# on 11-Nov-2016 (Fri)

#### Annotation 1418054733068

Subject 3. Other Financial Information Sources
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction
Financial Notes and Supplementary Schedules

Financial footnotes are an integral part of financial statements. They provide information about the accounting methods, assumptions and estimates used by management to develop the data reported in the financial statements. They provide additional disclosure in such areas as fixed assets, inventory methods, income taxes, pensions, debt, contingencies such as lawsuits, sales to related parties, etc. They are designed to allow users to improve assessments of the amounts, timing, and uncertainty of the estimates reported in the financial statements.

Supplementary Schedules: In some cases additional information about the assets and liabilities of a company is provided as supplementary data outside the financial statements. Examples include oil and gas reserves reported by oil and gas companies, the impact of changing prices, sales revenue, operating income, and other information for major business segments. Some of the supplementary data is unaudited.

Management Discussion and Analysis (MD&A)

This requires management to discuss specific issues on the financial statements, and to assess the company's current financial condition, liquidity, and its planned capital expenditure for the next year. An analyst should look for specific concise disclosure as well as consistency with footnote disclosure.

Note that the MD&A section is not audited and is for public companies only.

Auditor's Reports

See next subject for details.

Other Sources of Information

• Interim reports. Publicly held companies must file form 10-Q (interim report) on a quarterly basis. It is far less detailed than annual financial statements, as it contains unaudited basic financial statements, unaudited footnotes to financial statements, and management discussion and analysis.

• Proxy statements. An analyst should look for litigation, executive compensation, and related-party transactions, known as proxy statements. Proxy statements should be considered an integral part of the financial report, and they may contain special compensation "perks" for officers and directors, as well as lawsuits and other contingent obligations facing the company.

• Companies' websites, press releases, and conference calls.

#### Annotation 1418056568076

Subject 4. Auditor's Reports
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction
The auditor (an independent certified public accountant) is responsible for seeing that the financial statements issued comply with generally accepted accounting principles. In contrast, the company's management is responsible for the preparation of the financial statements. The auditor must agree that management's choice of accounting principles is appropriate and that any estimates are reasonable. The auditor also examines the company's accounting and internal control systems, confirms assets and liabilities, and generally tries to be sure that there are no material errors in the financial statements.

Though hired by the management, the auditor is supposed to be independent and to serve the stockholders and the other users of the financial statements.

An auditor's report (also called the auditor's opinion) is issued as part of a company's audited financial report. It tells the end-user the following:

• Whether the financial statements are presented in accordance with generally accepted accounting principles.
• It identifies those circumstances in which such principles have not been consistently observed in the current period in relation to the preceding period.
• Informative disclosures in the financial statements are to be regarded as reasonably adequate unless otherwise stated in the report.

An auditor's report is considered an essential tool when reporting financial information to end-users, particularly in business. Since many third-party users prefer or even require financial information to be certified by an independent external auditor, many auditees rely on auditor reports to certify their information in order to attract investors, obtain loans, and improve public appearance. Some have even stated that financial information without an auditor's report is "essentially worthless" for investing purposes.

The Types of Audit Reports

There are four common types of auditor's reports, each one representing a different situation encountered during the auditor's work. The four reports are as follows:

• An unqualified opinion report is issued by an auditor when the financial statements presented are free of material misstatements and are in accordance with GAAP, which, in other words, means that the company's financial condition, position, and operations are fairly presented in the financial statements. It is the best type of report an auditee may receive from an external auditor. It is regarded by many as the equivalent of a "clean bill of health" to a patient, which has led many to call it the "clean opinion."
• A qualified opinion report is issued when the auditor encountered one or two situations that did not comply with generally accepted accounting principles; however, the rest of the financial statements are fairly presented. This type of opinion is very similar to an unqualified or "clean opinion," but the report states that the financial statements are fairly presented with a certain exception which is otherwise misstated.
• An adverse opinion is issued when the auditor determines that the financial statements of an auditee are materially misstated and generally do not comply with GAAP. It is considered the opposite of an unqualified or clean opinion, essentially stating that the information contained to assess the auditee's financial position and results of operations is materially incorrect, unreliable, and inaccurate.

• A disclaimer of opinion, commonly referred to simply as a disclaimer, is issued when the auditor could not form, and consequently refuses to present, an opinion on the financial statements. This type of report is issued when the auditor tried to audit a company but could not complete the work due to various reasons and does not issue an opinion.

Auditor's Report on In...

#### Annotation 1418058403084

Subject 5. Financial Statement Analysis Framework
#cfa #cfa-level-1 #financial-reporting-and-analysis #introduction

The financial statement analysis framework provides steps that can be followed in any financial statement analysis project, including the following:

• Articulate the purpose and context of the analysis.

What is the purpose of the analysis? Evaluating an equity or debt investment? Or issuing a credit rating?

The context needs to be defined clearly too: Who is the intended audience? What is the nature and content of the final report? What is the time frame? What is the budget?

• Collect input data.

Gather a company's financial data from financial statements and other sources described in Subject c (other financial information sources). Also gather information on the economy and industry to understand the environment in which the company operates.

• Process data.

Compute ratios or growth rates, prepare common-size financial statements, create charts, perform statistical analyses, make adjustments to financial statements, etc.

• Analyze / interpret the processed data.

Interpret the output to support a conclusion (e.g., a buy decision).

• Develop and communicate conclusions and recommendations.

Communicate the conclusion or recommendation in an appropriate format.

Periodic review is required to determine if the original conclusions and recommendations are still valid.

#### Annotation 1418060238092

Subject 1. The Classification of Business Activities
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
Business activities can be classified into three groups:

• Operating activities involve those activities conducted in the course of running a business. These activities determine net income and changes in the working capital account (accounts receivable, inventory, and accounts payable). Examples:

• Selling goods and services
• Employing managers and workers
• Paying taxes

• Investing activities are those associated with spending funds to begin and continue operations. In general, these activities affect the long-term asset items on the balance sheet. Examples:

• Buying resources such as land, buildings, and equipment needed in the operation of the business.
• Selling these resources when no longer needed.

Selling land, buildings, and equipment is associated with investing activities, even though it results in a cash inflow, because it involves resources used to begin and continue operations.

• Financing activities are related to obtaining or repaying capital. In general, these activities affect the debt and the equity items on the balance sheet. Examples:

• Issuing stock
• Paying dividends to stockholders
• Obtaining loans from creditors
• Repaying amounts plus interest to creditors

Payments of dividends and interest are associated with financing activities, even though they involve cash outflows, because they are necessary to obtain funding.

In Reading 27 [Understanding the Cash Flow Statement] a more detailed discussion of different business activities and their impact on cash flows will be provided.

#### Annotation 1418062073100

Subject 2. Financial Statement Elements and Accounts
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
An account is a label used for recording and reporting a quantity of almost anything. It is the:

• Means by which management keeps track of the effects of transactions.
• Basic storage unit for accounting data.

A chart of accounts is a list of all accounts tracked by a single accounting system, and should be designed to capture financial information to make good financial decisions. Each account in the Anglo-Saxon chart is classified into one of the five categories: Assets, Liabilities, Equity, Income, and Expenses.

Assets

Assets are economic resources controlled by a company that are expected to benefit future operations.

• An asset is usually listed on the balance sheet.
• It has a normal or usual balance of debit (i.e., asset account amounts appear on the left side of a ledger).

It is important to understand that in an accounting sense an asset is not the same as ownership. In accounting, ownership is described by the term "equity."

Types of Assets

• Current assets are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current asset section are: cash, marketable securities, accounts receivables, inventories and prepaid expenses.
• Long-term investments are often referred to simply as investments. They are to be held for many years, and are not acquired with the intention of disposing of them in the near future.
• Property, plants, and equipment are properties of a durable nature used in the regular operations of a business. With the exception of land, most assets are either depreciable (such as a building) or consumable. The accumulated depreciation account is a contra-asset account used to total the depreciation expense to date on the asset.
• Intangible assets lack physical substance and usually have a high degree of uncertainty concerning their future benefits. They include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, and organization costs. Generally, all of these intangibles are written off (amortized) as an expense over 5 to 40 years.

Liabilities

Liabilities are the financial obligations that the company must fulfill in the future. They are typically fulfilled by cash payment. They represent the source of financing provided to a company by its creditors.

Types of Liabilities

• Current liabilities are obligations that are reasonably expected to be liquidated either through the use of current assets or the creation of other current liabilities within one year or within the operating cycle, whichever is longer. They are not reported in any consistent order. A typical order is: notes payable, accounts payable, accrued items (e.g., accrued warranty costs, compensation, and benefits), income taxes payable, current maturities of long-term debt, etc.
• Long-term liabilities are obligations that are not reasonably expected to be liquidated within the normal operating cycle but instead at some date beyond that time. Bonds payable, notes payable, deferred income taxes, lease obligations, and pension obligations are the most common long-term liabilities.

Owners' Equity

Equity represents the source of financing provided to the company by the owners.

Owners' Equity = Contributed Capital + Retained Earnings

Owner's equity is the owners' investments and the total earnings retained from the commencement of the company.

• Contributed capital is the amount invested in the busines
...

#### Annotation 1418063908108

Subject 3. Accounting Equations
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
Assets reported on the balance sheet are either purchased by the company or generated through operations; they are financed, directly or indirectly, by the creditors and stockholders of the company. This fundamental accounting relationship provides the basis for recording all transactions in financial reporting and is expressed as the balance sheet equation:

Assets (A) = Liabilities (L) + Owners' equity (E)

This equation is the foundation for the double-entry bookkeeping system because there are two or more accounts affected by every transaction.

If the equation is rearranged:

Assets - Liabilities = Owners' equity

The above equation shows that the owners' equity is the residual claim of the owners. It is the amount left over after liabilities are deducted from assets.

Owners' equity at a given date can be further classified by its origin: capital provided by owners, and earnings retained in the business up to that date.

Owners' equity = Contributed capital + Retained earnings

Net income is equal to the income that a company has after subtracting costs and expenses from total revenue.

Revenue - Expenses = Net income (loss)

Net income is informally called the "bottom line" because it is typically found on the last line of a company's income statement.

Balance sheets and income statements are interrelated through the retained earnings component of owners' equity.

Ending retained earnings = Beginning retained earnings + Net income - Dividends

The following expanded accounting equation, which is derived from the above equations, provides a combined representation of the balance sheet and income statement:

Assets = Liabilities + Contributed capital + Beginning retained earnings + Revenue - Expenses - Dividends

• Dividends and expenses decrease owners' equity.
• Revenues increase owners' equity.

Because dividends and expenses are deductions from owners' equity, move them to the left side of the equation:

#### Annotation 1418067315980

Subject 4. Effects of Transactions on the Accounting Equation
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics

The following illustrates how the business transactions of ABC Realty are recorded in a simplified accounting system.

1. Owners' Investments - Invested $50,000 in business in exchange for 5,000 shares of$10 par value stock.

 Assets = Liab. Owners' Equity Cash A/R Supplies Land Building A/P Common Stock Retained Earnings 1 $50,000$50,000 A = $50,000 L + OE =$50,000 Notice A = L + SE is always in balance.

2. Purchase of Assets with Cash - Purchased a lot for $10,000 and a small building on a lot for$25,000.

 Assets = Liab. Owners' Equity Cash A/R Supplies Land Building A/P Common Stock Retained Earnings 1 $50,000$50,000 2 -35,000 $10,000$25,000 $50,000 bal$15,000 $10,000$25,000 $50,000 A =$50,000 L + OE = $50,000 This transaction only affects one side of the accounting equation: assets. Whenever a transaction affects only one side of the accounting equation, both assets and liabilities and owners' equity remain unchanged. 3. Purchase of Assets by Incurring a Liability - Purchased office supplies for$500 on credit.

 Assets = Liab. Owners' Equity Cash A/R Supplies Land
...

#### Annotation 1418069150988

Subject 5. Accruals and Valuation Adjustments
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
Under strict cash basis accounting, revenue is recorded only when cash is received and expenses are recorded only when cash is paid. Net income is cash revenue minus cash expenses. The matching principle is ignored here, resulting inconformity with generally accepted accounting principles.

Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.

Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.

• A balance sheet must list all assets and liabilities at the end of the accounting period.
• An income statement must list all revenues and expenses applicable to the accounting period.

Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.

The four basic types of adjusting entries are:

• Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.

• Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.

• Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).

• Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.

In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.

• If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
• If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other com
...

#### Annotation 1418070985996

Subject 6. Financial Statements
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
Here are financial statements based on previous transactions for ABC Realty.

#### Annotation 1418079112460

Subject 7. Flow of Information in an Accounting System
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics #has-images
It is important for an analyst to understand the flow of information through a financial reporting system.

1. Journal entries and adjusting entries

Journalizing is the process of chronologically recording transactions.

• General journal is the simplest and most flexible.
• A separate journal entry records each transaction.
• Useful for obtaining detailed information regarding a particular transaction.

2. General ledger and T-accounts

The items entered in a general journal must be transferred to the general ledger. This procedure, posting, is part of the summarizing and classifying process. The general ledger contains all the same entries as those posted to the general journal; the only difference is that the data are sorted by date in the journal and by account in the ledger.

There is a separate T-account for each item in the ledger. A T-account appears as follows:

3. Trial balance and adjusted trial balance

A trial balance is a list of all open accounts in the general ledger and their balances.

• For every amount debited, an equal amount must be credited.
• The total of debits and credits for all the T-accounts must be equal.
• A trial balance is prepared to test this. It proves whether or not the ledger is in balance.
• It is usually prepared at the end of a month or accounting period.

Since certain accounts may not be accurately stated, adjusting entries may be required to prepare an adjusted trial balance.

4. Finance statements

The financial statements can be prepared from the adjusted trial balance.

#### Annotation 1418082520332

Subject 8. Using Financial Statements in Security Analysis
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-mechanics
Financial statements are the primary information that firms publish about themselves, and investors and creditors are the primary users of financial statements. Analysts, who work for investors and creditors, may need to make adjustments to reflect items not reported in the statements or assess the reasonableness of managements' judgments. For example, an important first step in analyzing financial statements is identifying the types of accruals and valuation entries in a company's financial statements.

Company management can manipulate financial statements, and a perceptive analyst can use his or her understanding of financial statements to detect misrepresentations.

For example, companies may improperly record costs as assets rather than as expenses and amortize the assets over future periods. The goal is to impress shareholders and bankers with higher profits. Consider advertising expenses, which should be charged against income immediately. Certain companies, particularly those selling memberships to customers (e.g., health clubs and Internet access providers), aggressively capitalize these costs and spread them over several periods.

Companies may amortize long-term assets too slowly. Slow depreciation or amortization keeps assets on the balance sheet longer, resulting in a higher net worth. With slow amortization, expenses are lower and profits are higher.

#### Annotation 1418083831052

Subject 1. The Objective of Financial Reporting
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
An awareness of the reporting framework underlying financial reports can assist in security valuation and other financial analysis. This framework describes the objectives of financial reporting, desirable characteristics for financial reports, the elements of financial reports, and the underlying assumptions and constraints of financial reporting. An understanding of the framework that is broader than knowledge of a particular set of rules offers an analyst a basis from which to infer the proper financial reporting, and thus security valuation implications, of any financial statement element transaction.

The objective of financial reporting:

• The objective of financial statements is to provide information about a company's financial position, performance, and any changes in financial position; this information should be useful to a wide range of end-users for the purpose of making economic decisions.
• Financial reporting requires policy choices and estimates. These choices and estimates require judgment, which can vary from one preparer to the next. Accordingly, standards are needed to attempt to ensure some type of consistency in these judgments.

#### Annotation 1418085666060

Subject 2. Financial Reporting Standard-Setting Bodies and Regulatory Authorities
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards

#### Private sector standard-setting bodies and regulatory authorities play significant but different roles in the standard-setting process. In general, standard-setting bodies make the rules and regulatory authorities enforce the rules. However, regulators typically retain legal authority to establish financial reporting standards in their jurisdictions.

International Accounting Standards Board (IASB)

This is essentially the international equivalent of the Financial Accounting Standards Board (FASB).

• It was preceded by the International Accounting Standards Committee (IASC), which was established in 1973.
• It is comprised of 14 members (12 full-time, 2 part-time); seven members are liaisons with a national board.
• It works toward harmonization of international accounting standards.
• The standard development process is open.
• Standards are principles-based.
• Since the establishment of the IASB, the focus is on global standard-setting rather than harmonization per se.

International Organization of Securities Commissions (IOSCO)

This is essentially the international equivalent of the U.S. Securities and Exchange Commission (SEC).

• It works to achieve improved market regulation internationally.
• It works to facilitate cross-border listings.
• It advocates for the development and adoption of a single set of high-quality accounting standards.

Financial Accounting Standards Board (FASB)

The FASB is a non-governmental body that sets accounting standards for all companies issuing audited financial statements. All FASB pronouncements are considered authoritative; new FASB statements immediately become part of GAAP.

U.S. Securities and Exchange Commission (SEC)

In the U.S., the form and content of the financial statements of companies whose securities are publicly traded are governed by the SEC through its regulation S-X. Although the SEC has delegated much of this responsibility to the FASB, it frequently adds its own requirements. The SEC functions as a highly effective enforcement mechanism for standards promulgated in the private sector.

Audited financial statements, related footnotes, and supplementary data are presented in both annual reports sent to stockholders and those filed with the SEC. These filings often contain other valuable information not presented in stockholder reports.

Convergence of Global Financial Reporting Standards

As capital markets become more international in scope, the need for global accounting standards and the demand for multiple listings has grown. The IASB and FASB, along with other standard-setters, are working to achieve convergence of financial reporting standards.

Pros:

• Expedite the integration of global capital markets and make the cross-listing of securities easier.
• Facilitate international mergers and acquisitions.
• Reduce investor uncertainty and the cost of capital.
• Reduce financial reporting costs.
• Allow for easy adoption of high-quality standards by developing countries.

Cons:

• Significant differences in standards currently exist.
• The political cost of eliminating differences.
• Will cause "standards overload" for some firms.
• Diverse standards for diverse places are acceptable.

#### Annotation 1418087501068

Subject 3. The International Financial Reporting Standards Framework
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
The IFRS Framework sets forth the concepts that underlie the preparation and presentation of financial statements for external end-users, provides further guidance on the elements from which financial statements are constructed, and discusses the concepts of capital and capital maintenance.

Objectives of Financial Statements

The Framework identifies the central objective of financial statements as providing information about a company that is useful in making economic decisions. Financial statements prepared for this purpose will meet the needs of most end-users. Users generally want information about a company's financial performance, financial position, cash flows, and ability to adapt to changes in the economic environment in which it operates.

The Framework identifies end-users as investors and potential investors, employees, lenders, suppliers, creditors, customers, governments, and the public at large.

Qualitative Characteristics of Financial Statements

The Framework prescribes a number of qualitative characteristics of financial statements. The key characteristics are relevance and reliability. Preparers can face a dilemma in satisfying both criteria at once. For example, information about the outcome of a lawsuit may be relevant, but the financial impact cannot be measured reliably.

Financial information is relevant if it has the capacity to influence an end-user's economic decisions. Relevant information will help users evaluate the past, present, and most importantly, future events in a company.

To be reliable, financial information must represent faithfully the effects of the transactions and events that it reflects. The true impact of transactions and events can be compromised by the difficulty of measuring transactions reliably.

• Financial information faithfully represents transactions and events when accounted for in accordance with their substance and economic realityand not merely their legal form. Commonly, a legal agreement will purport that a company has "sold" assets to a third party. However, an analysis of the substance of the arrangement indicates that the company retains control over the future economic benefits and risks embodied in the asset, and should continue to recognize it on its own balance sheet.
• Financial information is reliable if it is free from material error and is complete. Information is material if its omission or misstatement could influence decisions that end-users make on the basis of the financial statements. Information is reliable when it is neutral or free from bias and prudence. A degree of prudence when preparing financial information enhances its reliability. However, a company should not use prudence as the basis for the recognition of, for example, excessive provisions.

Financial information must be easily understandable in addition to being relevant and reliable. Preparers should assume that end-users have a reasonable knowledge of business and economic activities, and an ability to comprehend complex financial matters.

End-users must be able to compare a company's financial statements through time in order to identify trends in financial performance (comparability). Hence, policies on recognition, measurement, and disclosure must be applied consistently over time. Where a company changes its accounting for the recognition or measurement of transactions, it should disclose the change in the Basis of Accounting section of its financial statements and follow the guidance set out in IFRS.

The application of qualitative characteristics and accounting standards usually results in financial statements that show a true and fair view, or fairly present a company's financial position and performance.

The Elements of Financial Statements

The Framework outlines definition and recognition criteria fo...

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#### Annotation 1418089860364

Subject 4. General Requirements for Financial Statements
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards
The objective of IAS No. 1 is to prescribe the basis for the presentation of general-purpose financial statements, to ensure comparability both with the company's financial statements of previous periods and with the financial statements of other entities. To achieve this objective, this Standard sets out overall requirements for the presentation of financial statements, guidelines for their structure, and minimum requirements for their content.

Components of Financial Statements

A complete set of financial statements comprises:

• a balance sheet
• an income statement
• a statement of changes in equity showing either:

• all changes in equity, or
• changes in equity other than those arising from transactions with equity-holders acting in their capacity as equity-holders

• a cash flow statement
• notes, comprising a summary of significant accounting policies and other explanatory notes

Fundamental Principles Underlying the Preparation of Financial Statements

A company whose financial statements comply with IFRS shall make an explicit and unreserved statement of such compliance in the notes. Financial statements shall not be described as complying with IFRS unless they comply with all the requirements of IFRS.

Underlying principles:

• Fair presentation. Financial statements shall present fairly the financial position, financial performance, and cash flows of a company. In virtually all circumstances, a fair presentation is achieved by compliance with applicable IFRS.

• Going concern. A business is presumed to be a going concern. If management has significant concerns about the company's ability to continue as a going concern, the uncertainties must be disclosed.

• Accrual basis. IAS No. 1 requires that a company prepare its financial statements, except for cash flow information, using the accrual basis of accounting.

• Consistency. The presentation and classification of items in the financial statements shall be retained from one period to the next unless a change is justified either by a change in circumstances or requirements of new IFRS.

• Materiality and Aggregation. Each material class of similar items must be presented separately in the financial statements. Dissimilar items may be aggregated only if they are individually immaterial.

Presentation requirements:

• No offsetting. Assets and liabilities, and income and expenses, may not be offset unless required or permitted by IFRS.

• Classified balance sheet. A business must normally present a classified balance sheet, separating current and non-current assets and liabilities. Only if a presentation based on liquidity provides information that is reliable and more relevant may the current/non-current split be omitted.

• Minimum information on the face of the financial statements. IAS No. 1 specifies the minimum line item disclosures on the face of, or in the notes to, the balance sheet, the income statement, and the statement of changes in equity.

• Minimum information in the notes. IAS No. 1 specifies disclosures about information to be presented in the financial statements.

• Comparative information. Comparative information shall be disclosed in respect of the previous period for all amounts reported in the financial statements, both on the face of financial statements and in notes.

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#### Annotation 1418095365388

Subject 5. Comparison of IFRS with Alternative Reporting Systems
#cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-standards

#### Annotation 1418097200396

Subject 1. Components and Format of the Income Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement

The income statement presents information on the financial results of a company's activities over a period of time. The format of the income statement is not specified by U.S. GAAP and the actual format varies across companies.

Here are common components:

• Sales or revenue: amount charged for the delivery of goods or services.

• Follows the revenue recognition rule: Revenue is recognized even though cash may not be collected until the following accounting period.
• Net sales = gross sales - sales returns and allowances - discounts.
• Amount of sales and trends in net sales over time are used to analyze a company's progress.

• Cost of goods sold is the amount paid for merchandise sold, or the cost to manufacture products that were sold, during an accounting period.

• Gross margin = net sales - costs of goods sold. Also called gross profit.

Management is interested in both:

• The amount of gross margin; and
• The percentage of gross margin (gross margin/net sales).

Both are useful in planning business operations.

• Operating expenses are expenses other than the cost of goods sold that are incurred in running a business.

• These expenses are grouped into categories: selling expenses, general and administrative expenses, and other revenues and expenses.
• Careful planning and control of operating expenses can improve a company's profitability.

• Income from operations (also called operating income) is the difference between gross margin and operating expenses. It represents the income from a company's normal, or main, business. It is used to compare the profitability of companies or divisions within a company.

• Other revenues and expenses are not part of a company's operating activities. These include:

• Revenues or expenses from investments (e.g., dividends and interest).
• Interest and other expenses from borrowing.
• Any other revenue or expense not related to the company's normal business operations.

They are also called non-operating revenues and expenses.

• Income before income taxes is the amount a company has earned from all activities - operating and non-operating - before taking into account the amount of income taxes the company incurred.

This is used to compare the profitability of two or more companies or divisions within a company. Comparisons are made before income taxes are deducted because companies may be subject to different income tax rates.

• Income taxes (also called provision for income taxes) represent the expense for federal, state, and local taxes on corporate income.

The income taxes account is shown as a separate item on the income statement. Tax rates are substantial (usually 15-38%) and have a significant effect on business decisions. Most other types of taxes are shown among operating expenses.

• Net income is what remains of the gross margin after operating expenses are deducted, other revenues and expenses are added or deducted, and income taxes are deducted. It is the final figure, or "bottom line," of the income statement.

Net income = Income before income taxes - income taxes

Net income is an important performance measure.

• It represents the amount of business earnings that accrue to stockholders.
• It is the amount transferred to retained earnings from all income generating activities during the year.
• It is often used to determine whether a business has been operating successfully.

The...

#### Flashcard 1418099035404

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[...] and [...] during labour can decrease FHR variability
maternal acidemia (diabetic ketoacidosis); analgesic drugs

status measured difficulty not learned 37% [default] 0

#### Flashcard 1418100870412

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FHR Variability tends to [increase/decrease] ​with increasing fetal tachycardia.
decrease

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#### Flashcard 1418104016140

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What is a normal EFM tracing baseline?
110-160 bpm

status measured difficulty not learned 37% [default] 0

#### Annotation 1418104540428

Subject 2. Revenue Recognition
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
There are two revenue and expense recognition issues when accrual accounting is used to prepare financial statements:

• Timing: when should revenue and expense be recognized?
• Measurement: how much revenue and expense should be recognized?

Revenue is generally recognized when it is (1) realized or realizable, and (2) earned.

The general rule for revenue recognition includes the "concept of realization." Two conditions must be met for revenue recognition to take place:

1. Completion of the earnings process

The company must have provided all or virtually all the goods or services for which it is to be paid, and it must be possible to measure the total expected cost of providing the goods or services. No remaining significant contingent obligation should exist. This condition is not met if the company has the obligation to provide future services (such as warranty protection) but cannot estimate the associated expenses.

2. Assurance of payment

The quantification of cash or assets expected to be received for the goods or services provided must be reliable.

These conditions are typically met at the time of sale, but there are many exceptions, which will be discussed next.

#### Annotation 1418106375436

Subject 3. Revenue Recognition in Special Cases
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
In limited circumstances, specific revenue recognition methods may be applicable.

Long-term Contracts

A long-term contract is one that spans multiple accounting periods. How should a company apportion the revenue earned under a long-term contract to each accounting period?

• If the outcome of a long-term contract can be reliably measured, both IFRS and U.S. GAAP require the use of the percentage-of-completion method.
• If the outcome of a long-term contract can NOT be reliably measured:

• Under IFRS, revenue is only reported to the extent of contract costs incurred. Costs are expensed in the period incurred.
• Under U.S. GAAP, no revenue is reported until the contract is finished. This is called the completed contract method.

• If a loss is expected on a contract, the loss is reported immediately, regardless of the method used.

Percentage-of-completion

Revenues and expenses are recognized each period in proportion to the work completed. This is used for a long-term project if all of the following conditions are met:

• There is a contract.
• There are reliable estimates of revenues, costs, and progress towards completion.
• The buyer can be expected to pay the full contract price on schedule.

It recognizes profit corresponding to the percentage of cost incurred to total estimated costs associated with long-term construction contracts. It is the preferred method because it provides a better measure of operating activities and a more informative disclosure of the status of incomplete contracts. It also facilitates the forecast of future performance and cash flows. This method highlights the relationship among the income statement (revenues), the balance sheet (resulting receivables), and the cash flow statement (current collections).

The percentage-of-completion is equal to actual cost/estimated total cost, or it can be determined by an engineering estimate. Using the first approach:

• Percent completed = Costs incurred to date / Most recent estimate of total costs.
• Revenue to be recognized to-date = Percent complete x Estimated total revenue.
• Current period revenue = Revenue to be recognized to date - revenue recognized in prior periods.

To date, the most recent estimate of the total cost is used in computing the progress toward completion. It means that if cost estimates are revised as the project progresses, that effect is recognized in the period in which the change is made. Costs and revenues of prior periods are not restated.

Completed Contract

This method does not recognize revenue and expense until the contract is completed and the title is transferred. All profits are recognized when the contract is completed. The completed contract method is used when:

• There is no contract; or
• Estimates of revenues, costs, or progress towards completion are unreliable; or
• The ability to collect revenues from the buyer is uncertain.

This method is more conservative than the percentage-of-completion method. Analysts may need to rely on the statement of cash flows to assess the contribution of long-term contracts to a company's profitability.

Installment Sales

This method is used if the costs to provide goods or services are known but the collectability of sales proceeds cannot be reasonably determined. It recognizes both revenue and the associated cost of goods sold only when cash is received. Gross profit (sales - costs of goods sold) reflects the proportion of cash received. This method is sometimes used to report income from sales of noncurrent assets and real estate transactions.

Cost Recovery

This method is similar to the installment sales method but is more conservative. It ...

#### Annotation 1418108210444

Subject 4. Revenue Recognition Accounting Standards Issued May 2014
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
In May 2014, the IASB and FASB each issued a converged standard for revenue recognition. The standards are effective for reporting periods beginning after 1 January 2017 under IFRS and 15 December 2016 under U.S. GAAP.

Key aspects of the converged accounting standards:

The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services.

Companies under contract to provide goods or services to a customer will be required to follow a five-step process to recognize revenue:
1. Identify contract(s) with a customer
2. Identify the separate performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when the entity satisfies each performance obligation
There is new guidance on whether revenue should be recognized at a point in time or over time. The standard provides detailed guidance on various issues such as identifying distinct performance obligations, accounting for contract modifications, and accounting for the time value of money. Detailed implementation guidance is included on topics such as sales with a right of return, customer options for additional goods or services, etc. The standard also introduces new guidance on costs of fulfilling and obtaining a contract and specifying the circumstances in which such costs should be capitalized. Costs that do not meet the criteria must be expensed when incurred.

The standard introduces new, increased requirements for disclosure of revenue in a reporter's financial statements.

#### Annotation 1418110045452

#obgyn
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Annotation 1418111356172

Subject 5. Expense Recognition
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
The matching principle states that operating performance can be measured only if related revenues and expenses are accounted for during the same period ("let the expense follow the revenues"). Expenses are recognized not when wages are paid, when the work is performed, or when a product is produced, but when the work (service) or the product actually makes its contribution to revenue. Thus, expense recognition is tied to revenue recognition.

Expenses incurred to generate revenues must be matched against those revenues in the time periods when the revenues are recognized.

• If the revenues are recognized in the current period, the associated expenses should be recognized in the current period and appear in the income statement.
• If revenues are expected to be recognized in future periods, the associated expenses are capitalized (appearing on the balance sheet of the current period as an asset). When the revenues are recognized in future periods, the asset is converted to expenses in those periods.

The problem of expense recognition is as complex as that of revenue recognition. For costs that are not directly related to revenues, accountants must develop a "rational and systematic" allocation policy that will approximate the matching principle. However, matching permits certain costs to be deferred and treated as assets on the balance sheet when in fact these costs may not have future benefits. If abused, this principle permits the balance sheet to become a "dumping ground" for unmatched costs.

The Matching of Inventory Costs with Revenues

Some issues in expense recognition:

Doubtful Accounts

Account receivables arise from sales to customers who do not immediately pay cash. There are always some customers who cannot or will not pay their debts. The accounts owed by these customers are called uncollected accounts. Therefore, accounts receivables are valued and reported at net realizable value - the net amount expected to be received in cash, which is not necessarily the amount legally receivable. The chief problem in recording uncollectible accounts receivable is establishing the time at which to record the loss.

Under the direct write-off method, uncollectible accounts are charged to expense in the period that they are determined to be worthless. No entry is made until a specific account has definitely been established as uncollectible. This method is easy and convenient to apply. However, it usually does not match costs with revenues of the period, nor does it result in receivables being stated at estimated realizable value on the balance sheet.

Advocates of the allowance method believe that bad debt expense should be recorded in the same period as the sale to obtain a proper matching of expenses and revenues and to achieve a proper carrying value for accounts receivable. In practice, the estimate of bad debt is made either on the percentage-of-sales basis (income statement approach) or outstanding-receivables basis (balance sheet approach).

Warranties

Warranty costs are a classic example of a loss contingency. Although the future cost amount, due date, and customer are not known for certain, a liability is probable and should be recognized if it can be reasonably estimated.

Depreciation and Amortization

Financial Analysis Implications

In expense recognition, choice of method (i.e., the depreciation method and the inventory method) as well as estimates (i.e., uncollectible accounts, warranty expenses, assets' useful life, and salvage value) affect a company's reported income. An analyst should identify differences in companies' expense-recognition methods and adjust r...

#### Flashcard 1418111880460

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If abnormal FHR strip and resuscitation interventions ([...]) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour

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Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Flashcard 1418113453324

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to [...] if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
c/s

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Flashcard 1418115026188

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~[...] cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
3

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Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Flashcard 1418116599052

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~[...]cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
8

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Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Flashcard 1418118171916

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If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, [...] can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).
fetal scalp sampling

status measured difficulty not learned 37% [default] 0

Open it
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have assisted vag delivery (forceps/vacuum).

#### Flashcard 1418120531212

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Question
If abnormal FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have [...].
assisted vag delivery (forceps/vacuum)

status measured difficulty not learned 37% [default] 0

Open it
l FHR strip and resuscitation interventions (change position, IV fluid, O2 (only if need), stop oxy if abn tracing while in labour) not working, move on to c/s if ~3 cm. If ~8cm, fetal scalp sampling can be good to make sure baby okay to have <span>assisted vag delivery (forceps/vacuum).<span><body><html>

#### Annotation 1418122628364

Subject 6. Non-Recurring Items and Non-Operating Items
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
The goal of analyzing an income statement is to derive an effective indicator to predict future earnings and cash flows. Net income includes the impact of non-recurring items, which are transitory or random in nature. Therefore, net income is not the best indicator of future income. Recurring pre-tax income from continuing operations represents the company's sustainable income and therefore should be the primary focus of analysis.

Segregating the results of recurring operations from those of non-recurring items facilitates the forecasting of future earnings and cash flows. Generally, analysts should exclude items that are non-recurring in nature when predicting a company's future earnings and cash flows. However, this does not mean that every non-recurring item in the income statement should be ignored. Management tends to label many items in the income statement as "non-recurring," especially those that reduce reported income. For the purpose of analysis, an important issue is to assess whether non-recurring items are really "non-recurring," regardless of their accounting labels.

There are four types of non-recurring items in an income statement.

1. Discontinued operations

Discontinued operations are not a component of persistent or recurring net income from continuing operations. To qualify, the assets, results of operations, and investing and financing activities of a business segment must be separable from those of the company. The separation must be possible physically and operationally, and for financial reporting purposes. Any gains or disposal will not contribute to future income and cash flows, and therefore can be reported only after disposal, that is - when realized.

• Subsidiaries and investees also qualify as separate components.
• Disposal of a portion of a business component does not qualify as discontinued operations. Instead, this is recorded as an unusual or infrequent item.

2. Extraordinary items

Extraordinary items are BOTH unusual in nature AND infrequent in occurrence, and material in amount. They must be reported separately (below the line) net of income tax.

Common examples are:

• Expropriations by foreign governments.
• Uninsured losses from earthquakes, eruptions, and tornadoes.

Note that gains and losses from the early retirement of debt used to be treated as extraordinary items; SFAS No. 145 now requires them to be treated as part of continuing operations.

3. Unusual or infrequent items

These are either unusual in nature OR infrequent in occurrence but not both. They may be disclosed separately (as a single-line item) as a component of income from continuing operations. They are reported pre-tax in the income statement and appear "above the line," while the other three categories are reported on an after-tax basis and "below the line" and excluded from net income from continuing operations.

Common examples are:

• Gains or losses from disposal of a portion of a business segment.
• Gains or losses from sales of assets or investments in affiliates or subsidiaries.
• Provisions for environmental remediation.
• Impairment, write-offs, write-downs, and restructuring costs (such as those costs related to the integration of acquired companies).

4. Changes in accounting principles

Changes in accounting principles, such as from LIFO to another inventory method or from the percentage-of-completion method to the completed-contract method, can be either voluntary changes or changes mandated by new accounting standards. They are reported in the same manner as extraordinary items and discontinued operations. The cumulative impact on prior period earnings should be reported as a separate line item on the income statement on...

#### Annotation 1418124463372

Subject 7. Earnings per Share
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Earnings per share (EPS) is a measure that is widely used to evaluate the profitability of a company.

A company's capital structure is simple if it consists of only common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. Companies with simple capital structures only need to report basic EPS.

A complex capital structure contains securities that could have a dilutive effect on earnings per common share. Dilutive securities are securities that, upon conversion or exercise, could dilute earnings per share. These securities include options, warrants, convertible bonds, and preferred stocks.

Companies with complex capital structures must report both basic EPS and diluted EPS. Calculation of diluted EPS under a complex capital structure allows investors to see the adverse impact on EPS if all diluted securities are converted into common stock.

Basic EPS

To calculate EPS in a simple capital structure:

The current year's preferred dividends are subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Since the number of common shares outstanding may change over the year, the weighted average is used to compute EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. Analysts need to find the equivalent number of whole shares outstanding for the year.

Three steps are used to compute the weighted average number of common shares outstanding:

• Identify the beginning balance of common shares and changes in the common shares during the year.
• For each change in the common shares:

• Compute the number of shares outstanding after each change in the common shares. Issuance of new shares increases the number of shares outstanding. Repurchase of shares reduces the number of shares outstanding.
• Weight the shares outstanding by the portion of the year between this change and next change: weight = days outstanding / 365 = months outstanding / 12

• Sum up to compute the weighted average number of common shares outstanding.

Stock Dividends and Splits

In computing the weighted average number of shares, stock dividends and stock splits are only changes in the units of measurement, not changes in the ownership of earnings. A stock dividend or split does not change the shareholders' total investment (i.e., it means more pieces of paper for shareholders).

When a stock dividend or split occurs, computation of the weighted average number of shares requires restatement of the shares outstanding before the stock dividend or split. It is not weighted by the portion of the year after the stock dividend or split occurred.

Specifically, before starting the three steps of computing the weighted average, the following numbers should be restated to reflect the effects of the stock dividend/split:

• The beginning balance of shares outstanding;
• All share issuance or purchase prior to the stock dividend or split.
• No restatement should be made for shares issued or purchased after the date of the stock dividend or split.

If a stock dividend or split occurs after the end of the year but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in comparative form) must be restated.

Example

1. 01/01/15 - 100,000 s...

#### Annotation 1418129444108

Subject 8. Analysis of the Income Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Common-Size Analysis of the Income Statement

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Income Statement Ratios

The following operating profitability ratios measure the rates of profit on sales (profit margins).

• Net Profit Margin shows how much profit is generated on every dollar of sales.

Net income is earnings after tax but before dividends (EBIT - interest - taxes). It should be based on earnings from the company's continuing operation because the analysis is to forecast the company's future performance. Thus analysts should not consider earnings from discontinued operations, gains or losses from the sale of discontinued operations, and non-recurring income or expenses.

• Gross Profit Margin equals percent of sales available after deducting cost of goods sold.

This percentage is available to cover selling, general and administrative costs, and also earn a profit. It indicates the basic cost structure of a company and shows the company's cost-price position. Comparing this ratio with the industry average over time shows the company's relative profitability within the industry.

• A declining gross profit may indicate increasing costs of production or declining prices.
• The ratio can be affected by changes in the company's product mix: a change toward items with higher (lower) margin raises (reduces) the gross profit margin.
• A small change in gross profit can result in a much larger change in profit margin if the company has high fixed costs.

#### Annotation 1418134424844

Subject 9. Comprehensive Income
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-income-statement
Comprehensive income includes both net income and other revenue and expense items that are excluded from the net income calculation.

Comprehensive income is the sum of net income and other items that must bypass the income statement because they have not been realized, including items like an unrealized holding gain or loss from available-for-sale securities and foreign currency translation gains or losses. These items are not part of net income, yet are important enough to be included in comprehensive income, giving the user a bigger, more comprehensive picture of the organization as a whole.

The following table is from the Statement of Stockholders' Equity section of the 3M's 2001 annual report.

This section describes the composition of comprehensive income. It begins with net income and then includes those items affecting stockholders' equity that do not flow through the income statement. For 3M, these items include:

• Unrealized gains (losses) on available-for-sale investments.
• Unrealized gains (losses) on derivative investments.

FASB has taken the position that income for a period should be all-inclusive comprehensive income. Comprehensive income may be reported on an income statement or separate statement, but is usually reported on a statement of stockholders' equity.

#### Annotation 1418137832716

Subject 1. Components and Format of the Balance Sheet
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-balance-sheets
The starting place for analyzing a company is typically the balance sheet. Think of the balance sheet as a photo of the business at a specific point in time. It presents the assets, liabilities, and equity ownership of a company as of a specific date.

• Assets are the economic resources controlled by the company.
• Liabilities are the financial obligations that the company must fulfill in the future. Liabilities are typically fulfilled by payment of cash. They represent the source of financing provided to the company by the creditors.
• Equity ownership is the owner's investments and the total earnings retained from the commencement of the company. Equity represents the source of financing provided to the company by the owners.

The balance sheet provides users, such as creditors and investors, with information regarding the sources of finance available for projects and infrastructure. At the same time, it normally provides information about the future earnings capacity of a company's assets as well as an indication of cash flow implicit in the receivables and inventories.

The balance sheet has many limitations, especially relating to the measurement of assets and liabilities. The lack of timely recognition of liabilities and, sometimes, assets, coupled with historical costs as opposed to fair value accounting for all items on the balance sheet, implies that the financial analyst must make numerous adjustments to determine the economic net worth of the company.

The analyst must understand the components, structure, and format of the balance sheet in order to evaluate the liquidity, solvency, and overall financial position of a company.

Balance Sheet Format

Balance sheet accounts are classified so that similar items are grouped together to arrive at significant subtotals. Furthermore, the material is arranged so that important relationships are shown.

The table below indicates the general format of balance sheet presentation:

This format is referred to as the account format, which follows the pattern of the traditional general ledger accounts, with assets at the left and liabilities and equity at the right of a central dividing line. A report format balance sheet lists assets, liabilities, and equity in a single column.

Balance Sheet Components

Current Assets

These are cash and other assets expected to be converted into cash, sold, or consumed either in one year or in the operating cycle, whichever is longer. The operating cycle is the average time between the acquisition of materials and supplies and the realization of cash through sales of the product for which the materials and supplies were acquired. The cycle operates from cash through inventory, production, and receivables back to cash. Where there are several operating cycles within one year, the one-year period is used. If the operating cycle is more than one year, the longer period is used.

Long-Term Investments

Often referred to simply as investments, these are to be held for many years and are not acquired with the intention of disposing of them in the near future.

• Investments in securities such as bonds, common stock, or long-term notes that management does not intend to sell within one year.
• Investments in tangible fixed assets not currently used in operations, such as land held for speculation.
• Investments set aside in special funds, such as a sinking fund, pension fund, or plant expansion fund. The cash surrender value of life insurance is included here.
• Investments in non-consolidated subsidiaries or affiliated companies.
...

#### Flashcard 1418139667724

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Question
What is an atypical EFM tracing baseline?
-tachy >160bpm for >30 but <80 min
-rising baseline

status measured difficulty not learned 37% [default] 0

#### Flashcard 1418144386316

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What is an abnormal EFM tracing baseline?
-tachy >160bpm for >80min
-erratic baseline

status measured difficulty not learned 37% [default] 0

#### Annotation 1418144910604

Subject 2. Measurement Bases of Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Asset and liability values reported on a balance sheet may be measured on the basis of fair value or historical cost. Historical cost values may be quite different from economic values. The balance sheet must be evaluated critically in light of accounting policies applied in order to answer the question of how the values relate to economic reality and to each other.

Current Assets

Current assets are presented in the balance sheet in order of liquidity. The five major items found in the current assets section are:

• Cash. Valued at its stated value. Cash restricted for purpose other than payment of current obligations or for use in current operations should be excluded from the current asset section.
• Marketable securities. Valued at cost or lower of cost and market value.
• Accounts receivables. Amounts owed to the company by its customers for goods and services delivered. Valued at the estimated amount collectible.
• Inventories. Products that will be sold in the normal course of business. They should be measured at the lower of cost or net realizable value. Refer to Reading 29 [Inventories] for details.
• Pre-paid expenses. These are expenditures already made for benefits (usually services) to be received within one year or the operating cycle, whichever is longer. Typical examples are pre-paid rent, advertising, taxes, insurance policies, and office or operating supplies. They are reported at the amount of un-expired or unconsumed cost.

Current Liabilities

Current liabilities are typically paid from current assets or by incurring new short-term liabilities. They are not reported in any consistent order. A typical order is: accounts payable, notes payable, accrued items (e.g., accrued warranty costs, compensation and benefits), income taxes payable, current maturities of long-term debt, unearned revenue, etc.

Tangible Assets

These are carried at their historical cost less any accumulated depreciation or accumulated depletion. See Reading 30 [Long-Lived Assets] for details.

Intangible Assets

Intangible assets are long-term assets that have no physical substance but have a value based on rights or privileges that belong to their owner. Generally, identifiable intangible assets are recorded only when purchased (at acquisition costs). The cost of internally developed identifiable intangible assets is typically expensed when incurred. For example, R&D costs are not in themselves intangible assets. They should be treated as revenue expenditures and charged to expense in the period in which they are incurred. One exception is that IFRS allows costs in the development stage to be capitalized if certain criteria (including technological feasibility) are met.

