1. master revision cfa level i

CFA Level I December 2007

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MASTER REVISION NOTES December 2007


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CFA LEVEL I BODY OF KNOWLEDGE

Ethical and Professional Standards Study Session 1. Ethical and Professional Standards Investment Tools Study Session 2. Quantitative Methods: Basic Concepts Study Session 3. Quantitative Methods: Application Study Session 4. Economics: Microeconomic Analysis Study Session 5. Economics: Macroeconomic Analysis Study Session 6. Economics: Global Economic Analysis Study Session 7. Financial Statement Analysis: Basic Concepts Study Session 8. Financial Statement Analysis: Financial Ratios and Earnings Per Share. Study Session 9. Financial Statement Analysis: Inventories, Long-Term Assets and

Economic Reality Study Session 10. Financial Statement Analysis: Deferred Taxes, On- and Off-Balance-Sheet

Debt and Economic Reality Study Session 11. Corporate Finance: Corporate Investing and Financing Decisions Portfolio Management Study Session 12. Portfolio Management Asset Valuation Study Session 13. Securities Markets Study Session 14. Equity Investments Study Session 15. Debt Investments: Basic Concepts Study Session 16. Debt Investments: Analysis and Valuation Study Session 17. Derivative Investments Study Session 18. Alternative Investments

EXAM PRIORITIES Priority #1 Financial Statement Analysis (+ CF) 68 Questions Ethics 36 Questions Priority #2 Quantitative Analysis 28 Questions Economics 24 Questions Equity 24 Questions Fixed Income 24 Questions Priority #3 Alternative Assets 12 Questions Portfolio Mgmt 12 Questions Derivatives 12 Questions __________ 240 Questions


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STUDY SESSION 01 Ethics

I. PROFESSIONALISM A. Knowledge of the Law. Understand and comply with ALL applicable laws. Remember, the

country that is applicable is chosen for you. Benchmark that country. Always comply with the more strict law or C&S, whichever is higher. Must not knowingly participate or assist in and must dissociate from any violation of such laws, rules, or regulations. Step 1: Inform supervisor, Step 2: Seek internal counsel, Step 3: Dissociate oneself, Step 4: Resign and seek external counsel.

B. Independence and Objectivity. Gifts If from one with business relationship - may accept but must disclose. If from one without

business relationship cannot accept. Paid trips - Best answer pay own expenses. However, may accept but must disclose. You cannot

accept luxury items. Lowest correct answer dont go and write and objective report. Beneficial ownership - Must disclose all share ownerships and key positions held. C. Misrepresentation. Assurance When presenting, you cannot give any assurance or guarantee except the issuer. Plagiarism Must acknowledge properly when copying or using substantially the work done by

another. D. Misconduct. Members and Candidates must not engage in any professional conduct involving

dishonesty, fraud, or deceit or commit any act that reflects adversely on their professional reputation, integrity, or competence.

THE CODE OF ETHICS Members of CFA Institute (including Chartered Financial Analyst [CFA] charterholders) and candidates for the CFA designation (Members and Candidates) must: Act with integrity, competence, diligence, respect, and in an ethical manner with the public,

clients, prospective clients, employers, employees, colleagues in the investment profession, and other participants in the global capital markets.

Place the integrity of the investment profession and the interests of clients above their own personal interests.

Use reasonable care and exercise independent professional judgment when conducting investment analysis, making investment recommendations, taking investment actions, and engaging in other professional activities.

Practice and encourage others to practice in a professional and ethical manner that will reflect credit on themselves and the profession.

Promote the integrity of, and uphold the rules governing, capital markets. Maintain and improve their professional competence and strive to maintain and improve the

competence of other investment professionals.


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III. DUTIES TO CLIENTS A. Loyalty, Prudence, and Care. Have a duty of loyalty, must act with reasonable care and exercise

prudent judgment, and must act for the benefit of their clients and place their clients interests before their employers or their own interests. Must determine applicable fiduciary duty and must comply with such duty to persons and interests to whom it is owed.

Safe harbor must justify best execution if not directing trades to the cheapest broker.

Soft Dollars belongs to the client. Member must flowback the benefits to the clients equitably. Proxy Voting must disclose proxy voting policies. B. Fair Dealing. Must deal fairly and objectively with all clients. No discrimination unless disclose

prior. C. Suitability. Must make reasonable inquiries prior to making decisions. Decide on suitability with

the clients written objectives, mandates, and constraints, based on clients total portfolio. Must only make decisions that are consistent with the stated objectives and constraints of the portfolio.

D. Performance Presentation. Investment performance information must be fair, accurate, and

complete. May refer to GIPS. E. Preservation of Confidentiality. Keep within scope information about current, former, and

prospective clients confidential unless: illegal, required by law, or permitted disclosure.

II. INTEGRITY OF CAPITAL MARKETS A. Material Nonpublic Information. Those who possess material nonpublic information that could

affect the value of an investment must not act or cause others to act on the information. This is insider trading.

Mosaic Theory If a member collects non-material non-public information and put up a good

theory that a potential event may take place, he can trade. B. Market Manipulation. Members and Candidates must not engage in practices that distort prices or

artificially inflate trading volume with the intent to mislead market participants. This includes syndicated trading, internet chatting, and spreading rumours.


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IV. DUTIES TO EMPLOYERS A. Loyalty. Must act for the benefit of their employer and not deprive their employer of the advantage

of their skills and abilities, divulge confidential information, or otherwise cause harm to their employer.

Departing employees cannot remove database of clients, solicit clients and employees, and

intellectual property owned by the employer. Can solicit after date of resignation, make preparation to enter into competitive business, and inform clients and prospects of change.

B. Additional Compensation Arrangements.

Part-time jobs that compete with employers or additional agreement with clients require written consent from all parties involved.

C. Responsibilities of Supervisors.

Members must exercise reasonable supervision to detect and prevent violations of applicable lawsof all sub-ordinates. Member must inform senior management of the duty to exercise reasonable supervision. If not, must decline the role. If unable to decline, resign.

V. INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTION A. Diligence and Reasonable Basis. Must exercise diligence, independence, and thoroughness.

Must have a reasonable and adequate basis, supported by appropriate research and investigation, for any investment analysis, recommendation, or action.

Independence means: Cannot rely solely on management report. Cannot submit draft report to management for review of analysis and recommendation. Only

factual corrections allowed. Cannot subject to direct supervision on investment recommendations.

Firewall a physical and procedural barrier to regulate all communication between the investment banking and brokerage.

B. Communication with Clients and Prospective Clients. Must disclose to clients and prospective

clients the basic format and general principles of the investment processes used. Must promptly disclose any material changes. Use reasonable judgment in identifying which factors are important. Distinguish between fact and opinion in the presentation of investment analysis and recommendations.

C. Record Retention. Must develop and maintain appropriate records. Up to 7 years.


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VI. CONFLICTS OF INTEREST A. Disclosure of Conflicts. Must make full and fair disclosure of all matters that could reasonably be

expected to impair their independence and objectivity or interfere with respective duties to their clients, prospective clients, and employer. Disclosures are to be prominent.

B. Priority of Transactions. Investment transactions for clients and employers must have priority. C. Referral Fees. Must disclose to their employer, clients, and prospective clients, as appropriate, any

compensation, consideration, or benefit received by, or paid to, others for the recommendation of products or services.

VII. RESPONSIBILITIES AS A CFA INSTITUTE MEMBER OR CFA CANDIDATE A. Conduct as Members and Candidates in the CFA Program. Cheating candidates found cheating or disobeying exam proctors instructions come under this

Standard. Discussion about exam posting comments on exam questions is prohibited. B. Reference to CFA Institute, the CFA designation, and the CFA Program. Must not

misrepresent or exaggerate the meaning or implications of membership in CFA Institute, holding the CFA designation, or candidacy in the CFA Program.

For business do not imply superior performance by CFA charter-holders, no logo or name

association. Members right to carry the title CFA or Chartered Financial Analyst after name. Font type

and color must be identical. Font size must be smaller of same as name. No direct comparison to any degree.

Candidates -only if currently enrolled in the next exam. No partial qualification.


