PAK CFE Supplemental Formula Sheet (Spring 2023)

PAK CFE Supplemental Formula Sheet (Spring 2023)
Notes
- This file includes the important formulas (not all) in the syllabus.
- We also include the notations and the descriptions for the formulas so that you won't get
lost when you read them. =)
- Should you have any questions, please send us an email
(eddy.chan@pakstudymanual.com)
© 2023 PAK Study Manual 1 SOA CFE Exam

Textbook Reading: Corporate Finance Ch. 8
Calculate Unlevered Net Income

Year 1
(+) Sales 26,000
(−) Cost of Goods Sold (11,000)
(=) Gross Profit 15,000
(−) Selling, Gen, & Admin (2,800)
(−) R&D -
(−) Depreciation (1,500)
(=) EBIT 10,700
(−) Income Tax @ 40% (4,280)
(=) Unlevered Net Income 6,420
Net Working Capital

Net Working Capital = Current Assets – Current Liabilities
= Cash + Inventory + Receivables - Payables
Free Cash Flow

Unlevered net income
FCF = ( Revenus - Costs - Depreciation ) × (1 − τ c ) + Depreciation - CapEx - ΔNWC

= ( Revenus - Costs ) × (1 − τ c ) - CapEx - ΔNWC + Depreciation × τ c
Tax shield
Example of Continuation Value with Perpetual Growth

- Assume the cost of capital is 10% with the following projection of FCF:
Year Projection of FCF (in millions)

0 -$10.5
1 -$5.5
2 $0.8
3 $1.2
4 $1.3
5 $1.3 x 1.05
t $1.3 x 1.05^(t-5+1)
- Because the future FCF beyond year 4 is expected to grow at 5% per year, the continuation value in year 4 of
the FCF in years 5+ is:
FCF4 × (1 + g ) 1.05
Continuation Value in Year 4 = = $1.30m × = $27.3m
r−g 0.10 − 0.05

Textbook Reading: Corporate Finance Ch.18
WACC (Discount Rate)

E D
rwacc = rE + rD (1 − τ c )
E+D E+D
E = Market value of equity rE = Equity cost of capital τ c = Marginal corporate tax rate
D = Market value of debt (net of cash) rD = Debt cost of capital
Assumptions
- The firm maintains a constant debt-equity ratio
- The WACC remains constant over time
The Levered Value of an Investment and its NPV

n
FCFt
V0L =  (1 + r
t =1 wacc )
t
and NPV = V0L − (initial cost )
Debt Capacity
- An investment’s debt capacity (Dt) is the amount of debt at date t that is required to maintain the firm’s target
debt-to-value ratio (d)
Dt = d ×Vt L
Levered Continuation Value
FCFt +1 + Vt L+1
Vt L =
1 + rwacc
Adjusted Present Value (APV) Method

- The levered value (VL) of an investment is determined by first calculating its unlevered value (VU), which is its
value without any leverage, and then adding the value of the interest tax shield
APV : V L = V U + PV ( Interest Tax Shield )
The Unlevered Cost of Capital

- Because the project has similar risk to the firm's other investments, its unlevered cost of capital is the same as
for the firm as a whole
E D
Unlevered Cost of Capital with a Target Leverage Ratio: rU = rE + rD = Pretax WACC
E+D E+D
Valuing the Interest Tax Shield

- The interest paid in year t is estimated based on the amount of debt outstanding at the end of the prior year
Interest paid in year t = rD × Dt −1
- The interest tax shield is equal to the interest paid multiplied by the corporate tax rate τc
Interest tax shield in year t = ( Interest paid in year t ) × τ c
- To compute the present value of the interest tax shield, we need to determine the appropriate cost of capital
- When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s
cash flows, so they should be discounted at the project’s unlevered cost of capital
n
Interest tax shield t
PV ( Interest tax shield ) = 
t =1 (1 + rU )t
Net Borrowing
Net Borrowing at Date t: Net Borrowing t = Dt − Dt −1

Compute a Project’s FCFE Directly from Its FCF
FCFE = FCF − (1 − τ c ) × ( Interest Payments ) + ( Net Borrowing )
After-tax interest expense
Valuing Equity Cash Flows

- The project’s free cash flow to equity shows the expected amount of additional cash the firm will have available
to pay dividends (or conduct share repurchases) each year
- Because these cash flows represent payments to equity holders, they should be discounted at the project’s
equity cost of capital
n
FCFEt
NPV ( FCFE ) =  (1 + r )
t =0 E
t
Project Leverage and the Equity Cost of Capital

- Companies may fund the project using a different target leverage ratio so we can use the following formula to
get the project-based equity cost of capital
D
rE = rU + ( rU − rD )
E
- The project’s equity cost of capital depends on its unlevered cost of capital (rU) and the debt-equity ratio of the
incremental financing that will be put in place to support the project
Project-Based WACC Formula

rwacc = rU − dτ c rD where d is the project-based debt-to-value ratio D / ( E + D )
Constant Interest Coverage Ratio

- When the firm keeps its interest payments to a target fraction of its FCF, it has a constant interest coverage
ratio
Interest Paid in Year t = k × FCFt
- Because the tax shield is proportional to the project’s free cash flow, it has the same risk as the project’s cash
flow and so should be discounted at the same rate (the unlevered cost of capital rU)
PV ( Interest Tax Shield ) = PV (τ c k × FCF ) = τ c k × PV ( FCF )

= τ c k ×V U
- With a constant interest coverage policy, the value of the interest tax shield is proportional to the project’s
unlevered value
Levered Value with a Constant Interest Coverage Ratio
V L = V U + PV ( Interest Tax Shield ) = V U + τ c k × V U

V L = (1 + τ c k ) × V U
- If the investment’s free cash flows are expected to grow at a constant rate, then the assumption of constant
interest coverage and a constant debt-equity ratio are equivalent
Levered Value with Permanent Debt

V L = V U +τc × D

Impact of Imperfection
Impact of Imperfection = NPV(after change) − NPV(before change)
- If the impact of imperfection is negative (positive), then it is a loss (gain)
The PV of Interest Tax Shield (with Periodically Adjusted Debt)

τ c × Intt τ × Intt  1 + rU 
PV (τ c × Intt ) = t −1
= c × 
(1 + rU ) (1 + rD ) (1 + rU )t  1 + rD 
- We can value the tax shield by discounting it at rate rU as before, and then multiply the result by the factor
(1 + rU)/(1 + rD) to account for the fact that the tax shield is known one year in advance
WACC (with Annually Adjusted Debt)

 1 + rU 
rwacc = rU − dτ c rD  
 1 + rD 
Levered Value (with Annually Adjusted Debt)

- When the firm sets debt annually based on its expected future free cash flow, the levered value of the firm
under the constant interest coverage model is:
 1 + rU  U
V L = 1 + τ c k V
 1 + rD 
Leverage and the Cost of Capital with a Fixed Debt Schedule
E Ds Ds
rU =
rE + rD or rE = rU + ( rU − rD )
E + Ds E + Ds E
Project WACC with a Fixed Debt Schedule
rwacc = rU − dτ c [ rD + φ ( rU − rD ) ]
D
d= = Debt-to-value ratio
D+E
Ts
φ= = A measure of the permanence of the debt level (D)
τcD
Three Common Uses

PV of the interest tax shields Debt net of the A measure of the
Debt
from predetermined debt predetermined tax shields permanence of the debt level
Continuously adjusted φ =0
debt Ts = 0 Ds = D
Annually adjusted τ c rD D  r  rD
Ts = D s = D 1 + τ c D  φ=
debt 1 + rD  1 + rD  1 + rD
Permanent φ =1
T s = τcD D s = D (1 − τ c )
debt

Personal Taxes
(1 − τ i )
rD* ≡ rD
(1 − τ e )
Notation
τ e = The tax rate investors pay on equity income (dividends)
τ i = The tax rate investors pay on interest income
rD = The expected return on debt
rD* = The expected return on equity income that would give investors the same after-tax return
Unlevered Cost of Capital with Personal Taxes

E Ds
rU = s
rE + r*
s D
E+D E+D
Effective Tax Advantage of Debt

(1 − τ c )(1 − τ e )
τ * = 1−
(1 − τ i )
Interest Tax Shield

Interest Tax Shield t = τ * × rD* × Dt −1
PV(Interest Tax Shield)

Interest Tax Shield t
PV ( Interest Tax Shield ) =  (1 + rU )t
(if the firm maintains a target leverage ratio)
Interest Tax Shield t

PV ( Interest Tax Shield ) =  (1 + rD* )t
(if the debt is set according to a predetermined schedule)

Real Option Value

Real Option Value = Expected Profitwith real option − Expected Profitwithout real option
Black-Scholes Formula for European Call Option

ln  S x / PV ( K )  σ T
C = S x N ( d1 ) − PV ( K ) N ( d 2 ) where d1 =  + and d 2 = d1 − σ T
σ T 2
Black-Scholes Parameters vs. Real Option Parameters

Financial Option Symbol Real Option Example (Below)
Stock Price S Current Market Value of Asset $6 million
Strike Price K Upfront Investment Required $5 million
Expiration Date T Final Decision Date 1 year
Risk-Free Rate rf Risk-Free Rate 5%
Volatility of Stock σ Volatility of Asset Value 40%
Dividend Div FCF Lost from Delay $0.6 million
Calculate the Asset Value Without the Dividends

S x = S − PV ( Div )
Calculate the Risk-Neutral Probability of the Interest Rates Go Up

(1 + rf ) S − Sd
ρ=
Su − S d
Textbook Reading: Corporate Finance Ch. 25
PV( Lease Payments ) = Purchase Price – PV( Residual Value )

