1.

Ethics: Guidance for Standards I - VII

I. Professionalism
A. Knowledge of the law - follow strictest applicable law, including CFA standards
B. Independence and objectivity - only gifts for past performance and disclosed to boss, need employer consent for
gifts for future performances (cant ask for gifts & company visits paid by employees)
C. Misrepresentation - no performance promise & plagiarism (unless from recognized stat organization)
D. Misconduct - lie, cheat, steal, past bankruptcy due to fraud check references & inform violation consequences
II. Integrity of capital markets
A. Material nonpublic information - must prevent inside trade on nonpublic info that can affect stock price but
limited service across Chinese wall is allowed & can use nonmaterial/ irrelevant info combined with analysis
B. Market manipulation
III. Duties to clients
A. Loyalty, prudence, and care - place client before employer or own interest
B. Fair dealing - to all clients, clients with more interests & have to inform client recommendation changes before
executing order, give up own & immediate family for oversubscribed issue
C. Suitability - advisor needs to analyze suitability before recommending
D. Performance presentation - consider financial literacy of client & reasonable effort is fine & can use managers
previous track record at diff firm
E. Preservation of confidentiality - client info confidential to irrelevant ppl (unless its illegal to authority)
IV. Duties to employers
A. Loyalty - cant take property without consent but can contact clients (if no non-compete agreement) & can do
non-competing work outside work hours informing employer everything
B. Additional compensation arrangements - no gifts unless has written (email) consent from all parties
C. Responsibilities of supervisors - responsible to detect & prevent employees from violating rules
V. Investment analysis, recommendations and action
A. Diligence and reasonable basis - responsible for research & dont need disassociate from group recommendation
B. Communication with clients and prospective clients - distinguish opinions from facts
C. Record retention - maintain all records that were used (least 7 yrs)
VI. Conflicts of interests
A. Disclosure of conflicts
B. Priority of transactions - client > employer > personal
C. Referral fees - disclose to employer and clients for referral gifts, $ & benefits
VII. Responsibilities as a CFA Institute Member or CFA Candidate
A. Conduct as members or candidates in CFA program - cant talk about test but can say bad things
B. Reference to CFA institute, designation & program - candidate after register, CFA cant be bigger than name

Global Investment Performance Standards (GIPS)

Must:
Follow local law & disclose conflicts in GIPS presentation
Total firm value = fee paying + non-fee paying + discretionary + non-discretionary
Present GIP-compliant results for min 5 yrs or since firm inception & min 10 yrs total performance history
A composite (US Growth Stocks) must include
All discretionary & fee-paying portfolios (current & past) that firm managed until 5 yrs after discontinue
Assigned to composite beginning of the year
Asset weighted (not equal-weighted)
Recommend:
Verification is performed by independent 3
rd
party on firm-wide, all-regional basis
Definition of firm include offices in all countries
9 sections:
Fundamentals of compliance Presentation & reporting
Input data Real estate
Calculation methodology Private equity (VC, closed-end, mezzanine finance)
Composite construction Wrap fee/separately managed account portfolios
Disclosures



2. Quantitative: Time Value of Money

Required rate of return = real Rf + expected inflation + default risk premium + liquidity premium + maturity risk
Nominal Rf = real Rf + expected inflation rate
Effective annual rate - return after adjust for compounding
n compounding periods EAR = (1 +

)
n
-1
Continuous compounding periods EAR = e
stated annual rate
- 1
Annuity due CF occur at beginning of each period

Period Beginning
Balance
Payment Interest
Component
Principal
Component
Ending Balance
1 10,000 2,638 1,000 1,638 8,362
2 8,362 2,638 836 1802 6,560
3 6,560 2,638 656 1982 4,578
4 4,578 2,638 458 2,180 2,398
5 2,398 2,638 240 2,398 0

Discounted Cash Flow

Measuring portfolio performance
Money-weighted rate of return = IRR of investment portfolio
Time-weighted rate of return (preferred) = [(HPR1) (HPR2) (HPR3)]
1/3

Yield calculations
BEY (bond-equivalent yield) = 2 * semiannual YTM
RBD (bank discount yield) for T-bills =


*

not true yield bc based on face value

HPR or HPY (holding period return or yield) =


- 1
RMM (money market yield) = HPR *

annualized 360 day no compounding

EAY (effective annual yield) = (1+HPR)
365/t
- 1 annualized 365 day yes compounding
Semiannual YTM = (1+EAY)
1/2
-1

Statistical Concepts

Descriptive statistics (states characteristics) vs. Inferential statistics (make statements based on samples)
Population (all) vs. Sample (subset)
Data can be measured using diff scales:
Nominal scale - categories with no rank
Ordinal scale - category with rank
Interval - differences in data values are meaningful
Ratio - numbers/ratios of values are meaningful group 4 = twice group 2
Parameter - characteristic of a population
Frequency distribution - groups observations into intervals
Relative frequency - observations within interval
Cumulative relative frequency - observations equal or less than intervals max value
Histogram & Frequency polygon
Easily see where most observations lie
Arithmetic mean - forecasting single period return in future
Geometric mean - forecasting compound returns for multiple periods in future
Weighted mean - weights according to % of influence
Harmonic mean - average cost of shares purchased =

Quantile
Quartiles
Quintile
Decile
Percentile
Locationy = (n+1)

3
rd
quartile in 20 # L = (21)

= 15.75
th
smallest to largest #
3
rd
quartile = point below 75% of observations
MAD (mean absolute deviation) - average of deviations from mean =

Coefficient of variation - dispersion of observations (low = better) =



SR (sharpe ratio) - reward over risk (high = better) =
-

Skewness
Positive - to the right = mode < median < mean (outliers pull mean to right)
Negative - to the left (more risky) = mean < median < mode (outliers pull mean to left)
Sample skewness =

Kurtosis
Leptokurtic - peaked & fat tail (more risky) = excess kurtosis > 0
Platykurtic - flatter & thin tail = excess kurtosis < 0
Mesokurtic
Excess kurtosis = sample kurtosis - 3
Sample kurtosis =

Chebyshevs inequality - when cant assume normal distribution
y% of observations with lie within x SD of the mean
y = 1-

Probability Concepts
Random variable - uncertain value determined by chance
Outcome - realization of a random variable
Event - set of 1 or more outcomes
Mutually exclusive events - cant both occur
Exhaustive set of events - include all possible outcomes
3 kinds of probabilities:
Priori probability - based on well-defined inputs or logical analysis
Empirical probability - based on past data, observations or experiments
Subjective probability - based on guess
Odds for event =

Odds against event =

Both A & B will occur P(AB) = P(A|B) * P(B) or P(A) * P(B)
At least 1 event will occur P(A or B) = P(A) + P(B) - P(AB)
A will occur given different conditions P(A) = P(A|B1) * P(B1) + P(A|B2) * P(B2) + P(A|B3) * P(B3)
Where Bi is set of mutually exclusive & exhaustive events
Variance of A - how A moves with itself Var (A) =

Covariance of A&B - how A moves with B Cov (A,B) = ( )

Cov (A,B) = ( )

Correlation between A&B A,B =



Variance of 2-asset portfolio Var (Rp) = w1
2
1
2
* w2
2
2
2
+ 2w1w2 12 1,2
Var (Rp) = w1
2
1
2
* w2
2
2
2
+ 2w1w2 cov(1,2)
Combinations - order doesnt matter

# ways of choosing r out of n
Permutations - order matter

# ways of choosing r out of n

Common Probability Distributions

Probability distribution - lists all outcomes of an experiment with their probabilities
Discrete random variable - finite # of outcomes
Discrete uniform distribution - n equal-likely outcomes
Binomial distribution - 2 outcomes
If probability of success is S, probability of x success in n trial is = nCx * P
x
* (1-P)
(n-x)

Expected value of X = n*p
Variance of X = np(1-p)
Continuous random variable - infinite # of outcomes (0 probability for single value)
PDF (probability density function) - probability it will fall in a range
CDF (cumulative distribution function) probability random variable is less than or equal to specific value
Tracking error - portfolio return minus benchmark (index) return
Univariate (distribution of 1 random variable) vs. Multivariate (distribution of group of random variables)
Normally distributed random variable:
Completely described by mean & variance
Continuous & not discrete
Skew = 0
Kurtosis = 3
Confidence intervals:
68% = mean 1

90% or Z0.1/2 = mean 1.65

95% or Z0.05/2 = mean 1.96

99% or Z0.01/2 = mean 2.58

Z-value - # of SD from the mean =

Lognormal distribution - used to price asset prices bc it has minimal value of 0
Roys safety-first ratio (with target return Rt) =

Higher = minimize shortfall risk
Shortfall risk = F(- safety-first ratio)
Continuously compounding:
Continuously compounded rate (Rcc) = In(1+HPR)
HPRT = e
Rcc*T
- 1
Historical simulation:
Use past changes
No consideration of significant events that did not occur in past
Monte Carlo simulation:
Repeated generation of risk factor to produce distribution of security values
Complex & depends on assumptions
Cant provide insights that analytic methods can


Sampling & Estimation

Simple random sampling
Selecting a sample to represent a population
Each item has same probability of being included
Systematic sampling - selecting every nth item from population
Sampling error - diff between sample (mean, variance, SD) & population (mean, variance, SD)
Sampling distribution - probability distribution of a statistic from many samples
Stratified random sampling - use classification system to separate population into smaller groups
Time-series data - observations taken at equally spaced time
Cross-sectional data - observations taken at 1 time
Central limit theorem:
Population with mean () and finite variance (
2
)
All sample for n 30 will be normally distributed with mean () & variance (

) & SD (

)
Standard error of sample mean - SD of distribution of diff sample means Xmean =

Confidence interval for true parameter = point estimate (reliability factor * standard error)
Point estimates - single value estimates of population parameters computed from a formula
Confidence interval - range of values which population is expected to lie

When sampling from a: Small sample (n<30) Large sample (n>30)
Normal distribution with known variance z-statistics z-statistic
Normal distribution with unknown variance t-statistics t-statistics
Nonnormal distribution with known variance NA z-statistics
Nonnormal distribution with unknown variance NA t-statistics

T-distribution - flatter with fatter tails
Small sample (n < 30) or normal distribution
Unknown variance
df (degree of freedom) = n -1
90% or T29, 0.1/2 = mean 1.699

95% or T29, 0.05/2 = mean 2.045

99% or T29, 0.01/2 = mean 2.462

T-statistics > critical t = reject null hypothesis
Desirable estimator properties:
Unbiasedness - estimation error is random expected value = true value
Data mining - significant relationship occurred by chance
Sample selection bias - selection is non-random
Look-ahead bias - data not available at that time
Survivorship bias
Time-period bias - not hold overtime too short or too long
Efficiency sample size less than unbiased estimator
Consistency - variance of sampling error decreases with sample size


Hypothesis Testing

Null hypothesis hypothesis the researcher wants to reject & is being tested
Alternative hypothesis researcher wants to accept
One-tailed test test whether value is greater than or less than a number
Two-tailed test test whether a value is equal to a number

Type I error reject of null hypothesis when its true
Type II error fail to reject a false null hypothesis
Significance/ Confidence level
95% confidence interval - 5% significance level
Probability that a test statistic will reject null by chance when it is actually true (Type I error)
Reject null if confidence level > P-value
Reject null if Z-statistics computed > Z-critical (based on significance level)
Power of test successfully rejecting null when its false [1 - P(Type II)]
P-value
Probability null hypothesis is true
Smallest significance level which hypothesis would be rejected
Chi-square variance of 1 population
F-statistics variance of 2 normal population


Technical Analysis
Technical analysis benefits:
Observable
Price assets with no future CF
Technical analysis assumptions:
Prices determined by investor supply & demand for assets
Supply & demand are driven by both rational & irrational behavior
Actual shifts in supply & demand can be observed in market prices
Prices move in trends & patterns that tend to repeat over time
Chart patterns:
Upward trend (increasing lows) vs. Downward trend (decreasing highs)
Change in polarity principle:
Breached resistance lvl become support
Breached support lvl become resistance lvl
Reversal pattern - head and shoulders pattern, double top & triple top
Continuation patterns - triangles, rectangles, flags & pennants
Relative strength analysis - price against benchmark
Price-based indicators:
Moving average lines - mean of last n prices
Bollinger bands - SD of last n prices
Bands move closer with less volatility
Bands move further with more volatility
Buy at low band & sell at high band
Momentum oscillators - high oscillator is overbought
Relative Strength Index - ratio of price increases to price decreases
Moving average convergence lines - moving averages lines
Rate-of-change oscillators - 100 times diff between closing price & price n period earlier
Stochastic oscillators - latest price & highest or lowest prices reached recently
Used to identify changes in price trends, overbought & oversold markets
Sentiment indicators:
Contrarian indicator:
Put/call ratio
Volatility index
Short interest ratio
Margin debt outstanding
Opinion polls
Some believe market move in cycles:
Presidential election - 4 year
Decennial patterns - 10 year
Kondratieff wave - 54 year
Elliot wave theory:
5 waves to a trends (impulse wave)
3 waves against the trend (corrective wave)
Analysts use ratios from Fibonacci sequences to estimate price/ support/ resistance
Intermarket analysis - study relationships between diff asset markets
Relative strength analysis is used in asset allocation
3. Economics: Elasticity

