CFA Level II Flashcards
Informational Frictions
occur when information is not equally available or distribution. Purpose of regulations to combat information asymmetry. ECON pg. 314
Externalities
costs/benefits that affect a party that did no choose to incur that cost of benefit. Side effect. ECON pg. 314
regulatory capture theory
assumption that, regardless of the original purpose behind its establishment, a regulatory body will, as some point in time, be influenced or even possibly controlled by the very industry that is being regulated. ECON pg. 314
Regulatory Arbitrage
occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior. Also entails exploiting the difference between the economic substance and interpretation of a regulation. ECON pg. 314
Regularity Competition
regulators compete to provide the most business-friendly regulatory environment ECON pg. 314
Name three (3) regulatory tools available to regulators
- Price Mechanisms
- Restricting/Requiring certain activities
- Provision of public goods or financing of private projects
ECON pg. 315
What are the objectives of securities regulations?
- Protecting investors
- Creating confidence in markets
- Enhancing capital formation
ECON pg. 316
Growth rate of output (Real or Potential GDP)
Growth rate of output = rate of technological change + A(growth rate of capital) + (1 - A)(growth rate of labor)
Growth in per capita output (i.e. labor productivity) comes from two sources
- Capital Deepening
2. Technological Progress
Economic Income
is equal to the after-tax cash flow plus the change in the investment’s market value:
economic income = cash flow + (ending market value - beginning market value)
economic income = cash flow - economic depreciation
Economic Profit
is a measure of profit in excess of the dollar cost of capital invested in a project:
EP = Net Operating Profit after tax (EBIT x (1-tax rate) - $WACC (WACC x $ invested)
The NPV based on economic profit (EP) is called
Market Value Added (MVA)
If applied correct, the resulting NPV of a the economic profit and the basic approaches should be:
the same.
Residual Income
Residual Income = Net Income - Equity Charge
Equity charge is required return on equity multiplied by beginning book value of equity.
The residual income valuation approach focuses only on returns to equity holders, therefore, what is the appropriate discount rate?
Required Return on Equity
Claims Valuation Approach
divides operating cash flows based on the claims of debt and equity holders that provide capital to the company. These debt an equity cash flows are valued separately and then added together to determine the value of the company. REMEMBER: Calculates value of company - not project!
Replacement Project Initial Outflow
Outlay = FCInv + NWCInv - Sal(old) + Tax rate(gain)
What methods to use if project have unequal lives?
Replacement Chain
or
Equivalent Annuity Approach
Types of real options include:
Timing options, Abandonment options, expansion options, flexibility options, and fundamental options. (see page 234-235 book 2).
Factors effecting dividend payout policy
See page 298
- Investment Opportunities
- Expected volatility of future earnings
- Financial Flexibility
- Tax Considerations
- Floatation Costs
- Contractual and legal restrictions
Expansion Project Formulas
Initial Outlay = FCInv + WCInv
Cash Flow = (S-C-D)(1-t) + D
TNOCF = Salvage @ Terminal + NWCInv - Tax(Salvage @ Terminal - BV)
Costs of financial distress
increased costs a company faces when earning decline and the firm has trouble paying its fixed financing costs
The expected costs of financial distress for a firm have two components:
- costs of financial distress and bankruptcy can be direct or indirect
- Probability of financial distress
see page 266
Agency costs of equity
- Monitoring Costs
- Bonding Costs
- Residual Losses
Static trade-off theory
seeks to balance the costs o financial distress with the tax shield benefits from using debt
Pecking order theory
based on asymmetric information, s related to the signals management sends to investors through its financing choices. Pecking order:
- Internally generated equity (i.e., retained earnings)
- debt
- external equity (i.e., newly issued shares)
Three (3) theories of dividend policy
- Dividend irrelevance ~ no effect on company value
- Bird-in-hand
- Tax aversion
see page 282 CorpFin
Target Payout Ratio Adjustment Model
Expected Dividend = (Previous Dividend) + [(Expected increase in EPS) x (target payout ratio) x (adjustment factor)]
pg. 289 CorpFin
Five common rationales for share repurchases
- Potential Tax Advantages
- Share price support/signaling
- Added flexibility
- Offsetting dilution from employee stock options
- increasing financial leverage
pg. 291-292 CorpFin
Philosophies underlaying business ethics
Friedman Doctrine = “increase profits, but within the rules of the game”
Utilitarianism = highest good for most people - most utility
Kantian = people are more than factors of production, deserve dignity and respect
Rights Theory = minority should be stomped on to serve majority
Justice theories = just distribution of economic output
Steps Comparable Company Analysis
Step 1. Identify the set of comparable firms
Step 2. Calculate various relative value measures based on the current market prices of sample companies.
Step 3. Calculate descriptive statistics for the relative value metrics and ally those to the target firm.
Step 4. Estimate a takeover premium
Step 5. Calculate the estimated takeover price for the target as the sum of estimated stock value based on comparable and the takeover premium.
