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2013 ELAN GUIDES
QUANTITATIVE METHODS
CORRELATION AND REGRESSION

Sample covariance = Cov (X,Y) =
S (X - X)(Y - Y)/(n - 1)
i=1 i i
where: n = sample size Xi = ith observation of Variable X X = mean observation of Variable X Yi = ith observation of Variable Y Y = mean observation of Variable Y Cov (X,Y) sXsY
Sample correlation coefficient = r =
Sample variance = sX =
S (X - X) /(n - 1)
i=1 i 2
Sample standard deviation = sX = Test statistic r n-2 1 - r2 Where: n = Number of observations r = Sample correlation
sX
Test-stat = t =
Linear Regression with One Independent Variable Regression model equation = Yi = b0 + b1Xi + ei, i = 1,...., n b1 and b0 are the regression coefficients. b1 is the slope coefficient. b0 is the intercept term. e is the error term that represents the variation in the dependent variable that is not explained by the independent variable.
2013 ELAN GUIDES
=b +b X , i = 1,...., n Regression line equation = Y i 0 1 i Regression Residuals
S [Y - (b + b X )]
i=1 i 0 1 i
where: Yi = Actual value of the dependent variable +b X = Predicted value of dependent variable b 0 1 i The Standard Error of Estimate
SEE =
i=1
-b X )2 (Yi - b 0 1 i n-2
) ( )
1/2
S (e )
i=1 i
1/2
n-2
SSE n-2
1/2
The Coefficient of Determination Total variation = Unexplained variation + Explained variation R2 = Explained variation Total variation = Total variation - Unexplained variation Total variation
=1-
Unexplained variation Total variation
Hypothesis Tests on Regression Coefficients CAPM: RABC = RF + bABC(RM RF) RABC RF = a + bABC(RM RF) + e The intercept term for the regression, b0, is a. The slope coefficient for the regression, b1, is bABC
The regression sum of squares (RSS) RSS = ^ -Y) S (Y

i=1 i n 2
g Explained variation
The sum of squared errors or residuals (SSE) SSE =
S (Y - Y^ )
i=1 i i
g Unexplained variation
2013 ELAN GUIDES
ANOVA Table Source of Variation Regression (explained) Degrees of Freedom k Sum of Squares RSS Mean Sum of Squares MSR = RSS k = RSS 1 SSE n-2 = RSS
Error (unexplained) Total
n - (k + 1) n-1
SSE SST
MSE =
k = the number of slope coefficients in the regression.
Prediction Intervals
2 sf
=s
1 (X - X)2 1+ + n (n - 1) s 2 x
^t s Y c f
2013 ELAN GUIDES
MULTIPLE REGRESSION AND ISSUES IN REGRESSION
MULTIPLE REGRESSION AND ISSUES IN REGRESSION ANALYSIS

Multiple regression equation Multiple regression equation = Yi = b0 + b1X1i + b2X2i + . . .+ bk Xki + ei, i = 1,2, . . . , n Yi Xji b0 b1, . . . , bk ei n Residual Term = Y - (b +b X +b X + . . .+ b X ) i = Yi - Y e i i 0 1 1i 2 2i k ki Confidence Intervals (t s ) b j c bj estimated regression coefficient (critical t-value)(coefficient standard error) = the ith observation of the dependent variable Y = the ith observation of the independent variable Xj , j = 1,2, . . . , k = the intercept of the equation = the slope coefficients for each of the independent variables = the error term for the ith observation = the number of observations
F-statistic
F-stat = MSR RSS/k = MSE SSE/[n - (k + 1)]
R2 and Adjusted R2 Total variation - Unexplained variation Total variation SST - SSE SST RSS SST
R2 =
Adjusted R2 = R2 = 1 -
n-1 n-k-1
(1 - R2)
Testing for Heteroskedasticity- The Breusch-Pagan (BP) Test c2 = nR2 with k degrees of freedom n = Number of observations R2 = Coefficient of determination of the second regression (the regression when the squared residuals of the original regression are regressed on the independent variables). k = Number of independent variables
2013 ELAN GUIDES
MULTIPLE REGRESSION AND ISSUES IN REGRESSION
Testing for Serial Correlation- The Durban-Watson (DW) Test DW 2(1 r); where r is the sample correlation between squared residuals from one period and those from the previous period. Value of Durbin-Watson Statistic
(H0: No serial correlation) Reject H0, conclude Positive Serial Correlation 0 dl Reject H0, conclude Negative Serial Correlation 4 - dl 4
Inconclusive du