% =



Price elasticity of demand =


Cross elasticity =



More demand elastic:
More substitutes
Greater proportion of income spent on the good
In the long run (after price change)
Income elasticity of demand =



Negative - inferior good
Positive - normal good
0 - 1 - necessities
Greater than 1 - luxuries
Price elasticity of supply =



More supply elastic:
Resources used are not rare
Easy to produce good
In the long run
Along straight line demand curve:
Revenue is max when demand is unit elastic (price elasticity = -1)
Higher price - demand more elastic
Lower price - demand less elastic


Efficiency & Equity

Resources allocation by:
Market
Command system - central authority
Majority rule
Contests, first-come-first-served, lotteries, personal characteristics, force
Efficient allocation is when MB = MC
Greatest consumer surplus & producer surplus total
Deadweight loss = reduction in surplus
Obstacles to efficient allocation:
Price control
Tax & trade restrictions
Monopoly
External costs or benefits
Public good or common resources
Utilitarianism
Create greatest good for society
Transfer of wealth from rich to poor so everyone has same wealth
But will cause rich to work less & tax is inefficient
Symmetry principle
Similar people should be treated similarly
Fair opportunities & rules lead to fair outcomes


Markets in Action

Price ceiling - below equilibrium
Rent control
Price floor - above equilibrium
Minimum wage
Statutory incidence of tax - who legally pay tax
Actual incidence of tax:
Buyers pay more - demand is less elastic
Sellers pay more - supply is less elastic


Organizing Production

Accounting profit = only explicit cost
Economic profit = both explicit & implicit cost
Explicit - measurable costs
Implicit - opportunity costs
Implied rental rate - economic depreciation & foregone interest
Normal profit - opportunity cost of owners entrepreneurship
3 constraints on profit maximization
Cost of technology
Cost of information
Characteristics of the market
Efficiency
Technological efficiency - using least amount of input
Economic efficiency - using least cost so must be technological efficiency
Principal-agent problem
Ownership interest, incentive pay, long-term employment are used to reduce it
3 business organization
Proprietorship - business with single owner
Partnership - 2 or more owners
Corporation - legal entity owned by stockholders with limited liabilities & double tax on dividends
Market concentration - smaller = more competitive
Four-firm concentration ratio - sum of % market share of 4 largest firm (below 40% is competitive)
Herfindahl-Hirschman Index - sum of squared market share of 50 largest firm (greater than 1800 is not
competitive)
But not accurate due to:
Geographic scope
Barriers to entry & firm turnover
Market vs. industry differences


Output and Costs

Total product of labor
MPL - marginal product is at max when MC is at min
APL - average product is a max when AVC is at min
Total cost
AFC - slopes downward then flattens
AVC - declines first then increases
Min AVC occur before min ATV
MC intersect AVC & ATC at min
Law of diminishing returns:
Diminishing returns to labor
Diminishing returns to capital
Diseconomies of scale can occur due to inefficiencies with larger firms


Perfect Competition

Perfect competition:
Demand curve for individual firm are horizontal (perfectly elastic)
Homogeneous products
Many independent firms
Each seller is small
No entry or exit barrier
Max profit at MR = MC = Price = ATC
Short-run supply curve is MC above AVC
Long-run supply curve slopes down for economies of scale
Long-run supply curve slopes up for diseconomies of scale
Long-run economic profit = 0 because no entry or exit barrier
Firm should operate if price > AVC but temporarily < ATC
Firms should shut if price < AVC
Firm should shut if price always < ATC
Economic loss when price < ATC


Monopoly

Monopoly
Demand curve is downward sloping
One seller of specific product
High barrier of entry from economies of scale (MC < ATC), resource control, legal license or patents\
Rent seeking - try to become monopoly
Max profit at MR = MC
Search for profit-max price in the elastic range of demand curve
Price discrimination (diff price for diff people)
At least 2 identifiable groups with
Downward sloping demand curve
Different price elasticity of demand
No re-selling
Perfect price discrimination = producer get all consumer surplus
Non-perfect price discrimination leads to DWL
Regulations:
AC pricing - price = ATC
MC pricing - price = MC but require subsidy


Monopolistic Competition & Oligopoly

Monopolistic competition
Many sellers of differentiated products
Compete on price, quality & marketing for differentiation
Low barriers to entry
Max profit at MR = MC and eventually = ATC
Long-run economic profit = 0 because low barriers to entry
Oligopoly
Few sellers of similar or diff products
Interdependence among competitors (game theory)
High barriers to entry from economies of scale
Kinked demand curve
Price decrease will cause competitor price decrease
Price increase will not cause competitor price increase
Demand is elastic for price increase not for price decrease
Dominant firm model:
Low-cost producer set price
High-cost producer take as given
Collusion or form cartel = work together as if monopoly (P & Q) but cheat to their own profit


Markets for Factors of Production

Max profit at MRP = price of labor or wage
Demand for factors of production is derived from the demand for the products
Increase in demand:
Increase in product price
Increase in substitute resource price
Decrease in complementary resource price
Greater elasticity of demand for labor:
Longer adjustment period
Greater proportion of labor in production
Other factors can substitute for labor
Supply of labor increase with wage increase
Substitution effect - labor substitute for leisure
Income effect - worker demand for leisure with higher income
Labor union
Collective bargaining - cut supply by go on strike
Institute training program to increase productivity
Encourage consuming domestic goods
Limit import competition
Limit immigrant labor
Increase min wage for unskilled worker
Monopsonist - only employer in a area
Hire until MRP = MC
DWL from underemployment
Physical capital vs. financial capital
Firm will buy more physical capital when PV of MRP > cost of financial capital to buy it
Equilibrium interest rate
Demand for financial capital
Supply from savers depending on
Interest rate
Current income
Future income
Natural resources:
Nonrenewable - perfectly elastic supply @ P = PV of expected next period price
Hotelling principle - price rise at risk-free rate
Renewable - perfectly inelastic supply
Economic rent = laborers supplier surplus
Economic rent = income - opportunity cost (next jobs income)


Monitoring Jobs & the Price Level

Unemployed:
Available to work
Seeking work or waiting for new job to start
Cyclical - recession
Frictional - takes time for employers to find employees
Structural - economic change requiring workers to gain new skills or find new jobs
Unemployment rate =


* 100
Labor-force participation rate =

-
* 100
Employment-to-population ratio =

-
* 100
Full employment
0 cyclical unemployment
Frictional & structural are natural rate of unemployment
Aggregate hours- total # hours worked by all employed people in a year
Real wage rate - wage adjusted for price level
Consumer price index
CPI =


* 100 Real int rate = Nominal int rate - Exp inflation
Inflation % =
-

* 100
Overstate inflation by 1% per year
New goods & better quality
Outlet substitution


Aggregate Supply & Aggregate Demand

LR AS
Vertical at potential (full-employment) real GDP
Increase with more labor force, capital & technology
AS & AD adjust back to LR AS
AD = consumption + investment + govt spending + net export
Increase with more income, lower exchange rate & higher inflation expectation
Monetary & fiscal policies
Classical:
Wage will adjust to full-employment
Keynesian:
Wage is downward sticky
Need fiscal & monetary policies to boost economy to full-employment
Monetarists:
Economic cycles are caused by bad monetary policy
Steady increase in money supply & low tax = max GDP growth


Money, Price Level & Inflation

Money
3 functions
Medium of exchange
Unit of account
Store value
M1 - currency, travelers check & check deposits
M2 - M1 + time deposits, savings & money market mutual funds
Depository institutions - lending savers $ to borrowers:
Commercial banks
Thrift institutions
Money market funds
Federal Reserve:
Assets - Treasury, gold, IMF drawing rights & loans to banks
Liabilities (monetary base) - US currencies & banks reserve deposits
in quantity of money = change in monetary base (open market transaction) * money multiplier
Money multiplier =



c = currency as % of deposits
r = desired required reserve ratio
Fractional reserve banking system
Bank hold % as required reserves & lend out excess reserves
Required reserve ratio
Demand for money
Increase with real GDP & price level
Increase with lower ST interest rates
Decrease with credit card & ATM
Quantity theory of money
MV = PY
Money supply * velocity = price * real GDP or nominal GDP
GDP growth & money velocity are constant
Increase in money supply = increase in prices


US Inflation, Unemployment & Business Cycles

Inflation - persistent increase in price of almost all goods
Demand-pull - increase in AD & money supply
Cost-push - unexpected decrease in AS
Reduce GDP
Higher money supply growth rate = higher expected inflation = higher nominal interest rates
Phillips curve Unemployment = inflation
Short-run - inverse relation between unexpected inflation & unemployment
Long-run - unemployment independent of inflation
Move along SR curve - unexpected change in inflation
Shift of SR curve - expected
Business cycles
High GDP growth, inflation & low unemployment
Low GDP growth, low inflation & high unemployment
Mainstream business cycle theory - potential real GDP increase steadily but has variations in AD
Real business cycle theory - change in productivity growth lead to change in GDP growth


Fiscal Policies

Laffer curve
High tax = disincentive to work
So total tax revenue falls even with high tax rate
Investment (part of GDP)
National or personal savings = investments
Borrowing from foreigners
Government savings = govt tax revenue - govt expenditure
Capital income tax decrease private savings & investments
Crowding-out effect
Budget deficit = increase interest rate = lower private investments
Ricardo-Barro effect
No crowding-out effect because private saving increase
Generational effect - postpone tax & burden to future generation
Balanced budget multiplier = +ve multiplier because Govt expenditure multiplier > Tax multiplier
Discretionary fiscal policy - stabilize economic cycles but difficult to time due to lags:
Recognition lag
Law-making lag
Impact lag
Automatic fiscal stabilizers with no timing problem:
Induced taxes - less tax during recession
Need-tested spending - more & paid out during recession
Actual surplus/deficit = structural surplus/deficit + cyclical surplus/deficit (real GDP = potential GDP)


Monetary Policies

Goals of the Fed:
Full employment
Stable inflation
Moderate LT interest rate
Fed focuses on:
Core inflation (without food & energy prices)
Output gap (actual & potential GDP growth)
The Fed use open market operations by buying Treasury to increase bank reserve, money supply and decrease federal fund
rate:
Fed buys Treasury which increases bank reserve
FFR decreases as banks are more willing to lend their reserves
Other rates decreases and increase supply of money
LT rates also decrease and consumption increase
Dollar depreciate and export increase
Increase in AD increase inflation & GDP
To determine how to adjust FFR:
Instrument rules
Base FFR on current economic performance
Taylor rule FFR = 2% + actual inflation + 0.5 (actual inflation - 2%) + 0.5 (output gap)
Targeting rules
Base FFR on forecast of future inflation
Four alternatives rejected by the Fed:
McCallum rule - steady growth rate of monetary base
Friedman - money supply grow with GDP
Maintain stable exchange rate by controlling money supply
Inflation targeting - set inflation expectation as target rate


Overview of Central Banks

Central bank
Manage countrys money supply to maintain price stability, max employment & GDP
Issue currency & regulate banks
3 tools:
Open market operation to increase/decrease money supply
Increase/decrease bank reserve requirement
Increase/decrease the interest rate at which they lend to member banks