Enterprise Value
EV = market value of debt and equity - cash and equivalents
Comparable Transaction Analysis (CorpFin. Pg 361-362)
Step 1. Identify a set of recent takeover transactions
Step 2. Calculate various relative value measures based on completed deal prices for companies in the sample.
Step 3. Calculate descriptive statistics for the relative value metrics and apply those measures to the target firm.
Acquirers are like to earn positive returns on a deal characterize by:
- strong buyer
- low premium
- few bidders
- favorable market reaction
Objective of CorpGov
- climate or mitigate conflict of interests among stakeholders (particularly managers/shareholders)
- to ensure that assets of company used efficiently and productively - best interests of investors and other stakeholders
Return on Invested Capital (ROIC)
A measure of the after-tax profitably of the capital invested by the company’s shareholders and debt holders. Calculated as Net operating Profit minus adjusted taxes dived by invested capital (which is operating asses minus operating liabilities). Note that this measure is after tax and should be used when tax environments are the same for comparison purposes.
Return on Capital Deployed (ROCD)
Operating profit divided by capital employed (debt and equity capital. Note that this uses the operating profit in the numerator and is especially useful when comparing two firms with different tax structures. ROIC is after-tax.
Dividends are appropriate as a measure of cash flow in the following cases:
- The company has a history of dividend payments
- The dividend policy is clear an related to the earnings of the firm.
- the perspective is that of a minority shareholder.
Free Cash flow to Firm (FCFF)
Cash flow generated by the firm’s operating that is in excess of the capital investment required to sustain the firm’s current productive capacity.
Free Cash Flow to Equity (FCFE)
Cash available to stockholders after funding capital requirements and expenses associated with debt financing.
Free cash flow models are most appropriate:
- No dividend payment history, or dividend history that is not clearly and appropriately related to earnings.
- For Firms with free cash flow that corresponds with profits
- Valuation perspective is that of a controlling shareholder (because they get to keep the excess cash).
Residual Income
Amount of earnings during the period that exceeds the investors’ required return.
Residual Income approach appropriate for:
- Firms that do not have dividend history
- Firms that have negative free cash flow for the foreseeable future (usually do to CapEx demands).
- Firms with transparent FinReport and high quality earnings (based on actual earnings, not merely accruals).
The Gordon Growth Model assumes:
- that dividends increase at a constant rate indefinitely. Condenses to D1/(r - g).
- Firm will pay a dividend in D1
- Growth rate is less than the required rate of return.
Leading P/E
based on the earnings forecast for the next period
Trailing P/E
based on the earnings for the previous period
Justified P/E
relative valuation indicator based on the firm’s fundamentals
What is the primary difference between the Two-stage DDM and the H-Model?
The Two-Stage DDM assumes an abrupt drop in the growth rate. The H models takes a more realist and gradually approach in the decline of growth.
Sustainable Growth Rate (SGR)
in essence, the rate at which earnings (and dividends) can continue to grow indefinitely, assuming the that firm’s D/E ratio is unchanged and it doesn’t issue new equity.
SGT = Retention Ratio x ROE
Retention Ratio
1 - Dividend payout rate
PRAT Model
growth in firm’s earning
g = profit margin (P) x Retention Rate (R) x Asset Turnover (A) x Financial Leverage (T).
OAS
OAS = Option Adjusted Spread
Embedded options:
call, put, or more complex provisions for a sinking fund or an estate put
Callable bonds
give issuer right to call back (buy back) bond. Investor is SHORT the call option.
Potable bond
give investor right to put (sell) the bond back to the insure prior to maturity. Investor LONG the underlying put option.
Estate Put
sell back at death of investor
sinking fund bond (sinkers)
require issuer to set aside funds for bond retirement. Reduces credit risk of issuer.
Types of Multi-factor Models
- Macroeconomic factor models
- Fundamental factor models
- Statistical factor models
Covariance
is a statistical measure of the degree to which two variable moves together - not stated in unit. We standardize to make it more help (Correlation Coefficient)
Correlation Coefficient
r, is a measure of the strength of the LINEAR relationship between two variables. “Pure” measure of the tendency of two variables to move together.
Limitations to Correlations Analysis
Outliers, Spurious Correlations, Nonlinear relationship
Standard Error of Estimate (SEE)
SEE measures the degree of variability of the actual Y-values relative to the estimated Y-values from a regression equation. SEE gauges the “fit” of the regression line. Small the standard error, the better the fit.
Coefficient of Determination
better known as R2, (r-squared), the percentage of the total variation in the dependent variable explained by the independent variable. In simple linear regression can be found by squaring r (correlation coefficient). Not appropriate with multiple regression.
Analysis of Variance
ANOVA - is a statistical procedure for analyzing the total variability of the dependent variable.
Total Sum of Squares
SST measures the TOTAL variation in the dependent variable. SST is the sum of the squared differences between the actual and mean Y-values.
Regression Sum of Squares
RSS measures the variation in the dependent variable that is explained by the independent variable. RSS is the sum of the squared differences between the predicted and mean Y-values.