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GLOBAL INVESTMENT PERFORMANCE STANDARDS (GIPS) GIPS is a set of ethical principles based on a standardized, industry-wide approach. Investment firms can voluntarily follow GIPS in their presentation of historical investment results to prospective clients. These standards seek to avoid misrepresentations of performance. Verification. Once a firm claims to be GIPS-compliant, the firm has an option to hire an independent third party to verify the claim of compliance. The purpose of verification is to provide assurance that compliance has been adhered to on a firm-wide basis. Verification adds credibility. Use trade date, not settlement date. Calculate time-weighted geometric total return.

Do not annualize returns. Must include all actual fee-paying discretionary accounts in composites. Must not erase historical records of accounts terminated. Must disclose returns and volatility. Must disclose management fees

Eight major sections of the GIPS Standards. 0. Fundamentals of compliance. These are issues for firms to consider when claiming GIPS compliance. Definition of

the firm is part of this. 1. Input data. Input data should be consistent in order to establish full. fair, and comparable investment performance

presentations. 2. Calculation methodology. Certain methodologies are required for portfolio and composite return calculations.

Uniformity in methods is required. 3. Composite construction. Creation of meaningful, asset -weighted composites is important to achieve a fair

presentation . 4. Disclosures. Certain information must be disclosed about the presentation and the policies adopted by the firm. 5. Presentation and reporting. Investment performance must be presented according to GIPS requirements, and other

firm -specific information should be included when appropriate. 6. Real estate. These provisions apply to all real estate investments (land. buildings, etc .) regardless of the level of

control the firm has over management of the investment. 7 . Private equity. These must be valued according to the GIPS Private Equity Valuation Principles unless it is an open -

end or evergreen fund (which must follow regular GIPS)?

Objectives of the GIPS standards. To obtain global acceptance of

calculation and presentation standards in a fair, comparable format with full disclosure.

To ensure consistent, accurate investment performance data in areas of reporting, records, marketing, and presentations.

To promote fair competition among investment management firms in all markets without unnecessary entry barriers for new firms.

To promote global self regulation.

Key characteristics: To claim compliance, an investment management firm must

define its firm, and this definition should reflect the distinct business entity that is held out to clients and prospects as the investment firm.

GIPS are ethical standards for performance presentation which ensure fair representation of results and full disclosure.

Include all actual fee-paying, discretionary portfolios in composites for a minimum of five years or since firm or composite inception. After presenting five years of compliant data, the firm must add annual performance each year going forward up to a minimum of ten years.

Firms are required to use certain calculation and presentation standards and make specific disclosures.

GIPS contain both required and recommended provisions-firms are encouraged to adopt the recommended provisions.

There will be no partial compliance and only full compliance can be claimed.

For cases in which a local or country-specific law or regulation conflicts with GIPS, follow the local law, but disclose the conflict.


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Study Session 02 Quantitative Analysis

Descriptive Statistical Methods used to describe the important aspects of data sets that have been collected.

Population is defined as all members of a specified group. Sample is a subset of a defined population. Frequency Distribution: is a tabular display of data summarized into a relatively small number of intervals. Frequency distribution is the list of intervals together with the corresponding measures of frequency for the variable of interest. Data measurements are taken using one of four major scales: 1. Nominal scales categorize data but do not rank them. 2. Ordinal scales sort data into categories that are ordered with respect to some characteristic. 3. Interval scales provide not only ranking but also assurance that the differences between scale

values are equal. 4. Ratio scales have all the characteristics of interval scales as well as a true zero point as the origin.

The scale on which data are measured determines the type of analysis that can be performed on the data.

A histogram - graphical equivalent of a frequency distribution; it is a bar chart where continuous data on a random variables observations have been grouped into intervals.

A frequency polygon is the line graph equivalent of a frequency distribution; it is a line graph that joins the frequency for each interval, plotted at the midpoint of that interval.

Measures of central tendency summarize the location on which the data are centered. Population Mean: calculated as where there are N members in the population and each observation is Xi i =1, 2, N. Sample Mean: calculated as where there are n observations in the sample and each observation is Xi i =1, 2, n. It is also the arithmetic mean of the sample observations. Median: calculated as the middle observation in a group that has been ordered in either ascending or descending order. In an odd-numbered group this is the (n+1)/2 position. In an even numbered group it is the average of the values in the n/2 and (n+1)/2 positions. Mode: is the most frequently occurring value in the distribution. A distribution may have one, more than one, or no mode.

Statistical Concepts and Market Returns


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Risk Variance Total Risk

1)( 22

=

nXX

Downside Risk 1. The semivariance is the average squared

deviation below the mean; 2. Semideviation is the positive square root of

semivariance. 3. Target semivariance is the average squared

deviation below a target level; 4. Target semideviation is its positive square

root.

According to Chehvshevs inequality, the proportion of the observations within k standard deviations of the arithmetic mean is at least 1 1/k2 for all k > 1. Chehvshevs inequality permits us to make probabilistic statements about the proportion of observations within various intervals around the mean for any distribution. As a result of Chebvshevs inequality a two-standard-deviation interval around the mean must contain at least 75 percent of the observations, and a three-standard-deviation interval around the mean must contain at least 89 percent of the observations, no matter how the data are distributed.

Skewness Skew (describes the degree to which a distribution is not symmetric about its mean). A return distribution with positive skewness has frequent small losses and a few extreme gains. A return distribution with negative skewness has frequent small gains and a few extreme losses. Zero skewness indicates a symmetric distribution of returns.

( )( )( )

3

3

21 sXX

nnnS ik

=

Kurtosis Kurtosis measures the peakedness of a distribution and provides information about the probability of extreme outcomes. A distribution that is more peaked than the normal distribution is called leptokurtic; a distribution that is less peaked than the normal distribution is called platykurtic; and a distribution identical to the normal distribution in this respect is called mesokurtic.

)3)(2()1(3)(

)3)(2)(1()1( 2

4

4

+=

nnn

sXXi

nnnnnKE

Excess kurtosis is kurtosis minus 3, the value of kurtosis for all normal distributions.

Return

Risk,

Coefficient of variation, CV = /E(R). A scale-free measure of relative dispersion, by expressing the magnitude of variation among observations relative to their average size, the CV permits direct comparisons of dispersion across different data sets.

FR-E(R)ratio Sharpe =

RF


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PROBABILITY A discrete random variable is one for which the number of possible outcomes can be counted, and there is a measurable and positive probability for each and every possible outcome. An example of a discrete random variable is the number of days it rains in a given month because there is a finite number of possible outcomes. The number of days it can rain in a month is defined by the number of days in the month. A continuous random variable is one for which the number of possible outcomes is infinite, even if lower and upper bounds exist. The actual amount of daily rainfall between zero and 100 inches is an example of a continuous random variable because the actual amount of rainfall can take on an infinite number of values. Daily rainfall can be measured in inches, half inches, quarter inches, thousandths of inches, or in even smaller increments. Thus, the number of possible daily rainfall amounts between zero and 100 inches is essentially infinite. The variance of a random variable is the expected value (the probability-weighted average) of squared deviations from the random variables expected value E(X): 2 (X) = E{[X - E(X)]2), where 2 (X) stands for the variance of X.

Defining properties of probability

1. That 0 P(E) 1 (where P(E) denotes the probability of an event E) 2. That the sum of the probabilities of any set of mutually exclusive and exhaustive events

equals 1.

The probability of both A and B occurring is the joint probability of A and B, denoted P(AB). P(AB) = P(AB) / P(B), P(B) 0.

A probability of an event given (conditioned on) another event is a conditional probability. The probability of an event A given an event B is denoted P(AB). The multiplication rule for probabilities is P(AB) = P(AB)P(B). The probability that A or B occurs, or both occur, is denoted by P(A or B). The addition rule for probabilities is P(A or B) = P(A) + P(B) - P(AB).

A probability of an event not conditioned on another event is an unconditional probability. The unconditional probability of an event A is denoted P(A). Unconditional probabilities are also called marginal probabilities. When events are independent, the occurrence of one event does not affect the probability of occurrence of the other event. Otherwise, the events are dependent. The multiplication rule for independent events states that if A and Bare independent events, P(AB) = P(A)P(B). The rule generalizes in similar fashion to more than two events. According to the total probability rule, if S1 ,S2, ...,Sn are mutually exclusive and exhaustive scenarios or events, then P(A) = P(AS1)P(S1) + P(AS2)P(S2) +...+ P(ASn)P(Sn). The expected value of a random variable is a probability-weighted average of the possible outcomes of the random variable. For a random variable X, the expected value of X is denoted E(X). The total probability rule for expected value states that E(X) = E(XS1)P(S1) + E(XS2)P(S2) +...+ E(XSn)P(Sn) , where S1, S2, ...,Sn are mutually exclusive and exhaustive scenarios or events.