PV( Loan Payments ) = Purchase Price
Cash Flows for a True Tax Lease

Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Capital Expenditures (50,000) - - - - -
Depreciation Tax Shield @ 35% - 3,500 3,500 3,500 3,500 3,500
FCF (50,000) 3,500 3,500 3,500 3,500 3,500
Lease Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Lease Payments (12,500) (12,500) (12,500) (12,500) (12,500) -
Income Tax Savings @ 35% 4,375 4,375 4,375 4,375 4,375 -
FCF (8,125) (8,125) (8,125) (8,125) (8,125) -
The Lease-Equivalent Loan

- Let’s compute the difference between the cash flows from leasing versus buying, which is the incremental
FCF of leasing.
Lease vs. Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

FCF Lease (8,125) (8,125) (8,125) (8,125) (8,125) -
Less: FCF Buy (50,000) 3,500 3,500 3,500 3,500 3,500
Lease – Buy 41,875 (11,625) (11,625) (11,625) (11,625) (3,500)
n CFlease,t − CFbuy ,t
PV (Lease vs. Borrow) =  where rWACC = rD (1 − τ c )
t =0 (1 + rwacc )t

None
The Price Paid for a Target

Amount Paid = Target’s Pre-Bid Market Capitalization + Acquisition Premium
The Benefit from the Acquisition (from the Bidder’s Standpoint)
Value Acquired = Target Stand-Alone Value + PV(Synergies)
Method Description
Cash o The bidder simply pays for the target, including any premium, in cash.
o The bidder pays for the target by issuing new stock and giving it to the target shareholders.
o The price offered = the exchange ratio x the market price of the acquirer’s stock.
o The exchange ratio = the number of bidder shares received in exchange for each target share.
o A stock-swap merger is a positive-NPV investment if the share price of the merged firm > premerger price
of the acquiring firm.
Notation
A = premerger value of the acquirer
A+T + S A
> T = premerger value of the target
NA + x NA S = value of the synergies created by the merger
Stock NA = shares outstanding before the merger
x = new shares issued to pay for the target
x  T + S  N A PT  S 
o Exchange ratio = <  = 1 + 
N T  A  N T PA  T 
Notation
NT = premerger number of target shares outstanding
PT = T / NT
PA = A / NA
Covered Interest Parity (Derived for Risky Discount Rates)

- By the Law of One Price, this value must be equal to what the U.S. investor paid for the security:
CFC C
S× *
= F × FC*
(1 + rFC ) (1 + r$ )
(1 + r$* )
F =S× *
(1 + rFC )
The Foreign-Denominated Cost of Capital
(1 + r£* ) (1 + r£ ) S
= =
(1 + r$* ) (1 + r$ ) F
(1 + r£ )
r£* = (1 + r$* ) − 1
(1 + r$ )
r£* ≈ r£ + ( r$* − r$ )
r£* = Foreign cost of capital r$* = Domestic cost of capital

r£ = Foreign risk-free interest rate r$ = Domestic risk-free interest rate

F-135-19: Why Are the Parts Worth More than The Sum? “Chop Shop”, a Corporate Valuation Model
F-136-19: Corporate Value Creation, Governance and Privatization
None
F-157-23: Market Consistent Embedded Value Basis for Conclusions

Textbook Reading: International Financial Statement Analysis Ch. 6
Calculation of Activity Ratios

Activity Ratio Numerator Denominator
Inventory Turnover Cost of sales or cost of goods sold Average inventory
Days of Inventory on Hand (DOH) Number of days in period Inventory turnover
Receivables Turnover Revenue Average receivables
Days of Sales Outstanding (DSO) Number of days in period Receivables turnover
Payables Turnover Purchases Average trade payables
Number of Days of Payables Number of days in period Payables turnover
Working Capital Turnover Revenue Average working capital
Fixed Asset Turnover Revenue Average net fixed assets
Total Asset Turnover Revenue Average total assets
Calculation of Liquidity Ratios

Liquidity Ratio Numerator Denominator
Current Ratio Current assets Current liabilities
Quick Ratio Cash + Short-term marketable investments + Receivables Current liabilities
Cash Ratio Cash + Short-term marketable investments Current liabilities
Defensive Interval Ratio Cash + Short-term marketable investments + Receivables Daily cash expenditures
Calculation of Solvency Ratios

1. Debt ratios  focus on the balance sheet and measure the amount of debt capital relative to equity capital
2. Coverage ratios  focus on the income statement and measure the ability of a company to cover its debt payments
Debt Ratio Numerator Denominator

Debt-to-Asset Ratio
Total debt* Total assets
(Total Debt Ratio)
Debt-to-Capital Ratio Total debt* Total debt + Total shareholders’ equity
Debt-to-Equity Ratio Total debt* Total shareholders’ equity

Financial Leverage Ratio
Average total assets Average total equity
(Leverage Ratio)
* The definition of total debt used in these ratios varies among informed analysts and financial data vendors, with some using
the total of interest-bearing short-term and long-term debt, excluding liabilities such as accrued expenses and accounts
payable
Coverage Ratio Numerator Denominator

Interest Coverage
EBIT Interest payments
(Times Interest Earned)
Fixed Charge Coverage EBIT + Lease payments Interest payments + Lease payments

Calculation of Profitability Ratios

Profitability Ratio Numerator Denominator
Gross Profit Margin Gross profit Revenue
Operating Profit Margin Operating income Revenue

Return on Sales
Pretax Margin Pretax income (or EBT) Revenue
Net Profit Margin Net income Revenue
Operating ROA Operating income Average total assets
Return on Assets (ROA) Net income Average total assets

Return on Short- and long-term debt
Return on Total Capital EBIT
Investment and equity
Return on Equity (ROE) Net income Average total equity
Return on Common Equity Net income – preferred dividends Average common equity
Decomposing ROE
- Start with the ROE formula, which is equal to Net income / Average shareholders’ equity
- We can re-arrange to the following:
Net income Net income Average total assets
ROE = = × = ROA × Leverage
Average shareholders' equity Average total assets Average shareholders' equity
- We can further decompose ROA and express ROE as the following:
Net income Net income Revenue Average total assets

ROE = = × ×
Average shareholders' equity Revenue Average total assets Average shareholders' equity
= Net profit margin × Total asset turnover × Leverage
profitability efficiency solvency
- This decomposition illustrates that a company's ROE is a function of its net profit margin, its efficiency, and its
leverage
- To separate the effects of taxes and interest, we can further decompose the net profit margin and write:
Net income Net income EBT EBIT Revenue Average total assets
ROE = = × × × ×
Average shareholders' equity EBT EBIT Revenue Average total assets Average shareholders' equity
= Tax burden × Interest burden × EBIT margin × Total asset turnover × Leverage
effect of taxes effect of interest effect of efficiency solvency

operating
margin
Calculation of Valuation Ratios

Valuation Ratio Numerator Denominator
Price-to-Earnings Ratio
Price per share Earnings per share
(P/E)
Price-to-Cash Flow Ratio

Price per share Cash flow per share
(P/CF)
Price-to-Sale Ratio
Price per share Sales per share
(P/S)
Price-to-Book Value Ratio

Price per share Book value per share
(P/BV)

Per-Share Quantities Numerator Denominator

Weighted average number of ordinary shares
Basic EPS Net income – Preferred dividends
outstanding
Adjusted income available for ordinary shares, Weighted average number of ordinary and
Diluted EPS
reflecting conversion of dilutive securities potential ordinary shares outstanding
Weighted average number of shares

Cash Flow per Share Cash flow from operations
outstanding
Weighted average number of shares

EBITDA per Share EBITDA
outstanding
Weighted average number of ordinary shares

Dividends per Share Common dividends declared
outstanding
Dividend-Related Numerator Denominator

Quantities
Dividend Payout Ratio Common share dividends Net income attributable to common shares
Net income attributable to common shares –
Retention Rate Net income attributable to common shares
Common share dividends
Sustainable Growth Rate Retention rate x ROE
Definitions of Some Common Industry- and Task-Specific Ratios

Business Risk Numerator Denominator
Coefficient of Variation of
Standard deviation of operating income Average operating income
Operating Income
Standard deviation of net income Average net income
Net Income
Standard deviation of revenue Average revenue
Revenues
Financial Sector Ratios Numerator Denominator

Various measures (e.g. risk-weighted assets,
Capital Adequacy (banks) Various components of capital market risk exposure, or level of operational
risk assumed)
Monetary Reserve
Requirement Reserves held at central bank Specified deposit liabilities
(Cash Reserve Ratio)
Liquid Asset Requirement Approved “readily marketable” securities Specified deposit liabilities
Net Interest Margin Net interest income Total interest-earning assets
Retail Ratios Numerator Denominator

Average revenue growth year over year for
Same Store Sales N/A
stores open in both periods
Sales per Square Meter Revenue Total retail space in square meters
Service Companies Numerator Denominator

Revenue per Employee Revenue Total number of employees
Net Income per Employee Net income Total number of employees

Hotel Ratio Numerator Denominator

Average Daily Rate Room revenue Number of rooms sold
Occupancy Rate Number of rooms sold Number of rooms available
Calculation of Credit Ratios

Credit Ratio Numerator Denominator
Gross interest (prior to deductions for
EBIT Interest Coverage EBIT
capitalized interest or interest income)
EBITDA Interest Gross interest (prior to deductions for

EBITDA
Coverage capitalized interest or interest income)
Funds from Operations FFO + Interest paid – Operating lease Gross interest (prior to deductions for
(FFO) Interest Coverage adjustments capitalized interest or interest income)
Average capital
Return on Capital EBIT where capital = equity + non-current deferred
taxes + debt
FFO to Debt FFO Total debt
Free Operating Cash Flow

CFO (adjusted) – Capital expenditures Total debt
to Debt
Discretionary Cash Flow

CFO – Capital expenditures – Dividends paid Total debt
to Debt
Net Cash Flow to Capital
FFO – Dividends Capital Expenditures
Expenditures
Debt to EBITDA Total debt EBITDA
Total Debt to Total Debt