Sum of Squared Errors
SSE measures the unexplained variation in the dependent variable. Sum of squared residuals or residuals sum of squares. SSE is the sum of the squared differences between the actual and predicted Y-values.
Total Variation Formula
Total Variation = Explained Variation + Unexplained Variation
SST = RSS + SSE
What is the purpose of an F-Test?
An F-Test asses how well a set of independent variables, as a group, explains the variation in the dependent variable
Standard Error of Estimate
Standard Deviation of the Residuals Errors. Equals to the square root of the mean square error (MSE).
Covariance Stationary (CS)
requirement for Autoregressive models. Time series is CS if its mean, variance, and covariances with lagged and leading values do not change over time.
Mean Reverting Level
b0 / (1 - b1)
Mark-to-Market Value of Forward Contract
Vt - (FPt - FP)(contract size). If before maturity, discount back using days/360 in denominator.
International Fischer Relation
Fischer Effect: Rnominal = Rreal + E(inflation)
Intnl Fischer Effect: Rnominal A - Rnominal B = E(inflation A - E(inflation B)
Purchasing Power Parity
Law of one price. Spot (A/B) = CPI(A)/ CPI(B)
Relative Purchasing Power Parity
%ChangeS(A/B) = Inflation (A) - Inflation (B)
FX Dealer Spread Factors
- Spread in interbank market for the same currency spread
- size of transaction
- relationship between dealer and client
FX Interbank Spread Factors
- Currencies Involved
- time of day
- market volatility
Portfolio balance approach focuses _______
Portfolio balance approach focuses on long-term implications of fiscal policy on exchange rate.
Monetary approach focuses ________
Monetary approach focuses on implications of monetary policy.
Mundell-Fleming model focuses ________
Mundell-Fleming model focuses on short-term implications of monetary/fiscal policies.
Potential GDP - Growth Accounting Equation
growth rate in potential GDP = long-term growth rate of technology + α(long-term growth rate of capital) + (1 − α) (long-term growth rate of labor)
Arbitrage Pricing Theory (APT)
alternative to CAPM. Linear model with multiple systemic risk factors priced by the market
Assumption of Arbitrage Pricing Theory
- Unsystematic risk can be diversified away
- Returns are generated using a factor model
- No arbitrage opportunities exist
Three General Classifications of Multi-factor Models
- Macroeconomic Factor
- Fundamental Factor
- Statistical Factor
Describe Macroeconomic Factor Model
assumes returns are explains by “surprises” or deviations from expectations (GPD, inflation, interest rates). Return equation is basically expected return +/- surprises.
Describe Fundamental Factor Model
assumes asset returns are explained by multiple firm-specific factors (e.g., P/E, market cap, leverage ratio, earnings growth, etc.) Return equation is
Active Return
equals differences in returns between a managed portfolio and its benchmark. Active Return = Rp - Rb.
Active Risk
Also known as tracking error or tracking risk and is defined as the standard deviation of the active return. Active Return = TE = s(Rp - Rb).
Information Ratio
Active Return / Active Risk (think of Sharpe ratio except the information ratio uses a portfolio benchmark return in the numerator instead of the risk free rate). High is better. More active return for unit of active risk.
Active RETURN can be broken down into two components
- Factor Return (arising from managers decision to take on factors different from benchmark)
- Security Selection Return (arising from manager choosing different weight for specific securities compared to weight in benchmark).
Active RISK can be broken down into two components
- Active Factor Risk
2. Active Specific Risk
Carhart Four Factor Model
Based on Fama/French model but adds in a fourth factor (momentum).
- Market Risk
- Size
- Value
- Momentum
A factor portfolio is a portfolio with _________
A factor portfolio is a portfolio with a factor sensitivity of one to a particular factor and zero to all other factors.
A tracking portfolio is a portfolio with _________
A tracking portfolio is a portfolio with a specific set of factor sensitivities designed to replicate the factor exposures of a benchmark index.
An arbitrage portfolio is a portfolio with _______
An arbitrage portfolio is a portfolio with factor sensitivities of zero to all factors, positive expected net cash flow, and an initial investment of zero.
Break Even Inflation Rate
Difference between the yield on a zero-coupon, default-free nominal bond and on a zero-coupon, default-free real bond of the same maturity. Incorporates changing expectations about inflation and changing perceptions about the uncertainty of future inflation environment.
BEI = expected inflation + risk premium for uncertainty about inflation.
Break-even Inflation Rate = expected inflation + risk premium for uncertainty about inflation.
The three integrative steps in the portfolio management process are _______.
The three integrative steps in the portfolio management process are planning, execution and feedback.
The two major steps in the portfolio planning phase are ________.
The two major steps in the portfolio planning phase are determining investor objectives and constraints.
The five main classes of investment constraints are _______.
The five main classes of investment constraints are liquidity, time horizon, legal and regulatory concerns, tax considerations, and unique circumstances.