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The calculation of covariance in a forward-looking sense requires the specification of a joint probability function, which gives the probability of joint occurrences of values of the two random variables. When two random variables are independent, the joint probability; function is the product of the individual probability functions of the random variables. Bayess formula is a method for updating probabilities based on new information. Bayes formula is expressed as follows: Updated probability of event given the new information = [(Probability of the new information given event) / (Unconditional probability of the new information)] Prior probability of event. The multiplication rule (if counting says, for example, that if the first step in a process can he done in 10 ways, the second step, given the first, can be done in 5 ways, and the third step, given the first two, can be done in 7 ways, then the steps can be carried out in (10)(5)(7) = 350 ways. The number of ways to assign every member of a group of size n to n slots is n! = n(n - 1)(n - 2)(n - 3) ...1. (By convention, 0! = 1.) The number of ways that n objects can be labeled with k different labels, with n1 of the first type, n2 of the second type, and so on, with n1 + n2 +...+ nk = n, is given by n!/(n1!n2! ... nk!).

Variance is a measure of dispersion about the mean. Increasing variance indicates increasing dispersion. Variance is measured in squared units of the original variable. Standard deviation is the positive square root of variance. Standard deviation measures dispersion (as does variance), but it is measured in the same units as the variable. Covariance is a measure of the co-movement between random variables. The covariance between two random variables Ri and Rj is the expected value of the cross-product of the deviations of the two random variables from their respective means: Cov(Ri, Rj) = E{[Ri - E(Ri)][Rj - E(Rj)The covariance (if a random variable with itself is its own variance. Correlation is a number between -1 and +1 that measures the co-movement (linear association) between two random variables: (Ri, Rj) = Cov(Ri, Rj) [ (Ri) (Rj)].

To calculate the variance of return on a portfolio of n assets, the inputs needled are the n expected returns on the individual assets, n variances of return on the individual assets, and n( n - 1) 2 distinct covariances.

Portfolio variance of return is 2 (Rp) = = =

n

1i

n

1jjiji )R,R(Covww .


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A special case of the multinomial formula is the combination formula. The number of waxs to choose r objects from a total of n objects, when the order in which the r objects are listed does not matter, is

!r)!rn(!n

rn

Crn =

=

The number of ways to choose r objects from a total of n objects, when the order in which the r objects are listed does matter, is

!r)!rn(!nPrn =

This expression is the permutation formula.


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HYPOTHETICAL TESTING A hypothesis is a statement about a population created for the purpose of statistical testing. Hypothesis testing is a procedure based on probability theory and sample evidence used to evaluate whether the hypothesis is a reasonable statement. We could be making a wrong decision. Its all about the significant level. Use the power of test wisely.

The True Situation Decision H0 is True H0 is False Accept H0 as True Correct decision Type II Error Reject H0 Type I Error Correct decision

Study Session 03 Quantitative Analysis

Step 1 Make a statement: H0 = null hypothesis, hypothesis to be tested HA = alternative hypothesis, accept this if H0 is rejected. There are three ways to formulate hypotheses:

1. H0: = 0 versus Ha: 0 [Two-tailed hypothesis] 2. H0: 0 versus Ha: > 0 [One-tailed hypothesis] 3. H0: 0 versus Ha: < 0 [One-tailed hypothesis] where 0 is a hypothesized value of the population parameter and is the true value of the population parameter.

Step 2 Identify the correct test statistic to be used and its probability distribution: For population mean with known variance use z-statistic For population mean of a normally distributed population with unknown

variance, use t-statistic. Unless for large samples (> 30), the z-statistic may be used.

For observed difference between two means - If the samples are independent, conduct tests concerning differences between means. If the samples are dependent, conduct tests of mean differences (paired comparisons tests).

For variance of a single, normally distributed population, use chi-square (X2) with n-1 degrees of freedom, where n is sample size. Chi-square is a family of asymmetrical distributions, each distribution defined by the number of degrees of freedom and is sensitive to violations of its assumptions.

For differences between the variances of two normally distributed populations based on two random, independent samples, use F-test (the ratio of the sample variances).

Step 3 Specify the significance level.

= probability of Type I error

= probability of Type II error


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A critical value (rejection point) for a test statistic is a value against which the computed value of the test statistic is compared to decide whether to reject, or not to reject, the null hypothesis. The relationship between two variables is measured by the correlation coefficient (r,Y,X). To determine the precise form of the relationship, use regression analysis.

Accept Reject

Step 4 Make a statement of your decision rule

Test statistic = X

RP

SX 0

The p-value is the smallest level of significance at which the null hypothesis can be rejected. The smaller the p-value, the stronger the evidence against the null hypothesis and in favor of the alternative hypothesis.

Limitations of correlation analysis 1. The correlation coefficient assumes that the relationship between the two variables is liner,

whereas it could be nonlinear. 2. The presence of outliers can distort the correlation coefficient. 3. The existence of spurious correlation (sample showing high and significant relationship

whereas there is no real relationship).

Testing the significance of a correlation coefficient To test the significance of (r,Y,X), the test-statistics =

21

2

YX

YX

rnrt

= where the df = n-2 X

Y

Summary of Hypothesis Testing

Mean Difference in means Difference in variances Variance

z-test for population or sample > 30

t-test for population with unknown variance or sample < 30

Paired comparison tests for samples that are dependent

Chi-squared test F-test


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Simple Linear Regression Analysis Standard Error of Estimate (SEE) SEE is a measure of how imperfect the regression model is in predicting the dependent variable.

SEE = 22

2

11

^

0

^

2

=

n

XbbY

n

ii

Coefficient of Determination The coefficient of determination measures the percentage of the total variation in the dependent variable (Y) the is explained by the variation in independent variable (X). R2 = rYX2 Analysis of Variance (ANOVA) ANOVA summarizes the total variation and attributes this variation to its different sources. ANOVA df Sum of Squares Mean Sum of Squares Regression 1 RSS MSSR = RSS/1 Residuals (errors) n-2 SSE MSSE = SEE2 = SSE/(n-2) Total n-1 TSS MSST = TSS/(n-1)

X

Y Yi = b0 + b1X1 + i Where:

b1 = 2X

YX

SCOV (slope)

b0 = xbY 1 (intercept)

SEE measures deviations around the regression line


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STUDY SESSION 4 ECONOMICS: Microeconomic Analysis

Factors affecting consumer choice: Limited income necessitates choice. Consumers make choices purposefully. One good can be substituted for another. Consumers must make decisions without perfect

information, but knowledge and past experience will help.

Each consumer will maximize his/her satisfaction by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility. Reasons the demand curve slopes downward: Substitution effect: as a products price falls,

consumers will buy more of it . . . and less of other now more expensive products.

Income effect: as a products price falls, a consumers real income rises and so induces them to buy more of both it and other goods.

Income elasticity indicates responsiveness of a products demand to a change in income. A normal good is a good with a positive income elasticity of demand. As income expands, the demand for normal goods

will rise. Goods with a negative income elasticity are

inferior goods. As income expands, the demand for inferior goods

will decline.

Quantity

Price


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Total costs Explicit costs result when a monetary payment

is made (accounting costs) Implicit costs involve resources owned by the

firm and dont involve a monetary payment (opportunity costs).

Economic profit is total revenues minus total costs (including all opportunity costs). Total Costs (TC) = Total Fixed Cost + Total Variable Cost Average Total Costs (ATC): Average Fixed Cost + Average Variable Cost Marginal Cost (MC): The increase in Total Cost associated with a one-unit increase in production. MC will decline initially, reach a minimum, and then rise. Economies of Scale: Reductions in per unit costs as output expands. This can occur for three reasons: Mass production Specialization Improvements in production as a result of

experience Diseconomies of Scale: Increases in per unit costs as output expands. Constant Returns to Scale: Unit costs are constant as output expands. Factors that Cause Cost Curves to Shift Prices of Resources: Increase in price of

resources used (inputs to production) will cause a firms cost curves to shift upwards.

Taxes: Increased taxes shift up a firms cost curves. Tax on variable input shifts MC, AVC, & ATC. Fixed tax shifts AFC & ATC.

Regulations: Government may seek to control the prices of certain items.