A company should assess whether the useful life of an intangible asset is finite or infinite and, if finite, the length of its life. The straight-line method is typically used for amortization.

Goodwill is an example of an unidentifiable intangible asset which cannot be acquired singly and typically possesses an indefinite benefit period. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill.

Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth.

Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally hig...

#### Flashcard 1418147532044

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Question
What is normal EFM tracing variability?
- 6-25bpm
- =/< 5bpm for <40 min

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#### Annotation 1418148580620

Subject 3. Financial Instruments: Financial Assets and Financial Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Financial instruments are contracts that give rise to both a financial asset of one company and a financial liability of another company. Financial instruments come in a variety of forms which include derivatives, hedges, and marketable securities.

Measured at fair market value:

Financial assets:

• Financial assets held for trading.
• Available-for-sale financial assets.
• Derivatives (whether stand-alone or embedded in non-derivative instruments).
• Non-derivative instruments with fair value exposures hedged by derivatives.

Financial liabilities:

• Derivatives.
• Financial liabilities held for trading.
• Non-derivative instruments with fair value exposures hedged by derivatives.

Measured at cost or amortized cost:

Financial assets:

• Unlisted instruments (there is no reliable valuation measure).
• Held-to-maturity investments (bonds).
• Loans and receivables.

Financial liabilities:

• All other liabilities (such as bonds payable or notes payable).

Accounting for Gains and Losses on Marketable Securities

• Held-to-maturity securities. Debt securities that management intends to hold to their maturity dates. At year-end, they are reported at cost adjusted for the effect of interest (debit the securities account and credit the interest income account) and unrealized holding gains and losses are not recognized.

• Trading securities. Debt and equity securities bought and held mainly for sale in the short term to generate income on price changes. At year-end, they are reported at their fair market value. Any unrealized holding gains or losses are recognized on the company's income statement as part of net income. When they are sold, the realized gains or losses will also appear on the income statement. Realized gains and losses are not affected by any unrealized gains or losses recognized before.

• Available-for-sale securities. Debt and equity securities not classified as held-to-maturity or trading securities. Unrealized gains and losses are reported as part of other comprehensive income (in contrast, the unrealized gains or losses of trading securities are reported in the income statement as part of net income). Other than that, they are accounted for in the same way as trading securities.

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Question
What is atypical EFM tracing variability?
- =/< 5bpm for 40-80 min

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Question
What is abnormal EFM tracing variability?
- =/< 5bpm for >80 min
- =/> 25 bpm for > 10 min
- sinusoidal

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Question
What is normal EFM tracing decels?
- none
- occasional uncomplicated variables
- early decels

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What are atypical EFM tracing decels?
- repetitive (3+) uncomplicated variable decels
- occasional late decels
- single prolonged decel >2 but <3 min

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What are abnormal EFM tracing decels?
- repetitive (3+) complicated variables (decels to <70 bpm for >60 sec; loss of variability in trough or in baseline; biphasic decels; overshoots; slow return to baseline; baseline lower after decel; baseline tachy/brady)
- late decels >50% of contractions
- single prolonged decel >3 but <10 min

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What are features of complicated variables seen in abnormal EFM?
- decels to <70 bpm for >60 sec
- loss of variability in trough or in baseline
- biphasic decels
- overshoots
- baseline lower after decel

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Question
What are normal EFM tracing accels?
- spontaneous accels present
- FHR increases >15 bpm lasting > 15 sec (>10 bpm for >10 sec if <32 wk)
- accels present w/ fetal scalp stimulation

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Question
What are atypical EFM tracing accels?
absence of accel w/ fetal scalp stimulation

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What are abnormal EFM tracing accels?
usually absent (but if present, doesn't change classification of tracing)

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Question
What action can you take for normal EFM tracing?
EFM can be interrupted for periods up to 30 min if maternal-fetal condition stable and/or oxytocin infusion rate stable

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What actions can you take for atypical EFM tracing?
further vigilant assessment required (especially when combined features present)

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What action is required for abnormal EFM tracing?
ACTION REQUIRED
- review overall clinical situation
- obtain scalp pH if appropriate
- prepare for delivery

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What are the 10 steps of managing an abn fetal tracing?
1 . Reposition patient to increase uteroplacental perfusion or alleviate cord compression
2 . Check maternal vitals
3 . Correct maternal hypovolemia, if present, by increasing IV fluids
4 . Stop oxytocin if applicable
5 . Administer oxygen at 8 to 10 L/min
6 . Rule out fever, dehydration, drug effect, prematurity
7 . Consider initiation of electronic fetal monitoring to clarify and document components of FHR
8 . If external monitor already in place, consider applying an internal fetal scalp electrode
9 . Consider fetal scalp sampling if appropriate
10. If abnormal findings persist despite corrective measures and other tests are not available (like fetal scalp pH) or desirable, the delivery should be considered

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Question
fetal scalp blood sampling (FBS) is done when?
in pts with abn FHR patterns

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If fetal scalp pH is 7.25+ what should you do?
- continue w/ labour
- FBS (fetal scalp blood sampling) should be repeated if abnormality persists

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If fetal scalp pH 7.21 - 7.24, what should you do?
- continue w/ labour
- repeat FBS in 30 min or consider delivery if rapid fall since last sample

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If fetal scalp pH is =/< 7.20, what should you do?
delivery is indicated

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Question
What are the 6 steps to interpreting a FHR tracing?
1 . What is the uterine contraction frequency? (check the paper speed)
2 . What is the baseline fetal heart rate?
3 . What is the baseline variability?
• Absent
• Minimal
• Moderate/average
• Excessive
4 . Periodic changes noted on this tracing are:
• Accelerations
• Early decelerations
• Late decelerations
• Variable decelerations
5 . This tracing is classified as:
• Normal
• Atypical
• Abnormal
6 . What would be your management?

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Question
meconium aspiration syndrome is more likely to occur in:
- post-term pregnancy
- pregnancies complicated by IUGR

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#### Annotation 1418209398028

#obgyn
Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.

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Meconium aspiration may cause both [...] and chemical pneumonitis, in addition to severe pulmonary hypertension.
mechanical obstruction of the airways

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.

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Meconium aspiration may cause both mechanical obstruction of the airways and [...], in addition to severe pulmonary hypertension.
chemical pneumonitis

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to [...].
severe pulmonary hypertension

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Meconium aspiration may cause both mechanical obstruction of the airways and chemical pneumonitis, in addition to severe pulmonary hypertension.

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Question
List 5 predisposing factors to cord prolapse
- malpresentation
- prematurity
- abn fetus
- mult pregnancy
- polyhydramnios
- premature ROM
- AROM
- high presenting part
- obstetric procedures (ECV)

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#### Annotation 1418217262348

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If infant is vigorous and crying immediately after birth, suctioning the mouth and nares is not necessarily recommended in the presence of meconium

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If infant is vigorous and crying immediately after birth, [...] is not necessarily recommended in the presence of meconium
suctioning the mouth and nares

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If infant is vigorous and crying immediately after birth, suctioning the mouth and nares is not necessarily recommended in the presence of meconium

#### Annotation 1418220145932

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If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.

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If infant is depressed at birth, [...] and suctioning of meconium from the lower airway should be done.
tracheal intubation

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If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.

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If infant is depressed at birth, tracheal intubation and [...] should be done.
suctioning of meconium from the lower airway

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If infant is depressed at birth, tracheal intubation and suctioning of meconium from the lower airway should be done.

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What should you do when a multip is fully dilated and delivering and the cord pops out?
push cord back in and try to deliver quickly

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What is the management of cord prolapse on delivery? (3 main steps + components of each)
1. assess fetal viability
- check for cord pulsations
- if fetus already dead/too immature to survive/lethal anomaly, intervention for fetal reasons are inappropriate (allow vag deliv or c/s if transverse lie)
2. relieve cord compression
- if cord outside introitus, gently replace in vagina
- with hand in vagina, cradle cord in palm & use tips of fingers to elevate presenting part off of cord
- adjust maternal position to trendelenberg (head lower than pelvis) or knee-chest
3. method of delivery
- if cervix fully dilated & present part low, do assisted vag deliv
- if cervix not fully dilated/vag deliv dangerous, do immediate CS

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[#] ​ high-risk HPV types responsible for development of most cancers
13

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#### Annotation 1418230107404

Subject 4. Equity
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-balance-sheets
Equity is a residual value of assets which the owner has claim to after satisfying other claims on the assets (liabilities). There are five potential components that comprise the owner's equity section of the balance sheet:

• Contributed capital. The amount of money which has been invested in the business by the owners. This includes preferred stocks and common stocks. Common stock is recorded at par value with the remaining amount invested contained in additional paid-in capital.

• Minority interest.

• Retained earnings. These are the total earnings of the company since its inception less all dividends paid out.

• Treasury stock. This is a company's own stock that has

• Already been fully issued and was outstanding;
• Been reacquired by the company; and
• Not been retired.

It decreases stockholder's equity and total shares outstanding.

• Accumulated comprehensive income. This includes items such as the minimum liability recognized for under-funded pension plans, market value changes in non-current investments, and the cumulative effect of foreign exchange rate changes. Refer to Reading 25 [Understanding the Income Statement] for details.

Statement of Changes in Shareholders' Equity

This statement reflects information about increases or decreases to a company's net assets or wealth. It reveals much more about the year's stockholders' equity transactions than the statement of retained earnings.

• The statement of shareholders' equity is a financial statement that summarizes changes that occurred during the accounting period in components of the stockholders' equity section of the balance sheet. For example, it includes capital transactions with owners (e.g., issuing shares) and distributions to owners (i.e., dividends).
• The shareholders' equity section of the balance sheet lists the items in contributed capital and retained earnings on the balance sheet date.

#### Annotation 1418231942412

Subject 5. Uses and Analysis of the Balance Sheet
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-balance-sheets
Common-Size Analysis of Balance Sheets

This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques].

Balance Sheet Ratios

Liquidity ratios measure the ability of a company to meet future short-term financial obligations from current assets and, more importantly, cash flows. Each of the following ratios takes a slightly different view of cash or near-cash items.

• Current Ratio is a measure of the number of dollars of current assets available to meet current obligations. It is the best-known liquidity measure. A current ratio of less than 1 indicates the company has negative working capital.

• Quick Ratio (Acid-Test Ratio) eliminates less liquid assets, such as inventory and pre-paid expenses, from the current ratio. If inventory is not moving, the quick ratio is a better indicator of cash and near-cash items that will be available to meet current obligations.

• Cash Ratio is the most conservative liquidity ratio, determined by eliminating receivables from the quick ratio. As with the elimination of inventory in the quick ratio, there is no guarantee that the receivables will be collected.

Solvency ratios measure a company's ability to meet long-term and other obligations.

• Long-Term Debt-Equity Ratio is an indicator of the degree of protection available to the creditors in the event of insolvency of a company. Higher debt-equity ratio indicates higher financial risk.

• Debt-Equity Ratio includes short-term debt in the numerator.

The total debt includes all liabilities, including non-interest-bearing debt such as accounts payables, accrued expenses, and deferred taxes. This ratio is especially useful in analyzing a company with substantial financing from short-term borrowing.

• Total Debt Ratio =

• Financial Leverage Ratio =

Financial statement analysis aims to investigate a company's financial condition and operating performance. Using financial ratios helps to examine relationships among individual data items from financial statements. Although ratios by themselves cannot answer questions, they can help analysts ask the right questions in financial statement analysis. As analytical tools, ratios are attractive because they are simple and convenient. However, ratios are only as good as the data upon which they are based and the information with which they are compared.

From the...

#### Annotation 1418244787468

Subject 1. Classification of Cash Flows and Non-Cash Activities
#cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-cashflow-statements
The cash flow statement provides important information about a company's cash receipts and cash payments during an accounting period as well as information about a company's operating, investing and financing activities. Although the income statement provides a measure of a company's success, cash and cash flow are also vital to a company's long-term success. Information on the sources and uses of cash helps creditors, investors, and other statement users evaluate the company's liquidity, solvency, and financial flexibility.

Cash receipts and cash payments during a period are classified in the statement of cash flows into three different activities:

Operating Activities

These involve the cash effects of transactions that enter into the determination of net income and changes in the working capital accounts (accounts receivable, inventory, and accounts payable). Cash flows from operating activities (CFOs) reflect the company's ability to generate sufficient cash from its continuing operations. CFOs are derived by converting the income statement from an accrual basis to a cash basis. For most companies, positive operating cash flows are essential for long-run survival.

The major operating cash flows are (1) cash received from customers, (2) cash paid to suppliers and employees, (3) interest and dividends received, (4) interest paid, and (5) income taxes paid.

Special items to note:

• Interest and dividend revenue, and interest expenses, are considered operating activities, but dividends paid are considered financing activities. Note that interest expense is reported on the income statement while dividends flow through the retained earnings statement.

Remember that an interest/dividend item is an operating activity if it appears on the income statement. For example, payments of dividends do not appear on the income statement, and thus are not classified as operating activities.

• All income taxes are considered operating activities, even if some arise from financing or investing.

• Indirect borrowing using accounts payable is not considered a financing activity - such borrowing would be classified as an operating activity.

Investing Activities

These include making and collecting loans and acquiring and disposing of investments (both debt and equity) and property, plants, and equipment. In general, these items relate to the long-term asset items on the balance sheet. Investing cash flows reflect how a company plans its expansions.

Examples are:

• Sale or purchase of property, plant and equipment.
• Investments in joint ventures and affiliates and long-term investments in securities.
• Loans to other entities or collection of loans from other entities.

Financing Activities

These involve liability and owner's equity items, and include:

• Obtaining capital from owners and providing them with a return on (and a return of) their investments.
• Borrowing money from creditors and repaying the amounts borrowed.

In general, the items in this section relate to the debt and the equity items on the balance sheet. Financing cash flows reflect how the company plans to finance its expansion and reward its owners.

Examples:

• Dividends paid to stockholders (not interest paid to creditors!). Note that the cash outflow caused by dividends is determined by dividends paid, not dividends declared. Dividends paid are not reflected in the retained earnings account. The amount is provided in the supplementary information.
• Issue or repurchase of the company's stocks.
• Issue or retirement of long-term debt (including the current portion of long-term debt).

Purchase of debt and equity securities fro...

#### Annotation 1418246622476

Subject 2. Preparing the Cash Flow Statement
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #understanding-cashflow-statements
The beginning and ending cash balances on the statement of cash flows tie directly to the Cash and Cash Equivalents accounts listed on the balance sheets at the beginning and end of the accounting period.

Net income differs from net operating cash flows for several reasons.

• One reason is non-cash expenses, such as depreciation and the amortization of intangible assets. These expenses, which require no cash outlays, reduce net income but do not affect net cash flows.
• Another reason is the many timing differences existing between the recognition of revenue and expense and the occurrence of the underlying cash flows.
• Finally, non-operating gains and losses enter into the determination of net income, but the related cash flows are classified as investing or financing activities, not operating activities.

There are two methods of converting the income statement from an accrual basis to a cash basis. Companies can use either the direct or the indirect method for reporting their operating cash flow.

• The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.

• It adjusts each item in the income statement to its cash equivalent.
• It shows operating cash receipts and payments. More cash flow information can be obtained and it is more easily understood by the average reader.

• The indirect method reconciles net income to net cash flow from operating activities by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.

• It shows why net income and operating cash flows differ.
• It is used by most companies.

• The direct and indirect methods are alternative formats for reporting net cash flows from operating activities. Both methods produce the same net figure (dollar amount of operating cash flow).

• Under IFRS and U.S. GAAP, both the direct and indirect methods are acceptable for financial reporting purposes. However, the direct method discloses more information about a company. Partly because companies want to limit information disclosed, the indirect method is more commonly used.

• The reporting of investing and financing activities is the same for both direct and indirect methods. Only the reporting of CFO is different.

Direct Method

Under the direct method, the statement of cash flows reports net cash flows from operations as major classes of operating cash receipts and cash disbursements. This method converts each item on the income statement to its cash equivalent. The net cash flows from operations are determined by the difference between cash receipts and cash disbursements.

Assume that Bismark Company has the following balance sheet and income statement information:

• Receivables relate to sales and accounts payable relates to cost of goods sold.
• Depreciation of $5,000 and pre-paid expense both relate to selling and administrative expenses. Direct Method: • Cash sales: sales on the accrual basis are$242,000. Since the receivables have decreased by $8,000, the cash col ... status not read #### Annotation 1418257894668 Subject 3. Cash Flow Statement Analysis #cfa #cfa-level-1 #financial-reporting-and-analysis #understanding-cashflow-statements Evaluation of the Sources and Uses of Cash Analysts should assess the sources and uses of cash between the three main categories and investigate what factors drive the change of cash flow within each category. For example, if operating cash flow is growing, does that indicate success as the result of increasing sales or expense reductions? Are working capital investments increasing or decreasing? Is the company dependent on external financing? Answers to questions like these are critical for analysts and can help form a foundation for evaluating the financial health of an industry or company. Please refer to the textbook for specific examples. Common-Size Analysis of the Statement of Cash Flows This topic will be discussed in detail in Reading 28 [Financial Analysis Techniques]. Free Cash Flow to the Firm and Free Cash Flow to Equity From an analyst's point of view, cash flows from operation activities have two major drawbacks: • CFO does not include charges for the use of long-lived assets. Recall that depreciation is added back to net income in arriving at CFO. • CFO does not include cash outlays for replacing old equipment. Free Cash Flow (FCF) is intended to measure the cash available to a company for discretionary uses after making all required cash outlays. It accounts for capital expenditures and dividend payments, which are essential to the ongoing nature of the business. The basic definition is cash from operations less the amount of capital expenditures required to maintain the company's present productive capacity. Free cash flow = CFO - capital expenditure Free Cash Flow to the Firm (FCFF): Cash available to shareholders and bondholders after taxes, capital investment, and WC investment. FCFF = NI + NCC + Int (1 - Tax rate) - FCInv - WCInv • NI: Net income available to common shareholders. It is the company's earnings after interest, taxes and preferred dividends. • NCC: Net non-cash charges. These represent depreciation and other non-cash charges minus non-cash gains. The add-back of net non-cash expenses is usually positive, because depreciation is a major part of total expenses for most companies. • Int (1 - Tax rate): After-tax interest expense. Add this back to net income because: • FCFF is the cash flow available for distribution among all suppliers of capital, including debt-holders, and • Interest expense net of the related tax savings was deducted in arriving at net income. The add-back is after-tax, because the discount rate in the FCFF model (WACC) is also calculated on an after-tax basis. • FCInv: Investment in fixed capital. It equals capital expenditures for PP&E minus sales of fixed assets. • WCInv: Investment in working capital. It equals the increase in short-term operating assets net of operating liabilities. Example Quinton is evaluating Proust Company for 2014. Quinton has gathered the following information (in millions): • Net income:$250
• Interest expense: $50 • Depreciation:$130
• Investment in working capital: $20 • Investment in fixed capital:$100
• Tax rate: 30%
• Net borrowing: $180 • Proust has launched a new product in the market. It has capitalized$200 as an intangible asset out of a product launch expense of $240. • During the year, Proust has written down restructuring non-cash charges amounting to$30.
• The tax treatment of all non-cash items is the same as that of other items in the books. There are no differed taxes incurred.

Calculate the FCFF for Proust for the year.

Solution

NCC = Depreci...

#### Annotation 1418259729676

Subject 1. Analysis Tools and Techniques
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
Financial analysis techniques are useful in summarizing financial reporting data and evaluating the performance and financial position of companies. The results of financial techniques provide important inputs into security valuation.

Ratios

Ratios express one quantity in relation to another. As analytical tools, ratios are attractive because they are simple and convenient. They can provide a profile of a company, its economic characteristics and competitive strategies, and its unique operating, financial, and investment characteristics.

Ratio analysis is essential to comprehensive financial analysis. However, analysts should understand the following aspects when dealing with ratios:

• A ratio is not "the answer." A ratio is an indicator of some aspect of a company's performance in the past. It does not reveal why things are as they are. Also, a single ratio by itself is not likely to be very useful. For example, a current ratio of 2:1 may be viewed as satisfactory. If, however, the industry average is 3:1, such a conclusion may be questionable.
• Differences in accounting policies can distort ratios (e.g., inventory valuation, depreciation methods).
• Not all ratios are necessarily relevant to a particular analysis. Analysts should know the questions for which they want to find answers and know the questions that particular ratios can help answer.
• Ratio analysis does not stop with computation; interpretation of the result is also important.

Limitations: There are a significant number of estimates and subjective information that go into financial statements and therefore it is imperative that the analyst understands the numbers before calculating and relying on ratio analyses based on these numbers. An analyst needs to ask questions like:

• How homogeneous is the company? Are the ratios comparable between divisions within a company? It is critical to derive comparable industry ratios. However, many companies have multiple lines of business, making it difficult to identify the appropriate industry to use in comparing companies. Companies are required to provide segmented information that allows the user to see the impact of various segments on the overall company.

• Are the results of the ratio analysis consistent? An analyst needs to look at several ratios in conjunction in order to form a sensible conclusion. The total portfolio of the company should be used instead of only one set of ratios. A company must be viewed along all these lines since the company may have strengths and/or weaknesses in different areas. For example, a highly profitable company may have very poor short-term liquidity.

• Is the ratio within a reasonable range for the industry? Analysts must look at a range of values for a particular ratio because a ratio can be too high or too low.

• Are alternative companies' accounting treatments comparable? In comparsons companies, even within the same industry, companies may be using different accounting treatments and/or different estimates to capture the same event. Companies can use different estimates to calculate depreciation or bad debt expenses. Companies can use different inventory methods and may have operating versus capital leases in the financial statements. All of these accounting choices and estimates affect financial statements. Alternative treatments can cause a difference in results for the same events, especially when dealing with non-U.S. companies.

Common-size Analysis

Raw numbers hide relevant information that percentages frequently unveil. Common-size statements normalize balance sheet, income statement, and cash flow statement items to allow easier comparison of different-sized companies. They reduce all the dollar amounts ...

#### Annotation 1418264710412

Subject 2. Common Ratios
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
The ratios presented in the textbook are neither exclusive nor uniquely "correct." The definition of many ratios is not standardized and may vary from analyst to analyst, textbook to textbook, and annual report to annual report. The analyst's primary focus should be the relationships indicated by the ratios, not the details of their calculations.

Activity Ratios

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

• Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.

This ratio provides a better level of detail than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over very slowly, these ratios would not be a good measure of liquidity. The same applies for the inventory turnover below.

This ratio also implies an average collection period (the number of days it takes for the company's customers to pay their bills):

Remember, as with all ratios, these ratios are industry specific. The nature of the industry dictates a higher or lower receivables or inventory turnover. For receivables turnover, analysts don't want to derive too much from the norm, since a low number indicates slow-paying customers that cause capital to be tied up in receivables and bad debt and a high number indicates overly stringent credit terms that hurt sales. If a company's credit policy is 30 days and the days of sales outstanding is 45 days, then the credit policy needs to be reviewed.

• Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.

An abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.

• Payable turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers.

The following measures the number of days it takes for
...

#### Annotation 1418296429836

Subject 3. The DuPont System
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis #has-images
The breakdown of ROE into component ratios to assess the impact of those ratios is generally referred to as the DuPont Model.

• ROE = net income / common equity
• ROE = (net income / net sales) x (net sales / common equity). Therefore, ROE = (net profit margin) x (equity turnover).
• ROE = (net income / net sales) x (net sales / total assets) x (total assets / common equity)

Each of these components impacts the overall return to shareholders. An increase in profit margin, asset turnover, or leverage can all increase the return. There is a downside as well. If a company loses money in any year, the asset turnover or financial leverage multiplies this loss effect.

This implies that to improve its return on equity, a company should become more:

• Profitable (increase net profit margin, e.g., pricing and expense control).
• Efficient (increase total asset turnover, e.g., efficiency of asset use).
• Leveraged (increase its financial leverage ratio).

A company's over- or underperformance on ROA is due to one or both of these causes, or "drivers."

The extended DuPont model takes the above three factors and incorporates the effect of taxes and interest based on the level of financial leverage. It takes the profit margin and backs up to see the effect of interest and taxes on the overall return to shareholders. Therefore the extended model starts with EBIT (Earnings Before Interest and Taxes) rather than net income.

• EAT = EBT (1 - t), where t is the company's average tax rate. Substituting EBT(1 - t) for EAT in the expanded ROE equation gives us ROE = (EBT / sales)(sales / assets)(assets / equity)(1 - t).
• EBT = EBIT - I, where I equals the company's total interest expense. Substituting (EBIT - I) into the ROE equation for EBT gives us ROE = [(EBIT / sales)(sales / assets) - (interest expense / assets)] (assets / equity) (1 - t).
• Restated in accounting terms:

ROE = [(operating profit margin) x (total asset turnover) - (interest expense rate)] x (financial leverage multiplier) x (tax retention rate)

High financial leverage does not always increase ROE; higher financial leverage will lead to a higher interest expense rate, which may offset the benefits of higher leverage.

This breakdown will help an analyst understand what happened to a company's ROE and why it happened.

#### Annotation 1418299837708

Subject 4. Ratios Used in Equity Analysis, Credit Analysis, and Segment Analysis
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis
Equity Analysis

Analysts need to evaluate a company's performance in order to value a security. One of their valuation methods is the use of valuation ratios.

Some common valuations ratios are:

• P/E: Price per share / Earnings per share.

P/E is widely recognized and used by investors. Earning power is a chief driver of investment value, and EPS is perhaps the chief focus of security analysts' attention.

• P/CF: Price per share / Cash flow per share.

Cash flow is less subject to manipulation by management than earnings. Thus, P/CF ratios can be used to compare companies with different degrees of accounting aggressiveness. Moreover, cash flow is generally more stable than earnings, so P/CF ratios are more stable than P/Es. When EPS is abnormally high, low, or volatile, P/CF ratios are more reliable than P/Es.

• P/S: Price per share / Sales per share.

• Sales growth is the driving force for the growth of earnings and cash flows.
• Sales are positive even when EPS is negative.
• Sales are generally less subject to distortion or manipulation than are other fundamentals.

• P/BV: Price per share / Book value per share.

Similarly, book value is generally positive even when EPS is negative. Since book value per share is more stable than EPS, P/B may be more meaningful than P/E when EPS is abnormally high or low, or is highly variable.

These price multiples and dividend-related quantities are discussed in more detail in Study Session 14 (Equity Analysis and Valuation).

Credit Analysis

Credit analysis is the evaluation of credit risk.

How does an analyst who has calculated a ratio know whether it represents good, bad, or indifferent credit quality? Somehow, the analyst must relate the ratio to the likelihood that a borrower will satisfy all scheduled interest and principal payments in full and on time. In practice, this is accomplished by testing financial ratios as predictors of the borrower's propensity not to pay (to default). For example, a company with high financial leverage is statistically more likely to default than one with low leverage, all other factors being equal. Similarly, high fixed-charge coverage implies less default risk than low coverage. After identifying the factors that create high default risk, the analyst can use ratios to rank all borrowers on a relative scale of propensity to default.

Many credit analysts conduct their ratio analyses within ranking frameworks established by their employers. In the securities field, bond ratings provide a structure for analysis. Credit rating agencies such as Moody's and Standard & Poor's use financial ratios when assigning a credit rating to a company's debt issues. For example, credit ratios used by Standard & Poor's include EBIT interest coverage, funds from operations to total debt, total debt to EBITDA, and total debt to total debt plus equity.

Much research has been performed on the ability of ratios to assess the credit risk of a company (including the risk of bankruptcy) and predict bond ratings and bond yields.

Segment Analysis

A company may be involved in many different businesses, may do business in many different geographic areas, or may have significant number of customers. It is difficult to analyze a company with multiple business lines because of the inherent differences in financial structures, risk characteristics, etc,. amount the different lines. Aggregation of financial results for all the lines tends to obscure the true picture.

A company must disclose information related to various subdivisions of its business.

• Under IAS 14 (Segment Reporting), disclosures are required for reportable segments.
• U.S. GAAP requirements are similar to IFRS but less det
...

#### Annotation 1418301672716

Subject 5. Model Building and Forecasting
#cfa #cfa-level-1 #financial-analysis-techniques #financial-reporting-and-analysis
The results of financial analysis provide valuable inputs into forecasts of future earnings and cash flow. An analyst can build a model to forecast future performance of a company. Techniques that can be used include:

• Sensitivity Analysis. This is the study of how the variation in the output of a model can be apportioned to different sources of variation. (e.g., what will be the net income if more debt is issued?)

• Scenario Analysis. This considers both the sensitivity of financial outcome to changes in key financial variables and the likely range of variable values. The least "reasonable" set of circumstances (low unit sales, high construction costs, etc.) and the most "reasonable" set are specified first. The financial outcomes under the bad and good conditions are then calculated and compared to the expected, or base-case, outcome. Even though there are an infinite number of possibilities, scenario analysis only considers a few discrete outcomes.

• Monte Carlo Simulation. This is a risk analysis technique in which a computer is used to simulate probable future events and thus estimate the profitability and risk of a project. Random values of input variables are generated on a computer. The mean of the target variable is computed to measure the expected value. Standard deviation (or coefficient of variation) is computed to measure risks.

#### Annotation 1418303507724

Subject 1. Cost of Inventories
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
There are two basic issues involved in inventory accounting:

1. Determine the cost of goods available for sale: Beginning Inventory + Purchases.

2. Allocate the cost of total inventory costs (cost of goods available for sale) between two components: COGS on the income statement and the ending inventory on the balance sheet. Note that COGS = (Beginning Inventory + Purchases) - Ending Inventory. The cost flow assumption to be adopted includes specific identification, average cost, FIFO, LIFO, etc. This issue will be discussed in subsequent subjects.

Determination of Inventory Cost

IFRS and SFAS No. 151 provide similar treatment of the determination of inventory costs.

The cost of inventories, capitalized inventory costs, includes all costs incurred in bringing the inventories to their present location and condition.

• It includes production costs, invoice price (net of discount), transportation costs, taxes, part of fixed production overhead, etc.
• It does not include all abnormal costs incurred due to waste of materials, abnormal waste incurred for labor and overhead conversion costs from the production process, any storage costs, or any administrative overhead and selling costs. These costs are typically expensed in the accounting period instead of being considered inventory costs.

#### Annotation 1418305342732

Subject 2. Inventory Valuation Methods
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
In some cases, it's possible to specifically identify which inventory items have been sold and which remain. Using the specific identification method, the actual costs of the specific units sold are transferred from inventory to the cost of goods sold. (Debit Cost of Goods Sold; Credit Inventory.) This method achieves the proper matching of sales revenue and cost of goods sold when the individual units in the inventory are unique. However, the method becomes cumbersome and may produce misleading results if the inventory consists of homogeneous items. In most cases, companies may be unable to determine exactly which items are sold and which items remain in ending inventory.

The remaining three methods are referred to as cost flow assumptions under GAAP and cost formulas under IFRS. They should be applied only to an inventory of homogeneous items. The cost flow assumption may or may not reflect the physical flow of inventory.

Weighted Average Cost

Using the weighted average cost method, the average cost of all units in the inventory is computed and used in recording the cost of goods sold. This is the only method in which all units are assigned the same (average) per-unit cost.

• Average cost = (beginning inventory + purchases) / units available for sale
• Ending inventory = average cost x units of ending inventory
• COGS = cost of goods available for sale - ending inventory

FIFO

FIFO is the assumption that the first units purchased are the first units sold. Thus inventory is assumed to consist of the most recently purchased units. FIFO assigns current costs to inventory but older (and often lower) costs to the cost of goods sold.

LIFO

LIFO is the assumption that the most recently acquired goods are sold first. This method matches sales revenue with relatively current costs. In a period of inflation, LIFO usually results in lower reported profits and lower income taxes than the other methods. However, the oldest purchase costs are assigned to inventory, which may result in inventory becoming grossly understated in terms of current replacement costs.

LIFO is not allowed under IFRS. In the U.S., however, LIFO is used by approximately 36 percent of U.S. companies because of potential income tax savings.

Comparison of Inventory Accounting Methods

Inventory data is useful if it reflects the current cost of replacing the inventory. COGS data is useful if it reflects the current cost of replacing the inventory items to continue operations.

During periods of stable prices, all three methods will generate the same results for inventory, COGS, and earnings.

During periods of rising prices and stable or growing inventories, FIFO measures assets better (the most useful inventory data) but LIFO measures income better.

• Under LIFO, the cost of ending inventory is based on the earliest purchase prices, and thus is well below current replacement cost. For many firms using LIFO, the cost of inventory may be decades old and almost useless for analysis purposes. However, the cost of goods sold is based on the most recent purchase prices, and thus closely reflects current replacement costs. As a result, LIFO provides a better measurement of current income and future profitability.

• Under FIFO, the cost of ending inventory is based on the most recent purchase prices, and thus closely reflects current replacement cost. However, costs of goods sold are based on the earliest purchase prices, and this is well below the current replacement costs. The gain is actually holding gain or inventory profit. It is debatable whether this should be considered income; at least, analysts can say the underestimated COGS leads to inflated net income.

In an environment of declining inventory unit costs and constant or increasing inventory quantitie...

#### Annotation 1418307177740

Subject 3. Periodic versus Perpetual Inventory System
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The perpetual inventory system updates inventory accounts after each purchase or sale. Inventory quantities are updated continuously. When there is a sale, inventory is reduced and COGS is calculated.

The periodic inventory system records inventory purchase or sale in the "Purchases" account. The "Inventory" account is updated on a periodic basis, at the end of each accounting period (e.g., monthly, quarterly). Cost of goods sold or cost of sale is computed from the ending inventory figure.

With perpetual FIFO, the first (or oldest) costs are the first moved from the Inventory account and debited to the Cost of Goods Sold account. The end result under perpetual FIFO is the same as under periodic FIFO. In other words, the first costs are the same whether you move the cost out of inventory with each sale (perpetual) or whether you wait until the year is over (periodic).

With perpetual LIFO, the last costs available at the time of the sale are the first to be removed from the Inventory account and debited to the Cost of Goods Sold account. Since this is the perpetual system, we cannot wait until the end of the year to determine the last cost. An entry must be recorded at the time of the sale in order to reduce the Inventory account and increase the Cost of Goods Sold account.

If costs continue to rise throughout the entire year, perpetual LIFO will yield a lower cost of goods sold and a higher net income than periodic LIFO. Generally this means that periodic LIFO will result in lower income taxes than perpetual LIFO.

Example

Date....................................Units....Price
12.31.2008........Beginning Inventory....1.......85
1.1.2009..........Purchase...............1.......87
2.1.2009..........Purchase...............2.......89
6.1.2009..........Sales..................1.......89
12.1.2009.........Purchase...............1.......90

Under perpetual LIFO the following entry must be made at the time of the sale: $89 will be credited to Inventory and$89 will be debited from Cost of Goods Sold. If that was the only item sold during the year, at the end of the year the Cost of Goods Sold account will have a balance of $89 and the cost in the Inventory account will be$351 ($85 +$87 + $89 +$90).

Under periodic LIFO we assign the last cost of $90 to the one item that was sold. (If two items were sold,$90 would be assigned to the first item and $89 to the second item.) The remaining$350 is assigned to inventory. The $350 of inventory cost consists of$85 + $87 +$89 + $89. The$90 assigned to the item that was sold is permanently gone from inventory.

#### Annotation 1418309012748

Subject 4. The LIFO Method
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
In the U.S., firms that use LIFO must report a LIFO reserve. The LIFO reserve is the difference between the inventory balance shown on the balance sheet and the amount that would have been reported had the firm used FIFO. That is:

InventoryFIFO = InventoryLIFO + LIFO Reserve

It represents the cumulative effect over time of ending inventory under LIFO vs. FIFO.

When adjusting COGS from LIFO to FIFO: COGSFIFO = COGSLIFO - Change in LIFO Reserve.

LIFO Liquidations

So far, discussions have been based on the assumptions of rising prices and stable or growing inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO reserves can decline for either of the two reasons listed below. In either case, the COGS will be smaller and the reported income will be higher relative to what they would have been if the LIFO reserve had not declined. However, the implications of a decline in the LIFO reserve on financial analysis vary, depending on the reason for the decline.

• Liquidation of inventories. When a firm reduces its inventory, the old assets flow into income. The COGS figure no longer reflects the current cost of inventory sold. This is called LIFO liquidation. Gross profit margin will be abnormally high and unsustainable ("phantom" gross profits). To defer taxes indefinitely, purchases must always be greater than or equal to sales. A LIFO liquidation may signal that a company is entering an extended period of decline (and needs the "profit" to show as income). Analysts should exclude this profit from recurring earnings, as it is not operating in nature; the reported COGS should be restated by adding back the decline in the LIFO reserve to remove the artificial boost to net income.

• Price declines. The lower-cost current purchases enter reported LIFO COGS when purchase prices fall, reducing the cost differences between LIFO and FIFO ending inventories. As a result, the LIFO reserve declines. Such a decline is not considered a LIFO liquidation. Amounts on the balance sheet are still outdated but those on the income statement are still current. However, the tax benefits are lost under LIFO. For analytical purposes, no adjustment is required for declining prices, since price decreases are a normal business situation.

#### Annotation 1418310847756

Subject 5. Measurement of Inventory Value
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Under IFRS, inventories are reported at the lower of cost or net realizable value (NRV).

• If inventory declines in value below its original cost for whatever reason (obsolescence, price-level changes, damaged goods, etc.), the inventory should be written down to reflect this. If the NRV is lower than the cost, the ending inventory is written down to the NRV. The loss then is charged against revenues as an expense in the period in which the loss occurs, not in the period in which it is sold. However, if the NRV is higher than the cost, nothing is done. The increases in the value of the inventory are recognized only at the point of sale.
• A reversal (up to the amount of original write-down) is required if the inventory value goes up later.
• The amount of any reversal is recognized as a reduction in the cost of sales.
• This rule can be applied either directly to each inventory item, to each category, or to the total of the inventory. The most common practice is to price inventory on an item-by-item basis.

IFRS does not apply to the measurement of inventories held by producers of agricultural and forest products, mineral products, or commodity brokers and dealers. Their inventories are measured at net realizable value (above or below cost) in accordance with well-established practices in those industries.

Similarly, GAAP requires the use of the lower-of-cost-or-market valuation basis (LCM) for inventories, with market value defined as replacement cost. Reversal is prohibited, however. The LCM valuation basis follows the principle of conservatism (on both the balance sheet and income statement) since it recognizes losses or declines in market value as they occur, whereas increases are reported only when inventory is sold.

Here are some relevant terms:

• Net realizable value: Estimated selling price less estimated costs of completion necessary to make the sale.
• Historical cost: The cash equivalent price of goods or services at the date of acquisition.
• Market value (Replacement cost): The cost that would be required to replace an existing asset.
• Fair value: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm's length transaction.