Hedonic Index
Requires only one sale. Regression is developed to control for differences in property characteristics such as size, age, location, and so forth.
Debt Service Cover Ration
First Year NOI / Debt Service
Equity Dividend Rate
First Year Cash Flow / Equity
Drives of Demand for Property: Office Industrial Retail Multi-Family
Office - job growth
Industrial - the overall economy
Retail - consumer spending
Multi-Family - population growth
Types of REITs
- Retail or Shopping Center
- Office
- Residential (multi-family)
- Health Care
- Industrial
- Hotel
- Storage
- Diversified
Net Asset Value Per Share (REIT)
is the amount by which assets exceed liabilities, using current market values rather than accounting book value. Considered most appropriate measure of fundamental value of REIT (and REOC).
Real Estate - Funds from Operations (FFO)
FFO adjusts reported earnings and is a popular measure of continuing net income of a REIT or REOC. Think of Operating Cash Flow and the adjustments we make to it.
Private Equity Multiple: DPI
Distributed to Paid-In Capital - measures the LP’s realized return. Cumulative Distributions / Cumulative Invested Capital
Private Equity Multiple: RVPI
Residual Value to Paid-In Capital - measures the LP’s unrealized return. Value of Holding / Cumulative Invested Capital
Private Equity Multiple: TVPI
Total Value Paid-In Capital - measures the LP’s realized (DPI) and unrealized (RVPI) return. (DPI + RVPI) / Cumulative Invested Capital
Pre-Money Value
Post = PV (Exit Value) PRE = POST - INV
VC Ownership fraction: INV/POST
of Shares issues to VC
SharesVC = SharesFounder x (VC ownership fraction/ 1 - VC Ownership Fraction)
Adjusting Discount rate to taking into consideration probability of failure
R* = [(1+r) / (1-prob failure)] - 1
Sources of value creation in private equity (PE)
- Re-engineering the portfolio company
- Obtaining Favorable Debt Financing
- Alignment of interests between owners and managers
Control Mechanisms of PE Firms
Compensation; Tag-along, drag-along clause; board representation; Non-compete clauses; priority of claims; required approvals; Earn-outs.
The major due diligence factors that are likely to affect the value of a property include:
operating expenses; structural integrity; environmental issues; leases and lease history; lien, ownership, and property tax history; and compliance with relevant regulations and laws
Root causes of unethical behavior include:
Flawed personal ethics, failure to see an ethical dimension in business decisions, flawed organizational culture, pressure from top management to meet unrealistic goals, and unethical leadership.
The primary risks of an ineffective corporate governance system include:
Financial disclosure risk, asset risk, liability risk, and strategic policy risk.
The two key objectives of a corporate governance system:
(1) Eliminate or reduce conflicts of interest (particularly those between managers and shareholders), and (2) Ensure that the assets of a company are used efficiently and productively and in the best interests of its investors and other stakeholders.
A binomial interest rate tree has two desirable properties:
A binomial interest rate tree has two desirable properties: non-negative interest rates and higher volatility at higher rates. Binomial trees do not force mean reversion of rates.
For a 3-year, semiannual coupon bond, how many nodal periods will there be?
For a 3-year, semiannual coupon bond, there will be six nodal periods resulting in 2^(6-1) = 32 paths.
The three primary uses of swaptions are ________.
The three primary uses of swaptions are to lock in a fixed rate, interest rate speculation, and swap termination.
The pure expectations theory, also referred to as the _______, purports that forward rates _______.
The pure expectations theory, also referred to as the unbiased expectations theory, purports that forward rates are solely a function of expected future spot rates.
What is the Beneish Model?
The Beneath model is a probit regression model that estimates the probability of earnings manipulation using eight dependent variables. The M-score determines the probability of earnings manipulation - higher values indicate higher probabilities.
For a 3-year, semiannual coupon bond, how many nodal periods will there be?
For a 3-year, semiannual coupon bond, there will be six nodal periods resulting in 2^(6-1) = 32 paths.
High quality earnings are characterized by two elements:
Sustainable (persist into future) and Adequate (cover the company’s cost of capital).
Equity risk premium =
Equity risk premium = forecasted dividend yield + consensus long term earnings growth rate - long-term government bond yield.
Discuss residual income persistence factor:
A persistence factor of zero is used when residual income is expected to drop immediately to zero. A persistence factor of one is used when residual income is expected to persist at the current level forever. A persistence factor between zero and one is used when residual income is expected to decline over time.
Clawback:
return of previously paid profit.
Where do foreign currency gains/losses appear?
Depends on the method: Current (B/S), Temporal (I/S) - both plugs to make each statement balance.
High quality earnings are characterized by two elements:
Sustainable (persist into future) and Adequate (cover the company’s cost of capital).
For a time series to be covariance stationary:
1) the series must have an expected value that is constant and finite in all periods, 2) the series must have a variance that is constant and finite in all periods, and 3) the covariance of the time series with itself for a fixed number of periods in the past or future must be constant and finite in all periods.
