that the standard
error of estimate (SEE) is in the same units as ‘Y’ and hence should be viewed relative to
‘Y’.
Mean of c
i
values = 0
Standard deviation of c
i
=
standard error of the
estimate (SEE)
Least squares regression finds the straight
line that minimises the SEE by minimising:
SSE) errors, squared the of sum ( İˆ
2
i
=
¯
35
Significance of coefficients
Hypothesis Tests on a Regression Coefficient
To test statistical significance:
H
0
: b
i
= 0 H
a
: b
i
Į 0
Other tests are possible, for example:
H
0
: b
i
ı 1 H
a
: b
i
< 1
Confidence interval for the population value of a
regression coefficient
Predictions for the dependent
variable
Given the estimated regression
coefficients and an assumed value
for the independent variable(s) we
can predict the value of the
dependent value using:
Degrees of freedom = n – (k + 1)
i
i i
i
s
b b
ˆ
t , statistic Test
÷
=
i i
b
ˆ
of error standard s : Where =
( )
i i
s value t critical b
ˆ
× ±
1 1 0 i
X
ˆ
b
ˆ
b
ˆ
Y
ˆ
+ =
Confidence interval for the
prediction of Y
n – 2 degrees of freedom
( )
f
s value  t critical Y
ˆ
× ±
÷
÷
+ + =
2
2
2 2
) 1 (
)
ˆ
( 1
1
x
f
s n
X X
n
SEE s
36
i 1 0 i
X b
ˆ
b
ˆ
Y
ˆ
+ =
( ) SSE Y
ˆ
 Y
2
i i
÷
( ) SSR Y  Y
ˆ
2
i
÷
( ) SST Y  Y
2
i
÷
i
Y
0
b
ˆ
Y
X
Y
Components of Variation
Total variation = sum of squared totals (SST) = actual  expected
Explained variation = sum of squared regressions (SSR) = predicted – expected
Unexplained variation = sum of squared errors (SSE) = actual – predicted
37
Analysis of Variance Table
Coefficient of determination
R
2
= explained variation in y
total variation in y
R
2
is the proportion of the total
variation in y that is explained
by the variation in x’s
R
2
= r
2
for linear regression
Interpretation
When correlation is strong (weak, i.e. near to zero)
•R
2
is high (low)
•Standard error of the estimate is low (high)
Standard Error of Estimate
Source of
Variation
Degrees of
Freedom
Sum of Squares Mean Square
Regression
(explained)
1 = k Regression sum of squares (RSS) Mean sum of
squares (MSR) =
RSS/k
Error
(unexplained)
n – (k + 1) = n  2 Sum of squared errors
(SSE)
Mean squared error
(MSE) = SSE/(n – 2)
Total n  1 Sum of squares total (SST)
SST
RSS
=
( ) ( )
MSE
1 k n
SSE
1 k n
İˆ
SEE
n
1 i
i
=
+ ÷
=
+ ÷
=
¯
=
ANOVA, SEE and Rsquared
38
General form of model:
Predicting the dependent variable
i k k 2 2 1 1 0 i
X b .... X b X b b Y c + + + + + =
Independent
variables
Dependent
variable
Partial slope coefficients Yintercept
Error term,
residual
s t variable independen the of values assumed the are X
ˆ
..... , X
ˆ
, X
ˆ
b .... , b , b parameters regression for the estimates are b
ˆ
...., , b
ˆ
, b
ˆ
: where
k 2 1
k 1 0 k 1 0
k k 2 2 1 1 0 i
X
ˆ
b
ˆ
.... X
ˆ
b
ˆ
X
ˆ
b
ˆ
b
ˆ
Y
ˆ
+ + + + =
Multiple Regression
39
Hypothesis tests on individual
regression coefficients
To identify which independent variables are
individually important in a multiple
regression we perform a ttest on each
slope coefficient with b
i
= 0. (seen earlier)
Degrees of freedom = n – (k + 1)
Determining the collective significance
of the independent variables
Perform an Ftest:
H
0
: None of the independent variables
significantly explain the dependent variable.
b
1
= b
2
= b
3
= ……= b
k
= 0
H
a
: At least one of the independent
variables significantly explains the
dependent variable. At least one b
i
Į0
Reject H
0
if computed F > Fcritical
Test statistic:
i
i i
i
s
b b
ˆ
t , statistic Test
÷
=
i i
b
ˆ
of error standard s : Where =
( )) 1 k  (n
errors squared of Sum
k
squares of sum Regression
F
+
=
table) ANOVA from (data
MSE
MSR
error squared Mean
squares of sum regression Mean
=
=
Looking up the critical F
value
Use table corresponding to the
significance level of test (o) i.e.
(onetailed!!!!)
Numerator dof = k
Denominator dof = n – (k + 1)
Significance of coefficients
40
Other Issues in Multiple Regression
Adjusted R
2
• As you incorporate more variables R
2
can
only go up, even if some of the new
variables are statistically insignificant
• Hence in multiple regression we use
adjusted R
2
. This measure of fit does not
automatically increase when another
variable is added.
No calculations are required
Qualitative independent factors
• These are variables that attain
discrete states, rather than taking
values from a range.
• We use Dummy Variables for these
factors.
• To distinguish between n categories,
we need n1 dummy variables.
( )
( )
( )
÷
÷
÷ ÷ =
1  k n
1 n
R 1 1 R
2 2
Qualitative dependent variables with binary outcomes
• Logit models  estimate the probability that the event will occur based on logistic
distribution
• Probit models  as with logit, except based on normal distribution
• Discriminant models  based on regression analysis, but producing a score which
can then be used to assess likelihood of event (e.g. credit scoring)
Interpreting pvalues
• A pvalue is the smallest
significance level (ө) at which we
can reject H
0
41
Assumptions of a multiple regression
model
1. The relationship between the
dependent variable, Y, and the
independent variable, X, is linear
2. Expected value of the error term is 0
3. The variance of the error term is the
same for all observations
(homoskedasticity)
4. The error term is normally distributed
5. The error term is uncorrelated across
observations (i.e. no serial correlation)
6. No linear relationship exists between
two or more independent variables
(i.e. no multicollinearity)
Limitations of regression analysis
1. Regression relations change over
time (nonstationarity)
2. If assumptions are not valid, the
interpretation and tests of
hypothesis are not valid
Violations of regression assumptions
1. Heteroskedasticity – error term has
nonconstant variance
2. Serial correlation – error terms are
correlated with each other
3. Multicollinearity – linear relationship
between independent variables
Assumptions, Limitations, Violations
42
Description
• Variance of the error term is non
constant.
• Unconditional: Not related to
independent variables Æcauses no
major problems.
• Conditional: related to independent
variable Æthis is a problem.
Correction
• Compute robust standard errors
(aka Whitecorrected standard
errors) used to recalculate the t
statistics
Effect on statistical inference
• Estimated standard errors of the
regression coeffs. are likely to be wrong.
• With financial data they are likely to be
too small, hence actual tstats too high,
so coefficients might appear significant
when they are not (Type I error).
Detection
•Scatter diagrams (plot residual against each
independent variable and against time).
•BreuschPagan test: regress the residuals
2
against the independent variables, then test the
significance of the resulting R
2
using a one
tailed chisquare test. A significant value is
evidence of heteroskedasticity.
Heteroskedasticity
43
Serial Correlation
Description
• Autocorrelation (serial correlation)
arises when the residuals are
correlated with one another
• Usually arises with time series data
• Autocorrelation may be positive or
negative
Correction
• Adjust the coefficient
standard errors, e.g. using
the Hansen method (which
also corrects for
conditional
heteroskedasticity)
• Improve the specification
of the model.
Effect on statistical inference
• Positive autocorrelation can lead to too
low estimates of coefficient standard
errors, hence too large tstats, causing
Type I errors.
• Negative autocorrelation can cause the
standard errors to be overstated,
causing Type II errors.
Detection (if not autoregressive model)
•Scatter plot of residual errors
•Calculate the DurbinWatson Statistic, DW Ĭ2(1  r)
.
Where r = sample correlation coefficient between
consecutive residuals
0
2
4 d
L
d
U
4d
L
4d
U
Evidence of
positive
autocorrelation
Evidence of
negative
autocorrelation
No evidence of
autocorrelation T
e
s
t
i
s
a
m
b
i
g
u
o
u
s
T
e
s
t
i
s
a
m
b
i
g
u
o
u
s
44
Multicollinearity
Description
Two or more independent variables are
mutually correlated, making the
interpretation of the regression output
problematic.
Correction
Remove one or more of the
offending independent
variables
Alternatively perform a more
advanced technique such
as stepwise regression
Detection
• Conflicting t and Ftests: significant Fstatistic
combined with insignificant individual tstatistics
• High correlation coefficient between two
independent variables (rule of thumb: > 0.7 but
works only if no more than two independent
variables are present)
• When dealing with more than two independent
variables, low pair correlations could still lead to
multicollinearity
• Signs on the coefficients that are opposite to
what is expected
Effect on statistical inference
• Inflates SEE and coefficient standard
errors leading to lower computed tstats
• As a result, the null is rejected less
frequently leading to Type II errors
45
Model Specification Issues
biased and inconsistent
regression coefficients
Leading to:
Unreliable hypothesis testing
and inaccurate predictions
Examples of misspecification:
• Omitting a variable
• Failing to transform a variable
[e.g. using market cap as an independent
variable instead of ln(market cap)]
• Incorrectly pooling data
[e.g. using data spanning two distinct monetary
policy regimes when building a model to
predict inflation]
• Using the lagged value of the dependent
variable as an independent variable
• Forecasting the past
[using variables measured at the end of a
period to predict a value in the period]
• Errors in the measurement of the independent
variables
Model Misspecification
causes:
46
Trend Models
Variable is a
function of time
MovingAverage (MA)
models
Variable is a function of
weighted average of
previous error terms
Autoregressive (AR)
models
Variable is a function of
earlier value(s) of itself
Autoregressive Moving
Average (ARMA) models
A hybrid approach
Autoregressive Conditional
Heteroskedasticity (ARCH) models
Used when variance of the error term
is dependent on the size of earlier
errors
Types of TimeSeries Models
47
Trend Models
Linear trend model
Value of time series in period t,
y
t
= b
0
+ b
1
t + c
t
Average change in y is
constant in absolute terms = b
1
Loglinear trend model
The natural log of the value of time series in
period t,
ln(y
t
) = b
0
+ b
1
t + c
t
Exponential trend: average rate of change in y
is constant = e
b
1
– 1
Might be a better model to use if a linear trend
model produces serially correlated errors.
Limitations of trend model
• The one independent variable may be
insufficient to explain changes in the dependent
variable.
• Model errors are often serially correlated (use
DW to detect) and hence assumption violated.
data series
straight line
of best fit
y
t
t
y
Observation
Trend
48
Exists if time series
data is wellbehaved,
so process can be
represented with a
relatively simple
model (e.g. AR)
Covariance
stationarity
E.g. AR(p):
x
t
= b
0
+ b
1
x
t1
+ b
2
x
t2
+
…
+ b
p
x
tp
+ e
t
Series has:
• constant mean
• constant variance
• constant covariance
with itself over time
If not covariance
stationary then
regression results, both
statistically & financially,
are meaningless
Mean reversion
Time series has tendency to
converge to its mean:
Necessary
condition for
parameters to be
estimated by AR
regression
methods
No finite
mean
reverting level
¬not
covariance
stationary
First differencing
might help a time
series achieve
covariance
stationarity
( )
1
0
b 1
b
: AR(1) For
÷
Autoregressive Models
49
Chain rule of forecasting
Inputs used in multiperiod
forecasts are themselves
forecasts
x
t
= b
0
+ b
1
x
t1
+ b
2
x
t2
+
…
+ b
p
x
tp
+ ¦
t
Random walks
Value in one period is equal to the
value in previous period plus a random
error:
x
t
= b
0
+ x
t1
+ ¦
t
If b
0
Į0 then random walk with drift
This is an AR(1) model
with b
1
= 1
Known as a unit root
hence the mean
reverting level is
undefined
Serial correlation
• Serial correlation within an AR model
causes estimates of the regression
coefficients to be inconsistent ÷big
problem.
• Cannot test for it using the DW statistic.
• Instead use a ttest to see whether any of
the residual lag autocorrelations differ
significantly from zero.
• If some are significant then the model is
incorrectly specified.
• Increase the order of the model by
incorporating the offending lags.
• In case of seasonality, add x
t4
for quarterly
data, and x
t12
for monthly data
No finite
mean
reverting level
¬not
covariance
stationary
Autoregressive Models cont.
50
Q
th
order moving average model, MA(q)
x
t
= c
t
+ u
1
c
t1
+ u
2
c
t2
+
…
+ u
q
c
tq
• A time series will be well represented
by a MA(q) model if the first q
autocorrelations of that time series are
significantly different from 0, while
subsequent autocorrelations equal 0
(the autocorrelations drop suddenly to
0 after the first q)
• With most AR time series the
autocorrelations start large and decline
gradually as the lags increase.
ARMA models
Combines both autoregressive lags of the
dependent variable and movingaverage
errors.
Problems:
• Parameters can be very unstable  slight
changes in data sample or initial
guesses of parameters can give very
different final estimates
• Choosing the right model is more art
than science
• Model may not forecast well  in most
cases a much simpler AR model will do
as good a job
• Require large amounts of data (at least
80 observations)
Moving Average Models
51
Description of heteroskedasticity
• Variance of the error term is non
constant.
• Unconditional: Not related to
independent variables Æcauses
no major problems.
• Conditional: Is related to
independent variable Æthis is a
problem.
Correction
• Compute robust/corrected standard
errors (aka Whitecorrected
standard errors) or
• Use an ARCH model to forecast
the variance of the error term
Autoregressive Conditional
Heteroskedasticity
• Variance of error terms in one time period is
dependent on the variance of the error terms
in another period.
• SEs of the regression coefficients in models
will be incorrect and hypothesis tests will be
invalid.
• ARCH(1) detected by performing following
regression:
(u
t
is an error term)
• If a
1
is statistically different from zero then the
series is ARCH(1).
• Can then use ARCH model to predict variance
of errors with the following equation:
t
u a a + + =
2
1  t 1 0
2
t
ˆ ˆ c c
ARCH Models
2
t 1 0
2
1 t
ˆ ˆ c o a a + =
+
52
Insample vs Outofsample forecast errors
• Insample forecasts are for values within the estimation period. Can use the SEE to
compare the insample errors of competing models.
• Outofsample forecast errors represent the differences between actual and predicted
values of the time series outside of the period used to construct the model.
• Can use the RMSE (Root Mean Squared Error, i.e. the square root of the average
squared forecast error) to judge which model is most accurate.
The DickeyFuller (DF) Test for a Unit Root
• Test is based on a transformed version of the AR(1) model x
t
= b
0
+ b
1
x
t1
+ c
t
• Subtracting x
t1
from both sides produces:
x
t
 x
t1
= b
0
+ (b
1
– 1)x
t1
+ c
t
or x
t
 x
t1
= b
0
+ g
1
x
t1
+ c
t
where g
1
= (b
1
– 1)
• If there is a unit root in the AR(1) model, then g
1
will be 0 in a regression where the
dependent variable is the first difference of the time series and the independent
variable is the first lag of the time series.
• DF test: H
0
: g
1
= 0, time series has a unit root and is nonstationary
H
a
: g
1
Ћ0, time series does not have a unit root
• Test is conducted by calculating a tstatistic for g
1
and using a revised set of
critical values computed by DF.
Other Issues in Time Series
53
Cointegration
• Two time series are cointegrated if a longterm financial or economic relationship
exists between them such that they do not diverge from each other without bound in
the long run (e.g. they share a common trend)
With a simple regression the following scenarios are possible:
1. Neither time series
has a unit root
Can safely use linear regression
2. One or other time
series has a unit
root
Error term in the regression will not be covariance stationary
÷one or more regression assumptions violated ÷
regression coefficients might appear significant when not
3. A) Both time series
have a unit root but
are not cointegrated
As with 2. above
3. B) Both time series
have a unit root but
are cointegrated
Error term in the linear regression will be covariance
stationary but we should be very cautious in interpreting the
regression results. The regression estimates the longterm
relation between the two series but may not be the best
model of the shortterm relation.
Multiple Time Series
54
S
t
a
r
t
Time Series  Summary
55
Economics
Study Session 4
Weighting 5 – 10%
56
Study Session 4
Economic Growth
Regulation and Antitrust Policy
In a Globalized Economy
Trading with the World Currency Exchange Rates
Foreign Exchange Parity Relations
Measuring Economic
Activity
Overview of Level II Economics
57
Economic Growth
Real GDP = measure of inflationadjusted income and output
Standard of living = level of real GDP per labor hour = level of labor productivity
Economic growth = % change in real GDP per labor hour = growth in labor productivity =
improvement in standard of living
Rule of 70: a country’s economic activity will double every (70/growth rate) years
58
Economic Growth
PRECONDITIONS FOR
ECONOMIC GROWTH
Theories of Economic Growth
• Markets
• Property rights
• Monetary exchange
New Growth Theory
Neoclassical Growth Theory
• Saving and investment in new
capital
• Investment in human capital
• Discovery of new technologies
For economic growth
to continue
Classical Growth Theory GDP growth will be driven back to the subsistence level
LT GDP growth requires technological change
Discovery of new products and techniques is down to luck
At a given level of technology, on
average, a 1% increase in capital per
labor hour results in a one third of 1%
increase in real GDP per labor hour
PRODUCTIVITY
One Third Rule Methods for Increasing Economic Growth
• Encourage savings
• Encourage basic R&D
• Stimulate international trade
• Improve the quality of education
59
Regulation and Antitrust Policy
Government
regulation
Social regulation
Economic
regulation
Based upon
Product quality
Product safety
Employee safety
Natural Monopolies
Costofservice regulation
Rateofreturn regulation
Negative Side Effects
Creative response
Feedback effect
Regulator Behavior Theory
Capture Theory
Industry controls
regulator
Sharethegains, Share the Pains
Theory
Legislators
Customers
Regulated firms
60
Trading with the World
Comparative advantage refers to the lowest opportunity cost to produce a product.
Law of comparative advantage: trading partners can be made better off if they specialize