Total debt Total debt + Equity
Plus Equity
Definitions of Segment Ratios

Segment Ratio Numerator Denominator Definition
o Measures the operating profitability
Segment Margin Segment profit (loss) Segment revenue
of the segment relative to revenues
o Measures the operating profitability
Segment Turnover Segment revenue Segment assets
relative to assets
o Measures the overall efficiency of
Segment ROA Segment profit (loss) Segment assets
the segment
o Examines the level of liabilities
Segment Debt Ratio Segment liabilities Segment assets
(solvency) of the segment

Example 1
- The following information pertains to a fictitious company, Reston Partners:
Income Statement (Under Accounting Standard)

Reston Partners Consolidated Income Statement
Period Ending 31 March (£ Millions) Year 3 Year 2 Year 1
Revenue 40,000 30,000 25,000
Other net gains 2,000 0 0
Changes in inventories of finished goods and work in progress 400 180 200
Raw materials and consumables used -5,700 -4,000 -8,000
Depreciation expense -2,000 -2,000 -2,000
Other expenses -6,000 -5,900 -4,500
Interest expense -2,000 -3,000 -6,000
Profit before tax 26,700 15,280 4,700
- The principles used to calculate accounting profit (profit before tax) may differ from the principles applied for
tax purposes (the calculation of taxable income)
- For illustrative purposes, however, assume that all income and expenses on the income statement are treated
identically for tax and accounting purposes except depreciation
Depreciation Expenses Under the Accounting and Tax Standards

- The equipment was originally purchased for £20,000
- In accordance with accounting standards, over the next 10 years the company will recognize annual
depreciation of £2,000 (£20,000 ÷ 10) as an expense on its income statement and for the determination of
accounting profit
- For tax purposes, however, the company will recognize £2,857 (£20,000 ÷ 7) in depreciation each year
- Each fiscal year the depreciation expense related to the use of the equipment will, therefore, differ for tax and
accounting purposes (tax base vs. carrying amount), resulting in a difference between accounting profit and
taxable income
Income Statement (Under Tax Standard)

Taxable Income (£ Millions) Year 3 Year 2 Year 1
Revenue 40,000 30,000 25,000
Raw materials and consumables used -5,700 -4,000 -8,000
Depreciation expense -2,857 -2,857 -2,857
Other expenses -6,000 -5,900 -4,500
Taxable income 25,843 14,423 3,843

Calculate the Carrying Amount and Tax Base

- The carrying amount and tax base for the equipment is as follows:
(£ Millions) Year 3 Year 2 Year 1

Equipment value (at the Beginning of the Year) 16,000 18,000 20,000
Depreciation expense (for accounting purposes) 2,000 2,000 2,000
Equipment value (at the End of the Year) 14,000 16,000 18,000

Equipment value (at the Beginning of the Year) 14,286 17,143 20,000
Depreciation expense (for tax purposes) 2,857 2,857 2,857
Equipment value (at the End of the Year) 11,429 14,286 17,143

Equipment value for accounting purposes (carrying amount)
14,000 16,000 18,000
(depreciation of £2,000/year)
Equipment value for tax purposes (tax base)
11,429 14,286 17,143
Difference (Temporary Difference) 2,571 1,714 857
- At each balance sheet date, the tax base and carrying amount of all assets and liabilities must be determined
Calculate Income Tax Payable

- The income tax payable by Reston Partners will be based on the taxable income of each fiscal year
- If a tax rate of 30 percent is assumed, then the income taxes payable for Year 1, Year 2, and Year 3 are
£1,153 (30% × 3,843), £4,327 (30% × 14,423), and £7,753 (30% × 25,843)

Taxable income 25,843 14,423 3,843
Tax rate 30% 30% 30%
Income tax payable 7,753 4,327 1,153
Calculate the Deferred Tax Liability

- If the tax obligation is calculated based on accounting profits, it will differ because of the differences between
the tax base and the carrying amount of equipment
- In each fiscal year, the carrying amount of the equipment exceeds its tax base
- For tax purposes, therefore, the asset tax base is less than its carrying value under financial accounting
principles
- The difference results in a deferred tax liability

14,000 16,000 18,000
11,429 14,286 17,143
Tax rate 30% 30% 30%
Deferred Tax Liability 771 514 257
- The comparison of the tax base and carrying amount of equipment shows what the deferred tax liability should
be on a particular balance sheet date

Calculate Income Tax Expense (for Accounting Purpose)

- In each fiscal year, only the change in the deferred tax liability should be included in the calculation of the
income tax expense reported on the income statement prepared for accounting purposes
- On the income statement, the company's income tax expense will be the sum of the deferred tax liability and
income tax payable

Income tax payable (based on tax accounting) 7,753 4,327 1,153
Change in Deferred tax liability 257 257 257
Income tax (based on financial accounting) 8,010 4,584 1,410
(Difference between tax base and carrying amount)
Year 1: £(18,000 − 17,143) × 30% = 257
Year 2: £(16,000 − 14,286) × 30% − 257 = 257
Year 3: £(14,000 − 11,429) × 30% − 514 = 257
- Because the different treatment of depreciation is a temporary difference, the income tax on the income
statement is 30 percent of the accounting profit, although only a part is income tax payable and the rest is a
deferred tax liability
Consolidated Income Statement (Put All the Numbers Together)

- The consolidated income statement of Reston Partners including income tax is presented as follows:

Period Ending 31 March (£ Millions) Year 3 Year 2 Year 1
Revenue 40,000 30,000 25,000
Raw materials and consumables used -5,700 -4,000 -8,000 Accounting
Depreciation expense -2,000 -2,000 -2,000 Numbers
Other expenses -6,000 -5,900 -4,500
Profit before tax 26,700 15,280 4,700
DTL impacts
Income tax -8,010 -4,584 -1,410 here
Profit after tax 18,690 10,696 3,290
- Any amount paid to the tax authorities will reduce the liability for income tax payable and be reflected on the
statement of cash flows of the company

Changes in Income Tax Rates

- When income tax rates change, the deferred tax assets and liabilities are adjusted to the new tax rate
- If income tax rates increase, deferred taxes (that is, the deferred tax assets and liabilities) will also increase
- If income tax rates decrease, deferred taxes will decrease
- A decrease in tax rates decreases deferred tax liabilities, which reduces future tax payments to the taxing
authorities
- A decrease in tax rates will also decrease deferred tax assets, which reduces their value toward the offset of
future tax payments to the taxing authorities
Example 1
- To illustrate the effect of a change in tax rate, consider Example 1 again
- The carrying amount and tax base for the equipment is:

14,000 16,000 18,000
11,429 14,286 17,143
Tax rate 30% 30% 30%
- At a 30 percent income tax rate, the deferred tax liability was then determined
Change in Income Tax Rate

- For this illustration, assume that the taxing authority has changed the income tax rate to 25 percent for Year 3
- Although the difference between the carrying amount and the tax base of the depreciable asset are the same,
the deferred tax liability for Year 3 will be £643 (instead of £771 or a reduction of £128 in the liability)
Year 3: £(14,000 − 11,429) × 25% = £643

14,000 16,000 18,000
11,429 14,286 17,143
Tax rate 25% 30% 30%
The Reduction in the Deferred Tax Liability = 771 – 643 = 128
- Reston Partners' provision for income tax expense is also affected by the change in tax rates
- Taxable income for Year 3 will now be taxed at a rate of 25 percent
The benefit of Year 3 accelerated depreciation tax shield = (£2857 – 2000) × 25%
= £214 instead of the previous £257 (a reduction of £43)
- In addition, the reduction in the beginning carrying value of the deferred tax liability for Year 3 (the year of
change) further reduces the income tax expense for Year 3
- The reduction in income tax expense attributable to the change in tax rate is £85
Year 3: (30% − 25%) × £1,714 = £85
- These two components together account for the reduction in the deferred tax liability = £43 + £85 = £128

None
Rules for the Translation of a Foreign Subsidiary's Foreign Currency Financial Statements into the Parent's
Presentation Currency under IFRS and US GAAP
Foreign Subsidiary’s Functional Currency
Foreign Currency Parent’s Presentation Currency
Translation Method Current Rate Method Temporal Method
Assets
Monetary (e.g. cash and receivables) Current rate Current rate
Non-monetary (measured at current value) Current rate Current rate
Non-monetary (measured at historical rate) Current rate Historical rates
Liabilities
Monetary (e.g. accounts payable) Current rate Current rate
Non-monetary (measured at current value) Current rate Current rate
Non-monetary (not measured at current value) Current rate Historical rates
Equity
Other than retained earnings Historical rate Historical rates
(Beg. Balance + translated net income – dividends ) translated at
Retained earnings
historical rate
Revenues Average rate Average rate
Expenses
Most expenses Average rate Average rate
Expenses related to assets translated at historical
exchange rate (e.g. cost of goods sold, Average rate Historical rates
depreciation, and amortization)
Treatment of the translation adjustment in the Accumulated as a separate Included as gain or loss in net
parent's consolidated financial statements component of equity income

Note: There are a lot of calculation examples in the rest of the chapters in the ADMC textbook. We put the whole
calculations in this file so that you won’t miss them.
Textbook Reading: Accounting for Decision Making and Control Ch. 5
Return on Investment by DuPont
Earnings Sales Earnings

ROI = = ×
Total Investment Total Investment Sales
Sales Return
turnover on Sales
- ROI is the product of sales turnover and return on sales
- Given these data, managers could determine the causes of a product’s change in ROI
- Du Pont managers used these data to evaluate new capital appropriations by establishing the policy that there
be no expenditures for additions to the earnings equipment if the same amount of money could be applied to
some better purpose in another branch of the company’s business
Economic Value Added (EVA)