4. FSA: Financial Reporting Mechanics & Standards

Financial reporting - provide users with useful info about companys financials
Financial statement analysis - use data from statements to support economic decisions
6 steps of framework for financial analysis does not include client investment suitability
State objective of the analysis
Gather data
Process data
Analyze & interpret data
Report conclusion or recommendation
Update the analysis
Income statement shows results of business activities, P&L over a period
Revenue
Sales, interest income, dividend, investment income, dividend received, gains (non-recurring)
Expenses
COGS, SG&A, depreciation & amortization, interest, taxes, losses (non-recurring)
Balance sheet shows assets, liabilities & OE at a point in time
Assets - current & future economic benefits, economic resources, unexpired expenses
Cash, AR, prepaid expenses, accumulated depreciation (PPE), allowance for bad debt (AR), investment in
affiliates, deferred tax assets, intangible assets
Liabilities - future economic costs, creditors claim on firms resources
AP, unearned revenue, income tax payable, LT debt, deferred tax liabilities
OE = Asset - Liabilities
Paid-in capital (common & preferred stocks), retained earnings, cumulative other comprehensive income
(FX, unrealized gain & loss)
Cash flow statement shows sources & use of cash over a period
Operating - normal business transactions
Investing - acquisition or sale of PP&E, subsidiary, securities, investments in other firms
Financing - issuance or retirement of firms debt & equity, dividends
Statement of change in OE shows amount & sources of change in equity owners investment in the firm
assets = liabilities + contributed capital + beginning retained earnings + revenue - expenses - dividends
Other info include companys quarterly & semiannual reports, proxy statements (shareholder vote, compensation), press
releases, external report on industry & peers
Contra accounts - entries that offset values of another account (equipment & accumulated depreciation)
Accruals - revenue & expense recognized when transactions occur, not when cash is exchanged
Going concern - assumption that company will continue to exist for the foreseeable future
Information enters an accounting system as journal entries
General journal lists all transactions by date
General ledger lists them by account
Trial balances are formed at the end of an accounting period
Accounts are then adjusted & presented in financial statements.
Footnotes & supplementary schedules - info about accounting methods, estimates & assumptions, segment results,
commitments & contingencies, legal proceedings, acquisitions or divestitures, issuance of stock options, details of employee
benefit plans
Managements Discussion & Analysis - overview of company, business trends, future capital needs, liquidity, significant
events, choice of accounting methods
Audits - provide opinion on annual statements fairness & reliability appointed by board and audit committee
Give independent review & verification of statements & internal control
Unqualified (clean) opinion - fair representation
Qualified opinion - statement makes exception to accounting principles so its explained in audit report
Adverse opinion - presented unfairly
Management is responsible for maintaining good internal control system to ensure financials accuracy.
Sarbanes-Oxley Act - management of public companies in US needs to report their internal control, a description of the
method used to evaluate their effectiveness over accounting period
Reporting standards - ensure different firms statements are comparable to each other & sets standards
FASB/ GAAP - distinguishes between objectives for business & non-business entities and establishes hierarchy of
qualitative characteristics
IASB/ IFRS - requires users to consider framework in absence of specific standard & more accrual/ going concern
The IFRS Framework
Qualitative characteristic - understandability, relevance, reliability, comparability
Required reporting elements - assets, liabilities, OE, income & expenses
Constraints - timeliness, benefit vs. cost & balance between qualitative characteristics
Underlying assumptions - accrual basis & the going concern assumption
Standard-setting bodies
FASB - US
IASB - International
Regulatory authorities - government agencies that enforce reporting standards
SEC (Securities and Exchange Commission) - US
FSA (Financial Service Authority) - UK
IOSCO (Ioknternational Organization of Securities Commissions)
Companies that trade in US must reconcile to GAAP
One universal set of reporting standards
Yes - firms
No - standard-setting bodies & regulatory authorities & political pressure from business groups
Under both GAAP & IFRS, companies must disclose their accounting practices and estimates in the footnotes and MD&A
IAS No. 1(International Accounting Standard) states that:
Principals for preparing statements - fair, going concern basis, accrual basis, consistency between periods,
materiality
Principals for presenting statements - aggregation, no offsetting, classified balance sheet, minimum required info,
comparative info
Coherent financial reporting framework shows:
Transparency, comprehensiveness & consistency
But barriers include issues of valuation, standard setting & measurement


Understanding the Income Statement

Revenue is recognized when earned
Revenue recognition for LT contracts include:
Percentage-of-completion - recognizes revenue in proportion to costs
Completed-contract - recognizes revenue when contract is complete but loss recognized immediately
Revenue recognition for installment sales (payments expected to be received over extended period) include:
Highly certain - normal revenue recognition at time of sale when good shopped & delivered
Not certain - installment sales method - profit recognized as cash is collected (profit margin of sales)
Highly uncertain - cost recovery method - profit recognized only when cash collected exceeds costs
incurred (first few collections are applied to cost recovery)
Revenue from barter (exchange of goods without money) transactions - only recognized if its market price can be
estimated from historical data on similar non-barter transactions
IFRS
Cost reliably measured
Assurance of payment
Significant risk & reward transferred
Expense is recognized when incurred
Matching principle - COGS recognized in same period as the revenue it generated
Period costs - administrative overhead & depreciation of fixed assets
Gross & net revenue reporting:
Gross revenue reporting - firm reports sales revenue & expense
Net revenue reporting - firm only reports revenue which is the profit and no expense
Under GAAP, firm must be selling agent with no inventory stocking, take credit risks and have control
over supplier & price
Depreciation methods:
Straight-line - equal amounts of depreciation
Declining balance (DB) - constant rate of depreciation to the declining BV until equals residual value
Amortization methods for intangible assets:
Limited life - amortized reflecting their economic benefits
Indefinite lives - not amortized (goodwill)
Inventory valuation methods:
FIFO
COGS = oldest purchase
Ending inventory = newest purchase
Appropriate for goods with limited shelf life
LIFO - (only GAAP)
COGS = newest purchase
Ending inventory = oldest purchase
Widely used in US bc of tax advantage but not allowed under IFRS
Average cost - both COGS & ending inventory = average unit cost
Specific identification - each item in inventory is identified & COGS = historical cost
Operating income:
Non-financial firms - firms normal business operation
Financial firms - Income from investing & financing transactions
N on-recurring items:
Unusual OR infrequent items (gain or loss, impairment, write-offs, write-downs, restructuring cost) - reported
before income from continuing operations & tax
Extraordinary items, both unusual & infrequent (uninsured loss from natural disaster, gain or loss from early
retirement of debt) - reported after income from continuing operations & tax
Discontinued operations - reported after income from continuing operations & tax
Change in
Accounting standards, accounting methods, correction of errors - retrospective prior-period adjustment included
in current statement
Accounting estimation (new info on assets life) - prospective statement of only future statements
All firms must report basic EPS & diluted EPS if it has potentially dilutive securities:
Dilutive security - decrease EPS if converted to its common stock equivalent
Convertible Bond GAAP reports E by D
Dilutive if: Interest*(1-t)/N < Basic EPS
Convertible Preferred Stock
Dilutive if: Pre. Dividend/N < Basic EPS
Warrants
Dilutive if: Exercise Price < Average Market Price
If dilutive, denominator is added by [N*(1-EP/AMP)]
Antidilutive security - increase EPS
Basic EPS =
-









Revenue
Expense
Gross Profit
SG&A
R&D
D&A
Gains & Loss on Investments
Unusual OR Infrequent Items
Operating Income OR EBIT

EBIT
Interest Expense (non-operating for non-financial firms)
Tax
Discontinued Operation (net of tax)
Extraordinary Items (net of tax)
Cumulative Effects of Account Changes (net of tax)
Net Income (Retained Earnings)
Preferred Dividends
Income Available to Common Shareholders (Used in EPS)



Understanding the Balance Sheet

Balance sheet
Account form - lists asset on left etc
Report form - single column
Classified - groups accounts into subtotals such as current asset
Assets
Current - expected to be used up or converted to cash in less than 1 year or firms operating cycle (longer one)
Cash & cash equivalents
Short-term investments/marketable securities - trading securities - market price (unrealized gain or loss
are reported in net income)
Receivables - net realizable value (based on estimates of collectability)
Inventory - lower of historical cost or net realizable value
Prepaid expenses
Tangible assets (PP&E) - historical cost less accumulated depreciation
Intangible assets with definite lives - historical costs less accumulated amortization
Goodwill
Diff between purchase price of a business & market price (fair value) of its assets less liabilities
Not amortized but tested for impairment annually
LT investments
Available-for-sale securities (not traded in short-term or held to maturity) - market price (unrealized gain
or loss reported in other comprehensive income NOT net income)
Held-to-maturity securities - amortized cost or face value less unamortized discount plus unamortized
premium (unrealized gain or loss not reported)
Liabilities
Current - expected to be paid in less than 1 year or firms operating cycle (whichever is greater)
Payables
Accrued expenses
Notes payable/ST debt
Current portion of LT debt
Unearned revenue - magazine subscription
Financial liabilities held for trading - market price
LT debt
Bonds, note payable & mandatory redeemable preferred shares - amortized cost
Capital lease obligation
OE - transactions during a period that increase or decrease equity, including transactions with shareholders:
Contributed capital - amount paid by common & preferred shareholders
Outstanding shares = issued shares - treasury stock
# of shares =

Stock dividend = 12 months
Stock repurchase = #(months)
Only convertible preferred are included & no potential dilution of CB
Retained earnings - Net Income
Accumulated other comprehensive income - in OE but NOT in income statement
Gain & loss from FX
Pension obligation adjustments
Unrealized gain & loss from CF hedging derivatives
Unrealized gain & loss available-for-sale securities (not expected to be held to maturity)
Comprehensive income = Net income + other comprehensive income
Minority interest - portion of a subsidiary not owned by the parent (less than 50% outstanding shares)
Treasury stock
Common stock firm has repurchased by the firm
Treasury stock = Shares issued - shares outstanding
Non-voting & no dividend


Understanding the Cash Flow Statement

CFO - transactions affecting firms net income
Direct method sum cash in & out for operating activities
Cash from sales (sub AR & unearned revenue)
Sub COGS (sub increase in inventory & add payables)
Sub SG&A (adjust for accrued expense & add payables)
Sub interest expense (add payable)
Sub income tax (add tax payable & add deferred tax liability)
Buy or sell of trading securities
Indirect method relationship with net income
Net income
Add D&A
Sub noncash revenue
Sub gains and add loss resulted from investing or financing activities - add dividends
Sub asset items - inventory, receivables
Add liability items - payables, accrued liability
Analysts need to determine whether positive CFO is generated from operating activities or decrease in noncash working
capital (liquidating inventory & receivable or increasing payables)
CFI - acquisition or disposal of LT assets & certain investments
Cash paid for new asset = ending gross assets + gross cost of old assets sold - beginning gross assets
Cash from selling assets = decrease in asset + gain on sale (BV with any gain or loss on sale)
PP&E and Land
Buy or sell of equity/debt investment
Loan and principals received from loans made to others
CFF - transactions affecting firms capital structure, such as issuing or repaying debt & stocks
Net CF from creditors = new borrowings - principal amounts repaid
Net CF from shareholders = net equity issued - share repurchase - cash dividend PAID
Mortgage payment
Under US GAAP
Dividends PAID - F
Everything else (dividends RECEIVED, all interest & tax) - O
Under IFRS
Dividend & interest PAID- either O or F
Dividend & interest RECEIVED either O or I
Tax - O (unless arise from I or F decision)
FCFF (Free CF to the firm) is cash to both equity owners & debt holders
FCFF = net income + noncash charges (D&A) + [interest expense * (1 tax rate)] net capex working capital
investment
FCFF = CFO + [interest expense * (1 tax rate)] net capex
FCFE = CFO net capex + net borrowings
Net capex = cash spent on fixed assets cash received from selling fixed assets
Net borrowings = debt issued debt repaid
Performance Ratios
--

--

--

Coverage Ratios

Financial Analysis Techniques

Activity ratios asset utilization & management
Total asset turnover (asset utilization)

Fixed asset turnover

Working capital turnover

Solvency ratios
--

--

Profitability ratios

DuPont system of analysis on ROE

) (

) or

) (

) or

EPS




Diluted EPS calculate lowest possible EPS if all convertible debt, convertible preferred stock, options and
warrants are converted
Dividends
or









Business risk














Inventories

-
Costs included in inventory include:
Purchase cost
Conversion costs
Other costs to bring the inventory to present location
NO storage cost
Added to beginning inventory value and then allocated to either COGS or ending inventory
Inventory cost flow methods
FIFO - inventory best approximate current cost
LIFP - prohibited under IFRS
Weighted average cost
Specific identification
When prices are rising & inventory quantities are stable or increasing:
LIFO FIFO
- COGS
- gross profit
- taxes
- CF
- inventory balance
- inventory turnover
- COGS better represent reality
(replacement cost)
- COGS
- gross profit
- taxes
- CF
- inventory balances
- inventory turnover
- Inventory value better represent reality
(replacement cost)

LIFO FIFO
LIFO COGS - increase in LIFO reserve = FIFO COGS
LIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve) (1-t)
LIFO ending inventory + LIFO ending reserve = FIFO inventory
Periodic system COGS & inventory determined at end of accounting period
Perpetual system COGS & inventory are continuously updated
IFRS inventories are valued at lower of cost or net realizable value
Net realizable value = expected sales price selling cost
Cannot be written up more than it was written down
GAAP inventories are valued at lower of cost or market (replacement cost)
NRV - profit margin < Replacement cost < NRV
Cannot be written up
Inventory turnover =

