Professional Documents
Culture Documents
Module 6.1: EAY and Compounding Frequency: The Number of Compounding Periods Per Year
Module 6.1: EAY and Compounding Frequency: The Number of Compounding Periods Per Year
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)
- 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
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
- 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 ) !
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 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).
- 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)
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
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 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)
- 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.
- 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
- 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 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 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
- 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
o The test of the differences in means is used when there are two independent
samples.
- 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
- 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
- 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)
- 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
- 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
- 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.
- 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
- 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:
- 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
- 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 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
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.
o Monopoly: MC=MR<P
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
- 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)
- 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)
- 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)
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
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.
- 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
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:
- 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
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
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
- 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.
- 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
- 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.
- 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
- 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:
- 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
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)
Other income includes gains that may or may not arise in the ordinary
course of business.
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
- Auditors’ Opinions
o Unqualified opinion/ unmodified or clean opinion: statements are free from material
omissions and errors
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
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 Corporate reports, press releases, earnings guidance (before FS are released) and
conference call
o 2: Gather data
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
- 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)
- 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 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
o Objective: provide financial info that’s useful in making decisions about providing
resources to an entity
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
o fair representation
o going concern basis
- 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
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
- 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 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
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
o Discontinued ops:
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
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 Prospective application: prior statements are not restated, and the new policies are
applied only to future financial statements.
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)
Options – yes
Warrants – yes
o Calculations:
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
- 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 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
o Margin ratios:
Gross profit margin = gross profit (i.e. revenue – cogs) / revenue (i.e. sales)
Any subtotals/ revenue, e.g. operating profit margin (i.e. operating profit
over revenue), pretax margin (i.e. pretax accounting profit over revenue)
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 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
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).
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
- 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
- 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
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.
- 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
o About a company's cash receipts and cash payments during an accounting period
- 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
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 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
- 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
o Vertical common-size income statement ratios are especially useful for studying
trends in costs and profit margins:
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
- 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
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.
- 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
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
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
-
-
- 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
-
-
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
-
- 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
-
- 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
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
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)
Worried about un-public companies controlled by the directors
Cash flow: analysts like to see high and steady CFO
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
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
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
-
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:
-
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.
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
o
o
o Discounted payback period
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
- 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