Module 6.

1: EAY and compounding frequency

- Compound interest / interest on interest: deeply embedded in time value of money
(TVM) procedures
- Interest rates are our measure of the TVM, although risk differences in financial securities
lead to differences in their equilibrium interest rates. Interest rates are referred to also as
discount rates, opportunity cost
- Equilibrium interest rates are the required rate of return for a particular investment
- The real risk-free rate of interest: a theoretical rate on a single-period loan that has no
expectation of inflation on it. When we speak of a real rate of return, we’re referring to an
investor’s increase in purchasing power (after adjusting for inflation)
- Nominal risk free rates: expected inflation in future periods is not zero, e.g. the US
treasury bills are risk-free rates but not real rates of return as they contain an inflation
premium
- Nominal risk-free rate = real risk-free rate + expected inflation rate
- Securities may have one or more types of risks with each added risk increasing
required rate of return: default risk, liquidity risk, maturity risk
- Required interest rate on a security = real risk free rate + expected inflation rate
+ default risk premium + liquidity risk premium + maturity risk premium
- Effective annual rate (EAR) or effective annual yield (EAY): the annual rate of
return actually being earned after adjustments have been made for different compounding
periods (Financial institutions usually quote rates as stated annual interest rates, along with
a compounding frequency, as opposed to quoting rates as periodic rates)
- EAR = (1 + periodic rate)the number of compounding periods per year - 1

Module 6.2: calculating PV and FV

- FV (compound value): an amount to which a current deposit will grow over time when it’s
placed in an account paying compound interest
- I/Y: rate of return per compounding period
- Interest factor table
- PV: today’s value of a cash flow that is to be received at some point in future = the amount
to be invested today at a given rate of return over a given period of time to end up with a
specified FV
- Discounting: the process of finding the PV of a cash flow
- Discount rate (opportunity cost, required rate of return, cost of capital): the interest rate
used in the discounting process
- Annuities: stream of equal cash flows occurring at equal intervals over a given period
- Ordinary annuities: cash flows at the end of each compounding period
- Annuities due: payments or receipts at beginning of each period
- Perpetuity: a financial instrument that pays a fixed amount of money at set intervals over
an infinite period of time. E.g. preferred stocks

Calculator use
To find out: Calculator use to derive FV/ PV
Between annuities and annuities due, must switch between END and BNG on calculator (You will
normally want your calculator to be in the ordinary annuity (END) mode, so remember to switch out
of BGN mode after working annuity due problems. Note that nothing appears in the upper right
corner of the display window when the TI is set to the END mode)

Module 6.3: Uneven Cash Flows

- Cash flow additivity principle: present value of any stream of cash flows equals the
sum of the present values of cash flows

Module 7.1: Describing Data Sets

- Types of measurement scales: NOIR
- Frequency distribution: a tabular presentation of statistical data that aids the analysis of
large data sets. They summarize statistical data by assigning it to specified groups, or
intervals. Also, the data employed with a frequency distribution may be measured using any
type of measurement scale
- Relevant frequency: calculated by dividing the absolute frequency of each return interval
by the total number of observations
- Cumulative absolute frequency
- Cumulative relative frequency
- Frequency polygon: midpoint of each interval is plotted on the horizontal axis, and the
absolute frequency for that interval is plotted on the vertical axis

Module 7.2: Means and Variance

- Population mean (µ), sample mean ( X́ ) – are both arithmetic mean: is the sum of the
observation values divided by the number of observations
- Arithmetic mean has the following properties: all interval and ratio data sets have
one; all values are considered in the mean computation; only one / unique; sum of
deviations of each observation in the data set to the mean is always zero
- Weighted average / mean: illustrates an important investments concept – the return for
a portfolio is the weighted average of the returns of the individual assets in the portfolio
- Compound annual rate of return: geometric mean: used to calculate investment returns
over multiple periods or when measuring compound growth rates. G=(X 1 * X2 * X3 * … * Xn)1/n;
n
1 + RG = √ ( 1+ R1 )∗( 1+ R 2 )∗…∗(1+ Rn)
- Geometric mean is always less than or equal to the arithmetic mean and the difference
increases as the dispersion of the observations increases. The only time when two means
are equal is when there’s no variability in the observations (all values are equal)
N
N
- Average cost of shares purchased over time: harmonic mean. 1
∑ Xi
i=1
- Median and mode
 - Quantile: general term for a value at or below which a stated proportion of the data in a
distribution lies:
o Quartiles—the distribution is divided into quarters.
o Quintile—the distribution is divided into fifths.
o Decile—the distribution is divided into tenths.
o Percentile—the distribution is divided into hundredths (percents).
- 3 quartile = 75th percentile
rd

- The formula for position of the observation at a given percentile y with n data
y
points sorted in ascending order is: Ly=(n+1)
100
- Measuring variability – range and mean absolute deviation, variance and standard
deviation
- Mean absolute deviation (MAD): avg. of the absolute values of the deviations of
individual observations from the arithmetic mean, i.e. MAD =
| X 1− X́|+| X 2− X́|+ …+¿ Xi− X́ ∨ ¿ ¿
n
(X 1−μ)2 +( X 2−μ)2+ …+( Xi−μ)2
- Population variance σ2 =
N
(X 1− X́ ) +( X 2− X́)2 +…+(Xi− X́ )2
2
- Sample variance s2 =
n−1
- σ > MAD
- s2 is an unbiased estimator of σ2

Module 7.3: Skew and Kurtosis

- Chebyshev’s inequality states that for any set of observations, whether sample or
population data and regardless of the shape of the distribution, % of observations that lie
within k standard deviations of the mean is at least 1 – 1/k 2 for all k > 1
- Coefficient of variance and Relative dispersion: in order to be able to compare
dispersion, the concept of relative dispersion is introduced. It is the amount of variability in a
distribution relative to a reference point or benchmark, commonly measured with the
Sx standard deviation of x
coefficient of variance (CV) = = . In investment terms, CV
X́ average value of x
measure the risk (variability) per unit of expected return (mean)
- Distributional symmetry in returns: implies that intervals of losses and gains will
exhibit the same frequency. The extent to which a returns distribution is symmetrical is
important because the degree of symmetry tells analysts if deviations from the mean are
more likely to be positive or negative
- Skewness or skew: refers to the extent to which a distribution is not symmetrical.
Skewness results from the occurrences of outliers in the data set
- Positively skewed, unimodal distribution – mode < median < mean
- Negatively skewed, unimodal distribution – mode > median > mean
- In summary, mean is affected more by skew / outliers than the median and mode
- Kurtosis: a measure of the degree to which a distribution is more or less “peaked” than a
normal distribution
 - Leptokurtic: more peaked than a normal distribution; Platykurtic: less peaked/ flatter
than a normal distribution. Mesokurtic: same kurtosis as a normal distribution
- With regard to an investment returns distribution, a greater likelihood of a large deviation
from the mean return (leptokurtic) is often perceived as an increase in risk
- Excess kurtosis: a distribution exhibits excess kurtosis if it has either more or less kurtosis
than the normal distribution (=3). Excess kurtosis is kurtosis minus 3. A normal distribution
has excess kurtosis equal to zero, a leptokurtic distribution has excess kurtosis greater than
zero, a platykurtic distribution has excess kurtosis less than zero
- Skewness and kurtosis are critical concepts for risk management because when securities
returns are modeled using an assumed normal distribution, the predictions from the models
will not take into account the potential for extremely large, negative outcomes
1 n
Sample skewness =
n ∑
- * ¿¿ ¿ ¿ when a distribution is right skewed, sample skewness
i=1
is positive because the deviations above the mean are larger on average. A left-skewed
distribution has a negative sample skewness. Values of sample skewness in excess of
0.5 in absolute value are considered significant
1 n
Sample kurtosis =
n ∑
- * ¿¿ ¿ ¿ measured relative to 3. Positive values of excess kurtosis
i=1
indicate a distribution that is leptokurtic
- Use arithmetic or geometric means: when annual returns are compounded each
period, the geometric mean is appropriate since it tells us the single rate that if compounded
over the same periods would lead to the same increase in wealth as the individual annual
rates of return
- The arithmetic mean however is the best estimator of the next year’s returns ; to estimate
multi-year returns, the geometric mean is the appropriate measure

Module 8.1: Conditional and Joint Probabilities

- Probability: 2 defining properties – 1) the probability of occurrence of any event is
between 0 and 1; 2) for a set of mutually exclusive and exhaustive events, probabilities of
those events sum to 1, i.e. We are certain that one of the values in this set of events will
occur
- Empirical, a priori, subjective probabilities: empirical – established by analyzing past
data; a priori – determined using formal reasoning and inspection process, no experience;
subjective – least formal method of developing probabilities and involves use of personal
judgment
- Unconditional probability (a.k.a. marginal probability) refers to the probability of an
event regardless of the past or future occurrence of other events
- A conditional probability is one where the occurrence of one event affects the
probability of the occurrence of another event. Using probability notation, "the probability
of A given the occurrence of B" is expressed as P(A | B), where the vertical bar ( | ) indicates
"given," or "conditional upon." For our interest rate example above, the probability of a
recession given an increase in interest rates is expressed as P(recession | increase in interest
rates). A conditional probability of an occurrence is also called its likelihood
 - Multiplication rule : used to determine joint probability, i.e. both events will occur -
P(AB) = P(A | B) × P(B)
- Addition rule: used to determine the probability at least one of two events will occur -
P(A or B) = P(A) + P(B) − P(AB)
- Total probability rule is used to determine the unconditional probability of an event,
given conditional probabilities - P(A) = P(A | B1)P(B1) + P(A | B2)P(B2) + … + P(A | BN)P(BN),
where B1, B2, … BN is a mutually exclusive and exhaustive set of outcomes.

Module 8.2: Conditional Expectations, Correlation

- The total probability rule: in general, the unconditional probability of event R, P(R) =
P(R | S1) × P(S1) + P(R | S2) × P(S2) + . . . + P(R | SN) × P(SN), where the set of events {S1, S2, . . . SN}
is mutually exclusive and exhaustive. P(R) = P(RI) + P(RIC) - IC is read "the complement of I,"
which means "not I." Therefore, the probability of IC is 1 − P(I)
- Expected value: the weighted average of the possible outcomes of the variable - E(X) =
ΣP(xi)xi = P(x1)x1 + P(x2)x2 + … + P(xn)xn
- Variance and SD in probability model: σ2 = w1(X1– mean)2 + w2(X2 – mean)2 +…
+wi(Xi – mean)2
- Covariance in probability model: covariance measures how two assets move
together. It’s the expected value of the product of the deviations of the two random
variables from their respective expected values Cov(Ri,Rj) = E{[Ri − E(Ri)][Rj − E(Rj)]}
- Covariance and variance: the covariance of Ra with itself is equal to the variance of Ra
- Sample covariance using historical data – calculation of the sample covariance:
n

Cov1,2 =
∑ {[ R t ,1− Ŕ 1 ][ Rt ,2− Ŕ 2 ] } . Rt,1 = return on Asset 1 in period t
t=1
n−1
Cov ( Ri , Rj )
- Correlation coefficient: Corr (Ri, Rj) =ρ (rou)=
σ ( Ri ) σ ( Rj )
- The correlation between two random return variables may also be expressed as ρ(Ri,Rj),
or ρi,j. Correlation can be forward-looking if it uses covariance from a probability model,
or backward-looking if it uses sample covariance from historical data.
- Spurious correlation refers to correlation that is either the result of chance or present
due to changes in both variables over time that is caused by their association with a third
variable

Module 8.3: Portfolio Variances, Bayes and Counting Problems

- Expected value and variance for a portfolio of assets:
o Establish the portfolio weight for each asset: w i =
market value of the investment ∈asset i
the market value of entire portfolio
o Portfolio expected value: E(Ri) = w1E(R1)+w2E(R2)+…+wnE(Rn)
o Portfolio variance: Var(Rp) = wAwACov(RA,RA) + wAwBCov(RA,RB) +
wBwACov(RB,RA) + wBwBCov(RB,RB)

Because: Cov(RA,RB) = Cov(RB,RA), and Cov(RA,RA) = σ2(RA)

 So Portfolio variance Var(R ) = w σ + w σ + 2w w σ σ ρ(R ,R )
P A
2
A
2
B
2
B
2
A B A B A B

- The lower the correlation of A and B, the less variance (less uncertainty) about the
portfolio return  more diversified
- Bayes’ formula: updated probability given additional information. Prob(A|B) =
P (A∨C)
P ( A∨C )+ P( A∨C C )
- Labelling: n items to receive k labels where n1+n2+n3+…+nk=n. total number of ways labels
n!
can be assigned is:
n 1!∗n 2 !∗n 3!∗…∗nk !
- Combination formula: here k=2, it’s a special case of labelling. Choosing r objects from n
n!
objects: no order. nCr=
r ! ( n−r ) !
- Permutation formula: the order matters. A permutation is a specific ordering of a group
n!
of objects. E.g. 8 stocks and want to sell 3 one at a time in a given order. nPr =
( n−r ) !

Module 9.1: Uniform and Binomial Distributions

- Probability distribution: describes the probabilities of all possible outcomes of a random
variable. These probabilities must sum to 1
- Discrete random variable: one for which the number of possible outcomes can be
counted, and for each possible outcome, there’s a measurable and positive probability
- Probability functions – specifies the probability that a random variable is equal to a
specific value. denoted p(x) = P(X=x). The two key properties of a probability function
o 0 ≤ p(x) ≤ 1
o ∑p(x) = 1, the sum of the probabilities for all possible outcomes, x, for a random
variable, X, equals 1
- Continuous random variable: one for which the number of possible outcomes is infinite,
even if lower and upper bounds exist
- Discrete distribution vs. continuous distribution
o Discrete distribution: p(x) = 0 when x cannot occur, or p(x) > 0 if it can
o Continuous distribution: p(x) = 0 even though x can occur. It is customary, therefore,
to speak in terms of the probability of a range of possible price change, say between
$1.00 and $2.00. In other words p(price change = 1.33) is essentially zero, but p($1 <
price change < $2) is greater than zero
- Cumulative distribution function (cdf), i.e. the distribution function: denoted F(x) = P(X
≤ x)
- Discrete uniform distribution: one for which the probabilities for all possible outcomes
for a discrete random variable are equal
- Binomial distribution: a binomial random variable may be defined as the number of
“successes” in a given number of trials whereby the outcome can either be success or
failure. Probability of success “p” for each trial is constant and trials are independent. A
binomial random variable for which the number of trial is 1 is called a Bernoulli random
variable
 - Binomial distribution functions is therefore: p(x) = P(X = x) = (number of ways to
n!
choose x from n)px(1 − p)n–x . Number of ways = ; so
x ! ( n−x ) !
n!
 p(x) = P(X = x) = px(1 − p)n–x
x ! ( n−x ) !

- Expected value of a binomial random variable, E(X)= np

- Variance of binomial random variable X = np(1 − p)
- Continuous uniform distribution: for all a<=x1<x2<=b, p(x) =(x2-x1)/(b-a). outside a and
b, p(x)=0

Module 9.2: Normal distributions

- Normal distribution plays a central role in portfolio theory. Key properties of the normal
distribution:

o Completely described by its mean, μ, and variance, σ 2, stated as X ~ N(μ, σ2) which
means "X is normally distributed with mean μ and variance σ 2."

o Skewness = 0, meaning that the normal distribution is symmetric about its mean, so
that P(X ≤ μ) = P(μ ≤ X) = 0.5, and mean = median = mode.

o Kurtosis = 3; this is a measure of how flat the distribution is. Recall that excess
kurtosis is measured relative to 3, the kurtosis of the normal distribution.

o A linear combination of normally distributed random variables is also normally

distributed.

o The probabilities of outcomes further above and below the mean get smaller and
smaller but do not go to zero (the tails get very thin but extend infinitely).

- Univariate distribution vs. multivariate distributions

o Univariate distribution: the distribution of a single random variable
o Multivariate distribution: specifies the probabilities associated with a group of
random variables and is meaningful only when the behavior of each random variable
in the group is in some way dependent on the behavior of the others. Applies to
both discrete and continuous random variables
- Describing multivariate normal distribution: can be described by mean and variance
of the individual random variables. Additionally, necessary to specify the correlation
between the individual pairs of variables, e.g.

o n means of the n series of returns (μ1, μ2, …, μn).

o n variances of the n series of returns (σ 12 , σ22 , σ32 … σn2 )

o 0.5n(n − 1) pair-wise correlations

 - Applicability: When building a portfolio of assets, all other things being equal, it is desirable
to combine assets having low returns correlation because this will result in a portfolio with a
lower variance than one composed of assets with higher correlations
- Confidence interval: a range of values around the expected outcome within which we
expect the actual outcome to be some specified percentage of the time. A 95% confidence
interval is a range that we expect the random variable to be in, 95% of the time
- Confidence intervals for a normal distribution:
o 68% of the outcomes are within one standard deviation of the expected value
(mean); ~95% of the outcomes are within two standard deviations of …

o The 90% confidence interval for X is X́ − 1.65s to X́ + 1.65s.

o The 95% confidence interval for X is X́ − 1.96s to X́ + 1.96s.

o The 99% confidence interval for X is X́ − 2.58s to X́ + 2.58s.

- Calculating probabilities using z-values: z-table, i.e. cumulative probabilities for a standard
normal distribution. The values in the table are the probabilities of observing a z-value that is
less than a given value. F(–Z) = 1 − F(Z)

Module 9.3: Lognormal distribution, simulations

- Shortfall risk: the probability that a portfolio value or return falls below a particular/
target value or return over a given period
- Roy’s safety-first criterion: the optimal portfolio minimizes the probability that return
of the portfolio falls below some minimum acceptable level, called the threshold level
minimize P(Rp < RL)
- If portfolio returns are normally distributed, then this criterion can be stated as: maximize
[ E ( RP )−R L ]
the SFRatio where SFRatio =
σP
- Lognormal distribution: generated by the function ex , where x is normally distributed.
Lognormal distribution is skewed to the right and is bounded from below by zero so useful
for modelling asset prices
- Using a lognormal distribution to model price relatives: price relative is end-of-period
price of asset divided by the beginning price, it is equal to (1+the holding period return).
- End-of-period asset price: = multiply the price relative by the beginning of period asset
price
- Discretely compounded return: discrete compounding period, e.g. semiannual,
quarterly etc.
- Continuous compounding: the effective annual return just gets bigger and bigger with
compounding being more frequent
- Effective annual rate for continuous compounding =eRcc – 1 where Rcc is the stated
annual rate at which return is compounded
o Ln of ex = X; x is the continuous compounded rate
S1
- Ln( ) = ln(1+HPR)=Rcc where HPR is holding period return
S0
- In general, the holding period return after T years, when the annual continuously
compounded rate is R , is given by: HPRT = eRCCxT – 1
cc
 - Monte carlo simulation: a technique based on the repeated generation of 1 or more risk
factors that affect security values, in order to generate a distribution of security values
o For each risk factor, parameters of the probability distribution must be specified
o Computer generates random values for each risk factor based on assumed
probability distributions
o Each set of randomly generated risk factors is used with a pricing model to value the
security
o This procedure is repeated many times. Distribution of simulated asset values used
to draw inferences about the expected value of security
- Monte carlo simulation vs. historical simulation
o Historical simulation is based on actual changes in value or actual changes in risk
factors over some prior period; each iteration of the simulation involves randomly
selecting one of the past changes for each risk factor and calculating the value of
asset or portfolio in question

Module 10.1: Central Limit Theorem and Standard Error

- Simple random sampling: a method of selecting a sample in such a way that each item/
person in the population being studied has the same likelihood of being included in the
sample. One way is systematic sampling: selecting every nth number from a population
- Sampling error: the difference between a sample statistic (i.e. mean, variance, sd) and its
corresponding population parameter. E.g. sampling error of the mean = sample mean –
population mean = x́ – µ
- Sampling distribution: Sample statistic itself is a random variable and has a probability
distribution. The sampling distribution of the sample statistic – a probability distribution of
all possible sample statistics computed from a set of equal-sized samples randomly drawn
from the same population
o The sampling distribution is distinct from the distribution of the actual population
and will have different parameters
- Stratified random sampling uses a classification system to separate the population into
smaller groups based on one or more distinguishing characteristics. From each subgroup, or
stratum, a random sample is taken and the results are pooled. The size of the samples from
each stratum is based on the size of the stratum relative to the population
- Time-series data: observations taken over a period of time at specific and equally spaced
time intervals
- Cross-sectional data: sample of observations taken at a single point in time
- Longitudinal data: pooling time-series and cross-sectional data in the same dataset –
observations over time of multiple characteristics of the same entity
- Panel data: observations over time of the same characteristics for multiple entities
- Central limit theorem: The central limit theorem states that for simple random samples
of size n from a population with a mean µ and a finite variance σ , the sampling distribution
2

of the sample mean approaches a normal probability distribution with mean µ and a
σ 2 as the sample size becomes large
variance equal to
n
o If the sample size n is sufficiently large (n>=30), the sampling distribution of the
sample means will be approx. normal

o The mean of the population, µ, and the mean of the distribution of all possible
sample means are equal.
 σ 2 , the population variance
o The variance of the distribution of sample means is
n
divided by the sample size.

- Standard error of the sample mean is the standard deviation of the distribution of the
σ
sample means. σ x́ = when sd of population is known – however this is almost never
√n
known, then the standard error of the sample mean must be estimated by dividing the
s
standard deviation of the sample mean by √ n. . s x́ =
√n
- The desirable properties of an estimator are unbiasedness, efficiency, and
consistency
o Unbiased: expected value of the estimator is equal to the parameter you are trying
to estimate
o An unbiased estimator is also efficient if the variance of its sampling distribution is
smaller than all the other unbiased estimators of the parameter you are trying to
estimate
o A consistent estimator is one for which the accuracy of the parameter estimate
increases as the sample size increases

Module 10.2: Confidence Intervals and t-distribution

- Point estimate vs confidence interval: point estimate is a single sample value(s) used to
measure population parameters. The formula used to compute the point estimate is called

the estimator. E.g. x́=

∑x
n
- A confidence interval is a range of values in which the population parameter is expected
to lie
- Student’s t-distribution/ t-distribution: a bell-shaped probability distribution
symmetrical about its mean. Suitable for constructing confidence intervals based on small
samples (n<30) from populations with unknown variance and a normal, or approx. normal
distribution; may also be suitable when population variance is unknown and sample size is
large enough that according to central limit theorem, the sampling distribution is approx.
normal. Following characteristics apply:
o Symmetrical
o Defined by a single parameter - Degrees of freedom (df): n-1. The degrees of
freedom for tests based on sample means are n − 1 because, given the mean, only n
− 1 observations can be unique.
o Has more probability in the tails (fatter tails) than the normal distribution
o As the df gets larger (i.e. n gets larger), shape of the t-distribution more closely
approaches a standard normal distribution
- The thickness of the tails relative to those of the z-distribution is important in
hypothesis testing because thicker tails mean more observations away from the center of
the distribution (more outliers). Hence, hypothesis testing using the t-distribution makes it
more difficult to reject the null relative to hypothesis testing using the z-distribution.
- Calculate and interpret confidence interval for a population mean, given a normal
distribution with
 σ
o A known population variance: sample mean ± (Z score of α/2) *
√n
S
o An unknown population variance: sample mean ± (t stat of α/2) *
√n
- Calculate confidence interval for a population mean vs. for a single observation

o A 90% confidence interval for a single observation is 1.645 standard deviations from
the sample mean.

o A 90% confidence interval for the population mean is 1.645 standard errors from the
sample mean.
- Confidence interval estimates result in a range of values within which the actual value of
a parameter will lie, given the probability of 1- α. Where alpha is level of significance for
the confidence interval and 1- alpha is the degree of confidence

- Confidence interval is usu.: point estimate ± (reliability factor × standard error) where:

o point estimate = value of a sample statistic of the population parameter

o reliability factor = number that depends on the sampling distribution of the point
estimate and the probability that the point estimate falls in the confidence interval,
(1 − α)

o standard error = standard error of the point estimate

- If the distribution is nonnormal but the population variance is known, the z-statistic
can be used as long as the sample size is large (n ≥ 30). We can do this because the central
limit theorem assures us that the distribution of the sample mean is approximately normal
when the sample is large.

- If the distribution is nonnormal and the population variance is unknown, the t-

statistic can be used as long as the sample size is large (n ≥ 30). It is also acceptable to use
the z-statistic, although use of the t-statistic is more conservative.

- This means that if we are sampling from a nonnormal distribution (which is sometimes
the case in finance), we cannot create a confidence interval if the sample size is less than
30. So, all else equal, make sure you have a sample of at least 30, and the larger, the better.
- Describe the issues regarding selection of the appropriate sample size
o data-mining bias
o sample selection bias
o survivorship bias
o look-ahead bias
o time-period bias

Module 11.1: Hypothesis Tests and Types of Errors

- Null hypothesis (H0): the hypothesis that the researcher wants to test and reject. It’s a
simple statement about a population parameter
- Alternative hypothesis (Ha): is what is concluded if there’s sufficient evidence to reject
the null hypothesis. When the null hypothesis is discredited, the implication is alternative
hypothesis is valid

- One-tailed test: a one-sided test; two-tailed test: a two-sided test. Two-tailed e.g. H : μ = 0

μ versus H : μ ≠ μ
0 a 0

- Conclusion statements: if …, we reject the null and conclude that the sample statistic is
sufficiently different from the hypothesized value; if xxx, we conclude that the sample
statistic is not sufficiently different from the hypothesized value and we fail to reject the null
hypothesis

- Two statistics involved in hypothesis testing – test statistic calculated from the sample data
and the critical value of the test stat

- Test statistic: calculated by comparing the point estimate of the population parameter
sample statistic−hypothesized value
with the hypothesized value of the parameter: =
standard error of the samle stat
where, the standard error is:

o σx́ = σ / √ n when σ is known

o S x́ = S/ √ n when σ is unknown

- Test statistic is a random variable that may follow one of several distributions
depending on the characteristics of the sample and the population, including

o The t-distribution

o The z-distribution (standard normal distribution)

o Chi-square distribution

o The F-distribution

- Type I error: rejection of null when it’s actually true – probability of making a Type I error
is called significance level of a test

- Type II error: failure to reject null when it’s actually false

- Decision rule for a hypothesis test: it’s for rejecting or failing to reject the null hypothesis,
based on the distribution of the test stat

- Power of a test: probability of correctly rejecting the null when its false. i.e. = 1 - P(Type II
error)

- Decreasing the significance level (probability of a Type I error) from 5% to 1%, for
example, will increase the probability of failing to reject a false null (Type II error) and
therefore reduce the power of the test. Conversely, for a given sample size, we can
 increase the power of a test only with the cost that the probability of rejecting a true null
(Type I error) increases. For a given significance level, we can decrease the probability of a
Type II error and increase the power of a test, only by increasing the sample size

Module 11.2: Tests of Means and p-Values

- Statistical significance does not necessarily imply economic significance
- Other considerations are transaction costs, taxes, and risk
- P-value: the probability of obtaining a test statistic that would lead to a rejection of the null
hypothesis, assuming the null is true. It’s the smallest level of significance for which the null
can be rejected
- Identify the appropriate test statistic for a hypothesis test: factors are sample size, (normal)
distribution, variance known or unknown

sample statistic−hypothesized value

=
standard error of the sample stat
o T-test: it employs a test statistic distributed according to a t-distribution. used if
population variance is unknown and either of the following: sample size >=30;
sample is small but distribution of population is normal or approx. normal
X́−µ 0
 tn-1 (i.e. t-stat with n-1 degrees of freedom)=
S / √n
 where: x = sample mean; μ0 = hypothesized population mean (i.e., the null);
s = standard deviation of the sample; n = sample size
o z-test: appropriate when population is normally distributed with known variance.
X́−µ 0
 Z stat=
σ / √n
o Small sample and nonnormal population distribution – there are no reliable
statistical test

Module 11.3: Mean differences, difference in means

- Two t-tests used to test differences between the means of two populations. Conditions
o Samples are independent
o Samples are taken from two populations normally distributed
o Can be used when the population variance is unknown

o The test of the differences in means is used when there are two independent
samples.

o A test of the significance of the mean of the differences between paired

observations is used when the samples are not independent.