Do not Reject H0 4 - du
Inconclusive
Problems in Linear Regression and Solutions Problem Heteroskedasticity Effect Incorrect standard errors Solution Use robust standard errors (corrected for conditional heteroskedasticity) Use robust standard errors (corrected for serial correlation)
Serial correlation
Incorrect standard errors (additional problems if a lagged value of the dependent variable is used as an independent variable) High R2 and low t-statistics
Multicollinearity
Remove one or more independent variables; often no solution based in theory
Model Specification Errors Yi = b0 + b1lnX1i + b2X2i + e Linear Trend Models yt = b0 + b1t + et, t = 1, 2, . . . , T
where: yt = the value of the time series at time t (value of the dependent variable) b0 = the y-intercept term b1 = the slope coefficient/ trend coefficient t = time, the independent or explanatory variable et = a random-error term
2013 ELAN GUIDES
TIME SERIES ANALYSIS
TIME-SERIES ANALYSIS
Linear Trend Models yt = b0 + b1t + et, t = 1, 2, . . . , T
where: yt = the value of the time series at time t (value of the dependent variable) b0 = the y-intercept term b1 = the slope coefficient/ trend coefficient t = time, the independent or explanatory variable et = a random-error term Log-Linear Trend Models A series that grows exponentially can be described using the following equation: yt = eb0 + b1t where: yt = the value of the time series at time t (value of the dependent variable) b0 = the y-intercept term b1 = the slope coefficient t = time = 1, 2, 3 ... T We take the natural logarithm of both sides of the equation to arrive at the equation for the loglinear model: ln yt = b0 + b1t + et, t = 1,2, . . . , T
AUTOREGRESSIVE (AR) TIME-SERIES MODELS xt = b0 + b1xt - 1 + et A pth order autoregressive model is represented as: xt = b0 + b1xt - 1 + b2xt - 2+ . . . + bpxt - p + et Detecting Serially Correlated Errors in an AR Model t-stat = Residual autocorrelation for lag Standard error of residual autocorrelation
where: Standard error of residual autocorrelation = 1/ T T = Number of observations in the time series
2013 ELAN GUIDES
Mean Reversion b0 1 - b1
xt =
Multiperiod Forecasts and the Chain Rule of Forecasting ^ xt+1 = ^ b0 + ^ b 1 xt Random Walks xt = xt - 1 + et , E(et) = 0, E(et2) = s2, E(etes) = 0 if t s The first difference of the random walk equation is given as: yt = xt - xt - 1 = xt - 1 + et - xt - 1= et , E(et) = 0, E(et2) = s2, E(etes) = 0 for t s Random Walk with a Drift xt = b0 + b1xt - 1 + et b1 = 1, b0 0, or xt = b0 + xt - 1 + et , E(et) = 0 The first-difference of the random walk with a drift equation is given as: yt = xt - xt - 1 , yt = b0 + et , b0 0 The Unit Root Test of Nonstationarity xt = b0 + b1xt - 1 + et xt - xt - 1 = b0 + b1xt - 1 - xt - 1 + et xt - xt - 1 = b0 + (b1 - 1)xt - 1 + et xt - xt - 1 = b0 + g1xt - 1 + et
2013 ELAN GUIDES
Autoregressive Moving Average (ARMA) Models xt = b0 + b1xt - 1 + . . . + bpxt - p + et + q1et - 1 +. . . + qqet - q E(et) = 0, E(et2) = s2, E(etes) = 0 for t s
Autoregressive Conditional Heteroskedasticity Models (ARCH Models) ^ et2 = a0 + a1^ et2 - 1 + ut The error in period t+1 can then be predicted using the following formula: ^ ^ +a ^e ^2 st2+ 1 = a 0 1 t
2013 ELAN GUIDES
CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Currency Cross Rates For example, given the USD/EUR and JPY/USD exchange rates, we can calculate the cross rate between the JPY and the EUR, JPY/EUR as follows: JPY JPY USD = EUR USD EUR Cross Rate Calculations with Bid-Ask Spreads USD/EURbid = 1.3802 Represents the price of EUR (base currency). An investor can sell EUR for USD at this price (as it is the bid price quoted by the dealer). Determining the EUR/USDbid cross rate: EUR/USDbid = 1/(USD/EURask) Determining the EUR/USDask cross rate: EUR/USDask = 1 / (USD/EURbid) Forward exchange rates (F) - One year Horizom USD/EURask = 1.3806 Represents the price of EUR An investor can buy EUR with USD at this price.