in producing goods for which they are the lowopportunitycost producer and trade for the
goods for which they are the highopportunitycost producer
Restrictions on Trade
Tariff is a tax imposed on imported goods
Quota is a limitation on the quantity of goods imported
Voluntary export restraints (VERs) are agreements by exporting countries to limit the
quantity of goods they will export to an importing country
Two primary forces underlying trade restrictions:
¾ Governments like tariff revenue
¾ Domestic producers affected by lowercost imports use political means to gain
protection from foreign competition
61
Currency Exchange Rates
Foreign Exchange Quotations
Direct Quotes
• DC/FC
• Usual method of
quoting currencies
Indirect Quotes
• FC/DC
Triangular Arbitrage
Profit is calculated by “going around
the triangle”.
Choose the way > 1
Always sell the base currency and by
the quoted!
USD
CHF GBP
1
.
5
6
0
0
U
S
D
/
G
B
P
2.3182 CHF/GBP
1
.
4
8
6
0
C
H
F
/
U
S
D
USD ėGBP ėCHF ėUSD or
USD ėCHF ėGBP ėUSD
£/$ x CHF/£ x $/£ or
CHF/$ x £/CHF x $/£
£:$ £ base $ quoted
£/$ $ base £ quoted
62
Triangular Arbitrage
Bid and Ask
$
€
“BID”
means
turning
€ into $
“ASK”
means
turning
$ into €
CHF GBP
1
.
3
5
0
0
U
S
D
/
G
B
P
Ask rate = ?.???? CHF/GBP
1
.
5
0
0
0
C
H
F
/
U
S
D
1
.
5
0
1
0
C
H
F
/
U
S
D
Bid Rate = ?.???? CHF/GBP
1
.
3
5
1
0
U
S
D
/
G
B
P
63
Currency Exchange Rates
Bid – Ask Spread
Factors affecting spread:
• Volume
• Volatility
• Dealers long/short position
• Term (forward contracts
only)
Triangular Arbitrage
1. Choose a direction and formulate equations:
£/$ x CHF/£ x $/CHF
2. Check examiner has given the quotes for the
right base and quoted combinations.
If not you will need to take reciprocals noting
that the bid and ask swap when you do
3. Using the bids move round the triangle selling
the base and buying the quoted currency
4. Did you get > 1? If not take the reciprocal of
the ask quotes to move the opposite direction.
USD
CHF GBP
£/$ 0.7113 – 0.7116
Bid (lower)
Bank sells £
Bank buys $
Ask (higher)
Bank sells $
Bank buys £
Forward Contracts
Premium – base
currency buys more
future quoted
Discount – base
currency buys less
future quoted
Fwd – Spot
Spot
x
360
Contract Days
Fwd Pm
or Disc
=
64
Factors That Cause a Currency to Appreciate/Depreciate
Differences in income growth: Country with rapid income growth has more demand for imports and
foreign currency, domestic currency depreciates
Differences in inflation rates: Higher inflation means exports more expensive, imports cheaper,
domestic currency depreciates
Differences in real interest rates: Country with higher real rates will attract foreign investment,
increased demand for domestic currency so it appreciates
A fixed rate system has a set rate of exchange to another currency
A currency board creates domestic currency only in exchange for the other currency, held in
bonds and other liquid assets. The currency board promises to redeem the domestic
currency at the fixed exchange rate into dollars
A pegged exchange rate system is based on a commitment to use monetary policy to
keep exchange rates within a band
Other Exchange Rate Regimes
Foreign Exchange Parity Relations
65
Fiscal Policy and Exchange Rates
Expansionary monetary policy leads to:
Rapid economic growth (increases imports)
Higher inflation (decreases exports)
Lower real interest rates (increase investment to abroad)
All three cause the domestic currency to depreciate
Monetary Policy and Exchange Rates
Unanticipated restrictive fiscal policy leads to:
Slower growth (decreases imports) appreciation
Lower inflation (increases exports) appreciation
Lower real interest rates (increases investment abroad)
depreciation
Financial capital is more mobile, so third effect dominates in
short run
Expansionary policy ėShort run appreciation
Foreign Exchange Parity Relations
66
Purchasing Power Parity
Based on the “Law of One Price”
Absolute PPP: Same basket of goods will cost the same everywhere, after
adjusting for exchange rates
Relative PPP: Changes in exchange rates will just offset changes in price levels
(i.e., differences in inflation)
Uncovered Interest Rate Parity
• Countries with high interest rates (and high inflation rates) should have currency values that
fall over time
• Assumes PPP and Fisher hold
• Assumes constant real exchange rate
International Fisher Relation
• Inflation differentials between countries are the prime drivers of interest rate differentials
• Key = real interest rates the same in every country!
Foreign Exchange Parity Relations
Covered Interest Rate Parity
• Forward rates are arbitrage free rates set using interest rate differentials.
67
Foreign Exchange Parity Relations
International Fisher Effect
Spot
Forward
Interest
Rate
Parity
Purchasing
Power
Parity
The forward rate is the best unbiased predictor of the future spot rate
U
n
c
o
v
e
r
e
d
I
n
t
e
r
e
s
t
R
a
t
e
P
a
r
i
t
y
B
Q
INT 1
INT 1
+
+
0
t
Spot
Future Spot
) REAL 1 )( INF 1 (
) REAL 1 )( INF 1 (
B
Q
+ +
+ +
68
Purchasing Power Parity Interest Rate Parity (covered)
Parity Relationships
International Fisher Effect
Exact Methodology:
1+r = (1+real r)(1+E(i))
Linear Approximation:
r = real r + E(i)
Where:
r = nominal interest rate
real r = real interest rate
E(i) = expected inflation
Uncovered Interest Rate
Parity
Foreign Exchange Parity Relations
Foreign Exchange
Expectation Relation
E(S) = F
E(%S) = F  S
o
S
o
E(S
T
) = So x
(1+I
quoted
)
T
(1+I
base
)
T
Fwd = So x
(1+R
quoted
)
(1+R
base
)
E(S
T
) = So x
(1+R
quoted
)
(1+R
base
)
69
Measures of Economic Activity
Gross Domestic
Product (GDP)
Total market value
of all final goods
and services
provided in a
country over a
stated period of time
(1yr)
Gross National
Income (GNI)
Total goods and
services produced
by the citizens of a
country
Net National
Income (NNI)
GNI less
depreciation.
Amount of resources utilized or
worn out by the production process
Value of production
 cost of inputs
GDP
Output
Consumption
+ Investment
Total domestic expenditure
+ Exports of goods and services
Total final expenditure
 Imports of goods and services
GDP
Expenditure
Wages and salaries
+ Selfemployment income
+ Company trading profits
+ Government and
enterprise
trading surpluses
+ Rental income
GDP
Income
GDP
+ net property
income from
abroad
GNI
 Depreciation
NNI
Can be expressed in current or constant prices
GDP at market prices – indirect taxes + subsidies = GDP at factor prices
70
Financial Reporting &
Analysis
Study Sessions 5, 6 & 7
Weighting 15 – 25%
71
Overview of Level II FSA34
Inventories
Intercorporate
Investments
Study Session 5
Multinational
Operations
Study Session 6
Employee
Compensation
LongLived Assets
Integration of Financial
Statement Analysis
Techniques
Study Session 7
The Lessons We Learn Financial Reporting
Quality
72
Inventories
With inflation and LIFO,
COGS is higher and end.
inv. is lower.
With deflation and LIFO,
COGS is lower and end. inv.
is higher.
Weighted average cost is in
between FIFO and LIFO.
Inventory methods
Perpetual vs. Periodic
Systems
Perpetual: updates inv.
after each purchase/sale.
Periodic: records
purchase/sale in
"Purchases" account ,
inv./COGS determined at
period end.
LIFO reserve will increase
with rising prices and
stable/increasing inv.
inv
FIFO
= inv
LIFO
+ LIFO
reserve .
COGS
FIFO
= COGS
LIFO
–
LIFO reserve.
NI = LIFO reserve h
(1t).
LIFO reserve
Under LIFO, inv. purchased
last is treated as if it’s sold
first.
LIFO liquidation occurs
when a company appears
to sell the inventory it
purchased first.
LIFO liquidation
Under IFRS: Lower of cost
or NRV, NRV = sales price
 selling cost
Under US. GAAP: Lower of
cost or market
(replacement cost), NRV <
Market < NRV – Normal
profit margin
Inventory valuation
73
Longlived assets
IFRS: Annually, CV vs.
recoverable amount (FVselling
cost), can be reversed
US. GAAP: Tested, two steps:
recoverability test, then measuring
the loss, loss recoveries are
prohibited
Impairment
Longlived assets
disclosure
Fixed asset useful life,
Fixed asset SV,
Depreciation method,
Useful calculations
regarding a firm’s FA:
average age, average
depreciable life, remaining
useful life
In the year of impairment: NI
lower, ROA & ROE will
decrease
In subsequent year: lower
depreciation, NI higher, ROA
& ROE will increase
Impact of Impairment
US GAAP: upward revaluation is
prohibited, except for long lived assets
held for sale
IFRS : permitted
Upward revaluation: A & E increase, D/E
decrease, subsequent periods: Higher
depreciation, Lower ROA and ROE
Revaluation to FV
74
Leases
transfer title
bargain purchase option
75% of the asset’s economic life
90% of the fair value of the leased asset
Capital lease criteria
Capital lease:
Salestype lease: Manufacturer,
dealer, PV of the lease
payments is greater than
carrying value of the leased
asset (COGS)
Direct financing lease
Lessor: capital vs. operating
lease
Relative to operating leases, capital
leases will make assets higher,
liabilities higher, net income (early
years) lower, CFO higher, CFF lower,
total cash flow the same, EBIT higher
Lessee: capital vs. operating
lease
75
Intercorporate Investments
shares are a genuine small
investment for
dividend/capital gains
purposes
<20% votes
shares are to ensure a
significant influence is
exerted over the other
company (but NOT
outright control)
“Affiliate/Associate”
Equity Account
20 – 50% votes
shares are to take
over and control the
company
“Subsidiary”
Consolidate (Purchase
method)
Pooling (Merger method)
> 50% votes
Secondary market?
No
Heldtomaturity
securities
Availablefor
sale securities
Trading securities
Yes
Debt securities
which the
company
intends to hold
to maturity
Securities are
carried at
amortized cost
May be sold to satisfy company
needs
Debt or equity
Current or noncurrent
Carried in the balance sheet at
market value
Income statement same as cost
method
Acquired for the purpose of
selling in the near term
Carried in the balance sheet
as current assets at market
value
Income statement includes
dividends, realised &
unrealised gains/losses
B/S Historic Cost
I/S Dividends/Int
76
Equity Accounting
Equity Accounting: Significant Influence
“One line consolidation”
Initially recorded at purchase price (cost)
Subsequent periods:
B/S: Cost + earnings pickup – dividends
A B/S = %Share x A Retained earnings
I/S: Earnings pickup (% share of NI)
Purchase Price > Book Value
Investment initially recorded at cost
However within cost:
% Net Assets Acquired
%FMV adjustments
Goodwill
Cost paid
$m
X
X
X
X
FMV adjustments impact
future earnings
Adjust earnings for up/down stream
inter group unearned profits
Impairments
Carrying value > Fair value
Decline considered permanent
No reversal (US GAAP)
Reversal allowed (IAS)
Upstream
Profits recognized in
investee I/S
Unconfirmed profits –
eliminate prorata share
Downstream
Profits recognized in
investor I/S
Unconfirmed profits –
eliminate prorata share
Fiscal years beginning post Nov 2007 IFRS 159
Can elect to hold investment at fair value with
changes in fair value taken to the I/S
Convergence with IAS 28/39
77
Joint Ventures
Joint Ventures
•Equity account: Required US GAAP Permitted IAS
“one line consolidation”
•Proportional consolidation recommended by IAS
“line by line proportional consolidation
• Report prorata share of all accounts, net
out intercompany transfers
• Make both sides of intercompany
adjustments in joint venture accounts
• No minority interest (consolidated on the
basis of ownership not control)
• The rest is as per a normal consolidation
• Interest cover  overstated
• Return on assets  overstated
• Debt ratios skewed
Stockholders equity, Net Assets and NI
same under both methods
Total asset and total liabilities differ
Big impact on ratios
78
Consolidation (Purchase Method)
Steps
1. Record any finance raised in parent
company’s balance sheet
2. Record investment in subsidiary in
parent’s balance sheet.
(Investment recorded at purchase price)
3. Adjust subsidiary identifiable net assets
to fair market value (IAS 100% of FMV
adjustments, US GAAP parents share of
FMV adjustments)
4. Calculate goodwill on acquisition
Proceeds
% Identifiable Net Assets
Goodwill
5. Eliminate intercompany transactions
6. Add together assets and liabilities 100%
regardless of ownership
7. Eliminate investment in parent
company’s books
8. Include Common Stock and Additional
Paid in capital of parent only
9. Include parents reserves and % share of
any post acquisition retained earnings in
the subsidiary (unlikely)
10. Calculate Minority Interest
Minorities % share of Net Worth of sub (at
FMV IAS, at book value US GAAP)
11. Total Balance Sheet
X
(X)
X
•Control of subsidiaries decisions: Operating/Financing/Investing
•Share ownership > 50%
•Reflect control not ownership
79
Goodwill
Business Combination – with Less
100% Interests
Allowed in both US GAAP and
IFRS
= consideration / % of interests
acquired – fair value of net assets
MI is stated (% of MI shareholders
own) h(consideration / % of
interests acquired)
Full goodwill
Only allowed under IFRS
= consideration – fair value of net
assets X % of interests acquired
MI is stated (% of MI shareholders
own) X FV of net assets
Partial goodwill
80
Business Combinations
Purchase Method Pooling of Interests Method
US: no longer permitted (since 2001)
IAS: no longer permitted (since 2003)
US: required under SFAS 141
– Business Combinations
IAS: required under IFRS 3 –
Business Combinations
Treats transaction as acquisition of
target by buyer
Treats transaction as
merger of equals
Still studied, as move from pooling to purchase
has been prospective, not retrospective
No goodwill
No minority interest
No fair value adjustment
Restate prior periods
Post and pre acquisition
earnings pooled
Combine equity
Goodwill on consolidation
Purchase consideration 10
% FMV (assets – liabilities) (8)
Goodwill 2
Goodwill
Minority Interests
Fair value adjustments
Post acquisition earnings
81
Impact on Accounts
Cost vs.. Equity
If sub earnings > 0 and sub dividend
payout < 100%, parent results are more
favorable under equity method:
Parent earnings larger
Parent cash flows the same
Interest coverage and return on
investment ratios higher
Capital ratios lower
Cost method preferred if sub is not
profitable
Assets and liabilities are different, but equity
is the same
Revenues and expenses are different
(operating income), but net income is the
same
Reported cash flows are different
Equity method includes only capital
flows between parent and sub
Consolidation method includes all cash
flows except between parent and sub
Financial ratios different
Consolidation vs. Equity
Proportionate Consolidation vs. Equity Method
Equity, net income and ROE are the same under both methods
Most other accounts and ratios change
Equity method overstates ROA
Equity method hides liabilities
Equity method hides footnote info
82
Purchase vs.. Proportionate vs.
Equity A/C
Current Ratio
Consolidated > Proportionate > Equity
Assuming investee ratio > parents
Leverage
Consolidated > Proportionate > Equity
Net Profit Margin
Equity > Proportionate > Consolidated
Gross Margin
Consolidated > Proportionate > Equity
Assuming investee ratio > parents
Return on Assets ROA
Equity > Proportionate > Consolidated
Impact on Accounts
Purchase vs. Pooling
Assets
Purchase > Pooling
Equity
Purchase > Pooling
Assuming purchase is funded by
issuing equity
Net Income
Purchase < Pooling
Profit Margins
Purchase < Pooling
ROA and ROE
Purchase < Pooling
83
Impairment of goodwill
Identification:
Measurement:
Group Accounting
Carrying value of
reporting unit +
goodwill
Fair value of
reporting unit
>
Carrying value of
goodwill
Implied fair value
of goodwill
>
Fair value of reporting unit –
fair value of identifiable net
assets
Bargain Purchase (ve goodwill)
Price < % FMV of identifiable net assets
Reassess FMV of identifiable net assets
US GAAP reduce non current assets
 take remainder to I/S as an
extraordinary gain
IAS  take as gain to I/S
US GAAP & IFRS Differences
Inprocess R&D
Contingent liabilities
Contingent consideration
Convergence Project
FMV adjustments for 100% of net assets not
just purchased element
Minority interest calculated using FMV
Inprocess R&D capitalized
Contingent consideration recognized at
acquisition date
Minority interests in equity
Remaining Differences:
US GAAP full goodwill
IFRS full or partial goodwill
84
Special Purpose Entities
A separate legal entity established by asset
transfer to carry out some specific purpose
Uses
Access capital or manage risk
Characteri
stics
Issue
Securitized loans, synthetic
leases, sale of accounts
receivable, R&D costs
Thinly capitalized, lack of
independent management,
servicing agreements
Prior to Fin 46R consolidation
was based on voting rights not
risk and reward of ownership
Purpose
VIE Criteria Fin 46R
1. Equity interest less than
10% of total assets
2. Equity investor lacks:
• Decision making ability
• Obligation to absorb
losses
• Right to receive
residual returns
A VIE must be consolidated in a
company’s accounts if the
company is the primary beneficiary
(Previously only if controlled via
voting rights)
Variable Interests:
Guarantees of debt
Subordinated debt instruments
Lease residual interest guarantees
Participation rights
Asset purchase options
Qualifying SPEs US GAAP only
Not consolidated if SPE:
•Independent and legal separate from sponsor
•Has total control over asset
•May only hold financial assets
•Sponsor must have limited financial risk
85
Pension Plans
Employee directs
investment policy
Employer will appoint
an investment manager
Asset
manageme
nt
Employee owns
assets, employer
acts as agent
Employer owns assets
Asset
ownership
Employee carries
the risk
Employer carries the
risk
Risk
Defined
Contribution
Defined Benefit
Income Statement = Employer
Contribution
Balance Sheet  Asset/Liability =
excess or shortfall in payments
relative to specified contribution level
No major analyst issues
Income Statement = Pension expense
Balance Sheet  Asset/Liability = Cumulative
payments into plan less cumulative pension
expense SFAS 87 & IAS19
Post 2006 SFAS 158 Asset/Liability = Funded
status
Major issue for analysts
PBO (Projected Benefit
Obligation)
Present value of all future
pension payments earned to
date based on expected salary
increases over time. Assumes
employee works until
retirement. Estimate of liability
on a going concern basis
ABO = Accumulated Benefit
Obligation
VBO = Vested Benefit
Obligation
86
Pensions
Service cost
Interest cost
Actuarial gains or losses
Prior service cost
Benefits paid
ENDING PBO
/+
/+
+
+
=
BEGINNING PBO
X