- In one case, the population variances are assumed to be equal, and the sample observations
are pooled, to get the standard deviation of the difference in means; in the other case, no
assumption is made regarding the equality between the two population variances, and the t-
test uses an approximated value for the df, both sample variances are used to get the
standard error of the difference in means
- Paired comparisons test: used if the observations in the two samples both depend on some
other factor, test is constructed on whether means of the differences between observations
for the two samples are different. The paired comparisons test is just a test of whether the
 average difference between monthly returns is significantly different from zero, based on
the standard error of the differences in monthly returns
- The chi-square test: used for hypothesis tests concerning the variance of a normally
distributed population. E.g. Letting σ represent the true population variance and σ02
2

represent the hypothesized variance, hypotheses for a two-tailed test of a single

population variance are structured as: H0: σ2 = σ02 versus Ha: σ2 ≠ σ02
- Chi-square test statistic: hypothesis testing of the population variance requires the use of
a chi-square distributed test statistic, denoted χ 2. The chi-square distribution is asymmetrical
and approaches the normal distribution in shape as the degrees of freedom increase
- Chi-square distribution is bounded below by zero, chi-square values cannot be negative
- F-test: Hypotheses concerned with equality of the variances of two populations, based on
two independent random samples which are normally distributed. If we let σ12 and σ22
represent the variances of normal Population 1 and Population 2, respectively, the hypotheses for
the two-tailed F-test of differences in the variances can be structured as:

H0: σ12 = σ versus Ha: σ ≠ σ

2
2
1
2
2
2

- The test statistic for the F-test is the ratio of the sample variances. The F-statistic is computed as:
S 21
- F= 2 where: S21= variance of the sample of n1 observations drawn from Population 1; S22 =
S2
variance of the sample of n2 observations drawn from Population 2. Note that n1 − 1 and n2 − 1 are
the degrees of freedom used to identify the appropriate critical value from the F-table (provided in
the Appendix). Always put the larger variance in the numerator. Following this convention
means we only have to consider the critical value for the right-hand tail.
- F-distribution is right-skewed and is bounded by zero on the left-hand side. The shape of
the F-distribution is determined by two separate degrees of freedom, the numerator degrees
of freedom, df , and the denominator degrees of freedom, df
1 2

- Test of hypothesis that population correlation coefficient equals zero:

- Parametric tests: rely on assumptions regarding the distribution of the population, are
specific to population parameters.
- Nonparametric tests: either do not consider a particular population parameter of have few
assumptions about the population sampled
- Spearman rank correlation test: can be used when data is not normally distributed, e.g.
performance ranks of 20 mutual funds for two years

Module 12.1: Elasticity

- Own-price elasticity of demand (PED): responsiveness of the quantity demanded to a
%∆Q
change in price, i.e.
%∆P

- Negative own-price elasticity: downward-sloping demand (i.e. price increases and

quantity decreases)

- Elastic demand: absolute value of elasticity > 1

- Inelastic demand: absolute value of elasticity < 1

- Perfectly Inelastic and Perfectly Elastic Demand, we illustrate the most extreme cases:
 o Perfectly elastic demand (at any higher price, quantity demanded decreases to zero)

o Perfectly inelastic demand (a change in price has no effect on quantity demanded)

- What affects demand elasticity:

o Quality, availability of substitutes, portion of income spent on a good, time

(elasticity tends to be greater the longer time period since the price change)

- Price Elasticity Along a Linear Demand Curve: In the upper part of the demand curve,
elasticity is greater (in absolute value) than 1; in other words, the percentage change in
quantity demanded is greater than the percentage change in price. In the lower part of the
curve, the percentage change in quantity demanded is smaller than the percentage change
in price

- Price elasticity equals –1.0 (unit or unitary elasticity) is that total revenue (price × quantity) is
maximized at that price

- Income elasticity (of demand): holding other independent variables constant, income
%∆Q
elasticity =
% ∆ Income

- For most goods, income elasticity is positive – these are called normal goods; the opposite
are inferior goods

%∆Q
- Cross-price elasticity of demand= . When cross-price elasticity is
% ∆ P of relared good
positive: two goods are substitutes; when it is negative, two goods are complements

- Demand function: Q= A+B*P

- Demand curve: P=(Q-A)/B

Module 12.2: Demand and Supply

- Substitution effect: when price of Good X decreases, consumption shifts to more of Good X

- Income effect: as total expenditure on the consumer’s original bundle of goods falls when
price of Good X falls, there is income effect: 3 possible outcomes of a decrease in price of
Good X:

o The substitution effect is positive, and the income effect is also positive—
consumption of Good X will increase.

o The substitution effect is positive, and the income effect is negative but smaller than
the substitution effect—consumption of Good X will increase.
 o The substitution effect is positive, and the income effect is negative and larger than
the substitution effect—consumption of Good X will decrease. – Giffen good

- Substitution effect: always increases consumption of the good for which price has reduced

- Income effect: positive for normal goods, negative for inferior goods

- Giffen good: an inferior good for which the negative income effect outweigh positive
substitution effect

- Veblen good: higher price makes the good more desirable. Violates theory of consumer
choice. Both the substitution and income effects of a price increase will decrease
consumption of the good

- Factors of production: land, labor, capital (physical capital, plant and equipment), materials
(inputs into the productive process)

- Production function: in economic analysis, often only consider capital and labor. Quantity of
output a firm can produce is a function of the amount of capital and labor employed

- Marginal product of labor is increasing: the additional output with each added labor, holding
capital constant, will be more than twice the output of 1 labor, due to team work and
specialization of tasks

- Diminishing marginal productivity of labor: as we continue to add additional workers to a

FIXED amount of capital, at some point, adding one more worker will increase the total
product by less than the addition of the previous worker – we have reached the point of
diminishing marginal productivity of labor, or that labor has reached the point of diminishing
marginal returns. Beyond this point, marginal output will continue to decline. Theoretically,
there is some quantity of labor for which marginal product is actually negative

- Short run: defined for a firm as the time period over which some factors of production are
fixed – typically, capital assumed fixed, i.e. firm cannot change its scale of operations. In the
long run, all factors of production are variable

- Shutdown and breakeven analysis: if total revenue covers both fixed and variable costs,
we’re at breakeven output quantity and economic profit = 0. During period of lease (short
run, e.g. 1 yr), as long as items are sold for more than variable cost, store shouldcontinue
operating to minimize losses. In the long run, a firm should shut down if the price is less than
average total cost, regardless of the relation between price and average variable cost

- Under perfect competition (firm as the price taker), price = marginal revenue = average
revenue
o If AR ≥ ATC, the firm should stay in the market in both the short and long run.
o If AR ≥ AVC, but AR < ATC, the firm should stay in the market in the short run but will
exit the market in the long run.
o If AR < AVC, the firm should shut down in the short run and exit the market in the long
run.

- Shutdown and breakeven under imperfect competition:

 o TR = TC: break even.
o TC > TR > TVC: firm should continue to operate in the short run but shut down in the
long run.
o TR < TVC: firm should shut down in the short run and the long run.

- Describe how economies of scale and diseconomies of scale affect costs: the analysis helps
firm to choose their most profitable scale of operations (which will be fixed in the short run).
Long-run average total cost (LRATC) curve is drawn and each point along the curve represent
the minimum ATC for a given plant size or scale of operations

- The lowest point on the LRATC corresponds to the scale or plant size at which the average
total cost of production is at a minimum. This scale is sometimes called the minimum
efficient scale

Module 13.1: Perfect Competition

- Perfect competition, monopolistic competition, oligopoly, monopoly. Determined through
the following factors:
o Number of firms and their relative sizes
o Degree to which firms differentiate their products
o Bargaining power of firms w respect to pricing
o Barriers to entry into or exit from the industry
o Degree to which firms compete on factors other than price
- Perfect competition: identify products, many firms, low barriers, compete only on the basis
of price, firms face perfectly elastic (horizontal) demand curves at price determined in mkt
- Monopolistic competition: differs from perfect competition in that products are not
identical. Each firm differentiates thru some combination of differences in quality, features,
marketing. Demand curve is downward sloping. While demand is elastic, it’s not perfectly
elastic. Barriers to entry are low.
- Oligopoly: only a few firms competing. Each firm mist consider actions and responses of
other firms in setting price and business strategy. Such firms are interdependent. Barriers to
entry are high, often cuz economies of scale in production or marketing lead to very large
firms. e.g. the automobile market
- Monopoly: single seller of a product with no close substitutes. Downward-sloping demand
curve and has the power to choose price at which it sells its product. High barriers to entry,
sources of which include protection offered by copyrights and patents, control over a
resource needed to produce, or supported by government. A natural monopoly: average
cost of production is falling over the relevant range of consumer demand – having 2 or more
producers would result in a significantly higher cost of production. E.g. electric power and
distribution business and other public utilities
- Network effects or synergies: company gains market power through network effects once it
has reached a critical level of market penetration
- Summary table:

Factor Perfect Monopolistic Oligopoly Monopoly

competition competition

Nr of sellers Many firms Many A few Single

 Barriers to Very low Low High Very high
entry

Nature of Very good Good Very good No good

substitute substitutes substitutes but substitutes or substitutes
products differentiated differentiated

Nature of Price only Price, Price, Advertising

competition marketing, marketing,
features features

Pricing power None Some Some to Significant

significant

- Price, marginal revenue, marginal cost, economic profit and elasticity of demand under each
mkt structure
- Determine optimal price and output for firms under each mkt structure
- Factors affecting long-run equilibrium under each mkt structure
o Perfect competition:

o Economic profit = total revenue – opportunity cost of production

o Short run profit maximization: economic profit is maximized at the quantity for
which marginal revenue = marginal cost. Profit maximization also occurs when total
revenue exceeds total cost by the maximum amount
o An economic loss occurs on any units for which marginal revenue is less than
marginal cost
o Equilibrium in a perfectly competitive market: firms will not earn economic profits
for any significant period of time. In equilibrium, each firm produces at the quantity
for which P=MR=MC=ATC so that no firm earns economic profits
- Short-run loss: economic loss when p < ATC. When P just covers AVC (P=AVC), firms is at its
shutdown point. When P<AVC, losses will be greater than fixed costs, here the firm will shut
down, which will limit the loss to just fixed cost. If firm does not believe P will ever > ATC,
shutting down is the only way to eliminate FC
- The long-run equilibrium output level is where MR=MC=ATC
- Short-run supply curves:
 - Changes in demand, entry and exit, and changes in plant size
o Increase in mkt demand  shift of demand curve to the right increase equilibrium
P & Q  greater profit-maximizing output  economic profit in the short runin
the long run, new entrants and increased scale of operation  supply curve shifts
downward (to the right)  P reduces
o Decrease in mkt demand  decrease in equilibrium P&Q  decrease scale of
operations or exit the mkt
o Downsizing: strategy to decrease plant size to reduce economic losses

Module 13.2: Monopolistic competition

- Characteristics: downward sloping demand curves. Highly elastic as competing products are
close substitutes
- Firms in monopolistic competition maximize economic profits by producing where MR=MC.
Positive economic profit because P exceeds ATC. In the long run, entry of new firms shifts
the demand curve down to where P=ATC, such that economic profit becomes zero. Firms
continue to produce at MC=MR but no more economic profit
 - Benefits and costs:
o As a result of monopolistic competition, some benefits are brought to consumers
including product innovation. A firm is considered to be spending optimal amount
on innovation when MC = MR of additional innovation
o Advertising expenses are high – this increases the ATC for firms. However as it’s
spread out to number of outputs, if advertising leads to enough of an increase in
output/ sales, it could actually decrease firms ATC
o Brand name effect

Module 13.3: Oligopoly

- Characteristics: higher barriers to entry, fewer firms, firms are interdependent – price
change by one firm can be met by price change by competitors/ actions of another firm
directly affects a given firm’s demand curve for the product

o Kinked demand curve model

o Cournot duopoly model.

o Nash equilibrium model (prisoner's dilemma).

o Stackelberg dominant firm model.

- Kinked demand curve model

o Assumption: an increase in a firm’s price will not be followed by competitors, but
price drop will
o Demand curve is more elastic at higher price and less so lower (kinked)
o Qk is the profit maximizing level of output. A firm believes if it raises price above Pk,
other firms will remain and it will lose mkt share; if a firm decreases price below Pk,
other firms will match the price cut and all firms will experience a relatively small
increase in sales
o Gap in marginal revenue curve: price at which kink is located is the firm’s profit
maximizing price
o Shortcoming of the model is it is incomplete because what determines the market
price (where the kink is located) is outside the scope of the model
 - Cournot model:
o Based on only 2 firms competing (duopoly), both with identical and constant
marginal costs of production
o Each firm knows Q supplied by the other firm in the previous period & assumes it
will supply the same in the next period. By subtracting this amount from the linear
mkt demand curve, the firm can construct a demand curve and MR curve for its own
product and this determine the profit maximizing Q
o Firms determine their Q simultaneously each period and under the Cournot model
assumptions, these Q will change each period until they’re equal. When each firm
selects the same Q, there’s no linger any additional profit to be gained by changing
quantity – stable equilibrium – the resulting P is less than the profit maximizing
price, but higher than MC
o As more firms are added to the model, the equilibrium mkt price falls towards MC
- Strategic games and Nash equilibrium: Cournot model is an earlier version of strategic
games decision models
- A Nash equilibrium is reached when the choices of all firms are such that there is no other
choice that makes any firm better off (increases profits or decreases losses). Example is
prisoner’s dilemma
- If firms can enter into and enforce an agreement to restrict output and charge higher prices,
and share the resulting profits, they are better off. There are, however, laws (anti-trust laws)
against such collusive agreements to restrain competition to protect the interests of
consumers. Collusive agreements to increase price in an oligopoly mkt will be more
successful when:
o There are fewer firms
o Products homogeneous
o Cost structures are similar
o Purchases are relatively small and frequent
o Retaliation more certain and severe
o Less actual or potential competition from firms outside the cartel
- Dominant firm oligopoly: a single firm with significantly large mkt share because of greater
scale and lower cost structure – the dominant firm (DF). Price determined by DF and other
competitive firms (CF) take the price

Module 13.4: Monopoly and concentration

- Monopoly: downward-sloping curve. Profit maximization is a trade-off between price and
quantity. Firm tries to determine what price to charge, trying to find the price and output
combination that will bring the maximum profit to the firm. 2 pricing strategies:
o Single-price
o Price discrimination
- Monopolists will expand output until MR = MC
o MR=P(1−1/EP), where P is the current price, and EP is the absolute value of the
price elasticity of demand at price = P. Therefore, we can also express the single-
price profit-maximizing output as that output for which MC = P(1−1/EP)

o Profit maximizing output for a monopolistic firm is the one for which MR = MC. The
profit maximizing output is Q*, with a price of P*, and an economic profit equal to
(P* – ATC*) × Q*

o Monopolists are price searchers and have imperfect information regarding market
demand. They must experiment with different prices to find the one that maximizes
profit
o Price discrimination: the practice of charging different consumers different prices for
the same product or service, e.g. different airline ticket prices; different movie tix
prices based on age. With the goal to capture more consumer surplus as economic
profit

- For price discrimination to work, the seller must:

o Face a downward-sloping demand curve.

o Have at least two identifiable groups of customers with different price elasticities of
demand for the product.

o Be able to prevent the customers paying the lower price from reselling the product
to the customers paying the higher price.

- Allocative efficiency – perfect competition vs. monopoly:

 o The efficient quantity is the one for which the sum of consumer surplus and
producer surplus is maximized. In Perfect Competition vs. Monopoly, this quantity is
where S = D, or equivalently, where marginal cost (MC) = marginal benefit (MB).
Monopoly creates a deadweight loss relative to perfect competition because
monopolies produce a quantity that does not maximize the sum of consumer
surplus and producer surplus. A further loss of efficiency results from rent seeking
when producers spend time and resources to try to acquire or establish a monopoly
- Natural monopoly: an industry where the average cost of production for a single firm is
falling throughout the relevant range of consumer demand
- Because monopolists produce less than the optimal quantity (do not achieve efficient
resource allocation), government regulation may be aimed at improving resource allocation
by regulating the prices monopolies may charge. This may be done through average cost
pricing or marginal cost pricing
o Average cost pricing: forces monopolists to reduce price to where ATC=D
o Marginal cost pricing: also referred to as efficient regulation, forces monopolists to
reduce P to where MC=D. but monopolists will incur a loss because P<ATC, a subsidy
is required to provide them w a normal profit
- Supply function under each mkt structure:
o There is a well defined supply curve only for perfect competition (where P=MR,
horizontal and perfectly elastic), not for the rest because under them the Q is
determined y intersection of MC and MR and price determined by demand curve.
We cannot construct Q as a function of P as it depends on MC but also D and MR
- Pricing strategies for each mkt structure:

o Perfect competition: MC=MR=P

o Monopoly: MC=MR<P

o Monopolistic competition: MC=MR<P

 o Oligopoly: interdependence of firms' pricing and output decisions, the optimal
pricing strategy depends on our assumptions about the reactions of other firms to
each firm's actions

 Kinked demand curve: This assumes competitors will match a price decrease
but not a price increase. MC=MR, the marginal revenue curve is
discontinuous (there's a gap in it), so for many cost structures the optimal
quantity is the same, given they face the same kinked demand curve

 Collusion: MC=MR but the oligopoly firms must agree to share this total
output among themselves and share the economic profits as a result.

 Dominant firm model: one firm has the lowest cost structure and a large
market share as a result. The dominant firm will MC=MR. Other firms take
that price and produce the quantity for which their MC=P

 Game theory: interdependence of oligopoly firms' decisions, assumptions

about how a competitor will react to a particular price and output decision
by a competitor can determine the optimal output and pricing strategy.
Given the variety of models and assumptions about competitor reactions,
the long-run outcome is indeterminate. We can only say that the price will
be between the monopoly price (if firms successfully collude) and the
perfect competition price which equals marginal cost (if potential
competition rules out prices above that level)

- Concentration measures in identifying mkt structure:

o When examining the pricing power of firms in an industry, we would like to be able
to measure elasticity of demand directly, but that is very difficult. Regulators often
use percentage of market sales (market share) to measure the degree of monopoly
or market power of a firm. Often, mergers or acquisitions of companies in the same
industry or market are not permitted by government authorities when they
determine the market share of the combined firms will be too high and, therefore,
detrimental to the economy
o N-firm concentration ratio, which is calculated as the sum or the percentage market
shares of the largest N firms in a market. While this measure is simple to calculate
and understand, it does not directly measure market power or elasticity of demand
o One limitation of the N-firm concentration ratio is that it may be relatively
insensitive to mergers of two firms with large market shares. This problem is
reduced by using an alternative measure of market concentration, the Herfindahl-
Hirschman Index (HHI). The HHI is calculated as the sum of the squares of the
market shares of the largest firms in the market
o Both these do not consider barriers to entry

Module 14.1: GDP, Income, and Expenditures

- GDP, gross domestic product: the total mkt value of the goods and services produced in a
country within a certain time period.
o Includes only purchases of newly produced goods and services. The sale or resale of
goods produced in previous periods is excluded
 o Transfer payments made by governments (e.g. unemployment, retirement and
welfare benefits) are not economic output and excluded
o Only mkt values of final goods and services – not goods and services resold or used
in the production of other goods and services, e.g. value of computer chips not
included, rather included in final prices of computers; value of a Rembrandt painting
not included as it’s not produced during the period
o Goods and services provided by government are included, even though they’re not
explicitly priced in mkts
o Owner-occupied housing is included by estimating their value for inclusion
- Expenditure approach: GDP calculated by summing amounts spent on all final goods and
services produced during the period, also termed value-of-final-output-method
o Sum-of-value-added method: sum the additions to value created at each stage of
production and distribution
- Income approach summing amounts earned by households and companies during the period
- Total expenditure and total income must be equal
- Nominal GDP: valued at current mkt prices. As nominal GDP is based on current prices,
inflation will inflate it even if the physical output of goods and services remains constant
from one year to the next
- Real GDP measures output using prices from a base year, removing effect of changes in
prices so inflation is not counted as economic growth. Calculated relative to a base year
- GDP deflator: a price index used to convert nominal to real GDP, taking out the effects of
change in the overall price level. It’s calculated as:
nominal GDP∈ year t
o GDP deflator for year t = * 100
value of year t output at base year
- Expenditure approach: GDP = C+I+G+(X-M) consumption spending, business
investment (capital equipment, inventories), gov purchases and net exports, also expressed
as GDP = (C+GC)+(I+GI)+(X-M) consumption spending, government consumption, business
investment, government investment, net export
- Income approach: GDP/ GDI gross domestic income = national income + capital consumption
allowance (CCA) + statistical discrepancy
o CCA – measures depreciation of physical capital from the production of goods and
services over a period – the amount that has to be reinvested to maintain
productivity of physical capital from one period to the next
o Statistical discrepancy – an adjustment for the difference between GDP measured
under the income approach and the expenditure approach because they use
different data
- National income: sum of income received by all factors of production that go into creation of
final output. National income = compensation of employees (wages and benefits) +
corporate and gov enterprise profits before taxes + interest income + unincorporated
business net income + rent + indirect business taxes – subsidies (taxes and subsidies that are
included in final prices)
- Personal income: measure of the pretax income received by households. Also includes the
government transfer payments e.g. unemployment or disability benefits
- Household disposable income/ personal disposable income: personal income after taxes.
The amount households have available to either save or spend on goods and services
- Relationship among saving, investment, fiscal balance, trade balance
o Combining the expenditure and income approaches, GDP = C+S+T, consumption
spending, household and business savings, net taxes (taxes paid minus transfer
payments received)
o C+I+G+(X-M)=C+S+T  S = I + (G – T) + (X – M). G – T is the fiscal balance (gov
spending and tax receipts); X-M is trade balance. Stated in words: private savings
 must equal private investment, plus government borrowing or minus government
savings, and minus the trade deficit or plus the trade surplus

 (G – T) = (S – I) – (X – M)

o From this equation, we can see that a government deficit (G – T > 0) must be
financed by some combination of a trade deficit (X – M < 0) or an excess of private
saving over private investment (S – I > 0)

Module 14.2: Aggregate Demand and Supply

- Consumption is a function of disposable income
o MPC (marginal propensity to consume): proportion of additional income spent on
consumption
o MPS (marginal propensity to save): proportion of xxx saved
o MPC + MPS = 100%
- Investment is a function of expected profitability and cost of financing
o Expected profitability depends on overall level of economic output
o Financing costs are reflected in real interest rates: nominal interest rates – expected
inflation rate
- Government purchases: may be viewed as independent of economic activity but tax revenue
(therefore fiscal balance) a function of economic output
- Net exports: function of domestic disposable income, foreign disposable income and relative
prices of goods in foreign and domestic mkts
- IS curve (income-saving): negative relationship between real interest rates and real income
for equilibrium in the goods mkts
o Lower interest rates  decrease savings  more consumption  increase
investment by firms  decrease interest rates, decreases S – I, so (S – I) < (G – T) +
(X – M) . to satisfy the balance, income must increase. Greater income increases
savings S – I, increases tax receipts, which decreases G – T, increase imports, wich
decreases (X – M)
- LM curve (liquidity-money): positive relationship between real interest rates and income
consistent with equilibrium in the money market
o Higher interest rate  decrease quantity of real money balances individuals hold
- Simultaneous equilibrium in the goods mkt and the money mkt: the values of real interest
rates and income must be consistent with equilibrium in both goods and money mkts
- Money supply shifts the LM curve: level of real money supply = M/P. holding the nominal
money supply M constant, when p raises, money supply decreases. Greater real money
supply reduces equilibrium real interest rates and shifts the LM curve
- The aggregate demand (AD) curve:
o Reflects the total level of expenditure in economy by consumers, businesses,
governments, and foreigners. A price level change will cause movement along the
AD curve. Meanwhile, some factors cause AD curve to shift, indicating Q of goods
and services demanded is greater at any given price level - shift to the right. GDP =
C + I + G + net X.
 C increases: increase in consumers’ wealth; consumer expectation of future
income; expansionary monetary policy; expansionary fiscal policy
 I increases: when businesses are optimistic about future sales, they tend to
increase their investment in plant, equipment, inventory; high capacity
utilization; expansionary monetary policy
 G increases: expansionary fiscal policy
 Net X increases: exchange rates; global economic growth
- The aggregate supply (AS) curve: describes the relationship between price level and quantity
of real GDP supplied.
o VSRAS (very short run aggregate supply): adjust output w/o adjusting price – firms
will adjust output through adjusting labor hours and intensity of use of plant and
equipment
o SRAS: upward sloping curve – labor productivity; input prices; expectation of future
output prices; taxes and government subsidies; exchange rates
o LRAS: perfectly inelastic. Wages and other input prices change proportionally to the
price level so it has no long-run effect on AS. This level of output as potential GDP or
full-employment GDP – increase in supply and quality of labor; increase in the supply
of natural resources; increase in the stock of physical capital; technology
o
Module 14.3: Macroeconomic equilibrium and growth
- Decrease in aggregate demand in the short run, reduce both real output to below full-
employment GDP level and price level (called a recessionary gap)
o Causes: decrease in growth rate of money supply, increase in taxes, decrease in gov
spending, lower equity and house prices, decrease in the expectations of consumers
and businesses for future economic growth
o Classical economists – unemployment will drive down wages and increase SRAS and
return economy to its full employment level of real GDP; Keynesian economists –
this will be a slow and economically painful process and increasing AD through
government action is the preferred alternative
o Measures: expansionary fiscal policy (increasing gov spending or decrease taxes),
expansionary monetary policy (increasing growth rate of money supply to reduce
interest rates)
- Increase in aggregate demand  in the short run, an equilibrium at a level of GDP greater
than full-employment GDP, where both GDP and the price level are increased (called an
inflationary gap) in the long run, SRAS curve shifts to the left as prices faces upward
pressure  economy returns to full-employment GDP along the LRAS curve
o Measures: decrease government spending, increase taxes, slowing the growth rate
of money supply
- Stagflation: combination of declining economic output and higher prices (stagnant economy
with inflation) – caused when changes in wages or prices of other important productive
inputs  shifts SRAS curve  short run equilibrium at lower GDP and higher overall price
level for goods and services compared to the long-run equilibrium
o Subsequent decrease in input prices can return the economy to its long-run
equilibrium output  e.g. decrease in wages and prices of other inputs – might be
quite slow and doing nothing costs votes for government
o Increase in AD from either expansionary fiscal or monetary policy can also return the
economy to its full employment level, but price level still higher compared to the
initial equilibrium  even higher inflation
- Effect of combined changes in AS and AD on the economy:

Aggregate Supply Aggregate Demand Real GDP Price Level

Increase Increase Increase Increase or decrease

Increase Decrease Increase or decrease Decrease

Decrease Increase Increase or decrease Increase

Decrease Decrease Decrease Increase or decrease

- Sources of economic growth: labor supply (no. of people over age 16 who’re either working
or available for work but currently unemployed), human capital, physical capital stock,
technology, natural resources
- Sustainability of economic growth:
o Potential GDP = aggregate hours worked * labor productivity
o Growth in potential GDP = growth in labor force + growth in labor productivity
- The sustainable rate of economic growth is important because long-term equity returns are
highly dependent on economic growth over time. A country's sustainable rate of economic
growth is the rate of increase in the economy's productive capacity (potential GDP)
- Production function: relationship of output to the size of the labor force, the capital stock
and productivity
 o Y = A * f(L, K)

o Y = aggregate economic output

o L = size of labor force

o K = amount of capital available

o A = total factor productivity – closely related to technological advances

o On a per worker basis – Y/L = A * f(K/L)

- This relationship suggests that labor productivity can be increased by either improving
technology or increasing physical capital per worker, sustainable long-term growth cannot
necessarily be achieved simply by capital deepening investment—that is to say, increasing
physical capital per worker over time. Productivity gains and growth of the labor force are
also necessary for long-term sustainable growth

- A well-known model (the Solow model or neoclassical model) of the contributions of technology,
labor, and capital to economic growth is: growth in potential GDP = growth in technology +
WL(growth in labor) + WC(growth in capital)

- growth in per-capita potential GDP = growth in technology + WC (growth in the capital-to-labor

ratio)

Module 15.1: Business cycle phases

- The business cycle is characterized by fluctuations in economic activity. Real gross domestic
product (GDP) and the rate of unemployment are the key variables used to determine the
current phase of the cycle. There are four phases:
o expansion (real GDP is increasing)
o peak (real GDP stops increasing and begins decreasing)
o contraction or recession (real GDP is decreasing)
o trough (real GDP stops decreasing and begins increasing)
- A common rule of thumb is to consider two consecutive quarters of growth in real GDP as
the beginning of an expansion and two consecutive quarters of declining real GDP as
indicating the beginning of a contraction. Statistical agencies look at a wider variety of
economic data such as employment, industrial production, and real personal income to
identify turning points in the business cycle
- A key aspect of business cycles is that they recur, but not at regular intervals. Past business
cycles have been as short as a year or longer than a decade. The idea of a business cycle
applies to economies that consist mainly of businesses. For economies that are mostly
subsistence agriculture or dominated by state planning, fluctuations in activity are not really
"business cycles" in the sense we are discussing here
- Resource use, housing sector activity, external trade sector activity varies in the business
cycles:
o Resource use: inventories are an important indicator, ratio of inventory / sales
 Expansion approaching peak: increase in inventory-sales ratio above normal
level
 Unplanned inventory growth leads firms to reduce production and thus
begins contraction cycle. However increase in inventory can be counted in
GDP as economic output so analysts who only look at GDP growth rather
than the inventory-sales ratio might see economic strength
  When contraction reaches its trough, inventory-sales ratio decrease below
normal level. Firms increase output – inventory-sales ratio increase toward
normal level
o Housing sector activity: important determinants of the level of economic activity in
housing sector include:
 Mortgage rates: low rate – more buying
 Housing cost relative to income
 Speculative activity
 Demographic factors: proportion of population in the 25-40 year old
segment is positively related to housing sector activity
o External trade sector activity: imports and exports are determined by domestic GDP
growth, GDP growth of trading partners, currency exchange rates
o Business cycle characteristics

Trough Expansion Peak Contraction/

Recession

GDP growth rate From negative to Increase Decrease Negative

positive

Unemployment High, use of Decrease, hiring Decrease, but Increase. Hours

rate overtime and accelerates hiring slows worked decrease
temp workers

Consumer Spending on Investment Growth in Decreasing

spending durable goods & increase in consumer
housing may producer’s spending and biz
increase equipment and investment at
home slower rates
construction

Inflation Moderate or May increase. Increase Decrease, w a lag

decreasing

Imports/ export Increase as Decrease as

domestic income domestic income
growth growth slows
accelerate

- Theories of business cycles

o Neoclassical school: change in technology drives AD and AS. Strong tendency for
economy toward full-employment equilibrium. Business cycles result from
temporary deviation from long-run equilibrium
o Keynesian: fluctuations are primarily due to swings in the level of optimism of those
who run businesses. They overinvest and overproduce when they are too optimistic
about future growth in potential GDP, and they underinvest and underproduce
when they are too pessimistic or fearful about the future growth in potential GDP –
wages are downward sticky. Increase AD directly thru monetary policy or fiscal
policy
o New Keynesian: prices of productive inputs other than labor are also "downward
sticky," presenting additional barriers to the restoration of full-employment
equilibrium
 o Monetarist: variations in AD that cause business cycles are due to variations in the
rate of growth of the money supply, likely from inappropriate decisions by the
monetary authorities. Recessions can be caused by external shocks or by
inappropriate decreases in the money supply. They suggest that to keep AD stable
and growing, the central bank should follow a policy of steady and predictable
increases in the money supply

o Austrian: business cycles are caused by government intervention in the economy.