FFC/DC = SFC/DC
(1 + iFC) (1 + iDC)
FPC/BC = SPC/BC
(1 + iPC) (1 + iBC)
Forward exchange rates (F) - Any Investment Horizom
FFC/DC = SFC/DC FPC/BC = SPC/BC
1 + (iFC Actual 360) 1 + (iDC Actual 360) 1 + (iPC Actual 360) 1 + (iBC Actual 360)
Currencies Trading at a Forward Premium/Discount
FFC/DC - SFC/DC = SFC/DC FPC/BC - SPC/BC = SPC/BC
( (
(iFC - iDC) Actual 360 1 + (iDC Actual 360) (iPC - iBC) Actual 360 1 + (iBC Actual 360)
) )
2013 ELAN GUIDES
Covered Interest Rate Parity
FPC/BC = SPC/BC
1 + (iPC Actual 360) 1 + (iBC Actual 360)

FPC/BC - SPC/BC SPC/BC
The forward premium (discount) on the base currency can be expressed as a percentage as: Forward premium (discount) as a % =
The forward premium (discount) on the base currency can be estimated as: Forward premium (discount) as a % FPC/BC - SPC/BC iPC - iBC Uncovered Interest Rate Parity Expected future spot exchange rate:
SeFC/DC = SFC/DC
(1 + iFC) (1 + iDC)
The expected percentage change in the spot exchange rate can be calculated as: Expected % change in spot exchange rate = %DS PC/BC =
e
SePC/BC SPC/BC SPC/BC
The expected percentage change in the spot exchange rate can be estimated as: Expected % change in spot exchange rate %DSePC/BC iPC - iBC Purchasing Power Parity (PPP) Law of one price: PXFC = PXDC SFC/DC Law of one price: PXPC = PXBC SPC/BC Absolute Purchasing Power Parity (Absolute PPP) SFC/DC = GPLFC / GPLDC SPC/BC = GPLPC / GPLBC Relative Purchasing Power Parity (Relative PPP) Relative PPP: E(S
T FC/DC)
= S
FC/DC
1 + pFC 1 + pDC
Ex Ante Version of PPP Ex ante PPP: %DSeFC/DC peFC - peDC Ex ante PPP: %DSePC/BC pePC - peBC
2013 ELAN GUIDES
Real Exchange Rates The real exchange rate (qFC/DC) equals the ratio of the domestic price level expressed in the foreign currency to the foreign price level. qFC/DC = PDC in terms of FC PFC = PDC SFC/DC PFC = SFC/DC
( )
PDC PFC
The Fisher Effect Fischer Effect: i = r + pe International Fisher effect: (iFC iDC) = (peFC peDC) Figure 1: Spot Exchange Rates, Forward Exchange Rates, and Interest Rates Expected change in Spot Exchange Rate %DSeFC/DC
Ex Ante PPP
Forward Rate as an Unbiased Predictor
Foreign-Domestic Expected Inflation Differential peFC - peDC International Fisher Effect
Uncovered Interest Rate Parity
Forward Discount FFC/DC - SFC/DC SFC/DC

Covered Interest Rate Parity
Foreign-Domestic Interest rate Differential iFC - iDC
Balance of Payment Current account + Capital account + Financial account = 0 Real Interest Rate Differentials, Capital Flows and the Exchange Rate qL/H qL/H = (iH iL) (peH peL) (FH FL)
2013 ELAN GUIDES
The Taylor rule i = rn + p + a(p - p*) + b(y - y*) where i = the Taylor rule prescribed central bank policy rate rn = the neutral real policy rate p = the current inflation rate p* = the central banks target inflation rate y = the log of the current level of output y* = the log of the economys potential/sustainable level of output qPC/BC = qPC/BC + ( rnBC - rnPC) + a[(pBC - p*BC) - (pPC - p*PC)] + b[(yBC - y*BC) - (yPC - y*PC)] - (FBC - FPC)
2013 ELAN GUIDES
ECONOMIC GROWTH AND THE INVESTMENT DECISION

Relationship between economic growth and stock prices P = GDP
( )( )
E GDP P E
P = Aggregate price or value of earnings. E = Aggregate earnings This equation can also be expressed in terms of growth rates: DP = D(GDP) + D(E/GDP) + D(P/E) Production Function Y = AKaL1-a Y = Level of aggregate output in the economy L = Quantity of labor K = Quantity of capital A = Total factor productivity. Total factor productivity (TFP) reflects the general level of productivity or technology in the economy. TFP is a scale factor i.e., an increase in TFP implies a proportionate increase in output for any combination of inputs. a = Share of GDP paid out to capital 1 - a = Share of GDP paid out to labor y = Y/L = A(K/L)a(L/L)1-a = Ak a y = Y/L = Output per worker or labor productivity. k = K/L = Capital per worker or capital-labor ratio Cobb-Douglas production function DY/Y =DA/A + aDK/K + (1 - a )DL/L Potential GDP Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity Labor Supply Total number of hours available for work = Labor force Average hours worked per worker
2013 ELAN GUIDES
Neoclassical Model (Solows Model) Y 1 = K s
( )[( )
q +d+n Y (1-a)
s = Fraction of income that is saved q = Growth rate of TFP a = Elasticity of output with respect to capital y = Y/L or income per worker k = K/L or capital-labor ratio d = Constant rate of depreciation on physical stock n = Labor supply growth rate. Savings/Investment Equation:
sy =
[( )
q +d+n k (1 - a)
Growth rates of Output Per Capita and the Capital-Labor Ratio Dy q Y = + as -Y y (1-a) K Dk q Y +s -Y = (1-a) K k