Example

Historical cost: $5,000 Market cost:$2,000
Estimated selling price: $4,000 Estimated costs to complete sale:$1,000
Net realizable value: $4,000 -$1,000 = $3,000 • Inventory Valuation under IFRS:$3,000 (the lower of historical cost and NRV).
• Inventory Valuation under U.S. GAAP: $2,000 (the lower of historical cost and market cost). Now assume NRV increases from$3,000 to $4,000 and the market cost increases from$2,000 to $3,000. • Under IFRS,$1,000 of original write-down may be recovered to bring NRV up from $3,000 to$4,000. Note that reversals are limited to the amount of the original write-down ($2,000). • Under U.S. GAAP, the value of inventory is$2,000 even though the new market value is $3,000. No adjustment is made and reversal is prohibited. status not read #### Annotation 1418312682764 Subject 6. Financial Analysis of Inventories #cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories #inventories-long-lived-assets-income-taxes-and-non-current-liabilities Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company's inventory management. Presentation and Disclosure Consistency of inventory accounting policy is required under both U.S. GAAP and IFRS. If a company changes an inventory accounting policy, the change must be justifiable and all financial statements accounted for retrospectively. The one exception is for a change to the LIFO method under U.S. GAAP; the change is accounted for prospectively and there is no retrospective adjustment to the financial statements. Inventory Ratios Inventory turnover measures how fast a company moves its inventory through the system. This ratio can be used to measure how well a firm manages its inventories. The lower the ratio, the longer the time between when the good is produced or purchased and when it is sold. • An abnormally high inventory turnover and a short processing time could mean either effective inventory management or inadequate inventory, which could lead to outages, backorders, and slow delivery to customers (which would adversely affect sales). Revenue growth should be compared with that of the industry to assess which explanation is more likely. • An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory. Again, the analyst should compare the firm's revenue growth with that of the industry to assess the situation. Financial Analysis: FIFO versus LIFO The advantages of LIFO are: • Matching. Current costs are matched against revenues and inventory profits are thereby reduced. • Tax benefits. These are the major reason why LIFO has become popular. As long as the price level increases and inventory quantities do not decrease, a deferral of income tax occurs. "Whatever is good for tax is good for financial reporting." • Improved cash flow. This is related to tax benefits, because taxes must be paid in cash. • Future earnings hedge. With LIFO, a company's future reported earnings will not be affected substantially by future price declines. Since the most recent inventory is sold first, there isn't much ending inventory sitting around at high prices, vulnerable to a price decline. The disadvantages of LIFO: • Reduced earnings. Many managers would just rather have higher reported profits than lower taxes. However, non-LIFO earnings are now highly suspect and may be severely penalized by Wall Street. • Inventory understated. LIFO may have a distorting effect on a company's balance sheet. It makes the working capital position of the company appear worse than it really is. • Physical flow. LIFO does not approximate the physical flow of the inventory items except in particular situations. • Current cost income not measured. LIFO falls short of measuring current cost (replacement cost) income, though not as far as FIFO. Using replacement cost is referred to as the next-in, first-out method; it is not acceptable for purposes of inventory valuation. • Inventory liquidation. If the base or layers of old costs are eliminated ... status not read #### Annotation 1418319236364 Subject 1. Capitalizing versus Expensing #cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets The costs of acquiring resources that provide services over more than one operating cycle should be capitalized and carried as assets on the balance sheet. All costs incurred until an asset is ready for use must be capitalized, including the invoice price, applicable sales tax, freight and insurance costs incurred delivering equipment, and any installation costs. Costs of the long-lived asset should be allocated over current and future periods. In contrast, if these assets are expensed, their entire costs are written off as expense on the income statement in the current period. Accounting rules on capitalization are not straightforward. As a result, management has considerable discretion in making decisions such as whether to capitalize or expense the cost of an asset, whether to include interest costs incurred during construction in the capitalized cost, and what types of costs to capitalize for intangible assets. The choice of capitalization or expensing affects the balance sheet, income and cash flow statements, and ratios both in the year the choice is made and over the life of the asset. Here is a summary of the different effects of capitalization versus expensing: • Income variability. Firms that capitalize costs and depreciate them over time show "smoother" patterns of reported income. Firms that expense those costs as incurred tend to have higher variability of net income. • Profitability. In the early years expensing lowers profitability because the entire cost of the asset is expensed. In later years expensing results in higher net income because no more expense is charged in those years. This results in higher ROA and ROE because these expensing firms report lower assets and equity. • CFO. The net cash flow remains the same, but the compositions of cash flows differ. Cash expenditures for capitalized assets are included in investing cash flows and are never classified as CFO. In contrast, cash expenditures for expensed outlays are included in CFOand are never classified as investing cash flows. Capitalization results in higher CFO but lower investing cash flows, and the cumulative difference increases over time. • Leverage ratios. Capitalization firms have better (lower) debt-to-equity and debt-to-assets ratios, since they report higher assets and equities. Under SFAS 34, interest is capitalized for certain assets and only if the firm is leveraged. Therefore, the carrying amount of a self-constructed asset depends on the firm's financial decisions. The capitalized interest cost is added to the value of the asset being constructed. The amount of interest cost to be capitalized has two components: • Any interest on borrowed funds made specifically to finance the construction of the asset. The interest rate applicable is the interest rate on each borrowing. • The interest on other debt of the firm, up to the amount invested in the construction project. The interest rate applicable is the weighted-average interest rate on all outstanding debt not specifically borrowed for the asset under construction. Therefore, the total interest cost incurred during the accounting period has two parts: • Capitalized interest cost, which is reported as part of the asset on the balance sheet. Payments for capitalized interest cost are classified as an investing cash outflow and never as CFO. • Other interest cost, which is charged to expense on the income statement. Payments for such non-capitalized interest cost are reported as CFO. The total interest cost, along with the amount capitalized, must be disclosed as part of the notes to the financial statements. Once the construction is complete, capitalized interest costs will be written off as part of depreciation over the useful life of the asset. From ... status not read #### Annotation 1418321071372 Subject 2. Intangible Assets #cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets Intangible assets are identifiable nonmonetary resources controlled by firms. Examples include patents, copyrights, franchises, goodwill, trademarks, trade names, secret processes, property rights, and organization costs. Accounting for the Acquisition of Long-Lived Intangible Assets Accounting for an intangible asset depends on how it is acquired. 1. Intangible Assets Purchased in Situations Other than Business Combinations These are accounted for at acquisition costs. "Cost" includes purchase price, legal fees, and other expenses that make the intangibles ready for use. For example, fees paid to obtain a license or franchise are capitalized. Another example: expenditures on patents and copyrights purchased from another party are capitalized. They are amortized over their remaining legal lives or 40 years, whichever is less. The straight-line method is typically used for amortization. 2. Intangible Assets Developed Internally For internally generated intangible assets, it is difficult to measure costs, benefits, and economic lives. Generally, internally generated assets (such as costs of R&D, patents and copyrights, brands and trademarks, and advertising and secret processes) must be expensed in the period incurred. One exception is research and development (R&D) expenditures which add risk to investment with uncertain future economic benefits. As a result, they must be expensed as incurred in most countries (including the U.S.). SFAS 86 requires that all R&D costs to establish the technological and/or economic feasibility of software must be expensed. Subsequent costs that are beyond the point of technological feasibility can - but don't have to - be capitalized as part of product inventory and amortized based on revenues or on a straight-line basis. The point of technological feasibility is the point when a software prototype has been proven to be technologically feasible, as evidenced by the existence of a working model of the software. IFRS also requires research costs be expensed but allows development costs to be capitalized under certain conditions. As you can see, managers have considerable discretion in making decisions, such as whether or when to capitalize these costs and by how much. For software development costs, one particular risk is that capitalized costs will not be realized and a future write-down may be needed. If companies apply different approaches to capitalizing software development costs, adjustments can be made to make the two comparable. 3. Intangible Assets Acquired in a Business Combination Business combinations are accomplished when one entity (investor) acquires "control" over the net assets of another entity. The transaction is accounted for using the purchase method of accounting, in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. Any excess of cost over fair value of net assets acquired is recorded as goodwill. U.S. GAAP requires that in-process R&D (IPRD) of the target company should be expensed at the date of acquisition, which results in a large one-time charge. IFRS requires identifying IFRD as a separate asset with a finite life or including it as part of goodwill. Amortizing Intangible Assets with Finite Useful Lives An intangible asset with a finite useful life is amortized over its useful life. The estimates required for amortization calculations are: original valuation amount, residual value at the end of useful life, and the length of useful life. Example Torch, Inc. has developed a new device. Patent registration costs consisted of$2,000 in attorney fees and $1,000 in federal registration fees. The device has a useful life of 5 years. The legal life is 17 y... status not read #### Annotation 1418322906380 Subject 3. Depreciation Methods #cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets For accountants, depreciation is an allocation process, not a valuation process. It is important for analysts to differentiate between accounting depreciation and economic depreciation. Two factors affect the computation of depreciation: depreciable cost (acquisition cost - salvage or residual value) and estimated useful life (depreciable life). Note that it is depreciable cost, not acquisition cost, that is allocated over the useful life of an asset. The different depreciation methods are: • Straight Line Depreciation (SLD) This is the dominant method in the U.S. and most countries worldwide. It is based on the assumption that depreciation depends solely on the passage of time. The amount of depreciation expense is computed as: If income is constant, SLD will cause the asset base to decline, causing ROA to increase over time. For assets whose benefit may decline over time, the matching principle supports using an accelerated depreciation method. • Accelerated Depreciation Methods Accelerated depreciation methods are consistent with the matching principle because benefits from most depreciable assets are higher in the earlier years as the assets wear out. Therefore, more depreciation should be allocated to earlier years than to later years. Under the sum-of-the-years' digits (SYD) method, depreciation expense is based on a decreasing fraction of depreciable cost. The numerator decreases year by year but the denominator remains constant. As a result, this method applies higher depreciation expense in the early years and lower depreciation expense in later years. Where sum of years = (1 + 2 + 3 + ... + n) = n x (n + 1)/2, and years remaining = n - t + 1 (n: the estimated useful life. t: the index for current year). Double decline balance (DDB): Note that cost minus accumulated depreciation is the book value at the beginning of the year and that salvage value is not shown in the formula. For each year, however, depreciation is limited to the amount necessary to reduce book value to salvage value. With SYD and DDB methods, book value, net income, tax expense, and equity will be lower than with SLD in the earlier years of an asset's life. The percentage effect on net income is usually greater than the effects on assets and shareholders' equity. Consequently: • Profit margin is lower as net income is lower. • Asset turnover ratio is higher as assets are lower. • Debt-to-equity ratio is higher as equity is lower. • Return on assets ratio is lower; both net income and total assets are lower, but net income is lower by a larger percentage. • Return on equity ratio is lower; both net income and equity are lower, but net income is lower by a larger percentage. In later years the situation will reverse and income and book values will increase. This is true for individual assets. For a firm with stable or rising capital expenditures, however, the early-year impact of newly-acquired assets dominates. Therefore, an accelerated depreciation method will continuously result in lower reported earnings and tax expenses for these firms. • Units of Production (UOP) and Service Hours Method This method assumes that d ... status not read #### Annotation 1418329459980 Subject 4. The Revaluation Model #cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets Under U.S. accounting standards, it is compulsory to account for impairment in long-lived assets (downward revaluation). However, upward revaluation of long-lived assets to reflect fair market values is not allowed. The balance sheet is more informative when assets and liabilities are stated at market value rather than historical cost. IASB and some other non-U.S. GAAP do permit upward revaluations. The purpose of a revaluation is to bring into the books the fair market value of long-lived assets. • If an asset revaluation initially decreases the asset's carrying value, the decrease is recognized as a loss. Later, if there is an increase in the carrying value, the increase is recognized as a profit (up to the amount of the original decrease). • If an asset revaluation initially increases its carrying value, the increase bypasses the income statement and goes to equity (revaluation surplus). Later, if there is a decrease, it first decreases the revaluation surplus, then goes to income. Financial Statement Analysis Considerations • The leverage motivation. An upward revaluation may improve a firm's leverage. • Income manipulation. Revaluations are subjective in nature. For example, a downward revaluation will reduce ROE in the current period but make the firm more profitable in future years, since total assets and shareholders' equity will be lower. • Revaluation has no impact on cash flows. • What is the true value of the firm's long-lived assets? Why is the revaluation necessary? Who does the appraisal? How often is it done? status not read #### Annotation 1418331294988 Subject 5. Impairment of Assets #cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets Sometimes a long-term asset may lose some of its revenue-generating ability prior to the end of its useful life. (e.g., a significant decrease in the market value, physical change, or use of the assets). If the carrying amount of the asset is determined not to be recoverable, an asset impairment occurs and the carrying value should be written down. The amount of the write-down is recorded as a loss. GAAP and IFRS differ as to the methodology used to determine impairment. The GAAP methodology of determining impairment uses a two-step recoverability test. Occurrence of an impairment differs from recognition of an impairment. An impairment, whether recognized in financial reports or not, occurs as long as an asset's carrying value cannot be fully recovered in the future. However, only impairments that meet certain conditions are recognized in financial reports. SFAS 121 provides a two-step process: • Recoverability test. Impairment must be recognized when the carrying value of the assets exceeds the undiscounted future cash flows from their use and disposal. • Loss measurement. The excess of the carrying amount over the fair value of the assets. If the fair value is not available, the present value of future cash flows discounted at the firm's incremental borrowing rate should be used. That is: Impairment Loss = Book Value - Either Fair Value or Present Value of Future Cash Flows Conversely, IFRS methodology uses a one-step approach. This approach requires that impairment loss be calculated if "impairment indicators" exist. This approach does not rely on net undiscounted future cash flows and subsequent comparison to asset carrying value as required in GAAP methodology. In addition, the impairment loss is calculated as the amount by which the carrying amount of the asset exceeds it recoverable amount. The recoverable amount is the higher of the following: 1) fair value less cost to sell, or 2) value in use (i.e., the present value of future cash flows including disposal value). Impairment of Intangible Assets • Similar accounting treatment if the intangible asset has a finite life. • Tested annually for impairment for an intangible asset with an indefinite life. Among the most interesting intangible assets is goodwill. Goodwill is the present value of future earnings in excess of a normal return on net identifiable assets. It stems from such factors as a good reputation, loyal customers, and superior management. Any business that earns significantly more than a normal rate of return actually has goodwill. Goodwill is recorded in the accounts only if it is purchased by acquiring another business at a price higher than the fair market value of its net identifiable assets. It is not valued directly but inferred from the values of the acquired assets compared with the purchase price. It is the premium paid for the target company's reputation, brand names, customers or suppliers, technical knowledge, key personnel, and so forth. Goodwill only has value insofar as it represents a sustainable competitive advantage that will result in abnormally high earnings. Analysts need to be aware of the possibility that the goodwill recognized by accountants may, in fact, represent overpayment for the acquired company. Since goodwill is inferred rather than computed directly, it will increase as the payment price increases. It is only after the passage of time that analysts will be able to evaluate the extent to which the purchase price was justified. Under U.S. GAAP SFAS 142, goodwill is not amortized, but is tested annually for impairment. Goodwill impairment for each reporting unit should be tested in a two-step process at least once a year. 1. The fair value of a reporting unit is compared to its ... status not read #### Annotation 1418336275724 Subject 6. Derecognition #cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets For accounting purposes, an asset may be disposed of in three different ways. It may be: • sold for cash • exchanged for another asset • abandoned When plant assets are disposed of, depreciation should be recorded on the date of disposal. The cost is then removed from the asset account and the total recorded depreciation is removed from the accumulated depreciation account. Normally an asset's market value at the time of sale or disposal will most likely be different than the asset's book value (its original historical cost minus all accumulated depreciation on that asset). The sale of a plant asset at a price above or below book value results in a gain or loss to be reported in the income statement. Because different depreciation methods are used for income tax purposes, the gain or loss reported on income tax returns may differ from that shown in the income statement. It is the gain or loss shown in the financial statement that is recorded in the company's general ledger accounts. To illustrate each of these methods consider this. A machine was purchased on 1 January Year 1 for$1,000. The depreciation method was straight-line with a useful-life of 5 years and an estimated residual value of $200. On 31 July Year 3 the firm decides to dispose of the asset. The firm has a December year-end. The first step irrespective of the method of disposal is to calculate the depreciation up to the date of sale: Depreciation per year = (Cost - residual value) / Useful life = (1,000 - 200) / 5 =$160
Depreciation for year 1 = $160 Depreciation for year 2 =$160
Depreciation for year 3 = $93 (160 x 7/12) Total:$413

Remember that the depreciation for year 3 is only for 7 months, as the asset is disposed of on 31 July Year 3.

Sale of Long-Lived Assets

The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying value of the asset at the time of sale. Assume that the machinery is sold for cash in three scenarios:

a. Sold for $587 cash (Sale of machinery for carrying value) Debit: Cash (B/S)$587
Debit: Accumulated depreciation (B/S) $413 Credit: Machinery (B/S)$1000

b. Sold for $600 cash (Sale of machinery for above carrying value) Debit: Cash (B/S)$600
Debit: Accumulated depreciation (B/S) $413 Credit: Machinery (B/S)$1000
Credit: Profit on sale of machinery (I/S) $13 c. Sold for$500 cash (Sale of machinery for below carrying value)
Debit: Cash (B/S) $500 Debit: Accumulated depreciation (B/S)$413
Debit: Loss on sale of machinery (I/S) $87 Credit: Machinery (B/S)$1000

In summary, when disposing of an asset, entries are prepared to:

• eliminate the cost of the asset from the books.
• eliminate the accumulated depreciation from the books.
• record the proceeds on the sale. This is reported as cash from investing activities on the statement of cash flows.
• record the profit or loss on the sale (if applicable). This amount is excluded from net income when the indirect method is used to calculate cash flows from operating activities.

Exchange of Long-Lived Assets

If an asset is exchanged for another asset, the basic accounting is similar to the accounting for sales of plant assets for cash. If the trade-in allowance received is greater than the carrying value of the asset surrendered, there has been a gain. If the allowance is less, there has been a loss.

Level II will cover some special rules for recognizing these gains and losses, depending on the nature of the assets exchanged:

Abandoned

If an asset i...

#### Annotation 1418339683596

Subject 7. Presentation and Disclosures
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Property, Plant, and Equipment (PP&E)

IAS 16 provides a long list of disclosure requirements for PP&E. For each class of PP&E, the financial statements must disclose the following:

• the measurement bases used for determining the gross carrying amount.
• the depreciation methods and rates or useful lives.
• the gross carrying amount and the accumulated depreciation (aggregated with accumulated impairment losses) at the beginning and end of the period.
• the detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, depreciation, impairment losses, revaluation information, foreign currency translation impacts, and so on).

U.S. GAAP require a company to disclose the depreciation expense for the period, the balances of assets, accumulated depreciation and a general description of the depreciation method(s) used.

Intangible Assets

IAS 38 provides a considerable set of disclosure requirements for intangible assets. For each class of intangibles, and distinguishing between internally generated and other assets, the financial statements must disclose:

• whether the useful lives are indefinite or finite and, if finite, the length of the useful lives or the amortization rates used.
• the amortization methods used for intangible assets with finite useful lives.
• the gross carrying amount and any accumulated amortization (aggregated with accumulated impairment losses) at the beginning and end of the period.
• the line item(s) of the statement of comprehensive income in which any amortization of intangible assets is included.
• detailed reconciliation of the carrying amount at the beginning and end of the period (showing, for example, additions, amortization, impairment losses, revaluation information, foreign currency translation impacts, and so on).

Under U.S. GAAP, a company is required to disclose the gross carrying amounts and accumulated amortization, the aggregated amortization expense for the period, and the estimated amortization expense for the next 5 years.

Impairment of Assets

As with most other standards, IAS 36 provides a long list of disclosure requirements. To begin with, for each class of assets, the financial statements must disclose:

• the amount of impairment losses and reversals recognized in profit or loss during the period and the line item(s) of the statement of comprehensive income in which those impairment losses and reversals are included.
• the amount of impairment losses and reversals on revalued assets recognized in other comprehensive income during the period.

U.S. GAAP require a company to disclose a description of the impaired asset, what caused impairment, the method of determining fair value, the amount of impairment loss, and where the loss is recognized on the financial statements.

#### Annotation 1418341518604

Subject 8. Investment Property
#cfa #cfa-level-1 #financial-reporting-and-analysis #inventories-long-lived-assets-income-taxes-and-non-current-liabilities #long-lived-assets
Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rental income, capital appreciation, or both.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model.

• The cost model is identical to the cost model used for property, plant, and equipment (PP&E).
• The fair value model differs from the revaluation model used for PP&E. All changes in the fair value of investment property affect income.

Under U.S. GAAP, there is no specific definition of investment property. Investment properties are generally measured using the cost model.

#### Annotation 1418343353612

Subject 1. Key Terms
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The computation of income taxes poses problems in financial reporting. The major problems arise because current period taxable income is measured using different rules than those used in accounting for pretax income.

Taxes are paid based on tax reporting, but from a financial reporting standpoint, the tax expense in the income statement (IS) is based on the matching principle and is computed on pretax accounting income. In order to achieve matching between taxes based on taxable income and taxes based on pretax income for accounting purposes, deferred tax entries are put through the accounting books.

The differences between the tax expense for tax and the accounting tax expense create deferred tax liabilities (credits) and deferred tax assets (debits or prepaid taxes).

Here are key terms based on tax return:

• Taxable income: Income subject to tax based on the tax code.

• Taxes payable: Tax return liability resulting from current period taxable income. (U.S.) SFAS 109 calls this "current tax expense or benefit."

• Income tax paid: Actual cash flow for income taxes, including payments (refunds) for other years.

• Tax loss carry forward: Tax return loss that can be used to reduce taxable income in future years.

• The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

Here are key terms based on financial reporting:

• Pretax income or accounting profit: Income before income tax expense.

• The carrying amount is the amount at which the asset or liability is valued according to accounting principles.

• Income tax expense: Expense resulting from current period pretax income; this includes taxes payable (from the tax return) and deferred income tax expense. It is reported in the income statement.

• Deferred income tax expense: Accrual of income tax expense expected to be paid (or recovered) in future years (difference between taxes payable and income tax expense). Under (U.S.) SAAS 109, this results from changes in deferred tax assets and liabilities.

• Deferred tax asset: Balance sheet item that results from a temporary excess of taxes payable over income taxes expense. It is expected to be recovered from future operations; it is not created if the excess is a permanent difference.

• Deferred tax liability: Balance sheet item that results from a temporary excess of income taxes expense over taxes payable. It is expected to result in future cash outflows; it is not created if the excess is a permanent difference.

• Valuation allowance: Reserve against deferred tax assets based on likelihood that those assets will be realized.

• Timing difference: The result of the tax return treatment (timing or amount) of a transaction that differs from the financial reporting treatment.

• Temporary difference: Difference between tax reporting and financial reporting that will affect taxable income when those differences reverse. This is similar to but slightly broader than timing difference. It also considers other events that result in differences between the tax bases of assets and liabilities and their carrying amounts in financial statements.

• Permanent difference: Differences between tax reporting and financial reporting that will not reverse in the future.

#### Annotation 1418345188620

Subject 2. Deferred Tax Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Tax reporting and financial reporting are based on two different sets of assumptions. This is particularly true in the U.S. because financial reporting does not have to conform to tax reporting, as it does in Japan, Germany, and Switzerland. Numerous items create differences between accounting profit and taxable income. As a result, the taxes payable for the period are often different from the tax expenses recognized in the financial statements.

In the U.S.:

• Tax reporting is based on the Internal Revenue Code (the tax code).

• The modified cash basis of accounting is used in tax reporting to determine the periodic liability from currently taxable events.
• Revenue and expense recognition methods used in tax reporting often differ from those used in financial reporting.

• Financial reporting is based on GAAP.

• Accrual accounting is used in financial reporting to provide maximum information to allow evaluation of a firm's financial performance and cash flows.
• Management is allowed to select revenue and expense recognition methods. A firm has a strong incentive to use methods that allow it to minimize taxable income.

Because of the differences between tax accounting and financial accounting, the financial statements may include tax liabilities or assets - allowances that have been made in the financial statements for taxes that have not yet been or have already been paid.

Deferred tax liabilities generally arise when tax relief is provided in advance of an accounting expense, or when income is accrued but not taxed until received. Deferred tax liabilities on an individual transaction are expected to be reversed when these liabilities are settled, causing future cash outflows.

A typical example is depreciation: a company uses the Accelerated Cost Recovery System for tax reporting but uses straight-line depreciation for financial reporting.

• Recall that taxes payable is calculated based on taxable income, and tax expense is calculated based on accounting profit.
• Lower depreciation expense in financial reporting results in accounting profit that is higher than taxable income, and tax expense that is higher than taxes payable.
• Deferred tax liabilities are thus created.

Deferred tax assets generally arise when tax relief is provided after an expense is deducted for accounting purposes. Deferred tax assets on an individual transaction are expected to be reversed when these assets are recovered, causing future cash inflows. Different treatments of warranty expenses in tax reporting and financial reporting are a common cause of deferred tax assets:

• For tax reporting, warranty expenses cannot be recognized until they have been incurred. For financial reporting, warranty expenses are recognized each year using accrual accounting, regardless of whether they are incurred or not.
• Lower warranty expense in tax reporting results in taxable income that is higher than accounting profit, and tax payable that is higher than tax expense.
• Deferred tax assets are thus created.

In the U.S., deferred tax assets/liabilities are classified on the balance sheet as current or non-current based on the classification of the underlying asset or liability. However, deferred tax assets/liabilities are always classified as non-current under IFRS.

A deferred tax item cannot be created if it is doubtful that the company will realize economic benefits in the future.

Example

A company purchases an asset for $1,000 at the beginning of Year 1. It depreciates the asset at 33% per annum (straight-line) for financial reporting. The tax depreciation is 50% per annum (straight-line). The pretax income and taxable income are$2,000 bef...

#### Annotation 1418350169356

Subject 3. Determining the Tax Base of Assets and Liabilities
#cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
The tax base of an asset or liability is the amount attributed to that asset or liability for tax purposes.

The Tax Base of an Asset

An asset's tax base is the amount that will be deductible for tax purposes against any taxable economic benefits that will flow to an entity when it recovers the asset's carrying amount. It is the amount that would be tax deductible if the asset was sold on the balance sheet date.

For example, a firm has total accounts receivable of $100,000. At the end of the year, management recognized a specific doubtful debt division of$3,000 for financial reporting. However, provisions for doubtful debts are not allowed for tax purposes in the firm's tax jurisdiction. A tax deduction is received when the receivable is written off as bad debt.

The carrying amount of the accounts receivable becomes $97,000. The tax base of the asset still remains$100,000. The firm has a deductible temporary difference of $3,000. Management should recognize a deferred tax asset in respect to the deductible temporary difference. If the economic benefit will not be taxable, the tax base of the asset will be equal to the carrying amount of the asset. An example is dividends receivable from a subsidiary. If it is not taxable, the tax base and the carrying amount of the dividends receivable are equal. The Tax Base of a Liability The tax base of a liability is its carrying amount, less any amount that will be deductible for tax purposes with respect to that liability in future periods. • An unearned revenue item is treated as a liability for financial reporting but tax authorities often recognize it as taxable income. The tax base of such a liability is the carrying amount less any amount of the revenue that will not be taxable in the future. Examples are prepaid rent, prepaid subscriptions, etc. • If an item has already been expensed, then its tax base and carrying amount are both zero. One example is interest paid on long-term loans. Example At the beginning of the year a firm received a lump sum of$5 million for rent from a lessee. The rent was for the use of an office building for the next 5 years. Local tax authorities require 70% of rent received in advance to be taxable income.

At the end of the year, $4 million should be treated as a liability for financial reporting purposes. That's the carrying amount. The tax base of the liability is$1.2 million (30% of $4 million) and$2.8 million should be treated as taxable income.

Changes in Income Tax Rates

When tax rates change, the deferred tax liability or asset has to be adjusted immediately to the new amount that is now expected, based upon the new expected tax consequences. The effect of this change in estimate will be included in the income from continuing operations.

The effect of an income tax rate increase:

• It raises deferred tax liabilities and thus increases tax expense.
• It raises deferred tax assets and thus decreases tax expense.
• If deferred tax liabilities exceed deferred tax assets, the net effect is to increase tax expense, and vice versa.

#### Annotation 1418352528652

Subject 4. Temporary versus Permanent Differences
#cfa #cfa-level-1 #financial-reporting-and-analysis #has-images #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities
Numerous items create differences between accounting profit and taxable income. These differences can be divided into two types.

Permanent differences do not cause deferred tax liabilities or assets. These occur if a revenue or expense item:

• is recognized for tax reporting but never for financial reporting, or
• is recognized for financial reporting but never for tax reporting.

Therefore, permanent differences result from revenues and expenses that are reportable on either tax returns or in financial statements but not both. Permanent differences arise because the tax code excludes certain revenues from taxation and limits the deductibility of certain expenses.

• In the U.S., for example, interest income on tax-exempt bonds, premiums paid on officer's life insurance, and amortization of goodwill (in some cases) are included in financial statements but are never reported on tax returns.
• Similarly, certain dividends are not fully taxed, and tax or statutory depletion may exceed cost-based depletion reported in the financial statements.
• Tax credits are another type of permanent difference. Such credits directly reduce taxes payable and are different from tax deductions that reduce taxable income.

These differences are permanent because they will not reverse in future periods.

No deferred tax consequences are recognized for permanent differences; however, they result in a difference between the effective tax rate and the statutory tax rate that should be considered in the analysis of effective tax rates.

Example

A company owns a $50,000 municipal bond with a 4% coupon and has an effective tax rate of 50% and a statutory tax rate of 40%. Calculate the deferred tax created by this bond. Solution The bond does not result in deferred tax, as the difference it causes is a permanent difference that will not reverse. As a result, no deferred tax is recognized. Temporary differences result in deferred tax liabilities or assets. Different depreciation methods or estimates used in tax reporting and financial reporting are a common cause of temporary differences. There are two categories of temporary differences. Taxable Temporary Differences (TTD) • These will result in taxable amounts when an asset is recovered or a liability is settled. • Hence, these result in deferred tax liabilities. This means the company will pay more tax in the future. Items that give rise to taxable temporary differences are: • Receivables resulting from sales. • Prepaid expenses. • Tax depreciation rates > accounting rates. • Development costs capitalized and amortized. Deductible Temporary Differences (DTD) • These will result in deductible amounts when an asset is recovered or a liability is settled. • Hence, these result in deferred tax assets. This means the company will pay less tax in the future. Items that give rise to deductible temporary differences are: • Accrued expenses. • Unearned revenue. • Tax depreciation rates < accounting rates. • Tax losses. status not read #### Flashcard 1418357247244 Tags #obgyn Question Subtypes [...] ​& [...] ​responsible for ~70% of cases of invasive disease Answer 16 ; 18 status measured difficulty not learned 37% [default] 0 #### Annotation 1418357771532 Subject 5. Recognition and Measurement of Current and Deferred Tax #cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities Deferred tax assets and liabilities are re-assessed on each balance sheet date. • They are measured against the criteria of probable future economic benefits. • The tax rate used to calculate them should be the one that is expected to apply when the asset is realized or liability settled. • They are not discounted to present value although they are related to amounts at some future date. Valuation Allowance Deferred tax assets are reduced by a valuation allowance to amounts that are "more likely than not" to be realized, taking into account all available positive and negative evidence about the future. For determining whether deferred tax assets must be reduced by a valuation allowance, all available positive and negative evidence must be considered. Information concerning recent pretax accounting earnings generally is critical. For example, if a firm has been recording material cumulative losses recently, it will be hard to justify a conclusion that tax credits can be realized in the near future. This will be evidence supporting the use of a valuation allowance ("negative evidence"). It is not necessary to quantify positive evidence for the conclusion that a valuation allowance is not required unless significant negative evidence exists. Where both positive and negative evidence exist, judgment must be used in evaluating what evidence is more persuasive. More weight should be given to objectively verifiable evidence. Recognition of Current and Deferred Tax Charged Directly to Equity A firm's deferred tax liability during an accounting period represents the portion of income tax expense that has not been paid. Therefore, from a pure accounting perspective, deferred tax liabilities are an accounting liability. However, from a financial analyst's perspective, whether deferred tax liabilities should be considered liabilities or not depends on whether they will reverse in the future. If they will, resulting in a cash outflow, then they should be treated as liabilities. If not, then they should be treated as equity! As deferred tax liabilities are created by temporary differences, reversal of a deferred tax liability depends on the reversal of the temporary difference that created it. Changes in a firm's operations or tax law may result in deferred taxes that are never paid or recovered. For example, the use of accelerated depreciation methods for tax reporting creates a temporary difference. Normally, when there is less depreciation in later years, the deferred tax liability created by more depreciation in earlier years will be reversed. However, for firms with high growth rates, increased investments in fixed assets result in ever-increasing new deferred tax liabilities, which replace the reversing one. That is, a firm's growth may continually generate deferred tax liabilities. In this case, the deferred taxes are unlikely to be paid. Therefore, for such high-growth firms, deferred tax liabilities will not reverse and should be treated as equity. Deferred tax liabilities are recorded at their stated value. Even if deferred taxes are eventually paid, payments typically occur far in the future. The present value of those payments is considerably lower than the stated amounts. Thus, the deferred tax liability should be discounted at an appropriate interest rate and the difference should be treated as equity. In some cases, financial statement depreciation understates the value of economic depreciation. Instead, the accelerated depreciation in tax reporting is a better measure. Examples of such cases include equipment obsolescence due to technology innovation and rising price levels. Deferred tax liabilities are neither liabilities nor equity if they are not expected to reverse, and should be ignored by financial analysts. • They are not liabilities since they will not reverse. • They are not equity since adding the entire tax liabilities ... status not read #### Flashcard 1418359606540 Tags #obgyn Question Subtype 18 related often to [...] Answer adenocarcinoma status measured difficulty not learned 37% [default] 0 #### Flashcard 1418362752268 Tags #obgyn Question Pap tests should not be performed < [...] ​ weeks apart Answer 6 status measured difficulty not learned 37% [default] 0 #### Annotation 1418363800844 Subject 7. Comparison of IFRS and U.S. GAAP #cfa #cfa-level-1 #financial-reporting-and-analysis #income-taxes #inventories-long-lived-assets-income-taxes-and-non-current-liabilities Similarities FAS 109 Accounting for Income Taxes and IAS 12 Income Taxes provide the guidance for income tax accounting under U.S. GAAP and IFRS, respectively. Both pronouncements require entities to account for both current tax effects and expected future tax consequences of events that have been recognized (that is, deferred taxes) using an asset and liability approach. Further, deferred taxes for temporary differences arising from non-deductible goodwill are not recorded under either approach and the tax effects of items directly accounted for as equity during the current year are also allocated directly to equity. Finally, neither principle permits the discounting of deferred taxes. Significant Differences and Convergence Below we discuss the significant differences in the current literature. Tax basis: • U.S. GAAP: Tax basis is a question of fact under the tax law. For most assets and liabilities there is no dispute on this amount; however, when uncertainty exists, it is determined in accordance with FIN 48 Accounting for Uncertainty in Income Taxes. • IFRS: Tax basis is generally the amount deductible or taxable for tax purposes. The manner in which management intends to settle or recover a carrying amount affects the determination of tax basis. Uncertain tax positions: • U.S. GAAP: FIN 48 requires a two-step process, separating recognition from measurement. A benefit is recognized when it is "more likely than not" to be sustained based on the technical merits of the position. The amount of benefit to be recognized is based on the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement. Detection risk is precluded from being considered in the analysis. • IFRS: There is no specific guidance; IAS 12 indicates tax assets/liabilities should be measured at the amount expected to be paid. In practice, the recognition principles on provisions and contingencies in IAS 37 are frequently applied. Practice varies regarding consideration of detection risk in the analysis. Initial recognition exemption: • U.S. GAAP: No similar exemption for non-recognition of deferred tax effects for certain assets or liabilities. • IFRS: Deferred tax effects arising from the initial recognition of an asset or liability are not recognized when the amounts did not arise from a business combination and, upon occurrence, the transaction affects neither accounting nor taxable profit (for example, acquisition of nondeductible assets). Recognition of deferred tax assets: • U.S. GAAP: Recognized in full (except for certain outside basis differences), but valuation allowance reduces assets to the amount that is more likely than not to be realized. • IFRS: Amounts are recognized only to the extent it is probable (similar to "more likely than not" under U.S. GAAP) that they will be realized. Calculation of deferred asset or liability: • U.S. GAAP: Enacted tax rates must be used. • IFRS: Enacted or "substantively enacted" tax rates (as of the balance sheet date) must be used. Classification of deferred tax assets and liabilities in balance sheet: • U.S. GAAP: Current or non-current classification, based on the nature of the related asset or liability, is required. • IFRS: All amounts are classified as non-current in the balance sheet. Recognition of deferred tax liabilities from investments in subsidiaries or joint ventures (JVs) (often referred to as outside basis differences): • U.S. GAAP: Recognition is not required for investment in foreign subsidiary or corporate JVs that are essentially permanent in duration, unless it becomes apparent that the difference will reverse ... status not read #### Annotation 1418365635852 Subject 1. Reporting Quality and Results Quality #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality Financial reporting quality: a subjective evaluation of the extent to which financial reporting is free of manipulation and accurately reflects the financial condition and operating success of a company. It pertains to the information disclosed. Earnings are considered to be high quality if they exhibit persistence and are unbiased. Sustainable earnings enable better forecasts of future cash flows or earnings. This is referred to as results quality or earnings quality. Financial reporting quality is different from earnings quality. The two concepts are, however, interrelated because a correct assessment of earnings quality is possible only if we have some basic level of financial reporting quality. Low financial reporting quality makes it hard to assess earnings quality. status not read #### Annotation 1418367995148 Subject 2. Quality Spectrum of Financial Reports #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality Financial reporting quality varies across companies. GAAP, Decision-Useful, Sustainable, and Adequate Returns • GAAP compliance. • Useful: helpful in decision-making. Relevant, faithful representation and material. • Sustainable earnings indicate an adequate level of return on investment. GAAP, Decision-Useful, but Sustainable? • GAAP compliance and useful. • But not sustainable earnings. Biased Accounting Choices • Within GAAP. • Biased choices such as aggressive/conservative accounting, income smoothing, hidden reserves, and earnings management. Departures from GAAP It is difficult or impossible to assess earnings quality. Engaging in fraudulent financial reporting provides no quality of earnings. Conservative and Aggressive Accounting An aspect of financial reporting quality is the degree to which accounting choices are conservative or aggressive. "Aggressive" typically refers to choices that aim to enhance a company's reported performance and financial position by inflating the amount of revenues, earnings, and/or operating cash flow reported in the period or by decreasing the amount of expenses reported in the period and/or the amount of debt reported on the balance sheet. Conservatism in financial reports can result from either (1) accounting standards that specifically require a conservative treatment of a transaction or an event or (2) judgments necessarily made by managers when applying accounting standards that result in more or less conservative results. An example of conservatism in the oil and gas industry is the revenue recognition accounting standard. This standard permits recognition of revenue only at the time of shipment rather than closer to the time of actual value creation (which is the time of discovery). Big Bath Accounting The strategy of manipulating a company's income statement to make poor results look even worse. The big bath is often implemented in a bad year to artificially enhance next year's earnings. The big rise in earnings might result in a larger bonus for executives. Cookie Jar Reserve Accounting Companies shift earnings around by creating overly large reserve accounts in good years then drawing them down in bad years. status not read #### Annotation 1418369830156 Subject 3. Context for Assessing Financial Reporting Quality #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality Motivations for managers to issue less than high quality financial reports: • Mask poor performance • Boost stock price • Improve incentive compensation • Meet debt covenants Management might have an incentive to manipulate earnings lower as well, possibly to smooth higher earnings in the current quarter into weaker quarters. Conditions conductive to issuing low-quality financial reports: • Opportunity is generally provided through weaknesses in internal controls. • Motivation can be imposed due to personal financial problems or unrealistic deadlines and performance goals. • Rationalization occurs when an individual develops a justification for fraudulent activities. Mechanisms that discipline financial reporting quality: • The free market. A company seeking to minimize its long-term cost of capital should aim to provide high-quality financial reports. • Enforcement by market regulatory authorities, which plays a central role in encouraging high-quality financial reporting. • Auditors. An audit is intended to provide assurance that a company's financial reports are presented fairly. There are, however, inherent limitations. Auditors are only able to offer "reasonable assurance" of the truth and fairness of financial statements rather than absolute assurance. • Private contracts. External parties such as lenders and investors are motivated to ensure the quality of financial reports is high. status not read #### Flashcard 1418373762316 Tags #obgyn Question What is the LSIL rule of 3rds? Answer - 1/3 will go away on their own - 1/3 will stay as is - 1/3 will progress status measured difficulty not learned 37% [default] 0 #### Annotation 1418374286604 Subject 4. Detection of Financial Reporting Quality Issues #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-reporting-quality There is really nothing new in this reading, just a review of the previous material. A lot of the accounting practices are highlighted elsewhere in the curriculum but are reiterated here. Presentation Choice If a company uses a non-GAAP financial measure in an SEC filing, it is required to provide the most directly comparable GAAP measure with equivalent prominence in the filing. In addition, the company is required to provide a reconciliation between the non-GAAP measure and the equivalent GAAP measure. Similarly, IFRS require that any non-IFRS measures included in financial reports must be defined and their potential relevance explained. The non-IFRS measures must be reconciled with IFRS measures. Accounting Choices and Estimates Managers' considerable flexibility in choosing their companies' accounting policies and formulating estimates provides opportunities for aggressive accounting. Examples include: • Revenue recognition policies. • Inventory cost flow assumptions. • Capitalization policies. • Estimates of uncollectible account receivable. • Estimated realizability of deferred tax assets. • Depreciation method, estimated salvage value of depreciable assets, and estimated useful life of depreciable assets. Cash flow, especially operating cash flow and free cash flow, are always at the heart of any discussion of financial performance and valuation. Investors, creditors, and analysts are all interested in whether a firm is generating cash flow and where that cash flow can be expected to recur. Operating cash flow is usually unaffected by estimates and judgments. However, firms can still create the perception that sustainable operating cash flow is greater than it actually is. One technique is to misrepresent a firm's cash-generating ability by classifying financing activities as operating activities and vice versa. Additionally, management has discretion over the timing of cash flows and where to report cash flows. Warning Signs Analysts should pay attention to: • Revenue. Check revenue recognition policies and revenue relationship. • Inventories. Look at inventory relationships. • Capitalization policies and deferred costs. • The relationship of cash flow and net income. • Other warning signs. status not read #### Annotation 1418374810892 #obgyn evasion of host immune system + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer status not read #### Flashcard 1418376121612 Tags #obgyn Question [...] + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer Answer evasion of host immune system status measured difficulty not learned 37% [default] 0 Open it evasion of host immune system + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer #### Flashcard 1418377694476 Tags #obgyn Question evasion of host immune system + [...] → cervical cancer Answer integration of HPV DNA into susceptible epithelial cells in transformation zone status measured difficulty not learned 37% [default] 0 Open it evasion of host immune system + integration of HPV DNA into susceptible epithelial cells in transformation zone → cervical cancer #### Annotation 1418381364492 Subject 1. Evaluating Past Financial Performance #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications This reading describes selected applications of financial statement analysis. In all cases, the analyst needs to have a good understanding of the financial reporting standards under which financial statements are prepared. Because standards evolve over time, analysts must make sure their knowledge is current in order to make good investment decisions. Evaluating a company's historical performance addresses not only what happened but also the causes behind the company's performance and how the performance reflects the company's strategy. The analyst needs to create common-size financial statements, calculate the financial ratios of the company, its competitors, and the industry, and make necessary adjustments. After processing the data, the analyst should perform: • time series analysis to compare the company's performance to itself over time to examine the trend of its ratios (e.g., profitability, efficiency, liquidity, and solvency ratios). • cross-sectional analysis to compare these ratios to those of its competitors or the industry. When examining the data, the analyst should try to find answers to critical questions, including: • What are the key performance indicators of the company, in light of its competitive strategy? • What is driving the company's current performance? Specifically, what factors are causing the changes of a particular ratio over time? Why? • What aspects of performance are critical for the company to succeed in the market? How did the company do in the past? • What strategy does the company have and what were its impacts on the company's performance in the past? Two examples are presented in the textbook to illustrate the application. status not read #### Flashcard 1418382413068 Tags #obgyn Question What cofactors are thought to facilitate the process of HPV evading host immune system? Answer - smoking - immunodeficient states (HIV, drugs, diseases - DM) status measured difficulty not learned 37% [default] 0 #### Annotation 1418384248076 Subject 2. Projecting Future Financial Performance #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications The projection of a company's future net income and cash flow often begins with a top-down sales forecast in which the analyst forecasts industry sales and the company's market share. The company's sales are then estimated as its projected market share multiplied by projected total industry sales. Note that the key financial driver for most companies is the estimate of future sales from their products and services. By projecting profit margins and expenses, and the level of investment in working capital and fixed capital needed to support projected sales, the analyst can forecast net income and cash flow. When projecting profit margins: • For relatively mature companies operating in non-volatile product markets, historical information on operating profit margins can be used to estimate future operating profits. Non-recurring items should be removed from computations. • For a new company, or a company in a volatile market or a capital intensive industry, historical operating profit margins are usually less reliable in projecting future margins. Sensitivity analysis is often used to assess the impact of different assumptions on income and cash flow. These assumptions include sales forecasts, working capital requirements, profit margins, etc. status not read #### Annotation 1418386083084 Subject 3. Assessing Credit Risk #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications Credit risk is risk due to uncertainty about a counterparty's ability to meet its obligation. Credit analysis is the evaluation of credit risk. It focuses on debt-paying ability and cash flow rather than accrual-income returns. Moody's ratings focus primarily on four factors: 1. Company profile - Scale and diversification. These elements are indicative of other characteristics that mitigate risk and are a good indicator of market leadership, purchasing power, operational flexibility, the potential for enhanced access to financing and the capital markets, etc. 2. Financial policies - Tolerance for leverage. Cash flow available to service indebtedness is considered the most fundamental measure of credit stature. Various solvency ratios are used for that purpose: • Retained Cash Flow (RCF)/ Total Debt (TD) • (RCF - CapEx) / TD • TD / EBITDA • (EBITDA - CapEx) / Interest *CapEx: Capital expenditure • EBITDA / Interest 3. Operational efficiency. This factor is analogous to operating leverage. Since they can generate larger levels of cash flow, companies with low operating leverage (i.e., superior profit margins) can afford to have larger debt loads. Owing to the fact that debt loads can be restructured, low-cost companies have better prospects than high-cost companies when faced with financial stress/distress and forced reorganizations. 4. Margin stability. Lower volatility in margins would imply lower risk relative to economic conditions. status not read #### Annotation 1418387918092 Subject 4. Screening for Potential Equity Investments #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications A bottom-up manager is one who looks for stocks company by company. These are the classic "stock pickers," who don't care if a stock represents an airline or a drugmaker. If the stock meets their criteria, they go for it. This approach is the opposite of that of a top-down manager. These managers take a bird's-eye view of the economy. They try to select industry groups, and then stocks, that stand to benefit from the large trends they see. Regardless of their philosophy, portfolio managers employ ratios using financial statement data and market data to screen for potential equity investments. Fundamental decisions include: • Which metrics to use as screens? • How many metrics to include? • What values of those metrics to use as cutoff points? • What weighting to give each metric? Many studies have been done to determine the most effective accounting ratios for screening equity investments. Backtesting is the process of testing a trading strategy on prior time periods. Instead of applying a strategy for the time period forward (which could take years), an analyst can do a simulation of his or her trading strategy on relevant past data in order to gauge its effectiveness. However, as frequently heard, "past performance does not necessarily guarantee future returns"; backtesting may not provide a reliable indication of future performance because of survivorship bias, look-ahead bias, or data-snooping. status not read #### Annotation 1418389753100 Subject 5. Analyst Adjustments to Reported Financials #cfa #cfa-level-1 #financial-reporting-and-analysis #financial-statement-analysis-applications Analysts' adjustments to a company's reported financial statements are sometimes necessary (e.g., when comparing companies that use different accounting methods or assumptions). A balance-focused framework for analyst adjustments is presented in the textbook. Investments Adjustments Different categories of investment securities have different treatments regarding unrealized holding gains and losses. Depending on management's intention, investment securities can be classified as: • Trading securities. Any unrealized gains and losses are recognized on the income statement as part of the net income. • Available-for-sale securities. Any unrealized gains and losses are recognized on the balance sheet as part of other comprehensive income. Adjustments may be needed to facilitate the comparison of two otherwise comparable companies that have significant differences in the classification of investments. Inventory Adjustments IAS No.2 does not permit the use of LIFO. If a company not reporting under IFRS uses LIFO but another company uses FIFO, comparison of the two companies may be difficult. Reading 29 [Inventories] illustrates how to make an inventory adjustment and its impact. Property, Plant and Equipment Companies may choose different depreciation methods (e.g., a straight-line method or an accelerated method) and accounting estimates (e.g., salvage value or useful life) related to depreciation. Disclosures required for depreciation often do not facilitate specific adjustments. Analysts may evaluate the relationships between various depreciation-related items (e.g., gross PPE, accumulated depreciation, depreciation expense, cash flows for capital expenditure, and asset disposals). • Relative Age (in %) = Accumulated Depreciation / Ending Gross Investment. This equation suggests how much of the useful life of the company's overall asset base has passed. • Average Depreciable Life = Ending Gross Investment / Depreciation Expense. • Average Age (in years) = Accumulated Depreciation / Depreciation Expense. This equation indicates how many years' worth of depreciation expense has already been recognized. The above three indicators are discussed in Reading 30 [Long-Lived Assets]. • The ratio of Net PPE / Depreciation Expense suggests how many years of useful life remain for a company's overall asset base. • CapEx / (Gross PPE + CapEx) signifies what percentage of the asset base is being renewed through new capital investment. • CapEx / Asset Disposal indicates the growth of the asset base. Goodwill Goodwill is recorded as an asset if one company purchases another for a price that is more than the fair value of the assets acquired. Internally generated goodwill is not recorded on the balance sheet. Adjustments are needed to compare two otherwise comparable companies when one has a recorded goodwill asset. The textbook provides an excellent example of the ratio comparisons for goodwill. Off-Balance-Sheet Financing This topic is covered in Reading 32 [Non-current (Long-term) Liabilities]. status not read #### Flashcard 1418392898828 Tags #obgyn Question The depth of HPV cervical cancer invasion predicts nodal involvement. If >[...] ​mm, we need to do a more radical surgery (wider dissection). Answer >3 mm status measured difficulty not learned 37% [default] 0 #### Annotation 1418393423116 Subject 1. Capital Budgeting: Introduction #capital-budgeting #cfa #cfa-level-1 #corporate-finance Capital budgeting is the process of planning expenditures on assets (fixed assets) whose cash flows are expected to extend beyond one year. Managers analyze projects and decide which ones to include in the capital budget. • "Capital" refers to long-term assets. • The "budget" is a plan which details projected cash inflows and outflows during a future period. The typical steps in the capital budgeting process: • Generating good investment ideas to consider. • Analyzing individual proposals (forecasting cash flows, evaluating profitability, etc.). • Planning the capital budget. How does the project fit within the company's overall strategies? What's the timeline and priority? • Monitoring and post-auditing. The post-audit is a follow-up of capital budgeting decisions. It is a key element of capital budgeting. By comparing actual results with predicted results and then determining why differences occurred, decision-makers can: • Improve forecasts (based on which good capital budgeting decisions can be made). Otherwise, you will have the GIGO (garbage in, garbage out) problem. • Improve operations, thus making capital decisions well-implemented. Project classifications: • Replacement projects. There are two types of replacement decisions: • Replacement decisions to maintain a business. The issue is twofold: should the existing operations be continued? If yes, should the same processes continue to be used? Maintenance decisions are usually made without detailed analysis. • Replacement decisions to reduce costs. Cost reduction projects determine whether to replace serviceable but obsolete equipment. These decisions are discretionary and a detailed analysis is usually required. The cash flows from the old asset must be considered in replacement decisions. Specifically, in a replacement project, the cash flows from selling old assets should be used to offset the initial investment outlay. Analysts also need to compare revenue/cost/depreciation before and after the replacement to identify changes in these elements. • Expansion projects. Projects concerning expansion into new products, services, or markets involve strategic decisions and explicit forecasts of future demand, and thus require detailed analysis. These projects are more complex than replacement projects. • Regulatory, safety and environmental projects. These projects are mandatory investments, and are often non-revenue-producing. • Others. Some projects need special considerations beyond traditional capital budgeting analysis (for example, a very risky research project in which cash flows cannot be reliably forecast). status not read #### Flashcard 1418395258124 Tags #obgyn Question What is the #1 risk factor for development of cervical ca in Ontario? Answer lack of regular screening status measured difficulty not learned 37% [default] 0 #### Annotation 1418397093132 Subject 2. Basic Principles of Capital Budgeting #capital-budgeting #cfa #cfa-level-1 #corporate-finance #has-images Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of capital. Assumptions of capital budgeting are: • Capital budgeting decisions must be based on cash flows, not accounting income. Accounting profits only measure the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital budgeting, cash flows are what are relevant. Economic income is an investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income. • Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations. • The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost. • Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds. • Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing. Important capital budgeting concepts: • A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected. Since sunk costs are not increment costs, they should not be included in the capital budgeting analysis. For example, a small bookstore is considering opening a coffee shop within its store, which will generate an annual net cash outflow of$10,000 from selling coffee. That is, the coffee shop will always be losing money. In the previous year, the bookstore spent $5,000 to hire a consultant to perform an analysis. This$5,000 consulting fee is a sunk cost; whether the coffee shop is opened or not, the $5,000 is spent. • Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project. • Forget sunk costs. • Subtract opportunity costs. • Consider side effects on other parts of the firm: externalities and cannibalization. • Recognize the investment and recovery of net working capital. • Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. For example, to continue with the bookstore example, the space to be occupied by the coffee shop is an opportunity cost - it could be used to sell books and generate a$5,000 annual net cash inflow.