When policymakers force interest rates down to artificially low levels, firms invest
too much capital in long-term and speculative lines of production, compared to
actual consumer demand. When these investments turn out poorly, firms must
decrease output in those lines, which causes a contraction

o New Classical school: introduced real business cycle theory (RBC). RBC emphasizes
the effect of real economic variables such as changes in technology and external
shocks, as opposed to monetary variables, as the cause of business cycles. RBC
applies utility theory from microeconomic analysis, to macroeconomics. Based on a
model in which individuals and firms maximize expected utility, New Classical
economists argue that policymakers should not try to counteract business cycles
because expansions and contractions are efficient market responses to real external
shocks

Module 15.2: Inflation and Indicators

- Types of unemployment
o Frictional: results from time lag needed to match employees and employers – always
with us even at full employment
o Structural: caused by long-rum changes in economy that eliminate some jobs while
generating others. Workers need to reskill
o Cyclical: caused by changes in general level of economic activity. Cyclical can be
positive (economy < full capacity) or negative (employment > full employment)
- Measures of unemployment
o Unemployed: not working and searching
o Labor force: all who’re employment & unemployed. Voluntarily unemployed are not
counted in labor force
o Underemployed: employed part time but would prefer to work full time or is
employed at a low-paying job despite being qualified for a significantly higher-paying
one
o Participation ratio/ activity ratio/ labor force participation rate = labor force
(including employed + unemployed & seeking) / working-age population (i.e. above
16)
o Umeployment rate = unemployed / labor force
o Discouraged workers: who are available for work but neither employed or actively
seeking
- Lagging indicator: e.g. unemployment rate is a lagging indicator of business cycle—due to
the movement of discouraged workers out of and back into the labor force. In the beginning
of an expansion, discouraged workers re-enter the workforce faster than firms who hire
immediately – causes unemployment rate to go up even though employment is expanding
- Inflation, disinflation, deflation and hyperinflation:
 o Inflation: price index used as a proxy for price level. Consumer price index (CPI) is
the widely used indicator of inflation. CPI basket represents the purchasing patterns
of a typical urban household. Categories and weights are pre-defined
 CPI=cost of basket at current prices / cost of basket at base period
prices×100
o Alternatives of consumer price inflation: price index for personal consumption
expenditures (in US, this index is created by surveying businesses rather than
consumers), the GDP deflator
o For both consumer and producer prices, analysts and policymakers often distinguish
between headline inflation and core inflation
 Headline inflation refers to price indexes for all goods
 Core inflation refers to price indexes that exclude food and energy
o The price index we calculated in our example is a Laspeyres index, which uses a
constant basket of goods and services. Most countries calculate consumer price
inflation this way. This could be biased because:

 New goods. Older products are often replaced by newer, but initially more
expensive, products. New goods are periodically added to the market
basket, and the older goods they replace are reduced in weight in the index.
This biases the index upward.

 Quality changes. If the price of a product increases because the product has
improved, the price increase is not due to inflation but still increases the
price index.

 Substitution. Even in an inflation-free economy, prices of goods relative to

each other change all the time. When two goods are substitutes for each
other, consumers increase their purchases of the relatively cheaper good
and buy less of the relatively more expensive good
o Adjusting measures for CPI
 A technique known as hedonic pricing can be used to adjust a price index for
product quality
 To address the bias from substitution, reporting agencies can use a chained
or chain-weighted price index such as a Fisher index. A Fisher index is the
geometric mean of a Laspeyres index and a Paasche index. A Paasche index
uses the current consumption weights, prices from the base period, and
prices in the current period.
- Two types of inflation: cost-push, demand-pull
o Cost-push inflation: results from a decrease in AS – inflation can result from an initial
decrease in AS caused by an increase in the real price of an important factor of
production, e.g. wages or energy. SRAS moves left; price level increases, with no
initial change in AD, output reduces; if decline in GDP brings a policy response that
stimulates AD, would result in a further increase in price level
 Wage-push inflation: as labor is the most important cost of production,
wage pressure can be a source of cost-push inflation
 Non-accelerating inflation rate of unemployment (NAIRU):
o Demand-pull inflation: results from an increase in AD – can result from an increase
in money supply, increase government spending, or any other changes that increase
AD
- Economic indicators can be classified into 3 categories: leading, coincident and lagging:
o Leading: known to change direction before peaks or troughs in the business cycle
 o Coincident: change direction at roughly the same time as peaks or troughs
o Lagging: don’t tend to change direction until after expansion or contractions are
alrdy underway

Module 16.1: Money and inflation

- Fiscal policy: government’s use of spending and taxation to influence economic activity
o Balanced: tax revenue = government expenditures
o Budget surplus: tax revenue > expenditures
o Budget deficit: expenditure > tax revenue
- Monetary policy: central bank’s actions that affect the quantity of money and credit in an
economy in order to influence economic activity.
o Expansionary/ accommodative/ easy: central bank increases quantity of money and
credit in an economy
o Contractionary/ restrictive/ tight: cb reduces quantity of money and credit
- Both policies are used by policymakers with the goals of maintaining stable prices and
producing positive economic growth. Fiscal policy also a tool for redistribution of income
and wealth
- Three primary functions of money: medium of exchange/ means of payment, unit of account
(prices of all goods and services are expressed in units of money), store of value
- Narrow money is the amount of notes (currency) and coins in circulation in an economy plus
balances in checkable bank deposits. Broad money includes narrow money plus any amount
available in liquid assets, which can be used to make purchases
- Money creation process:
o Promissory notes: customers deposited gold (or other precious metal) and were
issued a promissory note as a promise by the banker to return the gold on demand
from the depositor
o Fractional reserve banking: bankers recognizing that all the deposits would never be
withdrawn at the same time, started lending of deposits to earn interest
o In a fractional reserve banking system, banks can loan the excess reserve that’s not
required to be reserved. In this process, money supply is generated: money created
= new deposit / reserve requirement; money multiplier = 1/ reserve requirement
- Quantity theory of money: quantity of money is some proportion of the total spending in an
economy and implies the quantity equation of exchange:
o Money supply * velocity = price * real output (MV = PY)
o Velocity – the average times per year each unit of money is used to buy goods and
services
o Monetarists: Assuming that velocity and real output remain constant, any increase
in the money supply will lead to a proportionate increase in the price level
o The belief that real variables (real GDP and velocity) are not affected by monetary
variables (money supply and prices) is referred to as money neutrality
- Demand for and supply of money: the amount of wealth that households and firms in an
economy choose to hold in the form of money – transaction demand, precautionary
demand, speculative demand
- Supply and demand for money: at lower interest rates, firms and households choose to hold
more money; at higher interest rates, firms and households will desire to hold less money
and more interest-bearing financial assets  downward sloping demand curve for money;
supply side: determined by the central bank and perfectly inelastic vertical curve
o Central bank can affect short-term interest rates by increasing or decreasing the
money supply. An increase in money supply will shift the curve to the right, putting
 downward pressure on interest rates. Firms and households will reduce their money
holdings by buying securities, increasing securities prices and decreasing the interest
rate until reaching a new equilibrium rate (lower)

- Fisher effect: the nominal interest rate is sum of the real interest rate and expected inflation:
R = R + E[I]. consistent with money neutrality, real rates are relatively stable, the
Nom Real

changes in interest rates are driven by changes in expected inflation. R = R + E[I] +

Nom Real

RP with RP being risk premium as investors are exposed to the risk that inflation and
other future outcomes may be different
- Roles of central banks: primary objective is to control inflation so as to promote price
stability. High inflation leads to menu costs (cost to businesses for constantly changing
prices) and shoe leather costs (costs to individuals for making frequent trips to the bank
so as to minimize their holdings of cash that are depreciating due to inflation)
o Sole supplier of currency. Traditionally such money was backed by gold; later on,
gold backing was removed and money supplied by central bank was deemed
legal tender by law.
 Money not backed by any tangible value is termed fiat money. As long as
fiat money holds value over time and acceptable for transactions, it can
continue to serve as a medium of exchange
o Banker to the government and other banks: banking services to government and
other banks in the economy
o Regulator, and supervisor of payments system: regulate the banking system by
imposing standards of risk taking allowed and reserve requirements of banks under
its jurisdiction; oversee payments system to ensure smooth operations of the
clearing system domestically and in conjunction with other central banks for intl
transactions
o Lender of last resort: with ability to print money, able to supply money to banks
with shortages, and such gov backing prevent runs on banks
o Holder of gold and foreign exchange reserves
o Conductor of monetary policy
- Target inflation rate: normally around 2-3%. A target of zero inflation is not used because it
increases the risk of deflation
- Pegging exchange rate with USD: some development and several developing countries
choose a target level for the exchange rate of their currency with that of another country,
primarily the USD. They pegging country essentially commits to a policy intended to make its
inflation rate equal to the inflation rate of the country to which they peg their currency
Module 16.2: Monetary policy
- Three main Monetary policy tools:
o Policy rate: the rate at which banks can borrow funds from central bank if they have
temporary shortfalls in reserves. In US, it’s called discount rate; in ECB, it’s call
refinancing rate. One way to do this is through a repurchase agreement (CB
purchases securities from banks and banks in turn repurchase at a higher price in the
future). A lower policy rate reduces banks’ cost of funds, encourages lending and
tends to decrease interest rates overall
 Different from: fed funds rate which is rate banks lend short-term to each
other. US fed sets a target for this rate
o Reserve requirements: this tool only works well to increase money supply if banks
are willing to lend and customers willing to borrow. Seldom changed
o Open market operations: refers to buying and selling of securities by the central
banks. Buying securities by the CB increases money supply and decreases interest
rate; selling securities reduces the money supply and increases interest rate. Most
often used
- Monetary transmission mechanism: refers to the ways in which a change in monetary policy,
specifically central bank’s policy rate, affects the price level and inflation. Four channels
through which a change in the policy rates are directly transmitted to prices: other short-
term rates, asset values, currency exchange rates and expectations
o Policy rate increase -> short-term lending rates increase -> decrease AD as
consumers reduce credit purchases and businesses cut back on investment
o Policy rate increase -> bond, equity, asset prices decrease as discount rates applied
to future expected cash flows are increased
o Expenditure (consumer and business) decrease due to expectation for future
economic growth decrease
o May attract foreign investment in debt securities -> appreciate domestic currency
relative to foreign currencies -> X-M increase
o Together, increase interest rate  decrease AD and downward pressure on price
- Effective central banks: independence (free from political interference, operational
independence – CB is allowed to independently determine the policy rate; and target
independence – CB is defines how inflation is computed, sets the target inflation level and
determines the horizon), credibility (follow thru on stated intentions), transparency
(periodically disclose the state of economic environment by issuing inflation reports)
- Monetary policy & economic growth, inflation, interest, exchange rates
o If money neutrality holds, changes in monetary policy and policy rate will have NO
effect on real output. However, in the short run, it can..
o E.g. expansionary monetary policy include:

 CB buys securities to increase bank reserves

 The interbank lending rate decreases

 Other short-term rates decrease as the increase in the supply of loanable

funds

 Longer-term interest rates decrease

 Currency depreciate in the foreign exchange market

  Increases business investment in plant and equipment.

 Consumers increase their purchases of houses, autos, and durable goods

 Depreciation of the currency increases foreign demand for domestic goods

 These increases in consumption, investment, and net exports all increase

aggregate demand

 The increase in aggregate demand increases inflation, employment, and real

GDP

- Use of inflation, interest rate, exchange rate targeting by central banks

o Interest rate targeting, increasing the money supply when specific interest rates rose
above the target band and decreasing the money supply (or the rate of money
supply growth) when rates fell below the target band
o Inflation targeting (most widely used tool, in fact, the method required by law in
some countries). The most common inflation rate target is 2%, with a permitted
deviation of ±1% so the target band is 1% to 3%. Central banks are not necessarily
targeting current inflation, which is the result of prior policy and events, but inflation
in the range of two years in the future
o Some countries, especially developing countries, use exchange rate targeting. That
is, they target a foreign exchange rate between their currency and another (often
the U.S. dollar), rather than targeting inflation.
 One result of exchange rate targeting may be greater volatility of the money
supply because domestic monetary policy must adapt to the necessity of
maintaining a stable foreign exchange rate
 The net effect of exchange rate targeting is that the targeting country will
have the same inflation rate as the targeted currency and the targeting
country will need to follow monetary policy and accept interest rates that
are consistent with this goal, regardless of domestic economic
circumstances
- Determine whether a monetary policy is expansionary or contractionary
o Real trend rate/ trend rate: an economy’s long-term sustainable real growth rate
o Neutral interest rate: the growth rate of the money supply that neither increases
nor decreases the economic growth rate: neutral interest rate = real trend rate of
economic growth + inflation target
o Policy rate > neutral rate -> contractionary; policy rate < neutral rate -> expansionary
- Limitations of monetary policy

Module 16.3: Fiscal Policy

- Fiscal policy: government’s use of spending and taxation to meet macroeconomic goals
- Discretionary fiscal policy refers to the spending and taxing decisions of a national
government that are intended to stabilize the economy
- In contrast, automatic stabilizers are built-in fiscal devices triggered by the state of the
economy. For example, during a recession, tax receipts will fall, and government
expenditures on unemployment insurance payments will increase. Both of these tend to
increase budget deficits and are expansionary. Similarly, during boom times, higher tax
 revenues coupled with lower outflows for social programs tend to decrease budget deficits
and are contractionary

- Objectives of fiscal policy may include: Influencing the level of economic activity and
aggregate demand. Redistributing wealth and income among segments of the population.
Allocating resources among economic agents and sectors in the economy

- Fiscal policy tools: include spending and revenue tools

- Spending tools:
o Transfer payments: also known as entitlement programs, redistribute wealth, taxing
some and making payments to others, e.g. social security and unemployment
insurance benefits
o Current spending: government purchases of goods and services on an ongoing and
routine basis
o Capital spending: government spending on infrastructure, such as roads, schools,
bridges, and hospitals. Capital spending is expected to boost future productivity of
the economy
- Revenue tools:
o Direct taxes: levied on income or wealth
o Indirect taxes: levied on goods and services, e.g. sales taxes, VAT, excise taxes.
Indirect taxes can be used to reduce consumption of some goods and services (e.g.
alcohol, tobacco, gambling)
- Desirable attributes of tax policy:
o Simplicity, efficient, fairness (horizontal equality – people in similar situations should
pay similar taxes; vertical equality – richer people should pay more taxes),
sufficiency (should generate enough revenues to meet spending needs of the gov)
- Advantages of fiscal policy tools:

o Social policies, such as discouraging tobacco use, can be implemented very quickly
via indirect taxes

o Quick implementation of indirect taxes also means that government revenues can
be increased without significant additional costs

- Disadvantages of fiscal policy tools:

o Direct taxes and transfer payments take time to implement, delaying the impact of
fiscal policy

o Capital spending also takes a long time to implement. The economy may have
recovered by the time its impact is felt

- Fiscal multiplier: determines the potential increase in aggregate demand resulting from an
increase in gov spending
1
o Fiscal multiplier =
1−MPC (1−t)
- Balanced budget multiplier:
o Changes in taxes have a magnified effect on AD  decrease disposable income and
consumption expenditure  decrease AD
- Ricardian equivalence:
- Arguments whether size of a national debt relative to GDP matters:
 o Debt ratio: ratio of aggregate debt to GDP. If the real interest rate on the debt is
higher than real growth rate of the economy, then the debt ratio will increase over
time (keeping tax rates constant).
o Arguments for being concerned: higher deficits lead to higher future taxes which will
lead to disincentives to work and entrepreneurship; mkts lose confidence in the gov
and investors may be unwilling to refinance the debt; gov may default or print
money leading to higher inflation; increased gov borrowings will tend to increase
interest rates, and firms may reduce their borrowing and investment, decreasing the
impact on AD of deficit spending – referred to as crowing-out effect bcuz
government borrowing is taking the place of private sector borrowing
o Arguments against being concerned: if the debt is primarily being held by domestic
citizens, scale of problem is overstated; debt used to finance productive capital
investment; may prompt tax reform; if pvt sector savings in anticipation of future tax
liabilities just offset gov deficit (Ricardian equivalence holds)
- Difficulties of implementation of fiscal policy: the lag between conditions in the economy
and the impact on the economy of fiscal policy changes can be divided into three types:
o Recognition lag: Discretionary fiscal policy decisions are made by a political process.
The state of the economy is complex, and it may take policymakers time to
recognize the nature and extent of the economic problems
o Action lag: The time governments take to discuss, vote on, and enact fiscal policy
changes
o Impact lag: The time between the enactment of fiscal policy changes and when the
impact of the changes on the economy actually takes place. It takes time for
corporations and individuals to act on the fiscal policy changes, and fiscal multiplier
effects occur only over time as well
- For the exam, an increase (decrease) in a revenue item (e.g., sales tax) should be considered
contractionary (expansionary), and an increase (decrease) in a spending item (e.g.,
construction of highways) should be considered expansionary (contractionary)

- Monetary policy and fiscal policy may each be either expansionary or contractionary, so
there are four possible scenarios:

o Expansionary fiscal and monetary policy: impact will be highly expansionary taken
together. Interest rates will usually be lower (due to monetary policy), and the
private and public sectors will both expand

o Contractionary fiscal and monetary policy: aggregate demand and GDP would be
lower, and interest rates would be higher due to tight monetary policy. Both the
private and public sectors would contract

o Expansionary fiscal policy + contractionary monetary policy: In this case, aggregate

demand will likely be higher (due to fiscal policy), while interest rates will be higher
(due to increased government borrowing and tight monetary policy). Government
spending as a proportion of GDP will increase

o Contractionary fiscal policy + expansionary monetary policy: In this case, interest

rates will fall from decreased government borrowing and from the expansion of the
money supply, increasing both private consumption and output. Government
spending as a proportion of GDP will decrease due to contractionary fiscal policy.
The private sector would grow as a result of lower interest rates
Module 17.1: International Trade Benefits
- Definitions: Autarky or closed economy: A country that does not trade with other countries.
Free trade: A government places no restrictions or charges on import and export activity.
World price: The price of a good or service in world markets for those to whom trade is not
restricted. Domestic price: The price of a good or service in the domestic country, which may
be equal to the world price if free trade is permitted or different from the world price when
the domestic country restricts trade
- Terms of trade: The ratio of an index of the prices of a country's exports to an index of the
prices of its imports expressed relative to a base value of 100. If a country's terms of trade
are currently 102, the prices of the goods it exports have risen relative to the prices of the
goods it imports since the base period
- Foreign direct investment: Ownership of productive resources (land, factories, natural
resources) in a foreign country
- GDP vs. GNP: GNP measures total value of goods and services produced by the labor and
capital of a country’s citizens. The difference is due to non-citizen incomes of foreigners
working within a country, the income of citizens who work in other countries, the income of
foreign capital invested within a country, and the income of capital supplied by its citizens to
foreign countries. GDP is more closely related to economic activity within a country and so
its employment and growth
- Overall, economics tells us that the benefits of trade are greater than the costs for
economies as a whole, so that the winners could conceivably compensate the losers and still
be better off. We now turn to the economic theory that supports this view
- A country is said to have an absolute advantage in the production of a good if it can produce
the good at a lower resource cost than another country. A country is said to have a
comparative advantage in the production of a good if it has a lower opportunity cost in the
production of that good, expressed as the amount of another good that could have been
produced instead. Economic analysis tells us that, regardless of which country has an
absolute advantage, there are potential gains from trade as long as the countries'
opportunity costs of one good in terms of another are different

- The Ricardian model of trade: one factor of production—labor. The source of differences in
production costs in Ricardo's model is differences in labor productivity due to differences in
technology

- Heckscher and Ohlin: model with two factors of production—capital and labor. The source of
comparative advantage (differences in opportunity costs) in this model is differences in the
relative amounts of each factor the countries possess. We can view the England and
Portugal example in these terms by assuming that England has more capital (machinery)
compared to labor than Portugal. Additionally, we need to assume that cloth production is
more capital intensive than wine production. The result of their analysis is that the country
that has more capital will specialize in the capital intensive good and trade for the less
capital intensive good with the country that has relatively more labor and less capital.

- In the Heckscher-Ohlin model, there is a redistribution of wealth within each country

between labor and the owners of capital. The price of the relatively less scarce (more
available) factor of production in each country will increase so that owners of capital will
earn more in England, and workers will earn more in Portugal compared to what they were
without trade. This is easy to understand in the context of prices of the two goods. The good
that a country imports will fall in price (that is why they import it), and the good that a
country exports will rise in price. In our example, this means that the price of wine falls, and
the price of cloth rises in England. Because with trade, more of the capital-intensive good,
 cloth, is produced in England, demand for capital and the price of capital will increase in
England. As a result, capital receives more income at the expense of labor in England. In
Portugal, increasing the production of wine (which is labor intensive) increases the demand
for and price of labor, and workers gain at the expense of the owners of capital

Module 17.2: Trade restrictions

- A tariff placed on an imported good increases the domestic price, decreases the quantity
imported, and increases the quantity supplied domestically. Domestic producers gain,
foreign exporters lose, and the domestic government gains by the amount of the tariff
revenues
- A quota restricts the quantity of a good imported to the quota amount. Domestic producers
gain, and domestic consumers lose from an increase in the domestic price. The right to
export a specific quantity to the domestic country is granted by the domestic government,
which may or may not charge for the import licenses to foreign countries. If the import
licenses are sold, the domestic government gains the revenue

- A voluntary export restraint (VER) is just as it sounds. It refers to a voluntary agreement by a

government to limit the quantity of a good that can be exported. VERs are another way of
protecting the domestic producers in the importing country. They result in a welfare loss to
the importing country equal to that of an equivalent quota with no government charge for
the import licenses; that is, no capture of the quota rents.

- Export subsidies are payments by a government to its country's exporters. Export subsidies
benefit producers (exporters) of the good but increase prices and reduce consumer surplus
in the exporting country. In a small country, the price will increase by the amount of the
subsidy to equal the world price plus the subsidy. In the case of a large exporter of the good,
the world price decreases and some benefits from the subsidy accrue to foreign consumers,
while foreign producers are negatively affected

- Most of the effects of all four of these protectionist policies are the same. With respect to
the domestic (importing) country, import quotas, tariffs, and VERs all:

o Reduce imports.

o Increase price.

o Decrease consumer surplus.

o Increase domestic quantity supplied.

o Increase producer surplus.

- With one exception, all will decrease national welfare. Quotas and tariffs in a large country
could increase national welfare under a specific set of assumptions, primarily because for a
country that imports a large amount of the good, setting a quota or tariff could reduce the
world price for the good

- Some countries impose capital restrictions on the flow of financial capital across borders.
Restrictions include outright prohibition of investment in the domestic country by
foreigners, prohibition of or taxes on the income earned on foreign investments by domestic
 citizens, prohibition of foreign investment in certain domestic industries, and restrictions on
repatriation of earnings of foreign entities operating in a country
- Trading blocs/ regional trading agreements (RTA), in order of their degrees of integration:
o Free Trade Areas: all barriers to import and export are removed. E.g. NAFTA
o Customs union: in addition to above, all countries adopt a common set of trade
restrictions with non-members
o Common market: in addition to above, all barriers to the movement of labor and
capital goods among member countries are removed
o Economic union: in addition to above, Member countries establish common
institutions and economic policy for the union. E.g. EU
o Monetary union: in addition to above, Member countries adopt a single currency.
E.g. Euro Zone

- Balance of payment (BOP) accounts and their components:

o Current account: comprises of merchandise and services, income receipts, unilateral
transfers
o Capital account: capital transfers, sales and purchases of non-financial assets
o Financial account: government-owned assets abroad, foreign-owned assets in the
country
- A country that has imports valued more than its exports is said to have a current account
(trade) deficit, while countries with more exports than imports are said to have a current
account surplus. For a country with a trade deficit, it must be balanced by a net surplus in
the capital and financial accounts
- As a result, investment analysts often think of all financing flows as a single capital account
that combines items in the capital and financial accounts. Thinking in this way, any deficit in
the current account must be made up by a surplus in the combined capital account. That is,
the excess of imports over exports must be offset by sales of assets and debt incurred to
foreign entities. A current account surplus is similarly offset by purchases of foreign physical
or financial assets
- X − M = private savings + government savings – investment: Lower levels of private saving,
larger government deficits, and high rates of domestic investment all tend to result in or
increase a current account deficit. The intuition here is that low private or government
savings in relation to private investment in domestic capital requires foreign investment in
domestic capital
- International organizations that facilitate trade:
o The world bank
o The IMF
o WTO

Module 18.1: Foreign Exchange Rates

- Nominal, real, spot, forward exchange rates:
o Exchange rate: price or cost of one currency in terms of another. Notation – 1.416
USD/EUR to mean that each euro costs $1.416. exchange rate is 1.416 per euro.
Here the USD is the price currency, euro is the base currency
- Exchange rate expressed as price currency/ base currency is a direct quote for the investor
of price currency country and an indirect quote for investor of the base currency country
- Real exchange rate = nominal exchange rate x (CPI of base currency/ CPI of price currency)
 - A spot exchange rate is the currency exchange rate for immediate delivery, which for most
currencies means the exchange of currencies takes place two days after the trade.