The Insurance Perspective
The insurance perspective focuses on the desire by commodity producers to hedge price risk. Since they are inherently long in the commodity, to offset this risk, they will short (sell) their commodities in the future. To entice speculators, they offer a reduced price. Future price is therefore lower than expected spot price resulting in NORMAL BACKWARDATION. Alts page 121.
Key man clause:
if a key named executive leaves the private equity fund or does not spend a sufficient amount of time at the fund, the GP may be prohibited from making additional investments until another key executive is selected. This is a prospectus term.
Describe the Ho-Lee Model.
The Ho-Lee model is calibrated by using current market prices to find the time-dependent drive term that generates the current term structure. The Ho-Lee model can then be sued to price zero-coupon bonds and to determine the spot rate. The model produces a symmetrical (normal) distribution of future rates. Note that this is an Arbitrage-Free model. Page 152
Tag-along, drag, along clause:
anytime an acquirer gains controls of the company, they must extend the acquisition offer to all shareholders, including firm management.
No-fault divorce clause:
this clause allows a GP to be fired if a supermajority (usually 75% or more) of the LPs agree to do so.
Liquidity Preference Theory of interest rate term structure
Forward rates reflect investors’ expectations of future spot rates, plus a liquidity premium to compensate investors for exposure to interest rate risk (movement - up/down). Liquidity premium is positively related to maturity. Biased estimate of market expectation.
Describe the Cox-Ingersoll-Rand Model.
CIR is based on the idea that interest rate movements are driven by individuals choosing between consumption today versus investing and consuming at a later time. Assumes that rates revert over time to mean level. Assumes that interest rate volatility increases with the level of interest rates. Note that the CIR is a Equilibrium Term Structure Model. Page 151
Preferred Habitat Theory of interest rate term structure
Proposes that forward rates represent expected future spot rates plus a premium, but it does not support the view that this premium is directly related to maturity. Suggestion of an imbalance between the supply and demand for funds in a given maturity range will induce lenders and borrowers to shift from their preferred habitats (maturity range) to one that has the opposite balance and pays better.
Present Value of Growth Ops (PVGO).
D1 / r , as you can see, there is no growth in this equation. You can compare this value from the current share price to derive the PVGO.
Define Unbiased Expectations Theory of interest rate term structure
Also known at the pure expectations theory, it is the investor’s expectations that determine the shape of the interest rate term structure. Rates are solely a function of expected spot rates. Underlying principle behind the pure expectations theory is risk neutrality: Investors don’t demand a risk premium for maturity strategies that differ from the investment horizon. Pg. 153
Local Expectations Theory of interest rate term structure
Similar to unbiased expectations theory (forward rates = expected future spot) with one major difference: preservation of risk-neaturlity for only short holding periods. Over longer periods, risk premia should exist.
Liquidity Preference Theory of interest rate term structure
Forward rates reflect investors’ expectations of future spot rates, plus a liquidity premium to compensate investors for exposure to interest rate risk (movement - up/down). Liquidity premium is positively related to maturity. Biased estimate of market expectation.
Segmented Markets Theory of interest rate term structure
Yields are not determined by liquidity premiums (liquidity preference theory) or expected spot rates (Unbiased Expectations). Rather, shape of the yield curve is determined by the preferences of borrowers and lenders, which drives the balance between supply of and demand for loans of different maturities. Pension plans and insurance companies may be obligated to participant in specific maturity segment of different bonds. Page 150
Remember:
Whether the economic profit, residual income, or claims valuation method for determining income is used, the key is that in THEORY, any of the three methods should results in the same value for the company. In PRACTICE, however, accounting complications, such as pension adjustments, goodwill, and deferred taxes, may complicate the calculation of income, leading some analysts to prefer a particular method.
Define economic income
Economic income is equal to the after-tax cash flow plus the change in the project’s market value.
Define and calculate Economic Profit
Measure of profit in excess of the dollar cost of capital invested in a project. EP = NOPAT - $WACC
NOPAT = EBIT*(1-t)
Market Value Added
NPV of a project based on economic profit. Calculated as EP / (1+WACC)^t. This approach focuses on returns to all suppliers of capital (hence WACC).
Residual Income
Focuses on equity and is determined by subtracting an equity charge from accounting net income. Residual Income = Net Income - (required RROE x BVt-1). This approach only focus on returns to equity holders, hence we use cost of equity (RROE).
Describe some international differences in the use of leverage:
Institutional and legal factors, financial markets and banking system factors, and macroeconomic factors.
Three Dividend Policy Theories
- Dividend Irrelevance (Merton/Modigliani)
- Bird-in-Hand (r decreases as (1-b) increases) - investors prefer a sure dividend versus a potential capital gain. Gordon/Lintner.
- Tax Aversion Theory - tax rate of dividends makes them more/less appealing.
Define economic income
Economic income is equal to the after-tax cash flow plus the change in the project’s market value.