Inventory turnover + sales growth = high efficiency rather than inadequate inventory
Inventory turnover + sales growth = obsolete inventory


Long-lived Assets

When a firm makes an expenditure, it can either capitalize the cost as an asset or expense the cost
Capitalize - smoother earning
Higher assets, equity, CFO, earnings & interest coverage than expensing
Lower earnings & interest coverage in subsequent years due to depreciation
Total CF & debt unaffected
Interest incurred during construction of an asset is capitalized and added to the assets value BUT since this results
in higher interest coverage ratio, some analysts reverse the transaction and add the capitalized interest to interest
expense for the period
Intangible assets
Purchased finite-lived - amortized over useful life
Infinite-lived - tested for impairment annually result in operating loss in IS but no CF or tax effect
Internally developed - expensed
R&D
IFRS - Research is expensed & Development is capitalized & soft development after tech feasible is capitalized
GAAP - both R&D are expensed
Goodwill
Developing is expensed
Acquiring is capitalized
Depreciation methods for both tangible & intangible assets with finite lives
Straight-line



Accelerated (declining balance) in year X

Units-of-production



IFRS requires component depreciation - parts of an asset is identified & depreciated separately
Average depreciable life =



IFRS, firms can revalue assets based on market price under the revaluation model BUT GAAP does not permit revaluation
If revaluation loss
Reported in income statement
Any later gains only reported in income statement to extent of previous loss
Any gains beyond the initial loss reported in OE as revaluation surplus
If revaluation gain
Reported as a revaluation surplus in OE
Later revaluation losses would reduce the surplus first
When a long-lived asset is
Sold - gain or loss in income statement
Abandoned - BV is removed from balance sheet & loss is recognized on income statement
Exchanged - gain or loss computed by comparing BV of old asset with market price of old asset
There are diff in the disclosure requirements under IFRS & GAAP but firms are required to disclose:
BV for each class of asset
Accumulated depreciation & amortization
Title restrictions & assets pledged as collateral
For impaired assets, the loss amount & circumstances that caused the loss
For revalued assets (IFRS only), the revaluation date & how market price was determined
Land (GAAP) - historical cost


Income Taxes

Tax return terminology
Taxable income - income subjected to tax based on tax return
Taxes payable - tax liability from the tax return as well as tax due but not yet paid
Tax loss carryforward - current or past loss that can be used to reduce future taxable income, results in deferred
tax asset
Financial reporting terminology
Accounting profit (earnings before tax) - pretax income from the income statement
Income tax expense - expense recognized in the income statement
Income tax expense = taxes payable or current income tax expense + DTL - DTA
Deferred tax liabilities
Income tax expense (income statement) > taxes payable (tax return)
Pretax income > taxable income and expected to reverse
(BV - tax base) * tax rate
Treat as equity if not expected to reverse
Deferred tax assets
Taxes payable (tax return) > income tax expense (income statement)
Taxable income > pretax income and expected to reverse
(Tax base - BV) * tax rate
Recognize valuation allowance if not expected to reverse
When firms tax rate increases (decreases), DTL & DTA increases (decreases)
Temporary difference
Difference between tax base and BV of the asset or liability
Will result in taxable amounts or deductible amounts in the future
Could be due to difference in depreciation, inventory methodsetc
Permanent difference
Difference between taxable income and pretax income that will not reverse in future
Do not create DTA or DTL
The effective tax rate should be adjusted
If DTA is likely to be not realized due to insufficient future taxable income to recover the tax asset
Then DTA must be reduced by increasing valuation allowance (contra account on the balance sheet)
Increasing valuation allowance = increase income tax expense & decrease earnings
If DTL not reverse - increase in equity
Firms are required to reconcile effective income tax rate & statutory rate in the local country which can help in predicting
future effective tax rates
GAAP prohibits upward revaluations BUT IFRS permits upward revaluation of fixed & intangible assets and any resulting
effects on deferred tax are recognized in equity


Non-Current Liabilities

When a bond is issued, A & L both increase by the bond proceeds
At all times, BV of bond liability = PV of remaining future CF discounted at market rate at issuance
Proceeds reported in CF statement as inflow from financing activities
Premium bond
Coupon > market yield at issuance
Reported on balance sheet at a value greater than its face
Premium is amortized until BV of bond liability reaches its face at maturity
Discount bond
Market yield at issuance > coupon
Reported on balance sheet at a value less than its face
Discount is amortized until BV of bond liability increases to face at maturity
Interest includes amortization of discount or premium at issuance
Using effective interest rate method:
Interest = BV of bond liability (at beg of period) * bonds yield at issuance
Premium bond
Interest < coupon payment (yield < coupon)
Difference between interest & coupon payment is subtracted from bond liability
Discount bond
Interest > coupon payment (yield > coupon)
Difference between interest & coupon payment is added to bond liability
When bonds are redeemed before maturity
Gain or loss = Redemption price - BV of bond liability
Bond covenants are restrictions on borrower that protect the bondholders
Reduce default risk & borrowing cost
Restriction on dividend pay, share repurchase, M&A, issuance of new debt
Require borrower to maintain safe level of ratios
Firm disclose details of long-term debt in the footnotes
Maturity dates, effective interest rates, restrictionsetc
Amount of debt maturing in next 5 years
Compared to purchasing assets, leasing may be less costly, less tax, less restrictions...etc
IFRS - lease = finance (capital) lease if all rights & risks of ownership transferred to the lessee
GAAP - lease = finance (capital) lease if any criteria is met:
Title is transferred to lessee at end of period
Bargain purchase option exists
Lease period = 75% or more of assets economic life
PV of lease payment = 90% or more of fair value/market value of asset

Finance lease - purchase of asset financed with debt
Lessee Lessor
Lower of PV of future lease payment and market value of lease
recognized both A & L






Lease payable = PV of remaining lease payment
Lease payments consists of depreciation of the asset & interest
expense
Principal reduction - financing outflow (CFF)
Interest expense - operating outflow (CFO)

Sales-type lease = if PV of lease payments > BV of asset
Gross profit at inception of lease
Asset removed and lease receivable created which
slowly gets replaced by lease payment
Direct financing lease = if PV of lease payments = BV of asset
No gross profit
Asset removed and lease receivable created with slowly
gets replaced by lease payment
Lease receivable = PV of remaining lease payment
Lease payments consists of part principal reduction & interest
income
Part principal reduction - investing inflow (CFI)
Interest income - operating inflow (CFO)

Operating Lease
Lessee Lessor
Rental arrangement with no asset or liability reported
Rental payment = rental expense (CFO)

Keep leased asset on balance sheet and depreciate over useful life
Rental payment = rental income (CFO)


Capital Lease Operating Lease
- Asset, Liabilities, D/E
- CFO (interest expense in CFO)
- EBIT (only sub depreciation not interest exp)
- Asset, Liabilities, D/E
- CFO
- EBIT
- NI (later yrs)
- NI (early yrs)
- CFF (principal payment is CFF)
- Current ratio, working capital, asset turnover
- ROA, ROE
- Interest Coverage
- Same total CF
- NI (later yrs)
- NI (early yrs)
- CFF
- Current ratio, working capital, asset turnover
- ROA, ROE
- Interest Coverage
- Same total CF

Both lessees & lessors are required to disclose in footnotes:
Description of leasing arrangement
Nature, timing & amount of payments in next 5 years
Lease revenue & expense reported in income statement
Receivable & unearned revenue
Restrictions imposed by lease
Pension is a form of deferred compensation earned over time through employee service:
Defined contribution plan
Employer contributes certain sum each period to employees retirement account
Employer makes no promise regarding future value of plan asset & assumes no risk
Defined benefit plan
Employer promises to make periodic payments after retirement & assumes risk
Defined benefit obligation
PV of future obligation or PV of amount owned to employees for future pension benefits
Funded status of the plan = defined benefit obligation - plan assets at market
Overfunded (reported as asset) = plan assets > defined benefit obligation
Underfunded (reported as liability) = plan assets < defined benefit obligation
Leverage ratios focus on balance sheet
--



--



--







Coverage ratios focus on income statement

Red Flags & Accounting Warning Signs

Management may be motivated to overstate to:
Meet expectations
Meet debt covenants
Increase their bonus
Management may be motivated to understate earnings to:
Get trade relief
Get better repayment terms with creditors
Get better contracts with union labor
Save earnings to report in next period
The fraud triangle consists of:
Incentives & pressure - motive to commit fraud
Threats to firms profitability
Excessive 3
rd
party pressures
Threats to personal net worth of management
Excessive pressure on management to meet internal targets
Opportunities - firm has weak internal control system
The nature of the industry
Ineffective monitoring of management
Complex organizational structure
Deficient internal control
Attitudes & rationalizations - the mindset that fraud is justified
Inappropriate supported ethical standards
Too many participation of nonfinancial management in choosing accounting methods
A history of legal violations by management
Obsessive attention to stock & earning trend
Aggressive commitments to 3
rd
parties
Failure to correct known problems
Minimizing earnings inappropriately for tax reporting
Continued use of materiality to justify inappropriate accounting
Poor relationship with auditors
Common signs of earning manipulation includes:
Aggressive revenue recognition or delaying expense recognition
Different growth rates of operating CF & earnings
Abnormal sales growth
Abnormal inventory growth compared with sales
Abnormal margin ratios
Moving non-operating income and non-recurring gains to operating income or revenue
Moving operating expense as non-recurring or extraordinary items to boost operating income
Excessive use of off-balance-sheet financing arrangements such as leases
LIFO liquidations during inflation (sell more inventory than purchases)
Decrease inventory
Decrease COGS
Increase net income
Aggressive assumptions and estimates
Year-end surprises
Equity method investment with little or no CF


Accounting Shenanigans on Cash Flow Statement

Stretching accounts payables - delaying payments
Increasing # of days in payables but is not sustainable
Financing accounts payables - delaying payments by getting 3
rd
party to finance payables for 1 period
Pay 3
rd
party with financing CF rather than operating CF
Securitizing accounts receivables - convert AR into cash
Borrowing against receivables = CFF
Selling or securitizing receivables = CFO with inaccurate gains or loss
Repurchasing stock to offset dilution when stock options are exercised - tax benefits bc financing CO


Financial Statement Analysis: Applications

Trends in financial ratios and comparisons with industry can reveal business strategies
Companys future income & CF can be projected by forecasting sales growth and using estimates of margins and the
increases in WC & fixed assets necessary to support sales growth
Credit analysis assess firms credit quality by looking at firms financials and its:
Scale & diversification
Operational efficiency
Margin stability
Use of financial leverage
Attractive equity investments can be identified by screening stocks with ratios but which ratios, how many, values & weights
are all challenges
Analysts must adjust the financial statements for comparability when firms use different accounting methods


International Standards Convergence

Marketable investment security Held-for-Trading (ST) Available-for-Sale (LT) Held-to-Maturity (LT)
Balance Sheet Market price Market price Amortized cost
Income Statement Unrealized gains or loss NA NA
OE (Other comprehensive income) NA Unrealized gains or loss NA

Intercorporate investment methods Ownership Degree of Influence
Market Less than 20% No significant influence
Equity 20% - 50% Significant influence
Proportionate Consolidation (IFRS only) Shared Joint Venture (Joint Control)
Consolidated More than 50% Control


* Recoverable amount = higher of market price less selling costs & value in use





















Other differences IFRS GAAP
Inventory lower of cost or net realizable value lower of cost or market (replacement)
Inventory upward revaluation Yes No
PPE & intangible assets upward revaluation Yes No
Asset impairments
Written down to
When BV > recoverable amount
Recoverable amount
When BV > undiscounted future CF
Market price or discounted CF
Revenue & profit recognition during project Profit recognized at completion Completed contract method
LIFO method No Yes
Choosing depreciation methods Reflect assets life & consumption -
Component depreciation Yes Seldom used
Extraordinary items in income statement No Yes
Dividends paid Either operating or financing Financing activity
Interest paid Either operating or financing Operating
Dividend & interest received Either operating or investing Operating
5. Corporate Finance: Capital Budgeting

Capital budgeting - evaluating projects
Steps
Generate ideas
Analyze ideas
Create firm-wide capital budget
Monitor decision & conduct post-audit
Categories
Replacement project to maintain business or cost reduction
Expansion project to grow
New product/market development
Mandatory project
Other such as R&D
NPV
Rank mutually exclusive projects
Best method
But ignores the size of project
Crossover rate - diff NPV rank for diff discount rate
IRR IRR > discount rate
Measure profitability as %
But unconventional CF - multiple or no IRR
Independent projects - NPV = IRR
Mutually exclusive projects - use NPV
Payback (discounted payback) Payback period = full years +



