Professional Documents
Culture Documents
2012 CFA L2 Summary PDF
2012 CFA L2 Summary PDF
Study Session 1
Code of
Ethics
Standards of
Professional
Conduct
CFA Institute
Soft Dollar
Standards
CFA Institute
Research
Objectivity
Standards
Study Session 2
Ethics Cases:
- Glenarm
Company
- Preston Partners
- Super Selection
Other topics:
- Fair dealing & disclosure
- Changing investment objectives
- Prudence in Perspective
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
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
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
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 issuer-paid research, flat fee structure is
preferred
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
members ability to perform
duties
Guidance
Material if disclosure of information would
impact a securitys 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 transactionbased 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
Guidance
Take investment actions in clients 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
III(C): Suitability
Know clients 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
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
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
11
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
IV(C): Responsibilities of
Supervisors
Must make reasonable efforts to
detect and prevent violations
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
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
Guidance
Maintain records to support research, and the
rationale for conclusions and actions
Records are firms property and cannot be
taken when member leaves without firms
consent
If no regulatory requirement, CFA Institute
recommends retention period of 7 years
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 market-making 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 employers business
14
15
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
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
16
17
Guidance
CFA Institute membership:
Failure to comply with results in an inactive
Complete PCS annually
Pay membership dues annually member status
Using the CFA designation:
Dont 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 charterholders name or as adjectives, not as nouns
18
Appendix: Permissible
research guidance
General
Principles
III. Selection of
brokers
IV. Evaluation of
research
V. Client-directed
brokerage
VI. Disclosure
19
20
Evaluation of research
Client-directed brokerage
Cannot use brokerage from another client to pay
Manager: Disclose duty of best execution
Disclose to client that clients selection may adversely affect execution and adequacy
of research
Disclosure
Disclose types of third-party 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 clients 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
Permissible research: 3 level analysis
Level I: define the product or service
Level II: determine usage
Level III: mixed-use analysis investment manager makes proper allocation
Objectives
Research
objectivity
policy
Public
appearances
Rating system
Disclosure
Investment
banking
Personal
investments
and trading
Reasonable
and adequate
basis
Research
analyst
compensation
22
Relationships
with subject
companies
Compliance
and
enforcement
Timeliness of research
reports and
recommendations
23
24
25
26
26
27
28
28
29
30
Case Studies
The Glenarm
Company
Super
Selection
Preston
Partners
Prudence in
Perspective
Changing Investment
Objectives
31
Quantitative Methods
Study Session 3
Weighting 5 10%
32
Study Session 3
Correlation and
Linear Regression
Multiple
Regression
Time-Series
Analysis
Correlation
R t,1 R1 Rt,2 R2
Cov1,2
r1,2
t 1
cov1,2
33
V 1V 2
n 1
H0: = 0
t=
Ha: 0
r n2
1 r2
Two-tailed test
Degrees of freedom are n 2
Linear Regression
34
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 Hi values = 0
Y, dependent
variable
Yi
Standard deviation of Hi =
standard error of the
estimate (SEE)
Hi error term
or residual
Yi
Yi
x
x
x
x
b0 b1 X i
x
x
x
x
x
x
Xi
X, independent
variable
Significance of coefficients
Hypothesis Tests on a Regression Coefficient
H0: bi = 0 Ha: bi 0
Other tests are possible, for example:
H0: bi 1
Ha: bi < 1
Test statistic, ti
bi bi
si
Y i
standard error of bi
Where : s i
35
b 0 b 1 X
Degrees of freedom = n (k + 1)
Y r critical t - value u sf
bi r critical t value u s i
n 2 degrees of freedom
sf2
1 ( X X )2
SEE 2 1
2
n (n 1)sx
Components of Variation
Y
b b X
Y
i
0
1 i
Yi
Y - Y o SSE
Y - Y o SSR
36
Y - Y
o SST
b0
37
Degrees of
Freedom
Sum of Squares
Mean Square
Regression
(explained)
1=k
Mean sum of
squares (MSR) =
RSS/k
n (k + 1) = n - 2
n-1
Error
(unexplained)
Total
Coefficient of determination
R2 =
explained variation in y
total variation in y
SEE
i
i 1
n k 1
SSE
n k 1
Interpretation
RSS
SST
Multiple Regression
General form of model:
38
Independent
variables
Dependent
variable
Error term,
residual
b0 b1 X1 b2 X2 .... bk Xk H i
Yi
Y-intercept
b X
.... b X
b b X
i
0
1 1
2
2
k
k
where :
b 0 , b1 , ...., b k are estimates for the regression parameters b 0 , b1 , .... b k
,X
, ..... X
are the assumed values of the independen t variable s
X
1
MSE
Significance of coefficients
Hypothesis tests on individual
regression coefficients
To identify which independent variables are
individually important in a multiple
regression we perform a t-test on each
slope coefficient with bi = 0. (seen earlier)
Test statistic, ti
Where : si
bi bi
si
standard error of bi
Degrees of freedom = n (k + 1)
Looking up the critical Fvalue
Use table corresponding to the
significance level of test (D) i.e.
(one-tailed!!!!)
Numerator dof = k
39
(n - k 1)
Denominator dof = n (k + 1)
40
Interpreting p-values
Adjusted R2
R2
n 1
1 1 R2
n k - 1
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)
2.
3.
4.
5.
6.
2.
2.
3.
Heteroskedasticity
Description
Variance of the error term is nonconstant.
Unconditional: Not related to
independent variables causes no
major problems.