( ) (
Production Function in the Endogenous Growth Model ye = f(ke) = cke
2013 ELAN GUIDES
INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS
INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

Ending Inventory = Opening Inventory + Purchases - Cost of goods sold
LIFO and FIFO Comparison with Rising Prices and Stable Inventory Levels LIFO COGS Income before taxes Income taxes Net income Total cash flow EI Working capital Higher Lower Lower Lower Higher Lower Lower FIFO Lower Higher Higher Higher Lower Higher Higher
LIFO versus FIFO with Rising Prices and Stable Inventory Levels
Type of Ratio Profitability ratios NP and GP margins Effect on Numerator Income is lower under LIFO because COGS is higher Same debt levels Effect on Denominator Sales are the same under both Effect on Ratio Lower under LIFO
Solvency ratios Debt-to-equity and debt ratio Liquidity ratios Current ratio
Lower equity and assets under LIFO Current liabilities are the same. Current liabilities are the same
Higher under LIFO
Current assets are lower under LIFO because EI is lower Quick assets are higher under LIFO as a result of lower taxes paid COGS is higher under LIFO Sales are the same
Lower under LIFO
Quick ratio
Higher under LIFO
Activity ratios Inventory turnover Total asset turnover
Average inventory is lower under LIFO Lower total assets under LIFO
Higher under LIFO Higher under LIFO
2013 ELAN GUIDES
LIFO reserve (LR) EIFIFO = EILIFO + LR where LR = LIFO Reserve COGSFIFO is lower than COGSLIFO during periods of rising prices: COGSFIFO = COGSLIFO - (Change in LR during the year) Net Income after tax under FIFO will be greater than LIFO net income after tax by:
Change in LIFO Reserve (1 - Tax rate)

When converting from LIFO to FIFO assuming rising prices: Equity (retained earnings) increases by: LIFO Reserve (1 - Tax rate) Liabilities (deferred taxes) increase by: LIFO Reserve (Tax rate) Current assets (inventory) increase by: LIFO Reserve
2013 ELAN GUIDES
Impact of an Inventory Write-Down on Various Financial Ratios Type of Ratio Profitability ratios NP and GP margins Solvency ratios Debt-to-equity and debt ratio Effect on Numerator COGS increases so profits fall Debt levels remain the same Effect on Denominator Sales remain the same Equity decreases (due to lower profits) and current assets decrease (due to lower inventory) Current liabilities remain the same. Effect on Ratio Lower (worsens)
Higher (worsens)
Liquidity ratios Current ratio
Current assets decrease (due to lower inventory) COGS increases Sales remain the same
Lower (worsens)
Activity ratios Inventory turnover Total asset turnover
Average inventory decreases Total assets decrease
Higher (improves) Higher (improves)
2013 ELAN GUIDES
LONG-LIVED ASSETS: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

Effects of Capitalization Initially when the cost is capitalized Effects on Financial Statements Noncurrent assets increase. Cash flow from investing activities decreases. Noncurrent assets decrease. Net income decreases. Retained earnings decrease. Equity decreases.
In future periods when the asset is depreciated or amortized
Effects of Expensing When the item is expensed Effects on Financial Statements Net income decreases by the entire after-tax amount of the cost. No related asset is recorded on the balance sheet and therefore, no depreciation or amortization expense is charged in future periods. Operating cash flow decreases. Expensed costs have no financial statement impact in future years.
Financial Statement Effects of Capitalizing versus Expensing Capitalizing Higher Net income (first year) Lower Net income (future years) Higher Total assets Higher Shareholders equity Higher Cash flow from operations activities Lower Cash flow from investing activities Lower Income variability Lower Debt to equity ratio Straight Line Depreciation Depreciation expense = Original cost - Salvage value Depreciable life
Expensing Lower Higher Lower Lower Lower Higher Higher Higher
Accelerated Depreciation DDB depreciation in Year X = 2 Book value at the beginning of Year X Depreciable life
2013 ELAN GUIDES
Accumulated depreciation Net investment in fixed assets Gross investment in fixed assets = + Annual depreciation expense Annual depreciation expense Annual depreciation expense
Estimated useful or depreciable life The historical cost of an asset divided by its useful life equals annual depreciation expense under the straight line method. Therefore, the historical cost divided by annual depreciation expense equals the estimated useful life.