- A forward exchange rate is a currency exchange rate for an exchange to be done in the
future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or
one year). A forward is actually an agreement to exchange a specific amount of one currency
for a specific amount of another on a future date specified in the forward agreement
- The primary dealers in currencies and originators of forward foreign exchange (FX) contracts
are large multinational banks. This part of the FX market is often called the sell side. On the
other hand, the buy side consists of the many buyers of foreign currencies and forward FX
contracts, including corporations, investment accounts (real money accounts refer to mutual
funds, pension funds, insurance companies and other that do not use derivatives; while
leveraged accounts refer to those that use derivatives), governments, retail markets
- Express real exchange rate percentage changes:

Module 18.2: Forward Exchange Rates

- A forward exchange rate quote: expressed in terms of the difference between the spot
exchange rate and the forward exchange rate. E.g. spot currency quote is 2.3481, each point
is 0.0001, a quote of +18.2 points for a 90-day forward exchange rate means the forward
rate is 0.00183 more than the spot exchange rate
- Arbitrage relationship: when currencies are freely traded and forward currency contracts
exist, the % difference between forward and spot exchange rates is approximately equal to
the difference between the two countries’ interest rates – this must hold and is called a No-
arbitrage condition. If this doesn’t hold then theres an opportunity to make a profit without
risk. Expressed in formula, no-arbitrage relation (i.e. interest rate parity) is
forward (1+interest rate of price currency)
o ¿
spot ( 1+interest rate of base currency )
- Forward discount/ premium: calculated relative to the spot exchange rate, is the percentage
difference between the forward price and the spot price

o USD/EUR spot = $1.312 USD/EUR 90-day forward = $1.320

o The (90-day) forward premium or discount on the euro = forward/spot − 1 = 1.320 /

1.312 − 1 = 0.609%. Because this is positive, it is interpreted as a forward premium
on the euro of 0.609%. Since we have the forward rate for 3 months, we could
annualize the discount simply by multiplying by 4
- Calculating the arbitrage-free forward exchange rate:
 1+ I of price currency
o Forward = spot *( ), note that usually the riskless rate is
1+ I of base currency
quoted as an annualized rate
o If the forward exchange rate differs from the no-arbitrage rate: assuming the
ABE/DUB no-arbitrage one-year forward exchange rate is 4.6558, if the forward rate
is 4.6000 – investor can borrow 1,000 DUB for one yr at 3% to purchase ABE  he
gets 4,567.1 ABE; he invests all the ABE at the rate of 5% (which is the interest rate
for ABE)  ends with 4,759.45 ABE at end of 1 year  enter into a forward contract
to exchange 4,795.45 ABE in one year at forward rate of 4.6 ABE/DUB  receives
1042.49 DUB  one year return on the 1000 DUB is 4.249% and higher than the 3%
1-yr DUB interest rate  after repaying 1000 DUB, the investor has a profit of 12.49
DUB with no risk and no initial out-of-pocket investment, this is called a pure
arbitrage profit
o Arbitrageurs will pursue this opportunity, buying ABE (driving down the spot
ABE/DUB exchange rate) and selling ABE forward (driving up the forward ABE/DUB
exchange rate), until the interest rate parity relation is restored and arbitrage profits
are no longer available

Module 18.3: Managing exchange rates

- Exchange rate regimes:
o Countries that do not have their own currency: 2 types – formal dollarization,
monetary union
o Countries that have their own currency: 7 types
 Currency board: e.g. Hong Kong, an explicit commitment to exchange
domestic currency for a specified foreign currency at a fixed exchange rate.
In HK, currency is only issued when fully backed by holdings of an equivalent
amount of USD
 Conventional fixed peg arrangement: a country pegs its currency within
margins of ±1% versus another currency or a basket that includes the
currencies of its major trading or financial partners
 Pegged exchange rates within horizontal bands/ target zone: permitted
fluctuations in currency value relative to another currency or basket of
currencies are wider compared to a conventional peg and monetary
authority has more policy discretion as a result
 Crawling peg: exchange rate is adjusted periodically, typically to adjust for
higher inflation versus the currency used in the peg
 Management of exchange rates within crawling bands: the width of the
bands that identify permissible exchange rates is increased over time
 Managed floating exchange rates: monetary authority attempts to influence
the exchange rate in response to specific indicators e.g. the balance of
payments, inflation rates, employment, without any specific target exchange
rate or predetermined exchange rate path
 Independently floating: the exchange rate is market-determined, and
foreign exchange market intervention is used only to slow the rate of change
and reduce short-term fluctuations, not to keep exchange rates at a target
level

- Effects of exchange rates on intl trade and capital flows

o The elasticities approach focuses on the impact of exchange rate changes on the
total value of imports and on the total value of exports. Because a trade deficit
(surplus) must be offset by a surplus (deficit) in the capital account, we can also view
the effects of a change in exchange rates on capital flows rather than on goods flows
 Marshall-Lerner condition: WX εX + WM (εM − 1) > 0
 In the case where import expenditures and export revenues are equal, W X =
WM, this condition reduces to εX + εM > 1, which is most often cited as the
classic Marshall-Lerner condition.
 Currency depreciation  greater improvement in trade deficit when either
import or export demand is elastic; composition of export and import goods
an important determinant of the success of currency depreciation in
reducing trade deficit
 Conclusion: currency depreciation will have a greater effect on the balance
of trade when M or X goods are primarily luxury goods, goods with close
substitutes, and goods that represent a large proportion of overall spending
 J-curve effect: M and X contracts for the delivery of goods most often
require delivery and payment in the future, M and X quantities may be
relatively insensitive to currency depreciation in the short run 
depreciation may worsen a trade deficit initially. Importers adjust over time
by reducing quantities. The Marshall-Lerner conditions take effect and the
currency depreciation begins to improve the trade balance
o The absorption approach to analyzing the effect of a change in exchange rates
focuses on capital flows

 Elasticities approach only considers the microeconomic relationship

between exchange rates and trade balances  however, capital flows also
change as a result of a currency depreciation that improves the balance of
trade

 The absorption approach is a macroeconomic technique that focuses on the

capital account and can be represented as: BT = Y – E where:

 Y = domestic production of goods and services or national income

 E = domestic absorption of goods and services, which is total expenditure

 BT = balance of trade
 Interpretation: for the balance of trade to improve in response to a domestic
currency depreciation  income relative to expenditure must increase
(domestic absorption must fall); national saving increase relative to
domestic investment in physical capital
 o exports − imports ≡ (private savings − investment in physical capital) + (tax revenue −
government spending) or X − M≡ (S − I) + (T − G)

Module 19.1: Financial Statement Roles

- describe roles of the statement of financial position, statement of comprehensive income,
statement of changes in equity, and statement of cash flows:
o balance sheet, i.e. statement of financial position, i.e. statement of financial
condition: financial position at a point in time
 assets – resources controlled by the firm
 liabilities – amounts owed to lenders and other creditors
 owners’ equity, i.e. shareholders’ equity, shareholders’ funds, net asset –the
residual interest in the net assets of an entity that remains after deducting
its liabilities from its assets
 fundamental accounting equation: assets = liabilities + owners’ equity
 capital structure: the proportions of liabilities and equity used to finance a
company
o statement of comprehensive income: all changes in equity except for shareholder
transactions (e.g. issuing stock, repurchasing stock, paying dividends).
 Income statement (can be combined with “other comprehensive income” or
be presented as a single statement of comprehensive income), i.e.
statement of operations, i.e. profit and loss statement: reports on the
financial performance of the firm over a period of time. It includes revenues,
expenses, and gains and losses

 Revenues are inflows from delivering or producing goods, rendering

services, or other activities that constitute the entity's ongoing
major or central operations.

 Expenses are outflows from delivering or producing goods or

services that constitute the entity's ongoing major or central
operations.

 Other income includes gains that may or may not arise in the ordinary
course of business.

o Statement of changes in equity: reports amounts and sources of changes in equity

investors’ investment in the firm over a period of time
 o The statement of cash flows reports the company's cash receipts and payments.
These cash flows are classified as follows:

 Operating cash flows: cash effects of transactions that involve the normal
business of the firm

 Investing cash flows: those resulting from the acquisition or sale of property,
plant, and equipment; of a subsidiary or segment; of securities; and of
investments in other firms

 Financing cash flows: those resulting from issuance or retirement of the

firm's debt and equity securities and include dividends paid to stockholders

Module 19.2: Footnotes, audit, analysis

- Financial statement notes: disclosures that provide further details about the info
summarized in the financial statements

- Management’s commentary/ management’s report/ operating and financial review/

management’s Discussion and Analysis: one of the most useful sections of the annual report
– should address nature of the business, management’s objectives, company past
performance, performance measures used, company’s key relationships, resources and risks
– some parts of management’s commentary may be unaudited

- Audits of financial statements: an independent review of an entity’s financial statements.

Public accounts examine the company’s accounting and internal control systems, confirms
assets and liabilities and generally tried to determine that there’re no material errors in the
financial statements

- Standard auditor’s opinion contain three parts: 1. Independent review; 2. Generally

accepted auditing standards were followed; 3. Statements were prepared in accordance
with accepted accounting principles and the principles chosen and estimates are reasonable

- Auditors’ Opinions

o Unqualified opinion/ unmodified or clean opinion: statements are free from material
omissions and errors

 Modified opinion: any opinion other than unqualified

o Qualified opinion: there are exceptions to be explained in the audit report

o Adverse opinion: statements are not presented fairly or are materially

nonconforming w accounting standards

o Disclaimer of opinion: unable to express an opinion

- Auditors opinion should also contain

 o Explanatory paragraph when a material loss is probable but amount cannot be
reasonably estimated  uncertainties relate to going concern assumption (the firm
will continue to operate for the foreseeable future), valuation or realization of asset
values, or to litigation  this type of disclosure a signal of serious problems

o Internal controls: processes by which the company ensures that it presents accurate
financial statements

o Key audit matters: highlights accounting choices that are of greatest significance to
users of financial statements

- Other analysts sources besides annual financial statements:

o Quarterly or semiannual reports (not necessarily audited)

o Securities and Exchange Commission (SEC) filings are available from EDGAR
(Electronic Data Gathering, Analysis, and Retrieval System, www.sec.gov). Including
Form 8-K, which a company must file to report events such as acquisitions and
disposals of major assets or changes in its management or corporate governance.
Companies' annual and quarterly financial statements are also filed with the SEC
(Form 10-K and Form 10-Q, respectively)

o Proxy statements: issued to shareholders when there are matters requiring

shareholder vote. Also filed with the SEC – info e.g. election of (and qualifications of)
board members, compensation, management qualifications, and the issuance of
stock options

o Corporate reports, press releases, earnings guidance (before FS are released) and
conference call

o Pertinent info on economic conditions and company industry, competitor

comparison

- Steps in financial statement analysis framework

o 1. State the objective and context

o 2: Gather data

o 3: Process the data

o 4: Analyze and interpret the data

o 5: Report the conclusions or recommendations

o 6:  Update the analysis. Repeat these steps periodically and change the conclusions
or recommendations when necessary
Module 20.1: Standards Overview
- Objective of financial reporting and importance of financial reporting standards

o To provide info about the firm to current and potential investors and creditors that’s
useful for making their decisions about investing or lending to the firm

o Reporting standards ensure that transactions are reported by firms similarly.

However, standards must remain flexible and allow discretion to management to
properly describe the economics of the firm

- Standard setting bodies: professional org of accountants and auditors that establish financial
reporting standards. 2 main ones: Financial Accounting Standards Board (FASB) – in the US,
it sets forth Generally Accepted Accounting Principles (GAAP); International Accounting
Standards Board (IASB) – outside the US, it sets forth International Financial Reporting
Standards (IFRS). Some IASB standards are referred to as International Accounting Standards
(IAS)

- Regulatory authorities: government agencies w legal authority to enforce compliance w

financial reporting standards. Securities and Exchange Commission (US), Financial Conduct
Authority (UK)

- Sarbanes-Oxley Act of 2002: prohibits a company’s external auditors from providing certain
paid services to the company, to avoid conflict of interest involved and promote auditor
independence. SEC has responsibility of enforcing it. In its required filings including:

o Form S-1: registration statement (before sale of new securities to public)

o Form 10-K: required ANNUAL filing that includes info abt business and its mgmt.,
audited financial statements and disclosures and disclosures abt legal matters
involving the firm. Similar to annual report but annual report not a substitute for 10-
K filing

o Form 10-Q: US firms required to file, quarterly, with updated financial statements
(unlike Form 10-K, these statements do not have to be audited) and disclosures
about certain events such as significant legal proceedings or changes in accounting
policy. Non-U.S. companies are typically required to file the equivalent Form 6-K
semiannually

o Form DEF-14A: When a company prepares a proxy statement for its shareholders
prior to the annual meeting or other shareholder vote, it also files the statement
with the SEC as Form DEF-14A

o Form 8-K: to disclose material events including significant asset acquisitions and
disposals, changes in management or corporate governance, or matters related to
its accountants, its financial statements, or the markets in which its securities trade

o Form 144: can issue securities to certain qualified buyers without registering the
securities with the SEC but must notify the SEC that it intends to do so
 o Forms 3, 4, 5: involve the beneficial ownership of securities by a company's officers
and directors. Analysts can use these filings to learn about purchases and sales of
company securities by corporate insiders

Module 20.2: Financial Reporting Framework

- IASB’s conceptual framework, inclg. Qualitative characteristics, constraints and required
reporting elements of financial reports

o Objective: provide financial info that’s useful in making decisions about providing
resources to an entity

o Qualitative characteristics – fundamental:

 Relevance: info can influence users’ economic decision or affect evaluation

of past events or forecast of future events. Predictive value, confirmatory
value or both. Materiality is an aspect

 Faithful representation: complete, neutral and free from error

o Qualitative characteristics – enhancing:

 Comparability: consistent among firms and across time periods

 Verifiability: independent observers, using same methods obtain similar

results

 Timeliness: info available to decision makers before info is stale

 Understandability: able to readily understand the info. Useful info should

not be omitted just cuz its complicated

- Required reporting elements:

o For measuring financial position: assets, liabilities, owners’ equity

 Assets: resources controlled as a result of past transactions that are

expected to provide future economic benefits

 Liabilities: obligations as a result of past events that are expected to require

an outflow of economic resources

 Equity: owners’ residual interest in the assets after deducting liabilities

o For measuring performance: income and expenses

 Income: increase in economic benefits, either increasing assets or

decreasing liabilities  increases owners’ equity – include revenues and
gains
  Expenses: decrease in economic benefits, either decreasing assets or
increasing liabilities  decreases owners’ equity – losses are included

o When: an item should be recognized in the fs element if a future economic benefit

from the item is probable and value or cost can be measured reliably

o How much: depends on their measurement base.

 Historical cost: amount originally paid

 Amortized cost: historical cost adjusted for depreciation, amortization,

depletion and impairment

 Current cost: the amount the firm would have to pay today for the same
asset

 Net realizable value: the estimated selling price of the asset in the normal
course of business minus the selling costs

 Present value: the discounted value of the asset's expected future cash
flows

 Fair value: the price at which an asset could be sold, or a liability transferred,
in an orderly transaction between willing parties

- Constraints, assumptions: tradeoffs exist of the enhancing characteristics. Benefit that users
gain from the info should be greater than cost of presenting it. 2 underlying assumptions of
fs:

o Accrual accounting: fs should reflect trx at time they actually occur, not necessarily
when cash is paid

o Going concern: assumes company will continue to exist for the foreseeable future

- Required financial statements: 5 of them

o balance sheet (statement of financial position)

o statement of comprehensive income

o cash flow statement

o statement of changes in owners’ equity

o explanatory notes, inclg a summary of accounting policies

- features for preparing fs (IAS No.1):

o fair representation
 o going concern basis

o accrual basis (applicable to all but statement of cash flows)

o consistency (between periods. Prior period amounts disclosed for comparison)

o materiality (free from misstatements or omissions which could influence decision)

o aggregation of similar items and separation of dissimilar items

o no offsetting of assets/ liabilities, income/ expenses, unless…

o reporting frequency: at least annually

o comparative info from prior periods

- structure and content: 1) should present a classified balance sheet showing current and
noncurrent assets and liabilities; 2) minimum info required on face of fs and in notes (must
include revenue, profit or loss, tax expense, and finance costs, among others); 3)
comparative info

Module 21.1: Income Statement Overview

- Components of income statement (also called statement of operations, statement of
earnings, or P&L statement): reports revenues and expenses of the firm over a period of
time

o The income statement equation: revenue – expenses = net income

o Income statement and a statement of OCI can be presented separately under both
US GAAP and IFRS

o Revenue: amounts reported from sale of goods and services in the normal course of
business

o Net revenue: revenue less adjustments for estimated returns and allowances

o The terms revenue and sales are sometimes used synonymously. However, sales is
just one component of revenue in many firms. In some countries, revenues are
referred to as "turnover”

o Expenses: amounts incurred to generate revenue, inclg. Cost of goods sold (cogs),
opex, interest, taxes. Grouped by nature or function

o Firms can present columnar data in chronological order from left-to-right or vice
versa. Also, some firms present expenses as negative numbers while other firms use
parentheses to signify expenses. Still other firms present expenses as positive
numbers with the assumption that users know that expenses are subtracted in the
income statement. Watch for these different treatments on the exam
 o Gains and losses: result in increase or decrease of economic benefits. May or may
NOT result from ordinary business activities

o Rearranging the equation:

 net income = revenues − ordinary expenses + other income − other expense

+ gains – losses

- When a firm has a controlling interest in a subsidiary, the statements of the two firms are
consolidated; the earnings of both firms are included on the income statement.
o the share (proportion) of the subsidiary's income not owned by the parent is
reported in parent's income statement as the noncontrolling interest (also known as
minority interest or minority owners' interest). The noncontrolling interest is
subtracted from the consolidated total income to get the net income of the parent
company.
- Format: income statement can be a single-step or multi-step format
o Single-step statement: all revenues are grouped together and all expenses are
grouped together
o Multi-step format: include gross profit (revenue – cogs, i.e. direct cost of providing a
product or service) operating profit/ income (minus SG&A and depreciation) 
Income before tax (minus interest expenses i.e. financing cost)  income from
continuing operations (minus provision for income taxes)  net income (minus
earnings/ losses from discontinued operations, net of tax). Net income is sometimes
called earnings or the bottom line

o For nonfinancial firms, operating profit is profit before financing costs, income taxes,
and non-operating items are considered

o Interest expense is usually considered an operating expense for financial firms.

Although there may be some differences between operating income and earnings
before interest and taxes (EBIT), we often use EBIT as a proxy for operating income
in analysis

Module 21.2: revenue recognition

- General principles of revenue recognition and accounting standards
o If sale of good is made on credit  revenue recognized at time of sale  an asset
(accounts receivable) is created on balance sheet  record revenue when cash
received
o If payment for the goods is received prior to transfer of goods  at time of cash
receipt, create a liability (unearned revenue) on balance sheet  recognize revenue
as goods are transferred

o Central principle: a firm should recognize revenue when it has transferred a good or
service to a customer  consistent w accrual accounting principle that revenue
should be recognized when earned

o Five-step process for recognizing revenue:

 Identify the contract(s) with a customer. [contract: an agreement between

two or more parties that specifies their obligations and rights]
  Identify the separate or distinct performance obligations [a promise to
deliver a distinct good or service] in the contract.

 Determine the transaction price.

 Allocate the transaction price to the performance obligations in the

contract.

 Recognize revenue when (or as) the entity satisfies a performance obligation

o A firm should recognize revenue only when it is highly probable they will not have to
reverse it. A firm may need to recognize a liability for a refund obligation (and an
offsetting asset for the right to returned goods) if revenue from a sale cannot be
estimated reliably
o For long-term contracts, revenue is recognized based on a firm's progress toward
completing a performance obligation.
 Input percentage: Progress toward completion can be measured from the
input side (e.g., using the percentage of completion costs incurred as of the
statement date).
 Output percentage: Progress can also be measured from the output side,
using engineering milestones or percentage of the total output delivered to
date
- Calculate revenue given info influencing choice of recognition method

Module 21.3: Expense Recognition

- General principles of expense recognition
o Accrual method of accounting, expense recognition is based on matching principle –
expense to generate revenue recognized in the same period as revenue (i.e.
inventory purchased prior, but both revenue and expense (cogs) are recognized in
later period when inventory is sold)
o Period costs: indirect expenses not tied to revenue generation. Admin costs e.g., are
expensed in the period incurred
- Inventory expense recognition:
o Specific identification method: can be used if a firm can identify exactly when items
were sold and when items remain in inventory, e.g. auto dealer records each vehicle
sold or in inventory by its identification number
o FIFO: cost of inventory acquired first (beginning inventory and early purchases) is
used to calculate the cost of goods sold for the period. Cost of the most recent
purchases is used to calculate ending inventory
 Appropriate for inventory that has a limited shelf life, food products
o LIFO: the other way around
 LIFO is appropriate for inventory that does not deteriorate with age. For
example, a coal distributor will sell coal off the top of the pile
 Popular in the US due to income tax benefits. In an inflationary
environment, LIFO results in higher cost of goods sold. Higher cost of goods
sold results in lower taxable income and, therefore, lower income taxes
o Weighted average cost: no assumption abt physical flow of inventory. Cost per unit =
(cost of available goods) / (total units available)
o US GAAP – allow all above three; IFRS – LIFO NOT allowed
- Depreciation expense recognition: allocation of cost over an asset’s life
o Cost of long-lived assets must be matched with revenues
 o Called depreciation (tangible assets), depletion (natural resources), amortization
(intangible assets)
o Straight-line deprecation method: equal amount each period

 SL depreciation expense= (cost – residual value)/ useful life

o Accelerated depreciation methods: generate more benefits (higher depreciation)

earlier on and fewer benefits (lower deprecation) in last yrs of their economic life
 Total depreciation expense over the life of the asset will be the same as it
would be if straight-line depreciation were used
o Declining/ diminishing balance method (DB): applies a constant rate of depreciation
to an asset's (declining) book value each year

 DDB depreciation=(2/useful life)*(cost–accumulated depreciation)

o Amortization: most use straight line method

 Intangible assets with indefinite lives (e.g., goodwill) are not amortized.
However, they must be tested for impairment at least annually. If the asset
value is impaired, an expense equal to the impairment amount is recognized
on the income statement
o Bad debt expense and warranty expense recognition: firms are required to estimate
bad debt expense and/or warranty expense. Expense recognized in the period of the
sale
- Implications of expense recognition choices for financial analysis
o Like revenue recognition, expense recognition requires a number of estimates. Since
estimates are involved, it is possible for firms to delay or accelerate the recognition
of expenses. Delayed expense recognition increases current net income and is
therefore more aggressive
o Consider the underlying reasons for a change in an expense estimate, e.g. bad debt
expense
o Compare estimate to those of other firms in the industry, e.g. warranty
- Non-recurring items (discontinued operations, unusual or infrequent items)

o Discontinued ops:

 A discontinued operation is one that management has decided to dispose of,

but either has not yet done so, or has disposed of in the current year after
the operation had generated income or losses. To be accounted for as a
discontinued operation, the business—in terms of assets, operations, and
investing and financing activities—must be physically and operationally
distinct from the rest of the firm

 The date when the company develops a formal plan for disposing of an
operation is referred to as the measurement date, and the time between
the measurement period and the actual disposal date is referred to as the
phaseout period

 Any income or loss from discontinued operations is reported separately in

the income statement, net of tax, after income from continuing operations
  Any past income statements presented must be restated, separating the
income or loss from the discontinued operations

 On the measurement date, the company will accrue any estimated loss
during the phaseout period and any estimated loss on the sale of the
business. Any expected gain on the disposal cannot be reported until after
the sale is completed

o Unusual or infrequent items: either unusual in nature or infrequent in occurrence.

E.g. Gains or losses from the sale of assets or part of a business, if these activities are
not a firm's ordinary operations. Impairments, write-offs, write-downs, and
restructuring costs

 Unusual or infrequent items are included in income from continuing

operations and are reported before tax

 Analytical implications: Even though unusual or infrequent items affect net

income from continuing operations, an analyst may want to review them to
determine whether they truly should be included when forecasting future
firm earnings. Some companies appear to be accident-prone and have
"unusual or infrequent" losses every year or every few years

- Accounting changes: changes in accounting policies, changes in accounting estimates, and

prior-period adjustments

o Standard setting bodies, at times, issue a change in accounting policy. Sometimes a

firm may change which accounting policy it applies, for example, by changing its
inventory costing method or capitalizing rather than expensing specific purchases

o May require either retrospective application or prospective application

o Retrospective application: any prior-period financial statements presented in a firm's

current financial statements must be restated, applying the new policy to those
statements as well as future statements

o Prospective application: prior statements are not restated, and the new policies are
applied only to future financial statements.

o Unless impractical, changes in accounting policies require retrospective application.

Option of modified retrospective application – does not require restatement of
prior-period statements; however, beginning values of affected accounts are
adjusted for the cumulative effects of the change

- Distinguish operating and non-operating components of the income statement

o Operating and nonoperating transactions are usually reported separately in the

income statement

 Nonfinancial firm: nonoperating transactions may result from investment

income and financing expenses, interest expenses as part of capital
structure  not part of the firm's normal business operations
  Financial firm: investment income and financing expenses are usually
considered operating activities

Module 21.4: EPS and Dilutive Securities

- Calculate EPS (basic and diluted) for both simple and complex capital structures

o Earnings per share is one of the most commonly used corporate profitability
performance measures for public-traded firms. Only reported for shares of common
stock (also called ordinary stock)

o Simple capital structure – contains no potentially dilutive securities  only report

basic EPS

 Common stock – yes

 Nonconvertible debt – yes

 Nonconvertible preferred stock – yes

o Complex capital structure – contains potentially dilutive securities  must report

both basic and diluted EPS

 Options – yes

 Warrants – yes

 Convertible securities – yes

o Calculations:

net income− preferred dividends

 Basic EPS =
weighted average number of common shares outstanding

 Weighted average number of common shares: number of shares

outstanding during the year, weighted by the portion of the year they were
outstanding

- Effect of stock dividends and stock splits

o Stock dividend: distribution of additional shares to each shareholder in amount

proportional to their current number of shares. If 10% stock dividend is paid, holder
of 100 shares will get 10 additional shares

o Stock split: division of each old share into a specific number of post-split shares.
Holder of 100 shares will have 200 after a 2-for-1 split or 150 shares after a 3-for-2
split

Shares outstanding on January 1: 10,000 × 1.10 × 12/12 of the year = 11,000

Shares issued April 1: 4,000 × 1.10 × 9/12 of the year = 3,300
Shares repurchased September 1: –3,000 × 4/12 of the year = –1,000
Weighted average shares outstanding = 13,300

- Dilutive securities such as convertibles and options are found in a complex capital structure
and always decrease EPS. Convertibles and options may also be antidilutive, which will
increase EPS hence the name antidilutive. The only way to know if a security is dilutive or
antidilutive is to compare the basic EPS to diluted EPS. If the diluted EPS is higher than the
basic EPS then the security is antidilutive and should not be included when determining
diluted EPS

- Diluted EPS:

o Dilutive/ antidilutive securities are stock options, warrants, convertible debt or

convertible preferred stock that would decrease/ increase EPS if exercised or
converted to common stock

o Numerator of the basic EPS equation contains income available to common

shareholders (net income less preferred dividends). In the case of diluted EPS, if
there are dilutive securities, then the numerator must be adjusted as follows:

adjusted income available for common shares

Diluted EPS = =
weighted−average common∧ potential common shares outstanding
[ net income−preferred dividends ] + [ convertible preferred dividends ] +(convertible debt interest )(1−t)
convers
weighted average shares +shares conversion of conv . pfd . shares+¿ shares ¿
¿

 A quick way to check whether convertible preferred stock is dilutive is to

divide the preferred dividend by the number of shares that will be created if
the preferred stock is converted. If it is less than basic EPS, the convertible
preferred is dilutive

 A quick way to determine whether the convertible debt is dilutive is to

calculate its per share impact by: convertible debt interest (1 – t)/
convertible debt shares. If this per share amount is greater than basic EPS,
the convertible debt is antidilutive, and the effects of conversion should not
be included when calculating diluted EPS

- Stock options and warrants

o They are dilutive only when their exercise prices are less than the average market
price of the stock over the year

o If the options or warrants are dilutive, use the treasury stock method to calculate
the number of shares used in the denominator

 The method assumes the funds received by the company from the exercise
of the options would be used to hypothetically purchase shares of the
company's common stock in the market at the average market price
  The net increase in the number of shares outstanding (the adjustment to the
denominator): the number of shares created by exercising the options less
the number of shares hypothetically repurchased with the proceeds of
exercise

Module 21.5: Common-size income statements

- Convert income statements to common-size income statements

o A vertical common-size income statement expresses each category of the income

statement as a % of revenue. Standardizes the income statement by eliminating
effects of size thus allows for comparison of income statement items over time and
across firm

o In most cases, expressing expense as a % of revenue is appropriate – except for

income tax expense -> tax is more meaningful as a % of pretax income

- Evaluate financial performance

o Margin ratios:

 Gross profit margin = gross profit (i.e. revenue – cogs) / revenue (i.e. sales)

 Net profit margin = net income / revenue

 Any subtotals/ revenue, e.g. operating profit margin (i.e. operating profit
over revenue), pretax margin (i.e. pretax accounting profit over revenue)

- Comprehensive income and other comprehensive income

o Retained earnings: at end of each accounting period, net income less dividends is
added to stockholders’ equity through retained earnings account  income
statement goes into stakeholder’s equity

o Comprehensive income measures all changes in equity except for owner

contributions and distributions, i.e. sum of net income and OCI e.g. foreign currency
translation gains and losses, adjustments for minimum pension liability, unrealized
gains and losses from cash flow hedging derivatives, unrealized gains and losses
from available for sale securities

- Debt securities under US GAAP

o Trading securities: firm owns but intends to sell – unrealized gains and losses are
reported on income statement

o Held to maturity: firms does not intend to sell prior to maturity. Reported at
amortized cost on the balance sheet (not fair value). Unrealized gains and losses not
reported on income statement or as oci
 o Available-for-sale securities: not expected to be held to maturity or sold in the near
term. Unrealized gains and losses on available-for-sale securities are reported as
other comprehensive income, not on the income statement

- Debt securities under IFRS

o Under IFRS, unrealized gains and losses can also be reported on the income
statement, included in other comprehensive income, or not reported (for securities
carried at amortized cost rather than fair value). While these alternatives are
consistent with those under U.S. GAAP, the terms used to classify securities are
different

o Securities measured at fair value through profit and loss (corresponds to trading
securities under U.S. GAAP).

o Securities measured at amortized cost (corresponds to held-to-maturity under U.S.