Reconciliation disclosed in foot notes
(SFAS 132)
Benefits paid to retirees
Fair value of plan assets at end of year
Fair value of plan assets at start of year
Actual return on plan assets
Employer contributions
Plan participant contributions
Expenses
X
+
+
+

=

Reconciliation disclosed in foot notes
(SFAS 132)
87
Pensions
Actual Events
Service Cost
Interest Cost
Smoothed Events (SFAS 87)
Expected Return on Plan Assets
Amortisation of gains/losses
Amortisation of prior service costs
Amortisation of transition asset or
liability
+
+

+/
+/
+/
Reported Pension Cost
X
Other Events
Curtailment/Settlements/
Termination
+/
Pension Expense
FV of Plan Assets – PBO = Funded Status
FV > PBO = Overfunded
FV < PBO = Underfunded
Funded Status = Economic Position of Plan
Funded Status ĮB/S Asset/Liability SFAS 158
Funded Status
Actuarial (Gain)/Loss
Prior Service Cost
Net Transition Asset
Balance Sheet (Liability)/Asset
+/
+/
+/
+/
+/
88
Actuarial Assumptions
Lower Lower Lower
Pension
Expense
No change No change Lower ABO
No change Lower Lower PBO
Higher Expected Return
on Assets
Lower wage
rate
increases
Higher discount
rate
Actuarial
Assumptions
3 main delayed events
Actuarial gains & losses
Prior service adjustments
Transition assets & liabilities
Net of:
Plan Assets
Actual vs.. Expected return
Plan Liabilities
¨ PBO due to ¨ actuarial assumptions
Amortised if net gain or loss > 10% of
opening PBO or Market related plan
assets value
Delayed Events
89
Post 2006 SFAS 158
SFAS 158 Impact on Financial Statements
Income Statement same as SFAS 87
Balance Sheet = Funded Status
Adjust balance sheet asset/liability to funded status
Adjust deferred tax asset
Adjust comprehensive income (equity)
Assuming net actuarial losses the new standard will
increase the pension liability and reduce equity
90
Income Statement:
Adjusted pension expense = service cost + interest cost – actual return on plan assets
Alternatively = ¨ funded status + employer contribution
Improvement in funded position reduced economic expense
Worsening of funded position increases economic expense
Required for both SFAS 87 and 158
Analyzing Pension Disclosures
Balance Sheet:
Replace accounting asset/liability with funded status take any change to equity
NB only required for SFAS 87 not 158
Cash Flow Statement
Cash flow = employer contribution into fund (ĘCFO)
Contribution > Economic Expense = Principal repayment ĘCFF ĖCFO
Contribution < Economic Expense = Source of funding ĖCFF ĘCFO
Analyst should adjust CFO and CFF for after tax amounts
Analyst
Adjustment
91
Employee Compensation
Employee compensation:
Salary
Bonus
Share based compensation
Managerial compensation disclosure:
US GAAP  Proxy statement to SEC
IAS – Accounting disclosure
Share based compensation
Advantages:
Reduces agency problem
No cash outlay
Disadvantages:
Dilution of EPS
Employees limited influence over share
price
Ėownership Ėrisk aversion
Stock options Ėrisk taking
Dilution of existing shareholders
Stock Based Appreciation Rights
Payments linked to share value performance
No shares held
Advantages:
Avoids dilution
Avoids Ėrisk aversion
Disadvantages:
Cash outflows
Expense spread over service life
92
Stock Compensation Plans
Stock Options
Prior to June 2005
Account APB 25
Footnote Disclosure SFAS 123
Post June 2005
Account SFAS 123
APB 25 Intrinsic value at grant date
SFAS 123 Fair value at grant date
(similar to IFRS 2)
Disclosure
Nature and extent of arrangement
Method of determining fair value
Impact on periods income
Fair value
Market premium of similar option or
valuation model:
BSM
Binomial
Monte Carlo
Stock Purchase Plans
Enable employees to purchase stock at a
discount to market value
Recognize expense over life of option if
compensatory (5% rule)
Service Based Awards
Compensation linked to length of service
Recognize expense over vesting period
Performance Based Awards
Non price related and price related
Recognize over estimated time to meet criteria
Can lead to accounting manipulation
All models require 6 inputs:
1. Exercise price
2. Stock price at grant date
3. Volatility
4. Risk free rate
5. Expected term (time to expiry)
6. Dividends
93
Foreign Currency Translation
Functional currency Reporting currency Local currency
The currency of the
primary economic
environment in which
the firm generates and
expends cash flows.
The currency in which the
multinational firm prepares
its final, consolidated
financial statements. For
exam purposes, most likely
to be the US$
The currency of the
country in which the
foreign subsidiary is
located
Temporal method of translation
aka “Remeasurement”
Current Rate method of translation
aka “Translation”
SFAS 52 Hyperinflation = cumulative 3 year inflation rate > 100%
Use temporal method – prevents book value of PP&E falling
Net asset position and depreciating local
currency  reduces $ value of net assets
¬negative translation adjustment under
current rate method
Temporal method if amount of liabilities
exposed to current rate exceeds exposed
assets – (net liability position) a
depreciating currency makes this liability
smaller
94
Temporal/Remeasurement
Liabilities (current)
Common Stock (historic)
Retained earnings (ß)
Liabilities + Equity
X
X
X
X
Temporal
1. Produce top of Balance Sheet
(Total Assets)
2. Produce Shareholders Funds and
Liabilities (retained earnings = plug
figure to ensure that the balance
sheet balances)
3. Produce reconciliation of retained
earnings
4. Net Income in the Income
Statement will be different from NI
in retained earnings. The
difference is the exchange
gain/(loss) which is taken to the
income statement
Opening retained earnings
Net income (ß)
Dividends
Closing Retained earnings
X
X
(X)
X
SFAS 52 Hyperinflation = use Temporal
IAS 21 Hyperinflation = use indexing
Monetary assets/liabilities = current rates
(cash, AR, AP, STD,LTD)
Non monetary assets/liabilities = historic
rates
95
Current/Translation
All Current Approach
1. Produce Income Statement – translating
at average rate
2. Derive closing retained earnings
3. Compute Balance Sheet
4. Top and bottom of the balance sheet will
not balance. The difference is the
translation gain/(loss)
5. Force the balance sheet to balance by
including the adjustment on the balance
sheet in the equity section
Opening retained earnings
NI (from income statement)
Dividends
Closing Retained earnings
X
X
(X)
X
All assets/liabilities = current rates
96
Impact on Ratios
Translation/All Current (Compared to LC)
No change from translation using all
current method for pure income statement
and balance sheet ratios
Mixed ratios are distorted
FX rate changes affect consolidated ratios,
even when no “real” change occurs
Comparing Temporal and All Current
Process:
Step 1: LC appreciating or depreciating?
Step 2: Examine numerator
Translated at which rate? (current, avg,
historic, etc.)
Will numerator be larger or smaller?
Step 3: Examine denominator
Same as numerator
Step 4: Determine impact on ratio
Remeasurement/Temporal
(Compared to LC)
Even pure ratios may be distorted
due to mix of current and historic
in B/S or average and historic in
I/S
Mixed ratios now a blend of
current, average and historic!
97
IAS & Transaction Risk
IAS 21 Similar to SFAS 52
Exceptions
Integral subsidiaries – temporal method
Foreign entities – all current
Revaluations – historic rate at time of revaluation
Hyperinflation – indexing
Goodwill – current or historic rate
Losses resulting from the acquisition of an asset invoiced in an overseas
currency can be expensed (SFAS 52) or added to capitalized cost
Transaction Gains/(Losses)
Transaction recorded at spot rate
Receipt or payment at a later date
Issue = movements in spot rate between entering and settling a contract
Gains and losses reported in income statement (no guidance to where)
• Within SGA
• Nonoperating income/expense
reduces
comparability
98
The Lessons & Derivatives
The lessons we learn
1. Read all info including MDA and Footnotes
2. Be sceptical – persistently higher than average growth rates
3. Understand what you are looking at: proforma information
4. Follow the money (cash flow and earnings divergence)
5. Understand the risks (business & financial)
Derivative Accounting
B/S fair value
Speculatively held – gains/losses I/S
Hedging purposes – location per SFAS 133
Fair Value Hedge
Hedging asset/liability value
Gains and losses I/S
Cash flow hedge
Hedging the future cash flows of a transaction
Unrealized gains/losses to comprehensive income
Accumulated gains/losses released to I/S when the
transaction affects earnings
Hedging foreign currency
exposure
All current – gains/losses to
comprehensive income
Temporal  gains/losses to I/S
99
Financial Reporting Quality
Accrual vs.. Cash Accounting
Cash:
Transaction recorded on payment/receipt
Advantages: No subjectivity/Easy to verify
Accrual:
Revenue/Expense triggered by earnings
process
Advantages: Timely and relevant
information/Indication of value creating activities
Disadvantages: Subjective
measurement/earnings management
1. Revenue Recognition:
• % completion method
• Earnings activities
complete
• Assurance of receipt
• Bill and hold
• Unearned income
2. Depreciation Choices:
• Method (S/L vs accel’)
• UEL
• Salvage value
3. Inventory Choices
• FIFO/LIFO/AVCO
• Normal cost
• LOCOM rules
4. Goodwill
• Fair value measurement
• Impairments
5. Deferred Tax
• Valuation allowance
6. Pension Accounting
• Discount rate
• Expected returns
• Salary growth
7. Assets held at FMV
8. Stock Options
9. Provisions
100
Financial Reporting Quality
Manipulation Incentives:
Analyst Expectations
Remuneration (Bonus/Stock Option)
Debt Covenants
Financing (raising further funds)
Disciplining Mechanisms:
External Auditors
Internal Audit/Committee
Management Certification
Class Action Law Suits
Regulators
Market Scrutiny
Earnings:
Quality = persistence/sustainability
Mean reversion
Cash flow and accruals elements
Accruals element – not sustainable
Accruals – naturally self correct
Richardson, Tuna, Wu – companies
restating earnings have highest
accruals
Calculations:
Aggregate
Accruals
Accrual based
earnings NI
Cash based
earnings
=

Net
Operating
Assets
NOA
Total assets 
cash
Total liabilities –
total debt
=

Aggregate
Accruals
NOA
t
NOA
t1
= 
Aggregate
Accruals
NI – (CFO
t
+ CFI
t
) = 
B/S based aggregate accruals
Cash flow based aggregate accruals
101
Earnings Management
Revenue Recognition Problems:
Range of problems:
Recognition of sale before completion of
earnings process
Recognition of sale without assurance of
receipt
Estimates:
Credit sales
Deferred/Unearned revenue
Warranty provisions
Sales returns
Warning Signs:
Large ĖAR
Large ĘUnearned Revenue
Lower future cashflows and accounting
rates of return
Accelerating Revenue Recognition
Range of problems:
Recognition of sale before completion of
earnings process (assessing the
completion date)
Lowering credit standards
Cut off issues (moving sales between periods)
Warning signs:
Bundled products
Management vested options ITM
Pressure to meet earnings forecasts
Raising additional finance
Large ĖAR
Large ĘUnearned Revenue
Disproportionate revenue in last ¼
Recognizing revenue to early:
Billandhold sales
Lessor use of sales type vs.. direct financing leases
Recording sales prior to acceptance by customer (sales of equipment prior to installation)
Incorrectly using % completion method for long term contracts
102
Earnings Management
Classification of non operating
earnings as operating:
Range of problems:
1.Investment income
2.Divestiture of non current assets
NB. No accrual or deferral reversal in
later periods
Warning signs:
Temporary inconsistency of items
included within definition of operating
income
Expense Recognition:
Range of problems:
Discretion over depreciation and amortization
Impairment recognition
Application of lower of cost and fair value
rules
Warning signs:
of methods or lives – depreciation
(disclosed in footnotes)
Conference calls – additional information
LIFO liquidations
Inventory obsolescence
Deferring Expenses:
Range of problems:
Capitalization of operating expenses
Warning signs:
ĖNet non current assets (B/S broad
measure accruals)
Consider asset growth in the context of
expected sales and margin growth
Software development costs  discretion
Classification of operating expenses
as non operating
Range of problems:
Incorrect classification reduces COGS
or SG&A
Warning signs:
Company’s with genuine special items
that can be piggy backed
Changes in operating profit margin or
gross margin accompanied by spikes in
special items
103
Earnings Management
Big Bath Provisions
Range of problems:
1. Impairments – future I/S
improvements via Ędepreciation
2. Restructuring or impairment charges
reversed in subsequent periods
3. Use of high or low bad debt reserves
out of line with peers
Off Balance Sheet Items
Range of problems:
1.Assets and liabilities avoiding
recognition:
Operating leases
Sale of AR with recourse
Take or pay/through put
agreements
Equity accounted SPVs
Warning signs:
SEC obligations to report future cash flow
obligations of operating leases – analyst
may discount to PV and restate
Goodwill:
Range of problems
FMV adjustments on acquisition
Future impairments
Warning signs:
Goodwill reported and not impaired for
companies where market cap < book value
IASB & FASB move to fair value accounting
Issues:
Some assets have readily identified fair values
e.g. listed equity
Some assets don’t have readily identified fair
values (assets with no actively traded
secondary markets)
e.g. unlisted equity
e.g. specialized equipment
Valuation models = discretionary inputs
104
Modifying the Balance Sheet
Unrecorded Items
Special Purpose Entities
Operating Leases
Guarantees
Contingent liabilities
Recorded Items
Marketable securities
Accounts receivable
Inventory
Proportional vs.. equity a/c
Property Plant and Equipment
Capitalized interest
Goodwill
Intangibles (R&D)
Redeemable Pref/Convertible Debt
Long term debt
Pension Liabilities (SFAS 87!)
Stock Option plans (Pre SFAS 123R)
Deferred Income Taxes
Comprehensive Income
Net Income
Pension adjustments
Unrealised gains and losses on
available for sale securities
Cumulative foreign currency
translation adjustments
Comprehensive Income
$
X
X
X
X
X
U
S
G
A
A
P
COGS LIFO – FIFO
Capitalization of operating leases
Reversal of deferred tax assets/liabilities
Mark to market LTD
Adjustments (not required by US GAAP)
Capitalized interest reversal
Off Balance sheet items
Funded status of pension plan
105
Adjust COGs to LIFO
Litigation or gov’t actions
Discontinued ops
LIFO liquidations
Capitalize Op leases
Capitalized interest
Economic cost of pension
plan
Temporal gains/(losses)
Normalized Earnings
Normalizing Operating Earnings
Discretionary accounting changes
Regulated accounting changes
Realised capital gains/losses
Gains/losses on repurchase of debt
Catastrophes
Insurance settlements
Strikes
Impairment or restructuring
Interfirm comparisons
(adjustments)
Inventory methods
Depreciation
assumptions/methods
Pension plan/Stock option
assumptions
Capital/operating leases
Cyclical Firms
Remove the impact for
valuation:
1. Averages over the
business cycle
2. Average ratios applies
to current sales or
equity
3. Regression model
approach
International
comparisons
LIFO prohibitions
Extraordinary items
Capitalized R&D
Accelerate Dep
n
Asset revaluation
Acquisition a/c
106
Corporate Finance
Study Sessions 8 – 9
Weighting 5% – 15%
107
Overview of Level II Corp Fin
Capital
Budgeting
Study Session 8
Capital Structure
and Leverage
Corporate
Governance
Study Session 9
Mergers and
Acquisitions
Dividends and
Dividends Policy
108
Capital Budgeting (1)
Expansion vs.
replacement (see
next slide)
Expansion –
investment to
increase the business
Replacement –
replacement of
existing equipment
with newer
alternatives
Inflation and capital budgeting
Real (or nominal) CF
discounted using real discount
rate (or nominal)
Inflation increases company’s
real taxes
Higher than anticipated inflation
decreases the worth of interest
payments to bondholders
Inflation does not affect sales
and expenses equally
Use cash not accounting profit
Incremental cash flows only
– Ignore sunk costs
– Use opportunity costs
–Include net working capital increases/decreases
Cash flows based on opportunity costs
Cash flow timing is important (time value of money)
Analyze aftertax cash flows
Financing costs reflected in required return
Depreciation methods
and cash flows
Accelerated methods
provide higher tax
savings and hence
better cash flows in the
earlier years compared
to straight line methods
Example of accelerated
method – MACRS
Comparing projects with
unequal lives
Least common multiple of lives
approach – look at NPVs over a
common life
Equivalent Annual Annuity – find
the annuity (PMT) that equates
the NPVs at the cost of capital
109
Expansion vs. replacement projects
Expansion Projects – investment to increase the business
1. Initial cash outflow = FCInv + NWCInv
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax
rate) + Depn
3. Terminal year nonoperating cash flow = Cash proceeds from sale of FCInv + NWCInv
– tax rate x (Cash proceeds – BV of FCInv Termination)
Replacement projects – replacement of existing equipment with newer alternatives
1. Initial cash outflow = FCInv + NWCInv – Cash proceeds of old asset + tax rate x (Cash
proceeds – book value of old asset)
2. Annual operating cash flow = (Sales – cash operating expenses – depreciation)(1 – tax
rate) + Depn
3. Terminal year nonoperating cash flow = (Cash proceeds from sale of FCInv + NWCInv
– tax rate x (Cash proceeds – BV of FCInv Termination)
110
Standalone – the project’s
individual risk
Sensitivity to e.g. assumed
sales
Best/worst scenario
analysis
Monte Carlo simulation
– random lots of scenarios
– generate probability
distribution for NPV and
IRR
Capital rationing
Management constraint
on the size of the capital
budget
Optimal choice is to select
investments that
maximize the overall NPV
within the capital budget
Using SML in Capital budgeting (Based on £)
K
project required return
= K
RF
+ (K
mkt
– K
RF
) £
project
K
project required return
= discount rate to discount project
cash flow
Use of project beta to calculate required return when
project risk is different from the company
Real Options
Real options are options that allow managers to make
decisions at a later date where these decisions are
dependent upon future events or information
Examples: Timing options; sizing options; flexibility
options and fundamental options
Real option analysis
Work out the NPV without including the real options.
If the NPV is positive, accept the project. There is no
need to consider the real options if these options
enhance the project value.
Work out the NPV based on estimated future cash
flows. Then add the value of the real options. This
approach is useful when the NPV is negative.
Capital Budgeting (2)
111
Capital Budgeting (3)
Economic versus accounting income
Economic income = cash flow + change in market value
NB: Change in MV = Ending MV – Beginning MV
or
Economic income = cash flow – economic depreciation
Accounting income differs from economic income in the following ways:
Accounting depreciation is based on initial cost of the investment and reflects the decline
in the book value. Economic depreciation reflects the decline in the market value of the
investment.
Interest expense is included in accounting income but ignored in economic income.
Other valuation models
Economic profit (EP) = NOPAT  $WACC = EBIT(1 – t) – [WACC x Capital]
NPV = MVA = sum of PV of all future EPs discounted at WACC
Residual income: RI
t
= NI
t
– r
e
B
t1
NPV = sum of PV of all future RIs discounted at cost of equity
Claims valuation – looks at the cash flows to debt holders and equity holders. The sum of
the PV of these cash flows equal project NPV
112
Capital structure
Objective of capital structure decision is to maximise firm value and minimises the WACC
Taxes and its impact on value of the firm & re
Interest are tax deductible, debt capital provides a
tax shield that increases the value of a company.
Proposition I (with taxes): value is maximised at
100% debt
Value of a leveraged firm = value of an
ungeared firm + value of the tax shield
Proposition II (with taxes): WACC is minimised at
100% debt
With tax, WACC is
Cost of equity is
( )
e d a
r
V
E
t 1 r
V
D
r

.

\

+ ÷

.

\

=
( ) t 1
E
D
r r r r
d a a e
÷

.