- A lot of companies now use EVA as a measure of performance
EVA = Adjusted accounting earnings – WACC x Total capital
- Other EVA-like terms have been created such as economic profit, shareholder value added, total business
return, and cash-flow return on investment
- And like EVA, these other metrics are variants of residual income
- The EVA formula is basically the same as residual income but differ in 2 ways:
1. Different accounting procedures are often used to calculate “adjusted accounting earnings” than are used
in reporting to shareholders (i.e. entire amount to be deducted from earnings or amortized over time)
2. Many companies implementing EVA not only adopt EVA as their performance measure but also link
compensation to performance measured by EVA

International Taxation
- When products are transferred overseas, the firm’s corporate tax liability in both the exporting and importing
country is affected if the firm files tax returns in both jurisdictions
- If the two tax jurisdictions tax income at different rates, then the firm will set the transfer price to shift as much
of the profit into the lower-rate jurisdiction as possible, subject to the taxing authorities’ guidelines
Example: Effect of Transfer Pricing on Combined Tax Liability

- Suppose Bausch & Lomb manufactures a box of contact lenses in the Netherlands and ships the lenses to an
Australian subsidiary that sells them for 85 Australian dollars
- The variable out-of-pocket cost of manufacturing the contact lenses is 50 euros
- The exchange rate is 0.70 Australian dollars to 1 euro
- Suppose the Dutch corporate tax rate is 30% and the Australian corporate tax rate is 40%
- Suppose Australian and Dutch tax treaties allow Bausch & Lomb to set a transfer price at anywhere between
80 and 110 euros
Transfer Price at 80 Euros Transfer Price at 110 Euros

Taxes Paid in the Netherlands
Revenue 80 110
Variable Cost -50 -50
Taxable income 30 60
Dutch taxes (30%) 30 x 30% = 9 60 x 30% = 18
Taxes Paid in the Australia

Revenue 85 85
Transfer price converted to
-80 x 0.7 = -56 -110 x 0.7 = -77
Australian dollars (0.7 A$/Euro)
Taxable income 29 8
Australian taxes (40%) 29 x 40% = 11.6 8 x 40% = 3.2
Australian taxes converted to
11.6 / 0.7 = 16.57 3.2 / 0.7 = 4.57
euros
Sum of Dutch and Australian

9 + 16.57 = 25.57 18 + 4.57 = 22.57
taxes
- By choosing the highest allowed transfer price, Bausch & Lomb can recognize more profits in the country with
the lowest corporate income tax rate

Example of How Profits are Reduced When Transfer Price is not Set at Opportunity Cost
- There are 2 profit centers: the Seller and Buyer divisions
- Both divisions are profit centers and maximize their division’s profits
- The cost structure of the 2 divisions are as follows:
Seller Buyer
Fixed costs $150 / day $100 (1st 100 units per day)
Variable costs $0.10 / unit $0.20 / unit (over 100 units)
- The Buyer Division faces a downward-sloping demand curve for its final product, which includes the
intermediate product with the following price-quantity relationship
Quantity Sold Price / Car Total Revenue

100 $2.00 $200
200 1.80 360
300 1.50 450
400 1.30 520
500 1.20 600
600 1.04 624
- Suppose the transfer price is set at $0.95 per unit (variable cost of $0.10 + fixed cost of $0.75 + $0.10 profit)
and 200 motors are transferred  seller’s profit would be 200 x $0.10 = $20
Output Revenue Cost Profit

100 $95 $160 -$65
200 190 = $0.95 x 200 170 = ($0.1 + $0.75) x 200 20 = $0.1 x 200
300 285 180 105
400 380 190 190
500 475 200 275
600 570 210 360
- Buyer’s profit would be maximized at 200 units:

Total Cost
Buyer’s Own Cost Cost from Seller Total
Output (Buyer’s Own Profit
($100 + 0.20/unit over 100) ($0.95/unit) Revenue
Cost + Transfer)
100 $100 $95 $195 $200 $5
200 120 190 310 360 50
300 140 285 425 450 25
400 160 380 540 520 -20
500 180 475 655 600 -55
600 200 570 770 624 -146

- Both divisions seem to be operating well, and both are making a profit, but the company is not maximizing
profits
Output Revenue Cost Profit

100 $95 $160 -$65
200 190 170 20
300 285 180 105
400 380 190 190
500 475 200 275
600 570 210 360
- Here is the firm profits for each output:
Output Seller Costs Buyer Costs Total Cost Total Revenue Profit
100 $160 $100 $260 $200 -$60
200 170 120 290 360 70
300 180 140 320 450 130
400 190 160 350 520 170
500 200 180 380 600 220
600 210 200 410 624 214
- Company profits are maximized at 500 motors

- In this example, the correct transfer price is at variable cost ($0.10)
- Transferring at $0.10/motors maximizes company profits
- Charging more than variable cost causes the Buyer to purchase too few motors
- But the Seller shows a loss (its fixed costs, if the transfer price is set at variable cost)

#1: External Reporting / Taxes

- External financial reports and tax accounting rules require that inventory be stated at cost, including indirect
manufacturing costs
- To avoid the extra bookkeeping costs of a second set of accounts that exclude the allocated costs, firms use
the same accounts internally as externally
- However, additional bookkeeping costs would likely be small and offset by the costs of dysfunctional decisions
from using the external system for internal operating decisions
- Thus, external reporting requirements are not likely to explain the widespread use of cost allocations for
internal reporting, such as divisional performance evaluation
Example
- Network Systems (NS) offers telecommunications design and consulting services to organizations
- The firm offers two types of contracts to its clients:
Type Description
o Total cost includes both direct costs and indirect overheads
1. Cost-plus 25% contract
o NS completes 10 cost-plus contracts at a total direct cost of $450,000
o NS completes 15 fixed-fee contracts
o Revenues collected from the fixed-fee contracts totaled $2,400,000
2. Fixed-fee contract
o The total direct cost of the fixed-fee contracts amounted to 75% of the collected
revenues, or 75% x $2,400,000 = $1,800,000
Q1: Allocate the indirect overhead of $350,000 to the fixed-fee and cost-plus 25% contracts using direct
cost as the overhead allocation base
A1:
Fixed Fee Cost-Plus Total
Direct cost $1,800,000 $450,000 $2,250,000
% of direct cost 80% 20% 100%
Allocated overhead based on 80% x $350,000 20% x $350,000
$350,000
direct cost = $280,000 = $70,000
Q2: Allocate the indirect overhead of $350,000 to the fixed-fee and cost-plus 25% contracts using number
of contracts as the overhead allocation base
A2:
Fixed Fee Cost-Plus Total
Number of contracts 15 10 25
% of contracts 60% 40% 100%
Allocated overhead based on 60% x $350,000 40% x $350,000
$350,000
number of contracts = $210,000 = $140,000
Q3: Should NS allocate overhead using direct cost or number of contracts? Explain why
A3: Assuming that
(1) the only use of overhead allocations is the computation of total cost for pricing cost-plus contracts and
(2) the total number of cost-plus contracts is insensitive to the final price
NS should allocate overhead using number of contracts. Using number of contracts leads to
$70,000 (= $140,000 - $70,000) more indirect costs allocated to the cost-plus contracts and hence to
$87,500 (= 1.25 X $70,000) of additional revenues on these contracts

Cost Allocations Are a Tax System

- Cost allocations act as an internal tax system
- Like a tax system, they change behavior
Example
- Table below summarizes the various combinations of salespeople required to sell $10 million of computers per
month
- Salespeople cost $4,000 per month and a banner ad costs $2,000 per ad for one hour
- To select the combination of salespeople and advertising, the branch manager will choose the one that
minimizes total costs, which is:
40 x $4,000 + 158.11 x $2,000 = 476,220
Total Cost
Number of Salespeople Number of Banner Ads
(Before Allocations)
30 182.57 $485,140
31 179.61 483,220
32 176.78 481,560
33 174.08 480,160
34 171.50 479,000
35 169.03 478,060
36 166.67 477,340
37 164.40 476,800
38 162.22 476,440
39 160.13 472,260
40 158.11 476,220
41 156.17 476,340
42 154.30 476,600
- Suppose corporate expense of $1,000 is allocated based on the number of salespeople  the lowest cost
combination now consists of 34 salespeople and 171.5 ads
34 x $4,000 + 171.5 x $2,000 + 34 x $1,000 = 476,220
Total Cost Total Cost

Number of Salespeople Number of Banner Ads
(Before Allocations) (After Allocations)
30 182.57 $485,140 $515,140
31 179.61 483,220 514,220
32 176.78 481,560 513,560
33 174.08 480,160 513,160
34 171.50 479,000 513,000
35 169.03 478,060 513,060
36 166.67 477,340 513,340
37 164.40 476,800 513,800
38 162.22 476,440 514,440
39 160.13 472,260 515,260
40 158.11 476,220 516,220
41 156.17 476,340 517,340
42 154.30 476,600 518,600
- The overhead rate, $1,000, is a tax on salespeople (labor)

- Like all taxes on consumption items, the tax discourages use of the item levied with the tax
- Overhead rates and cost allocations are de facto tax systems in firms
- The tax also “distorts” the price of the factor input. Instead of viewing the price of labor as $4,000 per month,
the branch manager sees the price for salespeople as $5,000 ($4,000 + $1,000) per month
- If the opportunity cost of salespeople is $4,000, but the branch manager is charged $5,000 (including the
$1,000 of overhead), the manager will employ too few salespeople

Total Cost of Human Resource Department
When the firm is small, it is

spending TC0 on the HR function.
This spending remains constant
until the number of salespeople
reaches A. Then a larger HR
department is required and
spending is increased. The HR
department is expanded at A
because as salespeople are hired
between 0 and A, the service
provided to each employee is
degraded. More employees are
sharing a fixed amount of service,
and the response time by the
human resource department to
service a request grows longer.
The firm acquires additional HR
department capacity when the
cost of the degraded service
exceeds the cost of the additional
capacity
Credit: Accounting for Decision Making and Control p. 291
- Cost allocation can be used to approximate these hard-to-observe externalities