GAAP).

o Securities measured at fair value though other comprehensive income (corresponds

to available-for-sale under U.S. GAAP).

Module 22.1: Balance Sheet

- Static statement: showing financial position of the company. Asset = liability + owners’
equity (analysts sometimes call this Net Asset)
- Assets: current assets (cash, others), long-lived assets (PPE, investment in other group
companies, intangible assets – goodwill etc.)
- Liabilities: current liabilities (due for payment in the short term), long-term liabilities (due for
payments in a longer time horizon)
- Owners’ equity: contributed capital (including common stock at par, and additional paid-in
capital), retained earnings
o Additional paid-in capital (APIC): when issued first time, at above par value. The
amount above common stock at par is called APIC
o Retained earnings: earnings from last years bs  opening retained earnings + this
year’s net income – any dividends to shareholders = closing retained earnings 
affect this year’s bs. This is the linkage between income statement and balance
sheet
 - Asset recognition: to recognize an asset, there must be an inflow of economic venefits in the
future. Must be reliably measured. Types of assets:
o Cash and cash equivalent (short-term, i.e. <90 days liquid money mkt instruments)
o Inventory/ stocks (three cats: raw materials, work in progress, finished goods)
o Trade and other receivables: trade receivables- a cash to be received from
customers after year-end
o Pre-paid expenses: paid for a good or services not yet used at year-end. When used,
it’s released into the income statement
o Financial assets: investments
o Deferred tax asset: paying more tax now, less in future
o Property, plant and equipment:
o Investment property: property held purely for investment purposes (capital gains
and rental incomes)
o Intangible assets: good will – results from acquisition
o Equity a/c investments: how we account for associates/ affiliates – other companies
we have influence over but no outright control
o Natural resources
o Assets held for sale
- Liabilities recognition
o Probable sacrifice of future economic benefits
o Deferred/ unearned revenue: amount received but have not met the criteria of a
sale
o Amounts reported as expenses but which have not been paid: accruals
o Examples: Bank borrowings, notes payable (interest-bearing), provision (estimates
for events incurring costs), unearned revenue, accounts payable (bought not paid),
financial liabilities (interest-bearing debt instruments, bonds etc.), accrued liabilities
(as soon as you’re aware of an accrued expense, has to go into income statement
and balance sheet), deferred tax liabilities

Module 22.2: Assets and liabilities

- Balance sheet used to assess firm’s liquidity, solvency and ability to make distribution to
shareholders
o Liquidity: ability to meet short-term obligation.
 Ratio: current assets/ current liabilities
o Solvency: ability to meet long-term obligation
 Ratio: debt/ equity, debt / total capital
o Shareholders: dividends, retained earnings
o Limitations: the bs elements should NOT be interpreted as mkt value or intrinsic
value as they contain a mixture of values, e.g. some assets are reported at historical
cost (e.g. PPE), amortized cost (historical cost – amortization, e.g. debt instruments),
or fair value (e.g. marketable securities). Even for those reported at fair value, it may
have changed since bs date. Additionally, some assets and liabilities don’t appear on
bs but have value, e.g. employees, reputation
- Formats of bs presentation:
o Report format: assets, liabilities, equity in a single column
o Account format: assets on the left, liabilities and equity on the right
 o Classified: Both IFRS and US GAAP require firms to separately report their current
assets and noncurrent assets/ liabilities – this current/ noncurrent format is known
as classified balance sheet
o Liquidity based: Under IFRS, firms can choose to use a liquidity-based format if the
presentation is more relevant and reliable. Liquidity-based presentations, which are
often used in the banking industry, present assets and liabilities in the order of
liquidity

Module 22.3: Current Assets and Liabilities

- Current assets: cash and other assets that will likely be converted into cash or used up
within 1 yr or 1 operating cycle whichever greater
o Operating cycle: time taken to produce or purchase inventory sell product 
collect cash
o Often presented in order of liquidity
o Current assets reveal info abt operating activities of the firm
- Current liabilities: obligations that will be satisfied within one yr or one operating cycle,
whichever is greater. Criteria for liability to be considered current: 1) settlement expected
during normal operating cycle; 2)settlement expected within 1 yr; 3) held primarily for
trading purposes; 4) there’s no unconditional right to defer settlement for > 1 yr
- Working capital = current assets – current liabilities
o Not enough working capital  indicates a liquidity problem; too much WC 
inefficient use of assets
- Noncurrent assets: wont be converted into cash or used within one yr or 1 operating cycle
 provides info abt firm’s investing activities
- Noncurrent liabilities: provides info abt firm’s long-term financing activities
- Types of current assets:
o Cash and cash equivalents: short-term, highly liquid investments readily
convertible to cash and near enough to maturity that interest rate risk is
insignificant. Cash equivalents e.g. t-bill, commercial paper, money mkts funds. As
other financial assets, they’re reported on bs at amortized cost or fair value
o Marketable securities: financial assets traded in a public mkt. e.g. t-bill, notes,
bonds, equity securities
o Accounts receivable/ trade receivables: represents amounts owed to the firm
by customers for goods or services sold on credit.
 Reported at net realizable value – based on estimated bad debt expense
which increases the allowance for doubtful accounts, a contra-asset account
 Accounts receivable at net realizable value = gross receivables – the
allowance for doubtful accounts
 When receivables are "written off" (removed from the balance sheet
because they are uncollectible), both gross receivables and the allowance
account are reduced
o Inventories: goods held for sale or used in manufacture. Manufacturing firms
separately report inventories of raw materials, work in progress and finished goods.
Costs included in inventory include purchase cost, conversion cost, and other costs
necessary to bring inventory to its present location and condition
 Methods to measure inventories:
 Standard costing: often used by manufacturing firms, assign
predetermined amounts of materials, labor and overhead to goods
produced
 Retail method: measure inventory at retail prices and subtract gross
profit in order to determine cost
 Using different cost flow assumptions, firms assign inventory costs to the
income statement (cogs)
 IFRS and US GAAP (FIFO and not retail): Inventories are reported at the
lower of cost or net realizable value
 Net realizable value = selling price – any completion costs and
disposal (selling) costs
 Under U.S. GAAP (LIFO or the retail method): report inventories at the lower
of cost or market
 Market = replacement cost
 Market cannot be greater than net realizable value or less than net
realizable value – a normal profit margin. If net realizable value
(IFRS) or market (U.S. GAAP) is less than the inventory's carrying
value, the inventory is written down and a loss is recognized in the
income statement. If there is a subsequent recovery in value, the
inventory can be written back up under IFRS. No write-up is allowed
under U.S. GAAP; the firm simply reports greater profit when the
inventory is sold. Lower of cost or net realizable value (IFRS)
 o Other current assets: amounts that may not be material if shown separately thus
combined into a single amount. E.g. prepaid expenses – operating costs that have
been paid in advance. When incurred, an expense is recognized in income statement
and prepaid expenses (asset) decrease
- Current liabilities types
o Accounts/ trade payable: amount firm owes to suppliers for goods and services
purchased on credit
o Notes payable and current portion of long-term debt: obligations in the form
of promissory notes owed to creditors and lenders

o Accrued liabilities (accrued expenses): expenses that have been recognized in

the income statement but are not yet contractually due. Accrued liabilities result
from the accrual method of accounting, under which expenses are recognized as
incurred

 Income tax payable may be a form of accrued liability. Taxes payable are
current taxes that have been recognized in the income statement but have
not yet been paid. Other examples of accrued liabilities include interest
payable, wages payable, and accrued warranty expense

o Unearned revenue (unearned income, deferred revenue, or deferred income):

cash collected in advance of providing goods and services. When payment is
received, assets (cash) and liabilities (unearned revenue) increase by the same
amount

Module 22.4: Noncurrent assets and liabilities

- Property, plant and equipment (PP&E): tangible assets used in production of goods and
services. PP&E includes land, buildings, machinery, equipment, furniture, natural resources
o IFRS: can be reported using cost model, or revaluation model
o US GAAP: only cost model allowed
 Cost model: PP&E other than land – reported at amortized cost (i.e.
historical cost – accumulated depreciation/ amortization/ impairment
losses); land is not depreciated
 Historical cost = purchase price + any cost necessary to get asset
ready for use (e.g. delivery, installation)
 PP&E must be tested for impairment: an asset is impaired if its
carrying value exceeds recoverable amount
  Recoverable amount of an asset is: the greater of (fair value – any
selling costs, or the asset's value in use).

o Value in use: present value of the asset's future cash flow

stream

o If impaired, the asset is written down to its recoverable

amount and a loss is recognized in the income statement.
Loss recoveries are allowed under IFRS but not under U.S.
GAAP

 Revaluation model: fair value less any accumulated depreciation changes

in fair value are reflected in shareholders' equity and may be recognized in
the income statement in certain circumstances

- Investment property:

o IFRS: investment property includes assets that generate rental income or capital
appreciation. Investment property can either be reported at amortized cost (just like
PP&E) or fair value. Under the fair value model, any change in fair value is
recognized in the income statement

o U.S. GAAP: no specific definition of investment property.

- Deferred tax assets: deferred taxes are the result of temporary differences between financial
reporting income and tax reporting income.
o Deferred tax assets are created when the amount of taxes payable exceeds the
amount of income tax expense recognized in the income statement. This can occur
when expenses or losses are recognized in the income statement before they are tax
deductible, or when revenues or gains are taxable before they are recognized in the
income statement
o Eventually, the deferred tax asset will reverse when the expense is deducted for tax
purposes or the revenue is recognized in the income statement
o Deferred tax assets can also be created by unused tax losses from prior periods,
which have value because they can be used to reduce taxes in subsequent periods

Module 22.5: Intangible assets

- Intangible assets: Non-monetary assets (e.g. securities are not) that lack physical substance
o Identifiable intangible assets: can be acquired separately or are the result of rights
or privileges conveyed to their owner. E.g. patents, trademarks, copyrights
o Unidentifiable intangible assets: cannot be acquired separately and may have an
unlimited life. E.g. goodwill
- Purchased vs. internally created identifiable intangible assets:
o Purchased:
 IFRS: Cost model or revaluation model (if active mkt for it exists)
 US GAAP: Only the cost model
o Created internally, e.g. R&D costs
 IFRS: firm identify the research stage and development stage, must expense
costs incurred during research stage but can capitalize costs incurred during
development stage
  Criteria IFRS for development cost to be capitalized: is it going to
lead to higher future earnings, via proof that it’s technologically
feasible, resources there to complete, is there a customer base to
sell

 US GAAP: expensed as occurred

- Finite-lived vs. infinite-lived
o Finite-lived: amortized over useful lives, tested for impairment (same as PP&E).
amortization method and useful life estimates reviewed at least annually
o Infinite-lived: not amortized, but are tested for impairment at least annually
- Good will: the excess of purchase price over the fair value of the identifiable net assets (i.e.
assets – liabilities) acquired in a business acquisition
o Acquirers are often willing to pay more than the fair value of the target's identifiable
net assets because the target may have assets that are not reported on its balance
sheet. E.g. reputation and customer loyalty certainly have value. However, the value
is not quantifiable. Also, the target may have R&D assets that remain off-balance-
sheet because of current accounting standards
o Finally, part of the acquisition price may reflect perceived synergies from the
business combination. For example, the acquirer may be able to eliminate duplicate
facilities and reduce payroll as a result of the acquisition
o Occasionally the purchase price of an acquisition is less than fair value of the
identifiable net assets. In this case, the difference is immediately recognized as a
gain in the acquirer's income statement
o Goodwill is only created in a purchase acquisition. Internally generated goodwill is
expensed as incurred
o Goodwill is not amortized but must be tested for impairment at least annually. If
impaired, goodwill is reduced and a loss is recognized in the income statement. The
impairment loss does not affect cash flow. As long as goodwill is not impaired, it can
remain on the balance sheet indefinitely

o Since goodwill is not amortized, firms can manipulate net income upward by
allocating more of the acquisition price to goodwill and less to the identifiable
assets. The result is less depreciation and amortization expense, resulting in higher
net income.

o Accounting goodwill should not be confused with economic goodwill. Economic

goodwill derives from the expected future performance of the firm, while
accounting goodwill is the result of past acquisitions.

- When computing ratios, analysts should eliminate goodwill from the balance sheet and
goodwill impairment charges from the income statement for comparability. Also, analysts
should evaluate future acquisitions in terms of the price paid relative to the earning power
of the acquired assets
Module 22.6: Marketable Securities
- Financial instruments: contracts that give rise to both a financial asset of one entity and a
financial liability or equity instrument of another entity. Include investment securities (stocks
and bonds), derivatives, loans and receivable
o Measured at historical cost: e.g. unquoted equity investments, loans and notes
receivable
o Measured at amortized cost:
 For Held-to-maturity securities: debt securities acquired w the intent to hold
them until they mature
 Amortized cost = original issue price – any principal payments +/-
any amortized discount/ amortized premium – any impairment
losses
o Measured at fair value/ mark-to-market accounting: include trading securities,
available-for-sale securities, and derivatives
 Trading securities (held-for-trading securities): debt securities acquired w
the intent to sell them over the near term – reported on balance sheet at
fair value, w unrealized gains and losses (I.e. changes in mkt value before
securities are sold) are recognized in the income statement
 Available-for-sale securities: debt securities that are not expected to be held
to maturity or traded in the near term. Like trading securities, available-for-
sale securities are reported on the balance sheet at fair value. However, any
unrealized gains and losses are not recognized in the income statement, but
are reported in other comprehensive income as a part of shareholders'
equity

- IFRS treatment of marketable securities

o Securities measured at amortized cost (corresponds to treatment of held-to-
maturity securities under US GAAP)
o Xxx measured at fair value thru OCI (corresponds to treatment of available for sale
securities under US GAAP)
o Xxx measured at fair value thru P&L (corresponds to treatment of trading securities
under US GAAP)
 - Non-current liabilities
o Long-term financial liabilities, e.g. bank loans, notes payable, bonds payable,
derivatives
 if the financial are not issued at face amount, liabilities usu reported on bs as
amortized cost, i.e. issue price – principal payments +/- any amortized
discount/premium
 reported at fair value for held-for-trading liabilities, derivative liabilities, and
non-derivative liabilities with exposures hedged by derivatives
o deferred tax liabilities: this liabilities is created on bs when amount of income tax
expense recognized in the income statement is greater than tax payable; or
revenues or gains are recognized in the income statement before they’re taxable.
Eventually, deferred tax liabilities will reverse when the taxes are paid.

Module 22.7: Shareholders’ equity and ratios

- Components of shareholders’ equity:
o Contributed capital/ issued capital: amount contributed by equity shareholders
 Total proceeds from issuing an equity security = Common stock at par +
additional paid-in capital
  Par value of common stock: a stated or legal value, not relationship
w the fair value. Some common shares are even issued w/o a par
value
 Number of common shares authorized, issued, and outstanding:
 Authorized: the total amount of shares that could be distributed
w/o having to go back to the shareholders . disclosed in footnotes.
Can be sold under the firm’s articles of incorporated
 Issued: number that have actually been sold to shareholders
 Outstanding = issued shares – shares reacquired by firm (i.e.
treasury stocks)
o Preferred stock: no voting rights. Dividend a fixed share of its par value. Closer to
debt than equity. If there’s no maturity date, then its recorded as equity; if there’s
maturity date, then its treated as a debt instrument rather than equity instrument.
Have priority over the claims of the common shareholders in even of liquidation
o Treasury stock: buy back and hold equity in itself. A negative balance in stockholders
equity as if this goes up, stockholders equity goes down. These lose voting rights,
and lose entitlement to dividends. stock that has been reacquired by the issuing firm
but not yet retired. reduces stockholders' equity. does not represent an investment
in the firm. no voting rights and does not receive dividends.
o Retained earnings: are the undistributed earnings (net income) of the firm since
inception, the cumulative earnings that have not been paid out to shareholders as
dividends
o Non-controlling/ minority interest: minority shareholders’ pro-rata share if the net
assets of a subsidiary not wholly owned by the parent
o Accumulated other comprehensive income: all changes in stockholders’ equity
except for transactions recognized in income statement (net income) and
transactions w shareholders, e.g. issuing, reacquiring stocks and paying dividends
 Don’t confuse comprehensive income and accumulated other
comprehensive income. Comprehensive income is an income measured over
a period of time, equal to net income plus other comprehensive income.
 Accumulated other comprehensive income does not include net income but
is a component of stockholders' equity at a point in time
o Common-size balance sheets: convert bs to common size bs and interpret
 Express each item as a % of total assets – allows for time-series analysis and
cross-sectional analysis of balance sheets
o Calculate and interpret liquidity and solvency ratios
 Liquidity ratios:
 Current ratio = current assets / current liabilities
 Quick ratio also called the acid test = (cash + mktable securities +
receivables) / current liabilities  excludes inventory from current
assets. So can also be expressed as quick ratio = (current assets –
inventory) / current liabilities
 Cash ratio = (cash + mktable securities) / current liabilities 
excludes inventory and receivables
 Solvency ratios – meet long term liabilities/ capital structure of company:
 Long term debt-to-equity = long-term debt / total equity
 Total debt-to-equity = total debt / total equity
 Debt ratio = total debt / total assets
 Financial leverage = total assets / total equity
 Debts are interest-bearing obligation. Financial leverage ratio
captures impact of all obligations, inclg. Non interest bearing
 o Limitations of balance sheet ratio analysis:

 Comparisons with peer firms are limited by differences in accounting

standards and estimates.

 Lack of homogeneity as many firms operate in different industries.

 Interpretation of ratios requires significant judgment.

 Balance sheet data are only measured at a single point in time.

Module 23.1: Cash flow

- Cash flow statement: provides info beyond the income statement which is based on accrual
rather than cash, accounting. Cash flow statements provide info:

o About a company's cash receipts and cash payments during an accounting period

o About a company's operating, investing, and financing activities

o An understanding of the impact of accrual accounting events on cash flows

- Cash flows are classified as either operating, investing or financing activities: items on the
cash flow statements come from 1) income statement items and 2) changes in balance sheet
accounts:
o Cash flow from operating activities (CFO): also called operating cash flow – inflows
and outflows of cash resulting from transactions that affect a firm’s net income
 E.g. cash collected from customers, interests and dividends received, sale
proceeds from trading securities; cash paid to employees and suppliers, cash
paid for other expenses, acquisition of trading securities, interest paid on
debt or leases
o Cash flow from investing activities (CFI): inflows and outflows of cash resulting from
acquisition or disposal of long-term assets and certain investments
 E.g. sale proceeds from fixed assets, sale proceeds from debt and equity
investments, principal received from loans made to others; acquisition of
fixed assets, acquisition of debt and equity investments, loans made to
others
o Cash flow from financing activities (CFF): resulting from transactions affecting a
firm’s capital structure
 E.g. principal amounts of debt issued, proceeds from issuing stock; principal
paid on debt or leases, payments to reacquire stock, dividends paid to
shareholders
- Difference between US GAAP and IFRS (as above): e.g. consider a company that sells land
that was held for investment for $1 million. Income taxes on the sale total $160,000. Under
U.S. GAAP, the firm reports an inflow of cash from investing activities of $1 million and an
outflow of cash from operating activities of $160,000. Under IFRS, the firm can report a net
inflow of $840,000 from investing activities.
- Noncash investing and financing activities: not reported in the cash flow statement as they
don’t result in inflows or outflows of cash. E.g. if firm acquires real estate w financing
provided by the seller - equivalent of borrowing the purchase price; exchange of debt for
equity – reduction of debt and increase in equity however no cash is involved in the trxn
o Noncash transactions must be disclosed in either a footnote or supplemental
schedule to the cash flow statement. Analysts should be aware of the firm's noncash
transactions, incorporate them into analysis of past and current performance, and
include their effects in estimating future cash flows
- Direct vs indirect methods of presenting cash from operating activities: direct method
encouraged by both standards. Most firms however use indirect method. Presentation of
investing and financing cash flows are the same under both methods
o Direct: each line item of the accrual-based income statement is converted into cash
receipts or cash payments

o Indirect: net income is converted to operating cash flow by making adjustments for
transactions that affect net income but are not cash transactions
 o The primary advantage of the direct method is that it presents the firm's operating
cash receipts and payments, while the indirect method only presents the net result
of these receipts and payments. Therefore, the direct method provides more
information than the indirect method. This knowledge of past receipts and
payments is useful in estimating future operating cash flows
- Cash flow link to balance sheet: OCF+ICF+FCF= change in cash balance + beginning cash
balance = ending cash balance. Usually:
o operating activities relate to the firm's current assets and current liabilities
o Investing activities typically relate to the firm's noncurrent assets
o financing activities typically relate to the firm's noncurrent liabilities and equity

Module 23.2: the direct and indirect methods

- steps in preparation of direct and indirect cash flow statements
o direct method: shows only cash payments and cash receipts over the period. Sum of
them is the co’s CFO
 gives more info than indirect method. Can see actual amounts going into
each use of cash and were received from each source of cash
 A common "trick" in direct method questions is to provide information on
depreciation expense along with other operating cash flow components.
When using the direct method, ignore depreciation expense—it's a noncash
charge. We'll see later that we do consider depreciation expense in indirect
 method computations, but we do this solely because depreciation expense
and other noncash expenses have been subtracted in calculating net income
(our starting point) and need to be added back to get cash flow.
 CFI are calculated by examining the change in gross asset accounts that
result from investing activities. Related accumulated depreciation or
amortization accounts are ignored since no cash expenses
 CFF are determined by measuring cash flows between firm and its suppliers
of capital. Cash flows result from new borrowings and debt principal
repayments
 Net cash flows from creditors = new borrowings – principal amounts
repaid
 Net cash flow from shareholders = new equity issued – share
repurchases – cash dividend paid
 Total cash flows = CFO + CFI + CFF
o Indirect method:
 CFO presented differently from direct method but amount the same

 Step 1: Begin with net income.

 Step 2: Add or subtract changes to balance sheet operating accounts as

follows:

 Increases in the operating asset accounts (uses of cash) are

subtracted, while decreases (sources of cash) are added

 Increases in the operating liability accounts (sources of cash) are

added, while decreases (uses of cash) are subtracted

 Step 3: Add back all noncash charges to income (such as depreciation and
amortization) and subtract all noncash components of revenue.

 Step 4: Subtract gains or add losses that resulted from financing or investing
cash flows (such as gains from sale of land).

- Above example: depreciation – not a cash flow; gain from sale of land – not a cash flow; in
provision for taxes, DTL and DTA are not cash flow
- Steps for indirect method to get CFO:

o Start w net income (means all the non-cash flows are included e.g. depreciation,
change in DTL, gains and losses from fixed asset disposal)

o Adjust net income for changes in relevant BS items

 Increase in asset deduct; increase in liability add

o Eliminate depreciation and amortization – add them back as they’ve been deducted
when deriving net income
 o Eliminate gains on disposal by deducting/ adding as they’re not operating cash flows

- Steps for indirect method to get CFI:

Module 23.3: Converting direct to indirect

- Convert cash flows from the indirect to direct method:
o The only difference between two methods is CFO
o CFO under the direct method can be computed using a combination of the income
statement and a statement of cash flows prepared under the indirect method
 o The general principle here is to adjust each income statement item for its
corresponding balance sheet accounts and to eliminate noncash and nonoperating
transactions
- Steps to convert indirect to direct:
o Cash collections from customers: Begin w net sales  subtract (add) any increase
(decrease) in AR as reported in indirect  add (subtract) any increase (decrease) in
unearned revenue
o Cash payments to suppliers: begin w COGS  if depreciation and/ or amortization
have been included in COGS (they increase COGS), these noncash expenses must be
added back when computing cash paid to suppliers  reduce (increase) COGS by
increase (decrease) in the AP as reported in indirect  add (subtract) any increase
(decrease) in inventory as in indirect  subtract any inventory write-off from this
period
- Analyze and interpret reported and common-size cash flow statements:
o Major sources and uses of cash: cash flow analysis begins w evaluation of firms
sources and uses of cash from Operating, Investing and Financing activities
o Operating cash flow: identify the major determinants of operating cash flow.
Positive operating cash flow could be from earnings-related activities; could also be
by decreasing noncash working capital, e.g. liquidating inventory and receivables or
increasing payables. A stable relationship of operating cash flow and net income is
an indication of quality earnings  earnings that significantly exceed operating cash
flow could indicate aggressive accounting choices e.g. recognizing revenues too soon
or delaying recognition of expenses
o Investing cash flow: increasing capital expenditure usu. Indicates growth. Generating
operating cash that exceeds capital expenditure is a desirable trait
o Financing cash flow: financing activities section of the cash flow statement reveals
information about whether the firm is generating cash flow by issuing debt or
equity. It also provides information about whether the firm is using cash to repay
debt, reacquire stock, or pay dividends

- Common-size cash flow statement: express each line item as % of revenue. Alternatively
each inflow of cash can be expressed as % of total cash inflows; each outflow a % of total
cash outflows
 - Earnings are high quality if they’re backed by cash and not from the accrual process. If net
income is high but CFO is low, then lot of the net income must have come from accruals –
accruals will automatically reverse in the future. CFO vs NI - Similar size or bigger is good

Module 23.4: Free Cash Flow and Ratios

- Free cash flows: a measure of cash available for discretionary purposes. The cash flow
available once firm has covered its capex. Often used for valuation
o Free cash flow to the firm (FCFF): cash available to all investors, both equity owners
and debt holders. Can be calculated by starting w net income or operating cash flow
 FCFF = Net income + noncash charges (i.e. depreciation, amortization) + cash
interest paid + fixed capital investment + working capital investment
 Fixed capital investment (net capital expenditure) = cash spent on
fixed assets – cash received from selling fixed assets
 FCFF = CFO + [cash interest paid * (1-tax rate)] – fixed capital investment
 o Free cash flow to equity (FCFE): the cash flow that would be available for distribution
to common shareholders
 FCFE = CFO – fixed capital investment + net borrowing (i.e. debt issued –
debt repaid)

- Cash flow ratios: including performance ratios and coverage ratios

o Performance ratios:
 Cash flow to revenue = CFO / net revenue
 Cash return-on-assets = CFO / average total assets
 Cash return-on-equity = CFO / average total equity
 Cash-to-income = CFO / operating income
 Cash flow per share = (CFO – preferred dividends) / weighted average
number of common shares
o Coverage ratios:
 Debt coverage = CFO / total debt
 Interest coverage = (CFO + interest paid + tax paid) / interest paid
 Reinvestment = CFO / cash paid for long-term assets
 Debt payment = CFO / cash long-term debt repayment
 Dividend payment = CFO / dividends paid
 Investing and financing = CFO / cash outflows from investing and financing
activities
Module 24.1: Financial Ratios
- Tools and techniques to convert financial statements into formats that facilitate analysis,
including ratio analysis, common-size analysis, graphical analysis and regression analysis
- Ratio analysis: consistency is paramount
o Key limitations:
 Financial ratios are not useful when viewed in isolation
 Comparisons made difficult by different accounting treatments, esp. US firm
and non-US firms
 Difficult to find comparable industry ratios when comparing across
industries
 All ratios must be viewed relatively to one another
 Determining the target or comparison value for a ratio is difficult
- Common size analysis: normalize balance sheets and income statements for comparison
across firms or over time
o Vertical common-size balance sheet: % of assets
o Vertical common-size income statement: % of sales

o Vertical common-size income statement ratios are especially useful for studying
trends in costs and profit margins:

 vertical common-size income statement ratios = income statement account/

sales

 vertical common-size balance-sheet ratios = balance sheet account / total

assets

o Horizontal common-size balance sheet or income statement. The divisor here is the
first-year values, so they are all standardized to 1.0 by construction
- Graphical analysis:
o Stacked column / bar graph: shows changes in items from year to year
o Line graph
- Regression analysis: used to identify relationships between variables. Often used for
forecasting, e.g. use relationship between GDP and sales to prepare a sales forecast