\

÷ + = ) (
MM Proposition without taxes
Proposition I: Capital structure
decision does not affect the
company’s market value
MM assumed no taxes and no cost
of bankruptcy
Value of ungeared firm = value of a
leveraged firm
Proposition II: The cost of equity is
linearly related to the firm’s debt to
equity ratio
Without taxes, WACC is
Cost of equity is
As D/E increases, cost of equity
would increase
e d a
r
V
E
r
V
D
r

.

\

+

.

\

=

.

\

÷ + =
E
D
r r r r
d a a e
) (
D/E
C
o
s
t
o
f
c
a
p
i
t
a
l
r
d
WACC
r
e
MM no tax
D/E
C
o
s
t
o
f
c
a
p
i
t
a
l
r
d
WACC
r
e
MM with taxes
113
Debt financing: other issues (1)
In reality, the value of a leveraged firm is affected by factors other than the interest on the debt.
These factors are:
Agency costs
Agency costs of equity – conflicts
between equity owners and managers
who managed the company.
The net agency costs of equity include:
Monitoring cost – incurred by
shareholders to supervise the
managers.
Bonding costs – incurred by
management to assure
shareholders that they are working
for shareholders’ interests.
Residual loss – incurred even
though there is monitoring and
bonding systems in place as these
systems are not flawless
Theory says that if a firm uses more
debt, it would reduce the net agency
costs of equity.
Financial distress
costs
Costs of financial
distress and
bankruptcy can
be direct or
indirect costs.
Probability of
bankruptcy
Higher operating
or financial
leverage leads to
higher probability
of financial
distress
Cost of asymmetric
information
Managers of the firm
have better information
compared to outsiders.
Valuation implications:
Stock offering ¬
negative signal
Debt offering ¬positive
signal
Pecking order theory
says that mangers
choose financing
methods that are the
least observable signals
to the most apparent
signals. Manager prefers
to use internally
generated funds, then
debt and finally equity.
114
Static tradeoff theory
Under the static tradeoff theory, as
higher proportion of debt is being used,
there exist a point where the benefit
arising from the use of debt (i.e. tax
shield) is offset by the costs of financial
distress.
An optimal capital structure exists where
the value of the firm is maximized.
The optimal capital structure is a function
of many factors
V
ungeared
V
Leveraged
Max firm value
M
V
o
f
f
i
r
m
Debt ratio
Optimal Debt ratio
PV tax
shields
Cost of financial
distress
C
o
s
t
o
f
c
a
p
i
t
a
l
Optimal D/E ratio
D/E ratio
r
d
WACC
r
e
Between 0% and
100%
Implications for managers’ decisions
MM I (No Taxes): Capital structure
irrelevant
MM I (With Taxes): 100% debt maximizes
value
Pecking order theory: Capital structure is
byproduct of individual financing choices
Static tradeoff theory: Trade off cheaper
debt financing with costs of financial
distress; optimal capital structure between
0% and 100%
115
Debt financing: other issues (2)
Target Capital Structure
Used when making decisions on raising new finance
For managers maximizing firm value target = optimal
capital structure
Practice – fluctuation around target:
Exploitation of opportunities in a specific financing
source
Fluctuating debt/equity markets affecting
weightings
Capital Structure and Valuation
Analyst considerations:
Changes in capital structure over
time
Capital structure of competitors
with similar business risk
Factors effecting agency cost –
corporate governance
International Difference in Leverage
Japan/France more debt than US/UK
Debt maturity – longer in US than Japan
Developed markets have more total debt
and longer maturity than emerging markets
Institutional/Legal Factors
• Strength of legal system
• Information asymmetry
• Taxes
Financial Markets/Banking
System
• Liquidity
• Reliance on banking system
• Institutional Investor presence
Macroeconomic
Factors
• Inflation
• GDP growth
Debt Rating Agencies
Cost of capital tied to debt ratings
Goals for achieving certain ratings may
effect capital structure
116
Dividends and dividend policy (1)
Factors affecting dividend payout policy
Taxation of dividends
Flotation costs of a new issue
Restrictions on dividend payments
Signalling effects
Clientele effects
Taxation of dividends:
Double taxation and split rate systems:
Effective tax rate
= corporate tax + (1 – corp tax) x individual tax
Split tax rate – use corporate tax rate for
distributed income
Imputation system – div taxed only at
shareholders’ rate
Signalling effect:
• Dividend initiation – mixed view
• Unanticipated dividend increase –
signal strong future prospects
• Unanticipated dividend decrease –
negative signal
Residual dividend model
Dividend = actual earnings
minus the equity portion of
firm’s capital budget
Advantages: simple to use;
investment opportunities
considered independent of
the dividend
Disadvantages: unstable
dividend payments;
uncertainty as to dividend
increases investors
assessment of risk
117
Dividends and dividend policy (2)
Pay a
specific % of
total
earnings
over long
term
Focus on
steady $
payout –
even though
earnings
may be
volatile
In practice
this
increases
with the long
term rate of
growth of the
company
Longer term
forecast of
capital
budget is
determined –
excess
earnings
over this
period are
then spread
more evenly
each year
Easy to use
BUT
Investors
may prefer
stable
dividends
Target
payout ratio
Dividend
stability
Longerterm
residual
dividend
Residual
Dividend
Dividend using the target payout approach:
   
   
 