Good measure of project liquidity
Ignores time value of $ & CF beyond payback period
Profitability index PI =



Greater than 1
Smaller, private, less educated & companies outside US use Payback more than NPV or IRR


Cost of Capital

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce)
Use target capital structure
Or current/ industry peers capital structure
After-tax cost of debt = kd (1 - marginal tax rate)
Interest expense is tax-deductible while dividend is not
Optimal capital budget - undertake all projects with WACC > IRR
Marginal cost of capital curve - upward-sloping
Marginal WACC increases
Break point =



Investment opportunity schedule
IRR of decreasing order
Project NPV
Use marginal WACC (for additional units of capital) & constant capital structure over life of project
Adjust if project risk diff from average risk of existing projects
Cost of debt
Rate at which firm can issue new debt
YTM approach - YTM on new (marginal) debt
Debt rating approach - peers with same rating & maturity
Cost of preferred stock




Cost of equity
CAPM approach kce = Rf + [E(Rm) - Rf]
Dividend discount model approach kce =

+ g
g = (1 - payout rate) * (ROE)
Bond yield + risk premium approach kce = long-term debt yield before tax + 3% to 5%
Pure-play method
Unlever beta of peers unlevered = levered [

-
] t & D/E of peers
Re-lever the beta levered = unlevered [ 1+[(1-t)

]] t & D/E of firm

Country risk premium
Added to market risk premium
kce = Rf + [E(Rm) - Rf +CRP]
CRP = (sovereign bond yield - T-bond yield) *



Sovereign yield spread = developing country government bond yield - treasury yield
Floatation cost
Fees charged by banks when firm raise external equity capital
2% to 7% to equity raised
Adjust initial CF outflow of project


Measures of Leverage

Operating leverage - business risk DOL =


=
-
- -

Increases with fixed operating cost
QBE (bc FC) but also profit if sales > QBE
Magnifies business risk
Variability in sales & expense leading to EBIT uncertainty
Sale risk - uncertainty about sales
Operating risk - uncertainty about operating earning
Financial leverage - financial risk DFL =

-
=



Increases with fixed financing cost
Default but also ROE (bc less Equity)
Magnifies financial risk
EPS uncertainty
DTL (degree of total leverage) DTL = DOL * DFL =




Breakeven quantity of sales QBE =

-

Total revenue = total cost
Operating breakeven quantity of sales QBE =

-

Total revenue = total operating cost


Dividends & Share Repurchases

Cash dividend - decrease asset & equity value
Decrease liquidity ratio
Increase leverage ratio
3 methods:
Regular dividend - quarterly
Special dividend - one time
Liquidating dividend - bankruptcy
Stock dividend & split - no change to asset & equity value
No effect on liquidity or leverage ratio
Chronological order of dividend issuance
Declaration date
Ex-dividend date - stock purchased on or after will not receive dividends
Holder-of-record date (2 business days after) - holder must own to receive dividend
Payment date
Share repurchase = cash dividend assuming same tax treatment
Use firms cash/equity to buy back shares
4 methods
Buy in open market - timing flexibility
Buy fixed # of shares at fixed price - tender offer at premium
Dutch auction - fixed # of shares at range of prices
Repurchase by direct negotiation - from large shareholder
Borrow to repurchase shares: After repurchase EPS =
- -


EPS/P = after-tax cost of borrowing (EPS no change)
EPS/P > after-tax cost of borrowing (EPS increase)
EPS/P < after-tax cost of borrowing (EPS decrease)
Effect on BV PS After repurchase BVPS =
-


Repurchase share price > original BVPS (BVPS increase)
Repurchase share price < original BVPS (BVPS decrease)


Working Capital Management

Liquidity position
Primary source of liquidity
Cash & equivalents
Secondary source of liquidity
Liquidating short-term & long-lived assets
Renegotiating debt
Filing bankruptcy
Drags on liquidity - delay cash inflow
Uncollected receivable
Bad debt
Obsolete inventory (takes longer to sell)
Pulls on liquidity - accelerate cash outflow
Paying vendor sooner
Tight ST credit
Liquidity ratios - use average BS numbers
Current ratio =



Quick ratio =



Cash ratio =



Defensive interval =



Inventory turnover =


# of days of inventory =

Receivable turnover =


# of days of receivables =

Payables turnover =


# of days of payables =

Operating cycle= days of inventory + days of receivable
Cash conversion cycle (net operating cycle) = days of inventory + days of receivable - days of payables
AR Management
Receivable aging schedule
Weighted average collection period
Inventory Management
Inventory level = average days inventory or inventory turnover
AP management
2/10 net 60 = 2% discount within 10 days, otherwise 60 days
Cost of trade credit =

-

ST securities to invest:
T-bills, agency securities, bank CDs, bankers acceptances, time deposits, repurchase agreement,, commercial paper,
money market mutual fund & preferred stock
Use annualized yields based on days to maturity
Discount-basis yield =
-

*

Money market yield =
-

Bond-equivalent yields =
-

Short-term borrowing when cash is low (in increasing cost):
Commercial paper
Bank lines of credit
Uncommitted
Committed - more costly
Revolving - longer years
Collateralized borrowing
Nonbank financing
Factoring - buyers of receivables


Financial Statement Analysis

Forecast sales growth rate
New product introduction
Business cycle
Industry/competition
Proportional COGS, current assets, current liabilities, fixed assets
Financial surplus
First iteration - assets < liabilities + OE


The Corporate Governance of Listed Companies

Corporate governance
Set of internal controls, processes & procedures of managing firms
Ensure board of directors are independent of management
Firms managers act in interest of shareholders
Board member owns company shares
Independent & meet regularly without management
Make decisions not controlled by management
Advise management with its experience & protect long-term shareholder interest
Able to hire consultants without management approval
Members serving over 10 years may become to close with management = not independent
Statutory voting - vote for one candidate
Cumulative voting - one or more candidates benefit shareholders with small # shares
No finders fee & no use of corporate assets (planes)
Code of ethics - integrity trust & honesty
Comply with firms country & stock exchange standards
Prohibit firm giving advantage to company insiders & not shareholders
Discourage paying board members for consultancy fee
Designate a person responsible for corporate governance
Audit committee - providing financial info to shareholders
Follow proper accounting & auditing steps
Appoint external auditor free from management bias
Resolve auditor/management conflicts in a way favoring shareholders
Approve or reject any non-audit engagements with external auditor
No restriction communicating with firms internal auditors
Control the audit budget
Compensation committee - sets compensation for executives
Determine if executive compensation is appropriate & lead to long-term profitability
Provide public info on executive compensation to shareholders
Require shareholder approval for share-based compensation
Nomination committee - recruiting new board members
Review performance of existing board member
Create nomination steps & policies
Prepare succession plans for senior management
Shareholder rights
Vote proxies
Confidential voting - promote interests of shareholders
Remote proxy voting - promote interests of shareholders
Cumulative voting - significant minority group can serve their own interest
Understand
Able to nominate board members?
Able to propose initiatives to be discussed at annual meeting?
Corporate structure changes can affect shareholders
Different classes of common equity
Takeover defense (defense against hostile takeover) benefit management but hurt shareholders
Greenmail - pay to avoid hostile takeover


















6. Portfolio Management - 90% variation in portfolio performance is due to asset class allocation

Risk tolerance Liquidity needs Income needs Investment horizon
Individual Depends Depends Depends Depends
Mutual funds Depends High Depends Depends
Banks Low High Pay interest Short
Insurance Low High Low
Short - P&C
Long - Life
Defined benefit pension High Low Depends on age Long
Endowments High Low Spending level Long

3 steps in portfolio management process:
Planning
Create IPS (investment policy statement)
State investors objective & constraints
State objective benchmark
Updated every few years or when objective or constraints change
Execution
Construct portfolio based on IPS
Top-down = economic condition
Bottom-up = mispriced security
Feedback
Monitor changes
Rebalance periodically or when client change objectives or constraints
Evaluate with IPS benchmark
Defined-contribution pension plan
Employee invests & accepts investment risk
Defined-benefit pension plan
Sponsor promise benefits to retirees
Mutual funds
Open-ended - price = NAV
Close-ended - fixed # of shares but price determined by market
Exchange-traded fund (ETF)
Track index that trade like a close-end fund/ stock
Higher brokerage fee
Separately managed accounts
Personalized portfolio for PWM clients
Hedge funds
Few but rich investors
2% management fee + 20% performance incentive
Buyout (PE) funds
Privatize company by buying all shares with debt issuance
Then restructure company to increase CF
Venture capital funds
Buy company at start-up phase


Portfolio Risk & Return I

Diversification ratio =
-


Holding period return =
--
--

Arithmetic mean return =

Geometric mean return =

Money-weighted rate of return = IRR considering all CF
Other return methods:
Gross return = return after subtracting commission & trading cost
Net return = gross return subtracting management & admin cost
Pretax nominal return = return before paying tax
After-tax nominal return = return after paying tax
Real return =



Leveraged return = return on cash investment only (rest paid with borrowed money)
Sample variance S
2
=
-
-

Sample covariance Cov1,2 =
- -
-

Correlation coefficient = 1>1,2>-1 1,2 =

or Cov1,2 = 12 1,2
Standard deviation for portfolio portfolio =

portfolio = w12+w12 for 12 =1
portfolio = w12 for risky + risk-free portfolio
Correlation decrease = SD of portfolio decrease
Asset with correlation coefficient < 1 added to portfolio = SD of portfolio decrease
Evaluating investments:
Excepted return & variance of return
Skew
Positive - upside tail
Negative - downside tail
Kurtosis
High - fat tail & even distribution
Low - skinny tail & concentrated distribution towards the mean
Liquidity
Efficient frontier
Top half of minimum-variance frontier
Minimum-variance portfolio - least risk for a given return
Global minimum-variance portfolio - least risk on the efficient frontier
Indifference curve
Steeper - more risk adverse


Portfolio Risk & Return II

CAL (capital allocation line)
From risk-free to risky portfolio
CML (capital market line) - see the allocation E(Rp) = Rf + p (
-

)
E(Rp) vs. p
Only efficient portfolios will be ON the CML depending on allocation between Rf & Rm
Borrow rate lend rate - kinked
With tax & transaction cost - band
Total risk = systematic risk + idiosyncratic risk
Around 30 stocks = 0 idiosyncratic risk and ALL systematic risk
Equilibrium return depends on systematic risk NOT idiosyncratic risk
Return generating model
Multifactor model - many factors E(Ri) = Rf +1*factor 1 + n*factor n
Market model - index as single factor E(Ri) = Rf +i [ E(Rm) - Rf ]
i =

A =

SML (security market line) - see the mispricing
E(Rp) vs. p
All properly priced securities & portfolios will be ON the SML depending on their beta
Sharpe ratio - excess return per portfolio risk SR =
-

M-squared (M
2
) - excess return for same p M
2
= [(Rp - Rf)

] - (Rm - Rf)
Treynor measure - Sharpe ratio for SML Treynor =
-

Jensens alpha - excess return for same p = (Rp - Rf) - p(Rm - Rf)


Portfolio Planning & Constructing

Investment Policy Statement
Introduction - describe client
Statement of purpose
Statement of duties & responsibilities - of client & manager
Procedures
Investment objectives - clients risk & return goal
Investment constraints
Liquidity
Time horizon
Tax consideration
Legal & regulatory - government restriction
Unique circumstances - religion
Investment guidelines - whether leverage, derivatives are allowed
Evaluation & review - feedbacks - updated at least annually or when change constraint/ goals
Appendices
Risk objective vs. Return objective
Absolute
Relative - compared with index
Clients risk tolerance - take the conservative
risk aversion coefficient = risk adverse
risk aversion coefficient = risk tolerate
Strategic asset allocation
Allocate to meet IPS
Tactical asset allocation short-term misprice
Deviation from strategic allocation to profit from forecast of shorter-term opportunities