• Externalities are the effects of a project on cash flows in other parts of a firm. Although they are difficult to quantify, they should be considered. Externalities can be either positive or negative:

• Positive externalities create benefits for other parts of the firm. For example, the coffee shop may generate some additional customers for the bookstore (who otherwise may not buy books there). Future cash flows generated by positive externalities occur with the project and do not occur without the project, so they are incremental.

• Negative externalities create costs for other parts of the firm. For example, if the bookstore is considering opening a branch two blocks away, some customers w
...

#### Annotation 1418402073868

Subject 3. Investment Decision Criteria
#capital-budgeting #cfa #cfa-level-1 #corporate-finance #has-images
When a firm is embarking upon a project, it needs tools to assist in making the decision of whether to invest in the project or not. In order to demonstrate the use of these four methods, the cash flows presented below will be used.

Net Present Value (NPV)

This method discounts all cash flows (including both inflows and outflows) at the project's cost of capital and then sums those cash flows. The project is accepted if the NPV is positive.

where CFt is the expected cash flow at period t, k is the project's cost of capital, and n is its life.

• Cash outflows are treated as negative cash flows since they represent expenditures of the company to fund the project.
• Cash inflows are treated as positive cash flows since they represent money being brought into the company.

The NPV represents the amount of present-value cash flows that a project can generate after repaying the invested capital (project cost) and the required rate of return on that capital. An NPV of zero signifies that the project's cash flows are just sufficient to repay the invested capital and to provide the required rate of return on that capital. If a firm takes on a project with a positive NPV, the position of the stockholders is improved.

Decision rules:

• The higher the NPV, the better.
• Reject if NPV is less than or equal to 0.

NPV measures the dollar benefit of the project to shareholders. However, it does not measure the rate of return of the project, and thus cannot provide "safety margin" information. Safety margin refers to how much the project return could fall in percentage terms before the invested capital is at risk.

Assuming the cost of capital for the firm is 10%, calculate each cash flow by dividing the cash flow by (1 + k)t where k is the cost of capital and t is the year number. Calculate the NPV for Project A and B above.

NPV = CF0 + CF1 + CF2 + CF3 + CF4

Project A's NPV = -1,000 + 750/1.101 + 350/1.102 + 150/1.103 + 50/1.104 = -1,000 + 682 + 289 + 113 + 34 = $118 (rounded) Project B's NPV = -1,000 + 100/1.101 + 250/1.102 + 450/1.103 + 750/1.104 = -1,000 + 91 + 207 + 338 + 512 =$148 (rounded)

Internal Rate of Return (IRR)

This is the discount rate that forces a project's NPV to equal zero.

Note that this formula is simply the NPV formula solved for the particular discount rate that forces the NPV to equal zero. The IRR on a project is its expected rate of return. The NPV and IRR methods will usually lead to the same accept or reject decisions.

Decision rules:

• The higher the IRR, the better.
• Define the hurdle rate, which typically is the cost of capital.
• Reject if IRR is less than or equal to the hurdle rate.

IRR does provide "safety margin" information.

Calculate Project A's and B's IRR.

Project A: -1000 + 750/(1 + IRR)1 + 350/(1+IRR)2 + 150/(1+IRR)3 + 50/(1+IRR)4 = 0

Since it is difficult to determine by hand, the use of a financial calculator is need...

#### Flashcard 1418413083916

Tags
#obgyn
Question
What groups of women are at greatest risk for cervical ca in Ontario?
- aboriginal
- low SES
- Northern Ontario
- immigrant
- refugee

status measured difficulty not learned 37% [default] 0

#### Annotation 1418413608204

Subject 4. NPV Profiles
#capital-budgeting #cfa #cfa-level-1 #corporate-finance #has-images
A NPV profile is a graph showing the relationship between a project's NPV and the firm's cost of capital. The point where a project's net present value profile crosses the horizontal axis indicates a project's internal rate of return.

Some observations:

• The IRR is the discount rate that sets the NPV to 0.
• The NPV profile declines as the discount rate increases.
• Project A has a higher NPV at low discount rates, while Project B has a higher NPV at high discount rates. The NPV profiles of Project A and B join at the crossover rate, at which the projects' NPVs are equal.
• The slope of Project A's NPV profile is steeper. This indicates that Project A's NPV is more sensitive to changes in the discount rates.

#### Flashcard 1418417802508

Tags
#obgyn
Question
Two important pieces of information should be contained within a cytology report.
1. satisfactory vs unsatisfactory cytologic sample for eval
2. epithelial cell abnormality detected vs no epithelial cell abnormality detected

status measured difficulty not learned 37% [default] 0

#### Annotation 1418418851084

Subject 5. Comparison of the NPV and IRR Methods
#capital-budgeting #cfa #cfa-level-1 #corporate-finance #has-images
The IRR formula is simply the NPV formula solved for the particular rate that sets the NPV to 0. The same equation is used for both methods.

The NPV method assumes that cash flows will be reinvested at the firm's cost of capital, while the IRR method assumes reinvestment at the project's IRR. Reinvestment at the cost of capital is a better assumption in that it is closer to reality.

For independent projects, the NPV and IRR methods indicate the same accept or reject decisions. Assuming that Project A and B are independent, consider their NPV profiles.

• The IRR criterion for accepting an independent project is IRR > hurdle rate. That is, the cost of capital must be less than (or to the left of) the IRR.
• Whenever the cost of capital is less than the IRR, the project's NPV is positive. Recall the decision rule for independent projects: accept if NPV > 0. Thus, both projects should be accepted based on the NPV method.

However, for mutually exclusive projects, ranking conflicts can arise. Assuming that Project A and B are mutually exclusive, consider their NPV profiles.

• If the cost of capital > crossover rate, then NPVB > NPVA and IRRB > IRRA. Thus, both methods lead to the selection of Project B.
• If the cost of capital < crossover rate, then NPVB < NPVA and IRRB > IRRA. Thus, a conflict arises because now the NPV method will select Project A while the IRR method will choose B.
• Therefore, for mutually exclusive projects, the NPV and IRR methods lead to same decisions if the cost of capital > the crossover rate and different decisions if the cost of capital < the crossover rate.

For mutually exclusive projects, the NPV and MIRR methods will lead to the same accept or reject decision when:

• Two projects are of equal size and have the same life.
• Two projects are of equal size but differ in lives.

However, the projects can generate conflicting results if the NPV profiles of two projects cross (and there is a crossover rate):

• As long as the cost of capital (k) is larger than the crossover rate, the two methods both lead to the same decision;
• A conflict exists if k is less than the crossover rate.

Two conditions cause the NPV profiles to cross:

• When project size (or scale) differences exist. The cost of one project is larger than that of the other.
• When timing differences exist. The timing of cash flows from the two projects differs in that most of the cash flows from one project come in the early years while most of the cash flows from the other project come in the later years.

The root cause of the conflict between NPV and IRR is the rate of return at which differential cash flows can be reinvested. Both the NPV and IRR methods assume that the firm will reinvest all early cash flows. The NPV method implicitly assumes that early cash flows can be reinvested at the cost of capital. The IRR method assumes that the firm can reinvest at the IRR.

Whenever a conflict exists, the NPV method should be used. It can be demonstrated that the better assumption is the cost of capital for the reinvestment rate (Hint: don't focus too much on this topic, as it is beyond the scope of the CFA exam).

Multiple IRRs is a situation where a project has two or more IRRs. This problem is caused by the non-conventional cash flows of a project.

• Conventional cash flows means that the initial cash outflows are followed by a series of cash inflows.
• Non-conventional cash flows means that a pr
...

#### Flashcard 1418420686092

Tags
#obgyn
Question
What are reasons for unsatisfactory cytology report? (pap tests)
- lack of sampling of entire transformation zone
- low cellularity on specimen
- evaluation obscured by inflammatory cells/blood

status measured difficulty not learned 37% [default] 0

#### Annotation 1418424093964

Subject 6. Popularity and Usage of the Capital Budgeting Method
#capital-budgeting #cfa #cfa-level-1 #corporate-finance
The usefulness of various capital budgeting methods depends on their specific applications. Although financial textbooks often recommend the use of NPV and IRR methods, other methods are also heavily used by corporations.

Capital budgeting is also relevant to external analysts in estimating the value of stock prices. Theoretically, if a company invests in positive NPV projects, the wealth of its shareholders should increase.

The integrity of a firm's capital budgeting processes can also be used to show how the management pursues its goal of shareholder wealth maximization.

#### Flashcard 1418425928972

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What is the bethesda classification for squamous cell abnormalities detected?
- atypical sq cells of undetermined sig (ASC-US)
- atypical sq cells - can't r/o high gr sq intraepithelial lesion (ASC-H)
- low gr sq intraepithelial lesion (LSIL)
- high gr sq intraepithelial lesion (HSIL)
- sq cell carcinoma

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#### Annotation 1418427763980

Subject 1. Cost of Capital
#cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images
Capital is a necessary factor of production, and has a cost. The providers of capital require a return on their money. A firm must ensure that stockholders or those that have lent the firm money (such as banks) receive the return that they require. This return is the cost that the firm will incur to maintain those sources of capital. Therefore, the return that the providers of funds require is equal to the cost to the firm of maintaining those funds.

Calculating the cost of capital is important for a firm, as this is the rate of return that must be used when evaluating capital projects. The return from the project must be greater than the cost of the project in order for it to be acceptable.

In general, a firm can finance its operations from three main sources of capital:

• equity or common stock
• preferred stock
• debt

Each of these sources of capital has a cost. The cost of capital used in capital budgeting should be calculated as a weighted average, or composite, of the various types of funds a firm generally uses.

• The weighted average cost of capital (WACC) is defined as the weighted average cost of the component costs of debt, preferred stock, and common stock or equity. It is also referred to as the marginal cost of capital (MCC), which is the cost of obtaining another dollar of new capital.
• wd = the weight for debt
• wp = the weight for preferred stock
• we = the weight for common stock
• r = required rate for each component
• t = the marginal tax rate

Taxes and the Cost of Capital

Interest on debt is tax deductible; therefore, to calculate the cost of debt, the tax benefit is deducted. This means that after-tax cost of debt = interest rate - tax savings (the government pays part of the cost of debt as interest is tax deductible).

There is no tax savings associated with the use of preferred stock or common stock.

Weights of the Weighted Average

The target capital structure is the percentage of debt, preferred stock, and common equity that a firm is striving to maintain and that will maximize the firm's stock price. Each firm has a target capital structure, and it should raise new capital in a manner that will keep the actual capital structure on target over time.

• If the target capital structure is known, it should be used.
• If not, market values of debt and stocks should be used to calculate weights. That is, the company's current capital structure is assumed to represent the company's target capital structure.
• If this is not possible, then trends in the company's capital structure or averages of comparable companies' capital structures should be used as targets.

Example

Firm A has a capital structure consisting of 40% debt, 5% preferred stock, and 55% common equity (made up of retained earnings and common stock). Firm A pays 10% interest on its debt and has a marginal tax rate of 35%. If Firm A's component cost of preferred stock is 12.5% and the component cost of common stock equity from retained earnings is 13.5%, calculate Firm A's WACC.

WACC = 0.4 x 10% (1 - 0.35) + 0.05 x 12.5% + 0.55 x 13.5% = 0.026 + 0.00625 + 0.07425 = 10.65%

Investment Opportunity Schedule

In any one year, a firm may consider a number of capital projects. The greater the number of projects undertaken, the more money the firm will have to raise in order to finance them.

There is a limit to the amount of money that can be raised in any one year (i.e.,...

#### Annotation 1418439036172

Subject 2. Cost of Debt and Preferred Stock
#cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images
Capital components are the types of capital used by firms to raise fund. They include the items on the right side of a firm's balance sheet (debt, preferred stock, and common equity). Any increase in the firm's total assets must be financed by one or more of these capital components.

The cost of debt is defined as the cost to the firm in terms of the interest rate that it pays for ordinary debt (rd) less the tax savings that are achieved. Interest on debt is tax-deductible and therefore to calculate the cost of debt the tax benefit is deducted.

Two methods to estimate the before-tax cost of debt (rd) are discussed.

Yield-to-Maturity Approach

This approach uses the familiar bond valuation equation. Assuming semi-annual coupon payments, the equation is:

The six-month yield (rd/2) is derived and then annualized to arrive at the before-tax cost of debt, rd.

See Reading 54 for details of the yield-to-maturity approach.

Debt-Rating Approach

This approach can be used if there isn't a reliable market price for a firm's debt. Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that are a close match to those of the firm's existing debt.

For example, assume that:

• A firm's debt has an average maturity of 5 years.
• Its credit rating is AAA.
• The yield on debt with the same debt rating and similar maturity is 6%.
• The marginal tax rate is 30%.

Then the company's after-tax cost of debt is 6% x (1 - 30%) = 4.2%.

Other factors, such as debt seniority and security, may complicate the calculation, so analysts must take care when determining the comparable debt rating and yield.

Issues in Estimating the Cost of Debt

• Fixed-rate debt versus floating-rate debt

Estimating the cost of floating-rate debt is difficult because the cost depends not only on the current yield but also on the future yields. The term structure of interest rates may be used to calculate an average rate.

• Debt with option-like features

Be aware that some debt can have call or put options. (Valuating such debts is a topic for Level II candidates.)

• Non-rated debt

The yields of a firm's debt may not be available, or a firm may not have rated bonds.

• Leases

If a company uses leasing as a source of capital, the cost of these leases should be included in the cost of capital (long-term debt).

Cost of Preferred Stock

The cost of preferred stock is calculated by dividing the dollar amount of the dividend (which is normally paid on an annual basis) by the preferred stock current price.

It is important to note that tax does not affect the calculation of the cost of preferred stock, since preferred dividends are not tax deductible.

#### Flashcard 1418440871180

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What is the bethesda classification for glandular cell abnormalities detected? (pap tests)
- atypical glandular cells (AGC)
- atypical glandular cells - favour neoplastic

status measured difficulty not learned 37% [default] 0

#### Annotation 1418445851916

Subject 3. Cost of Common Equity
#cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images
The cost of common equity (re) is the rate of return stockholders require on common equity capital the firm obtains. It has no direct costs but is related to the opportunity cost of capital: if the firm cannot invest newly obtained equity or retained earnings and earn at least re, it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. Firms should earn on retained earnings at least the rate of return shareholders expect to earn on alternative investments with equivalent risk.

Estimating the cost of common equity is challenging due to the uncertain nature of the amount and timing of future cash flows.

The CAPM Approach

where RF is the risk-free rate, E(RM) is the expected rate of return on the market, and βi is the stock's beta coefficient. [E(RM) - RF] is called the equity risk premium (ERP). Both E(RM) and βineed to be estimated.

For example, firm A has a βi of 0.6 for its stock. The risk-free rate, RF, is 5%. The expected rate of return on the market, E(RM), is 10%. The firm's cost of common equity is therefore calculated as 5% + (10% - 5%) x 0.6 = 8%.

There are several ways to estimate the equity risk premium.

• The historical equity risk premium approach examines the historical data of realized returns from a country's market portfolio and uses the average rate for both the market portfolio and risk-free assets. One study, cited in the textbook, found that the annualized U.S. equity risk premium relative to U.S. Treasury bills was 5.3% (geometric mean). However, there are some limitations to this approach. For example, the level of risk of the stock index and risk aversion of investors may change over time.

• The dividend discount model approach (or implied risk premium approach) analyzes how the market prices an index using the Gordon growth model:

where re is the required rate of return on the market, D1 is the dividends expected next period on the index, P0 is the current market value of the equity market index, and g is the expected growth rate of the dividends.

• The survey approach is a direct one: ask a panel of financial experts for their estimates and take the mean response.

Dividend Discount Model Approach

where D1 is the dividend expected to be paid at the end of year 1, P0 is the current price of the stock, and g is the constant growth rate of dividends.

P0 is directly known, and D1 can be predicted if the company has a stable dividend policy. However, it is difficult to establish the proper growth rate (g). One method is to forecast the firm's average future dividend payout ratio and its complement, the retention rate: g = (1.0 - Payout rate) (ROE), where ROE is the expected future rate of return on equity. Another method is to use the firm's historical growth rate, if the past growth rates are stable.

Bond Yield Plus Risk Premium Approach

Because the cost of capital of riskier cash flows is higher than that of less risky cash flows:

...

#### Flashcard 1418447686924

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What is the recommended management for ASC-US?
reflex HPV testing vs repeat cytology vs colposcopy

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#### Annotation 1418454240524

Subject 4. Estimating Beta and Determining a Project Beta
#cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images
The determination of cost of capital under the CAPM approach involves the estimation of β, risk-free rate, and market return. β is generally determined by comparing the return of the firm or the project (as the case may be) with the market return and ascertaining the relationship. The historical β is the first step in the determination of the ex-ante β. Either the historical β can be accepted as the proxy for the future β or modifications can be made to make it conform to the future.

If we are thinking of a new company for a single project, we will have no historical records to go by. We would then compute the β of companies of the same size and about the same lines of business and after making necessary adjustments, take this as the β for the firm. The pure-play method can be used to take a comparable publicly traded company's beta and adjust it for financial leverage differences.

The β that we impute to a project is likely to undergo changes with changes in the capital structure of the company. If the company is entirely equity-based, its β is likely to be lower than it would be if it undertakes borrowing.

Let us call the β of a firm that is levered "levered β" and that of a firm on an all-equity structure "unlevered β."

β of a levered firm:

where:
βL = β of a levered firm
βU = β of an unlevered firm
T = tax rate
D = component of debt in capital structure
E = component of equity in capital structure

If the β of a firm is available and that β has been estimated on the premise that the firm is unlevered, we can now ascertain the β of the firm should it undertake some borrowing by using the following formula:

β of an unlevered firm:

In the same way, given the β of a firm which is already levered, we can ascertain what its β would be if it chooses an all-equity structure. This also means that if the target firm has leverage different from the structure assumed in estimating the levered β, this can first be converted into an unlevered β and then re-converted into a levered β using the leverage parameters relevant to the firm.

As a first step, we have to identify firms that reasonably resemble the project for which the beta is to be estimated. The stock β of these firms is then taken. Their respective leverage position (ratio of debt to equity) is also considered. After duly adjusting the tax factor and applying the above formula, we can determine the proxy β of the project assuming that it is unlevered.

The procedure is illustrated below:

Suppose there are three firms, P, Q, and R, which closely resemble project X (that is to be embarked upon). The stock betas of the three firms are taken and found to be 2.73, 2.23, and 1.73 respectively. The ratio of debt to equity for the three firms averages to 0.67. The marginal tax rate is 36%.

The average stock β works out to 2.23. Translating these numbers into the formula for unlevered firms, we get: βU = βL / (1 + (1 - T)(D/E)) = 2.23/(1+0.64 x 0.67) = 1.56.

This suggests that on an all-equity basis the β of the project would be 1.56. Now, if the project is proposed to be financed by 50% equity and 50% debt, we can modify the above β by applying the formula for levered firms:

βL = βU (1 + (1 - T) D/E) = 1.56 (1 + 0.64 x 0.5/0.5) = 2.56

So, on a 1:1 debt equity ratio, the β will be 2.56. This β can be used now for determining the cost of equity for the project and its w...

#### Annotation 1418459221260

Subject 5. Country Risk
#cfa #cfa-level-1 #corporate-finance #cost-of-capital
β seems not be able to capture country risk for companies in developing countries. Analysts often need to add a country spread (country equity premium) to the market risk premium when using CAPM to estimate the cost of equity.

One simple approach is to use the sovereign yield spread, which represents the yield on a developing country's US$-denominated bond vs. a U.S. Treasury-bond of the same maturity, as a proxy for the country spread. The sovereign yield spread primarily reflects default risk. This approach may be too coarse to estimate equity risk premium. Another approach is to adjust the sovereign yield spread by using the following formula: Country equity premium = Sovereign yield spread x (Annualized σ of equity index / Annualized σ of the sovereign bond market in terms of the developed market currency) The country equity premium is then added to the equity premium estimated for a similar project in a developed country. Example • Yield on 10-year government US$-denominated bond in China: 8.5%
• Yield on 10-year U.S. Treasury bond: 6.5%
• Annualized σ of national stock index: 50%
• Annualized σ of the national US$-denominated bond index: 20% • Equity risk premium for a project in the US: 10% Estimate the equity risk premium for a similar project in China. Sovereign yield spread: 8.5% - 6.5% = 2% Country risk premium: 2% x (50%/20%) = 5% Equity risk premium: 5% + 10% = 15% status not read #### Flashcard 1418461056268 Tags #obgyn Question any woman with [...] or [...] and an abn cytology report should be referred for URGENT colpo eval, as they may already have cervical ca. Answer an abn appearing cx; sx's suggestive of cervical ca status measured difficulty not learned 37% [default] 0 #### Annotation 1418462891276 Subject 6. Marginal Cost of Capital Structure #cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images The marginal cost of capital (MCC) is the cost of obtaining another dollar of new capital. The marginal cost rises as more and more capital is raised during a given period. The marginal cost of capital schedule is a graph that relates the firm's weighted average cost of each dollar of capital to the total amount of new capital raised. The cost of capital is level to the point at which one of the costs of capital changes, such as when the company bumps up against a debt covenant, requiring it to use another form of capital. The break point (BP) is the dollar value of new capital that can be raised before an increase in the firm's weighted average cost of capital occurs. Break point = Amount of capital at which the source's cost of capital changes / proportion of new capital raised from the source Example Consider the following schedule of the costs of debt and equity for a company. Assuming the company's target capital structure is 50% debt and 50% equity, the corresponding marginal cost of capital schedule looks like this: The break points are at$10 million and $20 million. The company can invest up to$10 million with the WACC = 9%. After $10 million, the company will have to raise new equity and new debt at higher costs, and the WACC will rise to 12% if the company wants to raise an additional$10 million.

The MCC is the cost of the last dollar raised by the company, while the WACC is the weighted average cost of all capital components used by the company. The MCC will increase as a firm raises more and more capital.

• Large, established firms typically obtain all their equity capital from retained earnings.
• Due to the floating costs of issuing new stocks, the cost of retained earnings is always less than the cost of newly issued common equity.
• If a firm requires so much capital that it has to issue new common stock, the WACC will rise because of the increased cost of new equity.

#### Annotation 1418467872012

Subject 7. Flotation Costs
#cfa #cfa-level-1 #corporate-finance #cost-of-capital #has-images
Flotation costs are the costs of issuing a new security, including the money investment bankers earn from the spread between their cost and the price offered to the public, and the accounting, legal, printing and other costs associated with the issue.

The amount of flotation costs is generally quite low for debt and preferred stock (often 1% or less of the face value), so we ignore them here. However, the flotation costs of issuing common stocks may be substantial, so they must be accounted for in the WACC. Generally, we calculate this by reducing the proceeds from the issue by the amount of the flotation costs and recalculating the cost of equity.

Example 1

XYZ is contemplating issuing new equity. The current price of their stock is $30 and the company expects to raise its current dividend of$1.25 by 7% indefinitely. If the flotation cost is expected to be 9%, what would be the cost of this new source of capital?

Cost of external equity = (1.25 x 1.07) / (30 x (1 - 0.09)) + 0.07 = 11.9%

Without the flotation cost, the cost of new equity would be (1.25 x 1.07) / 30 + 0.07 = 11.46%.

Note that flotation costs will always be given, but they may be given as a dollar amount or as a percentage of the selling price.

This is a typical example found in most textbooks. One problem with this approach is that the flotation costs are a cash flow at the initiation of the project and affect the value of any project by reducing the initial cash flow. It is not appropriate to adjust the present value of the future cash flows by a fixed percentage. An alternative approach is to make the adjustment to the cash flows in the valuation computation.

Example 2

Continue with the above example. Assume that XYZ is going to raise $10 million in new equity for a project. The initial investment is$10 million and the project is expected to produce cash flows of $4.5 million each year for 3 years. Ignoring the flotation cost of issuing new equity, the NPV of the project will be -10 + 4.5/1.11461 + 4.5/1.11462 + 4.5/1.11463 =$0.9093 million.

Now consider the flotation cost of 9%. The NPV, considering the flotation costs, is 0.9093 - 0.9 = $0.0093 million. However, if we use the "typical" approach, the NPV. considering the flotation costs, will be -10 + 4.5/1.1191 + 4.5/1.1192 + 4.5/1.1193 =$0.8268 million.

#### Flashcard 1418469707020

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What is the recommended management for ASC - H?
colpo

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#### Flashcard 1418474425612

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What is the recommended management for LSIL?
repeat at 6 & 12 mo
- if normal x2, can resume normal screening
- if either abn, refer to colpo

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#### Flashcard 1418476784908

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What is the recommended management for HSIL?
colpo

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#### Flashcard 1418478619916

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What is the recommended management for AGC (atypical glandular cells)? (pap tests)
colpo, endocervical curettage (ECC), endometrial bx

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#### Annotation 1418479144204

Subject 1. Business Risk and Operating Leverage
#cfa #cfa-level-1 #corporate-finance #has-images #measures-of-leverage
Leverage

Leverage is the extent to which fixed costs are used in a company's cost structure.

• Operating leverage is the extent to which fixed operating costs (e.g., depreciation, rent) are used in a firm's operations.
• Financial leverage is the extent to which fixed-income securities (debt and preferred stock) are used in a firm's capital structure.

Leverage affects a firm's risk, as it can magnify earnings both up and down. The bigger the leverage, the more volatile the firm's future earnings and cash flows, and the greater the discount rate applied in the firm's valuation (by bondholders and stockholders).

Business risk is the uncertainty (variability) about projections of future operating earnings. It is the single most important determinant of capital structure. If other elements are the same, the lower a firm's business risk, the higher its optimal debt ratio.

Business risk is the combined risk of sales and operations risks.

• The sales risk is the uncertainty regarding the price and quantity of the firm's goods and services. If the demand for and the price of a firm's goods and services are stable, its sales risk is considered low.

• The operating risk is the uncertainty caused by a firm's operating cost structure. If a high percentage of operating costs are fixed costs, operating risk is considered to be high.

In general, management has more opportunity to manage and control operating risk than sales risk.

Operating Risk

A company that has high operating leverage is a company with a large proportion of fixed input costs, whereas a company with largely variable input costs is said to have low operating leverage (due to its small amount of fixed costs).

A company with a high degree of operating leverage that has a small change in sales will experience a large change in profits and rate of return. This is due to the fact that because the company has a large fixed cost component, any increase in sales will cause an even greater increase in net income, since the fixed costs have already been incurred.

In many respects operating leverage is determined by technology. High (low) operating leverage is usually associated with capital (labor) intensive industries.

The degree of operating leverage (DOL) is defined as the percentage change in EBIT (operating income) that results from a given percentage change in sales. It measures the impact of a change in sales on EBIT.

Here Q is the number of units, P is the average sales price per unit of output, V is the variable cost per unit, F is fixed operating cost, S is sales in dollars, and VC is total variable costs.

P - V is referred to as the per unit contribution margin, which is the amount that each unit contributes to covering fixed costs. S - VC is called the contribution margin.

For example, assume that a firm has sales of $100,000, variable costs of$50,000, and fixed costs of $20,000. Its DOL is (100,000 - 50,000) / (100,000 - 50,000 - 20,000) = 1.67. status not read #### Flashcard 1418480979212 Tags #obgyn Question What is the recommended management for AGC - favour neoplasia? Answer colpo, ECC, endometrial bx, cone bx status measured difficulty not learned 37% [default] 0 #### Flashcard 1418485173516 Tags #obgyn Question What is the recommended management for adenocarcinoma in-situ? Answer colpo, ECC, endometrial bx, cone bx status measured difficulty not learned 37% [default] 0 #### Flashcard 1418487008524 Tags #obgyn Question What is the recommended management for sq cell carcinoma/adenocarcinoma (of cervix)? Answer URGENT colpo status measured difficulty not learned 37% [default] 0 #### Annotation 1418488057100 Subject 2. Financial Risk and Financial Leverage #cfa #cfa-level-1 #corporate-finance #has-images #measures-of-leverage Financial risk is the additional risk placed on the common stockholders as a result of the decision to use fixed-income securities (debt and preferred stock). Increases in financial leverage (the use of fixed-income securities) increases financial risk and the expected return of stockholders, due to the obligation of servicing the fixed interest payments. The questions are: Is the increased rate of return sufficient to compensate shareholders for the increased risk? What is the optimal financial structure to maximize stock price and the firm's value? Financial risk depends on two factors: • Cash flow volatility. The more volatile (stable) a firm's cash flows, the higher (lower) the financial risk. • Financial leverage. The higher the financial leverage, the higher the financial risk. As a general proposition, financial leverage raises the expected rate of return, but at the cost of increased financial risk (and thus total risk). So, you are faced with a trade-off: if you use more financial leverage, you increase the expected rate of return, which is good, but you also increase risk, which is bad. The degree of financial leverage (DFL) measures the financial risk. It shows how a given percentage change in EBIT per share will affect EPS. The equation above is developed as follows: where: I = interest paid T = marginal tax rate N = number of shares outstanding I is a constant so ΔI = 0, therefore: Now the percentage change in EPS is the change in EPS divided by the original EPS, which is: DFL is defined as the percentage change in earnings per share (EPS) divided by the percentage change in EBIT. Consider a company with EBIT =$100,000 and interest = $20,000. Its DFL = 100,000 / (100,000 - 20,000) = 1.25. Therefore, a 100% increase in EBIT would result in a 125% increase in EPS. Unlike operating leverage, the degree of financial leverage is most often a choice by the company's management. Companies with a higher ratio of tangible assets to total assets may have higher degrees of financial leverage because lenders may feel more secure that their claims would be satisfied in the event of a downturn. status not read #### Flashcard 1418489892108 Tags #obgyn Question what are the 2 broad classifications of cervical dysplasia tx modalities? Answer destructive/ablative vs excisional status measured difficulty not learned 37% [default] 0 #### Annotation 1418493299980 #obgyn Acetic acid is used during colpo to highlight dysplastic cells which turn acetowhite in response to its application status not read #### Annotation 1418493824268 Subject 3. Total Leverage and Breakeven Points #cfa #cfa-level-1 #corporate-finance #has-images #measures-of-leverage Operating leverage (first-stage leverage) affects EBIT, while financial leverage (second-stage leverage) affects earnings after interests and taxes (net income), which are the earnings available to shareholders. Financial leverage further magnifies the impact of operating leverage on earnings per share (EPS) due to changes in sales. Both operating leverage and financial leverage contribute to the risk associated with a firm's future cash flows. The degree of total leverage (DTL) combines DOL and DFL, and measures the impact of a given percentage change in sales on EPS. If both DOL and DFL are high, a small change in sales leads to wide fluctuations in EPS. The breakeven point is the volume of sales at which total costs equal total revenues, causing net income to equal zero: PQ - VQ - F - I = 0. The breakeven number of units, QBE, is: The operating breakeven point is the number of outputs at which revenues = operating costs: PQOBE = VQOBE + F. QOBE is: Consider a project where the fixed costs are$10,000, the variable costs are $2 per unit, the selling price per unit is$4, and the interest expense is $1,000. The breakeven sales quantity is 11,000 / (4 - 2) = 5,500 units and the operating breakeven sales quantity is 10,000 / (4 - 2) = 5,000 units. In general, the farther unit sales are from the breakeven point for high-leverage companies, the greater the magnifying effect of this leverage. status not read #### Flashcard 1418503785740 Tags #obgyn Question [...] is used during colpo to highlight dysplastic cells which turn acetowhite in response to its application Answer Acetic acid status measured difficulty not learned 37% [default] 0 Open it Acetic acid is used during colpo to highlight dysplastic cells which turn acetowhite in response to its application #### Flashcard 1418505358604 Tags #obgyn Question Acetic acid is used during colpo to highlight [...] cells which turn acetowhite in response to its application Answer dysplastic status measured difficulty not learned 37% [default] 0 Open it Acetic acid is used during colpo to highlight dysplastic cells which turn acetowhite in response to its application #### Flashcard 1418506931468 Tags #obgyn Question Acetic acid is used during colpo to highlight dysplastic cells which turn [...] in response to its application Answer acetowhite status measured difficulty not learned 37% [default] 0 Open it Acetic acid is used during colpo to highlight dysplastic cells which turn acetowhite in response to its application #### Annotation 1418514533644 Subject 4. The Risks of Creditors and Owners #cfa #cfa-level-1 #corporate-finance #measures-of-leverage Creditors and stockholders bear different risks because they have different rights and responsibilities. • Creditors get pre-determined returns and principals back when due, regardless of the profitability of the firm. • Stockholders get what is left over after all expenses, including interest paid to creditors, have been paid. In exchange for this uncertainty of returns (which is the risk that stockholders face), stockholders exercise decision-making power over the business. They can also declare what portion of the business earnings they will take out as dividends. The use of greater amounts of debt in the capital structure can raise both the cost of debt and the cost of equity capital. • The higher the percentage of debt, the riskier the debt, hence the higher the interest rate creditors will charge. • In general, increasing the use of debt increases the expected rate of return, but more debt also means that the firm's stockholders must bear more risk. The cost of equity capital must be higher now than before. Creditors have priority over stockholders in a bankruptcy proceeding. When a firm files for bankruptcy, its leverage often determines the final outcome. • Reorganization. A firm with high financial leverage uses bankruptcy laws and protection to reorganize its capital structure to remain in business. • Liquidation. A firm with high operating leverage cannot use such bankruptcy protection, as it would not reduce operating costs. This means that the firm's business is terminated, all the assets are sold and distributed to the holders of claims on the organization, and no corporate entity should survive. Stockholders generally lose all value in such a case, and creditors typically receive a portion of their capital. status not read #### Annotation 1418515057932 #obgyn Lugol’s iodine may be used during colpo which stains normal epithelium, but not dysplastic epithelium. status not read #### Flashcard 1418516368652 Tags #obgyn Question [...] may be used during colpo which stains normal epithelium, but not dysplastic epithelium. Answer Lugol’s iodine status measured difficulty not learned 37% [default] 0 Open it Lugol’s iodine may be used during colpo which stains normal epithelium, but not dysplastic epithelium. #### Flashcard 1418520825100 Tags #obgyn Question Lugol’s iodine may be used during colpo which stains [...] Answer normal epithelium, but not dysplastic epithelium. status measured difficulty not learned 37% [default] 0 Open it Lugol’s iodine may be used during colpo which stains normal epithelium, but not dysplastic epithelium. #### Annotation 1418522397964 Subject 1. Dividends: Forms #cfa #cfa-level-1 #corporate-finance #dividends-and-shares-repurchase-basics When firms earn income they have choices about what to do with that income. There are a number of options: • Reinvest in operations. • Acquire securities. • Pay off debt. • Distribute to shareholders. This section deals with the policies that firms employ when distributing the income to shareholders. Dividend policy involves three issues: • What fraction of earnings should be distributed on average over time? • Should the distribution be in the form of cash dividends or stock repurchases? • Should the firm maintain a steady, stable dividend growth rate? Firms can pay dividends in a number of ways. Cash Dividends A cash dividend is the type most people are familiar with. It is a cash amount, usually paid on a per share basis. It is paid out of retained earnings. • Regular dividends These are dividends distributed by companies on a regular recurring basis, usually quarterly, semi-annually, or annually. Both evidence and logic suggest that investors prefer companies that follow a stable, predictable dividend policy. The "stable dividend policy" generally means increasing the dividend at a reasonably steady rate. It signals to investors that: • The company is growing. • The company is willing to share gains with shareholders. • The management has confidence in the future of the company. However, some investors interpret rising dividends as a tacit sign of lack of sufficient growth opportunities. • Dividend reinvestment plans (DRIPs) A DRIP is a program run by a company for its shareholders. Instead of sending dividend checks to shareholders enrolled in a company's DRIP, the company reinvests those dividends by purchasing additional shares (or fractional shares) in the shareholder's name. Companies like DRIPs for several reasons. • DRIPs provide a stable base of shareholders who are likely to have a long-term, "buy and hold" investment philosophy. Individuals, particularly those who are dollar-cost averaging into their DRIPs, may see the drop in a stock's share price as a buying opportunity, as opposed to institutions and traders who move in and out of stocks with short-term goals in mind. This base of individual shareholders can help stabilize a company's share price. • DRIPs keep capital inside the company by not paying cash dividends outright and having those dividends reinvested in additional share purchases. • DRIPs can also help companies raise additional capital without making a public offering. For shareholders, the best part about DRIPs is that most DRIPs allow additional purchases to be made without a fee or commission. Some companies even offer the additional benefit of purchasing shares at a discount (usually 3-5%) to the market price. Disadvantages for shareholders: • Extra bookkeeping: Shareholders must keep scrupulous records, including all statements, in order to determine the cost basis of shares when they sell them. • Taxes: Dividends that are paid on shares of stocks are taxable as ordinary income on income tax returns, regardless of whether they are reinvested or received in cash. Shareholders must pay taxes on all dividends, reinvested or not, in the year in which they received them. • Extra (or special) dividends An extra dividend is a non-recurring distribution of company assets, usually in the form of cash, to shareholders. • Generally, special dividends are declared after exceptionally strong company earnings results as a way to distribute the profits directly to shareholders. • Companies i ... status not read #### Flashcard 1418524232972 Tags #obgyn Question Ablative techniques include [...] ​, all of which destroy the tissue containing the presumed dysplastic cells Answer laser ablation, cryotherapy, and electrocoagulation status measured difficulty not learned 37% [default] 0 #### Flashcard 1418526067980 Tags #obgyn Question Most patients (90%) will require [#] ​ablative treatment for cervical dysplasia. The different ablative techniques are all equally effective. Answer one status measured difficulty not learned 37% [default] 0 #### Annotation 1418527902988 Subject 2. Dividends: Payment Chronology #cfa #cfa-level-1 #corporate-finance #dividends-and-shares-repurchase-basics #has-images The dividend payment procedure is as follows: • Declaration date: The date on which a firm's directors issue a statement declaring a dividend. At the time of the declaration, the company will state the holder-of-record date and the payment date. • Ex-dividend date (ex-date): The date on which the right to the current dividend no longer accompanies a stock. This is the first date that a share trades without ("ex") the dividend. For a share traded on the ex-dividend date, the seller will receive the dividend. That is, if you buy a stock before this day you can get the dividend; if you buy a stock on or after this day the prior owner gets the dividend. This date is determined by the exchange on which the shares trade. • Holder-of-record date: If the company lists the stockholder as an owner on this date, then the stockholder receives the dividend. On this day the company closes its stock transfer book. It is typically two business days after the ex-dividend date. Unlike the ex-dividend date, this is determined by the company. • Payment date: The date on which a firm actually mails dividend checks (or, more recently, electronically transfers dividend payments). The date is determined when the dividend declaration is made, and can be any day, including weekends or holidays. Interval between key dates: Except for the time between the ex-date and the record date, the time between the other pertinent dates is determined by each company and can vary substantially. status not read #### Flashcard 1418529737996 Tags #obgyn Question You must r/o cervical ca before proceeding with [...] therapy or [...] as both may undertreat a pt with undetected cervical ca. Answer ablative therapy; simple hysterectomy status measured difficulty not learned 37% [default] 0 #### Annotation 1418533145868 Subject 3. Share Repurchases #cfa #cfa-level-1 #corporate-finance #dividends-and-shares-repurchase-basics Under a stock repurchase plan, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Unlike stock dividends and stock splits, share repurchases use corporate cash. This is an alternative way of paying cash dividends. Shares that have been issued and subsequently repurchased become treasury shares, which are not considered for dividends, voting, or computing earnings per share. Reasons for Share Repurchase There are different reasons for share repurchases: • Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management's belief that the firm's shares are undervalued. There is no question that the company has more information about itself than does any other entity; it is therefore the ultimate insider. • A company can remove a large block of stock that is overhanging the market and keeping the price per share down. • If the excess cash is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than declare an increased cash dividend which cannot be maintained. • Companies can use the residual model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends. • In some countries the tax rate on capital gains is lower than that on cash dividends. • Repurchases can be used to produce large-scale changes in capital structures. For example, if a firm's capital structure is too heavily weighted with equity, it can sell debt and use the proceeds to buy back stocks, thus increasing the debt ratio. The disadvantages are: • Stockholders may not be indifferent about dividends and capital gains (e.g., different tax treatments), and the price of the stock might benefit more from cash dividends than from repurchases. • Repurchases normally occur in the greatest number when times are good and companies have lots of cash and, concurrently, when share prices are relatively high. The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining stockholders. Repurchase Methods The four most important methods are: • Open market repurchases through a designated broker. This is the most common method of repurchase, often used to support the share price. • Fixed-price tender offers. Usually there is a premium offered to induce shareholders to sell. If management thinks the stock is undervalued, it is willing to pay a premium. • Dutch auction. A Dutch auction specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock at any price within the stated range. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price. • Direct negotiation with major shareholders. Shares are often acquired at a premium to the market price. One purpose is to prevent raiders from acquiring company at an attractive price. status not read #### Annotation 1418534980876 Subject 4. Financial Statement Effects of Repurchases #cfa #cfa-level-1 #corporate-finance #dividends-and-shares-repurchase-basics #has-images A share repurchase should be equivalent to the payment of cash dividends of equal amounts in their effect on shareholders' wealth, all things being equal. This means the taxation and information content of cash dividends and share repurchases do not differ. Examples Example 1: Equivalent Share Repurchase and Cash Dividends Company XYZ is expected to have$10 million in earnings. It plans to distribute $6 million to shareholders through cash dividends or stock repurchases. The current stock price is$20. The company has 1 million shares outstanding. The stock repurchase can be completed at $20. • Cash dividends • Per share dividend:$6 million / 1 million = $6 • Per share value:$20 - $6 =$14
• Total wealth from ownership of one share: $14 +$6 = $20 • Share repurchase • Number of shares to be repurchased:$6 million / $20 = 0.3 million • Post-repurchase share price: [1,000,000 x$20 - $6,000,000] / (1,000,000 - 300,000) =$20
• Total wealth from ownership of one share is also $20. Example 2: A Share Repurchase that Transfers Wealth Continuing with the above example, assume that the company has to pay a premium to repurchase shares from a wealthy investor: the stock repurchase price can be completed at$25 per share.

• Share repurchase

• Number of shares to be repurchased: $6 million /$25 = 0.24 million
• Post-repurchase share price: [1,000,000 x $20 -$6,000,000] / (1,000,000 - 240,000) = $18.42 • Shareholders other than the wealthy investor would lose$20 - $18.42 =$1.58 for each share owned. Therefore, the transaction effectively transfers wealth from the other shareholders to this individual investor.

Example 3: Share Repurchases Using Borrowed Funds: The Effect on EPS When the After-Tax Cost of Borrowing Equals E/P

ABC Company wants to borrow $10 million to repurchase shares. With the after-tax cost of borrowing equal to the earnings yield (E/P) of the shares, the share repurchase has no effect on the company's EPS. However, if the after-tax cost of borrowing is greater (less) than the earnings yield, EPS will be less (more) than its pre-repurchase level. A share repurchase may cause the P/E ratio to change as well. For example, if a share repurchase causes a company's financial leverage to change, the financial risk of the company's earnings stream changes and the P/E ratio post-repurchase may change from its pre-repurchase level to reflect the change in risk. Example 4: The Effect of Share Repurchase on Book Value per Share Company X and Company Y have announced a$5 million buyback.

This example shows that book value per share (BVPS) will either increase or decrease depending on whether share price is higher or lower than BVPS. When share price is greater (less) than BVPS, BVPS will decrease (increase) after a share repurchase.

#### Annotation 1418539961612

Subject 1. Managing and Measuring Liquidity
#cfa #cfa-level-1 #corporate-finance #working-capital-management
Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Liquidity management refers to the ability of a company to meet its short-term financial obligations. There are two sources of liquidity. The main difference between the two sources is whether or not the company's normal operations will be affected.

• Primary sources of liquidity include cash, short-term funds, and cash flow management. These resources represent funds that are readily accessible at relatively low cost.
• Secondary sources include negotiating debt contracts, liquidating assets, and filing for bankruptcy and reorganization. They provide liquidity at a higher price and may impact a company's financial and operating positions.

Measuring Liquidity

Almost all liquidity measures are covered in Reading 26 [Understanding Balance Sheet] and Reading 28 [Financial Analysis Techniques].

Operating cycle = Number of days in inventory + Number of days of receivables
Net operating cycle (cash conversion cycle) = Number of days in inventory + Number of days of receivables - Number of days of payables

Example

Average accounts receivable: $25,400 Average inventory:$48,290
Average accounts payable: $37,510 Credit sales:$325,700
Cost of goods sold: $180,440. Total purchases:$188,920

How many days are in the operating cycle? How many days are in the cash cycle?

1. The receivable turnover rate tells you the number of times during the year that money is loaned to customers. Credit sales / Average accounts receivable = 325,700 / 25,400 = 12.8228.

Receivables period = 365 days / 12.8228 = 28.46 days. This tells you that it takes customers an average of 28.46 days to pay for their purchases.

2. The inventory turnover rate indicates the number of times during the year that a firm replaces its inventory. COGS / Average inventory = 180,440 / 48,290 = 3.7366

Inventory period = 365 days / 3.7366 = 97.68 days. This means inventory sits on the shelf for 97.68 days before it is sold. That's ok for a furniture store but you should be highly alarmed if a fast food restaurant has a 98-day inventory period.

3. The accounts payable is matched with total purchases to compute the turnover rate because these accounts are valued based on the wholesale, or production, cost of each item.

Payables turnover = Total purchases / Average accounts payables = 188,920 / 37,510 = 5.0365
Payables period = 365 / 5.0365 = 72.47 days. On average, it takes 72.47 days to pay suppliers.