- The human resource (HR) department of a firm maintains the records and answers employee questions
regarding retirement and medical benefits
- The HR department is represented by the step function in figure above
- Total HR department costs behave as a step function that depends on the number of salespeople, S, employed
in the sales division
- The scale (i.e., capacity) of the human resource department is added in large fixed increments rather than
continuously in small amounts
- The difference between the cost of the HR department (smooth curve) and the cost reported by the accounting
system (step function) is the opportunity cost of the degraded service
- This service degradation in the HR department is an externality created by hiring an additional employee
- The shape of the total cost varies across departments
- Focusing only on the accounting costs (step function) would lead to the conclusion that the opportunity cost in
the HR department of an additional salesperson was zero, unless the salesperson just happened to be at a
step
- But the opportunity cost in the HR department of an additional salesperson is the slope of the smooth curve
- The slope of the smooth curve represents the incremental delay cost in the HR department imposed on all the
other internal users of the HR department by adding one more salesperson

Case 1 At point c, or whenever R < MC, the cost

allocation rate, which is the average cost,
understates the marginal cost of the externality
 using a cost allocation to tax the externality
is better than no allocation
The slope of this

line is the average
cost of the HR
department when
there are C
salespeople
TCc
- At point c, the overhead rate, Rc, is equal to Rc = < MCc
C
where MC = marginal cost in the HR department and is the slope of the smooth curve
Case 2
At point b, the cost allocation rate and the

marginal cost are equal. It is highly unlikely
The slope of that the firm will be operating at this point. But
this line is the if it is, cost allocations perfectly mimic the
average cost of correct opportunity cost
the HR
department
when there are
B salespeople.
The slope also
happens to be
the marginal
cost of adding
one more
employee
TCB
- At point b, the overhead rate, Rb, is equal to Rb = = MCb
B

Case 3
At point a, or whenever R > MC, the cost

allocation rate, which is the average cost,
overstates the marginal cost of the externality
 taxing the branch manager might cause too
large a reduction in salespeople
The slope of
this line is the
average cost of
the HR
department
when there are
A salespeople
TC A
- At point a, the overhead rate, Ra, is equal to Ra = > MCa
A
NOTE: The analysis above demonstrates that situations do exist where allocating overhead is better than not
allocating. Whenever average cost is less than marginal cost, the costs allocated are less than the
marginal cost incurred by the firm. Although the firm is not allocating enough cost, it is probably better to
impose some tax than no tax on the managers who cause HR department costs to rise. Unfortunately, a
simple rule such as “always allocate” or “never allocate” does not exist

Flexible Budgets to Estimate Overhead
Steps in Budgeting Process

1. Estimate budgeted annual overhead
Budgeted annual overhead = Fixed overhead + Variable overhead
2. Calculate the budgeted annual overhead rate

Budgeted annual overhead rate = Budgeted annual overhead / usage rate
Example
- The Rosen Company has two manufacturing departments, production and assembly
- Each department has separate overhead rates
- Rosen made the following estimates for its production and assembly departments for the current calendar
year:
Production Assembly
Factory overhead $300,000 $100,000
Direct labor cost $1,000,000 $210,000
Machine hours 1,500 6,250
Direct labor hours 50,000 10,000
Q1: Calculate the overhead rate for each department
A1: Overhead rate for Production Department = Factory overhead / machine hours
= $300,000 / 1,500 = $200 per machine hour
Overhead rate for Assembly Department = Factory overhead / direct labor hours
= $100,000 / 10,000 = $10 per direct labor hour
Q2: Given the following information for job #77, calculate its overhead costs
Production Assembly
Direct materials used $3,000 $2,000
Direct labor cost $11,000 $15,500
Machine hours 100 250
Direct labor hours 500 750
A2: Overhead cost for Production Department = $200 x 100 machine hours = $20,000
Overhead cost for Assembly Department = $10 x 750 direct labor hours = $7,500
Total overhead cost = $27,500
Q3: Given the following actual operating results for the current year, calculate the over/underapplied
overhead for each department
Production Assembly
Factory overhead $325,000 $65,000
Direct labor cost $900,000 $230,000
Machine hours 1,550 6,250
Direct labor hours 47,000 10,500
A3: Over/underapplied overhead for Production Department = Actual overhead – Overhead applied
= $325,000 – 1,550 x $200 / machine hour
= $15,000 underapplied
Over/underapplied overhead for Assembly Department = Actual overhead – Overhead applied
= $65,000 – 10,550 x $10 / direct labor hour
= $40,000 overapplied

Expected vs. Normal Volume
2 Ways to Determine Budgeted Volume

1. Expected volume (volume expected for the coming year)
2. Normal volume (long-run average volume, or average volume over both upturns and downturns in the
economy)
Example 1
- Fast Change offers automobile oil changes at $30 each
- The variable cost ($20) of providing an oil change includes both direct labor and supplies (oil and oil filter)
- There is also a fixed cost of $4,000 per month
- Summary of operations from last month:
Price per oil change $30
Variable cost per service $20
Number of oil changes 500
Revenue $15,000
Variable cost (10,000)
Fixed cost (4,000)
Net income $1,000
Total cost $14,000
Number of oil changes ÷ 500
Cost per oil change $28
- This month, the price of an oil change ($30) remains constant, as does the variable cost and fixed cost
- However, the number of oil changes falls from 500 to 350, and the summary of operations for current month
would look like this:
Price per oil change $30
Variable cost per service $20
Number of oil changes 350
Revenue $10,500
Variable cost (7,000)
Fixed cost (4,000)
Net income $500
Total cost $11,000
Number of oil changes ÷ 350
Cost per oil change $31.43
- Notice that the net income dropped by $500 and the cost per oil change has risen
- A manager’s natural tendency when confronted by a cost increase is to raise prices
- But in Fast Change’s case, average costs rose because volumes fell
- The out-of-pocket costs (the variable cost) of the service did not change
- Since the cost of doing one more oil change is still $20, the opportunity cost of an oil service has not changed
and therefore, the price of an oil change should not be raised
- In fact, the price probably should be lowered because the demand for oil changes has dropped

Example
- Pacemakers Inc. manufactures and distributes pacemakers that are implanted into patients to regulate their
heart rate
- The projected overhead rate is based on a flexible budget
- Overhead is applied to pacemakers based on direct labor hours
- The following information is given:
2016 2017 2018
Fixed overhead $2,200 $2,300 $2,500
Variable overhead per DLH $1.10 $1.15 $1.20
Projected annual volume (DLH) 800 1,200 1,000
- Management forecasts that the plant’s average, long-run volume over the next 3 years will be 1 million direct
labor hours per year
Q1: Calculate the projected overhead rates for 2016 to 2018 using expected and normal volume
A1:
2016 2017 2018
Fixed overhead $2,200 $2,300 $2,500
Variable overhead per DLH $1.10 $1.15 $1.20
Projected annual volume (DLH) 800 1,200 1,000
Normal annual volume (DLH) 1,000 1,000 1,000
Flexible overhead budget:
$2,200 + 800 x $2,300 + 1,200 x $2,500 + 1,000 x
Based on expected volume
$1.10 = $3,080 $1.15 = $3,680 $1.20 = $3,700
$2,200 + 1,000 x $2,300 + 1,000 x $2,500 + 1,000 x
Based on normal volume
$1.10 = $3,300 $1.15 = $3,450 $1.20 = $3,700
Projected overhead rate / DLH:
$3,080 ÷ 800 $3,680 ÷ 1,200 $3,700 ÷ 1,000
Based on expected volume
= $3.85 = $3.07 = $3.70
$3,300 ÷ 1,000 $3,450 ÷ 1,000 $3,700 ÷ 1,000
Based on normal volume
= $3.30 = $3.45 = $3.70
Q2: Even though actual overheads for 2016 to 2018 are not known yet, using your estimated overhead rate based
on expected volume from Q1, forecast Pacemakers’ over/underabsorbed overhead for 2016 to 2018
A2:
2016 2017 2018
Projected overhead incurred $3,080 $3,680 $3,700
Projected overhead absorbed $3.85 x 800 $3.07 x 1,200 $3.70 x 1,000
based on expected volume = $3,080 = $3,680 = $3,700
Over/underabsorbed Overhead $0 $0 $0
Q3: Even though actual overheads for 2016 to 2018 are not known yet, using your estimated overhead rate based
on normal volume from Q1, forecast Pacemakers’ over/underabsorbed overhead for 2016 to 2018
A3:
2016 2017 2018
Projected overhead incurred $3,080 $3,680 $3,700
Projected overhead absorbed $3.30 x 800 $3.45 x 1,200 $3.70 x 1,000
based on normal volume = $2,640 = $4,140 = $3,700
Over/underabsorbed Overhead $440 ($460) $0

Example #1: Simple Example

- Cajun Peanut Butter Inc. uses process costing to compute product costs for inventory and cost of goods sold
- This firm has discovered and patented a peanut butter machine that makes Cajun-flavored peanut butter
through a continuous flow process whereby peanuts are dumped into the machine at the beginning of the
process and Cajun flavoring is added at the very end
- Conversion costs are incurred continuously and evenly throughout the conversion process
- The following relevant information for March is given below:
Dollar Quantity
Peanuts purchased and entered in process $32,000 20,000 lbs
Ending inventory in process (30% complete) Not available 1,200 lbs
Cajun spices $4,000
All other factory costs (conversion costs) $15,000
 The mechanics of process costing can be decomposed into 4 steps:
Step 1
- Step 1 summarizes the physical flow of the units and calculates the equivalent units of work in the
physical flows
- The summary of the physical flow is based on the accounting identity:
Beginning inventory + Unit started = Units transferred out + Ending inventory