Technology: Cost-reducing technological improvements will lower a firms cost curves. Which curves depend on whether technology affects fixed or variable costs.


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Types of Markets

Price Takers

Price Searchers (Low Barrier)

Price Searchers (High Barrier)

Monopoly

Price Takers

Price Takers Price Takers produce identical products and each seller is small relative to the market. Each seller has little or no effect on the market price. Each firm can sell as much as it wants at the market price It is unable to sell any output at a price greater than the market price. Example: agriculture (wheat, corn, soybeans) Also called a purely competitive market. Market forces (supply & demand) determine price. Price takers have no control over the price that they may charge in the market. If such a firm was to charge a price above

that established by the market, consumers would simply buy elsewhere. So, the price takers demand will be perfectly elastic. Only at the market price will there be any demand. Marginal Revenue of each unit of output sold = Market Price. Price-taking firm sets output so Marginal Cost of last unit of output produced equals market price = marginal revenue. If MR > MC then selling an additional unit adds to profit. If MR < MC then selling additional unit lowers profit. Maximum profit when MR = P = MC of last unit.


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Competitive Price-Searcher Markets Firms in price-searcher markets with low entry barriers face a downward sloping demand curve. Firms are free to set price, but face strong competitive pressure. Competition exists from existing firms and potential rivals Firms produce differentiated products. Output of other firms close substitutes, so individual firms demand curve is highly elastic. Low entry barriers allow entry or exit of firms if existing firms earn non-zero economic profits. Each firm faces competition from existing firms in industry & potential new entrants. Profits and Losses in the Long Run If firms are making economic profits, then rival firms will be attracted to the market. The entry of new firms will expand supply and lower price. The demand curve of each will shift inward until the economic profits are eliminated. Economic losses will cause price searchers to exit from the market. Demand for the remaining firms output will rise until the losses have been eliminated, ending the

incentive to exit. Competitive price searchers can make either profits or losses in the short run, but only zero

economic profit in the long run.

Entry barriers Economies of Scale Government Licensing Patents. Control over an Essential Resource

Price Searchers

Oligopoly

No general theory exists for price and outputunder oligopoly. If the firms operated independently, they

would drive down the price to the per unitcost of production.

If the firms colluded perfectly, the pricewould rise to the monopoly price.

The outcome is usually between these twoextremes.


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Markets with High Entry Barriers Oligopolists have a strong incentive to collude and to cheat on collusive agreements; Cartel seeks to create a monopoly in market. Once collusion by the cartel has established the monopoly price in the market, however, each member of the cartel has an incentive to cheat by increasing their own supply at the high price to increase its share of profits in the market. Government policy to reduce the problems stemming from high barriers to entry. Restructure existing firm or firms to stimulate competition. Reduce Artificial Barriers to Trade Regulate the Dominant Producer(s) Supply Market with Government Production

Gaining from Cheating Using industry demand Di and

marginal revenue MRi, oligopolists maximize their joint profit where MRi= MC at output Qi and price Pi .

Demand facing each firm df (where no other firms cheat) would be much more elastic than industry demand Di.

The firm maximizes its profit where MRf = MC by expanding output to qfand lowering its price to Pf from Pi.

Monopoly

The monopolist will reduce price and expand output as long as MR > MC.

MR > MC MR < MC The monopolist will raise price and reduce output when ever MR < MC.

Output level q will result At q the average total cost per unit for that scale of output is C.

As P > C (price > ATC) the firm is making economic profits equal to the area PABC.


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Real GDP

STUDY SESSION 05 Macroeconomics Analysis

Aggregate Demand Other things constant, the lower price level will increase the wealth of people holding the fixed quantity of money, lead to lower interest rates, and make domestically produced goods cheaper relative to foreign goods. All these factors will tend to increase the quantity of goods & services purchased at the lower price level.

The phases of the business cycle are: Expansion, Peak (or boom), Contraction, and, Recessionary trough.

Price

The short-run aggregate supply curve (SRAS) shows the relationship between the price level and the quantity supplied of goods & services by domestic producers. In the short-run, firms will generally expand output as the price level increases because the higher prices will improve profit margins since many components of costs will be temporarily fixed as the result of prior long-term commitments.

SRASLRAS

GDP GDP is the sum of expenditures on final user goods and services purchased by households, investors, governments, and foreigners. There are four components of GDP: personal consumption purchases (C), gross private investment (I), government spending (G) net exports ( exports - imports ) (E) Shortcomings: It does not consider non-market production, underground economy, for leisure. It understates output increases because estimating improvements in the quality of products is difficult. It does not adjust for harmful side effects.

Factors that shift AD to the right include increases in real wealth, positive business expectations, higher expected future inflation, lower real interest rates, higher incomes abroad (increased exports), and a declining value of the domestic currency. Factors affecting SRAS are drought, hurricanes, and changes in input prices (including wages).

An unexpected shift in AD to the left reduces prices and real GDP in the short run. As workers and suppliers begin to accept lower wages, the short-run aggregate supply curve shifts to the right, increasing GDP. Thus, the only long-run effect is a decrease in prices.

A favorable supply shock will shift SRAS to the right. The net result in the short run is lower prices, lower unemployment, lower real interest rates, and higher output. If the shock is temporary, all variables revert to their pre-shock levels.

Market economies have self-correcting mechanisms that tend to stabilize economic activity: changes in consumption demand, real interest rates, and resource prices.

LRAS is a vertical line indicating it is not sensitive to price level changes. LRAS is a function of resources and technology and should shift gradually to the right over time.

The permanent income hypothesis states that consumption will depend on expected long-run income. If consumers receive a temporary increase in income, a large portion of the increase will be saved instead of spent.


22

Classical economists believe that if the economy is below the full-employment level, declining wages and prices will result in increased employment, while Keynesian economists believe that if the economy is not producing at the full-employment level, the government should run deficits to increase aggregate demand.

3 Types of Unemployment 1. Frictional Unemployment. Caused by imperfect information in a world of dynamic change. 2. Structural Unemployment. Reflects an imperfect match-up of employee skills and the skill requirements of the

available jobs. Reflects structural and demographic characteristics of the labor market. 3. Cyclical Unemployment. Reflects business cycle conditions When there is a general downturn in business activity,

cyclical unemployment increases.

Fiscal Policy Fiscal policy affects AD directly through govt spending & indirectly through effects of taxes on consumption and investment. Taxes may affect AS by changing incentives for workers and firms. Fiscal policy can be restrictive (lowers AD) or expansionary (raises AD). Empirical In theory, higher govt budget deficits should lead to higher real interest rates by loanable funds market analysis. In practice effect is not as strong as expected. Higher govt budget deficits may lead to higher inflation rates if govt finances deficit by printing money. Problems: Recognition lag, implementation lag before policy passed, effectiveness lag before policy works. If timed correctly can stabilize economy, if not policy will bring more instability (usually in opposite direction). Solutions: Automatic stabilizers - Fiscal policies that automatically promote budget deficits during recessions and surpluses during booms. E.g. unemployment compensation, corporate profits tax, and progressive income tax. These policies affect AD in ways that offset economic fluctuations. Other dissenting views Supply-side effects of fiscal policy. Changes in tax rates, particularly marginal tax rates, affect aggregate supply through their impact on the relative attractiveness of productive activity in comparison top leisure and tax avoidance. Supply-side tax cuts are a long-term growth-oriented strategy that will eventually increase both SRAS and LRAS. Impact of expansionary and restrictive fiscal policy. Keynesian model assumes SRAS upward-sloping. If economy is in recession (below LRAS), expansionary fiscal policy shifts out AD, moves economy back to LRAS. Crowding out model similar but notes expansionary fiscal policy raises govt deficit, which changes interest rates and exchange rates. These changes lower investment and net exports, partly offsetting expansionary fiscal policy. New Classical model believes fiscal policy has no effect because any change in deficit (from spending or tax changes) is offset by changes in private savings behavior. Supply-side model believes tax changes affect productivity and so can increase equilibrium output in long run.


23

Monetary Policy The 3 Tools the Fed Uses to Control the Money Supply 1. Open Market Operations: the buying and selling of U.S. securities (national debt in the form of

bonds) by the Fed. This is the primary tool used by the Fed. a. Fed buys bonds the money supply expands: bond buyers acquire money bank reserves

increase, placing banks in a position to expand the money supply through the extension of additional loans.

b. Fed sells bonds the money supply contracts: bond buyers give up money for securities bank reserves decline, causing them to extend fewer loans.