The operating cycle begins on the day inventory is purchased and ends when the money is collected from the sale of that inventory. This cycle consists of both the inventory period and the accounts receivable period. Operating cycle = 97.68 + 28.46 = 126.14 days

The cash cycle is equal to the operating cycle minus the payables period. It is the number of days for which the firm must finance its own inventory and receivables. During the cash cycle, the firm must have sufficient cash to carry its inventory and receivables.

Cash cycle = 126.14 - 72.47 = 53.67 days

In this example, the firm must pay for its inventory 53.67 days before it collects the payment from selling that inventory. Controlling the cash cycle is a high priority for financial managers.

#### Annotation 1418541796620

Subject 2. Managing the Cash Position
#cfa #cfa-level-1 #corporate-finance #working-capital-management
Managing short-term cash flows involves minimizing costs. The two major costs are carrying costs, the return forgone by keeping too much invested in short-term assets such as cash, and shortage costs, the cost of running out of short-term assets. The objective of managing short-term finances and doing short-term financial planning is to find the optimal trade-off between these two costs.

The starting point for good cash flow management is developing a cash flow projection. To forecast short-term cash flows, a financial manager needs to:

• Determine minimum cash balances.
• Identify the typical cash inflows and outflows of the company.
• Develop a cash forecasting system.

Monitoring cash uses and levels means keeping a running score on daily cash flows.

• The most important task is to collect cash flow information on a timely basis.
• Establish a target cash balance for each bank.
• Use short-term investments and borrowing to help with cash position management.
• Consider other factors, such as seasonal factors, upcoming mergers and acquisition, etc.

#### Annotation 1418543631628

Subject 3. Investing Short-Term Funds
#cfa #cfa-level-1 #corporate-finance #working-capital-management
Cash does not pay interest. Companies should invest funds that are not needed in daily transactions. Short-term investment is discussed in the reading.

Nominal rate: a rate of interest based on a security's face value. For a non-zero-bond, the coupon rate is the nominal rate.

A yield is the actual return on the investment if it is held to maturity.

• Money market yield and bond equivalent yield. Refer to Reading 6 [Discounted Cash Flow Applications].
• Discount-basis yield (also referred to as the investment yield basis) is often quoted in the context of U.S. T-securities: [(Face value - Purchase price) / (Face value)] x (360 / Number of days to maturity).

Strategies

Short-term investment strategies can be grouped into two types:

• Passive strategy.

• One or two decision rules for making daily investments.
• Safety and liquidity first.
• Passive strategies must be monitored and the yield should be benchmarked against a comparable standard (such as a T-bill).

• Active strategy.

• More daily involvement and a wider choice of investments.
• Matching / mismatching: the timing of cash inflows and outflows.
• A laddering strategy is a strategy in which a bond portfolio is constructed to have approximately equal amounts invested in each maturity within a given range (to reduce interest rate risk).

A company should have a formal, written investment policy or guideline that protects the company and its investment managers.

#### Annotation 1418545466636

Subject 4. Evaluating Accounts Receivable, Inventory and Accounts Payable Management
#cfa #cfa-level-1 #corporate-finance #has-images #working-capital-management
Accounts Receivable

The most popular measures to evaluate receivables are receivable turnover and number of days of receivables.

Example

Build It Right, Inc. sells 5,500 curio cabinets a year at a price of $2,000 each. The credit terms of the sale are 2/10, net 45. Eighty percent of the firm's customers take the discount. What is the amount of the firm's accounts receivable? If 80% of the customers pay in 10 days, then the other 20% must pay in 45 days. How much does the firm sell each year? 5,500 x$2,000 = $11,000,000 The average collection period: [0.80 x 10] + [(1 - 0.80) x 45] = 8 + 9 = 17 days. The accounts receivable turnover: 365 / 17 = 21.470588. The average receivables balance:$11,000,000 / 21.470588 = $512,328.77. Inventory Managing inventory is a juggling act. Excessive stocks can place a heavy burden on the cash resources of a business. Insufficient stocks can result in lost sales, delays for customers, etc. The goal of inventory management is to identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Just-In-Time (JIT) is an inventory strategy implemented to improve a business's return on investment by reducing in-process inventory and its associated costs. Economic order quantity (also known as the EOQ Model) is a model that defines the optimal quantity to order that minimizes total variable costs required to order and hold inventory. To evaluate inventory management analysts compute the inventory turnover ratio and the number of days of inventory. These measures are covered in Study Session 8. Accounts Payable Two countering forces should be considered when managing accounts payable: • Paying too early is costly unless the company can take advantage of discounts. • Postponing payment beyond the end of the net (credit) period is known as "stretching accounts payable" or "leaning on the trade." Possible costs are: • Cost of the cash discount (if any) forgone. • Late payment penalties or interest. • Deterioration in credit rating. Trade discounts should be evaluated by computing the implicit rate of return: Example Today, June 10, you purchased$5,000 worth of materials from one of your suppliers. The terms of the sale are 3/15, net 45.

• Discounted price: $5,000 x (1 - 0.03) =$4,850
• Last day to receive discount: June 10 + 15 days = June 25
• Days credit: 45 - 15 = 30
• Implicit interest: 0.03 x $5,000 =$150
• Cost of credit (effective annual rate): (1 + 0.03/0.97)365/30 - 1 = 44.86%

Analysts often use the number of days of payables and payables turnover to evaluate accounts payable management.

• Payables turnover = Cost of goods sold / Accounts payables
• Number of days of payables = # of days in period / Payables turnover = Accounts payable / Average day's purchase

#### Annotation 1418548874508

Subject 5. Managing Short-Term Financing
#cfa #cfa-level-1 #corporate-finance #working-capital-management
There are two sources of short-term financing:

Bank Sources

Unsecured Loans: A form of debt for money borrowed that is not backed by the pledge of specific assets.

• Line of credit (L/C).

• A bank provides a letter of credit, for a fee, guaranteeing the investor that the company's obligation will be paid. It is a promise from a bank for payment in the event that certain conditions are met.
• It is frequently used to guarantee payment of an obligation.
• Committed lines of credit are stronger than those that are uncommitted because of the bank's formal commitment.

• Revolving credit agreement: A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
• Banker's acceptance.

• These are short-term promissory trade notes for which a bank (by having "accepted them") promises to pay the holder the face amount at maturity.
• They are used to facilitate foreign trade or the shipment of certain marketable goods.

Secured Loans: A form of debt for money borrowed in which specific assets have been pledged to guarantee payment.

• Factoring accounts receivable. Factoring is the selling of receivables to a financial institution, the factor, usually "without recourse."

• A factor is often a subsidiary of a bank holding company.
• A factor maintains a credit department and performs credit checks on accounts.
• This type of loans allows a firm to eliminate its credit department and the associated costs.
• Contracts are usually for 1 year, but are renewable.

• Inventory-backed loans. Loan evaluations are made on the basis of marketability, price stability, perishability, and difficulty and expense of selling for loan satisfaction.
• Floating Lien: A general, or blanket, lien against a group of assets, such as inventory or receivables, without the assets being specifically identified.
• Trust Receipt: A security device acknowledging that the borrower holds specifically identified inventory and proceeds from its sale in trust for the lender.
• Terminal Warehouse Receipt: A receipt for the deposit of goods in a public warehouse that a lender holds as collateral for a loan.

Nonbank Sources

• Commercial paper.

• Short-term, unsecured promissory notes, generally issued by large corporations (unsecured corporate IOUs).
• Cheaper than a short-term business loan from a commercial bank.
• Dealers often require a line of credit to ensure that the commercial paper is paid off.

• Nonbank finance companies.

The best mix of short-term financing depends on:

• Cost of the financing method;
• Availability of funds;
• Timing;
• Flexibility;
• Degree to which the assets are encumbered.

Cost of Borrowing

The fundamental rule is to compute the total cost of borrowing and divide that by the net proceeds.

• Collect basis: interest is paid at maturity of the note.

• Example: $100,000 loan at 10% stated interest rate for 1 year. •$10,000 in interest / $100,000 in usable funds = 10.00%. • Discount basis: interest is deducted from the initial loan. • Example:$100,000 loan at 10% stated interest rate for 1 year.
• $10,000 in interest /$90,000 in usable funds = 11.11%.

• Compensating balances: demand deposits maintained by a firm to compensate a bank for services provided, credit lines, or loans.

• Example: 1,000,000 loan at 10% stated inter ... status not read #### Annotation 1418550971660 Subject 1. Summary of Corporate Governance Considerations #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Research findings state that there is a strong correlation between good corporate governance and better valuation results of listed companies. It is important to alert investors to the importance of corporate governance. The manual considers how investors can evaluate the quality of corporate governance. The Board The primary responsibility of the Board is to foster the long-term success of the corporation, consistent with its fiduciary responsibility to shareowners. To carry out this responsibility, the Board must ensure that it is independent and accountable to shareowners and must exert authority for the continuity of executive leadership with proper vision and values. The Board is singularly responsible for the selection and evaluation of the corporation's chief executive officer; included in that evaluation is assurance as to the quality of senior management. The Board should also be responsible for the review and approval of the corporation's long-term strategy, the assurance of the corporation's financial integrity, and the development of equity and compensation policies that motivate management to achieve and sustain superior long-term performance. The Board should put in place structures and processes that enable it to carry out these responsibilities effectively. Certain issues may be delegated appropriately to committees (including the audit, compensation and corporate governance/nominating committees) to develop recommendations to bring to the Board. Nevertheless, the Board maintains overall responsibility for the work of the committees and the long-term success of the Company. Investors and shareowners should determine whether: • a Company's Board has, at a minimum, a majority of Independent Board Members; • Board Members have the qualifications the Company needs for the challenges it faces; • the Board and its committees have budgetary authority to hire independent third-party consultants without having to receive approval from management; • Board Members are elected annually or the Company has adopted an election process that staggers the terms of Board Member elections; • the Company engages in outside business relationships with management or Board Members, or individuals associated with them, for goods and services on behalf of the Company; • the Board has established a committee of Independent Board Members, including those with recent and relevant experience of finance and accounting, to oversee the audit of the Company's financial reports; • the Company has a committee of Independent Board Members charged with setting executive remuneration/compensation; • the Company has a nominations committee of Independent Board Members that is responsible for recruiting Board Members and • the Board has other committees that are responsible for overseeing management's activities in select areas, such as corporate governance, mergers and acquisitions, legal matters, or risk management. Management Investors and shareowners should: • determine whether the Company has adopted a Code of Ethics, and whether the Company's actions indicate a commitment to an appropriate ethical framework; • determine whether the Company permits Board Members and management to use Company assets for personal reasons; • analyze both the amounts paid to key executives for managing the Company's affairs and the manner in which compensation is provided (to determine whether compensation paid to executives is commensurate with the executives' level of responsibilities and performance and provides appropriate incentives); and • inquire into the size, means of financing, and duration of share-repurchase programs and price stabilization efforts. Shareowner Rights Investors and shareowners should determine: • whether the Company permits Shareowners to vote their shares by proxy re ... status not read #### Annotation 1418552806668 Subject 2. What is Corporate Governance? #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders, and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which company objectives are set and the means of attaining those objectives and monitoring performance. Corporate governance is about promoting corporate fairness, transparency, and accountability. Its purpose is to prevent one group from expropriating the cash flows and assets of one or more other groups. Good corporate governance practices: • Board Members act in the best interests of Shareowners. • The Company deals with all stakeholders in a lawful and ethical manner. • All Shareowners have the same right to participate in the governance of the Company and receive fair treatment from the Board and management. All rights of Shareowners and other stakeholders are clearly delineated and communicated. • The Board and its committees can act independently from other stakeholders such as management. • Appropriate controls and procedures are in place covering management's activities in running the day-to-day operations of the Company. • The Company's operating and financial activities, and its governance activities, are consistently reported to Shareowners in a fair, accurate, timely, reliable, relevant, complete, and verifiable manner. status not read #### Annotation 1418554641676 Subject 3. Board Independence #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Board Members must make decisions based on what ultimately is best for the long-term interests of Shareowners. The major factors that enable a board to act in the best interests of shareowners can be summarized as: • Independence, which means that the board has the autonomy to act independently and does not only vote along with the management. • Experience and expertise, which means the board has the competence to evaluate the best interests of the shareowners. Depending upon the business, specialized expertise might be required. • Resources, which means there are internal mechanisms that allow the board to exercise its independent work, including using outside consultants. Independence promotes integrity, accountability and effective oversight. We will address experience and resources in later discussions. The term "Board Member" refers to all individuals who sit on the Board, including: • Executive Board Members: the members of the executive management. They are not considered to be Independent; • Independent Board Members; • Non-Executive Board Members: they may represent interests that may conflict with those of other Shareowners. An Independent Board Member is defined as one who has no direct or indirect material relationship with the Company, its subsidiaries, or any of its members other than as a Board Member or Shareowner of the Company. Stated simply, an Independent Board Member must be free of any relationship with the Company or its senior management that may impair the Board Member's ability to make independent judgments or compromise the Board Member's objectivity and loyalty to shareowners. There are many different types of relationships between Board Members and the Company that may be material and preclude a finding of independence, including employment, advisory, business, financial, charitable, family, and personal relationships. In making determinations regarding Independence, the Board shall consider all relevant facts and circumstances and shall apply the following guidelines: • Independent Board Members should not be current or former employees of the Company; • Independent Board Members should not serve as or be affiliated with advisors (including external auditors) to the Company or its senior management; • Independent Board Members should not do business with the Company. The Board should be comprised of a substantial majority of Independent Board Members. A Board with this makeup and one which is diverse in its composition is more likely to limit undue influence of management and others over the affairs of the Board. The decisions of such a Board will be more likely to aid the Company's long-term success. Things to consider for investors: • Do Independent Board Members regularly meet without the presence of management and report on their activities at least annually to Shareowners? • Is the Board Chair also the CEO of the Company? If yes, Executive Board Members may have too much influence and impair the ability and willingness of Independent Board Members to exercise their independent judgment. • Is the Board chair a former chief executive of the Company? If yes, the chair may hamper efforts to undo the mistakes he or she previously made. • If the Board Chair is not Independent, do Independent Board Members have a lead Member? • If some Board Members are aligned with a Company-related entity (supplier, customer, auditor, etc.), do they recuse themselves on issues that may create a conflict? status not read #### Annotation 1418556476684 Subject 4. Board Member Qualifications #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Board Members who have appropriate experience and expertise relevant to the Company's business are best able to evaluate what is in the best interest of Shareowners. They must be able to contribute business judgment to board deliberations and decisions, based on their experience in relevant business, management disciplines, or other professional life endeavors. Depending on the nature of the business, this may require specialized expertise by at least some Board Members. If Board Members lack the skills, knowledge, and expertise to conduct a meaningful review of the Company's activities, and are unable to conduct in-depth evaluations of the issues affecting the Company's business, they are more likely to defer to management when making decisions. The following attributes should be considered desirable for Board Members: • Experience. Board Members must have extensive experience in business, education, the professions and/or public service so they can make informed decisions about the Company's future. Do they have the background, expertise, and knowledge in specific subjects needed by the Board? Board Members should be able to act with care and competence as a result of relevant expertise and understanding of: • the principal technologies, products, or services offered in the Company's business, • financial operations, • legal matters, • accounting, • auditing, • strategic planning, and • the risks the Company assumes as part of its business operations. • Personal. The Board Member should be of the highest moral and ethical character. Have they made public statements that can provide an indication of their ethical perspectives? • Relevant Board experience. Do they have experience serving on other Boards, particularly with Companies known for having good corporate governance practices? Have they had any legal or regulatory problems as a result of working for, or serving on, the Board of another company? • Availability. The Board Member must be willing to commit as well as have, sufficient time to discharge the duties of Board membership. Do they serve on a number of Boards for other Companies, constraining the time available to serve effectively? Do they regularly attend Board and committee meetings? • Term limits. Does the Board have term limits? Term limits can help insure that there are fresh ideas and viewpoints available to the Board. They can prevent a Board Member from developing a cooperative relationship with management that could impair his or her willingness to act in the best interest of Shareowners. However, term limits have the disadvantage of losing the contribution of Board Members who have developed, over a period of time, valuable insight into the Company and its operations and, therefore, provide an increased contribution to the Board as a whole. status not read #### Annotation 1418558311692 Subject 5. Board Resources #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors There need to be internal mechanisms to support the Independent work of the Board, including the budgetary authority to hire outside consultants without management's intervention or approval. This mechanism alone provides the Board with the ability to obtain expert help in specialized areas, to circumvent potential areas of conflict with management, and to preserve the integrity of the Board's Independent oversight function. Why does the Board need outside third-party consultants? • Independent Board Members typical have limited time to devote to their Board duties. They need support in gathering and analyzing a large amount of information relevant to managing and overseeing the Company. • Very specialized advice and expertise are needed when dealing with issues such as compensation, proposed mergers and acquisitions, legal, regulatory and financial matters, and reputational concerns. • Independent outside advisors, including public accountants, law firms, investment bankers, and consultants, can be critical to the effectiveness of corporate governance and enhance the legal and regulatory compliance of the corporate client. The Board should have the authority to decide whether to hire external consultants, whom should be hired, and how they are to be compensated, etc. without having to receive approval from management. status not read #### Annotation 1418560146700 Subject 6. Other Board Issues #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Board Member Terms Shareowners should determine whether Board Members are elected annually or whether the Company has adopted an election process that staggers the terms of Board Member elections. In annual votes, every Board Member stands for re-election every year. Such an approach ensures that Shareowners are able to express their views on individual members' performance during the year and to exercise their right to control who will represent them in corporate governance and oversight of the Company. Companies that prevent Shareowners from electing Board Members on an annual basis limit Shareowners' ability to change the Board composition when, for example, Board Members fail to act on their behalf, or to elect individuals with needed expertise in response to a change in Company strategy. Staggered Board: A Board of directors only a part of which is elected each year, usually to discourage takeover attempts. In a classified or staggered Board, Board Members are typically elected in two or more classes, serving terms greater than one year. A three-year staggered Board, for example, would have one third of the Board Members or nominees eligible for Shareowner ratification for a three-year period at each annual meeting. • Proponents of staggered boards argue that by staggering the election of Board Members, a certain level of continuity and skill is maintained. • Staggered terms for Board Members make it more difficult for Shareowners to make fundamental changes to the composition and behavior of the Board by making any challenge to (or change in) board control extremely difficult. In circumstances where a company's performance is deteriorating, this difficulty could result in a permanent impairment of long-term Shareowner value. Corporate governance best practice guidelines generally supports the annual election of directors as being in the best interest of investors. Investors should consider whether: • Shareowners may elect Board Members every year; • Shareowners can vote to remove a Board member under certain circumstances; • The size of the Board is appropriate. The Board should be large enough to allow key committees to be staffed by independent, qualified Board Members but small enough to allow all views to be heard and to encourage the active participation of all members. Related-Party Transactions Investors should investigate whether the Company engages in outside business relationships with management or Board Members, or individuals associated with them, for goods and services on behalf of the Company. Related-party transactions involve buying, selling, and other transactions with Board Members, executives, partners, employees, family members, and so on. These are not illegal or necessarily a violation of any kind. Current accounting and auditing standards require the disclosure of these transactions (only if material) but no more. Board Members are supposed to make independent decisions. Receiving personal benefits from the Company can create an inherent conflict of interest. Board Members should be discouraged from engaging in the following practices, among others: • Receiving consultancy fees for work performed on behalf of the Company. • Receiving finder's fees for bringing merger, acquisition, or sales partners to the Company's attention. When reviewing an issue, investors should determine whether: • the Company's ethical code or the Board's policies and procedures limit the circumstances in which insiders can accept remuneration from the Company for consulting or other services outside of the scope of their positions as Board Members, • the Company has disclosed related-party transactions with existing Board Members, such as finder's fees for their roles in acquisition, and • Board Members or exec ... status not read #### Annotation 1418561981708 Subject 7. Board Committees #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors The Board should delegate certain functions to committees. Under new U.S. regulations, three key committees must be comprised exclusively of independent directors: the audit committee, the compensation committee, and the corporate governance/nominating committee. The new requirements have also greatly expanded the responsibilities and necessary competencies of audit committee members. The credibility of the corporation will depend in part on the vigorous demonstration of independence by the committees and their chairs. Committees should have the right to retain and evaluate outside consultants and to communicate directly with staff below the senior level. The committees should report back to the board on important issues they have considered and upon which they have taken action. They should meet in executive session on a regular basis with management personnel, if appropriate (because of issues under discussion), and also without such personnel being present. If the company receives a shareholder proposal, the committee most appropriate to consider the matter should review the proposal and the management's response to it. Audit Committee Investors should determine whether the Board has established a committee of Independent Board Members, including those with recent and relevant experience of finance and accounting, to oversee the audit of the Company's financial reports. The audit committee of the Board is established to provide independent oversight of the Company's financial reporting, non-financial corporate disclosure, and internal control systems. This function is essential for effective corporate governance and for seeing that responsibilities to Shareowners are fulfilled. The committee represents the intersection of the board, management, independent auditors, and internal auditors, and it has sole authority to hire, supervise, and fire the corporation's independent auditors. When selecting auditors, the committee should: • consider the auditors' independence, • ensure the auditor's priorities are aligned with the best interests of Shareowners, and • ensure the quality and integrity of the company's financial statements. When evaluating the audit committee, investors should determine whether: • all of the Board Members on the committee are independent (note that some jurisdictions permit non-Independent members to be on the committee), • any of the Board Members are considered financial experts, • the appointment of the external auditors is subject to Shareowner approval, • the committee's independence is compromised by the provision of non-audit services. The committee should establish limitations on the type and amount of such services that the auditor can provide. The committee should also consider imposing limitations on the corporation's ability to hire staff from the auditor and requiring periodic rotation of the outside auditor. • the committee is responsible for the adequacy and effectiveness of the company's internal controls and the effectiveness of management's process of monitoring and managing business risks facing the company. The committee should establish a means by which internal auditors and other employees can communicate directly with committee members. • the committee and the external auditor had any discussions resulting in a change in the financial reports as a result of questionable interpretations of accounting rules, fraud, or other accounting problems, and whether the Company has fired its external auditors as a result of such issues, and • the committee controls the audit budget to enable it to address unanticipated or complex issues. Remuneration / Compensation Committee Investors should determine whether the Company has a committee of Independent Board Members charged with setting ... status not read #### Annotation 1418563816716 Subject 8. Implementation of Code of Ethics #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Investors should determine whether the Company has adopted a code of ethics and whether the Company's actions indicate a commitment to an appropriate ethical framework. A Company's Code of Ethics sets standards for ethical conduct based on basic principles of integrity, trust, and honesty. It provides personnel with a framework for behavior while conducting the Company's business, as well as guidance for addressing conflicts of interest. In effect, it represents a part of the Company's risk management policies, which are intended to prevent Company representatives from engaging in practices that could harm the Company, its products, or Shareowners. Reported breaches of ethics in a Company often result in regulatory sanctions, fines, management turnover, and unwanted negative media coverage, all of which can adversely affect the Company's performance. Investors should determine whether the Company: • gives the Board access to relevant corporate information in a timely and comprehensive manner; • is in compliance with the corporate governance code of the country where it is located; • has an ethical code and whether that code prohibits any practice that would provide advantages to Company insiders that are not also offered to Shareowners; • has designated someone who is responsible for corporate governance; • has an ethical code that provides waivers from its prohibitions to certain levels of management, and the reasons why; • waived any of its code's provisions during recent periods, and why; • regularly performs an audit of its governance policies and procedures to make improvements. status not read #### Annotation 1418566176012 Subject 9. Personal Use of Company Assets #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Investors should determine whether the Company permits Board Members, management, and their family members to use Company assets for personal reasons. Company assets are used to conduct Company business. If they are used by anybody for personal reasons, they are not available for investment in productive and income-generating activities. For Board Members, such use also creates conflicts of interest. When reviewing this issue, investors should determine whether the Company: • has an ethical code or policies and procedures that place strict limits on the ability of insiders to use Company assets for personal benefit; • has lent cash or other resources to Board Members, management, or their families; • has purchased property or other assets (such as houses or airplanes) for the personal use of Board Members, management, or their family members; • has leased assets such as dwellings or transportation vehicles to Board Members, management, or their family members, and whether the terms of such contracts are appropriate given market conditions. status not read #### Annotation 1418568011020 Subject 10. Executive Compensation #cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors Investors should analyze both the amounts paid to key executives for managing the Company's affairs and the manner in which compensation is provided to determine whether compensation paid to executives is commensurate with the executives' levels of responsibilities and performance and provides appropriate incentives. Every year, shareowners learn of new jaw-dropping executive compensation packages that seemingly defy rational explanation. In 2004, the average CEO of a major company received9.84 million in total compensation, according to The New York Times.

As described earlier, the Board is responsible for ensuring that an executive compensation program is in place that will attract, retain, and motivate strong management performance. Compensation plans should encourage executives to achieve performance objectives and, in so doing, create long-term shareowner value.

Executive compensation has four basic components: base salary, bonuses, stock options, and various perquisites. The amounts paid and the manner in which executive management is compensated can affect Shareowner value in various ways. Investors should examine the reported:

• Remuneration/compensation strategy. Does the program reward long-term or short-term growth? How does the remuneration/compensation committee set pay for executives? Does it use outside consultants or rely on internal resources? Is the program based on the performance of the Company relative to its competitors or other peers?

• Executive compensation. This requires the analysis of actual compensation paid to the top executives during recent years and the elements of the compensation packages offered to them. The analysis can help investors determine whether the investment made in executive management is producing adequate returns for the Company.

• Equity-based compensation. Equity-based compensation can be a critical element of compensation and can provide the greatest opportunity for the creation of wealth for managers whose efforts contribute to the creation of value for shareholders. Thus, equity-based compensation plans can offer the greatest incentives. Shareowner interests are also greatly affected by equity-based compensation plans: the ownership positions of existing Shareowners could be diluted, and executives could assume additional risks because of stock options granted to them, etc.

• Investors should examine the size of grants, potential value to recipients, cost to the company, and plan provisions that could have a material impact on the number and value of shares distributed.
• Should all plans that provide for the distribution of stock or stock options to executives be submitted to shareowners for approval?
• What's the impact on the income statement? IFRS and U.S. GAAP both require Companies to expense stock options grants.
• Are equity-based compensation plans linked to the long-term performance of the Company?
• Option repricing: Companies might want to re-price downward the strike prices of stock options previously granted. This would remove the incentives the original options created for management.
• Investors should examine the information about the extent to which individual managers have hedged or otherwise reduced their exposure to changes in the company's stock price. They should also determine if managers have share holdings other than those related to stock option grants.

#### Annotation 1418569846028

Subject 11. Shareowner Proxy Voting
#cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors
Investors should determine whether the Company permits Shareowners to vote their shares by proxy regardless of whether they are able to attend the meeting in person.

The ability to vote one's shares is a fundamental right of share ownership. A company's rules governing shareowner-sponsored board nominations, resolutions, and proposals are generally supportive of shareowner rights, but the rules and the procedures for exercising such rights should not be prohibitively cumbersome. If this is the case, shareowners cannot readily address their concerns in order to protect the value of their shares.

Sometimes a Company makes it difficult for Shareowners to vote their common shares by not allowing them the right to vote by proxy or by accepting only those votes cast at its annual general meeting. In examining whether a Company permits proxy voting, investors may ask questions like:

• Is proxy voting permitted?

• How easy it is for Shareowners to cast their votes by proxy?

• Does the Company offer electronic delivery of proxy materials? Can Shareowners view proxy materials online?
• Do Shareowners have to attend annual general meeting to vote or does the Company offer telephone or Internet voting (or some other remote mechanism)?
• Does the Company coordinate the timing of its annual general meeting with other Companies in its region to ensure they don't hold their meetings on the same day but in different locations? In some regions that require Shareowners to attend such meetings to vote, Shareowners may not be able to attend all the meetings if they are held at the same time in different locations.

• Is the Company permitted to use share blocking? Proxy voting in certain countries requires share blocking. Shareholders wishing to vote their proxies must deposit their shares shortly before the date of the meeting (usually one week) with a designated depositary. During this blocking period, shares that will be voted at the meeting cannot be sold until the meeting has taken place and the shares are returned to the clients' custodian banks.

• What are the state proxy regulations governing the Company?

#### Annotation 1418571681036

Subject 12. Shareowner Proposals
#cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors

Investors should determine whether and under what circumstances Shareowners can nominate individuals for election to the Board or vote to remove Board Members. By doing so they can force the Board or management to take steps to address Shareowner concerns and improve the Company's financial performance.

Investors should determine how the Company handles contested Board elections.

Investors should determine whether and under what circumstances Shareowners can submit resolutions for consideration at the Company's annual general meeting.

Shareowners are entitled to bring non-binding resolutions to a vote of the shareholders as part of the company's annual meeting process. They may bring resolutions on a wide variety of topics. U.S. SEC Rule 14a-8 governs Shareowner-sponsored resolutions. It appears to do more to protect corporations from shareowners: the SEC rule allows a corporations thirteen circumstances under which it can ignore a Shareowner's resolution. Investors, however, must understand what they can do if the Board or management fails to act in the best interests of all Shareowners. The ability to propose needed changes can prevent erosion of Shareowner value. This could pressure the Board or management to change the way they do business.

Investors need to determine how many votes are needed to pass a resolution, whether Shareowners can request a special meeting to address special concerns, and whether proposals benefit all Shareowners or just those making the proposals.

Investors should determine whether the Board and management are required to implement proposals that Shareowners approve.

The Company may tend to ignore those proposals that have been approved but are not binding. Investors should determine whether the Company has implemented or ignored such approved proposals before and whether there are any regulatory concerns about implementing these proposals.

#### Annotation 1418573516044

Subject 13. Ownership Structure
#cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors

Investors should examine the Company's ownership structure to determine whether it has different classes of common shares that separate the voting rights of those shares from their economic value.

The management team and the Board should act in the best interests of all Shareowners. However, if a Company has two classes of common shares (dual classes of common equity):

• Class A Shareowners have all the voting rights.
• Class B Shareowners don't have any voting rights.

then the management team and the Board are more likely to focus on the interests of Class A Shareowners. The rights of Class B Shareowners may suffer as a consequence of the ownership structure.

The Company's ability to raise equity capital for future investment may also be impaired, as it's difficult to sell unattractive Class B shares to investors. To finance future growth the Company may need to raise debt capital and increase leverage.

If you are reviewing the Company, you should consider:

• Does the Company have safeguards in its articles of organization or bylaws that protected the rights and interests of Class B shareowners?
• If the Company was recently privatized by the government, has the government retained voting rights that could veto certain decisions of management and the Board? If so, this situation could hurt other Shareowners.
• Have the super-voting rights of Class A Shareowners impaired the Company's ability to raise equity capital?

#### Annotation 1418575351052

Subject 14. Takeover Defenses
#cfa #cfa-level-1 #corporate-finance #the-corporate-governance-of-listed-companies-a-manual-for-investors
Shareowners should carefully evaluate the structure of an existing or proposed takeover defense and analyze how it could affect the value of shares in a normal market environment and in the event of a takeover bid.

The consequences of mergers and takeovers may include redistribution of income, closing of some plants and expansion of others, and elimination of specific managerial and other positions and creation of others. Various anti-takeover defenses (e.g., golden parachutes, poison pills, and greenmail) tend to favor the interests of managers over those of Shareowners. They often interfere with the ownership rights of Shareowners and constitute an obstacle to efficient reallocation of resources.

The justification for the use of various anti-takeover defenses should rest on the support of the majority of Shareowners and on the demonstration that preservation of the integrity of the company is in the long-term interests of Shareowners. However, it is also hard to establish whether these defensive actions cause financial prejudice to Shareowners.

Investors should consider the following factors when reviewing a Company's anti-takeover measures:

• Inquire whether the Company is required to receive Shareowner approval for such measures prior to implementation.
• Inquire whether the Company has received any formal acquisition overtures during the past two years.
• Is there a possibility that the Board or management will use the Company's cash and available credit lines to pay a hostile bidder to forego a takeover? (In general this is not good for Shareowners.)
• Inquire whether the local or national government will interfere with the sale and force so the seller to change the terms of the proposed merger or acquisition.
• Consider whether change-in-control provisions will trigger large severance packages and other payments to Company executives.

#### Annotation 1418577186060

Subject 1. A Portfolio Perspective on Investing
#cfa #cfa-level-1 #overview #portfolio-management

Why should investors take a portfolio approach instead of investing in individual stocks? Why put all your eggs in one basket?

Portfolio theory is used to maximize an investment's expected rate of return for a given level of risk or minimize the level of risk for a given expected rate of return.

For the purpose of investing, risk is defined as the variation of the return from what was expected (volatility). It is represented by a measure such as standard deviation.

Diversification is used to reduce a portfolio's overall volatility. Building a portfolio out of many unrelated (uncorrelated) investments minimizes total volatility (risk). The idea is that most assets will provide a return similar to their expected return and will offset those in the portfolio that perform poorly. The diversification ratio is the ratio of the standard deviation of an equally weighted portfolio to the standard deviation of a randomly selected security.

• The composition of a portfolio matters a great deal. Different portfolios have different risk-return trade-offs.
• Portfolio diversification does not necessarily provide the same level of risk reduction during times of severe market turmoil as it does when the economy and markets are operating normally.
• The modern portfolio theory says that the value of an additional security to a portfolio ought to be measured along with its relationship to all of the other securities in the portfolio.

#### Annotation 1418579021068

Subject 2. Investment Clients
#cfa #cfa-level-1 #overview #portfolio-management
There are different types of investment clients.

Different individual investors have different investment goals, levels of risk tolerance, and constraints. Some seek growth while others may invest to get regular income.

An institutional investor's role is to act as a highly specialized investor on behalf of others. There are many types of institutional investors.

A pension plan is a fund that provides retirement income to employees. It is typically considered a long-term investor with high risk tolerance and low liquidity needs.

• In a defined contribution plan, the employer agrees to contribute a certain sum each period based on a formula. Only the employer's contribution is defined; no promise is made regarding the ultimate benefits paid out to the employee. The employee accepts the investment risk.
• A defined benefit plan defines the benefits that the employee will receive at the time of retirement. That is, the employer assumes the risk of the investment, and is responsible for the payment of the defined benefits regardless of what happens in the investment.

An endowment or a foundation is an investment fund set up by an institution in which regular withdrawals from the invested capital are used for ongoing operations. Endowments and foundations are often used by universities, hospitals, and churches. They are funded by donations. A typical investment object is to maintain the real value of the fund while generating income to fund the objectives of the institution.

A bank typically has a very short investment horizon and low risk tolerance. Its investments are usually conservative. The investment objective of a bank's excess reserves is to earn a return that is higher than the interest rate it pays on its deposit.

Investments made by insurance companies are relatively conservative. Although the income needs are typically low, the liquidity needs of such investments are usually high (in order for insurance companies to pay claims).

Both the risk tolerance and the return requirement of mutual funds are predefined for each fund and can vary sharply between funds. They are more specialized than pension funds or insurance companies. Study Session 18 discusses mutual funds in more detail.

A sovereign wealth fund is a state-owned investment fund. There are two types of funds: saving funds and stabilization funds. Stabilization funds are created to reduce the volatility of government revenues, to counter the boom-bust cycles' adverse effect on government spending and the national economy.

#### Annotation 1418580856076

Subject 3. Steps in the Portfolio Management Process
#cfa #cfa-level-1 #overview #portfolio-management
Step One: The Planning Step

The first step in the portfolio management process is to understand the client's needs and develop an investment policy statement (IPS).

The IPS covers the types of risks the investor is willing to assume along with the investment goals and constraints. It should focus on the investor's short-term and long-term needs, familiarity with capital market history, and investor expectations and constraints. Periodically the investor will need to review, update, and change the policy statement.

A policy statement is like a road map: it forces investors to understand their own needs and constraints and to articulate them within the construct of realistic goals. It not only helps investors understand the risks and costs of investing, but also guides the actions of portfolio managers.

Step Two: The Execution Step

The second step is to construct the portfolio. The portfolio manager and the investor determine how to allocate available funds across different countries, asset classes, and securities. This involves constructing a portfolio that will minimize the investor's risk while meeting the needs specified in the policy statement.

Step Three: The Feedback Step

The process of managing an investment portfolio never stops. Once the funds are initially invested according to plan, the real work begins: monitoring and updating the status of the portfolio and the investor's needs.

The last step is the continual monitoring of the investor's needs, capital market conditions, and, when necessary, updating the policy statement. One component of the monitoring process is evaluating a portfolio's performance and comparing the relative results to the expectations and requirements listed in the policy statement. Some rebalancing may be required.

#### Annotation 1418582691084

Subject 4. Pooled Investments
#cfa #cfa-level-1 #overview #portfolio-management
"Pooled investments" is a term given to a wide range of investment types, such as mutual funds, exchange traded funds, and separately managed accounts.

When you invest in a pooled investment, your money goes into an investment fund. You pool your money with others to help spread the risk. Professional fund managers then invest the money on your behalf in a highly competitive environment.

Mutual Funds

An investment company invests a pool of funds belonging to many individuals in a single portfolio of securities. In exchange for this commitment of capital, the investment company issues to each investor new shares representing his or her proportional ownership of the mutually held securities portfolio (commonly known as a mutual fund).

Mutual funds are classified according to whether or not they stand ready to redeem investor shares.

• An open-end mutual fund continues to sell and repurchase shares after its initial public offering. It stands ready to redeem investor shares at market value.
• A closed-end mutual fund operates like any other public firm. It is initiated through a stock offering to raise capital. Its stock trades on the regular secondary market and the market price is determined by supply and demand. A typical closed-end fund offers no further shares and does not repurchases the shares on demand (no funds can be withdrawn). Therefore, investors must trade in public secondary markets (e.g., NASDAQ) to buy or sell shares.

Various fees charged by mutual funds:

• They charge fees for their efforts of setting up funds. Sales commissions are charged at purchase (front-end load) as a percentage of the investment.

• A load fund has sales commission charges. A load fund's offering price = NAV of the share + a sales charge (7.5 - 8% of the NAV). The NAV price is the redemption (bid) price and the offering (ask) price equals the NAV divided by 1 minus the percent load.
• A no-load fund imposes no initial sales charge.

• Redemption fee (back-end load). A charge to exit the fund. This discourages quick trading turnover; these funds are set up so that the fees decline the longer the shares are held (in this case, the fees are sometimes called contingent deferred sales charges). Load funds generally charge no redemption fees.
• All mutual funds charge annual fees.

There are four types of mutual funds based on portfolio makeup.

• Money Market Funds. These funds attempt to provide current income, safety of principal, and liquidity by investing in diversified portfolios of short-term securities, such as T-bills, banker certificates of deposit, bank acceptances, and commercial paper. They generally allow holders to write checks again their account, so they are essentially cash holdings for holders. However, they are not insured in the same way as bank deposits.
• Bond Mutual Funds. Bond funds concentrate on various types of bonds to generate high current income with minimal risk. Bonds held include government bonds, high-grade corporate bonds, and junk bonds.
• Stock Mutual Funds. These funds invest almost solely in common stocks. Some funds focus on growth companies while others specialize in specific industries. Different stock mutual funds can suit almost any taste or investment objective.

There are two investment styles.

• Passive mutual fund management is a long-term buy-and-hold strategy. Usually stocks are purchased with the intention that the portfolio's returns will track those of an index over time. The purpose is not to beat the index but to match its performance.
• Active mutual fund management is an attempt by the fund manager to outperform a passive benchmark portfolio on a risk-adjusted basis. Management fees are usually higher and there are u
...

#### Annotation 1418584526092

Subject 1. The risk management process
#cfa #cfa-level-1 #portfolio-management #risk-management-introduction
Risk is exposure to uncertainty. In investment, risk includes the possibility of losses.

Taking risks is an active choice by institutions and individuals. Risks must be carefully understood, chosen, and well-managed.

Risk exposure is the extent to which an entity's value may be affected through sensitivity to underlying risks.

Risk management is a process that defines risk tolerance and measures, monitors, and modifies risks to put them in line with that tolerance.

• It is NOT about minimizing, avoiding or predicting risks.
• It is about understanding, measuring, monitoring, and modifying risks.

A risk management framework is the infrastructure, processes, and analytics needed to support effective risk management. It includes:

• Risk governance is the top-level foundation for risk management. It provides the overall context for an organization's risk management, which includes risk oversight and setting risk tolerance for the organization. It directs risk management activities to align with and support the goals of the overall enterprise.

• Risk identification and measurement is the quantitative and qualitative assessment of all potential sources of risk and risk exposures.

• Risk infrastructure comprises the resources and systems required to track and assess an organization's risk profile.

• Risk policies and processes are management's complement to risk governance at the operating level.

• Risk monitoring, mitigation and management is the active monitoring and adjusting of risk exposures, integrating all the other factors of the risk management framework.

• Communication includes risk reporting and active feedback loops so that the process improves decision making.

• Strategic risk analysis and integration involves using these risk tools to rigorously sort out the factors that are and are not adding value as well as incorporating this analysis into the management decision-making process, with the intent of improving outcomes.

#### Annotation 1418586361100

Subject 2. Risk governance
#cfa #cfa-level-1 #portfolio-management #risk-management-introduction
Governance and the entire risk process should take an enterprise risk management perspective to ensure that the value of the entire enterprise is maximized. For example, a corporate pension fund manager should consider not only the pension assets and liabilities but also the parent corporation's business risk profile. In other words, the focus should be on the organization as a whole.

Useful approaches to ensuring a strong risk governance framework:

• Employ a risk management committee.
• Appoint a chief risk officer.

Risk Tolerance

Risk tolerance, a key element of good risk governance, establishes an organization's risk appetite.

Ascertaining risk tolerance starts from an inside view and an outside view. What shortfalls within an organization would cause the organization to fail to achieve some critical goals? What are the organization's risk drivers? Which risks are acceptable and which are unacceptable? How much risk can the overall organization be exposed to?

Risk tolerance is then formally chosen using a top-level analysis. The organization's goals, expertise in certain areas, and strategies should be considered when determining its risk tolerance. This process should be completed and communicated before a crisis.

Risk Budgeting

While risk tolerance determines which risks are acceptable, risk budgeting decides how to take risks. It is a means of implementing risk tolerance at a strategic level.

Risk budgeting is any means of allocating investments or assets based on their risk characteristics. Single or multiple dimensions of risk can be used. Common single-dimension risk measures are standard deviation, beta, value at risk, and scenario loss. The risk budgeting process forces the firm to consider risk trade-offs. As a result, the firm should choose to invest where the return per unit of risk is the highest.

Some risk budgeting practices:

• Limit the standard deviation of the entire portfolio to within 15%.
• Allocate 10%, 35% and 55% of total capital in T-bills, long-term corporate bonds, and stock market index-linked mutual funds, respectively.
• Use a risk factor approach to allocate assets.

#### Annotation 1418588196108

Subject 3. Identification of risks
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There are two general categorizations of risks.

Financial Risks

Financial risks originate from the financial markets.

• Market risk arises from movements in stock prices, interest rates, exchange rates, and commodity prices.
• Credit risk is the risk that a counterparty will not pay an amount owed.
• Liquidity risk is the widening of the bid-ask spread on an asset. It is usually caused by degradation in market conditions or a lack of market participants.

Non-Financial Risks

Non-financial risks arise from actions within an entity or from external origins, such as the environment, the community, regulators, politicians, suppliers, and customers. They include:

• Settlement risk: one party fails to deliver the terms of a contract with another party at the time of settlement.
• Legal risk: the risk of being sued, or of the terms of a contract not being upheld by the legal system.
• Compliance risk: regulatory risk, accounting risk and tax risk. Companies may fail to respond quickly when laws and regulations are updated.
• Model risk: the risk of improperly using a model. An example is tail risk which suggests that distribution is not normal, but skewed, with fatter tails.
• Operational risk: the risk that arises from within the operations of an organization and includes both human and system or process errors.
• Solvency risk: the risk that the entity does not survive or succeed because it runs out of cash to meet its financial obligations.

Individuals face many of the same organizational risks outlined here, as well as health risks, mortality or longevity risks, and property and casualty risks.

Risks are not necessarily independent. because many risks arise as a result of other risks; risk interactions can be extremely non-linear and harmful. For example, fluctuations in the interest rate cause changes in the value of the derivative transactions but could also impact the creditworthiness of the counterparty. Another example might occur with an emerging-market counterparty, where there is country and possibly currency risk associated with the counterparty (however creditworthy it might otherwise be).

#### Annotation 1418590031116

Subject 4. Measuring and modifying risks
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Drivers

To understand how to measure risk, we need to first understand what drives risk. Risk drivers are the fundamental global and domestic macroeconomic and industry factors that create risk.

• All risks come from uncertainties.
• Financial risks come from fundamental factors in macro-economies and industries.
• There are systematic risks and unsystematic (diversifiable) risks.

Risk management can control some risks but not all.

Metrics

Common measures of risk:

• Probability
• Standard deviation: measures dispersion in a probability distribution. This has significant limitations.
• Beta: measures the sensitivity of a security's returns to the returns on the market portfolio.
• Measures of derivatives risk: delta, gamma, vega and rho.
• Duration measures the interest rate sensitivity of a fixed income security.
• Value at Risk: measures the potential loss in value of a risky asset or portfolio over a defined period for a given confidence interval. If the VaR on an asset is $100 million at a one-week, 95% confidence level, there is only a 5% chance that the value of the asset will drop more than$ 100 million over any given week.
• CVaR: scenario analysis and stress testing, can be used to complement VaR.

It is difficult to measure rare events such as operational risk and default risk.

Methods of Risk Modification

There are four broad categories of risk modification.

Risk prevention and avoidance. Completely avoiding risk sounds simple, but it may be difficult or sometimes impossible. Furthermore, does it even make sense to do so? Almost every risk has an upside. There is always a trade-off between risk and return.

Risk acceptance. Risk can be mitigated internally through self-insurance or diversification. This is to bear the risk but do so in the most efficient manner possible.

Risk transfer. This is to pass on a risk to another party, often in the form of an insurance policy. An insurer attempts to sell policies with risks that have low correlations and can be diversified away.

Risk shifting. This refers to actions that change the distribution of risk outcomes. The principal device is a derivative which can be used to shift risk across the probability distribution and from one party to another. There are two categories of derivatives: forward commitments and contingent claims.