7. Equity: Market Organization & Structure

3 functions of financial system:
Allow entities to save, borrow, issue equity, manage risk, exchange assets & utilize information
Determine the return that equates total supply of savings & borrowing
Allocate capital efficiently
Assets can be classified as:
Physical derivative contracts vs. financial derivative contracts
Money markets (short-term debt - 1 yr or less) vs. capital markets (long-term debt & equity)
Financial intermediaries:
Broker, exchanges & trading system - match buyers & sellers
Dealers - buy & sell from own inventory & earn spread
Arbitrageurs - buy from one market & resell in another
Securitizer & depository institution - pack assets into a pool
Clearinghouses - reduce counterparty risk & improve integrity
Leverage / buy on margin
Margin loan & pay interest at call money rate (higher than t-bill)
Initial margin - initial min % of equity
Maintenance margin - min % of equity must maintain or else receive margin call & sell
Margin call price = P0 (
-
-
)
Execution instruction
Market order vs. Limit order
Behind the market limit order - unlikely execution
All-or-nothing order vs. Hidden order vs. Iceberg order
Day order vs. Immediate order (fill or kill) vs. Good-til-cancelled order
Stop buy order - buy if price certain level (limit loss on short sale)
Primary market:
Book building - bank find investors interested in investing
Underwritten offering - bank agrees to buy entire issue at agreed price
Best efforts offering - bank acts only as a broker, no obligation to buy if issue is undersubscribed
Private placement - sell directly to qualified investor without public offering
Shelf registration - issue the registered security over time when it needs capital or market is favorable
Dividend reinvestment plan - use dividends to buy new shares at discount
Rights offering - given rights to buy new shares at discount but ownership is diluted if rights not exercised
Secondary market:
Quote-driven markets (dealer market or price-driven or OTC)
Investors trade with dealers who maintain inventories of security
Most securities except stocks
Order-driven markets (other traders)
Order-matching rule - determine trade order using price, timing
Trade pricing rule - determine price
Brokered markets (brokers)
Broker find a counterparty for a trade
Illiquid asset
Call markets - only trade at specific times with 1 price that clears market
Continuous markets - trade at any time market is open
Well-functioning financial system:
Complete market - participants goals are met
Internal efficiency
Operational efficiency - low trading cost contribute towards informational efficiency
External efficiency
Informational efficiency - price reflect information quickly
Rate of return proportional to risk
Allocational efficiency


Security Market Indices

Indexes
Purpose:
Show market sentiment
Benchmark of manager performance
Measure of market return
Measure of beta & excess return
Model portfolio for index funds or ETF
Price index - only use prices to calculate return
Total return index - use both price & other income
Equity index
Broad market index - majority of stocks in a market
Multi-market equity index
Sector index
Style index - value vs. growth
Fixed-income index
Issuer, collateral, coupon, maturity, credit risk, inflation protectionetc
Large universe of securities & high turnover
Dealer market & low liquidity
Commodity index
Derivatives vs. real
Weighting methods
Hedge fund index - upward bias
Create an index:
Target market to measure
Which securities from the target market to include
Weighting method
Price-weighted



For stock split - adjust # of stocks in index to keep index value constant
Market cap-weighted/value-weighted (


) * base year index value
Most common
Equal-weighted frequent rebalancing (1+average % in index stock) * initial index value
Fundamental-weighted - company earnings, revenue, assets or CF
Contrarian effect weights shift away from value towards value during rebalance
Frequency of rebalancing index to target weights - most important for equal-weighted index
Frequency to re-examine security selection & weighting


Market Efficiency

Efficient capital market
Prices reflect all information & fast market reaction
More participants, arbitrage, short selling, low trading cost create efficiency
Passive investment better than active investment
Weak form
Price reflect all market / past info
Technical analysis does not work (past does not mean future)
Semi-strong form
Price reflect all public info
Technical & Fundamental analysis does not work
Strong form
Price reflect all public & private info
Market anomaly - not violation of EMH but are due to methodologies used to test EMH
Data-mining - technical analysis
Calendar anomalies - small caps outperform 1
st
5 days in January
Overreaction effect
Momentum effect
Size effect - small cap outperform large cap
Value effect - value (low PE) outperform growth (high PE) & high book-to-market companies
Close-end fund selling at a discount to NAV - but transaction cost eliminate arbitrage
Slow adjustment to earning surprise
Investor overreaction to IPO
Behavior finance
Study if investor behave rationally
How investor behavior affects markets
How cognitive biases may result in anomalies
Loss aversion - dislike loss more than like gain
Information cascades - uninformed investors wait & observe actions of informed investors
Herding behavior
Test show professional money managers underperform passive investing


Overview of Equity Securities

Equity
Common - vote (by proxy - someone else vote for them)
Statutory voting - 1 vote per election
Cumulative voting - 1 vote per share per election benefit minority shareholder
Callable common - allow firm to buy back shares (higher dividend yield)
Putable common - allow shareholder to sell to firm (lower dividend yield)
Preferred - no voting rights but priority during liquidation
Cumulative preferred - receive dividends missed before common shareholders & most during liquidation
Participating preference share - receive extra dividend if form profit exceed level
Non-participating preference share
Convertible preferred - converted to common
Compared with public firms, private firms have:
Greater ability to focus on long-term prospects
Greater potential return once firm goes public
Price determined by firm & investors not by market
Less liquidity
Limited financial disclosure & lower reporting cost
Weaker corporate governance
3 types:
Venture capital
Leveraged buyout
Private investment in public equity
Depository receipts
Sponsored (with vote) vs. unsponsored (no vote)
Buy foreign stocks in domestic exchange to avoid low liquidity & transparency
ADR (American depository receipts) - traded in US
GDR (Global depository receipts) - traded outside US & issuers home but denominated in USD
Global registered shares - common shares that trade in different currencies & exchanges
BLDR - ETF of depository receipts
Baskets of listed depository receipts - ETF
ROE =





Introduction to Industry & Company Analysis
Industry classification systems from commercial providers:
Global Industry Classification Standard - S&P
Russell Global Sectors
Industry Classification Benchmark - DJ & FTSE
Industry classification system from government agencies:
International Standard Industrial Classification
North American Industry Classification System
Non-cyclical - less dependent of business cycle
Defensive - utilities, consumer stables & gold
Growth - demand overpowers cycle
4 external factors:
Demographic factors - size & age
Government factor - tax, regulation
Social factor
Technology factor
Industry life-cycle model:
Embryonic - slow growth & high investment
Growth - rapid growth & little competition
Shakeout - slowing growth & high competition
Maturity - slow growth & stable competition
Decline - negative growth & declining prices
Industry rotation adjust industry weights based on business cycle stages
High pricing power:
High barrier of entry & low barrier of exit
Market concentration
Stable market share
Undercapacity (demand > supply)
Industry experience curve - show cost per unit relative to output
Equity Valuation

Discounted CF model - PV of cash (dividend or FCF) to shareholders after CapEx & working capital expenses
FCFE = net income + depreciation - in WC - CapEx - debt principle repayment + new debt issues
FCFE = CF from operation - CapEx + net borrowing
Preferred stock price =

Gordon growth model =

g = (1 - payout ratio) * ROE

Multiplier model - compare price to earnings, sales, BV, CF or EV to EBITDA, sales

where D1/E1 = expected dividend payout ratio

EV = Market cap + Market value of debt - cash short-term investments
P/S is more stable than P/E
P/B for financials
Asset-based discount model - firms assets are tangible & have fair value
price = assets - liabilities - preferred stock

Discounted CF Multiplier Asset-based
- Easy to calculate
- Widely accepted
-
- Useful for analyzing stocks
- Easy to calculate
- Widely accepted
- Provide floor value
- For tangible assets being liquidated
- Inputs must be forecast
- Value very sensitive to inputs
- Value very sensitive to inputs
- Denominator must be positive
-
- Not for intangible assets
- Difficult to value during hyperinflation

9. Fixed Income: Features of Debt Securities

Bond indenture
Contract between buyer & seller
Covenants - special conditions of the obligation
Affirmative covenants - actions the issuer must perform
Negative covenants - actions the issuer cannot perform
Bonds features:
Maturity - term of the loan
Par (face) value - principal amount
Coupon rate - rate used to determine periodic interest to be paid on the principal
Coupon rate > market yield = trade at premium to par
Coupon rate < market yield = trade at discount to par
Types of coupon rate structure:
Option-free (straight) bond - pay periodic interest & pay par at maturity
Zero-coupon - pay no periodic interest & sold at discount
Bullet bond - lump sum at maturity pays entire principal
Step-up notes - coupon rate that increase over time
Deferred coupon - no coupon initially & pay accrued interest near the end
Floating (variable) - coupon based on reference rate (LIBOR or CPI) & quoted margin
Cap - maximum coupon paid
Floor - minimum coupon paid
Collar - cap + floor
Full price/Dirty price = quoted price (clean price) + accrued interest
Quoted price - clean price without accrued interest
Accrued interest - interest earned since last coupon payment date & is paid by buyer to issuer
Bond retirement (payoff) provisions:
Amortizing securities - make both periodic interest & principal payments
Prepayment - option for borrower to pay off principal prior to maturity
Call provision - allow issuer to buy back (redeem) bond from investors at call price specified in bond indenture
Benefit issuer during declining interest rates
Callable but nonrefundable bonds - can be called prior to maturity but redemption cannot be funded by the
issuance of bonds with a lower coupon rate
Sinking fund provisions - require part of a bond to be retired at specific dates (obligation)
Conversion option - allow bondholders to convert bond to issuers common stocks
Put provision - allow bondholder to sell bond to issuer at put price
Security owner options - benefit issuer - reduce bonds value & higher yield
Call provisions
Prepayment option
Accelerated sinking fund provision - allow issuer to retire large proportion of the bond
Caps (max rates) on floating-rate bond
Security owner options - benefit bondholders - increase bonds value & lower yield
Conversion options
Put options - option of bondholders to return bonds to the issuer at predetermined price
Floors (min rates) on floating-rate bond
Margin buying - borrowing money & using security at collateral
Repurchase (repo) agreements - institution sells security with promise to buy back at agreed-upon higher price at specified
date
Seller borrows $ from buyer & pay back later with interest


Risks Associated with Investing in Bonds

Zero-coupon have HIGH interest rate risk but LOW reinvestment risk
Interest rate risk - change in market interest rate
Duration -



% change in price = -duration * (% change in yield)
Positively related to maturity
Negatively related to coupon rate
Negatively related to market YTM (yield)
Less for bonds with embedded options (call or put)
Duration of bond = % price change for 1% change in yield
Dollar duration of bond = dollar price change for 1% change in yield
Call or repayment risk - when interest rates fall
Timing of CF is uncertain
Principal is likely to be repaid early when interest rates for reinvestment are low
Potential price appreciation is less than option-free bond
Reinvestment risk - when interest rates fall, CF from fixed-income must be reinvested at a lower rate
Higher coupon rate
Longer maturity
Callable or has repayment option
Amortizing security (with premium) have higher reinvestment risk than non-amortizing
Yield curve risk - change in shape of yield curve
Non-parallel shift in yield curve/ change in shape
Duration of bond does not capture true price effects
Yields of different bonds will change differently
Credit risk
Default risk
Downgrade risk
AAA to BBB = investment grade bond
BB or lower = speculative or high yield
Credit spread risk - bonds yield spread to Treasuries based on its bond rating
Liquidity risk
High bid-ask spread
Exchange rate risk
Volatility risk - bonds with embedded options
For callable bond is risk that volatility will increase
For putable bond is that volatility will decrease
Value of callable bond = option-free bond - value of call
Value of putable bond = option-free bond + value of put
Inflation risk - unexpected inflation
Event risk
Sovereign risk - government default


Overview of Bond Sectors & Instruments

Sovereign debt
Regular auction cycle single price (US) - entire issue sold at single price for all bidders
Regular auction cycle multiple price - bonds issued at multiple prices for different bidders
Ad hoc auction system - no regular cycle, govt auctions when timing is good
Tap system - action new bonds identical to previously issued bonds
Securities issued by U.S. Treasuries
Bill (zeros less than 1 year) - 1, 3 or 6 months
Notes (semiannual) - 2 to 10 years
Bonds (semiannual) - over 10 years
TIPS (Treasury inflation protected securities)
Coupon rate is fixed but par is adjusted semiannually based on CPI changes
Semiannual coupon =

On-the-run issues - from most recent auctions & are more liquid & representative & smaller bid-ask
Off-the-run issues - from previous auctions
Treasury strips
Created by bond dealers who buy Treasuries, separate the CF & resell as zeros
Coupon strips & principal strips are taxed by IRS on their implicit, like other zeros
U.S. government agencies are considered almost riskless
Federally related institutions
Government sponsored enterprises
MBSs (mortgage-backed security) - collateralized by pool of mortgage which provide CF
Exposure to prepayment & reinvestment risk
Mortgage passthrough security
Holders receive proportional CF
Monthly CF including interest payments, scheduled principal payments & repayment of principal
CMOs (collateralized mortgage obligations)
borrowing cost by redistributing prepayment risk & alter maturity structure to match investor
Customized claims to interest payments & principals of mortgage passthrough securities
Tranche I = short-term segment & receive priority in principal payments
Tranche II = intermediate-term
Tranche III = long-term
Stripped MBSs
Either principal or interest portion of mortgage passthrough security
Munis
Usually exempt from US federal tax & state tax
Tax-backed bonds - backed by taxing power of government
Revenue bonds (more risky) - backed by muni projects revenue
Tax-free yield = tax-equivalent yield * (1 - marginal tax rate)
Taxable-equivalent yield
-
-