41
42
Serial Correlation
43
Correction
dL
Evidence of
positive
autocorrelation
dU
4-dU
No evidence of
autocorrelation
4-dL
Test is
ambiguous
Test is
ambiguous
4
Evidence of
negative
autocorrelation
Multicollinearity
44
Correction
Remove one or more of the
offending independent
variables
Alternatively perform a more
advanced technique such
as stepwise regression
Detection
Conflicting t- and F-tests: significant F-statistic
combined with insignificant individual t-statistics
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
45
Examples of misspecification:
Omitting a variable
causes:
Trend Models
Variable is a
function of time
Autoregressive (AR)
models
Variable is a function of
earlier value(s) of itself
Autoregressive Conditional
Heteroskedasticity (ARCH) models
Used when variance of the error term
is dependent on the size of earlier
errors
46
Moving-Average (MA)
models
Variable is a function of
weighted average of
previous error terms
Trend Models
47
ln(yt) = b0 + b1t + Ht
Average change in y is
constant in absolute terms = b1
Observation
Trend
y
data series
straight line
of best fit
Autoregressive Models
48
E.g. AR(p):
xt = b0 + b1xt-1 + b2xt-2 + + bpxt-p + et
Covariance
stationarity
Mean reversion
Time series has tendency to
converge to its mean:
If not covariance
stationary then
regression results, both
statistically & financially,
are meaningless
Series has:
constant mean
constant variance
constant covariance
with itself over time
First differencing
might help a time
series achieve
covariance
stationarity
For AR(1) :
No finite
meanreverting level
not
covariance
stationary
b0
1 b1
Necessary
condition for
parameters to be
estimated by AR
regression
methods
49
Serial correlation
Random walks
Value in one period is equal to the
value in previous period plus a random
error:
xt = b0 + xt-1 + t
If b0 0 then random walk with drift
No finite
meanreverting level
not
covariance
stationary
50
ARMA models
Qth order moving average model, MA(q)
ARCH Models
51
Autoregressive Conditional
Heteroskedasticity
Description of heteroskedasticity
Variance of the error term is nonconstant.
Conditional: Is related to
independent variable this is a
problem.
Ht2
Correction
a0 a1Ht2-1 ut
V t21
a0 a1Ht2
52
or
xt - xt-1 = b0 + g1xt-1 + Ht
where g1 = (b1 1)
If there is a unit root in the AR(1) model, then g1 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:
53
Cointegration
Two time series are cointegrated if a long-term 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)
54
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
Measuring Economic
Activity
Foreign Exchange Parity Relations
Economic Growth
57
Rule of 70: a countrys economic activity will double every (70/growth rate) years
Economic Growth
58
PRECONDITIONS FOR
ECONOMIC GROWTH
Markets
Property rights
Monetary exchange
to continue
PRODUCTIVITY
One Third Rule
Encourage savings
Encourage basic R&D
Stimulate international trade
Improve the quality of education
Economic
regulation
59
Based upon
Product quality
Product safety
Employee safety
Natural Monopolies
Cost-of-service regulation
Rate-of-return regulation
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:
Governments like tariff revenue
Domestic producers affected by lower-cost imports use political means to gain
protection from foreign competition
60
61
Direct Quotes
DC/FC
Usual method of
quoting currencies
:$ base $ quoted
/$ $ base quoted
Indirect Quotes
FC/DC
Triangular Arbitrage
USD
00 P
56 B
1. D/G
US
0
86 SD
4
1. F/U
CH
GBP
CHF
2.3182 CHF/GBP
Triangular Arbitrage
62
BID
means
turning
into $
ASK
means
turning
$ into
SD
US
01
0C
HF
/U
BP
BP
1.5
G
D/
US
/G
SD
0U
0C
HF
/
00
51
00
35
1 .3
1. 5
1.
GBP
CHF
Bid Rate = ?.???? CHF/GBP
/$ 0.7113 0.7116
Bid (lower)
Ask (higher)
Bank sells
Bank sells $
Bank buys $
Bank buys
63
Fwd Spot
360
Fwd Pm
x
or Disc =
Spot
Contract Days
Factors affecting spread:
Volume
Volatility
Dealers long/short position
Term (forward contracts
only)
Forward Contracts
Premium base
currency buys more
future quoted
Discount base
currency buys less
future quoted
Triangular Arbitrage
USD
CHF
GBP
64
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
65
Forward rates are arbitrage free rates set using interest rate differentials.
International Fisher Relation
Inflation differentials between countries are the prime drivers of interest rate differentials
Countries with high interest rates (and high inflation rates) should have currency values that
fall over time
66
67
The forward rate is the best unbiased predictor of the future spot rate
Forward
Spot
Future Spott
ov
Ra ere
te d I
Pa nte
rit res
y
Spot 0
Purchasing
Power
Parity
Un
c
Interest
Rate
Parity
1 + INT Q
1 + INT B
68
Parity Relationships
E(ST) = So x
(1+Iquoted)T
(1+Ibase)T
Fwd = So x
(1+Rquoted)
(1+Rbase)
E(ST) = So x
Foreign Exchange
Expectation Relation
E(S) = F
E(%S) = F - So
So
(1+Rquoted)
(1+Rbase)
69
Net National
Income (NNI)
GNI less
depreciation.
Gross National
Income (GNI)
Total goods and
services produced
by the citizens of a
country
Output
Expenditure
Income
Value of production
- cost of inputs
GDP
Consumption
+ Investment
Total domestic expenditure
+ Exports of goods and services
Total final expenditure
- Imports of goods and services
GDP
GDP
+ net property
income from
abroad
GNI
- Depreciation
NNI
70
71
Study Session 5
Inventories
Long-Lived Assets
Study Session 6
Intercorporate
Investments
Employee
Compensation
Multinational
Operations
Study Session 7
Financial Reporting
Quality
Inventories
72
Inventory methods
With inflation and LIFO,
COGS is higher and end.
inv. is lower.
Periodic: records
purchase/sale in
"Purchases" account ,
inv./COGS determined at
period end.
LIFO liquidation
Under LIFO, inv. purchased
last is treated as if its sold
first.
LIFO liquidation occurs
when a company appears
to sell the inventory it
purchased first.
Integration of Financial
Statement Analysis
Techniques
LIFO reserve
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
(1-t).
Inventory valuation
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
Long-lived assets
73
Long-lived assets
disclosure
Fixed asset useful life,
Fixed asset SV,
Depreciation method,
Useful calculations
regarding a firms FA:
average age, average
depreciable life, remaining
useful life
Impairment
IFRS: Annually, CV vs.
recoverable amount (FV-selling
cost), can be reversed
US. GAAP: Tested, two steps:
recoverability test, then measuring
the loss, loss recoveries are
prohibited
Impact of Impairment
In the year of impairment: NI
lower, ROA & ROE will
decrease
In subsequent year: lower
depreciation, NI higher, ROA
& ROE will increase
Revaluation to FV
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
Leases
74
Intercorporate Investments
<20% votes
shares are a genuine small
investment for
dividend/capital gains
purposes
75
> 50% votes
20 50% votes
shares are to ensure a
significant influence is
exerted over the other
company (but NOT
outright control)
Subsidiary
Secondary market?