The primary determinant of which method is best for modifying risk is weighing the benefits against the costs, with consideration for the overall final risk profile and adherence to risk governance objectives.

#### Annotation 1418595011852

Subject 1. Major Return Measures
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There are various types of return measures.

Holding Period Return

Refer to Reading 6 for a detailed discussion of this return measure.

Arithmetic or Mean Return

Refer to Reading 7 for a detailed discussion of this return measure.

Geometric Mean Return

Refer to Reading 7 for a detailed discussion of this return measure.

Money-Weighted Return or Internal Rate of Return

The dollar-weighted rate of return is essentially the internal rate of return (IRR) on the portfolio. Refer to Reading 6 for a detailed discussion of this return measure.

Annualized Return

Annualizing returns allows for comparison among different assets and over different time periods.

rannual = (1 + rperiod)c - 1

where c is the number of periods in a year and rperiod is the rate of return per period.

Example

Monthly return: 0.6%. The annualized return is (1 + 0.6%)12 - 1 = 7.44%.

Portfolio Return

The expected return on a portfolio of assets is the market-weighted average of the expected returns on the individual assets in the portfolio.

where Rp is the return on the portfolio, Ri is the return on asset i and wi is the weighting of component asset i (that is, the share of asset i in the portfolio).

Other Major Return Measures

1. A gross return is the return before any fees, expense, taxes, etc. A net return is the return after deducting all fees and expenses from the gross return.

2. Different types of investments generate different types of income and have different tax implications. For example, in the U.S. the interest income is fully taxable at an investor's marginal tax rate while capital gains are taxed at a much lower rate. Therefore, many investors therefore use the after-tax return to evaluate mutual fund performance.

3. The nominal return and the real return are two ways to measure how well an investment is performing. The real return takes into consideration the effects of inflation when calculating how much buying power has changed.

4. An investor can also use leverage to amplify his expected return (and risk).

#### Annotation 1418603138316

Subject 2. Variance and Covariance of Returns
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Investment is all about reward versus variability (risk). The return measures the reward of an investment and dispersion is a measure of investment risk.

The variance is a measure of how spread out a distribution is. It is computed as the average squared deviation of each number from its mean. The formula for the variance in a population is:

where μ is the mean and N is the number of scores.

To compute variance in a sample:

where m is the sample mean.

The formula for the standard deviation is very simple: it is the square root of the variance. It is the most commonly used measure of spread.

The standard deviation of a portfolio is a function of:

• The weighted average of the individual variances, plus
• The weighted covariances between all the assets in the portfolio.

In a two-asset portfolio:

The maximum amount of risk reduction is predetermined by the correlation coefficient. Thus, the correlation coefficient is the engine that drives the whole theory of portfolio diversification.

Example with perfect positive correlation (assume equal weights):

What is the standard deviation of a portfolio (E), assuming the following data?
σ1 = 0.1, w1 = 0.5, σ2 = 0.1, w2 = 0.5, ρ12 = 1

Solution:

Cov12 = σ1 x σ2 x ρ12 = 0.1 x 0.1 x 1 = 0.01
Standard Deviation of Portfolio [0.52 x 0.12 + 0.52 x 0.12 + 2 x 0.5 x 0.5 x 0.01]1/2 = 0.10 (perfect correlation)

If there are three securities in the portfolio, its standard deviation is:

#### Annotation 1418611264780

Subject 3. Historical Return and Risk
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The textbook examines the historical risk and return for the three main asset categories (1926 - 2008).

T-bills: the safest investment on earth. The price paid for this safety is steep: the return is only 3.7%, which is barely above the inflation rate of 3.0% for the period. Further, although many academicians consider T-bills to be "riskless," a quick perusal of the T-bill graph shows considerable variation of return, meaning that you cannot depend on a constant income stream. This risk is properly reflected in the standard deviation of 3.1%. The best that can be said for the performance of T-bills is that they keep pace with inflation in the long run.

Long-term bonds carry one big risk: interest rates risk. The longer the maturity of the bond the worse the damage. For bearing this risk, investors are rewarded with another 1.5% of long-term return. In the long run, investors can expect a real return (inflation-adjusted) of about 2% with a standard deviation of 10%.

The rewards of stocks are considerable: a real return of greater than 6%. This return does not come free, of course. The standard deviation is 20%. You can lose more than 40% in a bad year; during the calendar years 1929-32 the inflation-adjusted ("real") value of this investment class decreased by almost two-thirds.

$1 in 1900 would have grown to$582 in 2008 if invested in stocks, only $9.90 if invested in bonds, and to$2.90 if invested in T-bills. The message is clear: stocks are to be held for the long term. Don't worry too much about the short-term volatility of the markets; in the long run stocks will almost always have higher returns than bonds.

Stocks have outperformed bonds consistently over long periods of time. However, stocks are much riskier and investors demand compensation for bearing the risk. The question is: is the premium too big?

Other Investment Characteristics

Two assumptions are usually made when investors perform investment analysis using mean and variance.

• Returns are normally distributed.
• Markets are operationally efficient.

Is normality a good approximation of returns? In fact, returns are not quite normally distributed. The biggest departure from normality is that extremely bad returns are more likely than predicted by the normal distribution (fat tails).

There are operational limitations of the market that affect the choice of investments. One such limitation is liquidity, which affects the cost of trading.

#### Annotation 1418613099788

Subject 4. Risk Aversion and Portfolio Selection
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Risk Aversion

Every investor wants to maximize the investment returns for a given level of risk. Risk refers to the uncertainty of future outcomes. Risk aversion relates to the notion that investors as a rule would rather avoid risk. Given a choice of two investments with equal returns, risk-averse investors will select the investment with lower risk. Investors are risk-averse. Consequently, investors will demand a risk premium for taking on additional levels of risk. The more risk-averse the investor, the more of a premium he or she will demand prior to taking on risk.

Investors who do not demand a premium for risk are said to be risk-neutral (e.g., willing to place both a large and small bet on the flip of a coin and be indifferent) and those investors that enjoy risk are said to be risk seekers (e.g., people who buy lottery tickets despite the knowledge that for every $1 spent, on average they will get less than$0.1 back).

Example

Three investors, Sam, Mike, and Mary are considering two investments: A and B. Investment A is the less risky of the two, requiring an investment of $1,000 with an expected rate of return at 10%. Investment B also requires an investment of$1,000 and has an expected return of 10% but appears to have considerably more variability in potential returns than A. Sam requires a return of 14%, Mike requires 10%, and Mary seeks only an 8% return.

Question: Given the information above, which of the three investors is considered risk-averse?

Solution: Only Sam would be considered risk-averse. He is the only investor who demands a premium of return given the higher risk level. Mike would be considered risk-neutral since he demands no premium in return (despite the higher risk) and Mary would be considered a risk-seeker since she, in fact, will accept less return for a riskier situation.

Risk aversion implies that there is a positive relationship between expected returns (ER) and expected risk (Es), and that the risk return line (CML and SML) is upward-sweeping.

Evidence that suggests that individuals are generally risk-averse:

• Purchase of insurance. Most investors purchase various types of insurance (e.g., life insurance, car insurance, etc.). By buying insurance, an investor avoids the uncertainty of a potential large future cost by paying the current known cost of the insurance policy.

• Difference in the promised yield for different grades of bonds. The promised yield of a bond is its required rate of return. Different grades of bonds have different degrees of credit risk. The promised yield increases as you go from the lowest-risk grade (e.g., AAA) to a grade with higher risk (e.g., AA). That is, as the credit risk of a bond increases, investors will require a higher rate of return.

Utility Theory

Although investors differ in their risk tolerance, they should be consistent in their selection of any portfolio in terms of the risk-return trade-off. Because risk can be quantified as the sum of the variance of the returns over time, it is possible to assign a utility score (aka utility value, utility function) to any portfolio by subtracting its variance from its expected return to yield a number that would be commensurate with an investor's tolerance for risk, or a measure of their satisfaction with the investment. Because risk aversion is not an objectively measurable quantity, there is no unique equation that would yield such a quantity, but an equation can be selected, not for its absolute measure, but for its comparative measure of risk tolerance. One such equation is the following utility formula:

Utility Score = Expected Return - 0.5 x σ2 A

where A is the risk aversion coefficient (a number proportionate to the amount of risk aversion of the investor). It is positive f...

#### Annotation 1418621226252

Subject 5. Portfolio Risk
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Consider two mutual funds, D (specialized in bonds and debt securities) and E (specialized in equity). The weight of mutual fund D in the portfolio is wD and the weight of mutual fund E is wE, and their returns are rD and rE.

Expected return of the portfolio: E(rp) = wD E(rD) + wE E(rE)

Variance of the portfolio: σp2 = wD 2σD2 + wE2 σE2 + 2 wD wE Cov(rD, rE) = (wDσD)2 + (wEσE)2 + 2 (wDσD) (wEσE) ρDE = (wDσD + wEσE)2 + 2 (wDσD) (wEσE) (ρDE - 1) = (wDσD - wEσE)2 + 2 (wDσD) (wEσE) (ρDE + 1)

If the two assets are not perfectly positively correlated, the standard deviation of the portfolio is less than the weighted average of the standard deviations of the assets.

Covariance of returns measures the degree to which the rates of return on two securities move together over time.

• A positive covariance indicates that the rates of return on the two securities tend to move in the same direction.
• A negative covariance indicates that the rates of return on the two securities tend to move in opposite directions.
• A covariance of zero indicates that there is no relationship between the rates of return on the two securities.

The magnitude of the covariance depends on the magnitude of the individual stocks' standard deviations and the relationship between their co-movements. The covariance is an absolute measure of movement and is measured in return units squared. As the magnitude of the covariance is affected by the variability of return of each individual security, covariance cannot be used to compare across different pairs of securities.

The measure can be standardized by dividing the covariance by the standard deviations of the two securities being tested.

p(1,2) = cov(1,2)1σ2

Rearranging the terms gives: cov(1,2) = p(1,2)σ1σ2.

The term p(1,2) is called the correlation coefficient between the returns of securities 1 and 2. The correlation coefficient has no units. It is a pure measure of the co-movement of the two stocks' returns. It varies in the range of -1 to 1.

How should you interpret the correlation coefficient?

• A correlation coefficient of +1 means that returns always move together in the same direction. They are perfectly positively correlated.
• A correlation coefficient of -1 means that returns always move in completely opposite directions. They are perfectly negatively correlated.
• A correlation coefficient of zero means that there is no relationship between the two stocks' returns. They are uncorrelated.

Example

Two risky assets, A and B, have the following scenarios of returns:

What is the covariance between the returns of A and B?

The expected return is a probability-weighted average of the returns. Using this definition, the expected return of ...

#### Annotation 1418635644172

Subject 6. Efficient Frontier
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The mean-variance portfolio theory says that any investor will choose the optimal portfolio from the set of portfolios that:

• Maximize expected return for a given level of risk; and
• Minimize risks for a given level of expected returns.

Again, consider a situation where you have two stocks to choose from: A and B. You can invest your entire wealth in one of these two securities. Or you can invest 10% in A and 90% in B, or 20% in A and 80%in B, or 70% in A and 30% in B, or... There are a huge number of possible combinations even in the simple case of two securities. Imagine the different combinations you have to consider when you have thousands of stocks.

The minimum-variance frontier shows the minimum variance that can be achieved for a given level of expected return. To construct the minimum-variance frontier of a portfolio:

• Use historical data to estimate the mean, variance of each individual stock in the portfolio, and the correlation of each pair of stocks.
• Use a computer program to find the weights of all stocks that minimize the portfolio variance for each pre-specified expected return.
• Calculate the expected returns and variances for all the minimum-variance portfolios determined in step 2 and then graph the two variables.

The outcome of risk-return combinations generated by portfolios of risky assets gives you the minimum variance for a given rate of return. Logically, any set of combinations formed by two risky assets with less than perfect correlation will lie inside the triangle XYZ and will be convex.

Investors will never want to hold a portfolio below the minimum variance point. They will always get higher returns along the positively sloped part of the minimum-variance frontier.

The efficient frontier is the set of mean-variance combinations from the minimum-variance frontier where, for a given risk, no other portfolio offers a higher expected return.

Any point beneath the efficient frontier is inferior to points above. Moreover, any points along the efficient frontier are, by definition, superior to all other points for that combined risk-return tradeoff.

Portfolios on the efficient frontier have different return and risk measures. As you move upward along the efficient frontier, both risk and the expected rate of return of the portfolio increase, and no one portfolio can dominate any other on the efficient frontier. An investor will target a portfolio on the efficient frontier on the basis of his attitude toward risk and his utility curves.

The concept of efficient frontier narrows down the options of the different portfolios from which the investor may choose. For example, portfolios at points A and B offer the same risk, but the one at point A offers a higher return for the same risk. No rational investor will hold the portfolio at point B and therefore we can ignore it. In this case, A dominates B. In the same way, C dominates D.

#### Annotation 1418640624908

Subject 7. Optimal Portfolio
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The efficient frontier only considers the investments in risky assets. However, investors may choose to invest in a risk-free asset, which is assumed to have an expected return commensurate with an asset that has no standard deviation (i.e., zero variance) around the expected return. That is, a risk-free asset's expected return is entirely certain; it is known as the risk-free rate of return (RFR). Therefore, a risk-free asset lies on the vertical axis of a portfolio graph.

When a risk-free asset is combined with a risky portfolio, a graph of possible portfolio risks-return combinations becomes a straight line between the two assets.

Assume the proportion of the portfolio the investor places in the tangency portfolio P is wP:

• The expected rate of return for the new portfolio is the weighted average of the two returns: E(R) = (1 - wP) Rf + wP E(RT)
• The standard deviation of the new portfolio is the linear proportion of the standard deviation of the risky asset portfolio P: σportfolio = wP σP

The introduction of a risk-free asset changes the efficient frontier into a straight line. This straight efficient frontier line is called the Capital Market Line (CML) for all investors and the Capital Allocation Line (CAL) for one investor.

• Investors at point rf have 100% of their funds invested in the risk-free asset.
• Investors at point P have 100% of their funds invested in portfolio P.
• Between rf and P, investors hold both the risk-free asset and portfolio P. This means investors are lending some of their funds (buying the risk-free asset).
• To the right of P, investors hold more than 100% of portfolio P. This means they are borrowing funds to buy more of portfolio P. This represents a levered position.

Investors will choose the highest CAL (i.e., the CAL tangent to the efficient frontier). This portfolio is the solution to the optimization problem of maximizing the slope of the CAL.

Now, the line rf-P dominates all portfolios on the original efficient frontier. Thus, this straight line becomes the new efficient frontier.

Separation Theorem

Investors make different financing decisions based on their risk preferences. The separation of the investment decision from the financing decision is called the separation theorem. The portfolio choice problem can be broken down into two tasks:

• Choosing P, a technical matter (can be done by the broker)
• Deciding on the proportion to be invested in P and in the riskless asset.

Optimal Investor Portfolio

We can combine the efficient frontier and/or capital allocation line with indifference curves. The optimal portfolio is the portfolio that gives the investor the greatest possible utility.

• Two investors will select the same portfolio from the efficient set only if their utility curves are identical.
• Utility curves to the right represent less risk-averse investors; utility curves to the left represent more risk-averse investors.

This is portfolio selection without a risk-free asset:

The optimal portfolio for each investor is the highest indifference curve that is tangent to the efficient frontier.

This is portfolio selection with a risk-free asset:

...

#### Annotation 1418647178508

Subject 1. Capital Market Theory
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Introduction of a Risk-Free Asset

Adding a risk-free asset to the investment opportunities present on the efficient frontier effectively adds the opportunity to both borrow and lend. A U.S. Treasury bill (T-bill) is a common risk-free security proxy. Buying a T-bill loans the U.S. government money. Selling a T-bill short effectively borrows money. The concept of a risk-free asset is a major element in developing Capital Market Theory (CMT). Adding risk-free assets integrates investment and financing decisions. With risk-free asset:

• Expected return is entirely certain.
• Standard deviation of return is zero.
• Covariance with any risky asset or portfolio is always zero, as is the correlation.

The Capital Market Line

Introducing risk-free assets creates a set of expected return-risk possibilities that did not exist previously. The new risk-return trade-off is a straight line tangent to the efficient frontier at the market portfolio (point M) with a vertical intercept at the risk-free rate of return, Rf. This line is called the Capital Market Line (CML).

• The capital allocation line (CAL) is the graph of all possible combinations of the risk-free asset and the risky asset for one investor.
• The capital market line is the line formed when the risky asset is a market portfolio rather than a single risky asset or portfolio. The market portfolio is a mutual fund or exchange-traded fund (based on a market index, for instance).

The introduction of the risk-free asset significantly changes the Markowitz efficient set of portfolios. Investors are better off because they have improved investment opportunities.

This new line leads all investors to invest in the same risky portfolio, the market portfolio. That is, all investors make the same investment decision. They can, however, attain their desired risk preferences by adjusting the weight of the market portfolio in their portfolios.

• A strongly risk-averse investor will lend some funds at the risk-free rate and invest the remainder in the market portfolio.
• A less risk-averse investor will borrow some funds at the risk-free rate and invest all the funds in the market portfolio.

The Market Portfolio

The market portfolio of risky securities, M, is the highest point of tangency between the line emanating from Rf and the efficient frontier and is the singular optimal risky portfolio. In equilibrium, all risky assets must be in portfolio M because all investors are assumed to arrive at, and hold, the same risky portfolio.

All assets are included in portfolio M in proportion to their market value. For example, if the market for Google stock was 2 percent of the market value of all risky assets, Google would constitute 2 percent of the market value of portfolio M. Therefore, 2 percent of the market value of each investor's portfolio of risky assets would be Google. Think of portfolio M as a broad market index such as the S&P 500 Index. The market portfolio is, of course, a risky portfolio; its risk is designated σM.

Portfolio M in a Global Context. In theory, the market portfolio (M) should include all risky assets worldwide, both financial and real, in their proper proportions. It has been estimated that the value of non-U.S. assets exceeds 60 percent of the world total. Further, U.S. equities make up only about 10 percent of total world assets. Therefore, international diversification is important.

Portfolio M and Diversification. Because the market portfolio includes all risky assets, portfolio M is by definition complet...

#### Annotation 1418652159244

Subject 2. Pricing of Risk and Computation of Expected Return
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Systematic Risk and Unsystematic Risk

Total risk is measured as the standard deviation of security returns. It has two components:

• Systematic risk is the risk that is inherent in the market that cannot be diversified away. The systematic risk of an asset is the relevant risk for constructing portfolios. Examples of systematic risk or market risk include macroeconomic factors that affect everything (such as the growth in U.S. GNP, inflation, etc.).

Note that different securities may respond differently to market changes, and thus may have different systematic risks. For example, automobile manufacturers are much more sensitive to market changes than discount retailers (e.g., Wal-Mart). As a result, automobile manufacturers have higher systematic risk.

• Unique, diversifiable, or unsystematic risk (or nonsystematic risk) is risk that can be diversified away. This risk is offset by the unique variability of the other assets in a portfolio. An investor should not expect to receive additional return for assuming unsystematic risk.

Systematic risk is priced, and investors are compensated for holding assets or portfolios based only on that investment's systematic risk. Investors do not receive any return for accepting unsystematic risk.

Return-Generating Models

A return-generating model tries to estimate the expected return of a security based on certain parameters. Both the market model and CAPM are single-factor models. The common, single factor is the return on the market portfolio. Multifactor models describe the return on an asset in terms of the risk of the asset with respect to a set of factors. Such models generally include systematic factors, which explain the average returns of a large number of risky assets. Such factors represent priced risk, risk which investors require an additional return for bearing.

According to the type of factors used, there are three categories of multifactor models:

• In macroeconomic factor models, the factors are surprises in macroeconomic variables that significantly explain equity returns. Surprise is defined as actual minus forecast value and has an expected value of zero. The factors, such as GDP, interest rates, and inflation, can be understood as affecting either the expected future cash flows of companies or the interest rate used to discount these cash flows back to the present.

• In fundamental factor models, the factors are attributes of stocks or companies that are important in explaining cross-sectional differences in stock prices. Among the fundamental factors are book-value-to-price ratio, market cap, P/E ratio, financial leverage, and earnings growth rate.

• In statistical factor models, statistical methods are applied to a set of historical returns to determine portfolios that explain historical returns in one of two senses. In factor analysis models, the factors are the portfolios that best explain (reproduce) historical return covariances. In principal-components models, the factors are portfolios that best explain (reproduce) the historical return variances.

Here is a two-factor macroeconomic model.

Ri = ai + bi1 FGDP + bi2 FINT + εi

where

• Ri = the return for asset i.
• ai = expected return for asset i in the absence of any surprises.
• bi1 = GDP surprise sensitivity of asset i. This is a slope coefficient which is interpreted as the GDP factor sensitivity of asset i.
• FGDP = surprise in GDP growth. This is the GDP factor surprise, the difference between the expected value and the actual value of the GDP.
• bi2 = interest rate surprise sensitivity of asset i.
...

#### Annotation 1418653994252

Subject 3. The Capital Asset Pricing Model
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Assumptions of the CAPM

The assumptions of the CAPM include:

• All investors are Markowitz efficient investors who want to target points on the efficient frontier where their utility maps are tangent to the line. The exact location on the efficient frontier and, therefore, the specific portfolio selected, will depend on the individual investor's risk-return utility function.

• Markets are frictionless. There are no taxes or transaction costs involved in buying or selling assets. Investors can borrow and lend any amount of money at the risk-free rate of return.

• All investors have the same one-period time horizon (e.g., one year).

• All investors have homogeneous expectations: that is, they estimate identical probability distributions for future rates of return.

• All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio.

• All investors are price takers. Their trades cannot affect security prices.

The CAPM

Capital market theory builds on portfolio theory. CAPM refers to the capital asset pricing model. It is used to determine the required rate of return for any risky asset.

In the discussion about the Markowitz efficient frontier, the assumptions are:

• Investors have examined the set of risky assets and identified the efficient frontier.
• Every investor will choose the optimal portfolio of risky assets on the efficient frontier. The optimal portfolio lies at the point where the highest indifference curve is tangent to the efficient frontier.

The CAPM uses the SML or security market line to compare the relationship between risk and return. Unlike the CML, which uses standard deviation as a risk measure on the X axis, the SML uses the market beta, or the relationship between a security and the marketplace.

The use of beta enables an investor to compare the relationship between a single security and the market return rather than a single security with each and every other security (as Markowitz did). Consequently, the risk added to a market portfolio (or a fully diversified set of securities) should be reflected in the security's beta. The expected return for a security in a fully diversified portfolio should be:

E(RM) - Rf is the market risk premium, while the risk premium of the security is calculated by β[E(RM) - Rf].

Note that the "expected" and the "required" returns mean the same thing. The expected return based on the CAPM is exactly the return an investor requires on the security.

• To compute the required rate of return:.
• To compute the expected rate of return of an individual security, you need to use forecasted future security price and dividend: R = (Future price - current price + dividend) / Current price.

The SML represents the required rate of return, given the systematic risk provided by the security. If the expected rate of return exceeds this amount, then the security provides an investment opportunity for the investor. The difference between the expected and required return is called the alpha (α) or excess...

#### Annotation 1418660547852

Subject 4. Applications of the CAPM
#cfa #cfa-level-1 #has-images #portfolio-management #risk-and-return-part-ii
Estimate of Expected Return. Apply the CAPM formula to calculate the expected return of an asset or project.

Portfolio Performance Evaluation. Four ratios are commonly used for this purpose.

• Sharpe Ratio

It is a measure of the excess return per unit of risk. It defined as the portfolio's risk premium divided by its risk:. This ratio is easy to use. The two limitations are:

• It uses standard deviation, not beta, as a measure of volatility.
• The ratio itself is not very informative.

• Treynor Ratio

It measures the excess return on an investment which has no diversifiable risk. Systematic risk is used instead of total risk:. Again, the ratio itself is not very informative, and it cannot be applied to assets with negative βs. It is a ranking criterion which is easy to use.

• M-Squared (M2)

It is a performance measurement using return per unit of total risk as measured by the standard deviation. The investment portfolio's standard deviation is adjusted to reflect the standard deviation of the market benchmark portfolio. The return premiums of the adjusted investment portfolio and the market index portfolio are then compared.

• Jensen's Alpha

It is the abnormal return over the theoretical expected return. The theoretical expected return is calculated using CAPM (and beta): α p = Rp - [Rf + β(Rm - Rf)]. Since the CAPM return is supposed to be risk-adjusted, Jensen's α is also risk-adjusted. Investors are constantly seeking investments that have positive α or "abnormal returns."

If an investor holds a portfolio that is not fully diversified, total risk matters. Sharpe ratio and M-squared are appropriate performance measures in such cases. On the other hand, if the portfolio is well-diversified, Treynor ratio and Jensen's alpha are relevant, as only the systematic risk of the portfolio matters.

Security Characteristic Line. A security characteristic line (SCL) graphs the relationship between the excess market return and excess security return.

Ri - Rf = αi - βi (Rm - Rf)
If we compare the SML and the SCL:

While there is only one SML, there are many different SCLs for securities with different betas.

Security Selection. Overvalued and undervalued securities are those securities that do not lie on the SML line. By definition, securities that are efficiently priced should fall directly on the (calculated) SML line. If a security is above the line it is deemed undervalued since it is providing more expected return than what is demanded for that risk level. Securities falling below the SML line, on the other hand, provides less return than the market demands. Securities that fall below the SML are considered overvalued. In the former case, the security price will be bid up, such that the expected return declines and the security falls back to the SML line. In a situation where the security is overvalued, the security price declines until the expected return rises.

...

#### Annotation 1418670247180

Subject 1. The Investment Policy Statement and its Major Components
#basics-of-portfolio-planning-and-construction #cfa #cfa-level-1 #portfolio-management
The first step of the portfolio management process is to develop a policy statement. The statement covers the types of risks the investor is willing to assume along with the investment goals and constraints. It should focus on the investor's short-term and long-term needs, familiarity with capital market history, and expectations and constraints. Periodically the investor will need to review, update, and change the policy statement.

A policy statement should incorporate an investor's objectives (risk and return) and constraints. It should address the following issues:

• What are the risks of an adverse financial outcome?
• What are the emotional reactions to an adverse financial outcome?
• How knowledgeable is the investor about investments and markets?
• What other capital or income sources does the investor have? How important is the portfolio to the overall financial position?
• What legal restrictions may affect investment needs?
• What unanticipated consequences of interim fluctuations in portfolio value may affect investment policy?

Moreover, the policy statement should attempt to answer the following questions:

• Does the policy statement meet the specific needs and objectives of this investor?
• Does the policy statement enable a competent stranger to manage the portfolio in compliance with the client's needs?
• Does the client understand the investment risks and the need for a disciplined approach to the investment process?
• Does the portfolio manager have the discipline and flexibility to maintain the policy during an adverse market?
• Does the policy statement, if implemented, meet the client's needs and objectives?

A policy statement is like a road map: it forces investors to understand their own needs and constraints and to articulate them within the construct of realistic goals. It not only helps investors understand the risks and costs of investing, but also guides the actions of portfolio managers.

Performance cannot be judged without an objective standard. The policy statement should state the performance standards by which the portfolio's performance will be judged and specify the specific benchmark which represents the investor's risk preferences. The portfolio should be measured against the stated benchmark rather than the portfolio's overall performance.

Major components of an IPS include an introduction, statement of purpose, duties and responsibilities, procedures, investment objectives, constraints and guidelines, evaluation and review, and appendices.

#### Annotation 1418672082188

Subject 2. Investment Risk and Return Objectives, and Risk Tolerance
#basics-of-portfolio-planning-and-construction #cfa #cfa-level-1 #portfolio-management
The investor's objectives are his or her investment goals expressed in terms of both risk and return. Why?

• The investment decision is a trade-off between risk and return, and that trade-off varies depending on the preferences and situation of each investor.

• Investment objectives expressed solely in terms of returns can lead to inappropriate investment practices, such as the use of high-risk investment strategies or account "churning," which involves moving quickly in and out of investments in an attempt to buy low and sell high. If achieving high investment returns is the only goal, the portfolio manager may, for example, invest funds in high-risk assets, which have a high possibility of loss. For a risk-averse investor (e.g., a retiree), such an investment strategy makes little sense.

• A careful analysis of the client's risk tolerance should precede any discussion of return objectives; it makes little sense for a person who is risk-averse to invest funds in high-risk assets.

Investment firms survey clients to gauge their risk tolerance. Risk tolerance is an investor's attitude toward risk. It is segmented into ability and willingness to assume risk.

• The ability to assume risk is based on financial and circumstantial restrictions. Most often, a client's ability to take risks is determined by factors such as time horizon, current insurance coverage, cash reserves, family situation (i.e., number of children), age, current net worth, income expectations, etc.

• While the ability to accept risk is usually measured on a quantitative basis, an investor's willingness to assume risk is based on more psychological factors. It takes into account the investor's overall perception of investment fluctuation and losses.

The investment adviser should work with the investor and reach a conclusion about the investor's risk tolerance consistent with the lower of the two factors (ability and willingness).

Risk objectives are specifications for portfolio risk that reflect the risk tolerance of the client. Quantitative risk objectives can be stated on an absolute or a relative basis. For example:

• Absolute risk objectives: not to lose more than 5% of the capital within a 12-month period; portfolio standard deviation not to exceed 25% at any time, etc.
• Relative risk objectives: match the performance of S&P 500, achieve returns within 3% of the DJIA, etc.

Return objectives can be stated in terms of absolute or a relative percentage return, or other terms. For example:

• 20% capital growth.
• beat the S&P 500 by 2%.

The return measure can be stated:

• before or after fees.
• on either a pre- or post-tax basis.
• as nominal or real returns.

#### Annotation 1418673917196

Subject 3. Investment Constraints
#basics-of-portfolio-planning-and-construction #cfa #cfa-level-1 #portfolio-management
The following constraints affect the investment plan:

• Liquidity needs. Liquidity in the investment sense is the ability to quickly convert investments into cash at a price close to their market value. Investors may need some cash to meet unexpected needs (e.g., emergencies, good investment opportunities) but don't want to sell assets at unfavorable terms. The investment plan must take this need into consideration.

• Time horizon. This is the time between making an investment and needing the funds. There is a relationship between an investor's time horizon, liquidity needs and the ability to handle risk. Investors with long investment horizons generally require less liquidity and can tolerate greater portfolio risk; losses are harder to overcome during a short time frame for investors with short investment horizons.

• Tax concerns. Investment planning is complicated by the tax code. For example, income from dividends, interests, and rents is taxable at the investor's marginal tax rate. Capital gains are only taxable after the asset has been sold for a price higher than its cost or basis, but unrealized capital gains are not taxable at all (the tax liability can deferred indefinitely). Sometimes analysts have to make a trade-off between taxes and diversification needs. Other factors, such as tax-deductible IRA contributions and 401(k) plans (in the U.S.), also complicate this issue.

• Legal and regulatory factors. Individual investors are generally not affected by regulations, but professional and institutional investors need to be aware of regulations.

• Unique needs and preferences. There may be a number of unusual considerations that affects the investor's risk-return profile. For example, investment requirements may depend on goal spending. Thus, individuals will require adequate funds set aside to meet known spending demands. Moreover, many investors may want to exclude certain investments from the portfolio based on personal preferences. For example, investors may specify that no investments in their portfolio be affiliated with the manufacture or distribution of alcohol, pornography, tobacco, or environmentally harmful products.

#### Annotation 1418675752204

Subject 4. Portfolio Construction
#basics-of-portfolio-planning-and-construction #cfa #cfa-level-1 #portfolio-management
An asset class is a group of securities that exhibit similar characteristics and behave similarly in the marketplace (risk-return relationship). Examples of asset classes are money market funds, fixed-income (bonds), equities (stocks), real estate, natural resources, precious metals, collectibles and insurance products. We can even further break down equity investments into additional sub-classes, such as large-cap, mid-cap and small-cap equities.

Asset classes are the building blocks of asset allocation, which is the process of choosing among various kinds of possible asset classes. Empirical studies have shown that 85-95% of a portfolio's total returns come from the asset allocation policy decision, not the selection of specific stocks and bonds. Asset allocation determines what percentage of your total portfolio you devote to the numerous asset classes available.

A strategic asset allocation (SAA) involves an examination of capital markets, to gauge future investment returns, combined with an understanding of portfolio objectives, risk tolerance, and constraints, to distribute a portfolio's assets effectively and efficiently among several asset classes in order to achieve the best return possible within acceptable risk levels.

SAA involves:

• Capital market expectations. The key to any sound asset allocation decision is determining which asset class is expected to outperform others in the short, medium, and long terms and then positioning your portfolio appropriately by shifting more of your assets into the soon-to-be-outperforming asset class at the right time. For example, if the stock market is expected to outperform the bond market, you should have more of your portfolio dedicated to stocks. If the stock market is expected to be weak, add more bonds to your portfolio.
• Choosing eligible asset classes based on objective, risk tolerance, constraints, and capital market assumptions.
• Finding percentage allocations to each asset class (using optimization/simulation techniques). The best way to match expected returns and client objectives is to determine the efficient frontier for the client.
• Selecting benchmarks that reflect the expected performance of each asset class.

Steps toward an Actual Portfolio

Risk budgeting is a process by which investment managers determine how much risks should be taken and how risk can be most effectively allocated across different asset classes.

In addition to taking systematic risks, an investment committee may choose to take tactical asset allocation risks or security selection risks. The amount of return attributable to these decisions can be measured.

• Although all asset allocation strategies, by definition, involve regularly readjusting the asset mix of a portfolio, tactical asset allocation is an active portfolio management strategy that seeks to improve portfolio value by utilizing short-term asset class weightings that differ from the long-run asset mix. Since it is tactical in nature, it requires short-term deviations from the policy asset allocation and focuses on improving return at some expense to risk management.
• Security selection is an attempt to generate higher returns than the asset class benchmark by selecting securities with a higher expected return.

As time goes on, a client's asset allocation will drift from the target allocation; the amount of allowable drift as well as a rebalancing policy should be formalized.

#### Annotation 1418679160076

Subject 1. The Functions of the Financial System
Helping People Achieve Their Purposes Using the Financial System

The financial system helps people:

• Save money for the future. Saving here means buying notes, CDs, bonds, stocks, mutual funds, or real estate assets.
• Borrow money for current use. This is the opposite of the first purpose (above). Individuals, companies, and governments may need money to spend now (consumption, investment, paying taxes, expenses, etc).
• Raise equity capital. Companies can sell ownership rights to raise the equity capital they need.
• Manage risks. People can use financial contracts to offset risks.
• Exchange assets for immediate (in spot markets) and future (in futures markets) deliveries.
• Trade on information. Information-motivated traders can (or they believe they can) use the financial system to earn a return in excess of the fair rate of return because they have information whose value declines over time (as it becomes recognized by other market participants).

Determining Rate of Return

The price in the financial system is the rate of return. It is the result of interaction of the broad forces of supply and demand.

There are as many different prices (rates of return) as there are different types of assets in the financial system. For example, equities have higher rates of return than T-bills. All of the rates are determined in the financial system.

Prices rapidly adjust to new information. The prevailing price is fair because it reflects all available information regarding the asset.

Capital Allocation Efficiency

In the financial markets investors distinguish good firms from bad firms. This lets the market channel capital to good firms and away from problem firms.

Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Such information facilitates the rapid flow of capital to its highest value uses.

#### Annotation 1418680995084

Subject 2. Assets and Contracts

There are many different ways one can classify assets and contracts. The most common way is to classify them into one of these categories: debts, equities, currencies, derivatives (contracts), commodities, and real estate. In this subject we briefly describe the numerous assets and contracts available and provide a brief overview of each.

Fixed-Income Investments

These have a contractually mandated payment schedule. Their investment contacts promise specific payments at predetermined times. Investors who acquire fixed-income securities are really lenders to the issuers. Specifically, you lend some amount of money (the principal) to the borrower. In return, the borrower promises to make periodic interest payments and to pay back the principal at the maturity of the loan.

Bonds, notes, bills, CDs, commercial paper, repo agreements, loan agreements, and mortgages are examples of fixed-income investments.

Preferred stock is classified as a fixed-income security because its yearly payment is stipulated as either a coupon (e.g., 5% of the face value) or a stated dollar amount. Although preferred dividends are not legally binding (as are the interest payments on a bond), they are considered practically binding because of the credit implications of a missed dividend.

Equities

Equities differ from fixed-income securities because their returns are not contractual. They represent residual ownership in companies after all claims-including any fixed-income liabilities of the company - have been satisfied.

Common stocks represent ownership of a firm. Owners of the common stock of a firm share in the company's successes and problems.

A warrant allows the holder to purchase a firm's common stock from the firm at a specified price for a given time period. It provides the firm with future common stock capital when the holder exercises the warrant.

Pooled Investments

Rather than directly buying an individual stock or bond, you may choose to acquire these investments indirectly by buying shares in an investment company that owns a portfolio of individual stocks, bonds, or a combination of the two. People invest in pooled investment vehicles to benefit from the investment management services of their managers. Examples of these pooled investments include money market funds, bond funds, stock funds, balanced funds, etc.

Currencies

The currency market is a worldwide decentralized over-the-counter financial market for the trading of currencies. Market participants include commercial banks, central banks, retail brokers, etc.

Contracts

Financial contracts include the following:

• Forward contracts allow buyers and sellers to arrange for future sales at pre-determined prices. They represent a commitment to buy or sell.
• Futures contracts are standardized forward contracts guaranteed by clearing houses. They are traded on a futures exchange.
• Swap contracts are derivative securities in the form of agreements between two counterparties to exchange cash flows over a period of time, depending on the values of specified market variables.
• Options are rights to buy or sell an underlying instrument at a specified price within a designated time period.

Commodities

Commodities include agricultural products, energy, metals, etc. Commodities complement investment opportunities offered by shares of corporation that extensively use these raw materials in their production processes.

Real Assets

Real assets include tangible assets such as real estate, airplanes, machinery, or lumber stands. They are often illiquid and have high transaction costs compared to stocks and bonds.

#### Annotation 1418682830092

Subject 3. Financial Intermediaries
Financial intermediaries are institutions that function as the line of communication between buyers and sellers in the financial system. Functioning as a middleman, a financial intermediary seeks to match investors who have specific financial goals with investments opportunities that can aid in the achievement of those goals.

Brokers, Exchanges, and Alternative Trading Systems

A broker executes trade orders on behalf of a customer. A block broker helps fill larger orders.

Investment banks help their corporate clients raise capital by issuing shares or bonds. They also help their corporate clients identify and acquire other companies.

An exchange is like a market where stocks, bonds, options and futures, and commodities are traded. Most exchanges offer different categories of membership and regulate their members' behavior when trading on the exchange. They also regulate the issuers that list their securities on the exchange.

Alternative trading systems (ATSs) are non-exchange trading venues that bring together buyers and sellers of securities. ATSs do not exercise regulatory authority over their subscribers and do not discipline subscribers other than by exclusion from trading. For example, an electronic communication network (ECN) connects major brokerages and individual traders so that they can trade directly between themselves without having to go through a middleman. Dark pools are ATSs that don't display their orders (which are usually very large).

Dealers

A dealer trades for its own accounts. Individual dealers provide liquidity to investors by trading the securities for themselves. They buy or sell with one client and hope to do the offsetting transaction later with another client.

In practice, most brokerages are in fact broker-dealer firms. That is, as a broker, the brokerage conducts transactions on behalf of clients, and, as a dealer, it trades on its own account.

In the U.S. most broker-dealers must register with the SEC.

Securitizers

Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity) then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets.

In most securitized investment structures, the investors' rights to receive cash flows are divided into "tranches": senior tranche investors lower their risk of default in return for lower interest payments while junior tranche investors assume a higher risk in return for higher interest.

Financial intermediaries securitize many assets, such as mortgages, car loans, credit card receivables, and banks loans.

Depository Institutions and Other Financial Corporations

They accept monetary deposits from savers and investors, and then lend these deposits to borrowers. Both the depositors and borrowers benefit from the services they provide. Depository institutions also provide other services, such as transaction services, credit services, etc.

Insurance Companies

Insurance involves pooling funds from many insured entities (e.g., policyholders) in order to pay for relatively uncommon but severely devastating losses which can occur to these entities. The insured entities are therefore protected from risk for a fee. In other words, risks are transferred from these entities to the insurance company. The insurance company connects customers who want to insure against risks with investors who are willing to bear those risks.

Insurance companies make money in two ways:

• Through underwriting, the process by which insurers select the risks to insure and decide how much in premiums to charge for accepting those risks;
• By invest
...

#### Annotation 1418684665100

Subject 4. Positions
A long position is owning or holding securities or contracts. For example, an owner of 100 shares of Apple common stock is said to be "long the stock." Being long indicates an expectation of rising share/contract prices.

A short sale allows investors to profit from a decline in a security's price if they believe the security is overpriced. In this procedure an investor (the seller) borrows shares of stock from another investor (the lender) through a broker and sells the shares. The lender keeps the proceeds of the sale as collateral. Later, the investor (the short seller) must repurchase the shares in the market in order to return the shares that were borrowed (covering the short position) to the lender. If the stock price has fallen, the shares will be repurchased at a lower price than that at which they were initially sold, and the short seller reaps a profit equal to the drop in price times the number of shares sold short.

For options, to be long means you are the buyer of the option. To be short means you are the seller of the option. Since the put option contract holder (long) has the right to sell the underlying to the option writer, he or she is actually short the underlying instrument.

The profit in short selling is limited to the value of the security but the loss is theoretically unlimited. In practice, as the price of a security rises, the short seller will receive a margin call from the broker, demanding that the short seller either cover his short position (by purchasing the security) or provide additional cash in order to meet the margin requirement for the security (which effectively places a limit on the amount that can be lost).

Leveraged Positions

Margin transactions occur when investors who purchase stocks borrow part of the purchase price of the stock from their brokers and leave purchased stocks with the brokerage firm because the securities are used as collateral for the loan. The interest rate of the margin credit charged by the broker is typically 1.5% above the rate charged by the bank making the loan. The bank rate (the call money rate) is normally about 1% below the prime rate. The market value of the collateral stock minus the amount borrowed is called the investor's equity.

Investors can achieve greater upside potential, but they also expose themselves to greater downside risk. The leverage equals 1/margin%.

Buying stocks on margin increases the investment's financial risk and thus requires a higher rate of return.

• Percentage margin. The ratio of the net worth or "equity value" of the account to the market value of the securities.

• Maintenance margin. The required proportion of equity to the total value of the stock. It protects the broker if the stock price declines.

• Margin call. If the percentage margin falls below the maintenance margin, the broker issues a margin call requiring the investor to add new cash or securities to the margin account. If the investor fails to provide the required funds in time, the broker will sell the collateral stock to pay off the loan.

Example

Suppose an investor initially pays $6,000 toward the purchase of$10,000 worth of stock ($100 shares at$100 per share), borrowing the remaining from the broker. The maintenance margin is set at 30%. The initial percentage margin is 60%. If the price of the stock falls to $57.14, the value of his stock will be$5,714. Since the loan is $4,000, the percentage margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call. When investors acquire stock or other investments on margin, they are increasing the financial risk of the investment beyond the risk inherent in the security itself. They should increase their required rate of return accordingly. Return on margin transact... status not read #### Annotation 1418686500108 Subject 5. Orders #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #reading-46-market-organization-and-structure Orders are instructions to trade. They always specify instrument, side (buy or sell), and quantity. • Bid price: the highest price that a buyer wants to pay for the instrument. The best bid is the highest bid in the market. • Ask price: the lowest price a seller is willing to accept for the instrument. Also called offer price. The best offer is the lowest in the market. • Bid-ask spread: the difference between the best bid and the best offer. Orders usually also provide several other instructions. Execution Instructions These indicate how to fill the order. Market orders are simple buy or sell orders that are to be executed immediately at current market prices. They provide immediate liquidity for someone willing to accept the prevailing market price. A limit order is an order that sets the maximum or minimum at which you are willing to buy or sell a particular stock. For instance, if you want to buy stock ABC, which is trading at$12, you can set a limit order for $10. This guarantees that you will pay no more than$10 to buy this stock. Once the stock reaches $10 or less, you will automatically buy a predetermined amount of shares. On the other hand, if you own stock ABC and it is trading at$12, you could place a limit order to sell it at $15. This guarantees that the stock will be sold at$15 or more.

The primary advantage of a limit order is that it guarantees that the trade will be made at a particular price; however, it's possible that your order will not be executed at all if the limit price is not reached.

Traders choose order submission strategies on the basis of how quickly they want to trade, the prices they are willing to accept, and the consequences of failing to trade.

Validity Instructions

These indicate when the order may be filled.

A day order (the most common) is a market or limit order that is in force from the time the order is submitted to the end of the day's trading session.

A good-till-canceled order requires a specific canceling order. It can persist indefinitely (although brokers may set some limits, for example, 90 days).

An immediate-or-cancel order (IOC) will be immediately executed or canceled by the exchange. Unlike a fill-or-kill order, IOC orders allow for partial fills.

An order may be specified on the close or on the open, then it is entered in an auction but has no effect otherwise.

Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you place a stop or limit order, you are telling your broker that you don't want the market price (the current price at which a stock is trading), but that you want the stock price to move in a certain direction before your order is executed.