Module 24.2: Financial Ratios, Part I

- Ratios: activity, liquidity, solvency, profitability, valuation
o Activity ratios: several ratios also referred to asset utilization or turnover ratios.
Shows how a firm utilizes various assets e.g. inventory and fixed assets
o Liquidity ratios: shows ability to pay short-term obligations as they come due
o Solvency ratios: info on firms’ financial leverage and ability to meet long-term
obligations
o Profitability ratios: info on how well the company generates operating profits and
net profits from its sales
o Valuation ratios: sales per share, earnings per share, and price to cash flow share
etc. used in comparing the relative valuation of companies
- Activity ratios: also known as asset utilization ratio, operating efficiency ratio.
o Receivables turnover = annual sales / average receivables
 How many times we collect cash from customers in a year
 when a ratio compares a balance sheet account (such as receivables) with an
income or cash flow item (such as sales), the balance sheet item will be the
average of the account instead of simply the end-of-year balance. Averages
are calculated by adding the beginning-of-year account value to the end-of-
year account value, then dividing the sum by two
 it’s desirable to have a receivables turnover close to industry norm
o average collection period (days of sales outstanding) = 365 / receivables turnover
 the length of time between selling finished goods and collecting cash. i.e.
the credit period offered to customers
 good to have a collection period close to industry norm
o inventory turnover = cost of goods sold / avg inventory
 the number of times inventory have to be reordered during the year.
measures efficiency w respect to processing and inventory management
o days of inventory on hand (avg inventory processing period) = 365 / inventory
turnover
 good to have days of inventory on hand and inventory turnover close to
industry norm. length of time between receiving raw materials & selling
finished goods. = Raw materials holding period + production period +
finished goods holding period
o payables turnover = purchases / avg trade payables
 the number of times we pay the suppliers in a year
  You can use the inventory equation to calculate purchases from the financial
statements. Purchases = ending inventory – beginning inventory + cost of
goods sold
o Payables payment period (number of days of payables) = 365 / payables turnover
ratio
 Length of time between receiving goods from suppliers and actually having
to pay suppliers. i.e. the credit term we get from suppliers
 We have shown days calculations for payables, receivables, and inventory
based on annual turnover and a 365-day year. If turnover ratios are for a
quarter rather than a year, the number of days in the quarter should be
divided by the quarterly turnover ratios in order to get the "days" form of
these ratios
o Total asset turnover = revenue / avg total assets
 Effectiveness of firm’s use of its total assets to create revenue
o Fixed asset turnover = revenue / avg net fixed assets
 Net PP&E (PP&E net of accumulated depreciation). how we use the assets to
generate sales. Sales per dollar of fixed asset. Measures utilization of fixed
asset. If too low, might mean company has too much capital tied up in its
asset base or using the assets it has inefficiently; if too high, might mean
firm has obsolete equipment, or firm will have to incur capex in near future
to increase capacity to support growing revenues
o Working capital turnover = revenue / avg working capital
 Working capital = CA – CL. Shows how efficient we are in using working
capital to generate sales
- Liquidity ratios - pure ratios w only balance sheet items
o Current ratio = current assets / current liabilities
o Quick ratio
o Cash ratio

o Defensive interval = (cash + marketable securities + receivables) / avg daily

expenditure
 If the company’s no longer making money, how long can company survive
 Measures liquidity by indicating number of days of avg cash expenditure the
firm could pay w current liquid assets
 Expenditures here include cash expenses for COGS, SG&A, R&D. when taken
from income statement, NCC e.g. depreciation should be added back
 o Cash conversion cycle = days sales outstanding + days of inventory on hand –
number of days payable
 the length of time it takes to turn the firm's cash investment in inventory
back into cash, in the form of collections from the sales of that inventory.
The cash conversion cycle is computed from days sales outstanding, days of
inventory on hand, and number of days of payables
 young companies: paying suppliers way before collecting money from
customers – problem called over trading – overdraft getting bigger and
bigger  bank removes their credit facility  goes bankrupt. Cash
conversion cycle need to be financed by banking facilities. For most co, the
cash conversion cycle is positive. If current ratio is <1, co is in big trouble
 Negative cycle: retail companies  gets paid by customers before paying
suppliers (very short DOH, 0 DSO as it’s a cash based business, immense
power over their suppliers and can delay payment)

Module 24.3: Financial Ratios, Part II

- solvency ratios: measures firm’s financial leverage and ability to meet its long-term
obligations. Solvency ratios include various debt ratios (based on the balance sheet) and
coverage ratios (based on the income statement)
o debt-to-equity ratio = total debt / total shareholders’ equity
 suggests greater/ lesser reliance on debt as a source of financing
 total debt = long-term debt + interest-bearing short-term debt
o debt-to-capital ratio = total debt / (total debt + total shareholders’ equity)
 another way of looking at usage of debt
o debt-to-assets = total debt / total assets
 analyzes debt utilization
o financial leverage ratio = avg total assets / avg total equity
 avg is calculated by taking avg of beginning and ending values of a period
  measures company’s use of debt financing. greater use of debt financing
increases financial leverage and risk to equity holders and bondholders alike
o interest coverage ratio = earnings before interest and taxes / interest payments
 the lower this ratio, the more difficulty firm has in meeting debt payments
o debt-to-EBITDA = total debt / EBITDA
 as depreciation and amortization are not cash expenses, this ratio reflects
firm’s ability to meet debt obligations
o fixed charge coverage ratio = (EBIT + lease payments) / (interest payments + lease
payments)
 significant lease obligations will reduce this ratio significantly compared to
the interest coverage ratio. For companies that lease a large portion of their
assets (e.g. some airlines), fixed charge coverage is more meaningful a
measure
o With all solvency ratios, the analyst must consider the variability of a firm's cash
flows when determining the reasonableness of the ratios. Firms with stable cash
flows are usually able to carry more debt
- Profitability ratios: measure the overall performance of the firm relative to revenues, assets,
equity and capital
o Net profit margin = net income / revenue
o Operating profit margin = operating income / revenue = EBIT / revenue
o Pretax margin = EBT / revenue
o Return on asset (ROA) = net income / avg total assets
 Alternative calculation adds interest expense back: ROA = (net income +
interest expense (1 – tax rate)) / avg total assets
o Operating return on assets = operating income / avg total assets, or EBIT / avg total
assets
o Return on total capital (ROTC) = EBIT / avg total capital
o Return on equity (ROE) = net income / avg total equity
o Return on common equity = (net income – preferred dividends) / avg common
equity = net income available to common / avg common equity
o
- Key terms:
o gross profits = net sales – COGS
o operating profits = earnings before interest and taxes = EBIT
o net income = earnings after taxes but before dividends
o total capital = long-term debt + short-term debt + common and preferred equity
o total capital = total assets
-
Module 24.4: DuPont Analysis
- Apply DuPont analysis of ROE; calculate and interpret effects of change in its components
- DuPont system of analysis: an approach used to analyze Return on Equity - breaks down
ROE into function of different ratios so to see impact of leverage, profit margins and
turnover on shareholder returns
o Two variants: original three-part & extended five-part
o Original approach: ROE = net income / avg equity  expressed as (net income/
revenue) * (revenue / avg equity)  ROE = net profit margin * equity turnover
o Three part  ROE = (net income/ revenue)*(revenue/ avg total assets)*(avg total
assets / equity)  ROE = net profit margin * asset turnover * leverage ratio
 Leverage ratio is also called the “equity multiplier”
 Important equation. If ROE is relatively low, at least one of the following is
true: company has a poor profit margin, or poor asset turnover, or too little
coverage
o Five part  ROE = (net income/ EBT) * (EBT/ EBIT) * (EBIT/ revenue)* asset turnover
* leverage  ROE = tax burden * interest burden * EBIT margin * asset turnover *
financial leverage
 Decomposes net profit margin to three parts:
 Net income/ EBT  tax burden = (1 – tax rate)
 EBT/ EBIT  interest burden
 EBIT/ revenue  EBIT margin
 increase in interest expense as proportion of EBIT will increase the interest
burden (i.e., decrease the interest burden ratio). Increases in either the tax
burden or the interest burden (i.e., decreases in the ratios) will tend to
decrease ROE
 in general, high profit margins, leverage, and asset turnover will lead to high
levels of ROE
 However, this version of the formula shows that more leverage does not
always lead to higher ROE. As leverage rises, so does the interest burden.
Hence, the positive effects of leverage can be offset by the higher interest
payments that accompany more debt
 Higher taxes will always lead to lower levels of ROE
Always use avg for balance sheet items

Module 24.5: More financial ratios

- Ratios used in equity analysis and credit analysis
- Valuation ratios:
- Used in analysis for investment in common equity:
o Price-to-earnings (P/E) ratio: most widely used valuation ratio = current mkt price of
a share of stock / company’s earnings per share
o Per-share valuation measures, e.g. earnings per share (EPS), basic and diluted EPS,
cash flow per share, EBIT per share, EBITDA per share
  Per-share measures are not comparable because the number of outstanding
shares differ among firms
- Dividends: declared on a per-common-share basis
o Dividends declared: total dividends on a firm-wide basis
o EPS and net income is not reduced by paying common stock dividends. Net income –
dividends declared = retained earnings  these are earnings used to grow the
company rather than being distributed to equity holders. The proportion of firm’s
net income retained to fund growth is important determinant of is sustainable
growth rate
- Sustainable growth rate: how fast the firm can grow without additional external equity
issues while holding leverage constant
o Retention rate (RR): the proportion of earnings reinvested = (net income available to
common – dividends declared) / net income available to common = 1 – dividend
payout ratio
o Dividend payout ratio = dividends declared / net income available to common
o Formula: g = RR * ROE
- Ratios applicable to certain industries:
o Net income per employee, sales per employee: valuation of service and consulting
companies
o Growth in same-store sales: used in retail industries, restaurants to indicate growth
w/o effects of new locations. It measures how well firm attracts and keeps existing
customers and in case of locations w overlapping mkts, indicate new locations are
taking customers from existing ones
o Sales per square foot: used in retail industry
- Business risk: standard deviation of revenue, standard deviation of operating income, and
the standard deviation of net income are all indicators of the variation in and the uncertainty
about a firm's performance
o Since they all depend on the size of the firm to a great extent, analysts employ a
size-adjusted measure of variation. The coefficient of variation for a variable is its
standard deviation divided by its expected value.
 CV sales = sd of sales / mean sales
 CV operating income = sd of operating income / mean operating income
 CV net income = sd of net income / mean net income
o Ratios used in financial institutions:
 Capital adequacy: ratio of some dollar measure of the risk, both operational
and financial, of the firm to its equity capital. Value-at-risk: estimate of the
dollar size of the loss that a firm will exceed only some specific & of the
time, over a specific period of time
 Liquid asset requirement: the ratio of a banks liquid assets to certain
liabilities
 Net interest margin: interest income/ interest-earning assets. Measures
performance of lender
- Credit analysis: assess company ability to service and repay its debt
o Interest coverage ratios used
o Return on capital, debt-to-assets and cash flow to total debt
o Altman developed z-score to analyze and predict firm bankruptcies
- Segment reporting and segment ratios
 o Business segment: a portion of a larger company that accounts for > 10% of
company’s revenues, assets, or income, and distinguishable from other lines of
business in terms of risk and return of the segment
o Graphical segment: identified when they meet the size criterion and geographic unit
has a biz environment different from other segment or remainder of business
o Both US GAAP and IFRS require companies to report segment data
- Use ratio analysis and other techniques to model and forecast earnings
o Ratio analysis can be used in preparing pro forma financial statements that provide
estimates of financial statement items for one or more future periods
 Estimate next period revenue: use the most recent COGS
o Three methods of examining variability of financial outcomes around point
estimates:
 Sensitivity analysis: based on the “what if” question
 Scenario analysis: based on specific scenarios and will yield a range of values
for financial statement items
 Simulation: a technique where probability distribution for key variables are
selected and computer used to generate a distribution of values for
outcomes based on repeated random selection of values for the key
variables

Module 25.1: Cash flow methods

- Inventory: reported in one account on balance sheet for merchandising firms (wholesalers
and retailers); reported in three separate accounts (raw materials, WIP, finished goods) for
manufacturing firms
o COGS (also called cost of sales COS) = beginning inventory + purchases – ending
inventory
- Costs included in inventories and cost recognized as expenses
o Product costs: costs included in inventory – capitalized in inventories account on the
balance sheet. By capitalizing inventory costs, expense recognition is delayed until
inventory is sold and revenue recognized. These costs include:
 Purchase cost – trade discounts – rebates
 Conversion (manufacturing) costs = labor cost + overhead cost
 Other costs to bring inventory to present location and condition
o Period costs: the inventory costs expensed in the period incurred, e.g.:
 Abnormal waste of materials, labor or overhead
 Storage costs (unless required as part of production)
 Admin overhead
 Selling costs
- Different inventory valuation methods: as the cost of purchasing or producing inventory
changes over time, firms must select a cost flow method (known as the cost flow
assumptions in US GAAP and cost flow formula in IFRS) to allocate inventory cost to the
income statement (COGS) and balance sheet (ending inventory)
o IFRS:
 Specific identification: each unit sold is matched w units actual cost. Used
when inventory items are not interchangeable
 FIFO: EI is valued based on most recent purchases and is best approximation
of current cost; FIFO COGS is based on the earliest purchase cost.
  In an inflationary environment, COGS is understated compared to
current cost  earnings will be overstated
 WAC (weighted avg cost) = total cost of goods available for sale (beginning
inventory + purchases) / total quantity available for sale  COGS = avg cost
* number of units sold; EI = avg cost * number of units remaining
 In an inflationary environment, inventory value will be between
those produced by FIFO and LIFO
o US GAAP: same as IFRS + LIFO
 LIFO: EI in balance sheet is valued using earliest costs  in an inflationary
environment, LIFO COGS will be higher than FIFO COGS  earnings lower 
lower income taxes, increasing cash flow

Module 25.2: Inventory systems

- Firms account for changes in inventory using
o Periodic inventory system: inventory values and COGS are determined at end of
accounting period.
 No detailed records of inventory are maintained
 Inventory acquired during period is reported in a Purchases account
 At period end, purchases + beginning inventory – ending inventory = COGS
o Perpetual system: inventory values and COGS updated continuously
 Inventory purchased and sold is recorded directly in inventory when
transactions occur
 Do not use a Purchases account
- For the FIFO and specific identification methods, ending inventory values and COGS are the
same whether a periodic or perpetual system is used
o However, periodic and perpetual inventory systems can produce different values for
inventory and COGS under the LIFO and weighted average cost methods.
o Perpetual system matches each unit withdrawn with the immediately preceding
purchases
o The relationship of higher COGS under LIFO and lower ending inventory under LIFO
(assuming inflation) still holds whether the firm uses a periodic or perpetual
inventory system
- How inflation and deflation of inventory costs affect financial statements and ratios for
companies using different inventory valuation methods
o Inflationary period: LIFO COGS > FIFO COGS
o Deflationary period: LIFO COGS < FIFO COGS
o EI: FIFO provides the most useful measure of ending inventory
o COGS: LIFO provides the better approximation of current cost in the income
statement as its based on the most recent purchases
o Gross profit: inflation  higher COGS  lower gross profit (also operating profit,
EBT, NI affected the same way)

Module 25.3: Converting LIFO to FIFO

- When prices are rising, these relationships hold:
o LIFO inventory < FIFO inventory
o LIFO COGS > FIFO COGS
o LIFO net income < FIFO net income
 o LIFO tax < FIFO tax
- LIFO reserve: firms report under LIFO must report LIFO reserve – the amount by which LIFO
inventory is less than FIFO inventory. To compare LIFO inventory to FIFO firms, analysts must
o Add LIFO reserve to LIFO inventory on the balance sheet
o Increase the retained earnings of shareholders’ equity by the LIFO reserve *(1-tax
rate)
o Analyst often decrease LIFO firms cash by the tax rate * LIFO reserve
o Net effect is actually an increase in assets (inventory account increase & cash
account decrease) and shareholders’ equity of an amount equal to LIFO reserve net
of tax  two sides balance
- Converting LIFO COGS to FIFO COGS:
o FIFO COGS = LIFO COGS – (ending LIFO reserve – beginning LIFO reserve)
- Example:
LIFO FIFO impact on LIFO to FIFO Relationship
Ending Inventory 14,000 +10,000 balance sheet - asset increase by LIFO reserve
COGS 40,000 - 2,000 income statement COGS - (ending LIFO reserve - begn LIFO reserve)
EBT +2,000 income statement Higher by decrease in COGS
net income 2,400 +2,000*(1-40%)=1,200 income statement Higher by decrease in COGS net of taxes
Beginning reserve 8,000
ending reserve 10,000
Tax rate 40%
retained earnings +10,000*(1-40%)=+6,000 balance sheet - SH's equity + LIFO reserve*(1-tax)
cash - 10,000*40%=-4,000 balance sheet - asset - LIFO reserve *tax

net change in Balance Sheet LIFO reserve net of taxes

net change in Income Statement increase in net income by change in LIFO reserve net of taxes

- To convert a firm's financial statements from LIFO to what they would have been under FIFO:
o Add the LIFO reserve to LIFO inventory.
o Subtract the change in the LIFO reserve for the period from COGS.
o Decrease cash by LIFO reserve × tax rate.
o Increase retained earnings (equity) by LIFO reserve × (1 − tax rate).
- LIFO liquidation: occurs when a LIFO firm’s inventory quantities decline
o Inventory quantities decline  decrease in COGS  increase gross profits, pretax
income, and net income. Decreased cash expenses (from not producing inventory)
will increase operating cash flow, although higher income taxes on higher earnings
will partially offset this increase in cash flows.
o Extra profit reported with a LIFO liquidation inflates operating margins by
recognizing historical inflationary gains from increasing inventory prices as income in
the current period
o Management could use a LIFO liquidation (draw down inventory) to artificially
inflate current period earnings
o Inventory declines can also be caused by external events e.g. strikes or materials
shortage at a key supplier
o Analysts must look to the LIFO reserve disclosures in the footnotes to see if the LIFO
reserve has decreased over the period, which would indicate the possibility of a LIFO
liquidation that requires adjustment of profit margins if its impact has been
significant

Module 25.4: Inventory Valuation

- Measurement of inventory at the lower of cost and NRV
o All IFRS and US GAAP except LIFO and retail cost – inventory is reported on bs as
lower of cost or NRV
 Cost: use FIFO for merchandising firms and standard cost of producing for
manufacturing firms (i.e. excluding abnormal amounts, storage costs, admin
overheads, selling costs)
 NRV net realizable value = expected sales price – estimated selling costs and
completion costs
 Take the lower of cost or NRV
 If NRV is < bs value of inventory inventory is written down to NRV  loss
recognized in income statement  if subsequently recover, inventory can
be written up (only for IFRS)  recognize gain in income statement by
reducing COGS by recovery amount
 The write-down and write-up of inventory is done thru use of a
valuation allowance account: a contra-asset account similar to
accumulated depreciation. Firms use valuation account to separate
original cost of inventory from carrying value of inventory

o US GAAP: For LIFO or retail method, lower of cost or market:

 Cost: same as above
 Market is = replacement cost
 Bounded by NRV and (NRV – normal profit margin)
Under IFRS, inventories are valued at the lower of cost or net realizable value. Inventory write-ups are
allowed, but only to the extent that a previous write-down to net realizable value was recorded.

Under U.S. GAAP, inventories are valued at the lower of cost or net realizable value for companies using
cost methods other than LIFO or the retail method. For companies using LIFO or the retail method,
inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but
cannot exceed net realizable value or be less than net realizable value minus a normal profit margin. No
subsequent write-up is allowed for any company reporting under U.S. GAAP.

A write-down of inventory value from cost to net realizable value will:

 Decrease inventory, assets, and equity.

 Increase asset turnover, the debt to equity ratio and the debt to assets ratio.
 Result in a loss on the income statement, which will decrease net income and the net profit
margin, as well as ROA and ROE for a typical firm.

- Implications of valuing inventory at NRV for financial statements and ratios

o Write-down reported as part of COGS
 Decrease both current and total assets
 Current ratio decreases; quick ratio unaffected as inventories not included in
numerator
 Inventory turnover (COGS/avg inventory) increases  decrease days’
inventory on hand and cash conversion cycle
 Total asset turnover increase, increase debt-to-asset ratio
 Equity decrease; increase debt-to-equity ratio
 Reduce gross margin, operating margin, net margin
 % decrease in net income greater than % decrease assets or equity, both
ROA and ROE are decreased
- Financial statement presentation, disclosures re. inventories
 o Required inventory disclosures are similar for US GAAP and IFRS and include:
 The cost flow method used; total carrying value of inventory; carrying value
of inventories reported at fair value less selling costs; cost of inventory
recognized as COGS during the period; reversals of inventory write-downs;
carrying value of inventories pledged as collateral
- Inventory changes: firm can change inventory cost flow methods. In most cases, the change
is made retrospectively; that is, the prior years' financial statements are recast based on the
new cost flow method. The cumulative effect of the change is reported as an adjustment to
the beginning retained earnings of the earliest year presented.
o Firm must demonstrate that the change will provide reliable and more relevant
information and explain why the change in cost flow method is preferable
o An exception to retrospective application applies when a firm changes to LIFO from
another cost flow method. In this case, the change is applied prospectively; no
adjustments are made to the prior periods. With prospective application, the
carrying value of inventory under the old method simply becomes the first layer of
inventory under LIFO in the period of the change

Module 25.5: Inventory Analysis

- Calculate and compare ratios of companies
Module 26.1: Capitalization vs. Expensing
- For expenditures, firm can either capitalize the cost as an asset on balance sheet or expense
cost in income statement in the period incurred
o General rule: expenditure expected to provide a future economic benefit over
multiple accounting periods is capitalized
o If future economic benefit is unlikely or highly uncertain  expense

- For capitalized expenditure:

o Tangible assets & intangible with finite lives: Initially recorded as an asset on b/s at
cost  its fair value at acquisition + any cost necessary to prepare asset for use 
cost allocated to income statement over life of the asset as depreciation expenses
(tangible assets) or amortization (intangible w finite lives)
o Intangible asset w infinite lives (e.g. land, goodwill):
o Once an asset is capitalized, subsequent related expenditures that provide more
future economic benefits (e.g., rebuilding the asset) are also capitalized. Subsequent
expenditures that merely sustain the usefulness of the asset (e.g., regular
maintenance) are expensed when incurred
- Capitalized interest: when asset is constructed for own use, or resale, interest accrues during
construction period is capitalized as part of the asset’s cost
o Income statement treatment - not reported on i/s as interest expense
 If asset is held for use: interest cost allocated to depreciation expense
 If asset is held for sale: interest cost allocated to COGS
 o Cash flow statement
 US GAAP: capitalized interest is reported as an outflow from investing
activities (vs. interest expense an outflow from operating activities)
 IFRS: investing activities (vs. interest expense can be CFO, CFF or CFI)
- Financial reporting of intangible assets: purchased, internally developed, acquired in a
business
o Intangible assets: long-term assets lacking physical substance, e.g. patents, brand
names, copyrights, franchises
 Cost of finite-lived intangible – amortized over its useful life
 Cost of infinite-lived intangibles – not amortized, tested for impairment at
least annually. Impaired  reduction in value recognized in i/s as a loss
o Intangible assets: identifiable vs. unidentifiable
 Identifiable: must be capable of being separated from firm or arise from a
contractual or legal right; controlled by the firm; expected to provide future
economic benefits
 Unidentifiable: cannot be purchase separately, may have indefinite life
o Created internally – mostly are expensed as incurred, except R&D under IFRS and
software development costs
 R&D (IFRS): research costs expensed as incurred; development costs may be
capitalized
o Purchased –recorded on b/s at cost (fair value at acquisition)
o Intangible assets obtained in a Business Combination
 Acquisition method: purchase price is allocated to the identifiable assets and
liabilities of the acquired firm on the basis of fair value; any remaining
amount is recorded as good will
 Only goodwill created in a business combination is capitalized on
b/s; cost of any internally generated goodwill are expensed
- Capitalizing vs. expensing costs and how they affect financial statements and ratios
o Net income: capitalizing an expenditure delays expense recognition  higher net
income; subsequently, lower net income as expenditure is allocated to depreciation
expense  reduces variability of net income by spreading it over multiple periods
 Over the life of asset, total net income is identical under two methods
o Shareholders’ equity: capitalization  higher net income  higher retained
earnings  higher shareholders’ equity
o Total assets: capitalization  greater total assets. A=L+E holds as both A and E go up
o Cash flows: capitalizing expenditure will result in higher operating cash flow and
lower investing cash flow compared to expensing
- Financial ratios

Module 26.2: Depreciation

- Depreciation methods of PP&E: depreciation is the systematic allocation of an asset’s cost
over time. Key terms:
o Carrying (book) value: net value of an asset/ liability on the b/s. for PP&E, carrying
value = historical cost – accumulated depreciation
 Historical cost: the original purchase price of the asset, including installation
and transportation costs. Also known as gross investment in the asset
  Analyst should decide whether reported depreciation expense is more or
less than economic depreciation, i.e. the actual decline in value of the asset
over the period. E.g. depreciation by greater amount during 1 st year is better
approximation of economic depreciation for some products

- Depreciation methods
o Only affect timing when depreciation expenses hit the income statement; DOES NOT
affect the final amount

o Straight line: predominant. Depreciation is same amount each year over asset’s
estimated life
original cost−salvage value
 Depreciation =
depreciablelife
o Accelerated: more depreciation expense recognized in the early years of an asset’s
life. Lower net income in early years and higher in later years. One often used
method is double-declining balance (DDB) method:
2
 DDB depreciation in year X = * book value at
depreciable life∈ years
beginning of year X
o Units-of-production: based on usage rather than time. Depreciation expense is
higher in periods of high usage
original cost−salvage value
 Units-of-production depreciation = * output
life ∈output units
units in the period
  Referred to as depletion when this method is applied to natural resources

- Component depreciation:
o IFRS requires firms to depreciate the components of an asset separately, therefore
requiring useful life estimates for each component
o Allowed under US GAAP but seldom used

- Choice of depreciation method and useful life and residual value assumptions will affect
depreciation expense, financial statements and ratios
 o
o Firms can manipulate depreciation expense, and therefore net income by increasing
or decreasing either of useful life and salvage value estimates
o A change in an accounting estimate, such as useful life or salvage value, is put into
effect in the current period and prospectively. That is, the change in estimate is
applied to the asset's carrying (book) value and depreciation is calculated going
forward using the new estimate. The previous periods are not affected by the
change

- Amortization methods for intangible assets with finite lives: identical to depreciation of
tangible assets and same methods are permitted
o estimating useful lives is complicated by many legal, regulatory, contractual,
competitive, and economic factors that may limit the use of the intangible assets
o Another example of an intangible asset with an indefinite life is a trademark that
may have a specific expiration date, but can be renewed at minimal cost. In this
case, the trademark is considered to have an indefinite life and no amortization is
required
 o Exactly same effects are expected from choice of amortization methods as
depreciation methods on financial statement and ratios

Module 26.3: Impairment and revaluation

- Revaluation model for long-lived assets:
o US GAAP: long-lived assets reported at depreciated cost, i.e. original cost –
accumulated depreciation and any impairment charges
o IFRS - Revaluation model: permits a long-lived asset to be reported at its fair value,
as long as an active market exists so fair value can be reliably estimated
 Choose same treatment for similar assets so firms cannot revalue only
specific assets that are more likely to appreciate than depreciate
 Asset carried at depreciated cost, at each revaluation date, balance sheet
value is adjusted to fair value
 1st revaluation date: if fair value is less than the carrying value (i.e.
cost – accumulated depreciation), a loss is recorded on the income
statement; if more than the carrying value, difference is recorded as
revaluation surplus, a component of equity, so net income is not
affected
 Subsequent revaluation dates: if fair value > carrying value, a gain
first reported on the i/s and reverses any previous loss. If gain >
prior loss, excess is reported in revaluation surplus account
 Example:

Year Carrying value Fair value Treatment

1 30 mln 29 mln i/s: 1 mln loss
2 29 mln 30.5 mln (i.e. 1.5 mln i/s: 1 mln gain – offset
above carrying) OCI in shareholder’s
equity: 0.5 mln
increase in
revaluation surplus
account
3 30.5 mln 29.5 mln (i.e. 1 mln OCI: reduce 0.5 mln
below carrying) i/s: 0.5 mln loss
- Impairment of PP&E and intangible assets: both US GAAP and IFRS require firms to write
down impaired assets by recognizing a loss in i/s
o IFRS: annual assessment if impairment occurred
 Impairment: carrying value (original cost – accumulated depreciation) >
recoverable amount
 Recoverable amount = greater of (fair value – any selling costs) and
(value in use)
 Value in use is the present value of its future cash flow stream from
continued use
 If impaired, asset’s value written down on b/s to the recoverable amount
and impairment loss recognized in i/s
 Impairment loss = carrying value – recoverable amount
 An impairment loss can be reversed if asset’s value recovers in future,
limited to the original impairment loss
 o US GAAP: tested for impairment only when events and circumstance indicate firm
may not be able to recover carrying value through future use
 Step 1: Recoverability test: an asset is considered impaired if carrying value
(original cost – accumulated depreciation) > asset’s future undiscounted
cash flow stream
 Step 2: loss measurement: if impaired, asset’s value is written down to fair
value on b/s and loss recognized in i/s = carrying value – fair value of the
asset or discounted value of future cash flows if fair value is unknown
 Loss recoveries not permitted