Corporate debt securities
Corporate bonds
Secured - in forms of PP&E or financial assets
Unsecured - debentures (general claim on any assets)
Medium-term notes (MTN)
Issued periodically by corporations under shelf registration
Sold not all at once by agents on best-efforts basis
Maturities from 9 months to 30 years
Structured note
Bond + derivative to create security to match institutional investor preference
Commercial paper (CP)
Short-term, unsecured & does not require SEC registration if maturity < 270 days
Directly-placed paper = sold by issuer
Deal-placed paper = sold through broker
Certificate of Deposit (CD)
Backed by bank asset
Eurodollar CD - denominated in USD & issued outside the US
Bankers acceptances
Short-term & low liquidity
Issued by banks to guarantee future payments
Sold at discount to future payments
ABS (Asset-backed securities)
Backed by CF from pool of mortgage, auto loan, credit card receivableetc
Special purpose vehicle
Legally transfer financial assets to SPV to shield from corporations creditors
So that ABS issue has higher credit than corporation & has lower borrowing cost
CDOs (Collateralized debt obligations)
Backed by CF from pool of corporate bonds, loans, EM debt, MBS or other CDOs
Tranches of different seniority on CF claims have diff credit rating
Primary market
Underwritten & best-efforts public offerings
Private placements - tailor to small group of investor
Secondary market
Trading in dealer market
Electronic trading


Understanding Yield Spreads

Monetary policy tools - Fed manage short-term rates
Open market operation - buy treasuries to increase cash
Discount rate - rate at which banks can borrow reserve from the Fed
Bank reserve requirements - % of deposits that banks must retain
Persuading banks to tighten or loosen their credit policies
Yield curve - plot yield to maturity
Normal / Upward sloping
Inverted / downward sloping
Flat - expect stable inflation rate in future
Humped
Term structure of interest rate theories
Pure expectations theory
Long-term yield depends on expectations of future short-term rates
If short-term rates expected to rise = higher rates for longer maturity
Liquidity preference theory
Investors require liquidity premium for longer maturity with greater interest rate risk
Market segmentation theory
Lenders & borrowers have preferred maturity
Supply & demand of bonds determine equilibrium yields for various maturity
YTM (yield to maturity) - discount rate that makes PV of future CF equal to its price
Spot rates - appropriate discount rates for individual future CF
Yield spread - yield diff between 2 bonds
Absolute yield spread (nominal spread) = yield on higher-yield - yield on lower-yield
Basis points = 0.0001
Relative yield spread
-

(better)
%
Yield ratio


or =1+relative yield spread
%
Credit spread
Yield diff between 2 bonds due to diff in credit rating
Decrease when economy is good & expanding
Increase when economy is bad reflecting a flight to quality by investors
Increase yield & yield spread
Call option
Prepayment options
Smaller bond issue with less liquidity
Taxable bond
Decrease yield & yield spread
Put Option
Conversion options
Larger bond issue with more liquidity
Tax-exempt bond
LIBOR
Rates which large London banks lend money to each other
Most important reference for floating-rate & short-term loan


Valuation of Debt Securities

3 steps in bond valuation
Estimate the CF
Principal repayment is uncertain - embedded options
Coupon payment is uncertain - floating rate
Bond is convertible into another security
Determine discount rate
Annual discount rate = i
Semiannual discount rate = i/2
Calculate PV of the CF
Value of zero-coupon bond:
Using annual discount rate (i) =



Using semiannual discount rate (i/2) =





Yield Measures, Spot Rates & Forward Rates

Coupon bond 3 sources of return
Coupon CF
Reinvestment income on coupon CF
Capital gain or loss on principal CF
YTM (yield to maturity) - annualized IRR
Annual-pay YTM = annual discount rate that makes PV of bonds CF = market price + accrued interest
Semiannual-pay YTM = 2* semiannual discount rate
YTM = realized yield on investment if YTM = reinvestment rate
Current yield =

Nominal yield = coupon rate

Bond selling at: Relationship
Par Nominal yield/ coupon rate = current yield = yield to maturity
Discount Nominal yield/ coupon rate < current yield < yield to maturity
Premium Nominal yield/ coupon rate > current yield > yield to maturity

Yield to call/put
Calculated as YTM
Yield to first call
N = first call date
FV = first call price
Yield to first par call
N = first par call date
FV = par (100)
Cash flow yield
Monthly IRR based on presumed prepayment rate & market price of ABS or MBS
BEY (bond-equivalent yield)
Semiannual-pay YTM =
BEY =

EAY (equivalent annual yield)
Annual-pay YTM = *
-

3 yield spread measures:
Nominal spread
Bond YTM - Treasury YTM
Z-spread (zero-volatility spread) - more accurate than nominal spread
Additional yield that must be added to each Treasury spot rate to get spot rates that will produce a PV for
a bond equal to its market price
Yield curve is flat: Z-spread = Nominal spread
Yield curve is upward sloping: Z-spread > Nominal spread
Yield curve is downward sloping: Z-spread < Nominal spread
OAS (option-adjusted spread)
Spread to the spot yield curve after adjusting for effects of embedded options
Mostly reflects spread for credit risk & liquidity risk
Option cost for a bond with embedded option
Option cost in % = Z-spread - OAS
Callable bond: Z-spread > OAS (have a option cost/spread)
Putable bond: Z-spread < OAS (negative option cost/spread)
Forward rates
Current rates for short-term loans to be made in future
(1+S2)
2
= (1+S1) * (1+1f1)
(1+S3)
3
= (1+S2)
2
* (1+1f2)
(1+S3)
3
= (1+S1) * (1+1f1) * (1+1f2)


Measurement of Interest Rate Risk

Measuring interest rate risk:
Full valuation approach
Value individual bonds to find price impact
Most accurate & works for shape change in yield curve
Duration/convexity approach
Only for parallel shifts in yield curve (no change in shape)

Option-free Bond Callable Bond Putable Bond
Convexity Positive (convex to origin)
Price rise due to yield decrease
MORE than they fall due to yield
increase
Positive for high yield
Negative for low yield
Positive
Duration Low for high yield
High for low yield
Low for high yield
Lowest for low yield
Lowest for high yield
High for low yield
Reinvestment risk High for low yield

Duration -



% bond price for a 1% YTM
Approximate % bond price = -duration * % yield
Effective Duration =




% bond price = -effective duration * % yield
With embedded options
Macaulay duration, Modified duration & Modified convexity
No embedded options
Expected CF do not change as yield change
Convexity
More convex = less accurate of duration-based price change
Duration is only accurate for small yield
% bond price = [(-duration * yield )+(convexity * (yield)
2
)] * 100
Duration of portfolio = w1D1+ w2D2+ +wNDN based on market value
w =



Only when yield changes are equal for all bonds
Dollar duration =

* portfolio value
PVBS (price value of a basis point)
bond price or portfolio for 1 basis point yield
PVBS = duration * 0.0001 * bond (portfolio) value or diff in value when YTM is 1 BP
Uncertainty about bonds future price result from both:
Duration
Yield volatility
Volatility of its yield in the market
Standard deviation of the yield of a bond




































9. Derivatives and Alternative Investments: Derivative Markets & Instruments

Derivative - value derived from another asset or interest rate
Exchange-traded
Futures & some options
Standardized, regulated & default risk free
Over-the-counter
Forwards & swaps
Customized, illiquid & have default (counterparty) risk created by 1 party
Risky yet capable of hedging against risk
Promote efficient market price
Reduce transaction cost


Forward Markets

Forward
Customized obligation to buy or sell specific asset at predetermined price at specific time in future
Brokers earn pricing spread but bear default risk
Cash settlement - cash payment at settlement date instead of asset delivery
Early termination - new forward of opposite position but same expiration date
Eurodollar
USD-denominated short-term unsecured loans to large banks outside US
LIBOR
Reference rate for Eurodollar deposit
Quoted as annualized rate
Euribor
Reference rate for Euro-denominated deposits
Quoted as annualized rate
FRA (forward rate agreement)
Long FRA to hedge against rise in short-term rates (30 or 90 day LIBOR) in future
If rates rise, the long receives $ at settlement
If rates fall, the short receives $ at settlement
2 x 6 need to borrow in 60 days based on 120 day LIBOR
60 days from now, borrow for 180 days
Payment to long = notional principal amount *
-




Future Markets

Future
Like forward but exchange-traded, liquid & require daily settlement of gain/loss
No counterparty risk - clearinghouse acts as counterparty
Regulated by government
Lower transaction cost
Require margin deposits & are marked to market daily
Standardized asset quantity, quality, dateetc
Can be terminated by
Offsetting trade - most common
Cash settlement at expiration
Delivery of asset on
Exchange for physicals - delivery privately
Stock index future
Multiplier times index
Eurodollar future
Face of 1 million
Quoted as 100 - annualized 90 day LIBOR
Payoff of 25$ for every 0.01
Treasury bill future
Face of 1 million
Quoted as 100 - annualized 90 day LIBOR
Payoff of 25$ for every 0.01
Treasury bond future
Face value of 100,000
Quoted as % of face
Delivery option - short can choose the cheapest bond to deliver
Conversion factor - multiply with future price at settlement = delivery price
Currency future
Delivery of FX
Margin deposit - marking-to-market
Initial margin - required to initiate a futures position
Maintenance margin - if falls below, must be brought back to initial margin with variation margin
Settlement price - average of prices during closing period
Price limit
Exchange-imposed limits on how much price can change in 1 day
Limit up - reaching up limit
Limit down - reaching down limit
Locked limit - no trade bc limit move


Option Markets

Option
Contingent claim - only has value if certain future event takes place
American - any time
European - only at expiration
Exchange-traded or OTC
Interest rate options - payoff take place after expiration, at end of loan period
American call on dividend stocks & American puts may be better to exercise early
American call on non-dividend stocks will not be exercised early
Long interest rate call + short interest rate put = long FRA
Interest rate cap - series of call to ensure a max interest rate
Interest rate floor - series of put to ensure a min interest rate
Interest rate collar - buy cap & sell floor
Intrinsic value
C = max [0, S-X]
P = max [0, X-S]
Option value = intrinsic value + time value

Option Min Value Max Value
European Call ct max[ 0, St

] =St
American Call Ct max[ 0, St

] =St
European Put pt max[ 0,

St ] =

European Put Pt max[ 0, X-St ] =X

More time to expiration = more value except:
Far out-of-money
Far deep-in-money European options
Put-call parity for European options
Call +

= Stock + Put - PV of dividend

1 can be created with the other 3
Increase Rf = Increase call
Increase Rf = Decrease put
If underlying asset has positive CF, all S in min, max & put-call parity = (S - PV of expected CF)


Swap Markets

Swap
Series of forward contracts on interest rates, currencies or equity returns
Tenor - time frame of swap
Initiation - first swap payment
Early termination:
Enter offsetting swap (most common)
Swaption - option to enter into an offsetting swap
Negotiate with counterparty
Sell swap to 3
rd
party with agreement of original counterparty (uncommon)
Interest-rate swap
Plain vanilla = fix-for-floating
No exchange of principal
Periodic payments are netted (floating rates known at beginning of period)
Net fixed rate payment = notional principal * (swap fixed rate - LIBOR t-1) * (

)
Currency swap
Principal is exchanged at inception of swap
Periodic payments are exchanged on settlement date
Principal is exchanged (repaid) on termination date
Equity swap
% return on stock/index/portfolio swap for % fixed/floating rate
No exchange of principal
Periodic payments are netted (floating rates known at end of period)


Risk Management Applications of Option Strategies

Call
Max Loss Max Gain
Long Option cost Unlimited
Short Unlimited Option cost
Breakeven X + option cost

Put
Max Loss Max Gain
Long Option cost X - option cost
Short X - option cost Option cost
Breakeven X - option cost

Covered call
Stock + short call
Giving up stocks upside potential for receiving call premium
Max gain = (X - S0) + call premium
Max loss = S0 - call premium
Protective put
Stock + long put
Protect against downside potential
Max gain = S0 - put premium
Max loss = (S0 - X) + put premium