2. Discount Rate: the interest rate the Fed charges banking institutions for borrowed funds. An increase in the discount rate decreases the money supply (restrictive) because it discourages banks from borrowing from the Federal Reserve to extend new loans. A reduction in the discount rate increases the money supply (expansionary) because it makes borrowing from the Federal Reserve less costly.

3. Reserve requirements: a percent of a specified liability category (for example transaction accounts) that banking institutions are required to hold as reserves against that type of liability. When the Fed lowers the required reserve ratio, it creates excess reserves for commercial banks allowing them to extend additional loans, expanding the money supply. Raising the reserve requirements has the opposite effect.

Transmission of Monetary Policy When the Fed shifts to more expansionary monetary policy, it usually buys additional bonds, expanding the money supply. This increase in money supply (shifting S1 out to S2 in the market for money) provides banks with additional reserves. The Feds bond purchases and the banks use of new reserves to extend new loans increases the supply of loanable funds (shifting S1 to S2 in the loanable funds market) and puts downward pressure on real interest rates (a reduction to r2).

The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earnings assets like bonds. The supply of money is vertical because it is established by the Fed and, hence, the same regardless of interest rate.


24

Expectations determine how quickly SRAS adjusts to changes in AD Curve, leading the economy back to LRAS. Fiscal & monetary policies (expansionary & restrictive) will be less effective when people anticipate their effect on prices more quickly.

Unanticipated higher inflation reduces real wages, expands production, reduces unemployment below natural rate, UN. Once the higher inflation is recognized, real wage adjusts back to normal, unemployment returns to UN and output returns to LRAS. Under Adaptive Expectations, individuals underestimate future inflation when rate is rising. Temporary trade-off of higher inflation & lower unemployment. Once the higher inflation is recognized, trade-off disappears. Under Rational Expectations, individuals do not systematically under- or over-estimate future inflation. Very temporary trade-off of higher inflation & lower unemployment. Higher inflation recognized very rapidly and trade-off disappears.

Stabilization Policy Adaptive Expectations hypothesis: Individuals base their future expectations on actual outcomes in the recent past. (Backward-looking) Rational Expectations hypothesis: Individuals weigh all available evidence, including information about probable effects of current & future economic policy, when forming expectations about future economic events. (Forward-looking)

Unemployment

Inflation


25

STUDY SESSION 06 Global Economic Analysis

2 . W ithout trade, price o f good in H om e is P N T and P* N T in F oreign .1 . A ssu m e H o m e im ports the good and F oreign exports th e good .

H om e C ountry W orld M arket F oreign C ountry

S HD HD F

E xport Supply

Im port D em and

S F

P W

D om esticP rice

W orld P rice

ForeignPrice

4 . P rice o f good low er in H om e (th e im porter) so H om e consu m ers better o ff w ith trade.P rice o f good h igher in F oreign (the exporter) so F oreign producers better o ff.

P N T

P* N T

3 . W ith trade, price determ ined in w orld m arket as P W .

H om e Im po rt Lev el

Foreign E x port Level

E xports = Im ports

Nations can gain from trade if they produce goods in which they have a comparative advantage and trade for goods in which they have a comparative disadvantage. Comparative Advantage is the ability to produce a good at a lower opportunity cost than others can produce it. As long as the relative costs of production differ across nations, gains from specialization and trade will be possible. When nations produce and trade based on Comparative Advantage trade between nations leads to an expansion in total world output and mutual gains to each nation.

P rice , P

Q u an tity , Q

S H om e

P W

D 0

D H o m e

2 . C o n su m er su rp lu s fa lls b y a rea s:a + b + c + d

3 . P ro d u cer su rp lu s r ises b y a rea :a

4 . G o v ern m en t rev en u e r ises b y a rea :c

5 . D eadw eig h t lo ss (co st o f p ro tec tio n ):b + d (= p ro dn lo ss + co n sum p lo ss)

a b c da b c d

S T D T

P T

1 . Im p o rt ta r iff , t , ra ises d o m estic p rice P T = P W + t fo r sm a ll co u n try .

t

S T D T

P T


t

P T



t

S 0


26

Monetary Policy Expansionary Restrictive Real Interest rates Decline Rise Exchange Rate Depreciates Appreciates Flow of Capital Outflow Inflow Current Account Move to surplus Move to deficit Fiscal Policy Expansionary Restrictive Real Interest rates Rise Decline Exchange Rate Uncertain but Uncertain but likely appreciate likely depreciate Flow of Capital Inflow Outflow Current Account Move to deficit Move to surplus

Tariff is a tax levied on imports, has following effects: Domestic Price rises by amount of tariff. Reduction in the quantity of imports of the good. Loss of consumer surplus as less of good consumed at higher price. Gain of producer surplus as domestic production increases. Government revenue increases from tariff revenues. Net Deadweight loss to society. Effects of quota similar but larger deadweight loss as generates no government revenue.

Factors causing Nations Currency to Appreciate (Strengthen) Slow growth of domestic income relative to trading partners causes exports to increase more than imports. (decrease in Demand for FX) Inflation rate lower than trading partners will cause foreign goods to become expensive. (Demand for FX falls, Supply of FX rises) As result foreign currency weakens, its goods become competitive. Domestic real interest rates higher than trading partners will attract inflows of foreign capital, increasing demand for domestic currency. (Demand for FX falls, Supply of FX rises)

ExchangeRate

Supply of FX(from Foreign Citizens)

Supply of FX(from Foreign Citizens)

Demand for FX(from Domestic Citizens)

Demand for FX(from Domestic Citizens)

Quantity of Foreign Currency Exchanged

$/Foreign Currency

Flexible EXR

FX*

Flexible EXR

FX*

Fixed EXR1

FX Reserves > 0

Fixed EXR1

FX Reserves > 0

Fixed EXR2 FX Reserves < 0

Fixed EXR2 FX Reserves < 0


27

STUDY SESSION 07 Financial Statement Analysis Basic Concepts

Financial Reporting Environment

Financial Accounting Standards Board (FASB)

conceptual framework

International Organization of Securities Commissions

(IOSCO) and the International Accounting Standards Board

(IASB) in setting and enforcing global accounting standards;

The auditor is responsible for 1. Seeing that the financial statements issued conform with generally

accepted accounting principles. 2. Must agree that managements choice of accounting principles is

appropriate and any estimates are reasonable. 3. Examines the companys accounting and internal control systems,

confirms assets and liabilities, and generally tries to ensure that there are no material errors in the financial statements.

Principal financial statements: 1. Balance Sheet, 2. Income Statement, 3. Statement of Comprehensive

Income, 4. Statement of Cash Flows 5. Statement of Stockholders

Equity Additional sources: 1. information accompanying the

financial statements, including the financial footnotes,

2. supplementary schedules, 3. Management Discussion and

Analysis (MD&A) and 4. Proxy statements;

Statement of Financial Accounting Concepts (SFAC) 2 mandates the qualitative characteristics of accounting information. Financial statement information should facilitate comparisons of firms using alternative reporting methods and be useful for decision-making. For accounting information to be useful for an analyst , it should have the following characteristics: Relevance means that information could potentially affect a decision. The relevance of accounting information depends to a large extent on the purpose of the analysis. Timeliness is important because information loses value rapidly in the financial world. Timely data is helpful in making the projections on which market prices are based. Reliability refers to information that can be verified (measured accurately] and has representational faithfulness (it is what it is reported to be). Without these two characteristics, data cannot be relied upon in making investment decisions. Reliable information should also reflect neutrality (does not consider the economic impact of the reported information). Consistency. Accounting information should be reported using the same accounting principles over time. Comparability. Information should allow comparisons among companies. Comparability is often a problem in financial an analysis because companies use different accounting methods and estimates. Materiality. Material data are important enough for inclusion in the financial statements. Many an analysts define materiality in quantitative terms (e.g., 5% of assets): however, most analysts agree that an item is material if it affects the value of the firm.


28

5 revenue recognition methods The sales basis method is the most common and most businesses generate revenue under these

assumptions. The sales basis method is the standard to which we will compare all other methods.

Revenue Recognition

Long-term contract

Percentage-of-completion

Completed contract

The percentage-of-completion methodapproximates the sales basis method and is a logical extension of the sales basis method for long-term contracts. It is designed to measure current operating performance.