Average age of asset Annual depreciation expense times the number of years that the asset has been in use equals accumulated depreciation. Therefore, accumulated depreciation divided by annual depreciation equals the average age of the asset.
Remaining useful life The book value of the asset divided by annual depreciation expense equals the number of years the asset has remaining in its useful life.
Income Statement Effects of Lease Classification Income Statement Item Finance Lease Operating expenses Nonoperating expenses EBIT (operating income) Total expenses- early years Total expenses- later years Net income- early years Net income- later years Lower (Depreciation) Higher (Interest expense) Higher Higher Lower Lower Higher
Operating Lease Higher (Lease payment) Lower (None) Lower Lower Higher Higher Lower
Cash Flow Effects of Lease Classification CF Item Finance Lease CFO Higher CFF Lower Total cash flow Same
Operating Lease Lower Higher Same
2013 ELAN GUIDES
Table 9: Impact of Lease Classification on Financial Ratios Denominator Ratio Better or Numerator under under Finance Worse under Finance Lease Lease Effect on Ratio Finance Lease Sales- same Assets- higher Assets- higher Current liabilitieshigher Equity- same Assets- higher Equity- same Lower Lower Lower Worse Worse Worse
Ratio Asset turnover
Return on assets* Net income- lower Current ratio Current assetssame Debt- higher
Leverage ratios (D/E and D/A**)
Higher
Worse
Return on equity* Net income- lower
Lower
Worse
**Notice that both the numerator and the denominator for the D/A ratio are higher when classifying the lease as a finance lease. Beware of such exam questions. When the numerator and the denominator of any ratio are heading in the same direction (either increasing or decreasing), determine which of the two is changing more in percentage terms. If the percentage change in the numerator is greater than the percentage change in the denominator, the numerator effect will dominate. Firms usually have lower levels of total debt compared to total assets. The increase in both debt and assets by classifying the lease as a finance lease will lead to an increase in the debt to asset ratio because the percentage increase in the numerator is greater.
Financial Statement Effects of Lease Classification from Lessors Perspective Financing Lease Operating Lease Total net income Same Same Net income (early years) Higher Lower Taxes (early years) Higher Lower Total CFO Lower Higher Total CFI Higher Lower Total cash flow Same Same
2013 ELAN GUIDES
INTERCORPORATE INVESTMENTS
Summary of Accounting Treatment for Investments In Financial Assets Influence Typical percentage interest Not significant Usually < 20% In Associates Significant Business Combinations In Joint Ventures Controlling Shared Control
Usually 20% - 50% Usually > 50% Varies
Accounting Classified into one of Treatment four categories based on management intent and type of security. Debt only: Held-to-maturity (amortized cost, changes in value ignored unless deemed as impaired) Debt and Equity: Held for trading (fair value, changes in value recognized in profit or loss) Available-for-sale (fair value, changes in value recognized in equity) Designated at fair value (fair value, changes in value recognized in profit or loss)
Equity method
Consolidation
IFRS: Equity method or proportionate consolidation U.S. GAAP: Equity method (except for unincorporated ventures in specialized industries)
Combination Merger Acquisition Consolidation
Description Company A + Company B = Company A Company A + Company B = (Company A + Company B) Company A + Company B = Company C
2013 ELAN GUIDES
Adjusted Values Upon Reclassification of Sale of Receivables: Lower CFO Higher CFF Same Total cash flow Higher Current assets Higher Current liabilities Lower Current ratio (Assuming it was greater than 1) Difference between QSPE and SPE Securitized Transaction: Qualified Special Purpose Entity Originator of receivables sells financial assets to an SPE. The originator does not own or hold or expect to receive beneficial interest. SFAS 140 (before 2008 revision) allowed seller to derecognize the sold assets if transferred assets have been isolated from the transferor and are beyond the reach of bankruptcy, and are financial assets. Securitized Transaction: Special Purpose Entity Originator of receivables sells financial assets to an SPE. Seller is primary beneficiary; absorbs risks and rewards. Seller maintains some level of control. Seller is required to consolidate. Sellers balance sheet would still show receivables as an asset. Debt of SPE would appear on sellers balance sheet.
