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5/25/2017 Top9CFALevel1FormulasMustread|FinQuiz

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Top9CFALevel1FormulasMustread
PostedonNovember15,2016byjosephhogue

PeelingbackthecoveronyourCFALevel1bookscanbeashockatfirst.ThousandsofpagesandhundredsofCFALevel1formulassitin
frontofyouandcanseemoverwhelming.

Beforeyoufreakout,itsnotreallysobad.WhileformulasbecomecrucialontheCFAlevel2examanditsquantitativefocus,theformulason
thefirstexamaremuchmoreaboutlearningrelationshipsandtheprocess.Learnthewhyoftheformulaandyoullrememberhowtoworkit
ontheexameasily.

IthoughtIwouldcoversomeofthemostimportantCFAlevel1formulasandhowtoapproachthemountainofequations.Practiceproblems
andflashcardsaregoingtobeyourbestfriends.Theresreallynosubstituteforworkingformulasoverandoveragainforrememberingthem
ontheexam.Writeoutpracticeproblemsofthemostdifficultandmostimportantformulasandthenpracticethemdailyuntilyoucandothem
easily.

CFALevel1Formulas#1:FutureValueofaSingleCashFlow

Thefuturevalueofcashflowsisnotadifficultformulaandonethatyoulldoonyourfinancialcalculatorbutitsreallyabuildingblocktoalotof
themoredifficultformulasfortimevalueofmoney.Makesureyouunderstandthisbasicformulaandwhatthedifferentnotationsmean.

N
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5/25/2017 Top9CFALevel1FormulasMustread|FinQuiz

FVN=PV(1+r)N

i.e.ifyoursavingsaccountearnsinterestata5%rateandyouhave$100deposited,howmuchwillitbeworthin20years?

FV20=$100(1+.05)20
=$265.33

CFALevel1Formulas#2:NPVandIRR

BothNPVandIRRarealsofoundeasilywiththecalculatorbuttheypopupmanytimesinconceptualquestionssoyoureallyneedto
understandtheideabehindeach.RememberthatakeyassumptionofIRRisthatcashflowsarereinvestedatthatrate,whichmaynotbe
realistic.Also,iftherearemultiplecashoutflows,therewillbemultipleIRRsornoneatall.TheremaybeaconflictbetweenNPVandIRR
whenprojectsaremutuallyexclusiveorwhentherearemultiplecashoutflows.Inthiscase,NPVispreferred.

Usingthecalculatorisrelativelyeasy,

Theinitialprojectcostorinvestmentisanegative(outflow)asCF0
CO1throughxarethestreamofcashflowsandenteredasapositive(inflow)
Ifcashflowsareanequalamount,youcanenterthemasF(frequency)

PresstheNPVbuttonandentertheinterestrate
Downarrow
CPTNPV
ForIRR,justpresstheIRRbuttonandCPT

CFALevel1Formulas#3:SharpeRatio

TheSharpeRatioisameasureforadjustingriskacrossinvestmentsandmeasuringreturnonthesamescale.Whilebondsmayofferamuch
lowerrate,aretheyabetterorworseinvestmentthanstocksgiventheirlowervolatility?Itsaprettyeasycalculationandyoullseeitcomeup
inallthreeexamssomakesureyoucanrememberitquickly.

Sharperatio=(AssetReturnRiskFreeRate)/AssetStandardDeviation

CFALevel1Formulas#4:CapitalAssetPricingModel

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TherearealotofflawsintheCAPManditsusedmoreinacademicsbutitisstillaveryusefulformulaandwillappearthroughouttheCFA
exams.Beyondtheformula,youshouldpayattentiontodrawbacksofusingtheCAPM.

Ra=rf+Ba(rmrf)

Therequiredreturn(Ra)istheamountofreturnrequiredgivenaspecificassetsadditionalriskrelativetothemarketandtheriskfreerate.You
multipleanassetsbeta(Ba)bythedifferencebetweentheexpectedreturnonthemarket(rm)andtheriskfreerate(rf).Youthenaddbackin
theriskfreerate.

Thedifferencebetweenthemarketsexpectedreturnandtheriskfreerateiscalledthemarketpremium,theadditionalreturnrequiredfor
takingonmarketrisk.

CFALevel1Formulas#5:DuPontAnalysisofROE

DuPontanalysisbreaksdownthereturnonequity(ROE)intothreecomponents,profitmarginassetturnoverequitymultiplier.

ROE=(NetIncome/Sales)*(Sales/Assets)*(Assets/Equity)

Whichbecomes(NetIncome/Equity)initssimplestform.

Theformulaprovidesanotherlayerofanalysisonwhichtocomparecompanyprofitability.Itsnotenoughtobeabletosaythatonecompany
hasahighreturnonitsshareholderequitybutyouneedtoknowthesourceofthereturn.