The completed contract method is more conservative than the percentage-of-completion method - revenues will lag those of the percentage-of-completion method. Also, income will be less stable under the completed contract method than under the percentage-of-completion method. It is impossible to gauge the profitability of long-term contracts using the income statement - an analyst must rely on the statement of cash flows.

Payment is not certain

Installment method Cost Recovery

The installment method is similar to the percentage-of-completion method in how it accounts for earnings in stages. Nonetheless, it still lags the sales basis method, and an analyst must compare the cash flow statement with the income statement to fully understand the future profitability of the company.

The cost recovery method is similar to the completed contract method (in the same manner that the installment method is similar to the percentage-of-completion method) in that profit is not recognized until all aspects of the sale (revenues and costs) are made. An analyst must rely on the cash flow statement for some measure of sales profitability.


29

Comparative Analysis Percentage-of-Completion Completed Contract Cash flows Same Same Net income Greater - % of profit is recognized Less - none until final year Income volatility Less-some recognized each year Greater-all at completion Total assets Greater-% of profit recognized Less - no profit until complete Construction in progress Greater-profit included in Less construction in progress Amounts billed Same Same Net [construction in progress Greater (greater assets or smaller Less (greater liability or smaller minus advance billings] liability) assets) Shareholder equity Greater Less Ratio of liabilities-to-equity Less Greater and liabilities-to-assets Non-Recurring Items 1. Abnormal items - unusual or infrequent items. E.g. disposal of assets, gains and losses from financial

instruments and derivatives. 2. Extraordinary items - unusual and infrequent items (beyond management control). E.g. Uninsured

losses, early retirement of bonds. 3. Discontinued operations termination of branches or subsidiaries during the year under management 4. Accounting changes changes in accounting principles and estimates. 5. Prior period adjustments omitted transactions for last accounting periods. Earnings Management 1. Managerial discretion in areas such as classification of good news/bad news 2. Income smoothing use of capitalization and amortization to create a more stable profit pattern 3. Big bath behavior willful actions to produce lower profits during adverse market conditions 4. Accounting changes changing accounting policies to more aggressive ones.


30

Statement of Cash Flow

Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities _______________________________ Cash and cash equivalent

Direct Method Sales Acc Receivables Cash collected from customers - Cash Paid to suppliers - Other cash costs CFO

Indirect Method Net Income Non-cash items Net Working Capital CFO

* All interest expenses, interest incomes, taxes, and dividend incomes are classified as CFO.


31

A common-size balance sheet expresses all balance sheet accounts as a percentage of total assets. A common-size income statement expresses all income statement items as a percentage of sales. Ratios can be divided into four types - internal liquidity, operating performance, risk analysis, and growth potential. 1. Internal liquidity ratios indicate the companys ability to pay its short-term obligations. An average

amount for balance sheet accounts is used in the denominator. 2. Operating performance ratios include two categories: operating efficiency ratios (various turnover

ratios) and operating profitability (various margin ratios). 3. Risk analysis ratios address two types of risk: business risk (resulting from variability in sales and

operating costs) and financial risk (volatility resulting from the use of debt). 4. Growth analysis ratios indicate the companys ability to pay future obligations. The calculation of the

sustainable growth rate is g = RR x ROE, where RR = retention rate = 1 - (dividends declared / after-tax operating income) and ROE is return on equity.

Ratios and Earnings Per Share


32

In the event of rising prices FIFO results in better financial presentation higher profit, higher asset values, and favorable ratios (except turnover ratios and tax, and CFO). Disadvantage: Higher profits attract higher taxes

Additional requirements for adopting LIFO: Disclose LIFO Reserve to reconcile. Loss of tax benefit in the event of stock write-

down due to Lower of Cost or Market Value (LCM Principle).

LIFO Liquidation whenever salesunits > productionunits

Benefits of Capitalization: Higher profits (Income smoothing) Higher Asset values Better Cash Flow classification (Lower CFO and Higher CFI) Better ratios in all categories (except Turnover Ratios)

Inventory

FIFO LIFO

Intangible Assets Specific Issues: Goodwill (only purchased goodwill

allowed). No amortization allowed. To be tested for impairment.

R&D Not allowed. (Specific Software Development allowed under qualifications)

Patents & Trademarks only legal fees allowed.

Brand not allowed Interests on borrowing must capitalize

During periods of increasing inventory and rising prices: The FIFO method will result in the lowest COGS - first in, which goes to cost of goods sold, is the less

expensive - and the highest net income. The higher the net income, the greater the inventories on the balance sheet [under FIFO, the last in (most expensive) goes to inventory]. Higher net income also means the firm will pay higher taxes, which in turn results in lower cash flows.

LIFO will result in the highest cost of goods sold (last in is the most expensive) and lowest income. The lower the net income, the smaller the inventories on the balance sheet [under LIFO, the first in (least costly) goes to inventory]. Lower net income also means the firm will pay less in taxes, which in turn results in higher cash flows.

The average cost method, being an average, is in between FIFO and LIFO valuations. Specific identification cannot be generalized because it depends upon the specific situation.


33

During the early years: SLM results in: Better P&L, Better Asset values, and all ratios are favorable except activity ratios. No impact on the Cash Flow Statement

Asset Impairment: Assess the carrying amount to the recoverable amount. The recoverable amount the higher of Net Realizable Value and Value In Use (undiscounted cash flows)

LONG-TERM ASSETS

Years

$

Straight-line Depreciation

Double-Declining Method

Initial recognition of PPE includes all incidental expenses including interest on borrowing and provision for asset retirement obligation (ARO). ARO causes higher asset and higher liabilities. Profit will be lower as a result of incremental depreciation and amortization of provisions.

Assets are removed from the balance sheet via 3 approaches: 1. disposal 2. written off 3. exchange for another asset

(accounting treatment depends on whether the exchanged asset is similar or not). No gains or losses are recognized for the exchange of similar assets

All assets shall be depreciated using an appropriate depreciation method: 1. straight-line method 2. reducing balance method 3. production-based method


34

Leasing

Financial Operating

Deferred Taxes The standard has a balance sheet focus. It is based on the principle that a deferred tax liability or asset should be recognised if the recovery of the carrying amount of an asset or the settlement of a liability will result in higher (or lower) tax payments in the future than would be the case if that recovery or settlement were to have no tax consequences. Thus, a deferred tax liability or asset is recognised for the future tax consequences of past events. The standard assumes that each asset and liability will have a value for tax purposes: a "tax base". Differences between the carrying amount of an asset or liability and its tax base are called "temporary differences". 'Temporary' because a fundamental proposition that an entity will realise its assets and settle its liabilities continually over time. At some point, tax consequences will crystallise. The main requirements are as follows: (1) full provision for the effects of income taxes is required, with very limited exceptions; (2) deferred taxes should be recognised on asset revaluations and for fair value adjustments in a business

combination; (3) deferred tax assets (including those arising from tax losses) should be recognised when it is probable that

sufficient taxable profit will be available; (4) in general, a deferred tax liability should be recognised for the undistributed profits of associates; and (5) deferred tax assets and liabilities should not be discounted.

Financing Liabilities: All financial liabilities have to be carried at amortized cost. As a result, zero coupon bonds will greatly distort the cash flow presentation. It would overstate the CFO. Classification of financial liability is on substance over form. Redeemable Preference Shares are to be classified as financial liability. Any early retirement of debt will be classified as extraordinary.

If any one of the criteria is met, it will be treated as a financial lease. Transfer of title Bargain purchase option Lease life > 75% of Useful Life PV of Minimum Lease Payment (MLP) > 90%

of the Fair Value. Accounting treatment: DR Leased Asset CR Lease Liability. Leased asset must be depreciated and the Lease Liability to be amortized.

Accounting treatment: DR Rent Expenses (straight line) CR Cash During the early years: The use of operating lease will result in Higher profits Better ratios in all categories Lower CFO Take note of off-balance-sheet financing: Take-or-pay contracts Sale of receivables Throughput arrangements


35

Investment Appraisals

NPV IRR

STUDY SESSION 11 Corporate Finance

Advantages: Measures absolute wealth. Considers relevant cash flows. Disadvantages: Not comparable. Especially for mutually

exclusive projects and capital rationing (hard and soft)

Dependent on the WACC Solution: Profitability Index for different initial outlays. Equivalent Annualized Annuity (EAA) for

different lives.