Pecking Order of Financing
- Internally generated equity (RE)
- Debt
- External Equity (newly issued shares)
Pecking order Theory predicts that the capital structure is a by-product of the individual financing decisions.
Static Trade-off Theory
Seeks to balance the costs of financial distress with the tax shield benefits of using debt. Using the static trade-off theory, there is an optimal capital structure that has an optimal proportion of debt.
On the ratings scale, where does Investment Grade Debt start?
Baa (Moody’s) & BBB (Standard & Poor’s).
Characteristics of Strong Corporate Governance Amongst Board of Directors
- 75% independent directors
- independent chairman (isn’t service as CEO)
- qualified to serve
- not serve on more than 2 to 3 boards in total
- annual elections
- board self assessments
- regular meetings without management
- independent audit committee and audit oversight
- independent nominating committee
Common motivation for M&A activity
- synergies
- achieving more rapid growth
- increased market power
- gaining access to unique capabiltiies
- diversification (poor reason)
- bootstrapping EPS
- personal benefits to managers (increased comp)
- tax benefits
- unlocking hidden value
- achieving international business goals
- use technology in new markets
- product differentiation
- provide support to existing multinational clients
Effective Tax Rate under Double Taxation System
Effective tax rate = corporate rate + (1-corp rate)(individual rate)
5 Common rationales for share repurchases
- Potential Tax Advantages
- Share price support/signaling
- Added Flexibility
- Offsetting dilution from employee stock options
- Increasing Financial Leverage (if funded by new debt)
What is the effect on EPS if a company uses debt to repurchase share?
If the after-tax cost of debt is lower than the earnings yield (E/P) or cost of equity, than EPS will increase. Leverage will increase EPS.
Key nodes for Herfindahl-Hirschman Index analysis
HHI Index post-merger - if still under 1,000 industry is considered competitive. If over 1,000 but less than 1,800, moderately concentrated industry and a change in the index above 100 would likely cause an anticompetitive challenge. If over 1,800, considered highly concentrated; a change of over 50 will certainly prompt a challenge.
Characteristics of Strong Corporate Governance Amongst Board of Directors
- 75% independent directors
- independent chairman (isn’t service as CEO)
- qualified to serve
- not serve on more than 2 to 3 boards in total
- annual elections
- board self assessments
- regular meetings without management
- independent audit committee and internal audit oversight
- independent nominating committee
Gordon Growth Model Equity Risk Premium
Estimates risk premium as the expected dividend yield plus the expected growth rate minus the current long-term government bond yield.
GGM equity risk premium = (1-year forecasted dividend yield) + (consensus long-term earnings growth rate)- (long-term government bond yield).
Dividend + growth in earnings - risk free rate.
Describe Poison Pill
Pre-Offer Defense Mechanism: In most basic form, the poison pill give current shareholders the right to purchase additional shares of stock at extremely attractive prices which causes dilution and effectively increases costs to the potential acquirer.
What is a Flip-in Pill?
Specific form of poison pill - where the target company’s shareholders have the right to buy the target’s shares at a discount.
What is a Flip-over Pill?
Specific form of poison pill - where the target company’s shareholders have the right to buy the acquirer’s shares at a discount.
Key nodes for Herfindahl-Hirschman Index analysis
HHI Index post-merger - if still under 1,000 industry is considered competitive. If over 1,000 but less than 1,800, moderately concentrated industry and a change in the index above 100 would likely cause an anticompetitive challenge. If over 1,800, considered highly concentrated; a change of over 50 will certainly prompt a challenge.
How are deferred tax liabilities treated in the FCFF formula?
We look at the change in deferred tax liabilities or assets to determine what the cash flow effect was for the year. If there is an increase in deferred tax assets that means we had a cash inflow from not having to pay taxes, we’re postponing payment of tax into the future. DTA’s would be treated similarly. Page 353.
Gordon Growth Model Equity Risk Premium
Estimates risk premium as the expected dividend yield plus the expected growth rate minus the current long-term government bond yield.
GGM equity risk premium = (1-year forecasted dividend yield) + (consensus long-term earnings growth rate)- (long-term government bond yield).
Dividend + growth in earnings - risk free rate.
A firm’s formal written policy on the independence and objectivity of research must be:
(i) made available to all clients and prospective clients (investing/corporate)
(ii) disseminated to all firm employees.
Discuss Research Analyst Compensation
Structure must:
- Align compensation with the quality of the research and accuracy of the recommendations over time
- do NOT DIRECTLY link compensation to investment banking or other corp fin activities on which the analyst collaborated (impairs judgement)
Supply side estimate of risk premium
the Ibbotson-Chen model is an example: equity risk premium = (1+expected inflation) x (1+expected real EPS growth) x (1+expected changes in P/E ratio) - 1+expected yield on index - expected risk free rate.
Growth in GDP can be estimated by:
Sum of labor productivity growth and growth in labor supply.