CFALevel1Formulas#6:DividendDiscountModels

TheGordonGrowthModel(GGM)isarguablyoneofthemostusedformulasinthecurriculum.Itisasinglestagemodel,assumingthat
dividendswillgrowataconstantrateintoperpetuity.Thegeneralformulais:

Price=Div0(1+growth)/(Rcegrowth)

Animportantnoteisthattherequiredreturnmustbehigherthanthegrowthrateindividendstousetheformula.Thisisnotusuallyaproblem
insinglestagemodelsbecausethelongtermgrowthratewillprobablybefairlylow.Bereadytocalculatesomeofthedatapointsontheexam
(likefindingthediscountratethroughCAPMorthegrowthratethroughROEandthepayoutratio).

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TheGGMisnotappropriatewhenthecompanyisexperiencingsupernormalgrowthforaperiodbeforeitslowstoperpetualgrowth.Forthis
scenario,youneedoneofthemultistagemodels.

CFALevel1Formulas#7:WeightedAverageCostofCapital

UnderstandingandcalculatingtheWACCisanotherfoundationalconceptthatyouwillneedtomaster.Theconceptisprettyintuitive,afirms
costofcapital(spending)isaweightedaverageofthecostfromeachsource(debtorequity).Debtisnormallylessexpensiveandtaxshielded
butcanberiskyathighamounts.

WACC=E/V*Re+D/V*Rd*(1Tc)

TheWACCisequaltothepercentageoffinancingfromequity(E/V)timesthecostofequity(Re)plusthepercentageoffinancingfromdebt
(Rd)timesthecostofdebt,adjustedforthetaxshield.

Usethemarketvalueofdebtorequitywhenavailable.Remember,thecompanyscapitalstructuremaychangeovertimesoitispreferableto
usetargetweightsinsteadofcurrentmarketvalueweights.

CFALevel1Formulas#8:FreeCashFlows

FCFmodelsacknowledgethatinvestorshavearighttoallcashflowsfromacompanyandnotjustthosepaidoutasdividends.Freecash
flowsarethecashgeneratedfromoperationsafterthatneededforcontinuedoperationsisdeducted.

TheadvantageisthatFCFcomparedtodividendmodelsisthatFCFcanbecalculatedregardlessifthecompanypaysadividend.FCF
modelsarealsoappropriateforinvestorsthatmaybeabletoexerciseacontrolpremiumonthecompany.Themajordisadvantageisin
valuingthosecompanieswithhighcapitalexpenditures,makingfreecashflownegativeattimes.

Freecashflowisshowntwodifferentways,FreeCashFlowtoEquityandFreeCashFlowtotheFirm,eachappropriatetotwodifferent
ownershipperspectives.FCFFisthecashflowfromoperationsaftercapitalexpendituresthatisavailabletobothlevelsofownership(debtand
equity).FCFEisthatleftoverafterpayingdebtholders,sincetheyhaveapriorclaim.

FreeCashFlowtotheFirm(FCFF)isthecashflowavailabletoallcapitalproviders(debtandequity)andequals:

Netincome+NetnoncashCharges(depreciationandamortization)InvestmentinworkingcapitalInvestmentinFixedcapital+aftertax
interestexpense

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FreeCashFlowtoEquity(FCFE)isthecashflowavailabletocommonshareholdersandequals:

Netincome+NetnoncashCharges(depreciationandamortization)InvestmentinworkingcapitalInvestmentinFixed+/netborrowing

NoticethatFCFEisFCFFexceptwithoutaddingbackinterestexpenseandtakingnetborrowingintoaccount.
UnderstandhowtoarriveatFCFEorFCFFwithCFO

FCFF=CFO+INT(1t)investfixedcapital
FCFE=CFOinvestfixedcapital+/netborrowing

CFALevel1Formulas#9:TurnoverRatios

Thelastformulaisactuallyaseriesofratiosbutallrelativelyeasytoremember.Thesearetheturnoverratios:accountsreceivable,inventory
turnover,numberofdaysreceivables,numberofdayspayableandnumberofdaysinventory.Youllusethesetocalculatethenetoperating
cycleandallindividualratiosarefairgameontheexam.

Themostimportantthinghereistorememberthatwhenyouarecombiningincomestatementdataandbalancesheetdata,youneedtouse
anaverageofthebalancesheetdata.Forexample,theinventoryturnoverratioisthecostofgoodssold(incomestatement)dividedbythe
averageinventoryfromthecurrentandpreviousperiodbalancesheet.

Mostoftheseformulasarenotdifficultandareprettyintuitiveifyoujustthinkthroughthemforamoment.Youllneedthatdeepunderstanding
ofwhatisgoingonintheformulamorethanyoullneedtheformulaitself.Makesureyouhavethisconceptualmasteryandyoullhaveno
troubleontheCFAlevel1exam.

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tilnexttime,happystudyin
JosephHogue,CFA

Lastupdated:December22,2016at7:17am

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