Advantages: Relative measure. Comparable. Not dependent on changes on interest rates. Disadvantages: Reinvestment assumption Multiple IRRs for unconventional cash flows. Solution: Modified IRR

%

A m o u n t

W A C C

I n v e s t m e n t O p p o r t u n i t y

S e t ( I O S )

O p t im a l p o in t


36

Theories on Dividend Policies

Prefer low payout

Prefer high payout

Bird-In-Hand Investors assign dividend paying

companies as lower risk

Tax Preference Investors

dividends are taxable as income.

Considers the dividend policy of the company to be

irrelevant

Modigliani and Miller argue

that the wealth of shareholders will not be affected by

any policy

Cost of retained profit

Cost of new equity

%

$

Investment Opportunity Set

Retained profit Residual Dividend

Residual Dividend Policy argues that: 1. The cost of retained profit is lower than the

cost of new equity. 2. Retained profit can be reinvested in projects

where the expected ROE > existing ROE

Wealth is maximized when profit is retained

Other factors affecting dividend policy

Covenant restrictions from debtholders

Availability of cash

Signalling Hypothesis

Tax Efficiency planning

Clientele Effect argues that

investors will gravitate towards a known policy.


37

The Corporate Governance of Listed Companies: A Manual for Investors

Issues 1. Re-election - Anything beyond an annual limit on board member tenure (i.e., two- or three-year terms)

limits shareowners ability to change the boards composition, in the event that board members fail to represent shareowners interests fairly.

While reviewing firm policy regarding election of the board, investors should consider: Whether there are annual elections or staggered multiple-year terms (a classified board). Staggered

board may serve another purpose-to act as a takeover defense. Whether the board filled a vacant position for a remaining term without shareholder approval. Whether shareholders can remove a board member. Whether the board is the proper size for the specific facts and circumstances of the firm. An annually elected Board may provide more flexibility to nominate new Board Members to meet changes in the marketplace, if needed, than a classified Board. Staggered Boards also may serve as an anti-takeover device. On the other hand, a classified Board may provide better continuity of Board expertise.

Corporate governance is the system of internal controls and procedures by which individual Companies are managed. It provides a framework that defines the rights, roles and responsibilities of different groups - management, Board, controlling Shareowners and minority or non-controlling Shareowners -within an organization. This system and framework is particularly important for Companies with a large number of widely dispersed minority Shareowners.

Good corporate governance practices: Board Members act in the best interests of Shareowners; The Company acts in a lawful and ethical manner in

their dealings with all stakeholders and their representatives;

All Shareowners have the same right to participate in the governance of the Company and receive fair treatment from the Board and management, and all rights of Shareowners and other stakeholders are clearly delineated and communicated;

The Board and its committees are structured to act independently from management, individuals or entities that have control over management, and other non-Shareowner groups;

Appropriate controls and procedures are in place covering managements activities in running the day-to-day operations of the Company; and

The Companys operating and financial activities, as well as its governance activities, are consistently reported to Shareowners in a fair, accurate, timely, reliable, relevant, complete and verifiable manner.

Major factors that enable a board to exercise its duty to act in the best long-term interests of shareowners; 1. Independence - a majority of Independent

Board Members. 2. Experience - appropriate experience and

expertise. 3. Resources - Internal mechanisms to support

the Independent work of the Board.

To be independent, a board member must not have any material relationship with: The firm and its subsidiaries, including former

employees, executives, and their families. Individuals or groups, such as a shareholder(s)

with a controlling interest, which can influence the firms management.

Executive management and their families. The firms advisers, auditors, and their

families. Any entity which has a cross-directorship with

the firm. An independent board member must work to protect shareholders long-term interests.


38

2. Remuneration/Compensation strategy. Investors also should focus on whether the rewards offered to management are based on the performance of the Company relative to its competitors or other peers, or on some other metric.

3. Executive compensation. Help Investors determine whether the Company is receiving adequate

returns for the investment it has made in executive management. 4. Share-based compensation terms. Examination of the terms of this type of remuneration program,

including the total shares offered to key executives and other employees, should alert Investors to how the program can affect shares outstanding, dilution of Shareowner interests, and share values. Investors also should determine whether the Company seeks Shareowner approval for creation or amendments to such plans.

5. Stock-option expensing. Compensation, regardless of whether it is paid in cash, shares or share

options, involves payment for services received and should appear as an expense on the income statement. International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles both require Companies to expense stock option grants.

6. Performance-based compensation. Investors should determine whether stock options and stock

grants, as well as stock-appreciation rights and other performance-based compensation programs are linked to the long-term profitability and share-price performance of the Company relative to its competitors and peers. The purpose of compensation is to reward management for gains attributable directly to superior performance, and linking pay to performance is one way to achieve this purpose.

7. Option repricing. Investors should remain aware of efforts by the Company to reprice downward the

strike prices of stock options previously granted. Changes in the strike price remove the incentives the original options created for management, and therefore reduce the link between long-term profitability and performance and management remuneration.

8. Share ownership of management. Investors should determine whether members of management have

share holdings other than those related to stock option grants. Such holdings may align the interests of Company executives with those of Shareowners.

In evaluating the board of directors, investors should: Establish how many members are truly independent. Evaluate the qualifications of board members to meet challenges the firm faces. Assess whether the board of directors has authority to hire independent third-party consultants. Determine whether all board members are elected annually or if there are staggered terms (staggered

terms make it more difficult for shareholders to significantly change the board of directors). Investigate whether the firm has outside business relationships with board members, executives,

employees, or the families of these groups. Determine whether board members have relevant finance and accounting experience. Find out if the firm has a committee of independent members to set executive pay. Find out if the firm has a nominations committee to recruit new members. Inquire as to other board committees responsible for governance, mergers and acquisitions, legal

matters, and risk management.


39

RM

Systematic risk

Indifference Curve

Investment Policy

Statement (IPS)

Investment Objectives: Return Objective (total

return) Risk Tolerance Constraints: Investment Horizon Liquidity Needs Tax Implications Legal & Regulatory Unique Preference

Risk Capital Market Expectations

Return measurement: Holding Period Yield Rp = WaRa + WbRb Risk: = standard deviation p = Wa2a2 + Wb2b2 + 2WaWbCova,b a,b = Cova,b / ab

EFS

Portfolio Construction

# of securities

Risk

Security Selection

%

%

EFS

CML

SML

Rf

RM

Rf

1.0

Capital Asset Pricing Model [CAPM] Ra = Rf + [Rm Rf]

Arbitrage Pricing Theory [APT] Ra = Rf + 1F1 + 2F2 + ...+ nFn + e

STUDY SESSION 12 PORTFOLIO MANAGEMENT


40

STUDY SESSION 13 SECURITIES MARKETS

Organization and Functioning of Securities Markets

Primary Market Secondary Market Third Market

Fourth Market

New issuance of shares.

Normally on competitive bid or negotiated price.

Can be made via public offer or private placement.

A stock exchange for the trading of existing shares.

Normally traded on auction basis continuous or call basis.

Market orders buy orders or sell orders.

Limit Loss orders stop buy order or stop sell orders.

An Over-The-Counter (OTC market via an intermediary.

Broker agency trade.

Dealer Principal trade.

Market makers a trader that takes both deals.

A direct transfer of securities without intermediaries.

On negotiated basis.

Security market indexes are used: To evaluate the portfolio performance on a risk-adjusted basis. To create index funds to track the performance of the specific market series over time. To examine factors that affect aggregate market movements. To help technicians predict future market movement. As a proxy for the market portfolio to calculate the systematic risk of an asset.

In call markets, securities are traded at specific times at a single price after bids and offers have accumulated, while in continuous markets trading takes place at various prices and times as bids and offers for the securities arrive.

Stock exchanges are physical places where traders/dealers gather to trade with each other; the over-the-counter (OTC) market is a network of dealers (called market makers) in various locations who stand ready to purchase or sell securities at posted prices.

Exchange markets have members with different roles (specialists, commission brokers, floor brokers and traders), and the types of orders are market orders, limit orders, stop (loss) orders, and short sales.

Selling short refers to borrowing securities and selling them at the market price in an attempt to profit by buying (and returning) the securities at a lower price in the future.

A short seller may only sell on an uptick, must pay any dividends to the lender of the securities as they are due, and must deposit collateral to provide funds for any losses (if share price goes up) on the short position.

In a margin transaction, investors can borrow against securities in order to purchase them, leaving the securities at the brokerage house as collateral for the loan.