Impact of Different Accounting Methods on Financial Ratios Equity Method Leverage Net Profit Margin ROE ROA Better (lower) as liabilities are lower and equity is the same Better (higher) as sales are lower and net income is the same Proportionate Consolidation In-between In-between Acquisition Method Worse (higher) as liabilities are higher and equity is the same Worse (lower) as sales are higher and net income is the same Worse (lower) as equity is higher and net income is the same Worse (lower) as net income is the same and assets are higher
Better (higher) as equity is lower Same as under the equity method and net income is the same Better (higher) as net income is the same and assets are lower In-between
2013 ELAN GUIDES
EMPLOYEE COMPENSATION: POST-EMPLOYMENT AND SHARE-BASED

Final years salary = Current salary [(1 + Annual compensation increase)years until retirement] Estimated annual payment = (Estimated final salary Benefit formula) Years of service Annual unit credit = Value at retirement / Years of service Types of Post-Employment Benefits Amount of PostEmployment Benefit to Employee Amount of future benefit is not defined. Actual future benefit will depend on investment performance of plan assets. Investment risk is borne by employee. Amount of future benefit is defined, based on the plans formula (often a function of length of service and final years compensation). Investment risk is borne by company. Amount of future benefit depends on plan specifications and type of benefit. Obligation of Sponsoring Company Amount of the companys obligation (contribution) is defined in each period. The contribution, if any, is typically made on a periodic basis with no additional future obligation. Amount of the future obligation, based on the plans formula, must be estimated in the current period. Sponsoring Companys Pre-funding of Its Future Obligation Not applicable.
Type of Benefit Defined contribution pension plan
Defined benefit pension plan
Companies typically prefund the DB plans by contributing funds to a pension trust. Regulatory requirements to pre-fund vary by country. Companies typically do not pre-fund other postemployment benefit obligations.
Other postemployment benefits (e.g., retirees health care)
Eventual benefits are specified. The amount of the future obligation must be estimated in the current period.
A companys pension obligation will increase as a result of: Current service costs. Interest costs. Past service costs. Actuarial losses. A companys pension obligation will decrease as a result of: Actuarial gains. Benefits paid.
2013 ELAN GUIDES
Reconciliation of the Pension Obligation: Pension obligation at the beginning of the period + Current service costs + Interest costs + Past service costs + Actuarial losses Actuarial gains Benefits paid Pension obligation at the end of the period The fair value of assets held in the pension trust (plan) will increase as a result of: A positive actual dollar return earned on plan assets; and Contributions made by the employer to the plan. The fair value of plan assets will decrease as a result of: Benefits paid to employees. Reconciliation of the Fair Value of Plan Assets: Fair value of plan assets at the beginning of the period + Actual return on plan assets + Contributions made by the employer to the plan - Benefits paid to employees Fair value of plan assets at the end of the period Balance Sheet Presentation of Defined Benefit Pension Plans Funded status = Pension obligation - Fair value of plan assets If Pension obligation > Fair value of plan assets: Plan is underfunded Positive funded status Net pension liability. If Pension obligation < Fair value of plan assets: Plan is overfunded Negative funded status Net pension asset.
Calculating Periodic Pension Cost Priodic pension cost = Ending funded status - Beginning funded status + Employer contributions
Periodic pension cost = Current service costs + Interest costs + Past service costs + Actuarial losses - Actuarial gains - Actual return on plan assets Under the corridor method, if the net cumulative amount of unrecognized actuarial gains and losses at the beginning of the reporting period exceeds 10% of the greater of (1) the defined benefit obligation or (2) the fair value of plan assets, then the excess is amortized over the expected average remaining working lives of the employees participating in the plan and included as a component of periodic pension expense on the P&L.
2013 ELAN GUIDES
Components of a Companys Defined Benefit Pension Periodic Costs IFRS Component IFRS Recognition Service costs Recognized in P&L. U.S. GAAP Component Current service costs Past service costs U.S. GAAP Recognition Recognized in P&L. Recognized in OCI and subsequently amortized to P&L over the service life of employees. Recognized in P&L. Recognized in P&L as the following amount: Plan assets expected return. Recognized immediately in P&L or, more commonly, recognized in OCI and subsequently amortized to P&L using the corridor or faster recognition method.(b) Difference between expected and actual return on assets = Actual return (Plan assets Expected return). Actuarial gains and losses = Changes in a companys pension obligation arising from changes in actuarial assumptions.
Net interest income/ expense
Recognized in P&L as the following amount: Net pension liability or asset interest rate(a)
Interest expense on pension obligation Expected return on plan assets
Remeasurements: Recognized in OCI and Net return on plan not subsequently assets and actuarial amortized to P&L. gains and losses
Actuarial gains and losses including differences between the actual and expected returns on plan assets
Net return on plan assets = Actual return - (Plan assets Interest rate). Actuarial gains and losses = Changes in a companys pension obligation arising from changes in actuarial assumptions.