Affiliate/Associate
Consolidate (Purchase
method)
Equity Account
No
B/S Historic Cost
I/S Dividends/Int
Debt securities
which the
company
intends to hold
to maturity
Securities are
carried at
amortized cost
Yes
Held-to-maturity
securities
Available-forsale securities
Equity Accounting
76
Subsequent periods:
B/S: Cost + earnings pickup dividends
' B/S = %Share x ' Retained earnings
I/S: Earnings pickup (% share of NI)
$m
%FMV adjustments
Goodwill
Cost paid
Downstream
Profits recognized in
investor I/S
Unconfirmed profits
eliminate pro-rata share
Joint Ventures
77
Joint Ventures
Equity account: Required US GAAP Permitted IAS
one line consolidation
Proportional consolidation recommended by IAS
line by line proportional consolidation
78
X
(X)
X
Goodwill
79
Full goodwill
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)
Partial 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
Business Combinations
Purchase Method
US: required under SFAS 141
Business Combinations
IAS: required under IFRS 3
Business Combinations
Treats transaction as acquisition of
target by buyer
80
Pooling of Interests Method
US:
Goodwill
Minority Interests
No goodwill
No minority interest
Goodwill on consolidation
Purchase consideration
10
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
81
Impact on Accounts
Purchase vs.. Proportionate vs.
Equity A/C
Current Ratio
Consolidated > Proportionate > Equity
Leverage
issuing equity
Net Income
Gross Margin
Consolidated > Proportionate > Equity
Assuming investee ratio > parents
82
Profit Margins
Purchase < Pooling
ROA and ROE
Purchase < Pooling
Group Accounting
83
Impairment of goodwill
Identification:
Carrying value of
reporting unit +
goodwill
Measurement:
Carrying value of
goodwill
Fair value of
> reporting unit
>
IAS
Convergence Project
FMV adjustments for 100% of net assets not
just purchased element
Minority interest calculated using FMV
In-process R&D capitalized
Contingent consideration recognized at
acquisition date
Minority interests in equity
Remaining Differences:
US GAAP full goodwill
IFRS full or partial goodwill
Uses
Characteri
-stics
Issue
Variable Interests:
Guarantees of debt
Subordinated debt instruments
Lease residual interest guarantees
Participation rights
Asset purchase options
84
Pension Plans
Risk
Asset
ownership
Asset
manageme
nt
85
Defined Benefit
Defined
Contribution
Employee carries
the risk
Employee owns
assets, employer
acts as agent
Employee directs
investment policy
Pensions
X
BEGINNING PBO
Service cost
Interest cost
86
Employer contributions
-/+
-/+
Benefits paid
Expenses
ENDING PBO
Pensions
87
Pension Expense
Actual Events
Service Cost
Interest Cost
Amortisation of gains/losses
+/-
+/-
Funded Status
+/-
+/-
Actuarial (Gain)/Loss
+/-
+/-
+/-
+/-
Other Events
Curtailment/Settlements/
Termination
+/-
Actuarial Assumptions
88
Actuarial
Assumptions
Higher discount
rate
Lower wage
rate
increases
PBO
Lower
Lower
No change
ABO
Lower
No change
No change
Pension
Expense
Lower
Lower
Lower
Delayed Events
3 main delayed events
Net of:
Plan Assets
Plan Liabilities
PBO due to actuarial assumptions
89
90
Balance Sheet:
Replace accounting asset/liability with funded status take any change to equity
NB only required for SFAS 87 not 158
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
Cash Flow Statement
Cash flow = employer contribution into fund (CFO)
Contribution > Economic Expense = Principal repayment CFF CFO
Contribution < Economic Expense = Source of funding CFF CFO
Analyst should adjust CFO and CFF for after tax amounts
Analyst
Adjustment
Employee Compensation
Employee compensation:
Salary
Bonus
91
No shares held
Advantages:
Avoids dilution
Avoids risk aversion
Disadvantages:
Cash outflows
Expense spread over service life
Fair value
Market premium of similar option or
valuation model:
BSM
Binomial
Monte Carlo
Disclosure
Nature and extent of arrangement
Method of determining fair value
Impact on periods income
92
Functional currency
93
Reporting currency
The currency in which the
multi-national firm prepares
its final, consolidated
financial statements. For
exam purposes, most likely
to be the US$
Temporal/Remeasurement
Temporal
1.
2.
3.
Liabilities (current)
Retained earnings ()
Liabilities + Equity
Net income ()
Dividends
4.
94
(X)
X
Current/Translation
95
2.
Dividends
3.
4.
5.
1.