The rate of return on a margin transaction is calculated as the profit or loss on the security position divided by the equity or margin deposited to make the trade (the cost of the position minus the margin loan).

The maintenance margin percentage (typically 25 percent) is the minimum that the equity in a margin account can reach before the deposit of more funds is required.


41

It is an arithmetic average of current prices. Index movements are influenced by the differential prices of the components. Limitations: 1. Limited sample size 2. Not adjusted for stock

split or stock dividend. 3. Downward bias.

Types of Indexes

Price-Weighted Market-ValueWeighted

Unweighted

It is generated by deriving the initial total market value of all stocks used in the series. The importance of individual stocks in the sample depends on the market value of the stocks. There is an automatic adjustment for stock splits and other capital changes in this series. Limitation: Dominated by large-cap shares.

All stocks carry equal weight regardless of their price or market 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. Limitation: Downward bias.


42

Technical Analysis 1. The market value of any good or service is determined solely by the interaction of supply and

demand. 2. Supply and demand are governed by numerous factors, both rational and irrational. 3. The prices for individual securities and the overall value of the market tend to move in trends, which

persist for appreciable lengths of time. 4. Prevailing trends change in reaction to shifts in supply and demand relationships and these shifts can

be detected in the action of the market Advantages: Fundamental analyst must process new information and quickly determine a new intrinsic value, but

technical analyst merely has to recognize a movement to a new equilibrium Technicians trade when a move to a new equilibrium is underway but a fundamental analyst finds

undervalued securities that may not adjust their prices as quickly Trading rules The past may not be repeated Patterns may become self-fulfilling prophecies A successful rule will gain followers and become less successful Rules all require subjective judgement Types: Contrary-Opinion (behavioral finance the majority is always wrong) Smart Money (efficient market follow the insiders) Stock Price and Volume Techniques (chartists known patterns, e.g Candlesticks, Breadth,

Resistance & Support) breadth & reversal

Weak form asserts that stock prices already reflect all information that can be derived by examining market trading data such as the history of past prices and trading volume. Empirical evidence supports the weak-form. A strong body of evidence supports weak-form efficiency in the major U.S. securities markets. For example, test results suggest that technical trading rules do not produce superior returns after adjusting for transaction costs and taxes.

Holds that a firm's stock price already reflects all publicly available information about a firm's prospects. Empirical evidence mostly support the semi-strong form Evidence strongly supports the notion of semi-strong efficiency, but occasional market anomalies including the small-firm effect and the January effect) and events (e.g.,) stock market crash of October 1987) are inconsistent with this form of market efficiency. Anomalies: Calendar Effect Size effect Neglected Firm effect Value Line Investor

Holds that current market prices reflect all information, whether publicly available or privately held, that is relevant to the firm Empirical evidence suggests that strong-form efficiency does not hold. If this form were correct, prices would fully reflect all information, although a corporate insider might exclusively hold such information. Therefore, insiders could not earn excess returns. Research evidence shows that corporate officers have access to pertinent information long enough before public release to enable them to profit from trading on this information. Active fund managers may not be able to consistently outperformed the market, primarily due to transaction costs.

Efficient Market Hypothesis

Weak Form Semi-Strong Form Strong Form


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STUDY SESSION 14 EQUITY INVESTMENTS

Dividend payout ratio

Value = ( )

gkgD

e +10

Market Analysis

Industry Analysis

3 generic strategies Cost leadership, Differentiation & Focus

Life Cycle Pioneering, Growth, Maturity, & Decline

5 Competitive Forces Rivalry, New Entrants, Substitutes, Bargaining Power of Suppliers, and Buyers

Sales Forecast

Earnings Forecast

Degree of Total Leverage (DTL) = Degree of Operating Leverage (DOL)

DOL = EBIT

FCEBIT + x Degree of Financial Leverage (DFL)

DFL = CostsFinanceEBIT

EBIT

DTLHistorical growth rate

Sustainable growth rate

Substituted market (GDP) or industrial growth rate

g = (1 div payout) x ROE

EquityAssetsT

AssetsTSales

SalesNIROE .

.=

( )taxEquity

AssetsTAssetsT

ExpIntAssetsT

SalesSalesEBITROE

= 1.

..

CAPM: Ke = Rf + e[Rm Rf]

APT: Ke = Rf + 1F1 + 2F2 + ..+ NFN + e

Adjust for abnormal growth using: 2-stage 3-stage

equity = asset [ 1 + D(1-t)/E]

RELATIVE VALUATION MODELS

Price-to-Earnings (P/E) Ratio

A method of comparables Popular as a momentum

indicator Earnings power is a chief

driver of investment value It is recognized and applied

widely Differences in P/Es may be

related to differences in long-run average returns.

Price-to-Book Value (P/B)

Price-to-Sales (P/S) Ratio

Price-to-Cashflow

Book value is generally positive. Book value is stable. Appropriate for companies

composed mainly of liquid assets Where the going concern

assumption is questioned. Differences in P/B may be

related to differences in long-run average returns.

Sales less subject to distortion or manipulation. Sales are positive even

when EPS is negative. Sales are more stable.

More appropriate for valuing mature, cyclical, and zero-income companies.

Cash Flow is less subject to manipulation than earnings. Cash flow is

generally more stable than earnings. Better indicators as

earnings quality.


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Debt Investments Study Session 15: Basic Concepts Study Session 16: Asset Valuation

Types of Bonds

Government Corporate Agencies/Munis Collaterized

Option-free Option-embedded T-Bills T-Notes T-Bonds TIPS Treasury Strips

Coupon Strip and Principal strip

Bullet bonds (Straight / Regular)

Floaters Step-Up / Step-

down Revenue bond Income Bond

(binary payment) Ratchet

Callable bond (Issuer has the right to call)

Putable bond (Investors have the right to put)

Convertible bond (Investors have the right to convert)

Revenue bond (project financing)

General Obligation bond

Insured bonds and prefunded bonds

Asset-backed securities via Special Purpose Vehicle.

Collaterized Mortgage Obligation (CMOs)

Credit enhancement (external or internal)

5 Bond Theorems: Bond Price 1/ YTM Price Term-to-maturity at a diminishing rate Price 1/Coupon Rate Bond Price = convex

Interest Rate Risk. Interest rate risk = Price Effect + Reinvestment Risk (r) Risk (coupon) Duration = Price Reinvested amount Price = -MD(r) + Convexity(r)2 Where MD = Modified Duration = Duration / (1 + YTM)

Credit Risks Default Risk / Bankruptcy risk [Credit ratings] Downgrade Risk Credit Spread Risk [Widening and Narrowing]

ELEMENTS OF CORPORATE CREDIT ANALYSIS

The four Cs of credit: Character management & leadership quality Capacity cash flow, the source of repayment Collateral security pledged Covenants agreements to alter borrowers behavior ANALYSIS OF COVENANTS Affirmative covenants to pay interest, principal, and premium, if any, on a timely

basis to pay all taxes and other claims when due unless contested

in good faith to maintain all properties used and useful in the borrowers

business in good condition and working order to submit periodic certificates to the trustee

Negative covenants limitations on the companys ability to incur debt limits on the absolute dollar amount of debt that may be

outstanding require a ratio test

Interest rate

Price


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Option-Embedded Risk

The Term Structure and the Volatility of Interest Rates

Term Structure of Interest Rates:

Term-to-maturity

Yield Curve Types: Upward favorable economy Downward adverse economy Hump Back

Yield Curve risk happens when it changes unexpectedly flattening or steepening.

r

regular bondregular bond

callable bondcallable bond

strikestrike

Do NOT use Macaulays duration. Use Effective Duration and Effective Convexity.

r

regular bond

putable bondputable bond

Callable bonds will encounter negative convexity should interest rates decline. Putable bonds will have higher values should interest rates increase

Use the YTM of on-the-run zero-coupon Treasury bonds to compute the spot rates

Theories on the Term structure of interest

rate

Liquidity premium theory Investors require a premium for investing in longer-termed bonds for bearing liquidity risk.

Pure Expectations theory The spot rates shall be in parity with the forward rates provided by the financial institutions. Thus, it reflects the economic forecast of the country.

Segmentation / Preferred Habitat theory Long-term investors comprise of a different profile from mid-term and short-term investors. The yield curve reflects the demand and supply of each segment.

Reinvestment > Realized &g

1. master revision cfa level i

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