(a) The interest rate used is equal to the discount rate used to measure the pension liability (the yield on highquality corporate bonds.) (b) If the cumulative amount of unrecognized actuarial gains and losses exceeds 10 percent of the greater of the value of the plan assets or of the present value of the DB obligation (under U.S. GAAP, the projected benefit obligation), the difference must be amortized over the service lives of the employees.
2013 ELAN GUIDES
Impact of Key Assumptions on Net Pension Liability and Periodic Pension Cost Impact of Assumption on Net Impact of Assumption on Periodic Pension Liability (Asset) Pension Cost and Pension Expense Assumption Higher discount rate Lower obligation Pension cost and pension expense will both typically be lower because of lower opening obligation and lower service costs Higher service and interest costs will increase periodic pension cost and pension expense. Not applicable for IFRS No effect on periodic pension cost under U.S. GAAP Lower periodic pension expense under U.S. GAAP
Higher rate of compensation increase Higher expected return on plan assets
Higher obligation
No effect, because fair value of plan assets are used on balance sheet
2013 ELAN GUIDES
MULTINATIONAL OPERATIONS
The presentation currency (PC) is the currency in which the parent company reports its financial statements. It is typically the currency of the country where the parent is located. For example, U.S. companies are required to present their financial results in USD, German companies in EUR, Japanese companies in JPY, and so on. The functional currency (FC) is the currency of the primary business environment in which an entity operates. It is usually the currency in which the entity primarily generates and expends cash. The local currency (LC) is the currency of the country where the subsidiary operates.
Table 1
Transaction Export sale Import purchase
Type of Exposure Asset (account receivable) Liability (account payable)
Foreign Currency Strengthens Weakens Gain Loss Loss Gain
Methods for Translating Foreign Currency Financial Statements of Subsidiaries Current Rate/ Temporal Method Temporal Method Current Rate Method Local Currency Local Currency Local Currency T Functional Currency Functional Currency Functional Currency CR Presentation Currency Presentation Currency Presentation Currency
CR
The current rate is the exchange rate that exists on the balance sheet date. The average rate is the average exchange rate over the reporting period. The historical rate is the actual exchange rate that existed on the original transaction date.
2013 ELAN GUIDES
Rules for Foreign Currency Translation Current Rate Method FC = LC Income Statement Component Sales Cost of goods sold Selling expenses Depreciation expense Amortization expense Interest expense Income tax Net income before translation gain (loss) Translation gain (loss) Net income Less: Dividends Change in retained earnings Temporal Method FC = PC
Exchange Rate Used Average rate Average rate Average rate Average rate Average rate Average rate Average rate Average rate Historical rate Average rate Historical rate Historical rate Average rate Average rate Computed as Rev Exp Plug in Number Computed as DRE + Dividends Historical rate From B/S
N/A Computed as Rev Exp Historical rate Computed as NI Dividends Used as input for translated B/S Current rate Current rate Current rate Current rate Current rate Current rate Current rate Current rate
Balance Sheet Component Cash Accounts receivable Monetary assets Inventory Nonmonetary assets measured at current value Property, plant and equipment Less: Accumulated depreciation Nonmonetary assets measured at historical cost Accounts payable Long-term notes payable Monetary liabilities Nonmonetary liabilities: Measured at current value Measured at historical cost Capital stock Retained earnings Cumulative translation adjustment
Exchange Rate Used Current rate Current rate Current rate Historical rate Current rate Historical rate Historical rate Historical rate
Current rate Current rate Current rate Current rate Current rate Historical rate From I/S Plug in Number
Current rate Current rate Current rate Current rate Historical rate Historical rate To balance Used as input for translated I/S N/A
2013 ELAN GUIDES
Balance Sheet Exposure Balance Sheet Exposure Net asset Net liability Foreign Currency (FC) Strengthens Weakens Positive translation adjustment Negative translation adjustment Negative translation adjustment Positive translation adjustment
Effects of Exchange Rate Movements on Financial Statements Temporal Method, Net Monetary Liability Exposure Foreign currency strengthens relative to parents presentation currency hRevenues hAssets hLiabilities i Net income i Shareholders equity Translation loss Temporal Method, Net Monetary Asset Exposure hRevenues hAssets hLiabilities hNet income hShareholders equity Translation gain
Current Rate Method hRevenues hAssets hLiabilities hNet income hShareholders equity Positive translation adjustment i Revenues i Assets i Liabilities i Net income i Shareholders equity Negative translation adjustment
Foreign currency weakens relative to parents presentation currency
i Revenues i Assets i Liabilities hNet income hShareholders equity Translation gain
i Revenues i Assets i Liabilities i Net income i Shareholders equity Translation loss
Measuring Earnings Quality Aggregate accruals = Accrual-basis earnings Cash earnings Balance Sheet Approach Net Operating Assets (NOA) NOAt = [(Total assetst - Casht) - (Total liabilitiest - Total debtt)] Aggregate Accruals Aggregate accrualstb/s = NOAt - NOAt-1 Aggregate Ratio Accruals ratiotb/s = (NOAt - NOAt-1) (NOAt + NOAt-1)/2
2013 ELAN GUIDES
INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES
INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES

A Financial Statement Analysis Framework: Phase Sources of Information 1. Define the purpose and context of the analysis. The nature of the analysts function, such as evaluating an equity or debt investment or issuing a credit rating. Communication with client or supervisor on needs and concerns. Institutional guidelines related to developing specific work product. Financial statements, other financial data, questionnaires, and industry/economic data. Discussions with management, suppliers, customers, and competitors. Company site visits (e.g., to production facilities or retail stores) Data from the previous phase. Examples of Output Statement of the purpose or objective of analysis. A list (written or unwritten) of specific questions to be answered by the analysis. Nature and content of report to be provided. Timetable and budgeted resources for completion. Organized financial statements. Financial data tables. Completed questionnaires, if applicable.