× ×
 
 
\ . \ .
\ . \ .
expected target
previous adjustment
expected dividend = + increase payout
dividend factor
in EPS ratio
118
Dividends and dividend policy (3)
Investors will prefer
NOT to receive
dividends due to their
higher tax rates.
Low dividend payout
policy will be rewarded.
Evidence shows K
s
decreases
as payout ratio increases –
investors are rewarding the
certainty of near term
dividends with a lower level of
risk.
Higher dividend payout policy
will be rewarded.
Dividends can be
manufactured – sell a
little bit of stock to get the
cash you want.
Theory requires a number
of assumptions.
Policy has NO effect on
value.
The tax aversion theory The birdinthehand theory Dividend irrelevance
theory
Rationales for stock repurchases
Signal that future outlook is good
Share dilution due to exercise of stock
options
Distribute cash
Company views its own stock as good
investment
Change the capital structure
Dividend initiation
Based on dividend preference theory
Dividend initiation
Lower risk
Lower cost of equity
Higher PE ratio
119
Corporate governance (1)
Definition:
The system of principles, policies, procedures and clearly defined responsibilities
and accountabilities used by stakeholders to overcome conflicts inherent in the
corporate form” (McEnally and Kim)
Objectives:
Eliminate or reduce conflicts of interest
Use the company’s assets properly
An effective system will:
Define the rights of shareholders (and other important stakeholders)
Define and communicate to stakeholders the oversight responsibilities of
managers and directors
Provide fair and equitable treatment in all dealings between managers,
directors and shareholders
Have complete transparency and accuracy in disclosures regarding
operations, performance, risk, and financial position
120
Corporate governance (2)
Corporate shareholders
have no input in the day to
day mgmt of the firm – this
lack of control can create
conflict between managers
and shareholders
Similar to sole
proprietors – conflicts
between partners are dealt
with by implementing a
partnership agreement
Since owners and
managers are one in the
same no conflict exists
here. Conflicts mainly
involve creditors and
suppliers
Distinct legal entities –
managers act as agents of
co.
Two or more owner
managers
Owned and operated by a
single individual
Corporations Partnership Sole Proprietorship
Managers and shareholders
Management may act in their best
interests not those of the shareholders
Using funds to expand the size of the
firm
Granting excessive compensation and
perquisites
Investing in risky ventures
Not taking enough risk
Directors and shareholders
Directors may align more closely with managers
than shareholders
Lack of independence
Board members with personal relationships
with managers
Board members having consulting or other
business agreements with the firm
Interlinked boards
Directors are over compensated
Agency Relationships
Conflicts of Interest
121
Corporate governance (3)
Determining the effectiveness of the Board
Composition of board: 75% of directors independent
Independent chairman on board (not CEO)
Qualifications of directors
How board elected (annual elections)
Board selfassessment practices
Frequency of separate sessions for independent directors (annually)
Audit committee and audit oversight (only independent directors)
Nominating committee (only independent directors)
Compensation committee and management compensation (mostly performancebased)
Use of independent and expert legal counsel
Statement of governance policies
Disclosure and transparency (more disclosure is better)
Insider or relatedparty transactions (board approval for relatedparty transactions)
Responsiveness to shareholder proxy votes
122
Corporate governance (4)
Board Of Directors
The board of directors have a responsibility to:
Institute corporate values
Ensure firm complies with all legal and regulatory requirements
Create long term strategic objectives
Determine management’s responsibilities
Evaluate the performance of the CEO
Require management to supply the board with complete and accurate information
Meet regularly
Ensure board members are adequately trained
Investors and analysts should assess the
following policies of corporate governance:
Codes of ethics
Directors’ oversight, monitoring and review
responsibilities
Management’s responsibility to the board
Reports of directors’ oversight and review of
management
Board selfassessments
Management performance assessments
Directors’ training
Corporate Governance and Company
Value
Firms with strong/effective governance
systems exhibit:
Higher measures of profitability
Higher returns for shareholders
Weak/ineffective governance system:
Increased risk to investors
Reduced value
Extreme cases: bankruptcy
123
Mergers and acquisitions
Acquisition: One company buys only part of
another company
Merger: One company absorbs another
company entirely
Forms of integration
Statutory merger: target company ceases to
exist
Subsidiary merger: target company becomes a
subsidiary of the acquirer
Consolidation: acquirer and target form a
completely new company
Types of Merger
Acquirer
Forward
integration
Horizontal
Conglomerate
Brewery Another Brewery
Pubs
Training
Hops Farms
Merger motivations
Synergies
Achieving more rapid growth
Increased market power
Gaining access to unique capabilities
Diversification
Bootstrapping
Personal benefits for managers
Tax benefits
Unlocking hidden values
Achieving international business goals
Bootstrapping EPS
A way of packaging earnings from
two companies after a merger
Increase in earnings per share
Real economic gains are not
necessarily achieved
Occurs when a firm with a high P/E
ratio acquires a firm with a low P/E
ratio
Backward
integration
124
Industry life cycle and common mergers
Mature growth phase:
~ Industry characteristics: reduced profit
margins due to new competition, but potential
still exists for above average growth
~ Merger motivation: efficiency, economies of
scale/synergies
~ Horizontal and vertical
Stabilization phase:
~ Industry characteristics: competition has
reduced most of industry’s growth potential
~ Merger motivation: economies of scale,
reduced costs, improve management
~ Horizontal
Decline phase:
~ Industry characteristics: declining profit
margins, overcapacity, and lower demand
due to shifts in consumer tastes
~ Merger motivation: survival, operating
efficiencies, new growth opportunities
~ Horizontal, vertical, and conglomerate
Pioneer/development phase:
~ Industry characteristics:
uncertain of product acceptance,
low profit margins, and large
capital requirements
~ Merger motivation: access to
capital, management talent
~ conglomerate and horizontal
Rapid growth phase:
~ Industry characteristics: high
profit margins, accelerating sales,
and earnings, but still low
industry competition
~ Merger motivation: access to
capital, expand growth capacity
~ conglomerate and horizontal
125
Mergers transaction characteristics
Comparing Forms of Acquisition
Friendly merger offers
Acquirer approaches management
Negotiations and due diligence
Definitive merger agreement
Public announcement and
shareholders vote
Attitude of target management
Usually avoids
assuming
Acquirer
assumes
Liabilities
None S/H pay CG S/H taxes
Target pays CG None Corporate taxes
None for “small” Shareholders Approval
To target To shareholder Payment
Asset
Purchase
Stock Purchase
Hostile merger offers
Acquirer submits proposal to board of directors
Successful Unsuccessful
Tender offer Proxy battle
Offer made to shareholders Proxy solicitation
126
Takeover defense & HHI
Preoffer defense mechanisms
Poison pill: flipin pill and flipover pill
Poison put
States with restrictive takeover laws
Staggered board
Restricted voting rights
Supermajority voting provision for mergers
Fair price amendment
Golden parachutes
Postoffer defense mechanisms
“Just say no” defense
Litigation
Greenmail
Share repurchase
Leveraged recapitalization
Crown jewel defense
Pacman defense
White knight defense
White squire defense
Virtually
certain
50 or
more
High > 1800
Possible
100 or
more
Moderate
Between 1000
& 1800
No action
Any
amount
Not concentrated < 1000
Antitrust
Action
Change
in HHI
Industry
Concentration
Post merger
HHI
Herfindahl
Hirschman Index
Key measure of
market power for
determining antitrust
violations
n
2
i
i=1
HHI = (MS ? 100)
¯
127
Valuing a target company (1)
Discounted cash flow method
Similar to FCFF approach in
SS 12
Determine free cash flows
available to investors after
necessary expenditures
Choose appropriate discount
rate (target company WACC
adjusted for merger effects)
Discount cash flows back to
the present
Determine terminal value –
constant growth or market
multiple
Comparable transaction analysis
Also uses relative value metrics
for comparables
Comparables are recent takeover
transactions, not just comparable
firms!
No need to calculate separate
takeover premium
3 methods to evaluate a target company
Comparable company
analysis
Uses relative value metrics
from similar firms
Adds a takeover premium
to determine fair price to
pay
128
Valuing a target company (2)
Discounted cash flow
method
Advantages
Easy to model changes in
cash flow from synergies
Using forecasts avoids
biases that may exist in
current market data
Model is easy to customize
Disadvantages
Model is difficult to apply
when free cash flows are
negative (rapid growth firm)
Estimation error – terminal
value
Changing discount rates
can have large impact on
estimate
Comparable transaction
analysis
Advantages
No need to estimate a
takeover premium
Estimates of value are
derived directly from
recent deal prices
Disadvantages
Assumes past M&A
transactions were
accurately valued
May not be enough
comparable transactions
available
Difficult to incorporate
synergies or changing
capital structures into
analysis
3 methods to evaluate a target company
Comparable company
analysis
Advantages
Easy access to data
Estimates of value are
derived from the market
(reduces estimation error)
Disadvantages
Assumes market is
valuing comparable firms
correctly
Must determine takeover
premium separately
Difficult to incorporate
synergies or changing
capital structures
Historical data used to
estimate a takeover
premium may not be
timely
129
Evaluating a merger bid
Postmerger value of an acquirer: V
AT
= V
A
+ V
T
+ S – C
Gains accrued to the target: Gain
T
= TP = P
T
– V
T
Gains accrued to the acquirer: Gain
A
= S – TP = S – (P
T
– V
T
)
Adjustment for stock payment: P
T
= (N hP
AT
)
where: N = number of new shares target receives
P
AT
= price per share after merger announced
Effect of Payment
Cash offer
Acquirer assumes the risk and receives the potential reward
Gain for target shareholders is limited
If synergies more than expected, takeover premium for target is fixed, so acquirer wins
If synergies less than expected, acquirer loses
Stock offer
Some of the risks and potential rewards shift to the target firm
Target shareholders will own part of acquiring firm
Confident synergies will be realized
Acquirer wants to pay cash; target wants stock to participate in upside
Lack of confidence in synergy estimates
Acquirer wants to pay in stock to share risk; target wants cash to lock in any gains
130
Mergers benefits & restructuring
Distribution of merger benefits
Shortterm effect on stock price
Targets gain approximately 30%
Acquirer’s lose between 1% and 3%
Longterm effect on stock price
Acquirers tend to underperform
Failure to capture promised synergies
Corporate restructuring
Divestitures: Selling, liquidating, or spinning off a division or subsidiary
Equity carveouts: creates a new, independent company; sell shares to outside
stockholders through a public offering
Spinoffs: create a new, independent company; distribute shares to parent company
shareholders – no cash for parent
Splitoffs: existing shareholders must exchange shares for shares of new division
Liquidations: break up the firm and sell its assets piece by piece
Reasons for divestitures
Division no longer fits into
management’s longterm strategy
Lack of profitability
Reverse synergy – individual parts are
worth more than the whole
Infusion of cash
131
Equity Investments
Study Sessions 10,11 &12
Weighting 20 30%
132
Equity Investments  Overview
Valuation
process
Residual Income
Valuation
MarketBased
Valuation: Price
Multiples
Free Cash
Flow
Valuation
Valuation in
Emerging Markets
Return concepts
Industry Analysis
Five competitive
forces
Discounted Dividend
Valuation
Private
Company
Valuation
A note on
asset
valuation
133
Graham and Dodd 1934 – 1962
Value should be independent of price
Financial statement analysis, earnings
power, growth prospects
Relative valuation methods
“Blocking and tackling”
A Note on Asset Valuation
John Burr Williams (1938)
Value is the present value of cash flows
at an “opportunity cost of capital”
Discount rate was not clearly defined
DDM and FCF models
Forwardlooking
Modern Portfolio Theory (1959)
Harry Markowitz (Portfolio Selection):
Value includes growth and risk,
efficient frontier dominates other
portfolios, covariance is key,
diversification is a free lunch
William Sharpe:
Cost of capital is function of
systematic, nondiversifiable risk
Unsystematic risk can be diversified
away
Developed CAPM
Modern Valuation Techniques
Fixed income: PV of coupons and par
value discounted by YTM
Common stock: PV of future cash flows
discounted by the required return
DDM: PV of expected dividends
FCFF: discounted at WACC
FCFE: required return on equity
Relative value: earnings ͪ multiplier
Residual income: current book value +
PV of expected economic profit
134
Uses:
• Stock selection
• Reading the market
• Projecting the value of
corporate actions
• Fairness opinions
• Planning and
consulting
• Communications with
analysts and investors
• Valuation of private
business
• Portfolio construction
and management
Valuation = the estimation of an asset’s
value
Absolute – based on variables
perceived to be related to
future investment returns
Relative – based on comparisons
with similar assets
Inputs – should be qualitative
as well as quantitative
Valuation Process 
Overview
1. Understand the business
2. Forecast business
performance
3. Select the relevant
valuation model(s)
4. Convert forecasts to a
valuation
5. Make the
recommendation or
investment decision
Critical step that involves
financial statement
analysis (including quality
of earnings analysis)
combined with an
evaluation of industry
prospects, competitive
position and corporate
strategies.
Valuation Process
135
Industry Competitive Analysis
Five Elements of Industry structure:
Threat of new entrants, Threat of
substitutes, Bargaining power of Buyers,
Bargaining power of Suppliers, Rivalry
among Existing Competition
Three Generic Strategies: Cost
Leadership, Product Differentiation,
Focus
Valuation Process
Importance of F/S Footnotes
Footnotes reveal management’s discretion in
choices of accounting methods and estimates
Analyst’s ability to accurately forecast result
derived from quality inputs
Greater transparency in earnings results in
higher stock price—management’s ultimate goal
Accounting Shenanigans
Accelerating or Premature Recognition
of Income
Reclassifying gains and nonoperating
income
Expense recognition and losses
Amortization, depreciation, and discount
rates
Offbalance sheet issues
Considerations in Valuation
Fits the Characteristics of the Company (Does
it pay dividends? Is earnings growth estimable?
Does it has significant intangible assets)
Is appropriate based on the quality and
availability of input data
Is suitable given the purpose of the analysis
Considering only one model is not good
136
Perceived mispricing
• = any difference between the analyst’s estimate of intrinsic value and the market price
• reflected in the abnormal return, alpha, the analyst expects to earn.
Ex ante alpha = expected holdingperiod return – required return
Ex post alpha is used to assess the success of the analyst’s strategy
= actual holdingperiod return  contemporaneous required return
Model selected must be:
• consistent with the characteristics of the company being valued;
• appropriate given the availability and quality of data;
• consistent with the purpose of valuation, including the analyst’s ownership
perspective (i.e. extent of the investor’s influence over the company).
Valuation Process
Ownership Perspective
Marketable publicly traded minority interest—DDM approach is the benchmark value
Premiums for control—FCFE approach
Discounts for lack of marketability for nonpublicly traded stocks
Discounts for lack of liquidity for publicly traded stocks
137
Different Returns/Rates
• Holding Period Return, Realized Return, Expected Return, Required Return, Return from
Price Convergence, Discount Rate, Internal Rate of Return
Return Concepts
Ways of Measuring the Required Return
• Multifactor Models
Req’d Return=(factor sensitivity)
i
*(factor risk premium)
i
+ …. + (factor sensitivity)
n
*(factor
risk premium)
n
CAPM:
( ) ( )
f m f
r r E ȕ r E(r) ÷ × + =
“equity risk premium”
138
Return Concepts
Ways of Measuring the Required Return
Fama – French Model
Req’d return on stock j = R
f
+ b
mkt
,*(R
mkt
– R
f
) + b
SMB,j
*(R
SMALL
R
BIG
) + b
HML,j
*(R
HBM
R
LBM
)
R
mkt
– R
f
= return on a value weighted market index minus risk free rate
R
SMALL
R
BIG
=small cap return premium
R
HBM
R
LBM
=value return premium
PastorStambaugh Model
Builds on the Fama French Model by adding a liquidity factor
Macroeconomic Multifactor Models e.g. Burmeister, Roll and Ross Model
Uses economic variables believed to affect cash flows as factors within the model.
139
Return Concepts
Ways of Measuring the Required Return
BuildUp Method
Req’d return =R
f
+ Equity risk premium + size premiuim + specific company premium
Bond Yield Plus Risk Premium
Req’d return =YTM on long term debt + risk premium
Country Spread Model and Country Risk Rating Model
Calculates the premium to be added to the req’d return when investing in emerging mkts
140
Return Concepts
Estimating Beta
Public Companies
Use regression of company stock returns against the market
Adjust for beta drift by using adjusted beta
Adjusted beta=(2/3)*regression beta + (1/3)*1
Thinly traded/non public companies
Estimated beta for ABC=unlevered beta of similar quoted company *
(1+(debt of ABC/equity of ABC))
Unlevered beta of similar quoted company = Beta of similar co.*
1/[1+(debt of similar co/equity of similar co)]
141
Return Concepts
Estimating Equity Risk Premium using…..
Historical estimates
Strengths:
•Objective. Simple, unbiased if investors rational
Weaknesses:
•Assumes mean and variance are stationary
•Different ways of calculating mean return (geometric, arithmetic)
•Different ways of estimating risk free rate (can use long or short term bonds)
142
Return Concepts
Estimating Equity Risk Premium using…..
Forward looking / Ex Ante estimates
Strengths:
•Doesn’t depend on assumption of stationarity
3 Types…..
Gordons Growth Model
Strengths
Assumptions used are
reasonable and inputs to
the model can easily be
sourced
Weaknesses
• This estimate will change
over time and needs
updating, assumes stable
growth
Supply Side Estimates
Strengths:
• Uses proven models
and current information
Weaknesses:
• Only appropriate for
developed countries
Survey Estimates
Strengths:
• Uses expert opinions
and more likely to be
reliable
Weaknesses
• There maybe large
differences of opinion
143
Porter’s 5 forces
Topdown forecasting
1. Macroeconomic
2. Industry
3. Company
Understanding the business
• How attractive are the industries in which the
company operates, in terms of offering
prospects for sustained profitability?
• What is the company’s relative competitive
position within its industry?
• What is the company’s competitive strategy?
3.
2.
1.
FIRM
RIVALRY
SUPPLIERS BUYERS
SUBSTITUTES
Bargaining
power
Threat of substitute
products or services
Threat of
new entrants Bargaining
power
POTENTIAL ENTRANTS
Industry and Company Analysis
144
Risks of each generic strategy
Cost Leadership
• New entrant enters market with lower cost base and/or technological breakthrough
reduces rivals production cost
Differentiator
• Consumers cease to value differentiating factor and/or rival company does it better
Niche
• Interest in niche from big players and/or smaller players target subsectors of niche
Cost
Leadership
Differentiation
Narrow Target
Broad Target
Focus
Competitive
Advantage
Low costs in all market
segments
• economies of scale
• proprietary technology
• pref. access to raw materials
Satisfy particular consumer
needs
• product/delivery/marketing
• premium pricing
A focuser will be an above
average performer if it can
achieve product differentiation
in its chosen subsector
A focuser will be an above
average performer if it can
achieve cost leadership in
its chosen subsector
Competitive Strategies
145
Industry life cycle
Industry life cycle phases
Pioneer  Acceptance of the product or service uncertain, implementation of business
strategy is unclear. Period of high risk with many failures.
Growth – Acceptance of the product or service established. Accelerating sales and
earnings. Industry growth faster than the general economy. Profit margins above average.
Mature – Industry growth corresponds to the growth of the general economy. Participants
compete for share in stable industry.
Decline – Demand for the industry’s product steadily decreases due to shifting tastes or
technologies. Profit margins are diminished.
Classification by business cycle reaction
• Growth Industry Stocks  experience
accelerating sales and high profit margins
during all phases of the business cycle
• Defensive Industry Stocks  product demand
independent of the business cycle, therefore
less cyclical than the overall market
• Cyclical Industry Stocks  product demand
tends to vary directly with the business cycle
S
a
l
e
s
Time
Growth Maturity Decline Pioneer
Business and Industry Life Cycles
146
Industry External Factors
• Technology
• Government
• Social changes
• Demographics
• Foreign influences
Supply analysis
• In the long term, demand will equate to supply
• In the short term, there could be shortfalls in
supply due to long lead times etc
Demand analysis
An analyst is in a position to assess
future demand for the industry’s output
by developing
• A macroeconomic forecast
• An industry classification
• An external factor review
Two additional sources of information
• A study of the firm’s customers
• A study of the industry’s inputs and
outputs
Factors influencing pricing practices and hence profitability
• Product segmentation  Firm’s ability to differentiate its product over various market
segments.
• Concentration – The greater the concentration, the greater the likelihood of collusion.
• Ease of industry entry – Greater ease of entry ÷prices toward the marginal cost.
• Supply input price – Changes in resource prices will have major implications of profitability.
Industry Analysis
147
Dealing with inflation in emerging
market valuation
Country Risk Premium
•No satisfactory method for
estimation
•Premium is often
overstated
Real
valuation
approach
Nominal valuation
approach
Incorporating EM risks
Adjust the required
return by adding a
country risk
premium
Adjust the cash
flows in a scenario
analysis (preferred)
Valuation in Emerging Markets
148
Generic DCF model
return of rate required r
t time at flow cash expected CF
0) (t today asset the of value V
where
t
0
=
=
= =
( )
¯
·
=
+
=
1 t
t
t
0
r 1
CF
V
Consider using dividends for CF when:
• there is a dividend record to analyze;
• the dividend policy established by the board
bears an understandable and consistent
relationship to the company’s profitability;
• the investor takes a noncontrol perspective.
DCF
149
Generic DDM
equity on return required r
t time at dividend expected D
0) (t today share the of value V
where
t
0
=
=
= =
( )
¯
·
=
+
=
1 t
t
t
0
r 1
D
V
No growth model
r
E) (or D
V
0
=
Holding period of n years
Single Holding Period
( )
1
1 1
0
r 1
P D
V
+
+
=
t time at price share P
where
t
=
Expected HPR
0
1 0 1
P
D P P
r
+ ÷
=
( ) ( ) ( )
n
n n
2
2
1
1
0
r 1
P D
...
r 1
D
r 1
D
V
+
+
+ +
+
+
+
=
Present value of growth opportunities = market value of share  no growth value per
share
Gordon growth model
( )
g r
D
g r
g 1 D
V
1 0
0
÷
=
÷
+
=
Twostage DDM
( ) ( )
n
n
n
1 t
t
t
0
r 1
V
r 1
D
V
+
+
+
=
¯
=
Hmodel
H = half the number of years for
anticipated decline in growth
( ) ( )
L
L S 0
L
L 0
g r
g g H D
g r
g 1 D
÷
÷ ×
+
÷
+
Dividend Discount Models
150
Gordon growth model
Strengths:
• Suitable for stable, mature,
dividend paying firms
• Easily applied to indices
• Easily communicated &
explained
• Can be used to determine
growth rates, rates of return and
PVGO
• Supplements other methods
Limitations:
• Very sensitive to inputs
• Not easily applied to non
dividend paying stocks
• Unpredictable growth patterns
makes using the model difficult
Problem with twostage model with
constant growth in both stages
Assumption that a firm’s high growth rate will
suddenly drop to a lower level overnight is
highly unrealistic.
Improvement built into Hmodel
Over a set time the high initial growth will
decline in a linear fashion to the
sustainable longterm growth rate
Rationale for threestage model
• With a good product, some companies may
sustain a high growth rate in the shortterm
• The business is most likely to go through a
growth phase, transitional phase, then mature
phase
Spreadsheet approach
Used when even the threestage DVM is too simple for a reallife application
DCF Commentary
151
Multistage models
Strengths:
• Flexibility
• Can calculate implied growth rates
or required returns
• Can incorporate the impact of
different assumptions into the model
• Relatively easy to construct using
spreadsheet software
Limitations:
• Estimates are only as good as the
inputs used
• Model must be fully understood to
arrive at accurate estimates
• Estimates are very sensitive to
assumptions regarding growth and
the required return
• Formula and data input can lead to
errors that are difficult to identify
Sustainable growth rate
Rate at which earnings (and dividends) can
continue to grow indefinitely, assuming that the
firm’s leverage is unchanged and no new equity
finance is raised.
Estimating return on equity (ROE)
Equity
Assets
x
Assets
Sales
x
Sales
EBIT
EBIT
EBT
EBT
Income Net
Equity
Income Net
ROE
× × =
=
Further Aspects
g = b x ROE
Where: b = retention rate
ROE = expected return on equity
152
• FCFs are not published but need to be computed from published financial statements
• Free means after fulfilling all obligations and without impacting on the future growth
plans of the company
Free Cash Flows to Equity (FCFE)
= net income
f noncash items in income
statement
 investment in working capital
 investment in fixed assets
+ net increase in debt
or
= CFO*
 investment in fixed assets
+ net increase in debt
* Assuming interest received and paid
and dividends received have been
classified as an operating cash flow as
required under US GAAP
Free Cash Flows to the Firm (FCFF)
= net income
f noncash items in income statement
+ interest expense x (1 – tax rate)
 investment in working capital
 investment in fixed assets
or
= CFO
+ interest expense x (1 – tax rate)
 investment in fixed assets
or
= FCFE
+ interest expense x (1  tax rate)
– net increase in debt
NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations
FCF Models
153
Calculation of WACC is covered in Corporate Finance
( )
¯
·
=
+
=
1 t
t
t
r 1
FCFE
value Equity
( )
¯
·
=
+
=
1 t
t
t
WACC 1
FCFF
value Firm
Equity
Debt
capital. the
providing is whom of regardless
operations s firm' the of value
total the represents This value".
enterprise " as to referred Often
Constant growth
models:
( ) ( )
g WACC
g 1 FCFF
value Firm
g r
g 1 FCFE
value Equity
0 0
÷
+
=
÷
+
=
Generic 2stage
model:
( ) ( )
n
1 n
n
1 t
t
t
0
r 1
1
g r
FCF
r 1
FCF
V
+
÷
+
+
=
+
=
¯
Forecasting FCF  Apply a growth rate to most recent reported free cash flow or
forecast each component separately.
Sensitivity Analysis – Often utilized to assess the impact of uncertain assumptions.
FCF Models
154
Preferred to DDM when:
• Firm pays no dividends.
• Firm is paying dividends but
dividends differ significantly from the
firm’s capacity to pay dividends – i.e.
dividends imperfectly signal the
firm’s longrun profitability.
• Free cash flows appear to be better
aligned with profitability over the
analyst’s forecast period.
• Investor takes a control perspective
since the firm is being analyzed as a
takeover target
FCFE v FCFF models
For firms with relatively stable leverage, FCFE
is more direct and easier to use.
Situations where the FCFF approach is more
useful include:
• proposed purchase of entire firm (i.e. equity
and debt capital) with a subsequent
reorganization of the capital structure.
• firms where FCFE is negative.
• firms with history of leverage changes –
FCFF may be more meaningful than an
everchanging growth pattern in FCFE.
Free cash flow proxies
Both net income and EBITDA are regarded as fairly poor proxies since:
• both ignore the important distinction between profit and cash flow
• both ignore the reinvestment of earnings needed for growth
• EBITDA ignores the tax that the firm needs to pay before any distribution to investors
FCF Further Aspects
155
Overview
• Price multiples are ratios of a stock’s market price to some measure of value per share.
• Method of comparables involves comparing a stock’s price multiple to a benchmark
multiple to determine whether or not the stock is appropriately valued.
• Method based on forecasted fundamentals relates multiples to company fundamentals
using a discounted cash flow model.
• A justified price multiple is a multiple justified by an analyst based on either of the
above methods.
P/E multiple
• Earnings may not exist or be negative
• Need to adjust “book” earnings to
sustainable or recurring earnings
• Management discretion with
accounting practices distort earnings
and affect comparability of P/Es
across companies
• Earnings power is the primary driver
of investment value
• P/E ratio is a popular measure with
investors
• Empirical research shows that P/Es
may be related to differences in long
run average stock returns
Drawbacks of using P/E: Rationales for using P/E:
Price Multiples
156
P/E ratio based on fundamentals
g r
b 1
g r
E
D
E
P
P/E Leading
1
1
1
0
÷
÷
=
÷
= =
( )( )
g r
g 1 b 1
g r
E
g) (1 D
E
P
P/E Trailing
1
1
0
0
÷
+ ÷
=
÷
+
= =
Methods used to find normalized earnings
for cyclical businesses:
• Method of historical average EPS – use the
average EPS over the most recent full
cycle
• Method of average return on equity – use
the average ROE (based on the most
recent full cycle) multiplied by the current
book value per share
Value = earnings x P/E ratio
P/E multiple increases if:
• growth rate increases
• firm’s risk level decreases causing the
required return to decrease
• interest rates decrease causing the
required return to decrease
• payout ratio increases (although g will
also be negatively affected)
Determining earnings
Analyst may adjust for:
• company specific transitory,
nonrecurring components*
• transitory components due to
business or industry cyclicality
• accounting method differences*
• potential dilution (e.g. due to
options and convertibles)
Valuation using P/E
157
Steps for valuation using comparables
1. Select and calculate the price multiple that will be used in the comparison.
2. Select the comparison asset or assets.
3. Calculate the benchmark value of the multiple, i.e. the mean or median value of the
multiple for the comparison assets.
4. Compare the stock’s actual multiple with the benchmark value.
5. If possible, assess whether differences in the fundamental determinants of the price
multiple explain any of the difference in 4 and modify conclusions accordingly.
P/E to growth ratio
• Step 5 above could involve calculating the P/Etog (PEG) ratio.
• A high P/E should be justified by high growth – so this ratio should be roughly
constant for all firms in a sector.
• A high ratio may indicate an overpriced share, a low ratio an under priced share.
PEG Ratio
158
Value = book value x P/B ratio
• relies on consistent application of
accounting standards
• not good for firms with off Balance Sheet
human capital
• depreciated historical cost of assets may
be different across similar firms due to
the age of the assets
• book value more stable than EPS
• works with zero or negative earnings
• for some firms, book values of assets
may approximate market values
• empirical evidence suggests differences
in P/Bs may be related to differences in
longrun average returns
Drawbacks of using P/B: Rationales for using P/B:
Fundamental P/B
g r
g ROE
B
P
0
0
÷
÷
=
P/B multiple increases if:
• growth rate increases
• firm’s risk level decreases causing the
required return to decrease
• interest rates decrease causing the
required return to decrease
• ROE increases
Book value of equity is:
• net assets; or
• shareholders’ funds
P/B Ratios
159
Value = sales x P/S ratio
• fails to highlight cost control
issues within a firm
• does not reflect differences
in cost structures among
different companies
• meaningful even if EPS is negative
• sales figures less subject to manipulation
• less volatile than P/E
• viewed as appropriate for valuing the stock of mature,
cyclical and zeroincome companies
• research suggests that differences in P/Ss may be
related to differences in longrun average returns
Drawbacks of using P/S: Rationales for using P/S:
Fundamental P/S
E/S = profit margin
P/S multiple increases if:
• growth rate increases
• payout rate increases, but ….
• profit margin increases
• firm’s risk level decreases causing the
required return to decrease
• interest rates decrease causing the
required return to decrease
( )( )
g r
g 1 b 1
S
E
S
P
0
0
0
0
÷
+ ÷

.