0 + 20,000 = 18,800 + 1,200
- Since the ending inventory is 1,200 pounds and 20,000 pounds were started, 18,800 pounds must have been
finished and transferred
- These equations hold under the assumption of no spoilage
Units Conversion Peanuts Spices Total
Step 1
Physical flow:
Units started 20,000
Units to account for 20,000
Ending work in process (30%) 1,200 360 1,200 0
Transferred out 18,800 18,800 18,800 18,800
Units accounted for 20,000
- Costs and the amount of work done are accumulated for each of the two batches: (1) ending work-in-process
(WIP) inventory and (2) transferred out in March
- Consider the batch of ending work-in-process inventory
- In step 1 there are 1,200 pounds of ending WIP inventory, which are 30 percent complete with respect to
conversion costs
- This inventory was started in March. Conversion costs were incurred to produce this level of completion,
requiring 360 equivalent units of work (1,200 lbs @ 30 percent)
- All the peanuts are added at the beginning, so there are 1,200 equivalent units of peanuts in the ending WIP
inventory
- On the other hand, since all the Cajun spices are added at the end of the process, the ending work-in-process
inventory contains no equivalent units of spices
- All the units transferred out (18,800) are complete with respect to conversion, peanuts, and spices, so there
are 18,800 equivalent units of these items

Step 2
- Step 2 computes the cost per equivalent unit for the conversion costs, peanuts, and spices
- Total equivalent units are the sum of the equivalent units in the ending WIP inventory and units transferred out
in
Step 2
Equivalent units 19,160 20,000 18,800
Costs per unit:
Total costs $15,000 $32,000 $4,000
Cost per equivalent unit $0.7829 $1.600 $0.2128 $2.5957
- The three cost categories (conversion, peanuts, and Cajun spices) have different equivalent units
- For conversion costs, 19,160 equivalent units were produced
- For peanuts, 20,000 equivalent units were produced
- For Cajun spices, 18,800 equivalent units were produced
- The cost per equivalent unit is an average cost calculated as the ratio of the total costs incurred in the cost
category and the number of equivalent units of work performed in that category
- Costs per equivalent unit for conversion, peanuts, and spices are $0.7829, $1.6000, and $0.2128, respectively
- The total cost of a complete pound of peanut butter is the sum of the conversion, peanuts, and spice costs
($2.5957)
Step 3
- Step 3 lists all the costs to be assigned to either the ending WIP inventory or the units transferred out,
totaling $51,000
Step 3
Total costs to account for:
Conversion costs $15,000
Peanuts purchased 32,000
Cajun spices 4,000
Total costs $51,000
Step 4
- Step 4 uses the costs per equivalent unit to value work in process and units transferred out
Step 4
$0.7829 x 360 $1.60 x 1,200 $0.2128 x 0
Ending work in process $2,202
= $282 = $1,920 =0
18,000 x $2.5957
Transferred out
= $48,798
Total costs $51,000
- Costs are assigned to the ending WIP inventory by taking the equivalent units in ending WIP inventory for each
cost category and multiplying by the cost per equivalent unit in the same cost category
- These are then summed across categories to get the cost of the ending WIP inventory
- For example, the ending WIP inventory of $2,202 is composed of $282 of conversion costs (360 equivalent
units times $0.7829 per equivalent unit) and $1,920 of peanuts (1,200 equivalent units times $1.60 per
equivalent unit)
- There is no Cajun spice cost in the ending WIP inventory because these spices are only added when the
process is finished
- The cost of the units transferred out is $48,798 (18,800 x 2.5957)

Summary of Calculation
Step 1
Physical flow:
Transferred out 18,800 18,800 18,800 18,800
Step 2
Equivalent units 19,160 20,000 18,800
Costs per unit:
Total costs $15,000 $32,000 $4,000
Step 3
Conversion costs $15,000
Cajun spices 4,000
Total costs $51,000
Step 4
$0.7829 x 360 $1.60 x 1,200 $0.2128 x 0
= $282 = $1,920 =0
18,000 x $2.5957
Transferred out
= $48,798
Total costs $51,000

Example #2: FIFO Cost Flow

- This table provides the raw data, including the beginning inventory data
- All the data are the same as before, except the beginning inventory of 2,000 pounds is 40 percent complete
with respect to conversion costs and has a cost of $3,600
Dollar Quantity
Beginning inventory in process (40% complete) $3,600* 2,000 lbs
Peanuts purchased and entered in process $32,000 20,000 lbs
Ending inventory in process (30% complete) Not available 1,200 lbs
Cajun spices $4,000
All other factory costs (conversion costs) $15,000
* Composed of $600 conversion cost ($0.75 per equivalent unit x 2,000 lbs. x 40% complete) plus $3,000 peanut cost
($1.50 per equivalent unit x $2,000 x 100% complete)
Step 1
- The first change to notice is that the units transferred out are different from those in previous example
- From the earlier accounting identity,
Beginning inventory + Units started = Units transferred out + Ending inventory
2,000 lbs. + 20,000 lbs. = Units transferred out + 1,200 lbs
Units transferred out = 20,800 lbs
- Given the revised transferred out amount, the equivalent units for conversion, peanuts, and spices are
calculated

Step 1
Physical flow:
Beg. work in process (40%) 2,000
Transferred out 20,800 20,800 20,800 20,800
Step 2
- Under FIFO costing, the goal is to compute the cost per equivalent unit of only the work done in March
- The equivalent units in the beginning WIP inventory (800 equivalent units of conversion costs) are subtracted
out under step 2 to make sure the equivalent units computed are for work done in March only
- The beginning inventory contains equivalent units of work done in prior periods
- Step 2 also computes the cost per equivalent unit: $0.7367 for conversion costs, $1.60 for peanuts, and
$0.1923 for spices

Step 2
Less equivalent units in
(800) (2,000) 0
beginning WIP
Equivalent units of work done in
20,360 20,000 20,800
March
Costs per unit:
Total costs incurred in March $15,000 $32,000 $4,000

Step 3
- Total costs to account for now include the beginning WIP inventory ($3,600) plus the costs incurred in March

Step 3
Beginning work in process $3,600
Conversion costs 15,000
Cajun spices 4,000
Total costs $54,600
Step 4
- The unit costs from step 2 are used to compute the ending amount of work in process ($2,185) in step 4
- Ending WIP inventory ($2,185) is composed of the equivalent units of conversion, peanuts, and spices in the
ending WIP inventory multiplied by the respective cost per equivalent unit of conversion ($0.7367) and peanuts
($1.60). (Remember, since spices are added at the end of the process, WIP contains no spice costs)

Step 4
$0.7367 x 360 $1.60 x 1,200 $0.1923 x 0
= $265 = $1,920 =0
Transferred out:

60% x 2,000 x
Cost to complete beg. WIP 884
0.7367
385 2,000 x 0.1923
(20,800 - 2,000)
Started and Completed: x $2.5290
= $47,545
Total costs $54,600
- In step 4, the cost of units transferred to finished goods consists of the beginning WIP inventory ($3,600), the
costs to complete the beginning WIP inventory ($884 of conversion and $385 of spices), and the cost of units
started and completed in March ($47,545)

Summary of Calculation (FIFO Cost Flow)

Step 1
Physical flow:
Transferred out 20,800 20,800 20,800 20,800
Step 2
Less equivalent units in
(800) (2,000) 0
beginning WIP
20,360 20,000 20,800
March
Costs per unit:
Total costs incurred in March $15,000 $32,000 $4,000
Step 3
Cajun spices 4,000
Total costs $54,600
Step 4
$0.7367 x 360 $1.60 x 1,200 $0.1923 x 0
= $265 = $1,920 =0
Transferred out:

60% x 2,000 x
Cost to complete beg. WIP 884
0.7367
385 2,000 x 0.1923
(20,800 - 2,000)
Started and Completed: x $2.5290
= $47,545
Total costs $54,600

Example #3: Weighted Average Cost Flow

- The next example illustrates the weighted average method
- FIFO calculates an average cost per equivalent unit using only the costs incurred this period and the
- equivalent units produced this period
- The weighted average method calculates the average cost per equivalent unit using both the beginning
inventory and current production
- The weighted average cost includes not just the cost of work performed this period but also the costs incurred
in previous periods that are still in the beginning inventory
Step 1
- Total equivalent units are the sum of both the beginning WIP inventory equivalent units and the equivalent
units worked this period
- For example, equivalent units of peanuts (22,000) consist of 1,200 units in the ending inventory plus 20,800
units transferred out
- These 22,000 units include the peanuts in the beginning inventory

Step 1
Physical flow:
Transferred out 20,800 20,800 20,800 20,800
Step 2-3
- The total cost in step 3 is the sum of the costs in the beginning WIP inventory and costs incurred this period
- Thus, the cost per equivalent unit is a weighted average of the costs in the beginning WIP inventory and those
incurred this period

Step 2
21,160 22,000 20,800
March
Costs per unit:
Beginning work in process $600 $3,000
Current costs added $15,000 $32,000 $4,000
Total Cost $15,600 $35,000 $4,000
Step 3
Cajun spices 4,000
Total costs $54,600

Step 4
$0.7372 x 360 1.5909 x 1,200 $0.1923 x 0
= $265 = $1,909 =0
20,800 x $2.5204
Transferred out:
= $52,424
Total costs $54,600
Summary of Calculation (Weighted Average Cost Flow)

- The FIFO and weighted average methods give very similar numbers for the ending inventory and transferred-
out costs
- Whenever the beginning and ending inventories are a small fraction of the units started or finished, most of the
cost incurred is transferred out

Step 1
Physical flow:
Transferred out 20,800 20,800 20,800 20,800
Step 2
21,160 22,000 20,800
March
Costs per unit:
Beginning work in process $600 $3,000
Current costs added $15,000 $32,000 $4,000
Total Cost $15,600 $35,000 $4,000
Step 3
Cajun spices 4,000
Total costs $54,600
Step 4
$0.7372 x 360 1.5909 x 1,200 $0.1923 x 0
= $265 = $1,909 =0
20,800 x $2.5204
Transferred out:
= $52,424
Total costs $54,600