Porter’s Five Forces
- The threat of new entrants into the industry
- The threat of substitute products
- The bargaining power of buyers
- The bargaining power of suppliers
- The degree of rivalry among existing competitors
When are dividends an appropriate measure of cash flow?
- The company has a history of dividend payments
- The dividend policy is clear and related to the earnings of the firm.
- The perspective is that of a MINORITY shareholder.
When is a free cash flow model most appropriate?
- for firms that don’t pay dividends or have a dividend payment history that is not clearly appropriately related to earnings
- for firms with free cash flow that corresponds with their profitability
- when the valuation perspective is that of a MAJORITY or CONTROLLING shareholder
Define free cash flow to the firm:
cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s productive capacity.
Define free cash flow to equity:
cash flow generated by the firm’s operations that is in excess of the capital investment required to sustain the firm’s productive capacity and expenses associates with debt financing.
When is the residual income approach appropriate?
- firms that do not have dividend histories
- firms that have negative free cash flow for the foreseeable future
- firms with transparent financial reporting and high quality earnings
FCFF Model: Calculating FCinv
FCinv = ending NET PP&E - beginning NET PP&E + depreciation
What are normalized earnings?
average business cycle earnings
What are underlying earnings?
Earnings that exclude nonrecurring components, such as gains and losses from asset sales, asset write downs, provisions for future losses, and changes in accounting estimates.
State the justified P/B ratio
ROE - g / r - g
State the justified P/S ratio
Net Income Sales (NPM) x (1 - b) * (1+g) / r- g
Implied PE/G valuation rule
stocks with lower PE/Gs are more attractive than stocks with higher PE/Gs, assuming risk is similar
Drawbacks of using PE/G ratio:
- the relationship between P/E and g is not linear, which makes comparisons difficult
- the PE/G ratio still doesn’t account for risk
- the PE/G ratio doesn’t reflect the duration of the high-growth period for a multistage valuation model, especially if the analyst uses a short-term high-growth forecast.
Define Enterprise Value
EV = Mkt value of Debt + Mkt value of equity - cash and equives and investments.
Define Economic Value Added (EVA)
NOPAT - (WACC x total capital). EVA measure the value added for shareholders by management during a given year.
Define Market Value Added
is the difference between the market value of a firms’ debt and equity and the book value of invested capital supplied by investors. Measures the value created by management’s decisions since the firm’s INCEPTION.
Conceptually, whats the difference between EVA and MVA?
EVA is considering added value in a given year. MVA is considering added value since inception of firm.
Clean surplus accounting
clean surplus relation can be expressed as Ending BV = Beginning BV + Earnings - Dividends
Real Exchange Rate between currencies
Real Exchange Rate = St * (CPIb / CPI a) - notice here that we are making an exemption here to the a/b numerator, denominator rule.
What is an FX carry trade?
taking advantage of the misplacing of currencies. Borrowing in once currency, exchanging and investing in another, and then converting back to original currency, paying of loan and keeping the difference.
Explain what the hell the Cobb-Douglas Function is:
aims to model the effect of capital investment on economic growth and labor productivity. Takes the following form:
- Y=TK∂L^(1-∂)
Where ∂ and (1-∂) = the share of the output allocated to capital (k) and labor (l). T represents the technological progress of the economy, often referred to total factor productivity (TFP).
What is the Cobb-Douglas function trying to explain:
Essentially states that output (GDP) is a function of labor and capital inputs and their productivity.
What are the three theories of economic growth?
Classical, Neoclassical, Endogenous
Classical Growth Theory
Long-term population growth increases where there is an increase in per capita income above subsistence level due to an increase in capital or technological progress. Population explodes which leads to diminishing returns. Unsustainable growth. Not supported by empirical evidence. Key point is Non-permanent growth.
Neoclassical Growth Theory
Focus is on estimated economy’s long-term steady state growth rate (sustainable growth rate or equilibrium growth rate). Output to capital ratio is constant. When the output to capital ratio is constant, the labor-to-capital ratio and the output per capita also got at the equilibrium growth rate g.
Key point is Steady Growth.
Endogenous Growth Theory
end means coming from with - this theory contents that it s the investment in both physical and human captain that resulted in technological growth. Permanent increase of growth rate.
Under the current rate method, what exposure is required to have a gain (loss)?
If local currency is appreciating (depreciating), net asset exposure will result in a gain (loss).
If local currency is appreciating (depreciating), net liability exposure will result in a loss (gain).
Under the temporal rate method, what exposure is required to have a gain (loss)?
If local currency is appreciating (depreciating), net monetary asset exposure will result in a gain (loss).
If local currency is appreciating (depreciating), net monetary liability exposure will result in a loss (gain).
Under US GAAP, what method do we use to convert financial statements in a hyper-inflationary environment?
When hyperinflation is present, the functional currency is considered to e the parent’s presentation currency; thus, the temporal method is use to remeasure the financial statements.
Define hyperinflation according to US GAAP
One in which cumulative inflation exceeds 100% over a 3-year period. Assuming compounding, an inflation rate of more than 26% over three years will result in cumulative inflation over 100%.