With a stop order, your trade will be executed only when the security you want to buy or sell reaches a particular price (the stop price). Once the stock has reached this price, a stop order essentially becomes a market order and is filled. For instance, if you own stock ABC, which currently trades at $20, and you place a stop order to sell it at$15, your order will only be filled once stock ABC drops below $15. Also known as a "stop-loss order," this allows you to limit your losses. However, this type of order can also be used to guarantee profits. For example, assume that you bought stock XYZ at$10 per share and now the stock is trading at $20 per share. Placing a stop order at$15 will guarantee profits of approximately $5 per share, depending on how quickly the market order can be filled. Stop orders are particularly advantageous to investors who are unable to monitor their stocks for a period of time, and brokerages may even set these stop orders for no charge. One disa... status not read #### Annotation 1418688335116 Subject 6. Primary Security Markets #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #reading-46-market-organization-and-structure The primary markets are those in which new issues of bonds, preferred stock, or common stock are sold by government units, municipalities, or companies to acquire new capital. • New issue. • Key factor: issuer receives the proceeds from the sale. There are two important rules in the primary capital markets: • Rule 415 allows large firms to register security issues and sell them piecemeal over the following two years. Such issues are called shelf-registration. This rule allows a single registration document to be filed that permits the issuance of multiple securities. • Rule 144A allows corporations (including non-U.S. firms) to place securities privately with large, sophisticated investors. The issuer of a private placement reduces issuing costs because it does not have to complete the extensive registration documents. However, investors will require a higher return since no secondary market exists and thus the liquidity risk is high. New stock issues are divided into two groups: • Initial public offerings (IPOs). These are new shares that a firm offers to the public for the first time. They are typically underwritten by investment bankers through negotiated arrangements (the most common form), competitive bids, and best-effort arrangements (investment bankers act as brokers, not taking the price risk). • Seasoned equity issues. These are new shares issued by firms that already have stocks outstanding. A rights issue is an option that a company can opt for to raise capital under a secondary market offering or by using a seasoned equity offering of shares to raise money. It is a special form of shelf offering or shelf registration. With the issued rights, existing shareholders have the privilege of buying a specified number of new shares from the firm at a specified price within a specified time. Government bond issues are sold at Federal Reserve auctions. status not read #### Annotation 1418690170124 Subject 7. Secondary Security Market and Contract Market Structures #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #reading-46-market-organization-and-structure The secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to the public are traded between current and potential owners. • The existing owner sells to another party. • The issuing firm does not receive proceeds and is not directly involved. Secondary markets support primary markets. • The secondary market provides liquidity to the individuals who acquired these securities, and the primary market benefits greatly from the liquidity provided by the secondary market because investors would hesitate to acquire securities in the primary market if they thought they could not subsequently sell them in the secondary market. • Secondary markets are also important to issuers because the prevailing market price of the securities is determined by transactions in the secondary market. New issues of outstanding securities (seasoned securities) in the primary market are based on the prices in the secondary market. Forthcoming IPOs in the primary market are priced based on the prices of comparable stocks in the public secondary market. Trading Sessions Securities exchanges differ in when stocks are traded. In a call market, trading for individual stocks takes place at specified times. The intent is to gather all the bids and asks for the stock and attempt to arrive at a single price where the quantity demanded is as close as possible to the quantity supplied. • This trading arrangement is generally used during the early stages of development of an exchange when there are few stocks listed or a small number of active investors/traders. • Call markets also are used at the opening for stocks on the NYSE if there is an overnight buildup of buy and sell orders, in which case the opening price can differ from the prior day's closing price. • The concept is also used if trading is suspended during the day because of some significant new information. The mechanism is considered to contribute to a more orderly market and less volatility in such instances because it attempts to avoid major up-and-down price swings. In a continuous market, trades occur any time the market is open. Stocks are priced either by auction or by dealers. In an auction market, there are sufficient willing buyers and sellers to keep the market continuous. In a dealer market, enough dealers are willing to buy or sell the stock. Please note that dealers may exist in some auction markets. These dealers provide temporary liquidity and ensure market continuity if the market does not have enough activity. Although many exchanges are considered continuous, they (e.g., NYSE) also employ a call-market mechanism on specific occasions. status not read #### Annotation 1418692005132 Subject 8. Well-Functioning Financial Systems #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #reading-46-market-organization-and-structure Well-functioning financial systems have the following characteristics: • Complete markets. The instruments needed to solve investment and risk management problems are available to trade. • Liquidity. As asset can be bought and sold quickly (that is, it has marketability, which means an asset's likelihood of being sold quickly) at a price close to the prices for previous transactions (price continuity), assuming no new information has been received. In turn, price continuity requires depth, which means that numerous potential buyers and sellers must be willing to trade at prices above and below the current market price. • Operational efficiency. Low transaction costs (as a percentage of the value of the trade) include the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset. This attribute is often referred to as internal efficiency. • Informational (or external) efficiency. Timely and accurate information is available on the price and volume of past transactions and the prevailing bid-price and ask-price. Prices rapidly adjust to new information; thus the prevailing price is fair because it reflects all available information regarding the asset. Prices will be most informative in liquid markets because information-motivated traders will not invest in information and research if establishing positions based on their analysis is too costly. A well-functioning financial system promotes wealth by ensuring that capital allocation decisions are well-made. It also promotes wealth by allowing people to share risks associated with valuable products that would otherwise not be undertaken. status not read #### Annotation 1418693840140 Subject 9. Market Regulation #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #reading-46-market-organization-and-structure Regulators generally seek to promote fair and orderly markets in which traders can trade at prices that accurately reflect fundamental values without incurring excessive transaction costs. Governmental agencies and self-regulating organizations of practitioners provide regulatory services that attempt to make markets safer and more efficient. The objectives of market regulation are to: • control fraud. Customers may not know how to protect themselves, since the financial markets are quite complex. • control agency problems. Financial agents often have different goals from their customers. How to effectively measure the services they provide? • promote fairness. For example, insider trading is prohibited in most markets as it offends basic notions of fairness. • set mutually beneficial standards. Common financial standards allow investors to compare companies easily. • prevent undercapitalized financial firms from exploiting their investors by making excessive risky investments. Regulators generally require that financial firms maintain minimum levels of capital to reduce the probability that these firms will fail and hurt their customers. • ensure that long-term liabilities are funded. Insurance companies and pension funds need to maintain adequate reserves to ensure they can pay their liabilities when due. status not read #### Annotation 1418695675148 Subject 1. Index Definition and Calculations of Value and Returns #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #has-images #reading-47-security-market-indices A security market index is a means to measure the value of a set of securities in a target market, market segment, or asset class. The constituent securities selected for inclusion in the security market index are intended to represent the target market. There are usually two versions of the same index: • The price return takes into account only the capital gain on an investment. A price return index reflects only the prices of the constituent securities. The income generated by the assets in the portfolio, in the form of interest and dividends, is ignored. The value of a price return index is calculated as: ni: the number of units of security i in the index portfolio. Pi: the unit price of security i. D: the value of the divisor. • The total return takes into account not only the capital appreciation on the portfolio, but also the income received. A total return index reflects the prices and the reinvestment of all income received since the inception of the index. Single Period Returns The single-period price return of an index is the weighted average of the price returns of the individual securities: or Since the total return of an index includes price appreciation and income, we need to add the weighted average of income to the above formula to calculate the single-period total return: or Multiple-Period Returns The single-period returns should be linked geometrically. Similarly, to calculate the total return over multiple periods: status not read #### Annotation 1418708520204 Subject 2. Index Construction and Management #cfa #cfa-level-1 #equity-market-organization-indices-and-market-efficiency #has-images #reading-47-security-market-indices The steps to construct and manage a security market index: • The first decision is to identify the target market. Which market should the index represent? • The second decision is to select specific securities to include in the index. How many securities to include? Which ones? The following factors are important: • Size: the larger, the better - but eventually the costs of taking a larger sample will outweigh the benefits. • The breadth of the sample: the sample must represent the total population. • The source of the sample: samples must be taken from each different segment of the population. • The third decision is to determine the weight to be allocated to each security in the index (discussed below). • When should the index be rebalanced? • When should the security selection and weighting decisions be re-examined? Price Weighting This is an arithmetic average of current prices. Index movements are influenced by the differential prices of the components. The weight of each security is calculated using this formula: The index itself is computed by: • Adding up the market price of each stock in the index, then • Dividing this total price by the number of stocks in the index: price-weighted series = sum of stock prices / number of stocks in the series. Example Shares of firm A sell for$100 and shares of firm B sell for $25. The initial price index is (100 + 25) / 2 = 62.5. The divisor is therefore 2. • Normal situation. Suppose that A increases by 10% to$110 and B increases by 20% to $30; the price index would be (110 + 30) /2 = 70. The rate of return would be: (70 - 62.5) / 62.5 = 12%. • Stock split. If A were to split two for one, and its share price were therefore to fall to$50, we would not want the average to fall since that would incorrectly indicate a fall in the general level of market prices. Following a split, the divisor must be reduced to a value that leaves the average unaffected by the split. The new divisor is: (50 + 25) / 62.5 = 1.2, which will make the initial value of the average unaffected.

Price-weighting is simple, but a price-weighted index has a downward bias.

• High-priced stocks have a greater impact on the index than low-priced stocks, as the scheme assumes that an investor purchases an equal number of shares for each stock in the index.
• Large successful firms consistently lose weight within the index since high-growth companies tend to split their stocks more often. Over time, low-growth small firms with high prices will dominate the index.

Both the Dow Jones Industrial Average (DJIA) and the Nikkei-Dow Jones Average use this method to weight an index.

Equal Weighting

All stocks carry equal weight regardless of their price or market value. A $1 stock is as important as a$10 stock, and a firm with a $200 million market value is the same as one with a$200 billion value.

The actual movements in the index are typically based on the arithmetic average of the percent changes in price or value for the stocks in the index: each percent change has equal weight. Such an index can be used by individuals who randomly select stock for their portfolios and invest the same dollar amount in each stock.

The weight of each security is calculated using this formula:

It a...

#### Annotation 1418718219532

Subject 3. Uses of Market Indices
Security market indices are used:

• For predicting future market movements by technicians. Technicians believe past price changes can be used to predict future price movements. For example, to project future stock price movements, technicians would plot and analyze price and volume changes for a stock market series like the DJIA.

• To measure market rates of return in economic studies.

• As a proxy for the market portfolio of risky assets. When calculating the systematic risk of an asset, it is necessary to relate its returns to the returns of an aggregate market index that is used as a proxy for the market portfolio of risky assets.

• As benchmarks to evaluate the performance of professional money managers. A basic assumption when evaluating portfolio performance is that any investor should be able to experience a rate of return comparable to the market return by randomly selecting a large number of stocks from the total market. Therefore, a stock-market index can be used as a benchmark to judge the performance of professional money managers.

• To create and monitor an index fund or an exchange-traded fund (EFT). An index fund is created to track the performance of the specific market series (index) over time.

#### Annotation 1418720054540

Subject 4. Different Types of Security Market Indices

Equity Indices

There are different types of equity indices.

A broad market index represents an entire given equity market. Examples include the Russell 3000, the Wilshire 5000 Total Market Index, etc.

Local indices of individual countries lack consistency in sample selection, weighting, or computational procedures. Global equity indexes are created to solve this comparability problem. A multi-market index represents multiple security markets. For example, the Dow Jones World Stock Index includes 2,200 companies in 33 countries.

A sector index measures the performance of a narrow market segment, such as the biotechnology sector. It can be used to determine if a portfolio manager is good at sector allocation or not. It can also be used to track the performance of sector-specific funds.

Style strategies focus on the underlying characteristics common to certain investments. Growth is a different style than value, and large capitalization investing is a different style than small stock investing. A growth strategy may focus on high price-to-earnings stocks and a value strategy on low price-to-earnings stocks. Style indices are created to represent such securities.

Fixed Income Indices

The creation and computation of bond-market indices is more difficult than that for a stock market series.

• The universe of bonds is much broader than that of stocks.
• The universe of bonds is changing constantly because of new issues, bond maturities, calls, and bond sinking funds.
• The volatility of prices for individual bonds and bond portfolios changes because bond price volatility is affected by duration, which is changing constantly.
• Pricing individual bonds is difficult compared to the current and continuous transactions prices available for most stocks used in stock indexes.

All bond indices indicate total rates of return for the portfolio of bonds, including price change, accrued interest, and coupon income reinvested. They are relatively new and not widely published. Most indices are market-value weighted.

Bond indices can be categorized based on their broad characteristics, such as type of issuer, currency, maturity, and credit rating. For example, there are different indices for government bonds, high-yield bonds, corporate bonds, and mortgage-backed securities.

Commodity Indices

There are five major commodity sectors: energy, grains, metals, food and fiber, and livestock.

A commodity price index is a fixed-weight index of selected commodity prices, which may be based on spot or futures prices. It is designed to be representative of the broad commodity asset class or a specific subset of commodities, such as energy or metals.

• Different commodity indices have different weighting methods, which result in different risk and return profiles.
• A commodity index may track commodities directly, or indirectly by tracking futures contracts for certain commodities. For example, commodity indices may track energy products or currencies, or may tracks futures contracts in either of those. For a commodity index that consists of futures contracts on the commodities, the index returns are affected by factors such as the prices of the underlying commodity, the risk-free interest rate, and the roll yield.

Real Estate Investment Trust Indices

Types of real estate indices include appraisal indices, repeat sales indices, and REIT indices which track the performance of publicly traded REITs.

Hedge Funds Indices

There are many indices that track the hedge fund industry. Since hedge funds are illiquid, heterogeneous, and ephemeral, it is really hard to construct a satisfactory index.

Funds' participation in an index is voluntary, leading to self-selection bias because those funds th...

#### Annotation 1418721889548

Subject 1. The Concept of Market Efficiency
An efficient capital market is one in which security prices adjust rapidly to the arrival of new information and the current prices of securities reflect all information about the securities. Therefore, it is also called an informationally efficient capital market.

Why should capital markets be efficient? Competition is the source of efficiency, and price changes should be independent and random.

• A large number of competing profit-maximizing participants analyze and value securities, each independently of the others.
• New information regarding securities comes to the market in a random fashion, and the timing of an announcement is generally independent of others.
• Competing investors attempt to adjust security prices rapidly to reflect the effect of new information. The price adjustment is unbiased: sometimes the market will over-adjust and other times it will under-adjust; you cannot predict its behavior.

In an efficient market, the expected returns implicit in the current price of the security should reflect its risk. Investors buying the security should receive a return that is consistent with the perceived risk of the security.

In an efficient capital market the majority of portfolio managers cannot beat a buy-and-hold policy on a risk-adjusted basis. An index fund which simply attempts to match the market at the lowest cost is preferable to an actively managed portfolio.

Market Value versus Intrinsic Value

• Intrinsic value is the true, actual value of an asset. It is what the asset is really worth.
• Market value is the price of an asset. It is what buyers are willing to pay for the asset.

In an efficient market, the two values should be very close or the same. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value. Though market value and intrinsic value may differ over time, the discrepancy will get corrected as new information arrives.

In an inefficient market, the two values may differ significantly.

Factors Affecting a Market's Efficiency

Some factors contribute to and some impede the degree of efficiency in a financial market.

• The number of market participants. The more investors and analysts that follow a financial market, the more efficient it becomes.
• Information availability and financial disclosure. All investors should have access to the necessary information to value securities. This should promote market efficiency.
• Limits to trading. Some researchers argue that restrictions on short selling impede market efficiency.

Transaction costs and information-acquisition costs should also be considered when evaluating market efficiency.

#### Annotation 1418723724556

Subject 2. Forms of Market Efficiency
There are three versions of the Efficient Market Hypothesis (EMH); they differ in their notions of what is meant by the term "all available information."

• The weak-form hypothesis asserts that stock prices already reflect all the information that can be derived by examining market trading data, such as the history of past prices, trading volume, or short interest. This implies that trend analysis is fruitless: if such data ever conveyed reliable signals about future performance, all investors would have become familiar with such signals already.

• The semi-strong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes (in addition to past prices) fundamental data on the firm's product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Obviously this version encompasses the weak-form EMH. This hypothesis implies that an investor cannot achieve risk-adjusted excess returns using important publicinformation.

Event studies examine how fast stock prices adjust to specific significant economic events. The results for most of these studies have supported the semi-strong-form EMH. About the only mixed results come from exchange-listing studies.

• The strong-form hypothesis states that stock prices reflect all information (from public and private sources) relevant to the firm, including information available only to company insiders. This version of EMH encompasses both the weak-form and the semi-strong-form EMH. It is quite extreme. It implies that no investor has monopolistic access to information that influences prices. Thus, no investor can consistently derive risk-adjusted excess returns. In fact, the strong-form EMH assumes perfect markets, in which all information is cost-free and available to everyone at the same time. In contrast, in an efficient market prices adjust rapidly to new public information.

Implications of EMHs

Technical Analysis

The assumptions of technical analysis directly oppose the notion of efficient markets.

• The process of disseminating new information takes time.
• Stock prices move to new equilibriums in a gradual manner.
• Hence, stock prices move in trends that persist.

Therefore, technical analysts believe that good traders can detect the significant stock price changes before others do. However, as confirmed by most studies, the capital market is weak-form efficient as prices fully reflect all market information as soon as the information becomes public. Though prices may not be adjusted perfectly in an efficient market, it is unpredictable whether the market will over-adjust or under-adjust at any time. Therefore, technical analysts should not generate abnormal returns and no technical trading system should have any value.

Fundamental Analysis

Fundamental analysts believe that:

• At any time, there is a basic intrinsic value for the aggregate stock market, various industries, or individual securities;
• These values depend on underlying economic factors such as cash flows and risk variables;
• Though market price and the intrinsic value may differ over time, the discrepancy will get corrected as new information arrives.

Therefore, by accurately estimating the intrinsic value, a fundamental analyst can achieve abnormal returns by making superior market timing decisions or acquiring undervalued securities.

Fundamental analysis involves aggregate market analysis, industry analysis, company analysis, and portfolio management. However, using historical data to estimate the relevant variables is as much an art and a product of hard...

#### Annotation 1418725559564

Subject 3. Market Pricing Anomalies
Are the hypotheses supported by the data? Are there market patterns that lead to abnormal returns more often than not?

A market anomaly is a security price distortion in the market that seems to contradict the efficient market hypothesis. There are different categories of market anomalies.

Time-Series Anomalies

Calendar anomalies raise the question of whether some regularities exist in the rates of return during the calendar year that would allow investors to predict returns on stocks.

The January anomaly, also called small-firm-in-January effect, says that many people sell stocks that have declined in price during the previous months to realize their capital losses before the end of the tax year. Such investors do not put the proceeds from these sales back into the stock market until after the turn of the year. At that point the rush of demand for stock places an upward pressure on prices that results in the January effect.

The effect is said to show up most dramatically for the smallest firms because the small-firm group includes stocks with the greatest variability of prices during the year (and the group therefore includes a relatively large number of firms that have declined sufficiently to induce tax-loss selling).

Another possible reason for the January effect on stock markets is strategic selling by institutional investors at the end of their reporting periods. Portfolio managers may be reluctant to report holdings of stocks in their annual reports that have performed poorly in the previous period. Therefore, the managers sell these stocks at the end of their accounting periods (usually the end of December). This so-called "window-dressing" was suggested as a source of the January effect by Haugen and Lakonishok (1988).

Despite numerous studies, the January anomaly poses as many questions as it answers.

Other calendar anomalies include the monthly effect, weekend or day-of-the-week effect, and intraday effect.

Momentum and Overreaction Anomalies. The debate surrounding investor overreaction and contrarian investing is one of the most extensive and controversial areas of research in finance. The overreaction anomaly, evidenced by long-term reversals in stock returns, was first identified by De Bondt and Thaler (1985), who showed that stocks which have performed poorly in the past three to five years demonstrate superior performance over the next three to five years compared to stocks that have performed well in the past. The study provided evidence that abnormal excess returns could be gained by employing a strategy of buying past losers and selling short past winners, or the contrarian strategy.

Although the overreaction anomaly and market momentum do seem to exist, researchers have argued that the existence of momentum is rational, and the additional return (based on the contrarian investment strategy) would come simply at the expense of increased risk.

Cross-Sectional Anomalies

If the semi-strong EMH is true, all securities should have equal risk-adjusted returns because security prices should reflect all public information that would influence the security's risk. Using public information, is it possible to determine what stocks will enjoy above-average, risk-adjusted returns?

The size effect relates to the impact of size (measured by total market value) on risk-adjusted rates of return. Some researchers found that small firms outperformed large firms after considering risk and transaction costs.

Basu's study concluded that publicly available P/E ratios conveyed valuable information, and that the risk-adjusted returns for stocks in the lowest P/E ratio quintile were superior to those in the highest P/E ratio quintile. This is known as the value effect.

Fama and French found that both size and BV/MV ratio are significant when included toge...

#### Annotation 1418727394572

Subject 4. Behavioral Finance
Some investors behave highly irrationally and make predictable errors. Behavior finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioral finance attempts to fill the void.

Loss Aversion

This is a theory that people value gains and losses differently and, asa result, will base decisions on perceived losses rather than perceived gains. Thus, if people were given two equal choices, one expressed in terms of possible losses and the other in possible gains, they would choose the former.

Overconfidence

Most people consider themselves to be better than average in most things they do. For example, 80% of drivers contend that they are better than "average" drivers. Is that really possible? Studies show that money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Most fail to do so, however.

Other behavior theories include representativeness, gambler's fallacy, mental accounting, etc.

Information cascading is defined as a situation in which an individual imitates the trades of other market participants and completely disregards his or her own private information. A related concept is herding, which is clustered trading that may or may not be based on information. Some researchers argue that institutional investors trade together because they receive correlated private information or infer private information from previous trades, and institutional herding helps prices more quickly reflect market information and improve market efficiency. The result is that trading does not incorporate information and prices can move away from fundamentals.

Some researchers argue that information cascades help promote market efficiency.

#### Annotation 1418729229580

Subject 1. Equity Securities in Global Financial Markets
Equity securities play a fundamental role in investment analysis and portfolio management. The importance of this asset class continues to grow on a global scale because of the need for equity capital in developed and emerging markets, technological innovation, and the growing sophistication of electronic information exchange. Given their absolute return potential and ability to impact the risk and return characteristics of portfolios, equity securities are of importance to both individual and institutional investors.

Global equity securities have offered an average annualized real return of 5% based on historical data, while the average annual real return is about 1% or 2% for government bills and bonds. However, equity securities are more volatile than government bills and bonds. They represent a key asset class for global investors because of their unique return and risk characteristics.

#### Annotation 1418732375308

Subject 2. Types and Characteristics of Equity Securities
Common Shares

Common shares represent ownership shares in a corporation.

The two most important characteristics of common shares are:

• Residual claim means the shareholders are the last in line of all those who have a claim on the assets or income of the corporation.
• Limited liability means that the greatest amount shareholders can lose in the event of the failure of the corporation is the original investment.

Each share of voting common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation's annual meeting. Shareholders who do not attend the annual meeting can vote by proxy, empowering another party to vote in their name.

Statutory voting, also known as straight voting, is a procedure of voting for a company's directors in which each shareholder is entitled to one vote per share. For example, if you owned 100 shares, you would have 100 votes.

Cumulative voting is another procedure of voting for a company's directors. Each shareholder is entitled to one vote per share times the number of directors to be elected. For example, if you owned 100 shares and there were three directors to be elected, you would have 300 votes. This is advantageous for individual investors because they can apply all of their votes toward one person.

Common shares can be callable or putable. Callable common shares give the issuer the right to buy back the shares from shareholders at a pre-determined price. Putable common shares give shareholders the right to sell the shares back to the issuer at a pre-determined price.

Preference Shares

A preferred share, also called a preference share, has features similar to both equities and bonds.

• Like a bond, it promises to pay to its holder fixed dividends each year. In this sense it is similar to an infinite-maturity bond, that is, a perpetuity. It also resembles a bond in that it does not convey voting power regarding the management of the firm.
• A preferred share is an equity investment in the sense that failure to pay the dividend does not precipitate corporate bankruptcy. It has priority over a common share in the payment of dividends and upon liquidation.

Preferred dividends can be cumulative; that is, unpaid dividends cumulate and must be paid in full before any dividends may be paid to common shareholders. All passed dividends on a cumulative stock are dividends in arrears. A stock that doesn't have this feature is known as a noncumulative or straight preferred stock and any dividends passed are lost forever if not declared. The implication is that the dividend payments are at the company's discretion and are thus similar to payments made to common shareholders.

Participating preferred shares offer the holders the opportunity to receive extra dividends if the company achieves some predetermined financial goals. The investors who purchased these shares receive their regular dividends regardless of how well or how poorly the company performs, assuming the company does well enough to make the annual dividend payments. If the company achieves predetermined sales, earnings, or profitability goals, the investors receive additional dividends. Most preferred shares are non-participating.

Convertible preferred shares give the assurance of a fixed rate of return plus the opportunity for capital appreciation. The fixed-income component offers a steady income stream and some protection of capital. The option to convert these preferred shares into common shares gives the investor the opportunity to gain from a rise in share price.

#### Annotation 1418734210316

Subject 3. Private versus Public Equity Securities
Private securities are not publicly traded. They don't have market-determined quoted prices, and they are highly illiquid.

The most common investment strategies are:

• Venture capital is financing for privately held companies, typically in the form of equity in less mature companies, for the launch, early development, or expansion of a business. A venture firm must provide returns to its investors and has a long horizon to do so. Therefore, it has to make a high multiple on its investment and must hold out for a nice acquisition or an IPO. It must build the business from scratch to be able to carry a very high enterprise value.

• A leverage buyout (LBO) is the acquisition of a company or division of a company with a substantial portion of borrowed funds. A buyout fund seeks companies that are undervalued with high predictable cash flow and operating inefficiencies. If it can improve the business, it can sell the company or its parts, or it can pay itself a nice dividend or pay down some company debt to deleverage.

• A private investment in public equity, often called a PIPE deal, involves the selling of publicly traded common shares to private investors. Generally, companies are forced to pursue PIPEs when capital markets are unwilling to provide financing and traditional equity market alternatives do not exist for that particular issuer.

#### Annotation 1418736045324

Subject 4. Investing in Non-Domestic Equity Securities
There are a variety of methods for investing in non-domestic equity securities.

Direct Investing

Investors can buy and sell securities directly in foreign markets. However, they have to worry about currency conversions, unfamiliar market practices, and differences in accounting practices.

Depository Receipts

Depository Receipts (DRs) are domestically traded securities representing claims of shares of foreign stocks. Those shares are held in deposit in a local bank, which in turn issues DRs in the name of the foreign company. Investors buy and sell DRs in local currency and receive all dividends in local currency.

An unsponsored DR is issued by a broker/dealer or depository bank without the involvement of the company whose stock underlies the DR.

A sponsored DR is issued with the cooperation of the company whose stock underlies the DR. These shares carry all the rights of the common shares, such as voting rights.

A global depository receipt (GDR) is a DR issued outside the company's home country and outside the U.S. A GDR is very similar to an ADR. It is typically used to invest in companies from developing or emerging markets.

An American depositary receipt (ADR) is a U.S. dollar-denominated DR that trades on a U.S. exchange. Sponsored ADRs are classified at three levels:

• A Level I ADR is used when the issuer is not initially seeking to raise capital in the U.S. markets or does not wish to, or can't, list its ADRs on an exchange or on Nasdaq. A Level I ADR program offers an easy and relatively inexpensive way for an issuer to gauge interest in its securities and begin building a presence in the U.S. securities markets. Level I ADRs are traded in the over-the-counter (OTC) market.

• In a Level II ADR program, the ADRs are listed on the U.S. securities exchange or quoted on Nasdaq, thereby offering higher visibility in the U.S. market, more active trading, and greater liquidity. Level II ADR programs must comply with the full registration and reporting requirements of the SEC's Exchange Act.

• In the most high-profile form of sponsored ADR program, Level III, an issuer floats a public offering of ADRs in the U.S. and lists the ADRs on one of the U.S. exchanges or Nasdaq. The benefits of a Level III program are substantial: it allows the issuer to raise capital and leads to much greater visibility in the U.S. market.

• A SEC Rule 144A ADR allows foreign companies to raise capital by privately placing these DRs with qualified institutional investors. SEC registration is not required.

Other methods to invest in non-domestic equity securities include global registered shares and baskets of listed depository receipts.

#### Annotation 1418737880332

Subject 5. Risk and Return Characteristics of Equity Securities
Return Characteristics

There are two main sources of equity securities' total return:

• Capital gains/losses are the difference between the net sales price of a stock and its net cost.
• Dividends are the portion of the firm's earnings paid to common and preferred shareholders.

Investors who purchase non-domestic equities may incur foreign exchange gains or losses.

Reinvestment income of dividends is also a source of return.

Risk Characteristics

The risk of an equity security is the uncertainty of its expected total return. The measurement of the risk is typically the standard deviation of its expected total return over a number of periods.

Analysts use different methods to estimate an equity's expected return and risk.

Different types of shares have different risk characteristics. Common shares are more risky than preferred shares. Some shares (e.g., callable) are more risky than other shares (e.g., putable).

#### Annotation 1418740239628

Subject 6. Equity Securities and Company Value
Companies issue equity securities to raise capital and increase liquidity. The book value of a company's equity can be affected by its management directly, but the market value is determined by investors. Increases in book value may not be reflected in the company's market value. In fact, book value and market value are rarely equal.

Accounting Return on Equity

ROE is net income (available to common shares) divided by the total book value of equity (common shares).

The book value can be the book value at the beginning of the period or the average book value.

Apparently management's accounting choices (e.g., FIFO versus LIFO) can have a big impact on computed ROEs.

An increasing ROE is not always good. Investors should examine the source of changes in the company's net income and shareholders' equity over time to determine why its ROE is increasing.

A company's price-to-book ratio can be used to indicate investors' expectations for the company's future cash flows generated by its positive net present investment opportunities. The ratio should be used to compare companies mainly in the same industry.

The Cost of Equity and Investor's Required Rate of Return

The cost of debt is simply the periodic coupon rate or interest rate. The cost of equity, which is usually used as a proxy for investors' minimum required rate of return, is difficult to estimate because there is no existing one. Two models can be used to estimate the cost of equity: DDM and CAPM.

#### Annotation 1418742074636

Subject 1. Uses of Industry Analysis
Company analysis and industry analysis are closely interrelated. Company and industry analysis together can provide insight into sources of industry revenue growth and competitors' market shares and thus the future of an individual company's top-line growth and bottom-line profitability.

Industry analysis is useful for:

• Identifying active equity investment opportunities.
• Formulating an industry or sector rotation strategy.

#### Annotation 1418743909644

Subject 2. Approaches to Identifying Similar Companies
There are three main approaches to classifying companies:

• Products and/or service supplied. This is the main approach to industry classification. Companies are categorized based on the products and/or services they offer. The term "sector" is used to refer to a group of related industries.

• Business-cycle sensitivities. A cyclical industry is sensitive to business cycles. Its revenues are generally higher in periods of economic prosperity and lower in periods of economic downturn. The performance of a non-cyclical industry is independent of the business cycle.

Non-cyclical industries can be sorted into two categories:

• A defensive (or stable) industry demonstrates stable performance during both economic expansion and contraction.
• Companies in a growth industry achieve above-normal growth rates and profitability at any stage of the general business cycle.

However, there are limitations when using these industry descriptors. For example, some industries may include both growth companies and defensive companies.

Note two things:

• Business-cycle sensitivity is a continuous spectrum.
• A global company can experience economic expansion in one part of the world while experiencing recession in another part.

• Statistical similarities. Statistical cluster analysis is defined as the art of finding groups in data such that the degree of natural association is high among members within the same class (internal cohesion) and low between members of different categories (external isolation). This technique can be used to categorize companies into different industries.

#### Annotation 1418745744652

Subject 3. Industry Classification Systems
Commercial industry classification systems include:

• The Global Industry Classification Standard (GICS) is an industry taxonomy for use by the global financial community. It is used as a basis for S&P and MSCI financial market indexes in which each company is assigned to a sub-industry and to a corresponding industry, industry group, and sector, according to the definition of its principal business activity.

• The Russell Global Sectors classification system uses a three-tier structure to classify global companies based on the products or services they offer.

• The Industry Classification Benchmark (ICB) categorizes individual companies into subsectors based primarily on their source of revenue (or the majority of revenue).

Various governmental agencies use a number of classification systems to facilitate the comparison of data over time and among countries that use the same system. These systems include:

• The International Standard Industrial Classification of All Economic Activities (ISIC) is used by the United Nations, its agencies and many countries in the world.
• The Statistical Classification of Economic Activities in the European Community (NACE) is the European version of ISIC.
• The Australian and New Zealand Standard Industrial Classification.
• The North American Industry Classification System.

The structures of these systems are very similar. The limitation of current classification systems is that the narrowest classification unit assigned to a company generally cannot be assumed to constitute its peer group for the purpose of detailed fundamental comparisons or valuation.

Peer Group Analysis

This is the practice of comparing a firm's results to those of similar firms.

Commercial industry classification systems often provide a starting point for constructing a peer group. Start with companies in the same industry, review the subject company and its competitors' annual reports, and confirm that each comparable company's primary business activity is similar to that of the subject company. Useful questions to ask are:

• What proportion of revenue and operating profit is derived from business activities similar to those of the subject company?
• Does a potential peer company face a demand environment similar to that of the subject company?
• Does a potential company have a finance subsidiary?

#### Annotation 1418747579660

Subject 4. Principles of Strategic Analysis
A business has to understand the dynamics of its industries and markets in order to compete effectively in the marketplace. Porter identifies five forces that dictate the rules of competition in each industry. These forces determine industry profitability because they influence the prices, costs, and required investment of firms in an industry.

• The threat of substitutes. Substitutes not only limit profits in normal times, they also reduce the bonanza an industry can reap in good times. The threat of a substitute is high if it offers an attractive price-performance trade-off to the industry's product and/or the buyer's cost of switching to the substitute is low.

• The bargaining power of customers. How strong is the position of buyers? Can they work together in ordering large volumes? This force influences the prices that firms can charge. It can also influence cost and investment as powerful buyers demand costly services.

• The bargaining power of suppliers. How strong is the position of sellers? Suppliers, if powerful, can exert an influence on the producing industry, such as selling raw materials at a high price to capture some of the industry's profits. In some cases, a monopolist supplier can dictate its terms to entire industries. This force determines the cost of raw materials and other inputs.

• The threat of new entrants. How easy or difficult is it for new entrants to start competing? Barriers to entry are unique industry characteristics that define the industry. Barriers reduce the rate of entry of new firms, thus maintaining a level of profits for those already in the industry. From a strategic perspective, barriers can be created or exploited to enhance a firm's competitive advantage.

• The intensity of rivalry. Does strong competition between the existing players exist? Is one player very dominant or are all equal in strength and size?

The elements of a thorough industry analysis include the following:

Barriers to Entry

In theory, any firm should be able to enter and exit a market, and if free entry and exit exists, then profits always should be nominal. In reality, however, industries possess characteristics that protect the high profit levels of firms in the market and inhibit additional rivals from entering the market. These are barriers to entry. They are advantages that incumbents have relative to new entrants.

The threat of entry in an industry depends on the height of entry barriers that are present. If entry barriers are low, the threat of entry is high and industry profitability is moderated.

Generally, high barriers to entry can lead to better pricing and less competitive industry conditions. However, barriers to entry are not barriers to success, and high barriers to entry do not necessarily lead to good pricing power and attractive industry economics. Barriers to entry can also change over time.

Industry Concentration

Industry concentration is often, although not always, a sign that an industry may have pricing power and rational competition. Industry fragmentation is a much stronger signal, however, that the industry is competitive and pricing power is limited.

Certainly there are important exceptions. There are industries that are concentrated with weak pricing power and there are also industries that are fragmented with strong pricing power. The level of industry concentration is just a guideline.

Industry Capacity

Tight capacity -> more pricing power
Overcapacity -> price cutting

The analyst should think not only about current capacity conditions but also about future changes in capacity levels: how long does it take for supply and demand to reach equilibrium? Are the tight supply conditions sustainable?

In general it takes longer to shift physica...

#### Annotation 1418749414668

Subject 5. External Influences on Industry Growth, Profitability, and Risk
These external influences include:

Macroeconomic Influences

GDP, interest rates, inflation, the availability of credit, etc.

Technological Influences

Established companies face the threat of technological obsolescence, while technological developments may also help established industries reinforce growth. Infant industries face the threat of a new product not being accepted by the marketplace.

Demographic Influences

Broad shifts in population distribution, age, and income can have very marked effects on different industries. For example, a greater role of sports in the lives of many Americans has increased demand for sports trauma orthopedics.

In most cases, demographic shifts are easy to identify, because they occur over a very long time period. However, it is much harder to quantify such trends and determine their influence on a particular industry.

Governmental Influences

Government regulations, laws, and tax policies can have a marked influence on many industries. They may potentially increase or decrease an industry's prospects.

In certain cases, government policies create new industries. For example, after the Firestone case, governments required the original auto manufacturers to submit all information about their cars, which created a new auto business intelligence software industry.

Trade barriers established by governments support demand for specific domestic industries by fending off foreign competition (an example would be the steel industry in the U.S.).

Social Influences

Fashion changes tend to be short-term and less predictable. For example, new products in the cosmetics or film industries may enjoy a brief spark in demand, which will dissipate shortly.

Lifestyle changes tend to be long-term and more predictable. For example, as a result of greater health consciousness, natural foods and nutritional products enjoyed a boom and hard liquor sales were depressed.

#### Annotation 1418751249676

Subject 6. Company Analysis

After an analyst has gained an understanding of a company's external environment, he/she can start company analysis. This includes analysis of the company's financial position, products and/or services, and its competitive strategy. The analyst should try to determine if the strategy is primarily defensive or offensive and how the company intends to implement the strategy.

A firm can pursue one of the two basic types of competitive strategies: low cost or differentiation. To achieve abnormal profitability, a company should either incur low costs in its production process, or receive premium-to-average market price based on its products' differences preferential to customers. High profits will be possible only if the company with a cost advantage can sell its products at high-enough prices and if the company with a differentiation advantage can keep the costs of superior products sufficiently low.

A checklist for company analysis includes a through investigation of:

• Corporate profile;
• Industry characteristics;
• Demand for products/services;
• Supply of products/services;
• Pricing; and
• Financial ratio.

#### Annotation 1418753084684

Subject 1. Estimated Value and Market Price
Equity valuation models are used to estimate the intrinsic value of an equity security. By comparing the intrinsic value and market price, an analyst can draw one of three conclusions: the security is undervalued, fairly valued, or overvalued. Investment decisions are then made based on the comparison.

There are two uncertainties in this process:

• Which valuation model should we use?
• Are the inputs to be used in the model appropriate?

Analysts often use more than one valuation model because of concerns about the applicability of any particular model and the variability in estimates that result from changes in inputs.

The model should be kept as simple as possible. The goal is to minimize the inaccuracy of the forecast.

There are three major categories of equity valuation models:

• Present value models. Both dividend discount models and free-cash-flow-to-equity models belong to this category.
• Multiplier models. These are relative valuation models.
• Asset-based valuation models. These are based on the book value of assets and liabilities.

#### Annotation 1418754919692

Subject 2. Present Value Models: The Dividend Discount Model
Under the DDM, the value of a common stock is the present value of all future dividends. If the stock is sold at some point in the future, its value at that time will be the present value of all future dividends. In fact, the buyer is paying for the remaining dividend stream. If a stock does not pay dividends for some early years, investors expect that at some point in the future the firm will start to pay dividends. Thus, valuation of stocks paying no dividends uses the same DDM approach, except that some of the early dividends are zero.

One-Year Holding Period

Assume an investor wants to buy a stock, hold it for one year, and then sell it. To determine the value of the stock using DDM, the investor must estimate the dividend to be received during the period (D1), the expected sale price at the end of the holding period (P1), and the required rate of return (r). Then:

Multiple-Year Holding Period

If the investor anticipates holding the stock for several years and then selling it, the valuation estimate is harder. You must forecast several future dividend payments and estimate the sale price of the stock several years in the future.

Infinite Period DDM (The Gordon Growth Model)

Assume the future dividend stream will grow at a constant rate, g, for an infinite period, that r is greater than g, and that D1 is the dividend to be received at the end of period 1. Then:

From the formula we can see that the crucial relationship that determines the value of the stock is the spread between the required rate of return (r) and the expected growth rate of dividends (g). Anything that causes a decline in the spread will cause an increase in the computed value, whereas any increase in the spread will decrease the computed value.

The process of estimating the inputs to be used in the DDM:

• Estimate the required rate of return (r):

• Estimate the real risk-free rate.
• Estimate the expected rate of inflation.
• Calculate the nominal risk-free rate: (1 + real risk-free rate) x (1 + expected rate of inflation) - 1.
• Estimate the risk premium of the stock.
• Calculate the required rate of return on the stock: nominal risk-free rate + risk premium.

• Estimate the dividend growth rate (g):

• Estimate the firm's retention ratio.
• Estimate the firm's expected return on equity (ROE).
• Calculate the dividend growth rate: retention rate (b) x return on equity (ROE)

Multistage Dividend Discount Models

The infinite period DDM has four assumptions:

• The stock pays dividends.
• Dividends grow at a constant rate (g).
• The constant growth rate will continue forever.
• The required rate of return is greater than the growth rate; otherwise the model breaks down since the denominator is negative.

Growth companies are firms that have the opportunities and abilities to earn rates of return on investments that are consistently above their required rates of return. They may experience this high growth for some finite periods of time, and the infinite period DDM cannot be used to value these true growth firms because these high-growth conditions are temporary and therefore inconsistent with the assumptions of the D...

#### Annotation 1418761473292

Subject 3. Preferred Stock Valuation
A preferred stock pays a fixed dividend for an infinite period. Thus, a preferred stock is a perpetuity since it has no maturity. Payments of preferred dividends are made only after the firm pays its bond interest. Thus,

where r is the required rate of return on preferred stock, and the dividend is assumed to be perpetual.

The basic types of preferred stock include:

• Cumulative. The cumulative feature of a preferred stock means that if the company withholds any part of expected dividends, these payments are in arrears and must be settled before any other dividends. Most preferred stock carries this attribute.

• Callable. This feature gives the issuer the right to redeem the stock at a date and price outlined in the prospectus. Most preferred stock is callable. This feature essentially reduces the value of the preferred stock.

A retractable preferred share allows an investor to redeem the share whenever the investor wants. As a result, the value of the preferred share is increased.

• Convertible. This is an option for the preferred stockholder to convert the shares into a fixed number of common shares at any point after a pre-determined date. While exchanges are initiated by the shareholder, there is sometimes a provision allowing the company to call for the conversion.

• Participating. This attribute offers the investor the opportunity to earn a dividend beyond the stated rate as outlined in the prospectus. Most preferred stock is non-participating.

#### Annotation 1418767502604

Subject 4. Multiplier Models
A price multiple is a ratio of a stock's price to a measure of value per share, such as earnings, assets, sales, or cash flows. To tie a company's performance with its market valuation, an analyst needs to evaluate what a dollar of share price can "buy" in terms of the company's earnings, sales, cash flow, or assets. For example, an analyst can estimate that each dollar invested in the company generates $1.50 of sales. Using this information, the analyst can evaluate the attractiveness of investing in the company's stock at the current market price per share. The P/E ratio compares stocks on the basis of how many dollars an investor is willing to pay for a dollar of expected earnings. It is also called the earnings multiplier. The two alternative types of P/E are trailing P/E and leading P/E. • A trailing P/E (also current P/E) is a price multiple comparing the stock's current market price to the company's earnings during the last four fiscal quarters. The EPS in such calculations are sometimes referred to as trailing twelve months (TTM) EPS. Trailing P/E is the price/earnings ratio published in stock listings of financial newspapers. • A leading P/E (also forward P/E or prospective P/E) is a price multiple comparing the stock's current market valuation with the company's forecasted earnings for the next full fiscal year or for the next four quarters. You can use the DDM to develop the earnings multiplier model: • From DDM: P = D1/(k - g) • Divide both side of the above equation by E1: For example, a stock has an expected dividend payout ratio of 90%, a required rate of return of 15%, and expected growth rate of 10%. The P/E ratio is 0.9/(0.15 - 0.1) = 18. If an investor has projected next year's earnings to be$5, the current value of the stock is $5 x 18 =$90.

Thus the P/E ratio is determined by:

• The expected dividend payout ratio;
• The estimated required rate of return on the stock (k);
• The expected growth rate of dividends for the stock.

Since a firm's long-run target payout ratio is rather stable, the spread between k and g is the main determinant of the size of the P/E ratio.

A price-to-book ratio is a price multiple comparing a company's current market share price to its book value per share.

A P/S multiple is a price multiple that divides the price per share by the last 12 months' net sales per share.

A price-to-cash-flow ratio equals market price per share / cash flow per share.

The Method of Comparables

Price multiples are price-scaled by a measure of value, which provides the basis for the method of comparables. The method involves the comparison of a company's actual price multiple to some benchmark value to evaluate if an asset is relatively fairly priced, relatively undervalued, or relatively overvalued. The economic rationale is the law of one price - similar assets should sell at approximately equal prices. That is, if two companies are identical in all respects, their shares should be quoted at the same price in an efficient market.

Some of the most widely used benchmarks involve the multiple of a closely matched individual stock and the average or median value of the multiple for the stock's company or industry peer group.

This method is the most popular application of price multiples. It allows investors to determine a stock's relative valuation as compared to the benchmark. For example, many analysts point out that even after the technology market crash of 2000-2001, some technology stocks still remain o...

#### Annotation 1418770910476

Subject 5. Enterprise Value
Since EBITDA are distributed between all types of investors in a company (common shareholders, preferred shareholders, and creditors), they reflect the fundamental value of the company as a whole. Therefore, a multiple using total company value is logically most appropriate. The EV/EBITDA ratio responds to this need.

Enterprise value (EV) is total company value minus the value of cash and investments.

EV = MV of common stock + MV of preferred stock + MV of debt - cash and investments

EV/EBITDA is an indication of company value, not equity value.

Example

• Net income: 34.0
• Interest expense: 7.62
• Cash outflow for interest payments: 4.0
• Depreciation and amortization: 17.2
• Marginal tax rate: 25%
• Cash and marketable securities: 8.9
• Investments: 6.2
• Price per common share on the Paris Stock Exchange: 13.8
• Total number of shares issued: 20,000,000
• Total number of shares in treasury stock: 1,320,000

The company's financial statements show that the only interest-paying liability assumed by the company is a 5-year $200MM note maturing in 3 years' time and currently trading at 4.13%. The note is paying semi-annual coupons and all interest payments have been met so far. The company also has preferred stock that is not trading on any exchange. The book value of the preferred stock is$45. No preferred dividends are currently in arrears.

Solution:

1. Calculation of EBITDA

EBITDA = Net Income + Interest Expense + Depreciation and Amortization + Tax Expense
Tax Expense = (Net Income / (1 - Tax Rate)) - Net Income = [34.0 / (1 - 0.25)] - 34.0 = 11.3
EBITDA = 34.0 + 7.62 + 17.2 + 11.3 = 70.12

2. Calculation of Enterprise Value (EV)

Total market value of common stock = price per share of common stock x number of shares outstanding = Price per share x (shares issued - treasury stock) = 13.8 x (20,000,000 - 1,320,000) = 257.7 MM

Since the company's preferred stock is not publicly traded, we will use its book value for calculation of EV.