(X)
X
Impact on Ratios
Translation/All Current (Compared to LC)
No change from translation using allcurrent 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
96
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
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
Non-operating income/expense
reduces
comparability
98
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
Disciplining Mechanisms:
Analyst Expectations
External Auditors
Internal Audit/Committee
Debt Covenants
Management Certification
Earnings:
Regulators
Quality = persistence/sustainability
Market Scrutiny
Mean reversion
Cash flow and accruals elements
Accruals element not sustainable
Accruals naturally self correct
Richardson, Tuna, Wu companies
restating earnings have highest
accruals
Net
Operating = Total assets - - Total liabilities
cash
total debt
Assets
NOA
99
100
Calculations:
Aggregate = Accrual based - Cash based
Accruals
earnings NI
earnings
B/S based aggregate accruals
Aggregate = NOA - NOA
t
t-1
Accruals
Cash flow based aggregate accruals
Aggregate = NI (CFO
- t + CFIt)
Accruals
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 AR
Large Unearned Revenue
Lower future cash-flows and accounting
rates of return
101
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
102
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:
Net non current assets (B/S broad
measure accruals)
Consider asset growth in the context of
expected sales and margin growth
Software development costs - discretion
Earnings Management
Big Bath Provisions
Range of problems:
1. Impairments future I/S
improvements via depreciation
2. Restructuring or impairment charges
reversed in subsequent periods
3. Use of high or low bad debt reserves
out of line with peers
103
Goodwill:
Range of problems
FMV adjustments on acquisition
Future impairments
Warning signs:
Goodwill reported and not impaired for
companies where market cap < book value
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
Unrecorded Items
Special Purpose Entities
Operating Leases
Guarantees
Contingent liabilities
$
X
X
X
X
X
US GAAP
Comprehensive Income
Net Income
Pension adjustments
Unrealised gains and losses on
available for sale securities
Cumulative foreign currency
translation adjustments
Comprehensive Income
104
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
Normalized Earnings
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
105
Inter-firm comparisons
(adjustments)
International
comparisons
Inventory methods
LIFO prohibitions
Depreciation
assumptions/methods
Extraordinary items
Capitalized R&D
Accelerate Depn
Asset revaluation
Acquisition a/c
106
Corporate Finance
Study Sessions 8 9
Weighting 5% 15%
107
Study Session 8
Capital
Budgeting
Capital Structure
and Leverage
Dividends and
Dividends Policy
Study Session 9
Corporate
Governance
Mergers and
Acquisitions
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
108
109
2.
Annual operating cash flow = (Sales cash operating expenses depreciation)(1 tax
rate) + Depn
3.
Terminal year non-operating cash flow = Cash proceeds from sale of FCInv + NWCInv
tax rate x (Cash proceeds BV of FCInv Termination)
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 non-operating cash flow = (Cash proceeds from sale of FCInv + NWCInv
tax rate x (Cash proceeds BV of FCInv Termination)
110
111
Capital structure
112
Objective of capital structure decision is to maximise firm value and minimises the WACC
ra
E
D
rd re
V
V
D
Cost of equity is
re
D
ra (ra rd ) 1 t
E
re
WACC
rd
D/E
MM no tax
Cost of capital
Cost of capital
re
WACC
rd
D/E
MM with taxes
113
In reality, the value of a leveraged firm is affected by factors other than the interest on the debt.
These factors are:
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
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.
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.
Cost of financial
distress
VLeveraged
PV tax
shields
Vungeared
Debt ratio
Optimal Debt ratio
Cost of capital
MV of firm
114
WACC
re
Between 0% and
100%
rd
D/E ratio
Institutional/Legal Factors
Strength of legal system
Information asymmetry
Taxes
115
Financial Markets/Banking
System
Liquidity
Reliance on banking system
Institutional Investor presence
Macroeconomic
Factors
Inflation
GDP growth
116
Longer-term
residual
dividend
Dividend
stability
Target
payout ratio
Easy to use
BUT
Investors
may prefer
stable
dividends
Longer term
forecast of
capital
budget is
determined
excess
earnings
over this
period are
then spread
more evenly
each year
Focus on
steady $
payout
even though
earnings
may be
volatile
In practice
this
increases
with the long
term rate of
growth of the
company
Pay a
specific % of
total
earnings
over longterm
117
dividend in EPS
target
u payout
ratio
u adjustment
factor
Dividends can be
manufactured sell a
little bit of stock to get the
cash you want.
Theory requires a number
of assumptions.
118
Dividend initiation
Based on dividend preference theory
Dividend initiation
Lower risk
Lower cost of equity
Higher PE ratio
119
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 companys assets properly
120
Conflicts of Interest
Sole Proprietorship
Partnership
Corporations
Similar to sole
proprietors conflicts
between partners are dealt
with by implementing a
partnership agreement
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
Agency Relationships
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
121
122
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 managements 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
Managements responsibility to the board
Reports of directors oversight and review of
management
Board self-assessments
Management performance assessments
Directors training
Types of Merger
Backward
integration
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
Hops Farms
Conglomerate
Training
Acquirer
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
123
Horizontal
Brewery
Forward
integration
Another Brewery
Pubs
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
125
Stock Purchase
Asset
Purchase
Payment
To shareholder
To target
Approval
Shareholders
None
Target pays CG
S/H taxes
S/H pay CG
None
Liabilities
Acquirer
assumes
Usually avoids
assuming
Corporate taxes
Unsuccessful
Tender offer
Offer made to shareholders
Proxy battle
Proxy solicitation
HerfindahlHirschman Index
Key measure of
market power for
determining anti-trust
violations
126
Post merger
HHI
Industry
Concentration
Change
in HHI
Antitrust
Action
< 1000
Not concentrated
Any
amount
No action
Between 1000
& 1800
Moderate
100 or
more
Possible
> 1800
High
50 or
more
Virtually
certain
HHI =
(MSi ? 100)2
i=1
127
Comparable company
analysis
Uses relative value metrics
from similar firms
Adds a takeover premium
to determine fair price to
pay
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
128
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
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
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
Corporate restructuring
Divestitures: Selling, liquidating, or spinning off a division or subsidiary
Equity carve-outs: creates a new, independent company; sell shares to outside
stockholders through a public offering
Spin-offs: create a new, independent company; distribute shares to parent company
shareholders no cash for parent
Split-offs: existing shareholders must exchange shares for shares of new division
Liquidations: break up the firm and sell its assets piece by piece
131
Equity Investments
Study Sessions 10,11 &12
Weighting 20 -30%
Private
Company
Valuation
Residual Income
Valuation
Valuation
process
Market-Based
Valuation: Price
Multiples
Return concepts
Free Cash
Flow
Valuation
Five competitive
forces
Industry Analysis
132
Valuation in
Emerging Markets
Discounted Dividend
Valuation
133
Forward-looking
William Sharpe:
Valuation Process
134
1.
2.
3.
4.
5.
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 Process
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
135
Importance of F/S Footnotes
Footnotes reveal managements discretion in
choices of accounting methods and estimates
Analysts ability to accurately forecast result
derived from quality inputs
Greater transparency in earnings results in
higher stock pricemanagements ultimate goal
Considerations in Valuation
Valuation Process
136
Perceived mispricing
= any difference between the analysts estimate of intrinsic value and the market price
reflected in the abnormal return, alpha, the analyst expects to earn.