\

=
P/S Ratios
160
Value = cash flow x P/CF ratio
• certain cash flows are
ignored if proxies are used
such as EPS plus noncash
charges
• FCFE is superior for
valuation but introduces
volatility problems and may
also be negative at certain
times
• addresses the issue of differences in accounting
conservatism between companies (quality of
earnings)
• cash flows less subject to manipulation than earnings
• less volatile than P/E since CF tends to be more
stable than earnings
• research suggests that differences in P/CFs may be
related to differences in longrun average returns
Drawbacks of using P/CF: Rationales for using P/CF:
Fundamental P/CF
Measures of cash flows that may be used:
CFO = cash flow from operations
FCFE = free cash flow to equity
CF = earnings plus non fcash
charges or income
EBITDA = earnings before interest, tax,
depreciation and amortization
measure flow cash Chosen
model FCFE from equity of Value
CF
P
0
0
=
P/CF Ratios
161
• focus on D/P is incomplete as it ignores
capital appreciation
• dividends now would displace future
earnings, which implies a tradeoff between
current and future cash flows
Drawbacks of D/P approach:
• dividend yield is a component of total return
• dividends are not as risky as the capital
appreciation component of total return
Rationales for using dividend yield:
Dividend yield model
Value = annualized dividend / dividend yield
Enterprise Value/EBITDA
• EV = MV of all equity and debt less cash
& liquid investments = NPV of firm’s
earning activities
• EV should be a predictable multiple of
EBITDA
Rationales for using EV/EBITDA:
• Useful in comparing firms with different
financial leverage
• Eliminates accounting manipulation in
depreciation & amortization
• EBITDA more stable than other earnings
measures, and normally positive
Drawback of using EV/EBITDA:
• EBITDA ignores required capital and
working capital investments
price Market
quarters four next over dividends Forecasted
D/P Leading
price Market
4 dividend quaterly recent Most
D/P Trailing
=
×
=
Other Models
162
Overview
• Residual Income = accounting profit  charge for equity capital employed
• Residual income represents returns in excess of shareholder expectations, or
“economic income”
Forecasting residual income
• This might use internal management
forecasts for the next few years. Problem =
bias.
• Could use fundamental forecasts of earnings
growth and dividend policy.
The general model
where:
V
0
= value of share today
B
0
= current pershare BV of equity
B
t
= expected pershare BV at time t
r = required rate of return on equity
E
t
= expected EPS for period t
RI
t
= expected pershare RI
( )
( )
¯
¯
·
=
÷
·
=
+
÷
+ =
+
+ =
1 t
t
1 t t
0
1 t
t
t
0 0
r 1
rB E
B
r 1
RI
B V
Relationship with other models
• RI, DDM and FCF models = DCF models but
recognition of value is different in the RI
model.
• The total PV produced by all models should
be consistent, in theory, so long as each uses
fully consistent assumptions.
Residual Income Models
163
Drivers of RI and link to P/B
Assuming a constant growth rate in
earnings, g, and a constant ROE
and dividend payout, the residual
income valuation model simplifies
to:
This formula is linked to:
Multistage RI model – Continuing RI
• Continuing residual income is residual income
after the forecast horizon.
• It is likely that residual income will decline in the
long run until the firm is making a “normal” return
(i.e. ROE = r ÷RI = 0).
• Possible continuing RI assumptions are:
• RI continues indefinitely at a positive level
• RI is 0 from the terminal year forward
• RI declines to 0 as ROE reverts to r over time
• RI reflects reversion of ROE to some mean
Applicable RI model when RI fades over time from time T
w (fade rate) takes values between 0
and 1:
w = 0 ÷no expectation of any future RI
w = 1 ÷same level of RI continuing
forever
0 0 0
B
g r
r ROE
B V
÷
÷
+ =
g r
r ROE
1
g r
g ROE
B
P
0
0
÷
÷
+ =
÷
÷
=
( )
( ) ( )( )
1 T
1 T T
1 T
1 t
t
1 t t
0 0
r 1 r 1
rB E
r 1
rB E
B V
÷
÷
÷
=
÷
+ ÷ +
÷
+
+
÷
+ =
¯
e
Terminal value of RI
Residual Income Models
164
Implied Growth Rate
Can be calculated given the P/B
ratio and the required rate of return
on equity by rearranging the single
stage RI formula:
Justifying Continuing RI Persistence
Factors suggesting high ¹:
• Low dividend payout ratios
• High historical industry persistence
Factors suggesting low ¹:
• Very high rates of return (ROE)
• Large special items e.g. nonrecurring items
• Large accounting accruals
Problems Applying RI Models
• violations of clean surplus: currency translation adjustments, minimum liability adjustment,
unrealised gains/losses on availableforsale securities
• offbalance sheet items: operating leases, LIFO inventory, goodwill, assets/liabilities not at
FMV
• nonrecurring items: extraordinary items, discontinued operations, accounting changes
• Differing international standards
RI Models – Further Aspects
165
• Easily manipulated by changing
accounting assumptions
• Ignore changes in reserves other than
income and dividends
• Many adjustments may need to be made
to accounting data to get comparable
figures
• Terminal value doesn’t dominate
estimate
• Uses available accounting data
• Useful even if firm doesn’t pay dividend,
and not distorted by irregular dividends
• Can be used with unpredictable cash
flows
• Models focus on economic profitability,
not just accounting profitability
Weaknesses of RI models: Strengths of RI models:
When to use a RI model:
RI model is most appropriate when:
• company does not pay dividends, or its dividend are not predictable
• company’s expected FCFs are negative within the analyst’s forecast horizon
• great uncertainty exists in forecasting TVs using an alternative PV approach
RI model is least appropriate when:
• there are significant departures from “clean surplus accounting”
• determinants of RI are not predictable
RI Models Commentary
166
Alternative measures
RI (see earlier slide)
EVA® = NOPAT – (WACC x IC)
MVA = Market value of firm – IC
Accounting vs Economic Profitability
Economic profitability reflects the dollar
cost of debt and equity capital used to
generate cash flow.
Accounting profitability (ROE) only
includes an accounting accrual related to
interest expense.
One way of assessing relative economic
profitability is to compute an EVA spread:
EVA spread = ROC – WACC
where ROC = NOPAT/Invested Capital
Methods of Increasing EVA®
• Increase Revenues
• Reduce operating expenses
• Use less Invested Capital
• Take advantage of positive NPV
projects
• Reduce WACC
ValueBased Metrics
167
Private Company Valuation
Private Company Specific Factors
• Stage of lifecycle, size, Taxes
• Quality and Depth of Management
• Management/Shareholder overlap
• Quality of financial and information
• Liquidity, Marketability, Control
Private Company Valuation Approaches
• Income Approach ÎPV of expected future income ÎHigh Growth Phase Companies
• Market Approach ÎRecent Transaction Price Multiples ÎMature Phase Companies
• Assetbased Approach ÎFirm’s assets’ value minus liabilities ÎEarly Stage Companies
Liquidity and Marketability
• Minority referred to Liquidity
• Difficult to be sold referred to Marketability
DLOC = 1[1/(1+control Premium)]
Total discount = 1[(1DLOC)(1DLOM)]
Scenario Comparable Data Subject Valuation Adj. to Comp. data
for control
1 Controlling Interests Controlling Interests None
2 Controlling Interests Noncontrolling Interests DLOC
3 Noncontrolling Interests Controlling Interests Control Premium
4 Noncontrolling Interests Noncontrolling Interests None
168
Alternative Investments
Study Sessions 13
Weighting 5 – 15%
169
SS13 Overview
Alternative Asset
Valuation
Private Equity
Investment
Analysis
Income Property Hedge Funds
170
Real Estate Investments
Type Main Value
Determinants
Investment
Characteristics
Principal Risks Likely Investor
Raw Land Supply/demand
Location
Passive, illiquid,
limited leverage,
no tax
depreciation, CGT,
low current income
Alligator!
Uncertain
appreciation
Speculators,
developers,
longterm
investors
Apartments No of
households,
incomes,
location,
population
growth
Active
management, both
current income
and capital gains,
high liquidity and
leverage, inflation
hedge
Startup risks due
to uncertain
demand, need of
professional
management
Well capitalised
in need of tax
shelter
Office
buildings
Business
conditions,
location, tenant
mix
Active
management,
income and capital
gain, moderate
liquidity and
leverage
Startup risk,
obsolescence,
quality of
management ,
competing
properties
High net worth
companies and
individuals in
need of tax
shelter
171
Real Estate Investments cont.
Type Main Value
Determinants
Investment
Characteristics
Principal Risks Likely Investor
Warehouses Commercial
and industrial
activity,
flexibility of
design, easy
access and
convenience
Passive, moderate
liquidity and
leverage, mostly
income
Oversupply (cheap)
and obsolescence
Investors
seeking high
cash flow,
minimal
management
and tax shelter
Shopping
centres
Population,
income level,
location, tenant
mix, lease
terms
Active
management, low
liquidity, moderate
leverage, both
income and capital
gain, tax
advantages
The right tenant
mix, obsolescence,
competition,
maintaining quality
management, high
vacancy rates
Well capitalised
seeking tax
shelter
Hotels and
Motels
Level of
business and
tourist activity,
location
Active
management,
limited liquidity,
and leverage, tax
depreciation
Economies of
scale, quality
management,
competing facilities
Wealthy
investors or
REITS
172
Valuing Real Estate
Generally use NPV or IRR analysis
CFAT = cash flow after taxes
ERAT = equity revision after tax
EI = initial equity investment
Steps in Calculating CFAT
Step 1: Compute taxes payable
Taxes payable = (NOI – depreciation –
interest) htax rate
Step 2: Compute cash flows after tax (CFAT)
CFAT = NOI – debt service – taxes
payable
Step 3: Compute equity reversion after taxes
ERAT = selling price – selling costs –
mortgage balance – taxes on sale
IRR Problems
• Multiple or no IRR are the result of cash flow changing
signs more than once  common with property
renovations
• Misleading IRR decisions due to size and timing of cash
flows
• Conflicting IRR and NPV decisions for mutually exclusive
projects
• Solution  use the NPV methodology and select projects
with positive NPV
Evaluating Real Estate
• If NPV > 0, or NPV = 0, then
purchase the property. A
positive NPV means that the
present worth of the property
is greater than the equity cost
of the investment. A zero NPV
means the investors equity
cost is unaffected
• If NPV < 0, don’t invest in the
property as it destroys value
Valuing Real Estate
EI
IRR
ERAT
IRR
CFAT
IRR
CFAT
NPV
n n
n
÷
+
+
+
+ +
+
=
) 1 ( ) 1 (
...
) 1 (
1
1
173
Cap Rate and Discount Rate
•Discount rate (r)  the required rate of
return on a real estate investment given
the risk and uncertainty of cash flows
•Cap rate (r – g)  the required return less
the expected growth of net operating
income (NOI)
Methods to Estimate Cap Rate
Market Extraction Method – considered the
most accurate but depends on appraisal
data and comparable properties
BandofInvestment Method – useful for
properties that utilise both debt and equity
financing; uses a sinking fund factor to
calculate the cap rate as a WACC figure;
depends on comparable property data
Builtup Method  Useful when comparables
not available
Property Analysis and Appraisal
1 1
0
0
0
NOI NOI
MV
r g R
Where R = market capitalization rate
= =
÷
0
NOI
R (ME) =
MV
×
×
0
R (BOI) = (mtg weight mtg cost)
+ (equity weight equity cost)
0
R (BU) = pure rate + liquidity premium
+ recapture premium + risk premium
Limitations of Direct Income Capitalisation
•Selecting the correct cap rate may be difficult
due to lack of available market data, or low
quality data
•Approach is limited to incomegenerating
properties, not owneroccupied properties with
nonmonetary benefits
•Properties that provide little or no income or
benefits cannot use this method
174
Value Creation
Reengineer firm
Obtain lower cost
financing
Goal alignment
Exit Routes
IPO
Secondary
Market
MBO
Liquidation
VC v Buyout Characteristics
Cash flow
Product
Asset base
Management team entrepreneurial record
Leverage
Risk assessment
Exit strategy
Operations
Capital required in growth phase
Returns
Activity in public capital markets
Future funding
Carried interest
Private Equity
Risks
Liquidity
Competition
Agency
Capital
Regulatory
Tax
Valuation
Diversification
Market
Structure and Terms
Structure – LP
Terms
Management fees
Carried interest
Ratchet
Hurdle Rate
Target fund size
Vintage
Valuation
Due Diligence
Costs
Transaction Placement fee
Fund set up Performance fee
Administrative Management fee
Audit
175
Private Equity
Control Mechanisms in PE
Transactions
Compensation & Tagalong, dragalong
clauses
Board representation & Noncompete
clauses
Priority in claims, Required approvals, &
Earnouts
Corporate Governance terms
Key man clause & performance disclosure
and confidentiality
Clawback & distribution waterfall
Tagalong, dragalong clause & Remove for
cause
Nofault divorce & Investment restrictions
Coinvestment
Valuation Methodologies
DCF
Relative value or Market approach
Real option analysis
Replacement cost
VC method & leverage buyout method
Calculating Payoff Multiples and IRRs
Calculating the exit value
Calculating the claimant’s payoffs: Debt,
Preference shares, PE firms,
Management
Calculating the total investment and total
payoff, using these two can get the Payoff
Multiples for PE firms
Calculating the IRRs for PE investors and
management equity
176
Private Equity
Performance Measurement
Multiples: Popular, simple, easy to
use and differentiates between realized
and unrealized returns, specified by
GIPS
Paid in Capital (PIC) – % of capital
used by GP
Distributed to PIC (DPI) – measures
GP realized return, cash on cash return
Residual Value to PIC (RVPI) –
measures LP’s unrealized return
Total value to PIC – measures LP’s
realized and unrealized return, sum of
DPI, and RVPI
Valuation
Issue
Buyout Venture
Capital
Use of
DCF
Frequently
used
Uncertain
cash flow
Relative
Value
Validates
DCF
No comps
Use of
Debt
High Low, more
equity
Key
return
drivers
EPS
growth,
P/E
expansion,
debt
reduction
Premoney
valuation,
future
dilution
Other Valuation
VC – Single / Multiple financing rounds
LBO  Target IRR
 Cash flow
177
Private Equity
For a Single Financing Round
Step 1: PostMoney Valuation
POST = FV /(1+r)
N
Step 2: PreMoney Valuation
PRE = POSTINV
Step 3: Ownership Fraction
f = INV/POST
Step 4: No. of the shares to be held by
the PE firm
S
pe
= S
e
[f/(1f)]
Step 5: Price per share
P = INV/ S
pe
For Multiple Financing Rounds
Step 1: the compound discount rate
Step 2: PostMoney Valuation (round 2)
POST
2
= FV/ (1+ r
2
)
Step 3: PreMoney Valuation (round 2)
PRE
2
= POST
2
– INV
2
Step 4: PostMoney Valuation (round 1)
POST
1
= PRE
2
/ (1+ r
1
)
Step 5: PreMoney Valuation (round 1)
PRE
1
= POST
1
– INV
1
Step 6: Ownership Fraction (round 2)
f
2
= INV
2
/ POST
2
Step 7: Ownership Fraction (round 1)
f
1
= INV
1
/ POST
1
Step 8: No. of the shares to be held by the PE
firm
Spe1 = S
e
[f
1
/(1 f
1
)]
Step 9: Price per share after financing (round 1)
P
1
= INV
1
/ S
pe1
Step 10&11: Price per share after financing
(round 2)
S
pe2
= (S
e
+ S
pe1
) [f
2
/(1 f
2
)]
P
2
= INV
2
/ S
pe2
178
Private Equity
IRR Method
Ownership Fraction
Step 1: Investor’s expected future wealth W =
INV h(1+r)
N
Step 2: Ownership Fraction f = W/FV
Price per share
Step 3: No. of the shares to be held by the PE
firm S
pe
= S
e
[f/(1f)]
Step 4: Price per share P = INV/ S
pe
PostMoney & PreMoney Valuation
Step 5: PostMoney valuation
POST = INV/f or POST = P
h(S
pe
+ S
e
)
Step 6: PreMoney valuation
PRE = POST  INV or PRE = P
hS
e
Adjusting the Discount Rate
r* = [(1+r)/(1q)] – 1
r* = discount rate adjusted for probability
of failure
r = discount rate unadjusted for
probability of failure
q = probability of failure in a year
Target IRR Method
Target IRR must meet or exceed:
The cost of the LBO debt financing
The cost of equity capital for a similar unlevered
firm
The return that the fund managers market to
client investors
Equity Cash Flow Method
Discount the future value of equity back to the
present using an expected return on equity for
each period that reflects the then capital
structure
The beta for equity that accounts for the financial
leverage:
N
terminal equity value
PVof equityinvestment =
(1+target IRR)
Asset
Equity
E
D E
þ
þ =
+
Equity Equity Market
( ) [ ( ) ]
f f
E R R E R R þ = + ÷
179
179
Fee Structures
•Paid on quarterly or annual basis
•Highwater mark provision
Hedge Fund Returns
•Factor models
•Alpha: manager skill
•Beta: market exposure
•Hedge fund returns are often not normally
distributedǂSharpe ratio or other classical
ratios may be useless
Hedge Funds
Performance biases
•Voluntary report to databases
•Selection bias
•Backfill bias
•Survivor bias
Funds of funds (FOF)
•Retailing (exposure to a large number of
hedge funds)
•Access to funds closed to individuals
•Diversification
•Expertise
•Due Diligence Process
Hedge Fund Strategies
•Arbitragebased funds
•Convertible bond arbitrage strategies
•Equity market neutral funds
•Event driven funds
•Risk arbitrage (merger arbitrage)
•Fixedincome arbitrage
•Medium volatility arbitrage
•Global macro funds
•Longshort equity funds
•Managed futures funds
•Multistrategy funds
•Directional hedge fund strategies
•Dedicated short bias funds
•Emerging market hedge funds
180
180
Market risks
•Can be limited by understanding the beta
exposures of individual hedge funds and
increase the allocation to funds with lower
market risks
•Alternatively, allocate to managers with the
highest alpha and hedge away the common
factors at the FOF level
Hedge Fund Risk
Event risks
•Event driven funds, such as those following
mergers and distressed or special situation
investments
•Event driven funds have a lower correlation
with market indices, but their returns can
change dramatically with event risk
•Events may affect broader market risks
Operational risks
•Include inadequate resources, unauthorized
trading and style drift, the theft of investor
assets, and misrepresentation of investments
and performance
•Can be minimized by a strict delineation of
duties
Counterparty risk
•Arises when owed money on a swaps or
options contract and the seller of the contract
fails to deliver the gains
Leverage
•Can magnify market risk and counterparty
risk
•Can be gained through derivatives
181
Fixed Income Investments
Study Sessions 14 & 15
Weighting 5 – 15%
182
Overview of Level II Fixed Income
General Principles
of Credit Analysis
Term Structure and
Volatility of
Interest Rates
Valuing Bonds with
Embedded Options
Study Session 14: Valuation Issues
Mortgagebacked
Sector of the
Bond Market
Assetbacked
Sector of the
Bond Market
Valuing MBS/ABS
Study Session 15: Structured Securities
183
Credit Analysis
Key ratios
• Profitability
• Shortterm solvency
• Capitalization/Leverage
• Coverage
Credit Risk
Default Risk
Credit Spread Risk
Downgrade Risk
High yield issuer – Debt structure (bank
loans), corporate structure, covenants
Asset Backed Securities  Quality of
underlying collateral
Municipal Securities – Tax/revenue
generating ability of the issuer
Sovereign Debt  Economic and political
risk – 2 ratings (local & foreign currency
debt)
Key Considerations
The 4 Cs
• Character
• Capacity
• Collateral
• Covenants
184
Credit Analysis S&P Framework
Net income
+ Depreciation
+/ũ Other noncash items
Funds from operations
ũIncrease in NWC
Operating cash flow
ũCapital expenditures
Free operating cash flow
– Cash dividends
Discretionary cash flow
–Acquisitions
+Asset disposals
+Other sources (uses)
Prefinancing cash flow
Cash flow ratios
Coverage ratios
Funds from operations
Total debt
Funds from operations
Capex
Free operating CF + interest
Interest
Debt service coverage
Free operating CF + interest
Annual interest + principal
Debt payback period
Total debt
Discretionary CF
185
Term Structure
Parallel shifts
Yield Curve Shifts
Twists
Butterfly shifts
Yield curve construction: 4 bond
universes
• ontherun Treasuries
• ontherun + some offtherun Treasuries
• all Treasuries
• Treasury strips
Alternative: swap rate (LIBOR) curve
Shape of yield curve
Defined by “term structure” of interest
rates
Three theories:
 pure expectations (shape shows
expected implied forward rates)
 liquidity theory (longterm bonds give
higher yield to compensate for higher IR
risk)
 preferred habitat (investors must be
compensated for investing in less
preferred habitat)
Yield
Maturity
Yield
Maturity
New steepened
curve
Original curve
Yield
Maturity
Positive butterfly
shift
Original curve
Yield
Maturity
Original
curve
Megative
butterfly
shift
186
Volatility of Interest Rates
Impact of nonparallel shifts
on price measured by Key
Rate Duration
Approximate percentage
change in value in response to
a 100 basis point change in a
key rate, holding all other rates
constant
Historical
yield volatility
Implied
volatility
Yield volatility
and
measurement
Forecasting
yield volatility
Volatility
derived from
option pricing
models
( )
( )  
t day on yield the y
y y ln 100 X
Where
1 T
X X
Variance
t
1 t t t
T
1 t
2
t
=
=
÷
÷
=
÷
=
¯
¯
=
÷
=
T
1 t
2
t
1 T
X
iance var
Best estimate
of average X
is zero.
Hence:
Maturity
Spot
rate
key rate
Effective Portfolio Duration =
Sum of Key Rate Duration
187
Bonds with Embedded Options
Binomial Model
( )
o
=
2
L , 1 U , 1
e i i
Callable: call price is
effective cap at each node
Putable: put price is
effective floor at each node
Backward induction
1. Populate interest rate
tree with rates
2. Discount from end
3. At each node take
average price,
consider call/put and
add cash flow
Spread measures
Nominal spread
= YTM
corp
– YTM
Treas
(ignores shape of yield curve)
Zerovolatility/Z/Static spread
 spread added to spot rates to
get theoretical bond price =
actual bond price
OptionAdjusted Spread
 spread added to the interest
rate tree to get theoretical bond
price = actual bond price
Treasury term
structure
zspread: credit, liquidity and option risks
OAS: credit and liquidity risks only
“option cost”
( )
y y
0
y y 0
2
0
BV BV
ED
2 BV y
BV BV 2 BV
EC
2 BV y
÷A +A
÷A +A
÷
=
× × A
+ ÷ ×
=
× × A
188
Relative Value Analysis
Overvalued Overvalued Overvalued
Actual
OAS < 0
Fairly priced Overvalued Overvalued
Actual
OAS = 0
Undervalued
Undervalued if
actual OAS >
required OAS*
Undervalued if actual
OAS > required OAS*
Actual
OAS > 0
Issuer
Benchmark
Sector Benchmark
Treasury
Benchmark
*Relative to same benchmark
189
Convertible Bonds
( )( )
1 Premium . 7
interest
. 6
Premium 5.
. 4
. 3
. 2
. 1
÷ =
÷
=
=
=
÷ =
÷ =
× =
value straight
bond of price Market
value straight over
ratio conversion
share per dividends ratio conversion coupon
share per al differenti income Favourable
share per difference income favourable
share per premium conversion market
period payback
stock common of price market
share per premium conversion market
ratio premium conversion Market
price market price conversion premium conversion Market
ratio conversion CB of price market price conversion Market
ratio conversion stock the of price market value Conversion
Convertible bond value =
Straight value + equity call option – bond call option + bond put option
“Common stock equivalent” (conversion value > straight value) vs..
“Fixed income equivalent” (conversion value < straight value)
190
MortgageBacked Securities
US Mortgage market – key
features
Home loans in the form of
fixedrate levelpayment fully
amortized mortgages
Mortgage Passthrough Securities
Only one class of bond investor
Cash flows: net interest, principal
payments, curtailments
Mostly issued by agencies: Ginnie
Mae, Fannie Mae, Freddie Mac
principal
outstanding
t
Nonagency MBS
Collateral can be individual loans (vs.. passthrough securities for
agency MBS)
No government guarantee
Normally have max LTV, paymenttoincome and size criteria
Pool
Mortgage 1
Mortgage 2
Mortgage N
…
Investor 1
Investor 2
Investor N
…
Passthrough securities
backed by the pool are
issued to investors
191
MortgageBacked Securities
Prepayment Rates
PSA Benchmark
Assumes the monthly
prepayment rate
increases as it seasons
CPR
Conditional
prepayment rate
(CPR) is the expected
annual prepayment
rate.
Can be converted to
SMM (singlemonthly
mortality rate):
( )
12 / 1
CPR 1 1 SMM ÷ ÷ =
Contraction Risk: IR  hence prepayments  hence expected life 
Extension Risk: IR  hence prepayments  hence expected life 
Factors affecting
prepayment behaviour
1.Prevailing mortgage rates
2.Housing turnover
3.Characteristics of the
underlying mortgage loans
Annual
CPR
Age in
months
30
100 PSA
50 PSA
125 PSA
6%
3%
7.5%
192
MortgageBacked Securities
Mortgage Paythrough Securities
Several classes of investors
Collateralized Mortgage Obligations
Securities issued against passthrough securities
for which the cash flows have been reallocated
to different bond classes known as tranches
Planned
Amortization Class
Tranches
Amortized based on
a sinking fund
schedule established
within a range of
prepayment speeds
Support tranche
absorbs any excess
Stripped MBS
Principal and interest
payments are paid to different
security holders:
Interest Only (IO) Strips
Positively related to
mortgage rates: as IR 
there is more prepayment
of principal leading to less
cash flow for the IO strip
Principal Only
(PO) Strips
Very sensitive
to prepayment
rates
Prices rise as
IR 
Sequential Pay
Tranches
Each class of
bond retired
sequentially
Tranche A – Most
Contraction Risk
Tranche Z – Most
Extension Risk
193
Commercial MBS
• CMBS are backed by a pool
of commercial mortgage loans
on income producing property
• CMBS differ from residential
MBS in that they are non
recourse loans. Hence each
property must be assessed in
isolation rather than as a pool
• Call Protection at the Loan Level
– Prepayment lockout
– Defeasance
– Prepayment penalty points
– Yield maintenance charge
• Call Protection from the actual CMBS
structure: as the CMBS is sequential
paying (by credit rating), the AA rated
tranche cannot be repaid before the
AAA rated tranche
• Debttoservice coverage (DSC) ratio
= ratio of net operating income to debt
service.
• Need DSC need > 1, but also check
average & dispersion.
• Loan to Value (LTV) ratio
• The lower the LTV, the greater the
protection afforded to the lender
• Note value estimates may vary
considerably
Balloon Risk
Risk of default at end of loan,
when most of repayment is due
194
AssetBacked Securities
ABS: Key Features
Credit
Enhancements
Types
credit card receivables
auto loans
home equity loans
manufactured housing loans
Small Business Admin loans
corporate loans
bonds
other creditsensitive receivables
Amortizing (e.g. auto
loans) vs..
Nonamortizing
(e.g. credit card loans)
vs.
Prepayment (sequential pay
ABS, tranches having differing
prepayment/extension risks)
vs.
Seniorsubordinate structure
(senior tranche protected against
default by subordinate) a.k.a.
credit tranching
Internal credit enhancements:
1. Reserve funds
2. Overcollateralization
3. Senior/subordinated structure
External credit enhancements:
1. Corporate guarantee by seller
2. Bank letter of credit
3. Bond insurance
195
Types of AssetBacked Security
Credit Card Receivables
• Nonamortizing, with cash
flows = interest, fees,
principal
• 3 amortization structures:
passthrough, controlled
amortization, bullet payment
• Prepayment measured by
“monthly payment rate”
Home equity loans
• Often closedended HELs,
fixed or floating rate
• Cash flows similar to MBS
• Can be split into tranches:
NAS vs. PAC
• Prepayments are
modelled on issuer
specific prospectus
prepayment curve (PPC)
Manufactured housing
loans
• Amortizing over 1520 yrs
• Lower prepayments than
MBS because (1) small
loans, (2) depreciating
collateral, (3) low credit
quality of borrowers
• Prepayment model: CPR
with PPC
Student loans
• Floating rate, with
deferment, grace &
repayment periods
• Prepayments from defaults
or loan consolidations
SBA loans
• Variable rate, 525
years
• Prepayments
measured via CPR
Auto Loans
• Prepaid if sold, traded in, repossessed,
destroyed (insurance proceeds), early
repayment or refinanced – but…
• Refinancing uncommon since collateral
value depreciates rapidly and new car
loans often below market rates
• Prepayments: CPR & SMM
196
ABSs: Other issues
Collateralized Debt
Obligations
CDO = ABS
backed by
pool of bonds,
loans, MBSs
or ABSs
Arbitrage
transaction
(motivation: earn
the spread)
vs.
Balance sheet
transaction
(motivation:
remove debt from
B/S)
Cash CDO
(underlying =
cash debt
instruments)
vs.
Synthetic CDO
(credit
derivatives
create economic
equivalence to
cash instruments)
197
Valuing MBS/ABS
Techniques for valuing MBSs and ABSs
Cash flow yield analysis
Discount rate that makes
the present value of the
future cash flows equal to
the current price.
Prepayment assumption
required.
Can calculate bond equiv
yield:
] 1 ) i 1 [( x 2 BEY
6
M
÷ + =
Spread measures
Nominal spread: hides
prepayment risk
Zspread: same
problem, but considers
y.c. shape
OAS: best measure
Monte Carlo and spreads
The rates in the Monte Carlo model can be “tweaked”
so that model’s resultant price of MBS/ABS = market
price.
Level of “tweak” is the OAS, since the model
incorporates the prepayment option.
Hence for investing: biggest OAS = cheapest
investment
Best spread measure for
valuations
no option (or option exercise
unlikely): use Zspread
embedded option, not IR path
dependent: OAS with binomial
embedded option, IR path
dependent: OAS with Monte
Carlo
Monte Carlo vs. binomial
Monte Carlo incorporates IR
path, so can use prepayment
model to produce value.
Binomial model does not have
ability to value securities that
are IR path dependent, since
backward induction starts at
end of timescale.
198
Duration Measures MBS/ABS
MBS Duration Measures
Effective Duration
From Monte Carlo
model. Shock yield by
+/Ay, reapply the model
then plug results into
duration formula.
Cash Flow Duration
Estimate CF and hence CF
yield, shock yield by +/Ay,
reestimate CFs and hence
new prices, then plug results
into duration formula.
Coupon Curve
Duration
Calculate duration by
changing coupon
instead of yield.
Empirical Duration
Use linear regression
to identify how price
changes with yields.
0
2
P P
Duration
P y
÷ +
÷
=
A
199
Derivative Investments
Study Sessions 16 & 17
Weighting 5 15%
200
Overview of Level II Derivatives
Forward
Market and
Contracts
Future Market
and Contracts
Study Session 16: Derivatives Investments: Forwards and Futures
Options
Market and
Contracts
Interest Rate
Derivatives
Instruments
Credit
Derivatives
Study Session 17: Derivatives Investments: Options, Swap and Interest Rate
Swap Market
and Contracts
201
Forward Contracts
Obligation to:
buy (long)
sell (short)
an asset at an agreed price on an agreed forward date
Value & Price
– Value = PV of net advantage to long from
having contract at forward price (FP)
– Price = FP set when contract initiated, for
noarbitrage must = cash asset price + net
cost of carry
Credit risk
Party with the
positive value
faces credit risk
in that amount
202
Forward Contract Prices & Values
PV of difference between interest at FRA
rate and at the current forward rate for the
FRA period
Calculate the forward
interest rate. E.g. 4ͪ7
FRA, use fwd rate from
time 4 to 7
FRA
Currency
Forwards
Equity Index
Forwards
(S
o
 PVD) x (1+R
f
)
T
Equity
Forwards
VALUE (to the long at time t)
= (spot price – PV benefits)
– PV of forward price
FORWARD PRICE
= spot price
+ net costs of carry
TYPE
( )
( )