Semi-annual coupon on the bond = Cash outflow for interest payments / 2 = 4 / 2 = 2

We know:
the bond's term to maturity = 3 years
Yield to maturity = 4.13%
Semi-annual coupon payments = 2MM
Face Value = 200MM

Therefore, we can calculate the bond's total current market value = $188.1. EV = Total market value of common stock + Total market value of preferred stock + Total market value of debt - Cash balances - Investments = 257.7 + 45.0 + 188.1 - 8.9 - 6.2 = 475.7. 3. Calculation of EV/EBITDA ratio EV/EBITDA = 475.7 / 70.12 = 6.78 Advantages: • EBITDA is more often positive than net income. • By adding back depreciation and amortization, EBITDA does not vary according to the depreciation method used. The EV/EBITDA ratio is often used for valuation of capital-intensive companies. • It is more appropriate than P/E for comparing companies with different financial leverage, since EBITDA is not influenced by interest expenses. Disadvantages: • When capital expenditures do not equal depreciation, EBITDA is not a technically correct proxy to cash flow. This qualification to EBITDA comparisons can be meaningful for the capital-intensive businesses to which EV/EBITDA is often applied. • EBITDA includes non-cash revenues due to the accrual accounting principle. status not read #### Annotation 1418773269772 Subject 6. Asset-Based Valuation #analysis-and-valuation #cfa #cfa-level-1 #reading-51-equity-valuation-concepts-and-basic-tools The theory underlying the asset-based approach is that the value of a business is equal to the sum of the value of the business's assets. This is the principle of substitution: no rational investor will pay more for the business assets than the cost of procuring assets of similar economic utility. The approach estimates the intrinsic value of a common share from the estimated value of assets of a corporation minus the estimated value of its liabilities and preferred shares. Pursuant to accounting conventions, most assets are reported on the books of the subject company at their acquisition value, net of depreciation where applicable. These values must be adjusted to fair market value wherever possible. The value of a company's intangible assets, such as goodwill, is generally impossible to determine apart from the company's overall enterprise value. For this reason, the asset-based approach is not the most probative method of determining the value of going business concerns. In these cases, the asset-based approach yields a result that is probably less than the fair market value of the business. The result from an asset-based valuation model may be used as a "sanity check" when compared to other models of valuation. status not read #### Annotation 1418775629068 Subject 1. Basic Features of a Fixed-Income Security #basic-concepts #cfa #cfa-level-1 #fixed-income #reading-52-fixed-income-securities-defining-elements A fixed income security is a financial obligation of an entity (the issuer) that promises to pay a specified sum of money at specified future date. Issuers of bonds include supranational organizations, sovereign governments, non-sovereign governments, quasi-government entities, and corporate issuers. The risk of the issuer failing to make full and timely payments of interest and/or repayment of principal is called credit risk. Credit risk is inherent in all debt investments. The maturity date is the date when the bond issuer is obligated to pay the outstanding principal amount. It defines the remaining life of the bond. • It defines the time period over which the bondholder can expect to receive interest payments and principal repayment. • It affects the yield on a bond. • It affects the price volatility of the bond resulting from changes in interest rates: the longer the maturity, the greater the price volatility. The par value (principal, face value, redemption value, or maturity value) is the amount that the issuer agrees to repay the bondholder on the maturity date. • Bonds can have any par value, though a par value of$1,000 is the most common.
• The price of a bond is typically quoted as a percentage of its par value. For example, a value of 90 means 90% of the par value.

The interest rate that the issuer agrees to pay each year is called the coupon rate (or nominal rate). The coupon is the annual amount of the interest payment: par value x coupon rate.

In the U.S. most issuers pay the coupon semi-annually.

If you have a "6.5 of 12/1/2019 trading at 97," you have a bond that has a 6.5 coupon rate, matures on 12/1/2019 and is selling for 97% of its par value.

A floating-rate security's coupon payments are reset periodically according to some reference rate. The typical coupon formula is: coupon rate = reference rate + quoted margin.

• Examples of reference rates are LIBOR, U.S. Treasury yields.
• The quoted margin is the additional amount that the issuer agrees to pay above the reference rate. It is a constant value and can be positive or negative. It is often quoted in basis points.
• The coupon rate is determined at the coupon reset date but paid at the next coupon date.

A zero-coupon bond promises to pay a stipulated principal amount at a future maturity date, but it does not promise to make any interim interest payments. The value of a zero-coupon bond increases overtime, and approaches par value at maturity. The return on the bond is the difference between what the investor pays for the bond at the time of purchase and the principal payment at maturity. The implied interest rate is earned at maturity.

For example, if an investor purchases a zero-coupon bond for $60 with a par value of$100, the investor will earn $40 of interest over the life of the bond. The investor receives no payments until maturity of the bond when he or she will receive$100.

Bonds can be issued in any currency. If an issue has coupon payments in one currency and principal payments in another currency, it is called dual-currency issue. The holders of currency option bonds can choose the currency in which coupons and principals are paid.

#### Annotation 1418777464076

Subject 2. Bond Indenture
#basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-52-fixed-income-securities-defining-elements
An indenture is the contract between the issuer and the bondholder specifying the issuer's legal requirements. It contains the promises of the issuer and the rights of the holder of the bond.

Bondholders may have great difficulty in ascertaining whether the issuer has been fulfilling its obligations specified in the indenture. The indenture is thus made out to a third-party trustee as a representative of the interests of the bondholders; a trustee acts in a fiduciary capacity for bondholders.

Legal Identity of the Bond Issuer and its Legal Form

The issuer is identified in the indenture by its legal name. It is obligated to make timely payments of interest and repayment of principal. Bonds can be issued by a subsidiary of a parent legal entity. They can also be issued by a holding company. A special-purpose vehicle/entity (a separate legal entity) can issue bonds collateralized by assets transferred from its sponsor. If bankruptcy occurs, the sponsor's creditors cannot go after such assets; this is known as bankruptcy remote.

Source of Repayment Proceeds

The source of repayment proceeds varies, depending on the type of bond.

• Supranational bonds: repayment of previously loans, or the paid-in capital from members
• Sovereign bonds: taxing authority and money creation
• Non-sovereign government bonds: general taxing authority of the issuer, project cash flows, and special taxes
• Corporate bonds: the issuer's operating cash flows
• Securitized bonds: cash flows from the underlying financial assets

Asset or Collateral Backing

Collateral backing can increase a bond issuer's credit quality.

• Seniority ranking affect credit. In general, secured debt takes priority over unsecured debt if the issuer goes bankrupt. Within unsecured debt, senior debt ranks ahead of subordinated debt. Debentures can be either secured or unsecured.
• Types of collateral backing include collateral trust bonds, equipment trust certificates, mortgage-backed securities, and covered bonds.

An unsecured bond is not secured by collateral.

Covered bonds are debts issued by banks that are fully collateralized by residential or commercial mortgage loans or by loans to public sector institutions.

Credit Enhancement

Credit enhancement reduces credit risks. Internal credit enhancement considerations include:

• Tranche structure. The senior tranches get paid first, and the subordinated tranches get paid only if there are enough funds left. The subordinated tranches absorb the credit risk, making the senior tranches less risky.
• Overcollateralization. The amount of overcollateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is$105 million, then the first $5 million loss will not result in a loss to any of the tranches. • Excess spread. Underlying assets support a higher level of payment than that promised to security holders. External credit enhancements are financial guarantees from third parties. Examples include surety bonds, bank guarantees, and letters of credit. If the third-party defaults, the external credit enhancement will fail. A cash collateral account can mitigate this concern. Bond Covenants Affirmative covenants set forth certain actions that borrowers must take, such as: • Paying interest and principal on a timely basis • Paying taxes and other claims when due • Keeping assets in good conditions and in working order • Submitting periodic reports to a trustee so that the ... status not read #### Annotation 1418780871948 Subject 3. Legal, Regulatory and Tax Considerations #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-52-fixed-income-securities-defining-elements An important consideration for investors is where the bonds are issued and traded; this affects applicable laws, regulations, and tax status. The bond market can be classified into two markets: an internal market and an external market. Internal Bond Market The internal bond market is also called the national bond market. It is divided into two parts: the domestic bond market and the foreign bond market. The domestic bond market is where domestic issuers issue bonds and where these bonds are subsequently traded. A foreign bond (called a Yankee bond in the U.S., a Samurai bond in Japan, and a Bulldog bondin the U.K.) is a bond issued in a country's national bond market by an issuer not domiciled in the country where those bonds are subsequently traded. • Regulatory authorities in the country where the bond is issued impose rules governing the issuance of foreign bonds. • Issuers of foreign bonds include national governments and their subdivisions, corporations, and supranationals (entities formed by two or more central governments through international treaties). • They can be denominated in any currency. • They can be publicly issued or privately placed. External Bond Market This market is also referred to as the international bond market, the offshore bond market, or the Eurobond market. The bonds in this market are: • underwritten by an international syndicate. • offered simultaneously to investors in a number of countries at issuance. • issued outside the jurisdiction of any single country. Therefore, they are not registered through a regulatory agency. • in unregistered form. Eurobonds are subject to a lower level of listing, disclosure, and regulatory requirements than domestic or foreign bonds. Eurobonds are classified according to the currency in which the issue is denominated. For example, if a Eurobond is denominated in U.S. dollars, it is called a Eurodollar bond. A USD bond issued by Ford and sold in Japan is thus called a Eurodollar bond, not a Euroyen bond. A global bond is a debt obligation that is issued and traded in both the Eurobond market and at least one domestic market (for example, a USD bond issued by the Canadian government sold in the U.S. and Japan). Issuers of global bonds typically have high credit quality, and regularly have large fund needs. The first global bond was issued by the World Bank. Tax Considerations In general the income portion of a bond is taxed at the ordinary tax rate. Some countries implement a capital gains tax. Some countries even differentiate between long-term and short-term capital gains. There may be specific tax provisions for bonds issued at a discount or bought at a premium. status not read #### Annotation 1418784804108 Subject 4. Structure of a Bond's Cash Flows #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-52-fixed-income-securities-defining-elements Principal Repayment Structures Bullet bond. The issuer pays the full principal amount at the maturity date. Amortizing bond. Its payment schedule requires periodic payment of interest and repayment of principal. If the entire principal is not amortized over the life of the bond, a balloon payment is required at the end of the term. A sinking fund arrangement allows a bond's principal outstanding amount to be repaid each year throughout the bond's life or after a specific date. A call provision is the right of the issuer to retire the issue prior to the stated maturity date. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis. Coupon Payment Structures The coupon payments of a floating rate security are reset periodically (e.g., quarterly) according to a reference rate such as LIBOR. Example Suppose that the reference rate is the 1-month LIBOR and the quoted margin is 100 basis points: if the 1-month LIBOR on the coupon reset rate is 5%, the coupon rate is 5% + 100 basis points = 6%. The quoted margin does not need to be a positive value. For example, it could be -90 basis points. A floating-rate security may have upper and/or lower limits on the coupon rate. A cap is the maximum coupon rate of a floater. It is an attractive feature for the issuer since it limits the coupon rate. A floor is the minimum coupon rate, and it is an attractive feature for the investor. A collar is a floater with both a cap and floor. For example, assume the reference rate is the 1-month LIBOR, the quoted margin is 100 basis points, and there is a cap of 7%. If the 1-month LIBOR at reset date was 6.5%, the coupon rate per the formula would be 7.5% (6.5% + 1%), but with the cap the coupon rate is restricted to 7%. A typical floater's coupon rate increases when the reference rate increases and decreases when the reference rate decreases. However, an inverse floater's (also called a reverse floater) coupon rate moves in the opposite direction from the change in the reference rate: coupon rate = K - L x reference rate, where K and L are constant values set forth in the prospectus for the issue. To prevent a negative coupon rate there is a floor imposed. For example, an inverse floater's coupon rate = 12% - 2 x 3-month LIBOR. If the three-month LIBOR is 2%, then the coupon rate for the next interest payment period is: 12% - 2 x 2% = 8%. Step-up coupon bonds have low initial and gradually increasing coupon rates; that is, their coupon rates "step up" over time. Stepped spread floaters. The quoted margins for these coupons can step to either a higher or a lower level over the security's life. For example, a five-year floating-rate note's coupon rate may be six-month LIBOR + 1% for the first two years, and three-month LIBOR + 3% for the remaining years. Credit-linked coupon bonds. These coupons change when the issuer's credit rating changes. Payment-in-kind coupon bonds. These coupons allow the issuer to pay coupons with additional amounts of the bond issue rather than in cash. The payment structures for index-linked bonds vary considerably among countries. An inflation-linked bond or linker links its coupon payments and/or principal repayments to a price index. For example, the Treasury Inflation Protection Securities' (TIPS) coupon is based... status not read #### Annotation 1418789784844 Subject 5. Bonds with Contingency Provisions #basic-concepts #cfa #cfa-level-1 #fixed-income #reading-52-fixed-income-securities-defining-elements An embedded option is a provision in a bond indenture that gives the issuer and/or the bondholder an option to take some action against the other party. These options are embedded because they are an integral part of the bond structure. In contrast, "bare options" trade separately from any underlying security. Embedded options may benefit either the issuer or the bondholder. An embedded option benefits the issuer if it gives the issuer a right or it puts an upper limit on the issuer's obligations. An embedded option benefits the bondholder if it gives the bondholder a right or it puts a lower limit on the bondholder's benefits. Callable Bonds A bond issue that permits the issuer to call or refund an issue prior to the stated maturity date is referred to as a callable bond. • The price that the issuer must pay to retire the issue is the call price. • Bonds can be called in whole or in part. Most of the time, an entire bond issue is called. When only part of an issue is called, the bond certificates to be called are selected randomly or on a pro rata basis. This means that each bondholder will have the same percentage of his or her holdings redeemed. • Typically, call provisions have a deferment period; that is, the issuer may not call the bond for a number of years until a specified first call date is reached. This feature is called a deferred call. • The issuer has no obligation for early retirement of bonds. A call option becomes more valuable to the bond issuer when interest rates fall. If interest rates fall, the issuer can retire the bond paying a high coupon rate, and replace it with lower coupon bonds. However, call provisions are detrimental to bondholders, since proceeds can only be reinvested at a lower interest rate. Callable bonds exercise styles: • American call: any time starting on the first call date • European call: once on the call date • Bermuda-style call: on predetermined dates following the call protection period Putable Bonds A put option grants the bondholder the right to sell the issue back to the issuer at a specified price ("put price") on designated dates. The repurchase price is set at the time of issue, and is usually par value. Bondholders have the option of putting bonds back to the issuer either once during the lifetime of the bond (a "one-time put bond"), or on a number of different dates. The special advantages of put bonds mean that putable bonds have lower yield than otherwise similar bonds. The price behaviour of a putable bond is the opposite of that of a callable bond. The put option becomes more valuable when interest rates rise. Convertible Bonds A convertible bond is an issue that grants the bondholder the right to convert the bond for a specified number of shares of common stock. This feature allows the bondholder to take advantage of favorable movements in the price of the issuer's common stock without having to participate in losses. Example Suppose you can buy a 10%, 15-year,$100 par value bond today for $110 that can be converted into 10 shares at$10 per share. The market price of stock = $8; no dividends. • The conversion price is the price per share at which a convertible bond can be converted into common stock. In the example above, the conversion price would be$10.
• The conversion ratio is the number of common shares each bond can be converted into (in this case, 10). It is the par value / conversion price. It is determined at the time the convertible bond is issued.
• The conversion value, also known as parity value, is the market price of stock x conversion ratio ($8 x 10 =$80).
• The conversion premium is the difference between the bond's price and its conversion val
...

#### Annotation 1418791619852

Subject 1. Classification of Fixed-Income Markets
Below are common criteria used to classify fixed-income markets.

Type of Issuer

Three major market sectors are the government and government-related sector, the corporate sector, and the structured finance sector. In most countries, the largest issuers of bonds are national and local governments as well as financial institutions.

Credit Quality

A bond can be considered investment-grade or high-yield based on the issuer's creditworthiness (as judged by credit ratings agencies).

Maturity

Money market bonds have original maturities ranging from overnight to one year. Capital market bonds have original maturities longer than one year.

Currency Denomination

The majority of bonds are denominated in either Euros or U.S. dollars.

Type of Coupon

Some bonds pay a fixed rate of interest while others pay a floating rate of interest. The coupon rate of a floater is expressed as a reference rate, such as LIBOR, plus a spread. Different reference rates are used, depending on where a bond is issued and its currency denomination.

Interbank offered rates are sets of rates that reflect the rates at which banks believe they could borrow unsecured funds from other banks in the interbank market for different currencies and maturities. These rates may be used as reference rates for floating-rate bonds, mortgages, and derivatives.

Geography

There are domestic, foreign and Eurobond markets. Investors also make a distinction between the developed and emerging bond markets. Emerging market bonds usually exhibit higher risk than developed markets bonds.

#### Annotation 1418793454860

Subject 2. Primary and Secondary Bond Markets
In primary bond markets issuers first sell bonds to investors to raise capital. In secondary bond markets investors trade existing bonds.

Primary Bond Markets

Examples

• The sale of new government bonds by the U.S. Treasury to finance a government deficit
• A $100 million bond issue by P&G to finance the construction of a new soap production plant There are two mechanisms for issuing a bond in primary markets. Public Offering Any member of the public may buy the bonds in a public offering. • Underwritten offerings. The function of buying the bonds from the issuer is called the underwriting. An investment bank (called the underwriter) takes the risk of buying the whole issue as firm commitment underwriting. It makes a profit by selling the bonds for more than what it paid for them. There are six phases: the determination of the funding needs, the selection of the underwriter, the structuring and announcement of the bond offering, pricing, issuance, and closing. • Best effort offerings. The investment bank serves only as a broker to sell the bonds. It agrees to do its best, receives a commission for selling the bonds and incurs less risk associated with selling the bonds. • Shelf registrations. An issuer files the bond registration with regulators before it makes an actual public offering of the issue. The issuer may be able to offer additional bonds to the general public without preparing a new and separate offering circular. • Auctions. The issuer announces the terms of the issue and interested parties submit bids for it. Auctions often yield the most money for the issue. They allow the issuer to sell directly to the public, eliminating the underwriting fee. In major developed bond markets, newly-issued sovereign bonds are most often sold to the public via auction. Private Placement A private placement bond is a non-underwritten, unregistered corporate bond sold directly to a single investor or a small group of investors. Because the bonds are not registered, SEC regulations require firms to offer such bonds privately only to investors deemed sophisticated: insurance companies, pension funds, banks, and endowments. Secondary Bond Markets The secondary market arises after issue, when bonds are sold from one bondholder to another. Its purpose is to provide liquidity - ease or speed in trading a bond at price close to its fair market value. The buying and selling of existing bond issues is done primarily through a network of brokers and dealers who operate through organized exchanges and over-the-counter (OTC) markets. Most bonds are traded in OTC markets. Corporate bonds typically settle on a T + 3 basis. Government and quasi-government bonds typically settle at T + 1. status not read #### Annotation 1418795289868 Subject 3. Sovereign Bonds, Non-Sovereign Bonds, Quasi-Government Bonds, and Supranational Bonds #basic-concepts #cfa #cfa-level-1 #fixed-income #reading-53-fixed-income-markets-issuance-trading-and-funding Sovereign Bonds Sovereign bonds are issued by a country's central government for fiscal reasons. They take different names and forms, depending on where they are issued, their maturities, and their coupon types. For example, U.S. government bonds with an original maturity shorter than one year are known as T-bills. The most recently issued U.S. Treasury bond of a particular maturity is known as a on-the-run issue. Sovereign bonds are usually unsecured and are backed by the taxing authority of a national government. Credit rating agencies perform sovereign risk analysis in both local currency and foreign currency. The risk level of local and foreign currency is different. Generally, if an issuer is planning to default, it is more likely to do so with a foreign currency issue, as it has less control over foreign currency with respect to its exchange rate. Sovereign bonds can be domestic bonds, foreign bonds, and Eurobonds. They can be fixed-rate, floating-rate or inflation-linked bonds. For example, Treasury Inflation Protection Securities (TIPS) are T-notes or T-bonds that are adjusted for inflation. Non-Sovereign Bonds Non-sovereign bonds are bonds issued by local governments. The sources of repayment proceeds are (the): • General taxing authority of the issuer • Project cash flows • Special taxes This type of bonds receives high credit ratings due to low default rates. They often trade at a lower yield than their sovereign counterparts. Quasi-Government Bonds Quasi-government bonds are issued by the government through various political subdivisions. Most of them are not secured by collateral and don't have government guarantees. Their credit ratings are very high due to extremely low historical default rates. Supranational Bonds Supranational bonds are bonds issued by supranational agencies such as the World Bank. status not read #### Annotation 1418797124876 Subject 4. Corporate Debt #basic-concepts #cfa #cfa-level-1 #fixed-income #reading-53-fixed-income-markets-issuance-trading-and-funding Corporations issue different types of debt. Bank Loans and Syndicated Loans A bilateral loan is a loan from a single lender to a single borrower. A syndicated loan is a loan from a group of lenders to a single borrower. Most loans are floating-rate loans. Commercial Paper Commercial paper describes a short-term, unsecured promissory note that is used by companies as a source of short-term and bridge financing. • Although defaults are rare, investors in this market are still exposed to credit risk. • Many issuers roll over their paper on a regular basis. Issuers are required to secure backup lines of credit to minimize rollover risk. • Due to higher credit risk and less liquidity, the yield from commercial paper is higher than that of short-term sovereign bonds. • A U.S. commercial paper (USCP) is typically issued on a discount basis, while a Eurocommercial paper (ECP) is typically issued on an interest-bearing basis. Corporate Notes and Bonds Corporate bonds and notes take different forms, depending on the maturities, coupon payment and principal repayment structures, collateral backing and contingency provisions. These concepts are covered in the previous reading. Medium-term notes (MTN) are corporate debt obligations offered to investors continually over a period of time by an agent of the issuer. The maturities vary from nine months to 30 years. Note that the term "medium-term" is not related to the term to maturity of the securities. status not read #### Annotation 1418798959884 Subject 5. Short-Term Funding Alternatives Available to Banks #basic-concepts #cfa #cfa-level-1 #fixed-income #reading-53-fixed-income-markets-issuance-trading-and-funding Banks have different short-term funding sources. These include: • Retail deposits: checking accounts, savings accounts, money market accounts, etc. • Central bank funds: funds available from the central bank, or from other banks in the central bank funds market • Interbank funds: the market of loans and deposits between banks • Large denomination negotiable certificates of deposit: non-negotiable or negotiable CDs, large-denomination CDs or small denomination CDs Repurchase Agreements A repurchase agreement is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. It is actually a collateralized loan. The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan. The implied interest rate is called the repo rate. A loan for one day is called an overnight repo. A loan for more than one day is called a term repo. If a repo agreement lasts until the final maturity date, it is known as a "repo to maturity." The repo rate is lower than the cost of bank financing. It is a function of a few factors, including the risk associated with the collateral, the term of the repo, the delivery requirement for the collateral, the supply and demand conditions of the collateral, and the interest rates of alternative financing in the money market. The more difficult it is to obtain the collateral, the lower the repo rate. Hot collateral or special collateral is collateral that is highly sought-after by dealers and can be financed at a lower repo rate than general collateral. From a dealer's perspective, if it is lending cash, the repo is then referred to as a reverse repurchase agreement. Credit risks are faced by both parties. The difference between the market value of the security used as collateral and the value of the loan is the repo margin. It is most likely to be lower when: • The maturity of the repo is short. • The quality of the collateral is high. • The credit quality of the counterparty is high. • The underlying collateral is in short supply or there is a high demand for it. status not read #### Annotation 1418800794892 Subject 1. Bond Prices and the Time Value of Money #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation The idea that the value of any financial asset equals the present value of its expected cash flows is the fundamental principle of valuation. This principal is applicable to bonds, stocks and other financial assets. The present value of cash flows is calculated by discounting the cash flows at appropriate interest rates. The cash flows of a bond have two components: periodic coupon payments and principal repayment at maturity, or when the bond is retired. Both the amount and the timing of the cash flows should be identified to value the bond. For example a five-year Treasury coupon note with a par-value of$1,000 has a 10% coupon. Its cash flows are as follows:

For a given discount rate, the present value of a single cash flow to be received in the future is the amount of money that must be invested today to generate that future value. The present value of a cash flow will depend on when a cash flow will be received (i.e., the timing of a cash flow) and the discount rate (i.e., interest rate) used to calculate the present value.

i = the discount rate
t = the number of years to receive the cash flow

The sum of the present value for a security's expected cash flows is the value of the security:

N = the number of annual periods till maturity

The convention of the bond market is to quote annual interest rates that are double semi-annual rates. For most bonds coupon payments are semi-annual. Coupon payments are adjusted by dividing the annual coupon payment by two and adjusting the discount rate by dividing the annual discount rate by two:

The differences are:

A bond is priced at a premium above par value when the coupon rate is greater than the market discount rate. It is priced at a discount below par value when the coupon rate is less than the market discount rate. The amount of any premium or discount is the present value of the "excess" or "deficiency" in the coupon payments relative to the yield-to-maturity.

Yield-to-Maturity is the interest rate that will make the present value of the cash flows from a bond equal to its price. It is the promised rate of return on a bond if an investor buys and holds the bond to its maturity date.

Consider a 10%, two-year bond selling for $1,036.30 (selling at premium). The cash flows for this bond are (1) four payments of$50 every six months, and (2) a payment of $1,000 two years from now.$1036.30 = $50/(1 + YTM/2)1 +$50/(1 + YTM/2)2 + $50/(1 + YTM/2)3 +$1050/(1 + YTM/2)4. Through trial and error or by using a financial calculator, YTM is found to be 8%.

#### Annotation 1418811018508

Subject 2. Relationships between Bond Price and Bond Characteristics
#basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation
Price / Discount Rate Relationship

The value of a bond is equal to the present value of its coupon payments plus the present value of the maturity value.

The higher the discount rate, the lower a cash flow's present value and therefore since the value of a security is the present value of the cash flows, the higher the discount rate, the lower a security's value.

Example

A 1-year, semi-annual-pay bond has a $1,000 face value and a 10% coupon. • At a discount rate of 8%, the bond value is$1,019 (premium).
• At a discount rate of 10%, the bond value is $1,000 (par). • At a discount rate of 12%, the bond value is$982 (discount).

The degree of price change is not always the same for a particular bond. The price/yield relationship for an option-free bond is convex. In other words, this is not a straight-line relationship.

For a given change in yield, the price increases by more than it decreases. P1 - P > P - P2.

Option-free bonds exhibit positive convexity, which means that for a large change in interest rates, the amount of price appreciation is greater than the amount of price depreciation. This also means that the price change is greater when the level of required yield is low (and vice versa).

Coupon and Maturity Effects

All else being equal,

• Maturity effect: The longer the term to maturity, the greater the price volatility.
• Coupon effect: The lower the coupon rate, the greater the price volatility.

Constant-Yield Price Trajectory

As a bond moves closer to its maturity date, its value changes. More specifically, assuming that the discount rate does not change, a bond's value:

• decreases over time if the bond is selling at a premium
• increases over time if the bond is selling at a discount
• is unchanged if the bond is selling at par value

At the maturity date, the bond's value is equal to its par value ("pull to par value").

Pricing Bonds with Spot Rates

The valuation approach illustrated so far is the traditional approach, which uses a single interest rate to discount all of a bond's cash flows. It views all cash flows of a bond as the same, regardless of their timing. In reality, however, each individual cash flow of the bond is unique. Therefore, using a single discount rate in the bond valuation model may result in a mis-priced bond, thereby creating arbitrage opportunities.

The arbitrage-free approach values a bond as a package of cash flows, with each cash flow viewed as a zero-coupon bond and discounted at its own unique discount rate. These spot rates are used to discount cash flows to get the arbitrage-free value of a bond.

The arbitrage-free approach has three steps.

• Take each individual cash flow of a coupon as a stand-alone zero-coupon bond. Each cash flow is the face value of the corresponding zero.
• Value each zero-coupon bond by discounting its cash flow at the corresponding spot rate.
• Add up the value of each zero to calculate the total value of the zero-coupon bond portfolio.

...

#### Annotation 1418817572108

Subject 3. Flat Price, Accrued Interest, and the Full Price
#basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation
Coupon interest is paid not daily, but monthly, semi-annually or annually. If an investor sells a bond between coupon payments and the buyer holds it until the next coupon payment, the entire coupon interest earned for the period will be paid to the buyer. The seller gives up the interest from the time of the last coupon payment to the time until the bond is sold. The amount of interest over this period that will be received by the buyer (even though it was earned by the seller) is called accrued interest.

Accrued interest is calculated as a proportional share of the next coupon payment using either the actual/actual or 30/360 method to count days.

The amount that the buyer pays the seller the agreed upon price for the bond plus accrued interest is called the full price (dirty price). The agreed-upon bond price without accrued interest is simply referred to as the flat price (clean price). Flat prices are quoted in order to not to misrepresent the daily increase in the full price as a result of interest accruals.

Here is how to calculate the full price:

Note that the next coupon payment is discounted for the remainder of the coupon period.

An easier formula is used to to get the present value of the bond at the last coupon payment date and find its (future) value on the settlement date.

#### Annotation 1418825698572

Subject 4. Matrix Pricing
Most bonds don't trade on a daily basis. Usually only the most recent large issues have the greatest liquidity and pricing ability. There is rarely a consensus on the exact value of an individual bond.

Matrix pricing is the practice of interpolating among values for similar instruments arranged in a matrix format.

• It attempts to categorize bonds with similar features (e.g., type of issuer, credit rating, coupon, maturity, etc.) and apply a general yield level to the entire category of bonds. Typically a required yield over the benchmark rate is estimated.
• It then calculates the approximate price of a specific bond within a category using the derived yield level.
• It represents an educated guess and not an actual offer or trade price.

#### Annotation 1418827533580

Subject 5. Yield Measures for Fixed-Rate Bonds
#basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation
Yield measures are used to evaluate the rate of return on bonds.

• They are typically annualized.
• Money market rates are simple interest rates and non-money market rates are compounded.

The periodicity of an annual interest rate is the number of periods in the year.

Consider a two-year, zero-coupon bond priced now at 88 per 100 of par value.

Note:

• The effective annual rate is the same.
• The bond equivalent yield and the periodicity are inversely related.
• When comparing different bonds, it is essential to compare the yields for the same periodicity to make a statement about relative value.

To convert an annual yield from one periodicity to another:

Example

• A Eurobond pays coupons annually. It has an annual-pay YTM of 8%.
• A U.S. corporate bond pays coupons semi-annually. It has a bond equivalent YTM of 7.8%.
• Which bond is more attractive, if all else equal?

Solution 1

• Convert the U.S. corporate bond's bond equivalent yield to an annual-pay yield.
• Annual-pay yield = [1 + 0.078/2]2 - 1 = 7.95% < 8%
• Therefore, the Eurobond is more attractive since it offers a higher annual-pay yield.

Solution 2

• Convert the Eurobond's annual-pay yield to a bond equivalent yield (BEY).
• BEY = 2 x [(1 + 0.08)0.5 - 1] = 7.85% > 7.8%
• Therefore, the Eurobond is more attractive since it offers a higher bond equivalent yield.

Street convention yields assume that payments are made on scheduled dates, excluding weekends and holidays. The true yield is calculated using a calendar including weekends and holidays. The government equivalent yield is based on actual/actual day count.

The current yield relates the annual dollar coupon interest to the market price. For example, the current yield for a 5%, two-year bond with a price of $978 is 5.11% (($1000 x 5%) / $978)). This is the simplest of all yield measures, and fails to recognize any capital gain or loss, reinvestment income or accrued interest. The simple yield is similar to the current yield but includes the straight-line amortization of the discount or premium. The standard YTM measure assumes that the bond will be held to maturity. It is not an appropriate yield measure for callable bonds, because they may be retired before maturity. For callable bonds a yield to first call, which assumes that the bond will be called on the first call date, is computed. Callable bonds typically have multiple call dates, each with its own call price. The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting. It illustrates the worst possible yield an investor may realize. The option-adjusted-yield is the yield-to-maturity after adding the theoretical value of the call option to the price. status not read #### Annotation 1418832514316 Subject 6. Yield Measures for Floating-Rate Notes and Money Market Instruments #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation Floating-Rate Notes Interest rate volatility affects the price of a fixed-rate bonds. A floating-rate note (a floater, or an FRN) maintains a more stable price than a fixed-rate note because interest payments adjust for changes in market interest rates. With a floater, interest rate volatility affects future interest payments. The quoted margin is typically the specified yield spread over or under the reference rate, which is often LIBOR. It is used for compensating the investor for the difference in the credit risk of the issuer and that implied by the reference rate. The discount margin, also known as the required margin, is the spread required by investors and to which the quoted margin must be set in order for the FRN to trade at par value on a rate reset date. Changes in the discount margin usually come from changes in the issuer's credit risk. Money Market Instruments Unique characteristics: • Yield measures are annualized but not compounded. • Often quoted using non-standard interest rates (discount rate or add-on rate? 360-day year or 365-day year? redemption value amount (FV) or price at issuance (PV)?) • Different periodicities Money market instruments need to be converted to a common basis for analysis. Discount rate: Note that the denominator is FV, not PV. The rate of return is therefore understated. Add-on rate: Note the only difference: the denominator is PV, not FV. Bond equivalent yield: money market rate stated on a 365-day add-on rate basis. Example 90-day T-bill, face value 100, quoted discount rate: 2.5% for an assumed 360-day year. PV = 100 x (1 - 90/360 x 0.025) = 99.375 To calculate the bond equivalent yield for a 365-day year: AOR = (365/90) x (100 - 99.375)/99.375 = 2.55% status not read #### Annotation 1418841165068 Subject 7. The Maturity Structure of Interest Rates #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation A yield curve is typically constructed on the basis of observed yields and maturities. There are different types of yield curves. The most common type is the upward-sloping yield curve. The longer maturity issues have higher yields than the shorter maturity issues. A spot rate is the yield on a zero-coupon bond. A series of spot rates (spot curve) can be used to discount the cash flows of a bond. Default-free spot rates can be derived from the Treasury par yield curve by a method called bootstrapping. The basic principle of bootstrapping is that the value of a Treasury coupon security should be equal to the value of the package of zero-coupon Treasury securities that duplicate the coupon bond's cash flows. Example Determine the spot rate for the fourth period cash flow. The coupon rate is 4.11%, paid semi-annually. The coupon for each period should be discounted at the corresponding spot rate. 100 = 2.055/(1+0.03/2)1 + 2.055/(1+0.033/2)2 + 2.055/(1+0.035053/2)3 + 102.055/(1+i/2)4 = 2.0246 + 1.9888 + 1.9506 + 102.055/(1+i/2)4 i = 2.0669% and the annualized spot rate is 4.1339%. A par curve is a sequence of yields-to-maturity in which each bond is priced at par value. A par curve is obtained from a spot curve. All bonds used to derive the par curve are assumed to have the same credit risk, periodicity, currency, liquidity, tax status, and annual yields. A forward rate refers to the interest rate on a loan beginning some time in the future. In contrast, a spot rate is the interest rate on a loan beginning immediately. For example, the two-year forward rate one year from now is 4%. This means that if you borrow a two-year loan one year from now, you will pay an interest of 4%. A forward curve is a series of forward rates, each with the same time frame. Forward rate calculations are usually based on a theoretical spot rate curve. They are sometimes referred to as implicit forward rates. Given spot rates for maturities of j and k years, you can compute the forward rate (fj, k-j) that applies for the period from year j to year k using the relationship: Example Compute the annualized six-month forward rate two years from now. In order to compute the six-month forward rate two years from now, first determine the spot rate for the fifth period (0.087) and the spot rate for the fourth period (0.0700). Then complete the following calculation: [(1 + 0.0875/2)5/(1 + 0.0700/2)4] - 1 = 7.95%. Similarly, implied spot rates can be calculated as geometric average of forward rates. status not read #### Annotation 1418849291532 Subject 8. Yield Spreads #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-54-introduction-to-fixed-income-valuation A bond's yield-to-maturity can be separated into a benchmark and a spread. • Benchmark rates are usually yields-to-maturity on government bonds or fixed rates on interest rate swaps. Changes in benchmark rates (risk-free rate of return) capture macroeconomic factors that affect all bonds in the market: inflation, economic growth, foreign exchange rates, and monetary and fiscal policy. • Changes in spreads (risk premium component) typically capture microeconomic factors that affect a particular bond: credit risk, liquidity and tax effects. Different spread measures: • G spread: the spread over or under a government bond rate, also known as the nominal spread. For example, suppose a 10-year, 8%-coupon bond is selling at$104.19, yielding 7.40%. The 10-year Treasury bond (6% coupon rate) has a YTM of 6.00%. Therefore, the G spread is 7.40% - 6.00% = 1.40%, or 140 basis points.

• I spread: the yield spread over or under the standard swap rate in that currency of the same tenor.

• Z spread (zero volatility spread): the constant yield spread over the benchmark spot curve such that the present value of the cash flows matches the price of the bond.

• OAS (option-adjusted spread): Z spread - option value. It is used for bonds with embedded options.

• For callable bonds and bonds with prepayment options (e.g.' most mortgage-backed and asset-backed securities), option cost > 0 and thus OAS < Z-Spread. The option cost is positive since the options are a detrimental to bondholders.
• For putable bonds, option cost < 0 and thus OAS > Z-Spread.

Example

Phil Deter was interested in purchasing a non-Treasury bond for 110.2950. Given the Treasury spot rate data below, and assuming that the non-Treasury bond had a coupon of 9.60%, what is the likely Z-spread that Phil will earn over the duration of his investment?

It is important to add all of the cash flows for each bond (discounted at the appropriate spot rate) and compare these to the purchase price by trial-and-error.

The bond with a spread of 143 Basis Points has a purchase price of 4.70 + 4.58 + 4.46 + 4.32 + 4.15 + 4.00 + 84.08 = 110.2950. Since this purchase price corresponds with the bond corresponding with Phil's interest, the appropriate spread must be 143 Basis Points.

#### Annotation 1418852699404

Subject 1. Benefits of Securitization for Economies and Financial Markets
Securitization repackages relatively simple debt obligations, such as bank loans and consumer loans, into more complex structures. It then uses the cash flows from the pool of debt obligations to pay off the bond created in the process.

Securitization has several benefits:

• Investors can have direct access to mortgages and portfolios of receivable that would be unattainable if all the financing were performed through banks.
• Banks can remove assets from their balance sheets, therefore increasing the pool of available capital that can be loaned out.
• Borrowers can pay lower costs when borrowing.

The end result is lower cost and risk, more liquidity, and improved economic efficiency.

#### Annotation 1418854534412

Subject 2. The Securitization Process
The process:

• A lender originates loans, such as to a homeowner or corporation.
• The lender sells certain assets (e.g., loans) to a special purpose vehicle (SPV). The structure is legally insulated from management.
• The SPV issues debt, dividing up the benefits and risks among investors.
• Payments from borrowers are deposited into the SPV, then transferred to investors.

The parties to a securitization transaction:

• Originator: the seller of the collateral
• The SPV: the issuer of the securities, also called the trust
• The third parties: the loan servicer, attorneys, trustees, underwriters, rating agencies, and guarantors

The SPV is a bankruptcy-remote vehicle that plays a pivotal role in the securitization process. It issues securities backed by the underlying assets. The underlying assets are used as collateral for the securities. Cash flows generated from the underlying assets are used to service the debt obligations on the securities.

The SPV separates the assets used as collateral from the corporation seeking financing.

• It makes it possible that the asset-backed securities have a higher credit rating than the parent company.
• If bankruptcy occurs, the SPV can shield assets from the parent company's creditors.

Prepayment tranching refers to dividing cash flows from securitized assets among different classes of securities so that some receive repayment of principal before others. It is used to reallocate the prepayment risk of the underlying loans among different classes of securities. In the simplest cases, a deal might offer several classes of serially maturing securities. Some investors might prefer the securities with shorter maturities while others might favor the ones with longer maturities. Collateralized mortgage obligations (CMOs) are the most ubiquitous examples of time tranching.

Credit tranching refers to the creation of a multi-layered capital structure that includes senior and subordinated tranches (classes). The structure is designed so that any losses caused by defaults will be passed on to the subordinated tranches first. Credit tranching is thus used to reallocate the credit risk associated with the collateral.

#### Annotation 1418856369420

Subject 3. Residential Mortgage Loans
#basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-55-introduction-to-asset-backed-securities
A mortgage is a loan secured by the collateral of a specified real estate property. It obligates the borrower to make a predetermined series of payments. If the borrower fails to make the contracted payments, the lender can seize the property in order to ensure that the debt is paid off.

The interest rate on a mortgage loan is called the mortgage rate or contract rate. The ratio of the property's purchase price to the amount of the mortgage is called the loan-to-value ratio.

The basic idea behind the design of the fixed-rate, level-payment, fully amortized mortgage loan is that the borrower pays interest and repays principal in equal installments over an agreed-upon period of time, called the maturity or term of the mortgage. Thus at the end of the term the loan has been fully amortized.

Each monthly payment for this mortgage design is due on the first of each month and consists of:

• Interest of 1/12 of the fixed annual interest rate multiplied by the amount of the outstanding mortgage balance at the beginning of the previous month
• A repayment of a portion of the outstanding mortgage balance (principal)

The difference between the monthly mortgage payment and the portion of the payment that represents interest equals the amount that is applied to reduce the outstanding mortgage balance. Early payments are mostly interest with a small amount of principal repayment, while later payments are mostly principal repayment with a small amount of interest.

The following table illustrates the annual breakdown of a 30-year (360 month) mortgage on a $100k loan that yields 9.5% interest. As the example shows, the portion of the monthly mortgage payment applied to interest declineseach month, and the portion applied to principal repayment increases. The various mortgage designs throughout the world specify: • The maturity of the loan • How the interest rate is determined (fixed rate, variable rate or hybrid rate) • How the principal is repaid (i.e., whether the loan is amortizing or not, whether it is fully amortizing or partially amortizing with a balloon payment) • Whether the borrower has the prepayment option and whether there are any prepayment penalties • The rights of the lender in a foreclosure (whether the loan is a recourse or non-recourse loan) Prepayments and Cash Flow Uncertainty Mortgage borrowers may have an embedded option that allows them to prepay all or part of their loan at anytime during the life of the mortgage. Prepayments occur for one of several reasons: • Homeowners prepay the entire mortgage when selling their home. • Refinancing when market rates fall below the contract rate. • In the case of homeowners who cannot meet their mortgage obligations, the property is repossessed and sold, and the proceeds are used to pay off the mortgage. • If property is destroyed by fire or another insured catastrophe occurs, insurance proceeds are used to pay off the mortgage. The prepayment could be the entire outstanding balance or a partial paydown of the mortgage balance. When a prepayment does not cover the entire outstanding balance it is called a curtailment. Thus, lenders do not know with certainty what their cash flows (both the amount and timing) will be for any given period. This risk is referred to as prepayment risk. Usually, mortgages are prepaid when interest rates fall. Hence, lenders receive repayment at a time when they cannot reinvest the cash at the same high rate at which they had originally invested. Mortgages with prepayment penalties ori... status not read #### Annotation 1418859777292 Subject 4. Mortgage Pass-Through Securities #basic-concepts #cfa #cfa-level-1 #fixed-income #has-images #reading-55-introduction-to-asset-backed-securities A mortgage pass-through security is created when one or more mortgage holders form a collection (pool) of mortgages and sell shares or participation certificates in the pool. Below is an illustration of how the pass-through process channels mortgage payments from homeowners to coupon payments to mortgage bond investors. In the U.S., there are two sectors for securities backed by residential mortgages: • Agency pass-throughs have been pooled and securitized by one of the quasi-government mortgage agencies: Ginnie Mae, Fannie Mae and Freddie Mac. Note that only the Ginnie Mae securities are backed by the full faith and credit of the U.S. government. • Non-agency, or private-label mortgage-backed securities have been pooled and securitized by private banks or other corporations. Unlike agency, non-agency MBSs must rely on various types of credit enhancements to compensate for the lack of a government credit guarantee. Measures of Prepayment Rate The cash flow of a mortgage pass-through security depends on the cash flow of the underlying pool of mortgages and consist of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments, net of servicing and other fees. Estimating the cash flow from a pass-through requires forecasting prepayments. One way of forecasting is to assume that some fraction of the remaining principal in the pool is prepaid each month for the remaining term of the mortgages. The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR), is based on a pool's characteristics (including its historical prepayment experience) and the current and expected economic environment. The CPR is an annual prepayment rate. For example, if the CPR is 8%, we would expect that 8% of the remaining principal will be prepaid each year. The single-monthly mortality rate (SMM) is the percentage of a pool's remaining principal that is expected to be prepaid each month. SMM is the CPR converted from an annual term to a monthly rate. Example: if the CPR is 10%, the SMM = 1 - (1 - 0.1)1/12 = 0.87% Now suppose that the principal balance in a pool is$10 million and $200k is scheduled to be repaid in a given month. The SMM is 0.87%. The forecasted prepayment amount for the month is 0.0087 x (10,000,000 - 200,000) =$85,260.

Note that scheduled principal repayments are neither included in the starting principal nor in the prepayment forecast. Prepayment does not include scheduled repayment.

The Public Securities Association Prepayment Benchmark is a schedule of prepayment speeds deemed to be "usual." Actual prepayment speeds are quoted relative to the PSA benchmark. If prepayments are following the PSA schedule, the speed is said to be 100% PSA. If prepayments are twice as fast as the PSA benchmark, the speed is said to be 200% PSA.

Example: if a seven-year old mortgage pool is experiencing a CPR of 9%, Its relative to PSA speed is quoted as 150 PSA. The CPR for a seven-year old pool should be 6% according to PSA; 9% is 50% greater than the 6% PSA. Thus, the current speed is 150 PSA.

The PSA benchmark is generally not a good forecast. It is simply a way of communicating how qu