Ex ante alpha = expected holding-period return required return
Ex post alpha is used to assess the success of the analysts strategy
= actual holding-period 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 analysts ownership
perspective (i.e. extent of the investors influence over the company).
Ownership Perspective
Marketable publicly traded minority interestDDM approach is the benchmark value
Premiums for controlFCFE approach
Discounts for lack of marketability for non-publicly traded stocks
Discounts for lack of liquidity for publicly traded stocks
Return Concepts
137
Different Returns/Rates
Holding Period Return, Realized Return, Expected Return, Required Return, Return from
Price Convergence, Discount Rate, Internal Rate of Return
Ways of Measuring the Required Return
CAPM:
E(r) rf u Erm rf
equity risk premium
Multifactor Models
Reqd Return=(factor sensitivity)i*(factor risk premium)i + . + (factor sensitivity)n*(factor
risk premium)n
Return Concepts
138
Pastor-Stambaugh 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.
Return Concepts
139
Return Concepts
140
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)]
Return Concepts
141
Return Concepts
142
Survey Estimates
Strengths:
Uses expert opinions
and more likely to be
reliable
Weaknesses
There maybe large
differences of opinion
143
Top-down forecasting
1.
1. Macroeconomic
2.
2. Industry
3.
3. Company
POTENTIAL ENTRANTS
Threat of
new entrants
Bargaining
power
FIRM
RIVALRY
SUPPLIERS
Bargaining
power
BUYERS
Threat of substitute
products or services
SUBSTITUTES
Competitive Strategies
Broad Target
Cost
Leadership
Competitive
Advantage
Differentiation
144
Focus
Narrow Target
145
Growth
Maturity
Decline
Time
Industry Analysis
Industry External Factors
Technology
Government
Social changes
Demographics
Foreign influences
Supply analysis
146
Demand analysis
An analyst is in a position to assess
future demand for the industrys output
by developing
A macroeconomic forecast
An industry classification
An external factor review
Two additional sources of information
A study of the firms customers
A study of the industrys inputs and
outputs
Incorporating EM risks
147
Real
valuation
approach
Nominal valuation
approach
DCF
148
V0
CFt
1 rt
t 1
where
V0
value of the asset today (t
CFt
0)
Dt
t
t 1 1 r
V0
V0
where
V0
value of the share today (t 0)
Dt
expecteddividendat time t
requiredreturnon equity
149
D 1 P1
1 r 1
where
Pt
share price at time t
V0
D P
D1
D2
... n nn
1
2
1 r 1 r
1 r
Two-stage DDM
Expected HPR
Gordon growth model
V0
D0 1 g
r g
P1 P0 D1
P0
D1
r g
H-model
No growth model
V0
D (or E)
r
V0
Dt
Vn
1 r 1 r
t
t 1
D 0 1 gL D 0 u HgS gL
r gL
r gL
H = half the number of years for
anticipated decline in growth
Present value of growth opportunities = market value of share - no growth value per
share
DCF Commentary
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 nondividend paying stocks
Unpredictable growth patterns
makes using the model difficult
150
Spreadsheet approach
Used when even the three-stage DVM is too simple for a real-life application
Further Aspects
Multi-stage 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
151
g = b x ROE
Where: b = retention rate
ROE = expected return on equity
FCF Models
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 non-cash 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
NB: May be given EBIT or EBITDA as starting point for FCFE or FCFF calculations
FCF Models
153
Firmvalue
f
Equity
FCFEt
t
t 1
Debt
Constant growth
models:
t 1
1 r
Equity value
FCFFt
1 WACC
Equity value
Generic 2-stage
model:
FCFE0 1 g
r g
n
V0
FCFt
1 r
t 1
Firm value
FCFF0 1 g
WACC g
FCFn1 1
r g 1 r n
Forecasting FCF - Apply a growth rate to most recent reported free cash flow or
forecast each component separately.
Sensitivity Analysis OftenCalculation
utilized to
the impact
of uncertain
of assess
WACC is covered
in Corporate
Finance assumptions.
154
Price Multiples
155
Overview
Price multiples are ratios of a stocks market price to some measure of value per share.
Method of comparables involves comparing a stocks 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
Rationales for using P/E:
156
P0
E1
Leading P/E
Trailing P/E
P0
E0
D1
1 b
rg
E1
rg
D1(1 g)
r g
E1
1 b1 g
r g
PEG Ratio
157
Select and calculate the price multiple that will be used in the comparison.
2.
3.
Calculate the benchmark value of the multiple, i.e. the mean or median value of the
multiple for the comparison assets.
4.
5.
P/B Ratios
158
P0
B0
ROE g
r g
Rationales for using P/B:
P/S Ratios
159
P0
S0
E0 1 b1 g
S
0
r g
P/CF Ratios
160
Fundamental P/CF
P0
CF0
Other Models
161
Enterprise Value/EBITDA
162
Overview
Residual Income = accounting profit - charge for equity capital employed
Residual income represents returns in excess of shareholder expectations, or
economic income
V0
RIt
t
1 1 r
B0
t
B0
where:
V0 =
B0 =
Bt =
r
=
Et =
RIt =
t 1
E t rB t 1
1 r
V0 B0
r g
B0
P0
B0
163
ROE g
ROE r
1
r g
r g
Et rBt1 ET rBT1
1 r t 1 r Z1 r T1
t 1
T1
V0 B0
Terminal value of RI
164
RI Models Commentary
165
Strengths of RI models:
Weaknesses of RI models:
company does not pay dividends, or its dividend are not predictable
companys expected FCFs are negative within the analysts forecast horizon
Value-Based Metrics
Alternative measures
RI
EVA
MVA
166
167
Comparable Data
Subject Valuation
Controlling Interests
Controlling Interests
None
Controlling Interests
Noncontrolling Interests
DLOC
Noncontrolling Interests
Controlling Interests
Control Premium
Noncontrolling Interests
Noncontrolling Interests
None
168
Alternative Investments
Study Sessions 13
Weighting 5 15%
SS13 Overview
169
Alternative Asset
Valuation
Investment
Analysis
Income Property
Private Equity
Hedge Funds
170
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,
long-term
investors
Apartments
No of
households,
incomes,
location,
population
growth
Active
management, both
current income
and capital gains,
high liquidity and
leverage, inflation
hedge
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
171
Type
Main Value
Determinants
Investment
Characteristics
Principal Risks
Warehouses
Commercial
and industrial
activity,
flexibility of
design, easy
access and
convenience
Passive, moderate
liquidity and
leverage, mostly
income
Shopping
centres
Population,
income level,
location, tenant
mix, lease
terms
Active
management, low
liquidity, moderate
leverage, both
income and capital
gain, tax
advantages
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
CFAT1
CFATn
ERAT
...