.

\

+
÷ ÷
÷t T
f
t
R 1
FP
PVD S
( )T į R
0
e S
÷
( ) ( )

.

\

÷

.

\

÷ ÷ t T R t T į
t
e
FP
e
S
T
base f,
T
quoted f,
0
) R (1
) R (1
S
+
+
×
( ) ( )


.

\

+
÷


.

\

+
t  T
quoted
t  T
base
t
) R (1
F
) R (1
S
203
Futures Contracts
Like forwards, but standardised, exchange
traded and subject to margining
Basis = spot price – futures price
Contango = negative basis. Most likely
scenario.
Backwardation = positive basis. It will
occur if benefits holding assets large
enough
Convergence ШAs maturity approaches,
basis converges to zero (due to arbitrage)


.

\

÷


.

\

=
market to mark last of
time at futures of price
price futures
current
contract futures
of Value
Futures price v. Forward
price
– In principle same no
arbitrage price applies to
both
– But investors preference for
marktomarket feature
(cash flow effect) could
make futures more (/less)
valuable than forwards
– Effect of marktomarket
ignored on following slides
204
Futures pricing
Futures arbitrage
– Futures price (like forward) determined by arbitrage
If futures trades above theoretical FP then:
Cash and carry arbitrage
– Buy cash asset with borrowed money and sell future
If futures trades below theoretical FP then:
Reverse cash and carry arbitrage
– Short sell cash asset, invest proceeds, and buy future
Generic futures pricing formula:
FP = S
0
ͪ (1 + R
f
)
T
+FV(NC)FVD
NC=Storage CostConvenience Yield
FVD=Future Value of Cash Flow
Convenience Yield: Non
monetary benefits from
holding asset, e.g., holding
asset in short supply with
seasonal/highly risky
production process
Eurodollar deposits vs Tbills
•Eurodollar deposits are US$ denominated
deposits outside the US priced off the
LIBOR curve using 360 day convention
•While Tbills are discount instruments,
Eurodollar deposits are addon instruments
Difficulty in pricing Eurodollar futures
•Eurodollar futures cannot be priced
easily as LIBOR is an addon interest and
arbitrage transaction cannot be
constructed perfectly as is the case with
Tbill futures
205
Pricing Financial Futures
FP = [(S
o
x (1+R
f
)
T
) – FV(Coupons)]/CF
S
0
,CF = Price, Conversion Factor of CTD bond
(Cheapest To Deliver bond gives highest implied
repo rate)
TBond
Exactly the same as for forwards Equity & Currency
Price Type of Future
Normal Backwardation
• Hedgers (shorts) are rejecting
price risk
• Speculators (longs) will require
compensation to accept risk
•Result: Futures price < expected spot
price
Normal Contango
• Hedgers (longs) are rejecting
price risk
• Speculators (shorts) will require
compensation to accept risk
•Result: Futures price >expected spot
price
206
Options basics (refresher)
call payoff = max(0, S
T
– X)
call profit = max(0, S
T
– X) – C
0
put payoff = max(0, X – S
T
)
put profit = max(0, X – S
T
) – P
0
Long Long Short Short
Call Put
B/E = strike +
prem
B/E = strike 
prem
Max loss = premium
Max profit = premium
Max profit =
unlimited
Max loss =
unlimited
Max loss
= B/E
Max profit
= B/E
207
Options Jargon (refresher)
Call Put
In the money S – X = +ve; S – X = –ve
Out of the money S – X = –ve; S – X = +ve
At the money S – X = 0; S – X = 0
– Moneyness
– Strike/exercise price (X)
– Underlying price (S)
– expiration
– European/American
– Intrinsic value
– Time value
Intrinsic value
– Call: Max (SX,0)
– Put: Max (XS,0)
Time value
– Premium minus Intrinsic value
208
Caps, floors, collars
Collar
– (long) collar = long cap + short floor
– zero cost if cap premium = floor premium
Cap
– series of interest rate caplets,
calls with identical strikes &
equallyspaced expiries
– bought by borrower
Floor
– series of interest rate floorlets, puts
with identical strikes & equallyspaced
expiries
– bought by lender
209
Putcall parity
Synthetics
– c
0
= p
0
+ S
0
 X/(1+r)
T
(synthetic call = long put + long underlying + short bond)
– p
0
= c
0
 S
0
+ X/(1+r)
T
(synthetic put = long call + short underlying + long bond)
– S
0
= c
0
 p
0
+ X/(1+r)
T
(synthetic underlying = long call + short put + long bond)
– X/(1+r)
T
= p
0
 c
0
+ S
0
(synthetic bond = long put + short call + long underlying)
Arbitrage – If Putcall parity doesn’t hold then any of
the equations below tells you how to get a profit
e.g. if c
0
> p
0
+ S
0
 X/(1+r)
T
then sell call and buy
synthetic call (buy put & U/L & sell bond [=borrow])
for options on futures:
c
0
+ [X  f
0
(T)]/(1+r)
T
= p
0
Cost of fiduciary call (long call + Zero Coupon Bond): c
0
+ X/(1+r)
T
must equal cost of protective put (long put + stock): p
0
+ S
0
210
Option pricing models
Discrete time – underlying asset
is assumed to move only at
discrete points in time
Continuous time – underlying
asset can move at any point in
time
e.g. Binomial
e.g. BlackScholesMerton
limit of discrete time model as
period length Ш0
211
Binomial option pricing
Symbols
S = stock price at start of period
S+ = upper potential endofperiod stock price = S ͪ u
S = lower potential endofperiod stock price = S ͪ d
(if d is not given, then assume d = 1/u)
c+ = call value at expiry if stock rises = Max(0,S+  X)
c = call value at expiry if stock falls = Max(0,S  X)
r = riskfree rate per period
Hedge ratio (delta) – a
riskfree portfolio requires
n units of stock per call,
where n (hedge ratio) =
÷ +
÷ +
÷
÷
S S
c c
Option value – for no arbitrage, call price at start of a
period:
where:
r 1
)c (1 c
c
+
÷ +
=
÷ +
d u
d r 1
÷
÷ +
=
Valuing American
options
At each point, substitute
intrinsic value if larger than
‘rollback’ value
Given call value can
estimate put from putcall
parity
212
2period Binomial example (1)
Stock price = $100
Each period stock either rises 25% or falls 20% (so u = 1.25, d = 0.8)
European call option expires at end of two periods, strike = $97.5
Risk free rate = 7% per period
Stock =
$100
Call = ?
Stock = $125
Stock = $80
e
it
h
e
r
o
r
Stock = $156.25
Call = $58.75
Stock = $100
Call = $2.50
e
it
h
e
r
o
r
Stock = $64
Call = $0
e
it
h
e
r
o
r
A
B
C
213
2period Binomial example (2)
At all three points (because r, u, and d are the
same each period): 6 . 0
8 . 0 25 . 1
8 . 0 07 . 0 1
d u
d r 1
ʌ =
÷
÷ +
=
÷
÷ +
=
Point B (i.e. at end of first period, assuming stock price rose):
   