Example
- A photocopy store owner expects long-run average volume (normal volume) to be 175,000 copies per month
- Assume the following:
o The store is leased for $1,000 per month
o Employees are paid $2,000 per month
o A copier is leased for $500 per month + $0.005 per copy
o Paper costs are $0.005 per sheet
- The store completes a customer order for 5,000 flyers at $0.04 per page, or $200
- Assuming that taking this job did not require forgoing another job, the opportunity cost of this job was $50 (the
paper at $0.005 per page and the additional copier fee at $0.005 per page)
- But the accounting cost of this order is $150, which incorporates some allocated overhead
Overhead Costs per Month
Office rental $1,000
Labor 2,000
Copier rental 500
$3,500
Divided by normal copy volume 175,000
Overhead costs per normal cop $0.020
This is the long-run
Paper costs 0.005 average cost, meaning
at a normal volume of
Additional copier charge per page 0.005 175,000 copies per
Total cost per page $0.030 month, the store must
charge at least $0.03
Number of pages in job 5,000 per page to break even
Total job cost $150
Demand Curve under Normal Demand
Under normal demand, 175,000

copies being demanded at a price
of $0.04 per copy

Demand Curve under Low Demand
Under low demand, 100,000

copies being demanded at a price
of $0.04 per copy
Profit-maximizing point
Price = $0.04 Price = $0.034

Copies = $100,000 Copies = $135,000
Revenue $4,000 $4,590
Variable costs (1,000) (1,350)
Fixed costs (3,500) (3,500)
Loss ($500) ($260)
- Under both pricing scenarios, the store is losing money. However, the loss is smaller when the price is cut to
$0.034 per copy
- Notice that in both cases fixed costs remain constant at $3,500
- Since fixed costs do not vary (by definition) between the two pricing scenarios, fixed costs are irrelevant for the
pricing decision
- But they are relevant when it comes to the shutdown decision

Textbook Reading: Implementing ERM from Methods to Applications Ch. 9
None
Textbook Reading: Implementing ERM from Methods to Applications Ch. 16
#1: NIACC
NIACC = Net Income – Economic Capital Charge = Net Income – (Economic Capital x Ke)
where net income = what company makes minus its costs

economic capital charge = total amount of economic capital multiplied by the cost of equity (Ke)
Ke = cost of equity, which can be calculated using the CAPM
- NIACC can be thought of as a company’s economic profit, or a firm’s revenue after deducting its monetary
costs and opportunity costs
#2: SVA
- SVA is the discounted value of the NIACC
#3: RAROC
RARIC = Risk-Adjusted Return / Economic Capital
Key Relationships between Risk, EC, and Value Creation

- Value can be expressed in terms of RAROC as follows:
M / B = (RAROC – g) / (Ke – g)
where M = market value

B = book value
Ke = cost of equity capital
g = annual earnings growth rate
- The advantage of EC and RAROC models is that the analytical results are linked to earnings, capital
management, and shareholder value maximization
Ceded RAROC
- Ceded RAROC indicates the degree to which the transfer reduces risk and represents the effective cost of
risk transfer:
Ceded RAROC = ∆ Risk-Adjusted Return / ∆ Economic Capital
- If the ceded RAROC < Ke, the risk transfer creates shareholder value
- If the ceded RAROC > Ke, the risk transfer is destroying shareholder value
Textbook Reading: Implementing ERM from Methods to Applications Ch. 17-19

Textbook Reading: Managing Business Process Flows Ch. 1-2
F-155-21: Product Costing in Service Organizations
None

F-156-21: Activity-Based Costing and the Life Insurance Industry
Example
- Assume that there are 4 term life products with the same maturities
- Also assume that the designated cost drivers for promotion and policy-handling are the principal determinants
of overhead costs and that all costings are accurately recorded by the organization’s accounting system
- Direct labor cost per hour = $5
- Overhead support costs = $30,800 comprising $10,920 sales promotions and $19,880 policy handling costs
Direct Non-Labor Direct Labor Hours per Number of Sales
Policy Ref. Policies Sold
Costs Policy Promotions Made in Period
A 10 20 1 2
B 10 80 3 2
C 100 20 1 5
D 100* 80 3 5
Total 220 14
* based on the calculation in the source material, this should be 100 instead of 1,000
Product Costing Using Conventional Method

A B C D Total
10 policies sold x
Direct Labor 100 x 3 x 5 =
1 direct labor hour 10 x 3 x 5 = 150 100 x 1 x 5 = 500 2,200
($5 per hour) 1,500
x $5 per hour = 50
10 policies sold x
Other Direct
20 direct non- 10 x 80 = 800 100 x 20 = 2,000 100 x 80 = 8,000 11,000
Costs
labor costs = 200
$30,880 / 440
hours = $70
 $70 x 1 direct 70 x 3 x 10 = 70 x 1 x 100 = 70 x 3 x 100 =
Overheads $30,800
labor hour x 2,100 7,000 21,000
10 policies
sold = 700
Total $950 $3,050 $9,500 $30,500 $44,000
Policies
10 10 100 100 200
Produced
Hours Worked 10 30 100 300 440
$3,050 / 10 = $9,500 / 100 = $30,500 / 100 =
Cost per Unit $950 / 10 = $95
$305 $95 $305

Product Costing Using ABC

A B C D Total
10 policies sold x
Direct Labor 100 x 3 x 5 =
1 direct labor hour 10 x 3 x 5 = 150 100 x 1 x 5 = 500 2,200
($5 per hour) 1,500
x $5 per hour = 50
10 policies sold x
Other Direct
20 direct non- 10 x 80 = 800 100 x 20 = 2,000 100 x 80 = 8,000 11,000
Costs
labor costs = 200
$10,920 / 14 =
$780 per
Sales
promotion 780 x 2 = 1,560 780 x 5 = 3,900 780 x 5 = 3,900 10,920
Promotion
 780 x 2 =
1,560
$19,880 / 14 =
$1,420 per
Policy Handling 1,420 x 2 = 2,840 1,420 x 5 = 7,100 1,420 x 5 = 7,100 19,880
promotion
1,420 x 2 = 2,840
Total $4,650 $5,350 $13,500 $20,500 $44,000
Policies
10 10 100 100 200
Produced
$4,650 / 10 = $5,350 / 10 = $13,500 / 100 = $20,500 / 100 =
Cost per Unit
$465 $535 $135 $205
Textbook Reading: Measuring Market Risk Ch.9

None

The Time-to-First-Exceedance Test

- If the probability of an exceedance is p,
Prob( probability of observing the first exceedance by period T) = 1 − (1 − p )T
The Basic Frequency Backtest (Binomial Dist.)

n
- Probability of x tail losses = Pr( x | n, p ) =   p x (1 − p ) n − x
 x
Notation
p = 1 – confidence level (α)
n = sample size
Likelihood ratio (LR) test

- The test statistic under the prediction of correct unconditional coverage:
 x n − x  x  x 
LRuc = −2 ln[(1 − p ) n − x p x ] + 2 ln   1 −     distributed as a χ (1)
2
  n   n  
Notation
x = number of exceedances in the sample
n = number of observations
p = predicted probability of exceedances
- The test statistic under the hypothesis of independence:
(
] + 2 ln  1 − π 01 ) (1 − π ) π 11n 
n01 + n11 n00 n01 n10
LRind = −2 ln[(1 − π 2 ) n00 + n11 π 2 π 01 11
11
distributed as a χ (1)
2
 
Notation
nij = number of days that state j occurred after state i occurred the previous day
π ij = probability of state j in any given day, given that the previous day’s state was i
n01 n11 n01 + n11
π 01 = π 11 = π 2 =
n00 + n01 n10 + n11 n00 + n10 + n01 + n11
- Combined hypothesis of correct coverage and independence

LRcc = LRuc + LRind distributed as a χ 2 (2)

Textbook Reading: Fundamentals of Machine Learning for Predictive Data Analytics Ch. 2-3
None

Textbook Reading: Fundamentals of Machine Learning for Predictive Data Analytics Ch. 9
#1: Confusion Matrix-Based Performance Measures

- Basic confusion matrix-based measures:
Measure Formula
True Positive Rate (TPR) TPR = TP / (TP + FN) = 1 - FNR
True Negative Rate (TNR) TNR = TN / (TN + FP) = 1 – FPR
False Positive Rate (FPR) FPR = FP / (TN + FP) = 1 – TNR
False Negative Rate (FNR) FNR = FN / (TP + FN) = 1 - TPR
- All these measures can have values in the range [0, 1]

- Higher values of TPR and TNR indicate better model performance
- Higher values of FPR and FNR indicate poor model performance
#2: Precision, Recall, and F1 Measure

- These can be calculated directly from the confusion matrix:
Measure Formula Description
o How confident we can be that an instance predicted to
Precision Precision = TP / (TP + FP) have the positive target level actually has the positive
target level
o How confident we can be that all the instances with the

Recall Recall = TPR = TP / (TP + FN)
positive target level have been found by the model
o This a useful alternative to the simpler misclassification
rate
( precision × recall ) o It is the harmonic mean of precision and recall
F1 Measure F1 measure = 2 × (The harmonic mean tends toward the smaller values in a
( precision + recall ) list of numbers and so can be less
sensitive to large outliers than the arithmetic mean, which
tends toward higher values)
#3: Average Class Accuracy

- Classification accuracy can mask poor performance
- To address this issue, we can use average class accuracy instead
- The average class accuracy (using arithmetic mean) is calculated as:
1
average class accuracy AM =  recalll
levels ( t ) l∈levels ( t )
where levels(t) = set of levels that the target feature (t) can assume
|levels(t)| = size of the set
recalll = recall achieved by a model for level l
- The average class accuracy (using harmonic mean) is calculated as:

1
average class accuracyHM =
1 1

levels ( t ) l∈levels (t ) recalll
Textbook Reading: Fundamentals of Machine Learning for Predictive Data Analytics Ch. 12 and 14
None