EI
(1 IRR)1
(1 IRR)n (1 IRR)n
Likely Investor
172
Steps in Calculating CFAT
Step 1: Compute taxes payable
Taxes payable = (NOI depreciation
interest) h tax 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
Liquidity
Structure LP
Competition
Terms
Agency
Management fees
Capital
Carried interest
Regulatory
Ratchet
Tax
Hurdle Rate
Valuation
Diversification
Vintage
Market
Valuation
Due Diligence
174
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
Exit Routes
Costs
NOI
MV
Private Equity
Risks
173
Value Creation
IPO
Reengineer firm
Secondary
Market
MBO
Goal alignment
Audit
Liquidation
Transaction
Placement fee
Fund set up
Performance fee
Private Equity
175
Control Mechanisms in PE
Transactions
Compensation & Tag-along, drag-along
clauses
Valuation Methodologies
DCF
Private Equity
176
Use of
DCF
Frequently
used
Uncertain
cash flow
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
Relative
Value
Validates
DCF
No comps
Use of
Debt
High
Low, more
equity
Key
return
drivers
EPS
growth,
P/E
expansion,
debt
reduction
Pre-money
valuation,
future
dilution
Valuation
Issue
Buyout
Venture
Capital
Other Valuation
VC Single / Multiple financing rounds
LBO
- Target IRR
- Cash flow
Private Equity
For a Single Financing Round
Step 1: Post-Money Valuation
POST = FV /(1+r)N
Step 2: Pre-Money Valuation
PRE = POST-INV
Step 3: Ownership Fraction
f = INV/POST
Step 4: No. of the shares to be held by
the PE firm
Spe = Se [f/(1-f)]
Step 5: Price per share
P = INV/ Spe
177
For Multiple Financing Rounds
Step 1: the compound discount rate
Step 2: Post-Money Valuation (round 2)
POST2 = FV/ (1+ r2)
Step 3: Pre-Money Valuation (round 2)
PRE2 = POST2 INV2
Step 4: Post-Money Valuation (round 1)
POST1 = PRE2 / (1+ r1)
Step 5: Pre-Money Valuation (round 1)
PRE1 = POST1 INV1
Step 6: Ownership Fraction (round 2)
f2 = INV2 / POST2
Step 7: Ownership Fraction (round 1)
f1 = INV1 / POST1
Step 8: No. of the shares to be held by the PE
firm
Spe1 = Se [f1 /(1- f1)]
Step 9: Price per share after financing (round 1)
P1 = INV1 / Spe1
Step 10&11: Price per share after financing
(round 2)
Spe2 = (Se + Spe1) [f2 /(1- f2)]
P2 = INV2 / Spe2
Private Equity
IRR Method
Ownership Fraction
Step 1: Investors 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 Spe = Se [f/(1-f)]
Step 4: Price per share P = INV/ Spe
Post-Money & Pre-Money Valuation
Step 5: Post-Money valuation
POST = INV/f or POST = P
h(Spe+ Se)
Step 6: Pre-Money valuation
PRE = POST - INV or PRE = P
hSe
178
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
PV of equity investment =
E Asset
E
DE
E ( REquity )
R f E Equity [ E ( RMarket ) R f ]
Hedge Funds
Fee Structures
Paid on quarterly or annual basis
High-water mark provision
Hedge Fund Strategies
Arbitrage-based funds
Convertible bond arbitrage strategies
Equity market neutral funds
Event driven funds
Risk arbitrage (merger arbitrage)
Fixed-income arbitrage
Medium volatility arbitrage
Global macro funds
Long-short equity funds
Managed futures funds
Multi-strategy funds
Directional hedge fund strategies
Dedicated short bias funds
Emerging market hedge funds
179
Performance biases
Voluntary report to databases
Selection bias
Backfill bias
Survivor bias
Hedge Fund Returns
Factor models
Alpha: manager skill
Beta: market exposure
Hedge fund returns are often not normally
distributed Sharpe ratio or other classical
ratios may be useless
Funds of funds (FOF)
Retailing (exposure to a large number of
hedge funds)
Access to funds closed to individuals
Diversification
Expertise
Due Diligence Process
179
180
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
180
181
182
General Principles
of Credit Analysis
Mortgage-backed
Sector of the
Bond Market
Valuing MBS/ABS
Asset-backed
Sector of the
Bond Market
Credit Analysis
Credit Risk
Default Risk
Credit Spread Risk
Downgrade Risk
183
Key Considerations
The 4 Cs
Character
Capacity
Collateral
Covenants
Key ratios
Profitability
Short-term solvency
Capitalization/Leverage
Coverage
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
184
Term Structure
185
Twists
Parallel shifts
Yield
New steepened
curve
Yield
Original curve
Maturity
Maturity
Butterfly shifts
Yield
Yield
Original
curve
Positive butterfly
shift
Megative
butterfly
shift
Original curve
Maturity
Maturity
Approximate percentage
change in value in response to
a 100 basis point change in a
key rate, holding all other rates
constant
186
Forecasting
yield volatility
Historical
yield volatility
T
Variance
t 1
X
T 1
t
Best estimate
of average X
is zero.