Impairment test i/s b/s

IFRS Carrying value > recoverable amount Recognize Write down to
--- impairment loss = the recoverable
*carrying value = cost – depreciation carrying value – amount
*recoverable amount = greater of (fair value – recoverable
selling cost) and (value in use) amount
*value in use = PV of future cash flow from
continued use
US GAAP Carrying value > future undiscounted cash flow Recognize loss = Write down to
stream carrying value – fair fair value
value or discounted
value of future
cash flows
- Long-lived assets held for sale
o If firm intends to sell asset and asset is available for immediate sale, then it must be
reclassified form held-for-use to held-for-sale reclassified asset is no longer
depreciated or amortized  impaired if carrying value exceeds NRV  written down
to NRV and loss recognized in i/s
- Derecognition of PP&E and intangible assets
o Assets are sold, exchanged, or abandoned  Derecognition: long-lived assets are
eventually removed from b/s  difference between sale proceeds (no proceeds if
abandoned) and carrying value is reported on i/s as part of “other gains and losses”,
or reported separately if material
o If asset is exchanged for another, a gain or loss is computed by comparing carrying
value of the old asset with fair value of the old or new asset

o
- Impairment, revaluation and derecognition of PP&E and intangible assets affect f/s and
ratios
o Impairment  reduce asset carrying value on b/s  loss in i/s  reduce asset and
equity in retained earnings  in the year of impairment: ROA and ROE decrease as
impairment charges reduce net income  subsequent years: net income will be
higher  both ROA and ROE increase as equity and assets will fall as result of
impairment charge. Asset turnover increase in impairment period and subsequent
periods as well

o
 o

Module 26.4: Fixed Asset Disclosures

- f/s presentation of and disclosures relating to PP&E and intangible assets
o Must disclose for EACH class of PP&E (e.g. land, buildings, vehicles, machinery, fixes
and fittings)
 Basis for measurement, i.e. (historical cost – accumulated depreciation), or
(fair value – accumulated depreciation)
 IFRS: Useful lives or depreciation rate
 Carrying value for each class of asset
 Accumulated depreciation (tangible) or amortization (intangible)
 Reconciliation of carrying amounts from the beginning of the period to end
of the period (shows how each asset changed over the period)
 Title restrictions (something prevents from selling the asset) and assets
pledged as collateral for lending purposes
 Agreements to acquire PP&E in the future
 For impaired assets (fv<cv), the loss/ reversal amount, where losses/ loss
reversals are recognized in i/s and circumstances that caused the
impairment loss or reversals
 US GAAP, method for deriving fair value for impaired assets
 For revaluation assets (IFRS only)
 The revaluation date
 How fair value is determined
 Carrying value using historical cost model
- Analyze and interpret disclosures
- Methods for estimating the average age, economic life, and remaining useful life of a firm’s
assets
o Assumptions: assuming straight line depreciation, zero salvage value

- Financial reporting of Investment property

o IFRS classifies some property as investment property, while US GAAP does not
distinguish investment property from other kinds of long-lived assets
o A firm must use the same valuation model (cost, or fair value) for all its investment
properties

o A firm may change property use. Under the cost model, property’s carrying value
amount does not change when it’s transferred into or out of investment property
Module 27.1: Tax Terms
- Differences between accounting profit and taxable income: amount of income tax expense
recognized in the income statement may differ from the actual taxes owed to the taxing
authorities
- Two sets of financial statements – one presented to investors, one for tax
o Accruals accounting used in f/s – recognize revenue when accrued, not when cash is
received
o Modified cash accounting used for tax accounting: remove uncertainties for
estimates and judgments

- Time difference:
o The same amount goes to tax returns and the accounts, only period is the period –
creates the DTA or DTL
- Permanent difference:
o the amount goes to one but never goes to another, e.g. client entertaining expense
- reporting methods: e.g. depreciation
o accounts: depreciation is calculated often using straight line method
o tax returns: a form of double declining balance method
- Tax return terminology:
o Taxable income: income subject to tax based on the tax return
o Taxes payable: statutory rate* taxable income. the tax liability caused by taxable
income – also known as current tax expense, but different from income tax expense
o Income tax paid: the actual cash flow for income taxes including payments or
refunds from other years
 o Tax loss carryforward: a current or past loss that can be used to reduce taxable
income in the future, can result in a deferred tax asset
 Can take this negative taxable income to offset future taxable income to pay
less tax  results in deferred tax asset
o Tax base: net amount of an asset or liability used for tax reporting purposes
- Financial reporting terminology:
o Accounting profit: pretax financial income based on financial accounting standards
 i.e. income before tax, earnings before tax
o Income tax expense: expense recognized in i/s including taxes payable and changes
in deferred tax assets and liabilities.
 Income tax expense = tax payable + change in DTL – change in DTA
o Temporary timing differences (same amount goes to accounts and tax return)
 Deferred tax liabilities: b/s amounts that result from excess of income tax
expense over taxes payable that are expected to result in future cash
outflows
 Deferred tax assets: b/s amounts that result from an excess of taxes payable
over income tax expense that are expected to be recovered from future
operations
o Valuation allowance: a US GAAP phrase, not in IFRS. Contra account. reduction of
deferred tax assets based on the likelihood the assets will not be realized
o Carrying value: net b/s value of an asset/ liability
o Permanent difference: a difference between taxable income (tax return) and pretax
income (i/s) that will not reverse in the future
o Temporary difference: a difference between the tax base and carrying value of an
asset or liability that will result in either taxable amounts or deductible amounts in
the future

Module 27.2: Deferred Tax Liabilities and Assets

- Differences between treatment of an accounting item for tax reporting vs. for financial
reporting can occur due to:
o Timing of revenue and expense recognition in i/s and tax return differ
o Some revenues/expenses are recognized in i/s but never on tax return, vice versa
o Assets and/or liabilities have different carrying amounts and tax bases
 o Gain or loss recognition in i/s differs from tax return
o Tax losses from prior periods may offset future taxable income
o f/s adjustments may not affect tax return or may be recognized in different periods
- Creation of deferred tax liabilities and assets
o A DT liability is due to temporary differences, when income tax expense (i/s) > taxes
payable (tax return). Occurs when:
 Revenue or gain is recognized in i/s BEFORE they are included on the tax
return
 Expense or loss is tax deductible before they’re recognized in the i/s
 Most often created when an accelerated depreciation method is used on the
tax return and straight-line depreciation is used on the i/s
 If deferred tax liabilities are expected to reverse in the future, they are best
classified by an analyst as liabilities. If, however, they are not expected to
reverse in the future, they are best classified as equity (DTL decreased and
equity increased by the same amount)
o A DT asset occurs when:
 Revenue or gain is taxable before recognized on i/s
 Expense or loss is recognized in i/s before being tax deductible
 Tax loss carryforwards are available to reduce future taxable income
o Post-employment benefits, warranty expenses, and tax loss carryforwards are
typical causes of deferred tax assets
- Calculate tax base of a company’s assets and liabilities
o Tax base of assets: amount that will be deducted (expensed) on the tax return in the
future as the economic benefits of the assets are realized. While carrying value is
asset reported on the f/s net of depreciation and amortization
o Examples:
 Depreciable equipment: cost is 100k, depreciation expense (i/s) = 10k
recognized for 10 years. On tax return, asset is depreciated at 20k per year
for 5 years.
 At end of year 1: tax base is 80k (100k – 20k). carrying value is 90k
(100k – 10k). a DTL is created to account for the timing difference
for tax and for financial reporting
 Sale of machine for 100k, results in 10k gain on i/s and 20k gain on
tax return. This reverses the DTL
 R&D: 75k R&D expense expensed in i/s. on tax return, R&D capitalized and
amortized on straight line basis over 3 years
 At end of year 1: tax base is 50k (75k – 25k). carrying value = 0
 Deferred tax asset created since earnings before tax < taxable
income
 Accounts receivable: gross receivables of 20k are outstanding
 Recognize bad debt expense of 1.5k in i/s
 For tax purposes, bad debt expense cannot be deducted until
receivables are deemed worthless
 At end of year, tax base is 20k, but carrying value is 18.5k (20k –
1.5k). DTA created
o A liability’s tax base is the carrying value of the liability – any amounts that will be
deductible on the tax return in the future.
 o The tax base of revenue received in advance is the carrying value – amount of
revenue that will not be taxed in the future
o Examples:
 Customer advance: year end, 10k received from customer for goods to be
shipped next year
 on tax return, revenue received in advance is taxable when collected
 a DTA is created as the customer advance liability has a tax base of 0
(10k carrying value – 10k revenue not taxed in the future)
 warranty liability: year end, estimate 5k of warranty expense will be
required on goods alrdy sold
 tax return: warranty liability is not tax deductible until warranty
work is actually performed
 carrying value of warranty liability is 5k, tax base = 5k carrying value
– 5k warranty expense deductible in future. Results in a DTA
 note payable: firm has outstanding promissory note w principle balance 30k,
interest 10%, paid at end of each quarter
 promissory note is treated same way on the tax return and in f/s
 carrying value and tax base equal = 30k
 interest paid is included in both pre-tax income on i/s and taxable
income on tax return. No deferred tax item created

Module 27.3: Deferred Tax Examples

-
-
- Above DTL created by the temporary timing differences due to depreciation. It’s created and
then reversed. The amount is equal to tax rate *(Tax return depreciation – accounts
depreciation)
- Tax base approach:

-
- DTA example: revenue 5k each for 2 years. Warranty expense estimated to be 2% of revenue
each year. Actual expenditure of 200 to meet warranty claims was not made til 2 nd year. Tax
rate us 40%. Compute tax implications
o For accounting purpose, warranty accounted for at time of sale; for tax, it’s
accounted for when repairing the goods or giving refund
 -

-
- Tax base approach

-
- To summarize, if taxable income (on the tax return) is less than pretax income (on the
income statement) and the difference is expected to reverse in future years, a deferred tax
liability is created. If taxable income is greater than pretax income and the difference is
expected to reverse in future years, a deferred tax asset is created

Module 27.4: Change in Tax Rates

- Evaluate the effect of tax rate change on company’s f/s and ratios
 o Income tax rate change  DTA and DTL are adjusted to reflect new rate and income
tax expense
 Increase in tax rate will increase both DTA and DTL; decrease will decrease
both
o Increase (decrease) in tax rate  previously deferred income is recognized for tax 
tax due will be higher (lower)  expense items previously reported in f/s are
reported for tax, benefits will be greater (less)

-
 -

Module 27.5: Permanent Differences

- Distinguish temporary and permanent differences in pre-tax accounting income and taxable
income
o Permanent difference: a difference between taxable income and pretax income that
won’t reserve in the future
 Does not create deferred tax assets or deferred tax liabilities
 Can be caused by revenue that’s not taxable, expenses that are not
deductible, or tax credits that result in a direct reduction of taxes
-
o Tax credit is obtained when buying PP&E. given by governments to promote
investment
- Permanent difference will cause firm’s effective tax rate to differ from statutory tax rate
o If only temp timing differences, then effective tax rate = statutory rate (no overseas
ops)
 But as soon as there are permanent differences, no longer equal
 Income tax expense = tax payable + change in DTL – change in DTA
- A temporary difference is a difference between the tax base and carrying value of an asset or
liability that will result in taxable amounts or deductible amounts in the future
o DTA or DTL created
o Can be taxable temporary differences that result in expected future taxable income
or
o Deductible temporary differences that result in expected future tax deductions
o E.g. temp difference leading to DTL: investment in another firm  parent company
recognizes earnings from the investment before dividends are received
o Temp difference from an investment will result in a DTA if temp difference is
expected to reverse in the future and sufficient taxable profits are expected to exist
when reversal occurs
o Have to explain stat vs. effective tax rate and explain why they’re different in the
footnotes to the accounts
- Temporary differences at initial recognition

o
- Business combinations: a company that owns other companies
-
- Likely to have a timing difference in recognition of earnings and dividends
o US GAAP requires recording a DTL if reversals are likely in future
o IFRS requires recording DTL unless: if parent controls timing of reversal AND timing
difference is unlikely to reverse

-
- Valuation allowance for DTA
o Deferred taxes  created from temporary differences which are expected to
reverse in the future  neither DTA nor DTL are carried on the b/s at discounted
present value  deferred tax assets are assessed at each b/s date to determine
likelihood of sufficient future taxable income to recover the tax assets
o US GAAP: it’s likely that some or no DTA will be realized, then DTA must be reduced
by a valuation allowance
o Valuation allowance: a contra account that reduces the net b/s value of DTA
 Increase in valuation allowance  decrease in net b/s DTA  increase
income tax expense  decrease net income  changing the valuation
allowance can manipulate earnings
o Under IFRS, similar cals made but valuation allowance is not separately disclosed
o Management discretion to recognize DTA: if a co has order backlogs or existing
contracts to generate future taxable income then a valuation allowance might NOT
be necessary; if co has cumulative losses in the past or been unable to use tax loss
carryforwards, then valuation allowance needed to reflect the likelihood that a DTA
will never be realized
o Whenever a company reports substantial deferred tax assets, an analyst should
review the company's financial performance to determine the likelihood that those
assets will be realized. Analysts should also scrutinize changes in the valuation
allowance to determine whether those changes are economically justified.
-
o Valuation allowance: Can be used to potentially move profits across periods
 Implication: analyst assumptions  If VA has increased in the accounts 
means company doesn’t believe its future earnings are big enough to
benefit from the reversals of DTA

-
o DTA
 impairment (equivalent to a massive depreciation charge, accounted for at
date of impairment, not tax deductible)
 Restructuring results in DTA, LIFO (accounts) to FIFO (tax returns) creates
 In the US, inventory cost flow method must be the same
 Defined-benefit pensions can cause DTA: account for costs of pension during
employees life, payout after retirement – expenses going through the i/s;
tax deductible when payment’s paid out to employees after retirement

-
- Example
 -

Module 28.1: Bond Issuance (long term liability)

- Exam focus:
o Understand the f/s effects of issuing bond at par, discount, premium
o Calculate book value, interest expense using the effective rate method
o Calculate gain or loss from retiring a bond before its maturity date
o Understand how classification of a lease as either operating or financial lease affects
the b/s, i/s and cash flow from both lessee and lessor pov
o Distinguish between two types of pension plans and identify the f/s reporting of a
defined benefit plan
o Evaluate firm’s solvency using the various leverage and coverage ratios
- Bond (long term liability): a contractual promise between a borrower (bond issuer) and a
lender (the bond holder) that obligates the bond issuer to make payments to the
bondholder over the term of the bond. Two types of payments involved: periodic interest
payments, repayment of principal at maturity
- Terminology:
o Face value/ maturity value/ par value: the amount of principal that will be paid to
the bondholder at maturity
o Coupon rate: the interest rate stated in the bond, used to calculate coupon
payments
o Coupon payments: the periodic interest payments. = face value * coupon rate
o Effective rate of interest: interest rate that equates the PV of the future cash flows
of the bond and the issue price. Is the market rate of interest required by
bondholders and depends on the bond’s risks e.g. default, liquidity risks, as well as
the overall structure and timing of the bond’s cash flows
  Not to be confused with coupon rate
 Coupon rate is fixed while market rate of interest will likely change over
bond’s life
o Balance sheet liability (also known as book value or carrying value of the bond):
equal to the present value of its remaining cash flows (coupon payments and face
value), discounted at the market rate of interest at issuance. At maturity, liability =
face value of bond
o Interest expense: reported in i/s. = book value of the bond liability at beginning of
the period * market rate of interest of bond at issuance

- At issuance, bond is
o A par bond/ priced at fair value: if mkt rate = coupon rate
o A discount bond/ priced below par: if mkt rate > coupon rate
o A premium bond/ priced above par: if mkt rate < coupon rate
- b/s measurement
o at issuance – asset and liabilities both initially increase by bond proceeds
o at any point in time – book value of bond liability = pv of the remaining future cash
flows (coupon payments and face value) discounted at the bond’s yield at issuance
 Interest expense and the book value of a bond liability are calculated using
the bond's yield at the time it was issued, not its yield today. This is a critical
point.
o A premium bond is reported on b/s at more than its face value. As premium is
amortized, book value of the bond liability will decrease until it reaches face value of
bond at maturity
o A discount bond is reported on b/s at less than its face value. As discount is
amortized, the book value of the bond liability will increase until it reaches face
value of bond at maturity
-

-
- Example:

-
-

-
- Amortization method

-
Module 28.2: Discount and Premium Bonds
- For bond issued at premium or discount, interest expense ≠ coupon interest payments
o Interest expense: includes amortization of any discount/ premium
 Effective interest rate method: interest expense = book value of the bond
liability at beginning of the period * bond’s yield at issuance
 Premium bond: interest expense < coupon payment (difference
being the amortization of premium). Interest expense decreases
over time as bond liability decreases
 Discount bond: interest expense > coupon payment
o Amortizing discount or premium
 IFRS: effective interest rate method required
 US GAAP: effective interest rate method preferred but straight line method
allowed if results not materially different
 Straight line: total discount/ premium at issuance is amortized by
equal amounts each period over life of the bond
- Zero-coupon bonds (also known as pure-discount bond): no periodic interest payments.
Issued at a discount from its par value

Module 28.3: Issuance Cost, derecognition and disclosures

- Issuance cost: issuing a bond involves legal and accounting fees, printing costs, sales
commissions, etc.
o Under IFRS, US GAAP: initial bond liability on b/s (i.e. the proceeds from issuing the
bond) is reduced by the amount of issuance costs, increasing bond’s effective
interest rate
o Still allowed under US GAAP: capitalize issuance costs as an asset and allocate to i/s
over life of bond. Controversial as this cost does not lead to future economic benefit
o Bond issuance cost usu. Netted against bond proceeds and reported on cash flow
statement as CFF
-

-
- Effects of changing interest rates
o Change in interest rate, change in credit quality  change in yields of bond changes
 not reflected in the b/s. b/s value is amortized cost, not mkt value
 o
- Fair value reporting option:
o Book value of bond liability is based on mkt yield at issuance – as long as bond’s
yield doesn’t change, the bond liability represents fair mkt value; if bond’s yield
changes b/s liability no longer equal to fair value
 Increase in bond’s yield  decrease in fair value of bond liability
 Decrease in bond’s yield  increase fair value
o IFRS and US GAAP give firms the irrecoverable option to report debt at fair value
 Gains and losses that result from changes in bonds’ mkt yield are reported in
i/s

o
- Cash flow impact of issuing a bond

- i/s impact of issuing a bond

o interest expense = mkt rate at issue * b/s value of liability at beginning of period
o interest expense = cash paid + amortization of discount (if any) – amortization of
premium (if any)
 o therefore, interest expense decreases (increases) over time for bond issued at a
premium (discount)
- b/s impact of issuing a bond
o long-term debt is carried at the pv of the remaining cash payments discounted at
the mkt rate prevailing when debt was issued

- the derecognition of debt

o when bonds mature, any original discount or premium has been fully amortized,
thus the book value of a bond liability and its face value are the same
 the cash outflow to repay a bond is reported in the cash flow statement as
CFF
o firms may choose to redeem bonds before maturity because interest rates have
fallen, because firm has generated surplus cash thru operations or because funds
from the issuance of equity makes it possible/ desirable
 bonds redeemed before maturity  gain or loss is recognized by (book
value of the bond liability – redemption price)  gain or loss reported in I/s
usually as part of continuing ops and additional info disclosed separately 
analysts often eliminate this from i/s for analysis and forecasting as
redeeming debt is usu. Not part of the day-to-day ops
 if redeemed bonds’ issuance costs were capitalized, any remaining
unamortized costs must be written off and included in the gain or loss
calculation
 cash flow statement: indirect method – any gain/ loss is subtracted from/
added to net income in CFO. Redemption price reported as an CFF

o
- debt covenants in protecting of creditors
 o
o debt covenants: restrictions imposed by the lender on the borrower to protect
lender’s position. Can reduce default risk and thus reduce borrowing costs.
Analyzing covenants is necessary to credit analysis of a bond. Bond covenants
typically discussed in the f/s footnotes
 affirmative covenants: borrower promises to do certain things, e.g.
 make timely payments of principal and interest
 maintain certain ratios in accordance with specified levels
 maintain collateral
 negative covenants: borrower promises to refrain from activities adversely
affecting its ability to repay outstanding debt, e.g.
 increase dividends or repurchase shares
 issue more debt
 engage in M&A
o technical default: when firms violates a covenant bondholders can demand
immediate repayment of principal
o covenants protect bondholders from actions firm may take that would harm the
value of the bondholders’ claims to the firm’s assets and earnings
- f/s presentation of and disclosures relating to debt
o
o outstanding long-term debt -> in a single line on the b/s
o portion that’s due within the next year -> reported as a current liability
o more detail about its long-term debt -> in the footnotes including discussions of
 nature of the liabilities
 maturity dates
 stated and effective interest rates (the IRR that makes the initial liability =
the PV of the coupon payments and principal / future cashflows)
 call provisions (allow the issuer to buy back before maturity, typically paying
above par) and conversion privileges (bonds to common stock)
 restrictions imposed by creditors
 assets pledged as security
 amount of debt maturing in each of the next 5 yrs
o management discussion and analysis section

Module 28.4: Lease and Pension Accounting

- motivations for leasing assets instead of purchasing
o a lease can be considered an alternative to financing purchase of an asset for
advantages below:
  less costly financing: The interest rate implicit in a lease contract may be less
than the interest rate on a loan to purchase the asset, and typically no down
payment is required
 less restrictive provisions: compared to other borrowing (bank loans, bond
issuance), the terms of a lease may be less restrictive. Lessor will typically
not require all covenants that are included in most loan agreement or bond
indentures
 less risk of obsolescence: lessee does not bear the risk of an unexpected
decline in asset’s end-of-lease value


 Financial reporting: lessee’s pov  potential advantages: operating leases ->
don’t show any asset or liability in the b/s. it’s off-b/s finance (for US GAAP)
but changing in IFRS
- financial reporting of leases from a lessee’s perspective:
o IFRS: lessee reports an asset and a liability on the b/s, both equal to the pv of
promised lease payments
 Asset recorded on b/s: not the asset itself but the right to use the leased
asset for the specified period; depreciated over the term of the lease
 Periodic lease payments: reported like payments on an amortizing loan
 portion of each lease payment reported as interest expense
 Principal repayment portion: reduces the outstanding lease liability
 Short-term lease and leases of low-value assets: no b/s entries required 
rent expense reported on the i/s-> classified as COO


o US GAAP: a lease is either classified as a finance lease or an operating lease
 Finance lease: where the benefits and risks of ownership have been
substantially transferred to the lessee
 Reported the same as IFRS
 Otherwise -> operating lease: same as for finance lease except for:
 Entire lease payment is recorded as a lease expense on the i/s; no
separate interest expense reported
 
 “hire purchase agreements” – for bullet point 1
 Meet any of the criteria, not all
- Financial reporting of leases from a lessor’s perspective:
o IFRS: two lease classifications for lessors – financial and operating
 At initiation of a finance lease -> lessor removes the leased asset from its b/s
and adds a lease receivable asset equal to value of the expected lease
payments and any estimated residual value
 If lessor is manufacturer or dealer, it reports revenue equal to lease
asset amount and cogs equal to net book value of the asset -> over
term of the lease, lessor reports the interest portion of the lease
payments as income
 Operating lease -> lessor reports lease payments as income and
depreciation and other costs associated with leasing the asset as expenses




 PV lower than fair value, and both b/s asset and liability are
reported at the lower, i.e. PV
  If fair value is lower, then use fair value, but i/y needs to be
computed working backwards. This is referred to as rate implicit in
the lease (5.5%)


 Calculator use: use the amortization function


 o US GAAP: classify
 Sales-type lease: if meets transfer of ownership criteria and collection of
lease payments judged to be probable
 Direct financing lease: if transfer of ownership criteria not met, 3 rd party
guarantees residual value of the asset at end of lease & sum of the promised
lease payments and asset’s residual value is greater than or equal to fair
value of the asset
 Other leases -> operating leases

o
- Presentation and disclosure of defined contribution and defined benefit pension plans:
o Pension: a form of deferred compensation earned over time through employee
service, with the most common pension arrangements being defined contribution
plans and defined benefit plans:
 Defined contribution plan: a retirement plan in which the firm contributes a
sum each period to employee’s retirement account. Firm’s contribution can
be based on any number of factors, e.g. years of service, emloyees age,
compensation, profitability, or % of employees contribution
 Financial reporting: pension expense = employer’s contribution
 No future obligations to report on b/s as a liability
 Defined benefit plan: firm promises to make periodic payments to
employees after retirement. Benefit is usu. Based on years of service,
employee compensation at or near retirement. E.g. someone w 20 years of
service, final salary of 100,000  100000 final salary * 2% * 20 years of
service = 40,000 each year upon retirement till death
 A company that offers defined pension benefits typically funds the
plan by contributing assets to a separate legal entity, usu. A trust.
The plan assets are managed to generate income and principal
growth necessary to pay pension benefits as they come due
 Financial reporting: employer must estimate the value of future
obligation to its employee  must forecast variables e.g. future
 compensation levels, employee turnover, avg. retirement age,
mortality rates, appropriate discount rate
o The net pension asset or net pension liability is a key
element for analysis
 Overfunded: fair value of the plan’s assets >
estimated pension obligation  report a net
pension asset on b/s
 Underfunded  report a net pension liability
 The change in net pension asset/ liability ->
recognized on f/s with some components in net
income, others as OCI
 Components that directly go to equity (OCI)
are amortized to the i/s under US GAAP, not
amortized under IFRS
- Leverage and coverage ratios:
o Solvency ratios – measure a firm’s ability to satisfy long term obligations:
 Leverage ratios: focus on the b/s by measuring the amount of debt in a
firm’s capital structure. “debt” refers to interest-bearing obligations  non
interest bearing liabilities, e.g. accounts payable, accrued liabilities, deferred
taxes are NOT considered debt
 Debt-to-asset ratio = total debt / total asset  measures % of total
assets financed with debt
 Debt-to-capital ratio = total debt / (total debt + total equity) 
measures % of total capital financed with debt
 Debt-to-equity ratio = total debt / total equity
 Financial leverage ratio = average total assets / average total equity
 The higher the ratios, the higher the leverage. In some countries debt
financing is more popular than equity financing and firms in these countries
will have higher leverage
 Coverage ratios – focuses on the i/s by measuring the sufficiency of earnings
to repay interest and other fixed charges when due
 Interest coverage = EBIT / interest payments -> firms with lower
interest coverage will have more difficulty meeting its interest
payments
 Fixed charge coverage = (EBIT + lease payments) / (interest
payments + lease payments)

Module 29.1: Reporting Quality

- Distinguish financial reporting quality and reported results quality
o Financial reporting quality: characteristics of a firm’s f/s. criteria:
 Adherence to GAAP in the jurisdiction where firm operates
 However, as GAAP provide choices of methods, estimates, specific
treatment of items, compliance itself doesn’t result in highest quality
 Other criteria:
  Decision useful: relevance (info presented in f/s is useful to users),
faithful representation (completeness, neutrality, absence of errors)
o Quality of reported results:
 Quality of earnings: can be judged based on sustainability of the earnings as
well as on their level
 Sustainability: evaluate by determining % of reported earnings that
can be expected to continue in the future
o E.g. increases in reported earnings resulting from changes in
exchange rates or by sales of assets that have appreciated
over many periods are not sustainable
- Spectrum for assessing financial reporting quality:

Categorization GAAP compliance Earnings quality

1 Yes Sustainable and adequate
2 Yes Low (not sustainable or not adequate)
3 Yes Low (choice and estimates are biased)
4 Yes Earnings actively managed to increase,
decrease or smooth reported earnings
5 No Numbers reflect actual economic activities
6 No Numbers fictitious/ fraudulent
- Conservative vs. aggressive accounting
o Conservative accounting: if choices made within GAAP with respect to reported
earnings tend to decrease company’s reported earnings and financial position on the
b/s for the current period
 Results in increase future period earnings
o Aggressive accounting
 Results in decreased future period earnings
o Both are used by management for different periods in attempt to smooth earnings
over time because greater earnings volatility tends to reduce value of shares
 Earnings smoothing: achieved through adjustment of accrued liabilities
(based on management estimates)
 GAAP can introduce conservatism by imposing a higher standard of
verification for revenue and profit than for expenses and accrual of liabilities

o We should avoid thinking about conservatism in financial reporting as "good" and

aggressive reporting as "bad." Conservative bias can also be considered as a
 deviation from neutral reporting or faithful representation that reduces the
usefulness of financial statements to analysts and investors
- Motivations that might cause management to issue f/s not high quality:
o To meet or exceed a benchmark number for earnings per share. Mgtmt may be
motivated to report earnings that are greater than: earnings guidance offered earlier
by mgtmt, consensus analyst expectations, those of the same period in the peior yr
- Conditions conducive to issuing low-quality, or fraudulent f/s
o Motivation
o Opportunity: weak internal controls, inadequate oversight from board of directors,
applicable accounting standards provide a large range of acceptable accounting
treatments and inconsequential penalties in the case of accounting fraud
o Rationalization of the behavior
- Mechanisms that discipline financial reporting quality and potential limitations of them
o Regulatory bodies responsible for publicly traded securities and the mkts in which
they trade. SEC (US), FCA (UK), IOSCO (intl org of securities commissions)
coordinates securities regulation on an intl basis with over 200 members; European
Securities and mkts Authority (ESMA)
o Securities regulations typically require:
 Registration process for issuance of new publicly traded securities
 Specific disclosure and reporting reqs
 Independent audit of financial reports
 Statement of financial condition made by mgtmt
 Signed statement by person responsible for prep of the financial reports
 Review process for newly registered securities and periodic reviews after
registration
o In addition to the audit opinion, a requirement for securities that trade in the United
States is that management must include an assessment of the effectiveness of the
firm's internal controls
o Another source of discipline on financial reporting quality is private contracts, such
as those with lenders. Such contracts will often specify how financial measures
referenced in the loan covenants will be calculated. The counterparties to private
contracts with the firm have an incentive to see that the firm produces high-quality
financial reports.
- Report accounting measures not defined or required under GAAP, typically exclude some
items in order to make the firm's performance look better than it would using measures
defined and required by GAAP
o Where non-GAAP measures are reported in f/s, firms required to:
 Display the most comparable GAAP measure with equal prominence.
 Provide an explanation by management as to why the non-GAAP measure is
thought to be useful.
 Reconcile the differences between the non-GAAP measure and the most
comparable GAAP measure.
 Disclose other purposes for which the firm uses the non-GAAP measure.
 Include, in any non-GAAP measure, any items that are likely to recur in the
future, even those treated as nonrecurring, unusual, or infrequent in the
financial statements.
o IFRS – firms required to:
  Define and explain the relevance of such non-IFRS measures.
 Reconcile the differences between the non-IFRS measure and the most
comparable IFRS measure.