Under IFRS, what method do we use to convert financial statements in a hyper-inflationary environment?
The temporal method is NOT used (like US GAAP). Instead, the foreign currency financial statements are restated for inflation and then translated using the current exchange rate. This means adjusting for changes in the price index and then multiplying by the current exchange rate.
Holding monetary assets in a hyper inflationary environment results in:
A purchasing power loss. Think about this as your foreign currency units are worth less and it takes more of them to buy something now. Someone owning me $10 as valuable as it used to be. The opposite is true with monetary liabilities. Hyperinflation results in a purchasing power gain because our debts are denominated where we still paying off the same “amount” but it’s worth less. Its like paying off a mortgage in the future after inflation. The mortgage payment doesn’t feel as significant as it used to.
Accounting for Stock Grant:
Compensation expense for stock granted to an employee is based on the fair value of the stock on the grant date. The compensation expense is allocated over the employee’s service period.
Phantom stock
Payoff is based on hypothetical shares, not performance of actual shares.
Accounting for Stock Option Compensation:
Compensation expense is based on the fair value of the options on the grant date based on the number of options that are expected to vest. Expense is allocates to the income statement over the service period. Recondition of compensation expense will decrease net income but result in a offsetting increase to paid-in capital. Therefore, no change to equity occurs.
What happens when a firm amends its pension plan?
If the amendment results in increased benefits and therefore costs, under US GAAP the cost is reporting under other comprehensive income and amortized over the remaining service life of the affected employees. Under IFRS the expense is recognized immediately.
Calculation of Total Periodic Pension Cost
Two ways:
(1) TPPC = Contributions - ∆funded status
(2) TPPC = Current Service Costs + Interest Costs - actual return on plan assets ± actuarial losses/gains due to changes in assumptions affecting PBO
Recognizing impairment of equity method investment
Equity method investments must be tested for impairment. Under US GAAP, if the fair value of the investment falls below the carrying value (investment account on B/S) and the loss is considered permanent, the investment is written down to fair value and a loss is recognized on the income statement under continuing operations.
Recognizing goodwill on equity method investment
If the price paid for the investment does not equal the propionate book value of the investee’s assets, the excess is attributed to goodwill. HOWEVER, under the equity method we still report it as single line-item. This will probably mean that we will need to include additional depreciation expense in our calculation of ending equity method value. This will affect the net income from equity investment that we report. Pg 68.
Calculate conversion value of convertible bond
Conversion Value = MARKET price of bond x conversion ratio
Calculate Market conversion price of convertible bond
Market Conversion Price = Market Price of Convertible bond / conversation ratio (what is the price that we’d essentially be paying for the stock?)
Calculate Market conversion premium per share
Market Conversion Premium Per share = Market Conversation Price - Market Price. Essentially, what’s the difference between what we are converting and what we could buy outright in the marketplace?
A convertibile bond can behave as:
(1) A busted convertible - basically a bond that someone wouldn’t consider converting to shares because market conversion price is way to high.
(2) Common stock equivalent - conversion feature is so value the security behaves a stock
(3) hybrid - characteristics of both fixed income and equity
Define Style: Less Malleable & Less Predictable
Adaptive
Define Style: Less Malleable & More Predictable
Classical
Define Style: More Malleable & Less Predictable
Shaping
Define Style: More Malleable & More Predictable
Visionary
Which B/S account are most closely tied to forecasted I/S?
Inventory - PP&E is less directly tied and requires understanding of capital expenditures
How is ROIC or ROCE calculated, what does it mean, and when is it useful?
Calculation: NOPLAT ÷ Invested Capital (Op assets - Op liabs)
Meaning: Return to both debt and equity holders is preferable to ROE as it allows profitability comparisons between companies with different capital structures.
Higher equals competitive advantage. Return on Capital Employed (ROCE) is similar but using pretax operating earnings to facilitate comparison between different tax rates.
Alts: Funds From Operations
Net Income + Depreciation - gains from debt restructuring/ property sales + losses from sales and debt restructuring
Think of Delta as___
Delta is the change in the option price for a given instantaneous change in the stock price. The change is equal to the slope of the option price diagram.
Computation of Gamma
Gamma = change in delta/change in the price of the underlying
What do we need in order to value an option (BSM)?
In order to compute the market price of the option, we need the risk-free rate (rho), the current asset price (∆), the time to expiration (theta), the exercise price, and the implied volatility (vega).
If I’m only given Call Option ∆, how do I find Put Option Delta?
Subtract 1. Call Option ∆ - 1 = Put option ∆.
Equation of Growth Rate of Potential GDP - Labor Productivity Growth Accounting Equation
Growth Rate of Potential GDP = Growth in Labor x Growth in Labor Productivity
Equation of Growth Rate of Potential GDP - Growth Accounting Equation
Growth Rate of Potential GDP = Long term growth rate of technology + ∂(long term growth rate of capital) + (1 - ∂) Long-term growth rate of labor