Hence:
T
Where
Xt
100 >ln yt yt 1 @
yt
variance
t 1
Implied
volatility
Volatility
derived from
option pricing
models
key rate
Maturity
Xt2
T 1
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
= YTMcorp YTMTreas
(ignores shape of yield curve)
Zero-volatility/Z/Static spread
- spread added to spot rates to
get theoretical bond price =
actual bond price
Option-Adjusted Spread
- spread added to the interest
rate tree to get theoretical bond
price = actual bond price
187
ED
BV'y BV'y
EC
2 u BV0 u 'y
2 u BV0 u 'y 2
188
Treasury
Benchmark
Sector Benchmark
Issuer
Benchmark
Actual
OAS > 0
Undervalued if actual
OAS > required OAS*
Undervalued if
actual OAS >
required OAS*
Undervalued
Actual
OAS = 0
Overvalued
Overvalued
Fairly priced
Actual
OAS < 0
Overvalued
Overvalued
Overvalued
Convertible Bonds
189
Mortgage-Backed Securities
US Mortgage market key
features
Home loans in the form of
fixed-rate level-payment fully
amortized mortgages
principal
outstanding
190
Mortgage 1
Investor 1
Mortgage 2
Investor 2
Pool
Mortgage N
Pass-through securities
backed by the pool are
issued to investors
Investor N
Non-agency MBS
Collateral can be individual loans (vs.. passthrough securities for
agency MBS)
No government guarantee
Normally have max LTV, payment-to-income and size criteria
Mortgage-Backed Securities
191
Prepayment Rates
PSA Benchmark
Assumes the monthly
prepayment rate
increases as it seasons
CPR
Factors affecting
prepayment behaviour
1.Prevailing mortgage rates
2.Housing turnover
3.Characteristics of the
underlying mortgage loans
Conditional
prepayment rate
(CPR) is the expected
annual prepayment
rate.
Can be converted to
SMM (single-monthly
mortality rate):
Annual
CPR
7.5%
6%
125 PSA
100 PSA
3%
50 PSA
SMM 1 1 CPR
1 /12
30
Age in
months
Mortgage-Backed Securities
192
Sequential Pay
Tranches
Each class of
bond retired
sequentially
Tranche A Most
Contraction Risk
Tranche Z Most
Extension Risk
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:
Principal Only
(PO) Strips
Very sensitive
to prepayment
rates
Prices rise as
IR p
Commercial MBS
193
Balloon Risk
Risk of default at end of loan,
when most of repayment is due
Asset-Backed Securities
194
Types
credit card receivables
auto loans
home equity loans
manufactured housing loans
Small Business Admin loans
corporate loans
bonds
other credit-sensitive receivables
Amortizing (e.g. auto
loans) vs..
Non-amortizing
(e.g. credit card loans)
vs.
Student loans
Floating rate, with
deferment, grace &
repayment periods
196
Collateralized Debt
Obligations
Arbitrage
transaction
(motivation: earn
the spread)
vs.
Balance sheet
transaction
(motivation:
remove debt from
B/S)
195
Cash CDO
(underlying =
cash debt
instruments)
vs.
Synthetic CDO
(credit
derivatives
create economic
equivalence to
cash instruments)
CDO = ABS
backed by
pool of bonds,
loans, MBSs
or ABSs
Valuing MBS/ABS
197
Spread measures
Nominal spread: hides
prepayment risk
Z-spread: same
problem, but considers
y.c. shape
OAS: best measure
198
Effective Duration
From Monte Carlo
model. Shock yield by
+/-'y, reapply the model
then plug results into
duration formula.
Duration
P P
2 P0 'y
Empirical Duration
Use linear regression
to identify how price
changes with yields.
Coupon Curve
Duration
Calculate duration by
changing coupon
instead of yield.
199
Derivative Investments
Study Sessions 16 & 17
Weighting 5 -15%
200
Forward
Market and
Contracts
Future Market
and Contracts
Study Session 17: Derivatives Investments: Options, Swap and Interest Rate
Options
Market and
Contracts
Credit
Derivatives
Swap Market
and Contracts
Interest Rate
Derivatives
Instruments
Forward Contracts
201
Obligation to:
buy (long)
sell (short)
an asset at an agreed price on an agreed forward date
Credit risk
Party with the
positive value
faces credit risk
in that amount
FORWARD PRICE
= spot price
+ net costs of carry
Equity
Forwards
Equity Index
Forwards
FRA
Currency
Forwards
S0eR T
Calculate the forward
interest rate. E.g. 47
FRA, use fwd rate from
time 4 to 7
S0 u
(1 R f,quoted ) T
(1 R f, base ) T
202
FP
Tt
1
R
f
St PVD
St FP
T t R T t
e
e
PV of difference between interest at FRA
rate and at the current forward rate for the
FRA period
St
F
T- t
T- t
(1
R
)
(1
R
)
base
quoted
Futures Contracts
203
Value of
futures contract
futures price of last mark to market
Futures pricing
204
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
205
Type of Future
Price
T-Bond
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
Call
Put
Short
Short
B/E = strike +
prem
Max profit =
unlimited
Long
Max loss =
unlimited
Max loss
= B/E
Max profit
= B/E
Moneyness
Strike/exercise price (X)
Underlying price (S)
expiration
European/American
Intrinsic value
Time value
In the money
Out of the money
At the money
207
Call
Put
S X = +ve; S X = ve
S X = ve; S X = +ve
S X = 0;
SX=0
Intrinsic value
Call: Max (S-X,0)
Put: Max (X-S,0)
Time value
Premium minus Intrinsic value
Cap
series of interest rate caplets,
calls with identical strikes &
equally-spaced expiries
bought by borrower
208
Floor
series of interest rate floorlets, puts
with identical strikes & equally-spaced
expiries
bought by lender
Collar
(long) collar = long cap + short floor
zero cost if cap premium = floor premium
Put-call parity
209
Synthetics
c0 = p0 + S0 - X/(1+r)T
p0 = c0 - S0 + X/(1+r)T
S0 = c0 - p0 + X/(1+r)T
X/(1+r)T = p0 - c0 + S0
210
e.g. Binomial
e.g. Black-Scholes-Merton
211
c (1 )c
1r
where:
1rd
ud
Symbols
S = stock price at start of period
S+ = upper potential end-of-period stock price = S u
S- = lower potential end-of-period 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 = risk-free rate per period
c c
S S
Valuing American
options
At each point, substitute
intrinsic value if larger than
roll-back value
212
B
A
Stock =
$100
Call = ?