Module 29.2: Accounting choices and estimates

- Accounting methods (choices and estimates) could be used to manage earnings, cash flow,
b/s items
o Revenue recognition:
 Timing of revenue recognition
 Shipping terms: revenue recognition is when legal title changes
hands
 Discounts: massive discounts to boost sales in this period to
accelerate purchase


o Free-on-board (FOB) at the shipping point -> revenue is

recognized earlier compared to FOB at the destination
o FOB at the destination (customer location)
 Can be managed by accelerating or delaying shipment of goods:
o Channel stuffing: overload a distribution channel with more
goods than would normally be sold during a period. Book it
as a sale when doing that  good sales figure in this period
but affects sales in the next
o Delay recognition of revenue to the next period and hold or
delay customer shipments in periods where high earnings
are expected
o Bill-and-hold transaction: customer buys the goods and
receives an invoice but requests that firm keep the goods at
their location for a period of time  bill customers and
recognize a sale even though you haven’t shipped the goods
yet (allowed in US GAAP and IFRS but tightly controlled, only
allowed if buyer has committed to making the purchase and
requested a delay in delivery of the item) -> watch out for
bill and hold transactions
o Estimates of credit losses:
 On b/s, reserve for uncollectible debt is an offset to accounts receivable
 If mgtmt determines probability that AR will be uncollectible is
lower than current estimate  decrease reserve for uncollectible
accounts  increase net receivables on b/s  reduce expenses on
i/s  increase net income
o Mtgmt can adjust bad-debt reserve in order to smooth
earnings: in periods of high earnings, the allowance for bad
debt is increased to reduce reported earnings, effectively
storing these earnings for later use; in subsequent periods, if
earnings are below benchmark values, the bad-debt reserve
can be reduced to meet earnings targets
 Other reserves can be used the same way: reserve for warranty
expense
 Valuation allowance  reduces carrying value of a DTA based on
probability it wont be realized: increase VA  decrease net DTA 
reduce net income
 Depreciation methods and estimates: using accelerated method vs.
straight line: increase expenses and decrease net income in early
years
o Estimates of useful life and salvage value also affect net
income and carrying value of the asset
 Amortization and impairment: ignoring or delaying impairment
charge, mgtmt can increase earnings in the current period
 Inventory method: FIFO, LIFO impact on COGS and net income
o In terms of relevance:
 More accurate b/s invenrory: FIFO
 COGS closer to current cost and gross profit and
margin better reflect economic reality: WAC
 Related-party transactions: public firm does business w a supplier
that’s private and controlled by mgtmt, adjusting the price of goods
supplied can shift profits either to or from the private company to
manage the earnings of the public company
 Capitalization: any expense that can be capitalized creates and asset
on the b/s and impact of the expense on net income can be spread
over many years. Also affects cash flow classifications: capitalized –
a CFI; and CFO increased by that amount
 Other cash flow effects:
o mgtmt can affect classification of cash flows thru other
methods, mainly w the goal of increasing CFO.
 Stretching payables: Take longer to pay suppliers 
increase CFO

 Management of accruals
 Allowance of bad debt (loan loss provisions for financial
institutions):
 By manipulating: liabilities and income (bad debt expense)
 Loan loss provisions: making loans  some will default  bank
estimates the amount of default and deduct from amount owed 
affects earnings
 Warranty expense: accruals concept  must recognize cost at time
of sale  warranty expense is estimated and can reduce earnings
 Depreciation methods: switching between – is a change in accounting
estimate, not principal  no need to change prior years


 Worried about un-public companies controlled by the directors
 Cash flow: analysts like to see high and steady CFO
 

Module 29.3: Warning signs

- Accounting warning signs

o Revenue recognition


 Revenue growth out of line w peers for long period
 Change in revenue recognition method: change of when revenue is
recognized to allow earlier revenue recognition… MD&A must
discuss any business reasons for these changes (but MD&A is
unaudited)
 Bill-and-hold: allowable under tightly controlled conditions –
customer commitment, customer asks to
 Change in rebate estimates: warranty provisions etc.
 Receivables turnover (sales/ avg. sales receivables) related to days
sales outstanding: decreasing -> days sales outstanding increasing 
red flag – problem collecting from customers, selling to customers
who cannot afford to buy? Or offering of better credit terms?
 Total asset turnover (sales/ avg. total assets): declining  not using
assets sufficiently to generate revenues
  Non-operating or one time times included in revenue: could be firms
trying to mask declining revenue (e.g. reclassify investment income
as a revenue other than OCI when the firm isn’t a financial services
co.)
o Inventories


 Inventory turnover -> decline -> days of inventory on hand goes up: cannot
sell items produced?
 Reduced inventory under LIFO: inventory liquidation -> release old inventory
costs
o Capitalization policies


 Compare the b/s items to see what are capitalized vs. peers
 CFO/ net income < 1 or declining over time: if CFO is below net income.
Income is not backed by cash; cash based earnings vs. accruals based
earnings: cash backed is higher quality. Accruals will revert sometime in
future. Maybe firm is boosting earnings by under-depreciating assets ->
higher carrying value  impairment and lower future earnings  losses in
asset disposal in future if I don’t impair…
o Other warning signs


 Segmental disclosure which cannot be gauged from b/s, i/s. is it granular
enough?
  Numerous acquisitions: distorts the result of year-to-year analysis, makes it
harder to compare as all the earnings, revenues costs are added to parent
co’s i/s and b/s  harder to compare results from year to year; fair mkt
value adjustments: when acquiring subs or associates, must adjust current
value to fair mkt value  subjective
 companies have a tendency to understate the value of net assets
acquired goodwill is calculated as purchase price – fair value of
net assets acquired  good will bigger  impact on future earnings
when goodwill is impaired… impairments are very subjective

Module 30.1: Forecasting

- evaluate co’s past financial performance and explain how its strategy is reflected in past
financial performance

o
- forecast a firm’s future net income and cash flow
o often begins w forecasting sales
  stable firms: ratios have been relatively constant over time. Stable firm –
variable cost based. Constant industry. Strip out non-recurring items
(subjective).
 shorter horizons: top down approach – GDP growth  historical relationship
between GDP growth and growth of industry sales  adjust growth rate
depending on change of firms’ mkt share
 simple forecasting model: historical avg, or trend-adjusted measure of
profitability can be used (i.e. operating margin, EBT margin, net margin)
 complex forecasting model: each item on i/s and b/s can be estimated based
on separate assumptions about its growth in relation to revenue growth
 multi-period forecasts: analyst typically employs a single estimate of sales
growth at some point expected to continue indefinitely
o cash flow estimate:


 make assumptions about future sources and uses of cash, most important
being:
 increases in working capital
 capital expenditures on new fixed assets
 issuance or repayment of debt
 issuance or repurchase of stock
 typical assumption is noncash working capital as a % of sales remains
constant


 
 Earnings increasing but cash is dropping – might be due to net cash
operating cycle  might need future borrowing

Module 30.2: Credit and equity analysis

- Use f/s analysis to assess credit quality of a potential debt investment
o Traditionally, 3Cs of credit analysis: character, collateral, capacity to repay.
 Capacity to repay requires close examination of f/s and ratios
 Character: history, trading history, results over time, who’s running
it, board of directors, internal controls, fraud in the past
 Collateral: security that can be used to secure debt
 Covenants: covenants built into debt issuance (affirmative, negative)
 Capacity: capacity to service the debt, means of paying principal and
interests, ratios (solvency ratios, i.e. debt-to-equity, debt over debt-
plus-equity; coverage ratios, i.e. EBIT over interest)

o
o Credit rating agencies employ formulas which are weighted averages of several
specific accounting ratios and business characteristics
 Scale and diversification: larger co w wider variety of product lines and
geographic diversification better
 Operational efficiency: operating ROA, operating margin, EBITDA margins
 Margin stability: stable profitability margins
 Leverage: ratios of operating earnings, EBITDA, measure of free cash flow to
interest expense, total debt make up. Greater earnings in relation to debt
and interest expense better
 
 Vertical integration: ownership of distributors (guaranteed access to
mktplace), suppliers (guaranteed access to materials needed for
product)


- Use f/s analysis in screening potential equity investments
o Backtesting: using a specific set of criteria to screen historical data to determine how
portfolios based on those criteria would have performed
 No guarantee that screening criteria which outperformed in the past will
continue to do so
 Also pay attention to survivorship bias, data mining bias, look-ahead bias

o
 Growth: looking for young companies with high growth potential
 Value: undervalued companies – share price lower than intrinsic value. Low
PE ratio, low P/B ratios
- Adjustment to co’s f/s to facilitate comparison w another co
o Different accounting methods used: different depreciation schedules, US GAAP vs.
IFRS etc.
o Investment securities: classification of investment securities affects reported
earnings and assets – unrealized gains and losses on held-for-trading securities 
recorded as income; available-for-sale or held-to-maturity securities are not
o Inventory accounting differences
 o Differences in depreciation methods and estimates

Module 31.3: Stakeholder Management

- Corporate governance: the system of internal controls and procedures by which individual
companies are managed. Provides a framework that defines the rights, roles and
responsibilities of various groups within an org

-
o Various stakeholder groups

o
o Shareholders: have a residual interest in the corp. as they have claim to the net
assets after all liabilities have been settled
o Principal – agent relationship
 Might be conflict between principal interest and agent interest

o
o Potential conflicts of interest: principal – agent conflict
 Conflicts of interest between shareholders and managers or directors: risk,
information asymmetry
 Conflicts between groups of shareholders: in the event of acquisition,
controlling shareholders may get better terms for themselves relative to the
terms forced on minority shareholders; majority shareholders may cause the
co to enter into related party transactions
 Conflicts of interest between creditors and shareholders: shareholders may
prefer more business risk than creditors do as creditors have limited upside
 from good results compared to shareholders. Equity owners could also act
against the interests of creditors by issuing new debt that increases the
default risk faced by existing debt holders, or by company paying greater
dividends to equity holders thereby increasing creditors’ risk of default
 Conflicts of interest between shareholders and other stakeholders: co may
decide to raise prices or reduce product quality to increase profits to the
detriment of customers. Co may employ strategies that significantly reduce
the taxes they pay to government

o
 AGM: held after end of the firm’s fiscal year. Management provides
shareholders w the audited f/s for the year, addresses co’s performance and
significant actions over the period and answer shareholder questions.
certain things to be dealt with, elections BOD, approving external auditors to
f/s etc.
 Dictated by corporate laws – typically anyone owning shares
permitted to attend, speak and ask questions and vote
 A shareholder who doesn’t attend can vote her shares by proxy:
assigns her right to vote to another who will attend the meeting
(often a director, member of mgtmt or shareholder’s investment
advisor)
o Simple majority vote: ordinary resolutions, e.g. approval of
auditor, election of directors
o 2/3 or ¾: special resolution, e.g. merger, takeover,
amendment of corporate bylaws
 EGM: special resolutions. Large acquisition, divestiture, changes must be
voted. Can be called anytime
 Proxy voting: most shareholders don’t attend the meeting. They receive a
proxy – election of board members – majority election, or cumulative voting
 Majority: 1 vote per share per each board seat – 10 seats, 10
different elections
 Cumulative: 10 seats on the board, each share – 10 votes, 1 election,
vote for anyone on the list. Minority shareholders better
represented  more shareholder-friendly
- BOD:
o Co often have directors w expertise in specific areas of the firm’s business, e.g. risk
mgtmt, finance, industry strategy.
o With a one-tier structure, chairman of the board is sometimes the company CEO.
However now more common to separate. When a lead independent director is
appointed, he has the ability to call meetings of the independent directors, separate
from meetings of the full board.
o


 One-tier:
 Internal directors: CEO, CFO, general counsel – could have some
conflicts with shareholder interests external directors important
to shareholder interests
 Two-tier:
o Responsibilities:


 

Module 31.2: Factors affecting corporate governance

-
o Activist shareholders: pressure companies in which they hold a significant number of
shares for change that they believe will increase shareholder value
 They may bring pressure by initiating shareholder lawsuits or by seeking
representation on the BOD
 Proposing shareholder resolutions for a vote and raising their issues to all
shareholders or the public to gain wider support
 Hedge funds engage more and more in shareholder activism to increase the
mkt values of firms in which they hold significant stakes
 Proxy fight: a group may initiate proxy fight where they seek the proxies of
shareholders to vote in favor of their alternative proposals and policies
 Tender offer: an activist group may a tender offer for a specific number if
shares of a company to gain enough votes to take over the co.
o Hostile takeover: a takeover is hostile if a group buys the company and intends to
get rid of existing management. Senior managers and BODs can be replaced by
shareholders if they believe company performance is poor and would be improved
by a change
 A hostile takeover, is one not supported by co’s management
 Issues of corporate governance and conflicts of interest arise when
company management proposes and the board passes anti-takeover
measures to protect their jobs. Staggered board elections make a
hostile takeover more costly and difficult
-
o Common law system – judges’ rulings become law in some instance. Said to be more
shareholder friendly. In civil law system, judges are bound to rule based only on
specifically enacted laws. In general, rights of creditors are more clearly defined than
those of shareholders  easier to enforce thru the courts for creditors than
shareholders
o Sustainable investing: ESG factors and rate companies on their corporate
governance, social and environmental impacts
- Poor corporate governance can decrease company value

o
- Factors relevant to the analysis of corporate governance and stakeholder management
o Company ownership and voting structure
 Dual class structure: companies w a dual-class share structure have traded
on average at a discount to comparable companies with a single class of
shares
o Composition of a company’s board
 Executive, non-executive, independent directors
 Any involved in related-party transactions
 Have diversity of expertise suiting company’s strategy and challenges
 Have served for many yrs and have become too close to co’s mgtmt
o Management incentives and remuneration
 Does the remuneration plan offer greater incentives for short term or long
term benefits of company
 Performance-based incentive pay is fairly stable over time indicating targets
are possibly easy to achieve
 Mgtmt remuneration is very high relative to comparable companies
 Mgtmt incentives are not aligned w current co strategy and objectives
o Composition of shareholders:
 If a significant portion of co outstanding shares are held by an affiliated co
o Relative strength of shareholders’ rights
  If shareholder rights are weak, perceived increases in shareholder returns
from being acquired or significant changes in co strategy may be difficult to
realize. Examples of weak shareholders' rights are the existence of anti-
takeover provisions in the corporate charter or bylaws, staggered boards,
and a class of super voting shares, which all restrict the rights of
shareholders to effect change
o Mgtmt of long-term risks: co does not manage risks of stakeholder conflicts well

-
o
o Founders share is 10 vote per share, e.g., so founders can control the company even
though they don’t own over 50% of the economic value of the company

-
o Anti-takeover provision: protects company’s management. Goes against good
shareholder rights…

-
o Is the fund acting in the best interest of shareholders when they engage in ESG
investing
 o

-
o Negative screening: e.g. ruling out tobacco companies, gun manufacturers, mining,
oil drilling companies as they don’t have the right ESG factors
o Positive: concentration risk in certain industries
o Alternative to them: best in class: relatively ESG. E.g. choose companies in
international oil industry with the best ESG. Preserve the industry weight but within
each sector, select companies to improve overall ESG profile of he portfolio

-
o Fundamental analysis: expected earnings per share, other f/s ratios
 Full integration refers to the inclusion of ESG factors or ESG scores in
traditional fundamental analysis. A company's ESG practices are included in
the process of estimating fundamental variables, such as a company's cost
of capital or future cash flows. To the extent that ESG practices will affect
such variables, integrating them into the analysis can help in determining
which companies are currently overpriced or underpriced.
o Thematic: social goals, environmental goals, governance
 -

-
o Overlay/ portfolio tilt strategies: managing the overall characteristics, tilt towards
clean technology. For example, a fund manager may seek to reduce the
environmental pollution or carbon footprint of their portfolio stocks as a whole
o Integrate risk factor into other risk factors when doing portfolio valuation,
optimization. Risk factor/risk premium investing refers to the treatment of ESG
factors as an additional source of systemic factor risk, along with such traditional risk
factors as firm size and momentum.

Module 32.1: Capital projects, NPV and IRR

- Capital budgeting process: the process of identifying and evaluating capital projects, i.e.
cash flow to the firm will be received over a period > a year; impact on future earnings
o Steps:
 Idea generation: generate project ideas, from senior mgtmt, functional
divisions, employees, or outside the co.
 Analyze project proposals: cash flow forecast to be made  pick out the
profitable projects
 Create firm-wide capital budget: the profitable projects need to be
prioritized based on timing of project cash flows, available company
resources, company overall strategic plan
 Monitor decisions and conduct post audit: follow up on ALL capital
budgeting decisions. Compare actual results to the projected results. Project
managers should explain why did not match. A post audit should identify
systematic errors in the forecasting process and improve co. operations.
- Categories of capital budgeting projects:
o Replacement projects: to maintain the business  usu. No detailed analysis. Q:
whether existing ops should continue and if so existing procedures / processes
should be maintained
o Replacement projects for cost reduction: determine whether equipment that’s
obsolete, but still usable, should be replaced.  detailed analysis needed
o Expansion: to grow the biz; complex decision making process; explicit forecast of
future demand  very detailed analysis needed
o New product, mkt development: complex, detailed analysis
 o Mandatory projects: may be required by gov or insurance company, typically
involving safety-related or environmental concerns  typically generate little to no
revenue, but accompany new revenue-generating projects undertaken
o Other: not easily analyzed, may include a pet project of senior mgtmt, a high risk
project (R&D) that’s difficult to analyze w typical capital budgeting assessment
methods

Basic principles of capital budgeting: Five principles

o
o Decisions are based on cash flows, not accounting income
 The relevant cash flows considered as part of capital budgeting process are
incremental cash flow: the changes in cash flows that will occur if project is
undertaken
 Sunk costs: costs that cannot be avoided, even if project isn’t
undertaken
 Externalities: effects the acceptance of a project have on other firm
cash flows. E.g. negative externality: cannibalization – new project
takes sales from an existing product  analysts should subtract lost
sales of the existing product from the expected new sales of the new
product when estimating incremental project cash flows
 Conventional flow pattern: if the sign on the cash flows changes only
once, with one or more cash outflows followed by one or more cash
inflows
 Unconventional cash flow pattern: more than one sign change
 Cash flows are based on opportunity costs:
 Opportunity cost: the cash flows that a firm will lose by undertaking
the project under analysis – cash flows generated by an asset the
firm alrdy owns that would be foregone if the project under
 consideration is undertaken  these must be included in project
costs
 The timing of cash flows is important: capital budgeting decisions account
for time value of money; cash flows received earlier are worth more than
later
 Cash flows are analyzed on after-tax basis: impacts of taxes must be
considered
 Financing costs are reflected in projects required rate of return: don’t
consider financing costs specific to project when estimating incremental
cash flows. The discount rate used in capital budgeting analysis takes
account of firm’s cost of capital -> projects expected to return more than
cost of capital needed will increase value of the firm
- Evaluation and selection of capital projects is affected by:
o Mutually exclusive projects: vs. independent projects – only one project in a set of
possible projects can be accepted and projects compete with each other
o Project sequencing: some projects must be undertaken in a certain order so
investing in a project creates the opportunity to invest in other projects in the future
 Add on projects are treated as options – consider the positive benefits when
evaluating the initial decision
o Capital rationing: vs. unlimited funds: if a firm has unlimited access to capital, it can
undertake all projects w expected return exceeding the cost of capital. Otherwise, it
must ration, or prioritize capex that it achieves the max increase in value

o
- NPV: sum of the present values of all the expected incremental cash flows if a project is
undertaken
o Discount rate: the firm’s cost of capital, adjusted for the risk level of the project
CF 1 CF 2 CF t
o NPV = CF0 + 1 + 2 +…+
(1+k ) (1+k ) (1+k )t
o CF0 is the initial investment outlay (a negative cash flow)
o CF1 is the after tax cash flow at time t
o K is the required rate of return for project
o A positive NPV project is expected to increase shareholder wealth, a negative NPV
project is expected to decrease shareholder wealth, and a zero NPV project has no
expected effect on shareholder wealth.
o For independent projects, the NPV decision rule is simply to accept any project with
a positive NPV and to reject any project with a negative NPV.
 o

o
- IRR: the discount rate that makes the present value of the expected incremental after-tax
cash inflows just equal to the initial cost of the project
o IRR is the k which makes NPV = 0
o IRR decision rule: First, determine the required rate of return for a given project
 This is usually the firm's cost of capital. Note that the required rate of
return may be higher or lower than the firm's cost of capital to adjust for
differences between project risk and the firm's average project risk
o If IRR > the required rate of return, accept the project
o If IRR < the required rate of return, reject the project
o For this reason, the minimum IRR that a firm requires internally for a project to be
accepted is often referred to as the hurdle rate. Projects with IRRs above this rate
will be accepted, while those with IRRs below this rate will not be accepted.

o
 o

Module 32.2: Payback Period, Project Ranking

- Payback period (PBP): the number of years it takes to recover the initial cost of an
investment
unrecovered cost at beginning of recovery year
o PBP = full years until recovery +
cash flow during recovery year
o PBP is a measure of liquidity  for a firm with liquidity concerns, the shorter PBP is,
the better
o However, project decisions should NOT be made based on PBP due to the method’s
drawbacks:
 Not a measure of profitability:
 Doesn’t take into account time value of money
 Doesn’t take into account cash flows beyond PBP – terminal/
salvage values
 Main benefit:
 A good measure of project liquidity. Firms with limited access to
additional liquidity often impose a maximum payback period and
then use a measure of profitability, such as NPV or IRR, to evaluate
projects that satisfy this maximum payback period constraint
o Discounted payback period: uses the present values of projects estimated cash flows
– the number of years it takes a project to recover its initial investment in PV terms
and must be greater than the PBP without discounting
 The discounted payback period addresses one of the drawbacks of PBP by
discounting cash flows at the projects required rate of return

o
 o
o Discounted payback period

- Profitability index (PI)

o The present value of a project’s future cash flows divided by the initial cash outlay
PV of future cash flows NPV
o PI = = 1+
CF 0 CF 0
 If PI > 1.0, accept the project
 If PI < 1.0, reject the project

o
o Designed to RANK projects, the positive return per dollar of project
o
- Summary of formulas:
- NPV profile: a project’s NPV profile is a graph showing project’s NPV for different discount
rates
o Discount rates on x-axis and corresponding NPVs on the y-axis
o Projects’ IRRs are the discount rates where the NPV profiles intersect the x-axis
o Crossover rate: where two NPV profiles intersect – so the discount rate used in the
analysis can determine which of 2 mutually exclusive projects will be accepted

o
o
- Compare NPV and IRR methods:

o
o NPV key advantage: it’s a direct measure of the expected increase in the value of the
firm
  Theoretically the best method. Main weakness is it doesn’t include any
considerations of the size of the project, e.g. NPV of 100 is great for a
project costing 100 but not great for a project costing 1 mln
o IRR key advantage: it measures profitability as a percentage, showing return on each
dollar invested. Provides info on margin of safety that NPV doesn’t.
 Disadvantage: 1. The possibility of producing rankings of mutually exclusive
projects different from those from NPV analysis 2. The possibility that a
project as multiple IRRs or no IRR
o NPV is the only acceptable criterion when ranking projects
o NPV and IRR may give conflicting project ranking due to: cash flow timing
differences, and differences in project size
o The multiple IRR and no IRR problems:
 if a project has cash outflows during its life or at end of its life in addition to
its initial cash outflow the project is said to have an unconventional cash
flow pattern  may have more than one IRR (i.e. more than 1 discount rate
that will produce an NPV equal to 0)
 also possible to have no discount rate that results in 0 NPV. But the project
may be a profitable one
 NPV method does not have these problems. If a project has non-normal
cash flows, NPV method will give the right decision
- Expected relations among investment’s NPV, company value, share price
o In theory, a positive NPV project  increase in stock price
o In fact, more complex  changes in stock price will result more from changes in
expectations about a firm’s positive NPV projects -> whether it will increase future
earning streams

Module 33.1: Weighted Average Cost of Capital (WACC)

- Capital budgeting process: analysts need to know the firm’s proper discount rate. WACC is
the proper rate at which to discount the cash flows associated with a capital budgeting
project
o WACC is also referred to as marginal cost of capital (MCC)
o Basic definition:
 Liability side of b/s -> debt, preferred stock, common equity  referred to
as the capital components of the firm  cost of each of these is called
component cost of capital
 Component costs include:
 kd – rate at which firm can issue new debt. The yield to maturity on
existing debt. Called the before-tax component cost of debt
  kd (1-t) – after tax cost of debt  this is used to calculate WACC. In
most countries, interest paid on corporate debt is tax deductible
 kps – the cost of preferred stock. Typically no tax deduction allowed
for payments to common or preferred stocks, so no equivalent
deduction to k ps or k ce
 kce – the cost of common equity
 WACC reflects the average risk of the projects that make up the firm 
should be adjusted upward for projects w greater-than-average risk and
downward for projects with less-than-average risk
 WACC = (Wd)*[kd * (1-t)] + (Wps)*(kps) + (Wce)*(kce)
 W stands for the percentage of xxx in the capital structure

- Use of target capital structure in estimating WACC

o Weights in the calculation of WACC should be based on firm’s target capital
structure, i.e. the proportions based on mkt values of debt, preferred stock and
equity the firm expects to achieve over time. When lacking info, use the firm’s
current capital structure as best indication; or may use the industry avg. capital
structure as the target capital structure

- Marginal cost of capital and investment opportunity schedule  determine optimal capital
budget:
o A firm’s WACC may increase as larger amounts of capital are raised -> margin cost of
capital can increase as larger amounts are invested in new projects -> upward
sloping marginal cost of capital curve
o Downward sloping investment opportunity schedule by ordering expenditures on
additional projects from highest to lowest IRR
o Intersection: optimal project budget, i.e.
 Firm should undertake all those projects with IRRs greater than the cost of
funds
- MCC in determining NPV of a project
- Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the
debt-rating approach
o E.g. issue new debt at an interest rate of 7.5%, 40% marginal tax rate, kd(1-
t)=7.5%*60%=4.5%
o In jurisdictions where interest payments are not deductible for tax purposes, pre-tax
and after-tax cost of debt are the same
o Cost of debt is the market interest rate (YTM) on new (marginal) debt, not the
coupon rate on the firm’s existing debt
o Matrix pricing: value a bond based on the yields of comparable bonds
- Calculate and interpret cost of noncallable, nonconvertible preferred stock
o Kps = Dps/P
 Dps= preferred dividends
 P= market price of preferred stock
- Calculate and interpret cost of equity capital
o The cost of equity kce is the required rate of return on the firm’s common stock – the
firm could avoid part of the cost of common stock outstanding by using retained
earnings to buy back shares of its own stock. Three approaches can be used to
estimate the cost of common equity
 Capital asset pricing model approach (CAPM)
 Estimate the risk-free rate, Rf – yields on default risk-free debt e.g.
US T-notes can be used, choose the maturity closest to useful life of
the project
 Estimate the stock’s beta – the stock’s risk measure
 Estimate the expected rate of return on the market, E(R mkt)
 CAPM equation: kce = Rf + ß[E(Rmkt) – Rf]
 Dividend discount model approach
 If dividends are expected to grow at a constant rate, g, then current
D1
value of the stock is: P0 =
k ce −g
D1
 So kce = +g
P0
 To estimate the g, can use growth rate as projected by security
analysts; or use the following equation: g = (retention rate) (return
on equity) = (1 – payout rate)(ROE)
 Bonds yield plus risk premium approach
 Analysts often use an ad hoc approach -> add a risk premium (3-5%)
to the mkt yield on the firm’s long-term debt
 Kce = bond yield + risk premium