Alternative Investments

Mutual fund - investment company
Open-end fund
Investment company itself provides liquidity
will create new shares or redeem shares for cash if investors draw out
Charge load or no-load fee
Share price = NAV
Close-end fund - trades like a stock or ETF
Market determines liquidity
Fixed # of shares
Share price determined in secondary market
Issued at small premium to compensate for issuance cost
May trade at big discount/ premium to NAV
NAV (net asset value) = (assets - liabilities) / # of shares outstanding
Have management, admin & marketing fees which affect fund performance
Strategies:
Style - growth
Sector - biotech
Index - S&P 500
Global - all countries
Stable value - short-term debt security
ETF (exchange traded fund)
Trades like close-end fund or stock
Holds portfolio that matches a real index
Advantages
Better risk management
Intraday valuation & trading
Underlying asset published daily
Low expense - no load & lower capital gain tax compared to open-end fund
Use of in-kind creation & redemption eliminate trading discounts/premium to NAV
Better dividend management
Disadvantages
Poorly structured outside US
Long horizon investors dont need liquidity
Inefficient market (large bid-ask) for low volume ETF
Index portfolio has lower expense & tax than ETF
Risks
Exposure to market risk
Class or sector risk for specific ETF
Currency & country risk for international ETF
Leverage & credit risk for ETF that use derivatives
Prices can differ from NAV due to liqudity
Tracking error risk
Real estate - illiquid & hard to value
Investment forms
Outright ownership
Leveraged equity position
Mortgages
Aggregation vehicles - limited partnership & REITs
Valuation methods:
Cost approach
Replacement cost of house + value of land
Sales comparison approach
Comparable real estate recent sale price & adjust for diff
Income approach
NOI / required rate of return (cap rate)
NOI = income (1 - vacancy & bad debt %) - RE taxes - maintenances - insurance - utility
Before financing cost & personal income taxes & no depreciation
Discounted after-tax CF approach
After-tax CF / required rate of return (cap rate)
After-tax CF = [potential income (1-vacancy) - operating expense - depre] (1-t) + depre
Venture capital
Illiquid, long horizon, limited comparable data & require high investor inputs
Formative stages - no production
Seed stage - R&D or ideas
Early/1
st
stage - marketing & production
Later stage - production
2
nd
stage - producing but not yet generating income
3
rd
stage - fund major expansion
Mezzanine/ bridge financing stage - prep for IPO
Valuation is difficult due to:
Probability of failure?
Timing of exit?
Payoff at exit? - sale or IPO
NPV = Initial investment + (Payoff * % of success) / cost of equity
Hedge fund
Absolute return objective
May have no hedging strategy
Use leverage to magnify gain/loss
Historically have lower standard deviations & higher Sharpe Ratio & low correlations of return with traditional asset
classes
Exempt from SEC regulations
Limited partnership
Limited liability corporation
Offshore
Limited investors so each invests a lot
2 part management fee
Base fee
Incentive fee
Strategies:
Long/short - exploit mispricing
Market neutral - hedge market risk
Global macro - profit from trends
Event-driven - exploit unique opportunities
Additional risks
Illiquidity
Valuation problem
Counterparty risk
Settlement risk
Short covering
Margin calls
Fund of funds - diversification of hedge funds & give investors more opportunities but costly
Performance based upward
Self-selection bias - only positive info is reported
Backfilling bias - only historically profitable managers are reported
Survivorship bias - poor performance funds die
Smoothes pricing of assets that trade infrequently has stable price & lower volatility
Option-like strategies - SD does not account for limited upside but unlimited downside
Fee structure & gaming - incentivize managers to take risk if they have nothing to lose
Low risk measure bias - risky funds die
Closely held investment
Corporation or partnership
No SEC reporting requirement
Valuation methods
Cost method - replacement cost
Comparables method - recent market price of peers
Income approach - NPV base on discounted CF
Adjust for
Liquidity discount
Lack of marketability
Minority position & premium for controlling interest
Distressed securities
Brink of bankruptcy or already filed for bankruptcy
Debt holders gets equity & equity holders gets diluted
Illiquid
Long time horizon
Require extensive valuation analysis
Require high investor input (management)


Investing in Commodities

Benefits
Diversification - little correlation
Hedge inflation
Contango
Future price > spot price
Market dominated by long hedgers
Backwardation
Future price < spot price
Market dominated by short hedgers
Return on commodity investment includes:
Collateral yield - return on collateral used for margin requirement
Price return - spot price gain/loss
Roll yield - gain/loss from re-establishing positions as contracts expire
Positive during backwardation
Negative during contango
Commodity index strategy
Active investment
Commodity linked bond or company equity
Manage forward/future contracts (roll over as they mature)
Manage collateral (roll over as they mature)



Formulas
Effective annual rate
n compounding periods EAR = (1 +

)
n
-1
Continuous compounding periods EAR = e
stated annual rate
- 1

Money-weighted rate of return = IRR of investment portfolio
Time-weighted rate of return (preferred) = [(HPR1) (HPR2) (HPR3)]
1/3

BEY (bond-equivalent yield) = 2 * semiannual YTM
RBD (bank discount yield) for T-bills =


*

HPR or HPY (holding period return or yield) =


- 1
RMM (money market yield) = HPR *

annualized 360 day no compounding

EAY (effective annual yield) = (1+HPR)
365/t
- 1 annualized 365 day yes compounding


Harmonic mean average cost of shares purchased =

3
rd
quartile in 20 # L = (21)

= 15.75
th
smallest to largest #
MAD (mean absolute deviation) average of deviations from mean =

Coefficient of variation dispersion of observations (low = better) =



SR (sharpe ratio) reward over risk (high = better) =
-

Chebyshevs inequality y = 1-

Roys safety-first ratio (with target return Rt)

Continuously compounding:
Continuously compounded rate (Rcc) = In(1+HPR)
HPRT e
Rcc*T
- 1

Odds for event

Odds against event

Both A & B will occur P(AB) = P(A|B) * P(B) or P(A) * P(B)
At least 1 event will occur P(A or B) = P(A) + P(B) - P(AB)

Variance of A Var (A) =

Covariance of A&B Cov (A,B) = ( )

Correlation between A&B A,B =



Variance of 2-asset portfolio Var (Rp) = w1
2
1
2
* w2
2
2
2
+ 2w1w2 12 1,2
Var (Rp) = w1
2
1
2
* w2
2
2
2
+ 2w1w2 cov(1,2)

Combinations order doesnt matter

# ways choosing r out of n
Permutations order matter

# ways choosing r out of n

Binomial distribution - 2 outcomes
Probability of x success in n trial is nCx * P
x
* (1-P)
(n-x)

Expected value of X n*p
Variance of X np(1-p)
Normally distributed random variable confidence intervals:
68% = mean 1

90% or Z0.1/2 = mean 1.65

95% or Z0.05/2 = mean 1.96

99% or Z0.01/2 = mean 2.58

CPI


* 100
Real int rate Nominal int rate - Exp inflation
Inflation %
-

* 100
Money multiplier



c = currency as % of deposits
r = desired required reserve ratio
Quantity theory of money Money supply * velocity = P * real GDP

The IFRS Framework Qualitative characteristic Understandability, relevance, reliability, comparability
FCFF = net income + noncash charges (D&A) + [interest expense * (1 tax rate)] net capex working capital investment
FCFF = CFO + [interest expense * (1 tax rate)] net capex
FCFE = CFO net capex + net borrowings
LIFO FIFO
FIFO COGS = LIFO COGS - increase in LIFO reserve
FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve) (1-t)
FIFO inventory = LIFO ending inventory + LIFO ending reserve


LIFO vs. FIFO (when prices are rising) Capitalize vs. Expense Operating Lease vs. Financial Lease
GOGS, gross profit, taxes, inventory
balance, taxes, net income, inventory
turnover, which better represent reality
(GOGS or inventory)
Smoother earning, CFO, EBIT, NI (1
st

yr), interest coverage (1
st
yr), NI (later yr),
interest coverage (later yr), total CF, debt
CFO, CFF, EBIT, NI (1
st
yr), NI (later
yr), Interest coverage, ROA, ROE,
working capital, current ratio, asset
turnover, Asset, Liabilities, D/E

Marketable investment security Held-for-Trading (ST) Available-for-Sale (LT) Held-to-Maturity (LT)
Balance Sheet Market price Market price Amortized cost
Income Statement Unrealized gains or loss NA NA
OE (Other comprehensive income) NA Unrealized gains or loss NA

Intercorporate investment methods Ownership Degree of Influence
Market Less than 20% No significant influence
Equity 20% - 50% Significant influence
Proportionate Consolidation (IFRS only) Shared Joint Venture (Joint Control)
Consolidated More than 50% Control

Other differences IFRS GAAP
Inventory lower of cost or net realizable value lower of cost or market (replacement)
Inventory upward revaluation Yes No
PPE & intangible assets upward revaluation Yes No
Asset impairments
Written down to
When BV > recoverable amount
Recoverable amount
When BV > undiscounted future CF
Market price or discounted CF
Revenue & profit recognition during project Profit recognized at completion Completed contract method
LIFO method No Yes
Choosing depreciation methods Reflect assets life & consumption -
Component depreciation Yes Seldom used
Extraordinary items in income statement No Yes

* Recoverable amount = higher of market price less selling costs & value in use


Profitability index PI =



Unlever beta of peers unlevered = levered [

-
] t & D/E of peers
Re-lever the beta levered = unlevered [ 1+[(1-t)

]] t & D/E of firm

Country Risk Premium = (sovereign bond yield - T-bond yield) *



kce = Rf + [E(Rm) - Rf +CRP]
Operating leverage - business risk DOL =


=
-
- -

Financial leverage - financial risk DFL =

-
=



DTL (degree of total leverage) DTL = DOL * DFL =




Breakeven quantity of sales Total rev = total cost QBE =

-

Operating breakeven quantity of sales Total rev = total operating cost QBE =

-

2/10 net 60 2% discount within 10 days, otherwise 60 days
Cost of trade credit

-

Discount-basis yield
-

*

Money market yield
-

Bond-equivalent yields
-

Diversification ratio
-


Sample variance S
2
=
-
-

Sample covariance Cov1,2 =
- -
-

Correlation coefficient 1,2 =

or Cov1,2 = 12 1,2
Standard deviation for portfolio portfolio =

Margin call price P0 (
-
-
)
Price-weighted



Market cap-weighted/value-weighted (


) * base year index value
Equal-weighted frequent rebalancing (1+average % in index stock) * initial index value
Fundamental-weighted company earnings, revenue, assets or CF


Absolute yield spread (nominal spread) yield on higher-yield - yield on lower-yield
Dividends paid Either operating or financing Financing activity
Interest paid Either operating or financing Operating
Dividend & interest received Either operating or investing Operating
Relative yield spread
-

(better)
Yield ratio


or = 1+relative yield spread
BEY (bond-equivalent yield)
Semiannual-pay YTM =
BEY =

Annual-pay YTM = *
-

Increase yield/yield spread vs. Decrease yield/yield spread:
Call, put, repayment option, taxable bond, tax-exempt bond, larger bond, smaller bond
Conversion option, repayment option, accelerated sinking fund provision, floor, cap
Nominal spread Bond YTM - Treasury YTM
Z-spread (zero-volatility spread) - more accurate than nominal spread
Yield curve is flat Z-spread = Nominal spread
Yield curve is upward sloping Z-spread > Nominal spread
Yield curve is downward sloping Z-spread < Nominal spread
OAS (option-adjusted spread)
Option cost in % Z-spread - OAS
Callable bond Z-spread > OAS (have a option cost/spread)
Putable bond Z-spread < OAS (negative option cost/spread)

Current yield Coupon / Price
Nominal yield Coupon rate
Bond selling at Premium vs. Par vs. Discount
Effective Duration =




% bond price = [(-duration * yield )+(convexity * (yield)
2
)] * 100
Duration of portfolio = w1D1+ w2D2+ +wNDN based on market value
Dollar duration =

* portfolio value
PVBS = d * 0.0001 * bond (portfolio) value or diff in value when YTM is 1 BP


FRA 2 x 6 need to borrow in 60 days based on 120 day LIBOR
60 days from now, borrow for 180 days
Payment to long notional principal *
-

Put Call Parity Call +

= Stock + Put - PV of dividend

Income approach NOI / required rate of return (cap rate)
NOI = income (1 - vacancy & bad debt %) - RE taxes - maintenances - insurance -
utility Before financing cost & personal income taxes & no
depreciation
Discounted after-tax CF approach After-tax CF / required rate of return (cap rate)
After-tax CF = [potential income (1-vacancy) - operating expense - depre] (1-t) + depreciation
Formative stage
Seed stage
Early/ 1
st
stage
Later stage
2
nd
stage
3
rd
stage
Mezzanine stage