er
eith
or
Stock = $125
er
eith
or
Stock = $80
er
eith
or
Stock = $156.25
Call = $58.75
Stock = $100
Call = $2.50
Stock = $64
Call = $0
1 0 . 07 0 . 8
1 . 25 0 . 8
c (1 )c
1 r
0 .6
1.07
$33.88
cC
1 r d
ud
cB
213
c (1 )c
1 r
>0.6 u $ 2 .5 @ >(1 0 .6 ) u $0 @
1.07
$1.40
cA
c B (1 )c C
1 r
$19.52
214
Black-Scholes-Merton model
215
Assumptions of BSM
Underlying asset price follows a geometric lognormal diffusion process
Risk-free 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
S 0 N(d 1 ) Xe r T N(d 2 )
d1
ln S 0 X r c 2 /2 T
T
d2
d1 T
Extensions of BSM
216
c
d1
S 0 e T N(d 1 ) Xe r T N(d 2 )
c
- T
ln S 0 e X r c 2 /2 T
T
d2
d1 T
er
f 0 (T)
d1
T
The Greeks
Factor
217
Factor sensitivity
Underlying price
Delta
Passage of time
Theta
Interest rate
Rho
Volatility
Vega
Call
Put
Positive
Negative
Negative
Negative
Positive
Negative
Positive
Positive
Estimating volatility:
Historical (std. devn. of past log returns)
Implied (by pricing model & current premium)
Gamma
' Delta
' asset price
Delta hedging
218
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 = number of shares
(but beware of gamma)
call delta
Intrins ic value
Total value
delta (right ax is )
1
16
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
14
12
10
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
36
34
32
30
28
26
24
22
20
18
16
14
0
12
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
450 slope)
219
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 floatingrate bond in currency A, converting
proceeds to currency B and buying a fixedor floating-rate bond in the latter currency
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
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
Swaption
Payer swaption
Receiver swaption
221
Uses
Speculate on IR changes
222
Characteristics
Insurance contract on
reference obligation (a specific
bond or loan)
223
Strategies
Basis trade
Credit curve flattener
Credit curve steepener
Index trade
Options trade
Capital structure trade
Correlation trade
224
Portfolio Management
Study Session 18
Weighting 5 15%
225
PORTFOLIO MANAGEMENT
Portfolio Management
Process & the Investment
Policy Statement
Portfolio Concepts
A Note on
Market
Efficiency
Variance
(for standard
deviation take
square root)
E (R )
For a portfolio
probabilit y u
potential return
return
226
E(Rport)
V 2 port
w E(R )
i 1
wi Vi wi wjCovij
i 1
i 1 j 1
for iz j
If estimating an
investments 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
V port
Covi,j =
E[(Ri-E(Ri))(Rj-E(Rj))]
Correlatio n, rij
Cov ij
V iV j
BCD is the
efficient frontier
opportunity set of
available
portfolios
227
Assumptions:
Investors are risk-averse
Investors know expected returns,
variances, and covariances for all
assets
Investors use Markowitz
framework
Frictionless markets: no taxes or
transactions costs
228
E(r)
30%
1
n 1
P2 = i2 +
Cov
n
n
20%
10%
= +1
= 1
= 0.3
= +0.3
0%
0%
10%
20%
Total Risk
229
Expected Return
RF
E(R)
All investors
want to be on
CML
L
CM
Borrowing
at RF
RF
M is the market
portfolio (optimal
risky portfolio)
Lending at RF
Standard deviation
230
E(RM) - RF
E(RC ) R F
VC
VM
Risk measure
Application
Definition
Slope
E(RT) - RF
E(RC ) R F
VC
VT
CML
Systematic
Total
Graph of CAPM
Sharpe ratio
231
Total Risk
Market
Risk
Unsystematic Risk
Systematic Risk
Number of Stocks in the Portfolio
232
E(Ri)
RM
RF
SML shows
expected return
(per CAPM)
EM=1
SML
Ei
Compare this to
anticipated
(forecast) return
233
234
R i = D i + E iR M + H i
Expected return:
E(Ri) = Di + EiE(RM)
Variance:
Vi 2
Covariance:
Cov
Ei VM VH
2
ij
= E iE jV M 2
235
Information Ratio
Active return per unit of active risk
IR =
(rP rB )
s(rP rB )
Multifactor models/APT
APT (Arbitrage Pricing Theory)
(5L 5I EO EO EO ENON
EN =
ON =
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 risk-free
lending/borrowing
Homogenous expectations
One-period investment
horizons
Frictionless markets
236
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
ICAPM
238
Form of ICAPM:
E(R) = Rf + bGMRPG + J1FCRP1 + JkFCRPk
where
E( R) = expected return required on investment x
Rf = risk free rate in investors home country (domestic)
bG = the world beta of stock x (sensitivity to changes in global portfolio value)
MRPG = the world risk premium
Jk = sensitivity of stock* x to changes in real exchange levels
FCRPk = foreign currency risk premium
*in domestic currency returns
Foreign Currency Risk Premium
E(S 1) - S 0
FCRP =
rquoted - rbase
S0
OR
FCRP =
E(S 1) - F
S0
J = JLC + 1
Exporter JLC < 0
Importer JLC > 0
J = domestic currency sensitivity
JLC = local currency sensitivity
239
Bond Markets
Traditional Model
causes
Currency
depreciation
Increased long-run
economic activity
causes
Higher equity
prices
Negative
currency
exposure
Negative
currency
exposure
prices
Active Management
Higher bond
prices
Positive
currency
exposure
240
wi =
2(i )
2
j=1 (j )
The cost of less-than-full diversification comes from the non-systematic risks of the
mispriced stocks, 2(e), which offsets the benefit of the alphas.
Estimates of , and 2(e) are used to determine securitys weights (+ or -) in the
n
n
n
active portfolio
A = w
2(A)= wi22()
A = wii
i i
i
i=1
i=1
i=1
Active Management
241
A = 2A M2 + 2 ( A )
Combine the active portfolio and M to create the optimal portfolio which will maximize
the Sharpes 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
Constraints:
Time horizon(s)
Liquidity needs
Taxes
Legal & Regulatory needs
Unique circumstances
242
Importance of ethical
conduct (managers are in
a position of trust)