F-131-16: Heavy Models, Light Models And Proxy Models
General Setting
- Suppose we have N risk drivers, R1,…,RN which take on the values r1(s),…,rN(s) for scenario s and each
scenario produces value y(s).
- We would like to fit this with a proxy function, so we select a number of basis functions of the risk drivers,
Xk(r1,…,rN) for k=1,…,K.
Item Notation
N risk drivers o R1,…,RN
The values of N risk drivers o r1(s),…,rN(s) for scenario s
The value of the scenario s o y(s)
A number of basis functions (1 to K) of the risk drivers o Xk(r1,…,rN) for k=1,…,K
The value of coefficient for basis function k o βk
The Formula for Portfolio (Scenario) Values
Formulaic form: 
k =1,..., K
β k X k ( r1 ( s ),..., rN ( s )) = y ( s ) (for scenarios s=1,…,S where S ≥ K)
Matrix form: βX = y
- For S > K, the problem is one of regression for which an exact solution may not be possible.
- The least squares solution is then found by minimizing the function S given by:
2
S (β ) = y − X β
The formula coefficients are given by the vector: β = ( X T X ) −1 X T y
Weighted Least Squares

2
 
Formulaic form: w( s )  y ( s ) −  β k X k ( r1 ( s ),..., rN ( s ))  = 0, s = 1,..., S , S ≥ K
 k =1,..., K 
Matrix form: W 1/2 ( y − X β ) where W is the diagonal matrix of weights w(s) for each scenario s=1,…,S.
- The least squares solution is then found by minimizing the function S given by:
1 2
S (β ) = W ( y − X β )
2
The formula coefficients are given by the vector: β = ( X T WX ) −1 X T Wy

Radial Basis Functions (RBFs)

- An RBF approximates the unknown function f(x) by a function of the form:
g(x)=Σ ψi Φ(||x,xi ||)
Notation Description
o The xi are the fitting points where the value of the unknown function is known.
xi o The unknown function is the cost of guarantees and each xi is the value of the risk drivers (equity, rates,
lapse etc.) at that fitting point.
ψi o The ψi are weights assigned to each fitting point.
o The function Φ(||x,xi ||) is the radial basis function.
o It is "radial" because its value depends only on the Euclidean distance between the point to be
approximated x, and the fitting point xi .
Φ(||x,xi ||) o The RBFs are all interpolations rather than regressions.
o Hence at each of the fitting points xi , the value of the function to be approximated f(xi) equals g(xi).
o We solve for the weights ψi, and so this gives n linear equations in n unknowns.
o In general, this will have a unique solution and it is possible to choose Φ to ensure that this is the case.
o If the function Φ is positive definite, then the system of equations for ψi will have a solution.
Common Choices for Φ

Choices Form
2
Gaussian φ ( r ) = e − (ε r )
Multi-quadric φ ( r ) = 1 + (ε r )2
Inverse Multi-quadric φ ( r ) = 1 / 1 + (ε r )2
Thin plate splines φ ( r ) = r 2 ln( r )
Commutation Functions
Vector

Nominal Amount Life Cover vector o N = ( n1 ,..., nLast )

Discount Factors vector o D = ( D1 ,..., DLast )

Survival vector o l = (l1 ,..., lLast )

Persistency vector o P = ( per1 ,..., perLast )
The Present Value of the Cash Flows

Last
Classic Commutation Form: PV =  ni ⋅ d i ⋅ li ⋅ peri
i =1
   
Generalized Commutation Form: PV = f ( N , D, l , P ) (a function of vectors)
Last
CFi 
Discounted Cash Flows: PVCommutator =  i
= f (CF , r )
i =1 (1 + r )

F-139-19: How to Improve the Quality of Stress Tests through Backtesting

F-147-20: Modeling in Life Insurance Ch. 11
None
F-148-20: A Guide To Risk Measurement, Capital Allocation And Related Decision Support Issues
#1: Independent “First In”

- The independent method estimates the risk for each sub-portfolio as if it were a stand-alone business unit
- In practice, the sub-portfolios are unlikely to be perfectly correlated so there should be some diversification
benefit at the overall portfolio level
- This diversification benefit is shared pro-rata according to the independent risk values
Example
(1) (2) (3)
1st Percentile
Actual % Scaled
A 60.1 33.3% 42.8
B 60.1 33.3% 42.8
C 60.1 33.3% 42.8
Total 180.3 100.0% 128.4
(2) = % of each row

(3) = (1) x (2)
NOTE: This approach can be repeated using risk measure other than 1st percentile
Advantages and Disadvantages of Independent “First In”

Advantage Disadvantages
o It does not penalize highly correlated portfolios nor
o It is the simplest approach
reward those which give rise to an overall diversification
o It is easy to understand
effect
o It always generates positive capital requirements for
o It is not a coherent allocation method (failing the “no
every business line
undercut” criterion)
#2: Marginal “Last In”

- The marginal method considers the risk of a portfolio, with and without each sub-portfolio, for which the
allocation is to be undertaken
- The sum of the marginal risk values will be less than the overall value unless all risks are perfectly correlated
- Uncorrelated sub-portfolios are over rewarded, leaving a relatively harsh allocation for correlating sub-
portfolios
Example
(1) (2) (3) (4)
1st Percentile
Excluding Portfolio Marginal Impact % Scaled
A 79.6 (BC) 48.8 (ABC – BC) 46.1% 59.2
B 79.7 (AC) 48.7 (ABC – BC) 46.1% 59.2
C 120.2 (AB) 8.2 (ABC – AB) 7.8% 10.0
Total 105.8 100.0% 128.4
(2) = 128.4 – (1)

(4) = (2) x (3)
NOTE: This approach can be repeated using risk measure other than 1st percentile
Disadvantage of Marginal “Last In”

o It is not a coherent allocation method (failing the “no undercut” criterion)

#3: Shapley
- Game Theory is applied to Shapley
- The key limitation in applying this to risk allocation problems is the issue of having a whole number of players
- The calculation of Shapley values is a natural extension of the independent and marginal methods, and based
on the average of the “1st in”, last in” and all the intermediate “ins”
- No scaling is required under this method
Example
(1) (2) (3) (4)
1st Percentile
“1st in” Average “2nd in” “Last in” Average
A 60.1 39.8 48.8 49.6
B 60.1 39.8 48.7 49.6
C 60.1 19.5 8.2 29.3
Total 180.3 99.2 105.8 128.4
(1) = Same as Independent “1st in”

(2) Average of the “2nd in” calculations:
“2nd in” Calculations
A 60.1 (AB – B) 19.6 (AC – C)
B 60.1 (AB – A) 19.5 (BC – C)
C 19.6 (AC – A) 19.5 (BC – B)
(3) = Same as Marginal “last in”

(4) = Average of (1), (2), and (3)

PAK CFE Supplemental Formula Sheet (Spring 2023)

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© 2023 PAK Study Manual 1 SOA CFE Exam

Textbook Reading: Corporate Finance Ch. 8

Calculate Unlevered Net Income

Net Working Capital

Free Cash Flow

FCF = ( Revenus - Costs - Depreciation ) × (1 − τ c ) + Depreciation - CapEx - ΔNWC

Example of Continuation Value with Perpetual Growth

Year Projection of FCF (in millions)

© 2023 PAK Study Manual 2 SOA CFE Exam

Textbook Reading: Corporate Finance Ch.18

WACC (Discount Rate)

The Levered Value of an Investment and its NPV

Adjusted Present Value (APV) Method

The Unlevered Cost of Capital

Valuing the Interest Tax Shield

© 2023 PAK Study Manual 3 SOA CFE Exam

Compute a Project’s FCFE Directly from Its FCF

FCFE = FCF − (1 − τ c ) × ( Interest Payments ) + ( Net Borrowing )

After-tax interest expense

Valuing Equity Cash Flows

Project Leverage and the Equity Cost of Capital

Project-Based WACC Formula

Constant Interest Coverage Ratio

PV ( Interest Tax Shield ) = PV (τ c k × FCF ) = τ c k × PV ( FCF )

Levered Value with a Constant Interest Coverage Ratio

V L = V U + PV ( Interest Tax Shield ) = V U + τ c k × V U

Levered Value with Permanent Debt

© 2023 PAK Study Manual 4 SOA CFE Exam

The PV of Interest Tax Shield (with Periodically Adjusted Debt)

WACC (with Annually Adjusted Debt)

Levered Value (with Annually Adjusted Debt)

Leverage and the Cost of Capital with a Fixed Debt Schedule

Three Common Uses

© 2023 PAK Study Manual 5 SOA CFE Exam

Unlevered Cost of Capital with Personal Taxes

Effective Tax Advantage of Debt

Interest Tax Shield

PV(Interest Tax Shield)

Interest Tax Shield t

© 2023 PAK Study Manual 6 SOA CFE Exam

Textbook Reading: Corporate Finance Ch.22

Real Option Value

Black-Scholes Formula for European Call Option

Black-Scholes Parameters vs. Real Option Parameters

Calculate the Asset Value Without the Dividends

Calculate the Risk-Neutral Probability of the Interest Rates Go Up

Textbook Reading: Corporate Finance Ch. 25

PV( Lease Payments ) = Purchase Price – PV( Residual Value )

Cash Flows for a True Tax Lease

Lease Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

The Lease-Equivalent Loan

Lease vs. Buy Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

© 2023 PAK Study Manual 7 SOA CFE Exam

Textbook Reading: Corporate Finance Ch.27

Textbook Reading: Corporate Finance Ch.28

The Price Paid for a Target

The Benefit from the Acquisition (from the Bidder’s Standpoint)

Value Acquired = Target Stand-Alone Value + PV(Synergies)

Textbook Reading: Corporate Finance Ch.31

Covered Interest Parity (Derived for Risky Discount Rates)