$33.88
1.07
$2.5 ) 6 . 0 (1 75 . 58 $ 0.6
r 1
ʌ)c (1 ʌc
c
B
=
× ÷ + ×
=
+
÷ +
=
÷ +
Point C (i.e. at end of first period, assuming stock price fell):
   
$1.40
1.07
$0 ) 6 . 0 (1 5 . 2 $ 0.6
r 1
ʌ)c (1 ʌc
c
C
=
× ÷ + ×
=
+
÷ +
=
÷ +
Point A (now, using c
B
as c
+
and c
C
as c

):
   
$19.52 =
× ÷ + ×
=
+
÷ +
=
1.07
$1.40 ) 6 . 0 (1 88 . 33 $ 6 0.
r 1
ʌ)c (1 ʌc
c
C B
A
214
Valuing interest rate options
Valuing an option on a bond
 work backwards to value the
bond at each point in the tree
 value option on bond using
conventional binomial
approach
Valuing a cap or a floor
 use rates in tree to evaluate
payoff for each caplet/floorlet
 use rates in tree to discount p
weighted payoffs back to a PV
interest rates in tree will be
provided, and assume p = 0.5
Binomial Model
( )
o
=
2
L , 1 U , 1
e i i
215
BlackScholesMerton model
Assumptions of BSM
– Underlying asset price follows a geometric lognormal diffusion process
– Riskfree rate and volatility of asset known and constant over option life
– No cash flows (e.g. dividends) on the underlying
– No transaction costs or taxes
– European style options
) N(d Xe ) N(d S c
2
T r
1 0
c
÷
÷ =
( ) ( ) ( )
T ı
T /2 ı r ln
d
2 c
X
S
1
0
+ +
=
T ı d d
1 2
÷ =
As per binomial, given call value can
estimate put from putcall parity
216
Extensions of BSM
) N(d Xe ) N(d e S c
2
T r
1
įT
0
c
÷ ÷
÷ =
BSM Model with dividends
( )
( ) ( ) ( )
T ı
T /2 ı r ln
d
2 c
X
e S
1
T į
0
+ +
=
  ) XN(d ) (T)N(d f e c
2 1 0
T r
c
÷ =
÷
Black’s model (options on futures)
( ) ( )
T ı
T /2 ı ln
d
2
X
(T) f
1
0
+
=
Application to interest rate options –
replace f
0
(T) with forward interest rate
from the date of expiration of option to
end of period of underlying interest rate
in the option
T ı d d
1 2
÷ =
217
The Greeks
Positive Positive Vega Volatility
Interest rate
Passage of time
Underlying price
Factor
Negative Positive Rho
Negative Negative Theta
Negative Positive Delta
Relationship between change in
factor and change in premium
Put Call
Factor sensitivity
price asset
ue option val
A
A
expiry to time
ue option val
A
A
rate interest ǻ
ue option val ǻ
y volatilit price
ue option val
A
A
price asset
Delta
A
A
= Gamma
Estimating volatility:
Historical (std. devn. of past log returns)
Implied (by pricing model & current premium)
218
Delta hedging
0
2
4
6
8
10
12
14
16
1
2
1
4
1
6
1
8
2
0
2
2
2
4
2
6
2
8
3
0
3
2
3
4
3
6
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Intrinsic value Total value delta (right axis)
Delta is the
slope of the
premium versus
asset price line.
Call deltas vary
between 0 and +1
(since the line
moves from
being flat to a
45
0
slope)
Gamma is the
slope of this line,
it measures how
fast delta
changes as the
underlying price
moves. It is
positive, and
greatest for ATM
options
A long position in a stock with a short position in call options so value of portfolio
does not change with the value of the stock.
Number of calls required =
(but beware of gamma)
delta call
shares of number
219
Swaps and swaptions
Plain Vanilla Interest Rate Swap
• An agreement to exchange fixed rate
payments for floating rate payments
• Based on a notional principal.
• Payments are netted off
• Equivalent to issuing a fixedcoupon bond
and using proceeds to buy a floatingrate
bond
• Equivalent to a series of offmarket FRAs
• Equivalent to a series of interest rate calls
and puts
Currency Swap
• An agreement to exchange payments
denominated in one currency with
payments in another currency.
• Principal amounts are exchanged at the
start and end of the swap.
• Interest payments not netted off as they
are in different currencies
• Equivalent to issuing a fixed or floating
rate bond in currency A, converting
proceeds to currency B and buying a fixed
or floatingrate bond in the latter currency
Equity Swap
• An agreement to swap fixed
payments for a return on a stock
or stock index
• If the equity returns are negative,
the fixed rate payer must also pay
the percentage decline
• Equivalent to buying/
selling equity A and selling/buying
the bond/equity B
Swaptions
Payer Swaption
An option to enter into a pay fixed swap
As interest rates increase, the option
becomes more valuable
Receiver Swaption
An option to enter into a receive fixed swap.
As interest rates decrease, the option
becomes more valuable
220
Pricing and valuing swaps
Pricing (setting the fixed rate)
Interest rate swap pricing
Use the premise that an interest
rate swap is equivalent to issuing
a fixed rate bond and investing in
a floating rate bond.
The fixed rate must be set so that
the values of the 2 bonds are the
same at initiation.
At issue, the floating rate bond has
a value equal to its face value.
Therefore, the value of the fixed
rate must be:
( )
( )
¯
=
flow i for DF
flow last for DF  1
F
th
Valuation
 Difference between PVs of the two
flows
 Discount fixed cash flows at the new
LIBOR rates
 use fact that PV of FRN at coupon
date = par to simplify floating rate PV
 NB LIBOR at the start of each
coupon period determines the
coupon paid at the end of the period
221
Swaption
Value of Payoff for a Payer Swaption)
PV of the difference between
payments based on higher existing
(market) swap rate and payments
based on strike rate
Discount CFs based on “spread”
between contract and market
Payer swaption
Right to enter swap as fixed
rate payer (wins if rates
increase)
Receiver swaption
Right to enter swap as fixed
rate receiver (wins if rates fall)
Uses
Hedge anticipated floating rate
exposure in the future
Speculate on IR changes
Terminate an existing swap (i.e.,
buy the right to enter into an
offsetting position)
222
Interest rate options
Interest rate call payoff:
Notional principal ͪ
Max(0,underlying rate at expiry – exercise rate) ͪ (days in underlying rate/360)
Interest rate put payoff:
Notional principal ͪ
Max(0,exercise rate  underlying rate at expiry) ͪ (days in underlying rate/360)
For both types:
• payoff is at end of underlying notional loan period, rather than at expiry (for other
options payoff is at expiry)
• compare with FRAs
• Cap = series of interest rate calls
• Floor = series of interest rate puts
223
Credit Default Swap
Strategies
Basis trade
Credit curve flattener
Credit curve steepener
Index trade
Options trade
Capital structure trade
Correlation trade
Characteristics
Insurance contract on
“reference obligation” (a specific
bond or loan)
Buyer pays seller default swap
premium (default swap spread)
Protects buyer from losses due
to default
Swap seller is long the credit
risk only
224
Portfolio Management
Study Session 18
Weighting 5 – 15%
225
PORTFOLIO MANAGEMENT
Portfolio Concepts
A Note on
“Market
Efficiency”
Portfolio Management
Process & the Investment
Policy Statement
The Theory of Active
Management
International
Asset Pricing
Overview of Portfolio Management
226
Mean and standard deviation
2 , 1 2 1
2
2
2
2
2
1
2
1
2
: assets 2 for e.g.
Cov w w w w
port
+ + = o o o
Cov
i,j
=
E[(R
i
E(R
i
))㬍(R
j
E(R
j
))]
Variance
(for standard
deviation take
square root)
Expected
return
For a portfolio For an individual investment
j i for
1 1 1
2 2 2
=
= = =
¯ ¯¯
+ =
n
i
n
i
n
j
ij j i i i
port Cov w w w o o
¯


.

\
 ×
=
return potential
y probabilit
) (R E ) ( ) (
1
i
n
i
i port
R E w R E
¯
=
=
¯


.

\



.

\

÷ × =
2
2
) (R E
return
potential
prob o
j i
ij
Cov
r
o o
=
ij
n, Correlatio
If estimating an
investment’s E(R) & s
from time series data
then use these
formulae, but use
actual return for each
period in place of
potential, and set all
probs equal
Most important factor when adding
an investment to a portfolio that
contains a number of other
investments is average covariance
with all the other investments
227
Mean Variance Analysis
.
.
.
A
B
C
.
D
o
E(R)
.
.
.
A
B
C
.
D
o
E(R)
BCD is the
efficient frontier
opportunity set of
available
portfolios
ABCD is the minimum variance frontier
Assumptions:
• Investors are riskaverse
• Investors know expected returns,
variances, and covariances for all
assets
• Investors use Markowitz
framework
• Frictionless markets: no taxes or
transactions costs
Minimum Variance FrontierSmallest variance among all portfolios with the same expected return
Construction:
1. Estimation: Forecast expected return, E(R), and variance, Ӻ
2
, for each individual asset
2. Optimization: Solve for weights that minimize the portfolio Ӻ
2
given target return and portfolio
weights that sum to one
3. Calculation: Calculate E(R) and Ӻ
2
for all the minimum variance portfolios from Step 2
228
Correlation and Diversification
Lower correlation ¬higher bow ¬greater diversification
This is for a twoasset portfolio
E(r)
30%
20%
10%
0%
0% 10% 20%
Total Risk
= –1
= –0.3
= +0.3
= +1
Variance for an equalweighted
portfolio:
2 2
P i
1 n 1
ı = ı + Cov
n n
÷
229
Adding in a riskfree asset
Combinations of a risk portfolio
and a riskfree asset will lie on a
straight line:
Standard deviation
E
x
p
e
c
t
e
d
R
e
t
u
r
n
.
.
P
R
F
Lending at R
F
Borrowing
at R
F
.
.
P
R
F
.
M
C
M
L
E(R)
o
Hence, given assumptions on next slide: CML
(Capital Market Line)
M is the market
portfolio (optimal
risky portfolio)
All investors
want to be on
CML
230
CML vs. CAL
Security Market Line CML
Risk measure Systematic Total
Application Required return for
securities
Asset allocation for R
f
and M
Definition Graph of CAPM Graph of efficient frontier
Slope Market risk premium Sharpe ratio
• The Capital Market Line assumes
homogeneous expectations
• CML Equation
• The Capital Allocation Line assumes
heterogeneous expectations
• CAL Equation
C o
o
+ =
M
F M
F C
R  ) E(R
R ) E(R C o
o
+ =
T
F T
F C
R  ) E(R
R ) E(R
231
Total Risk
Market
Risk
Total Risk = Unsystematic Risk + Systematic Risk
Unsystematic Risk
Systematic Risk
Number of Stocks in the Portfolio
Systematic vs. Unsystematic Risk
232
Using the SML
.
R
F
.
M
R
M
þ
i
E(R
i
)
þ
M
=1
S
M
L
.
R
F
.
M
R
M
þ
i
E(R
i
)
þ
M
=1
S
M
L
SML shows
expected return
(per CAPM)
Compare this to
anticipated
(forecast) return
• A stock that is overpriced will plot below the SML
• A stock that is underpriced will plot above the SML
• A stock that is correctly priced will plot on the SML
E(R
i
) = RF + þ
i
(E(R
M
) R
F
)
㱍= Expected Return – Required Return
ƽ
233
CAPM in The Real World
Two key assumptions…
1. Investors can borrow/lend at riskfree rate
2. Unlimited shortselling and access to short proceeds
…yields two implications…
1. Market portfolio lies on the efficient frontier (market portfolio is efficient)
2. Linear relationship between expected return and beta
If the 2 key assumptions are violated…
1. Market portfolio might lie below the efficient frontier (might be inefficient)
2. Relationship between expected return and its beta might not be linear
234
The Market Model
LOS 71.a: discuss how the Index Model simplifies CAPM
• Regression of an asset’s returns against an observable index’s returns:
• Expected return:
• Variance:
• Covariance:
E(Ri) =oi +þiE(RM)
Ri = oi +þiRM +ci
oi
2
= þi
2
oM
2
+ oc
2
Cov ij = þiþjoM
2
Beta Instability Problem
Historical beta not necessarily a good predictor of future relationships….
Adjusted beta
Meanreverting level of beta = 1
Adjust beta to reflect this meanreverting level
Ӫ
i,t
= ө
0
+ ө
1
Ӫ
i,t–1
, where 㱍
0
+ 㱍
1
= 1
Most popular values: 㱍
0
= 1/3 and 㱍
1
= 2/3
Adjustment moves beta towards 1
Adjusted beta moves toward 1 more quickly for larger values of 㱍
0
235
Active Risk and Return
• Active return is the difference
between the portfolio return (P) and its
benchmark (B): R
P
– R
B
• Active risk (“tracking risk”) is the
standard deviation of the active return
• Source of active risk can be active
factor risk and active specific risk
• Factor portfolio vs. tracking
portfolio
Information Ratio
Active return per unit of active risk
Measures manager’s consistency in
generating active returns
P B
P B
(r r )
IR=
s(r r )
÷
÷
236
Multifactor models/APT
E(R
i
) = R
f
+ b
1
ì
1
+ b
2
ì
2
+ b
3
ì
3
+ ಹಹ.+ b
k
ì
k
APT (Arbitrage Pricing Theory)
b
k
= sensitivity of the actual return from security i to
changes in an index representing risk factor k
ì
k
= the difference between the expected return for a
one unit exposure to factor k and the riskfree
return
APT assumptions:
• Security returns can be
described by a factor
model
• Sufficient securities to
diversify away the
unsystematic risk
• No arbitrage opportunity
CAPM assumptions:
• Competitive capital market
• Markowitz investors
• Unlimited riskfree
lending/borrowing
• Homogenous expectations
• Oneperiod investment
horizons
• Frictionless markets
Multifactor models
• analyst chooses
number and the
identity of the factors 
enough so model
adequately predicts
security returns (but
not too many)
• Macroeconomic
models use underlying
economic influences
(e.g. real GDP growth,
unexpected inflation)
• Fundamental factor
models use specific
aspects of the
securities (e.g. P/E
ratio, firm size)
237
International Asset Pricing
Real Exchange Rate Risk
The possibility of exchange rate changes that are not explained
by inflation differentials
Real exchange rate = spot rate x
foreign price level
domestic price level
(dc/fc)
%A real spot = %A nominal spot rate – (inflation
Q
– inflation
B
)
(dc/fc)
238
ICAPM
Form of ICAPM:
E(R) = R
f
+ b
G
MRP
G
+ ¸
1
FCRP
1……
+ ¸
k
FCRP
k
where
E( R) = expected return required on investment x
R
f
= risk free rate in investor’s home country (domestic)
b
G
= the world beta of stock x (sensitivity to changes in global portfolio value)
MRP
G
= the world risk premium
¸
k
= sensitivity of stock* x to changes in real exchange levels
FCRP
k
= foreign currency risk premium
Foreign Currency Risk Premium
OR
Domestic Currency Sensitivity
Exporter ¸
LC
< 0
Importer ¸
LC
> 0
¸ = domestic currency sensitivity
¸
LC
= local currency sensitivity
¸ = ¸
LC
+ 1
*in domestic currency returns
( ) base quoted r  r
S
S  ) E(S
= FCRP
0
0 1
÷
FCRP =
E(S1)  F
S0
239
Equity & Bond Exposures
Currency Exposures of National Economies
Equity Markets Bond Markets
Increased longrun
economic activity
Currency
depreciation
Higher equity
prices
causes
causes Negative
currency
exposure
Traditional Model
Increased longrun
economic
activity
Currency
appreciation
Higher equity
prices
causes
causes
Positive
currency
exposure
Money Demand Model
Increase in real
interest rates
Currency
appreciation
Lower bond
prices
causes
causes
Negative
currency
exposure
Free Markets Theory
Government to
decrease real
rates
Currency
appreciation
Higher bond
prices
causes
causes
Positive
currency
exposure
Government Intervention Theory
240
Active Management
TreynorBlack Model:
• Only a limited number of securities are analyzed. The rest are assumed to be fairly priced.
• The market index portfolio (M) is the baseline portfolio. The expected return and the
variance of M are known.
• To create the active portfolio:
• Estimate the beta of each security to find mispricings. Those with nonzero alphas will be
put into the active portfolio with the following weights: (+ alpha ¬+ weight,  alpha ¬
weight)
• The cost of lessthanfull diversification comes from the nonsystematic risks of the
mispriced stocks, Ӻ
2
(e), which offsets the benefit of the alphas.
• Estimates of ө, Ӫand Ӻ
2
(e) are used to determine security’s weights (+ or ) in the
active portfolio
n
A i i
i=1
ȕ = wȕ
¯
n
2 2 2
A i i
i=1
ı(İ )= wı(İ)
¯
Active management and market equilibrium:
• empirical evidence:
• abnormal returns produced by some managers
• some anomalies in realized returns have persisted over prolonged periods
• if no one can beat the passive strategy, money will flow away from active managers and their
expensive analysis  prices will no longer reflect sophisticated forecasts  subsequent profit
opportunity lures back active managers who once again become successful
n
j
i
i
2 2
j=1
i j
Į
Į
w =
ı (İ) ı (İ )
¯
n
A i i
i=1
Į = wĮ
¯
241
Active Management
TreynorBlack Model (cont’d):
• The expected return and the standard deviation of the Active portfolio (A):
E(R
A
) = 㱍
A
+ 㱎
A
{E(R
M
) – R
F
}
• Combine the active portfolio and M to create the optimal portfolio which will maximize
the Sharpe’s ratio
• When short positions are prohibited, simply discard stocks with negative alphas.
• We should adjust the alpha estimated by an analyst by his past accuracy. Therefore if a
manager has consistently overestimated alpha on a stock in the past, we have to
“discount” his analysis . That will give a smaller weight to the stock
2 2 2
A A M A
ı = ȕ ı +ı (İ )
242
The portfolio management process
Steps:
1. Planning
• Specify investor’s objectives and constraints
• Create the investment policy statement (IPS) –
formal document governing all investment decision
making, with a central role in the whole portfolio
management process
• Formalize capital market expectations
• Create the strategic asset allocation
2. Execution step
• Construct a portfolio with the appropriate asset
allocation
3. The feedback step
• Monitor objectives and constraints and capital
market conditions, rebalance portfolio as needed
Objectives:
• Return
• Risk tolerance
(ability & willingness)
Constraints:
• Time horizon(s)
• Liquidity needs
• Taxes
• Legal & Regulatory needs
• Unique circumstances
Typical IPS elements:
• Client description
• Purpose of the IPS
• Identification of duties and
responsibilities
• Formal statement of objectives
and constraints
• Calendar schedule for portfolio
performance and IPS review
• Performance measures and
benchmarks
• Considerations for developing
the strategic asset allocation
• Investment strategies and
investment styles
• Guidelines for portfolio
adjustments and rebalancing
Time horizon directly
affects ability to take risk
Importance of ethical
conduct (managers are in
a position of trust)
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