2. Collect input data.
3. Process input data, as required, into analytically useful data. 4. Analyze/interpret the data. 5. Develop and communicate conclusions and recommendations (e.g., with an analysis report). 6. Follow-up.
Adjusted financial statements. Common-size statements. Forecasts. Analytical results Analytical report answering questions posed in Phase 1 Recommendations regarding the purpose of the analysis, such as whether to make an investment or grant credit. Update reports and recommendations
Input data and processed data Analytical results and previous reports Institutional guidelines for published reports
Information gathered by periodically repeating above steps as necessary to determine whether changes to holdings or recommendations are necessary
DuPont Analysis ROE = Tax Burden Interest burden EBIT margin Total asset turnover Financial leverage ROE = NI EBT EBT EBIT EBIT Revenue Revenue Average Asset Average Asset Average Equity
2013 ELAN GUIDES
CAPITAL BUDGETING
CAPITAL BUDGETING
Expansion Project Initial investment outlay for a new investment = FCInv + NWCInv NWCInv = DNon-cash current assets DNon-debt current liabilities Annual after-tax operating cash flows (CF) CF = (S C D) (1 t) + D or CF = (S C) (1 t) + tD
Terminal year after-tax non-operating cash flow (TNOCF): TNOCF = SalT + NWCInv t(SalT BVT) Replacement Project Investment outlays: Initial investment for a replacement project = FCInv + NWCInv Sal0 + t(Sal0 BV0) Annual after-tax operating cash flow: DCF = (DS DC) (1 t) + tDD Terminal year after-tax non-operating cash flow: TNOCF = SalT + NWCInv t(SalT BT) Mutually Exclusive Projects with Unequal Lives 1. Least Common Multiple of Lives Approach In this approach, both projects are repeated until their chains extend over the same time horizon. Given equal time horizons, the NPVs of the two project chains are compared and the project with the higher chain NPV is chosen. 2. Equivalent Annual Annuity Approach (EAA) This approach calculates the annuity payment (equal annual payment) over the projects life that is equivalent in present value (PV) to the projects NPV. The project with the higher EAA is chosen. SML Ri = RF + i[E(RM) RF] Ri = Required return for project or asset i RF = Risk-free rate of return i = Beta of project or asset i [E(RM) RF] = Market risk premium
2013 ELAN GUIDES
CAPITAL BUDGETING
Economic Income Economic income = After-tax operating cash flow + Increase in market value Economic income = After-tax operating cash flow + (Ending market value Beginning market value) Economic income = After-tax operating cash flow (Beginning market value Ending market value) Economic income = After-tax cash flows Economic depreciation Economic Profit Economic profit = [EBIT (1 Tax rate)] $WACC Economic profit = NOPAT $WACC NOPAT = Net operating profit after tax $WACC = Dollar cost of capital = Cost of capital (%) Invested capital Under this approach, a projects NPV is calculated as the sum of the present values of economic profit earned over its life discounted at the cost of capital. NPV = MVA = Residual Income Residual income = Net income for the period Equity charge for the period Equity charge for the period = Required return on equity Beginning-of-period book value of equity The RI approach calculates value from the perspective of equity holders only. Therefore, future residual income is discounted at the required rate of return on equity to calculate NPV. NPV =
S (1 + WACC)
t=1
EPt
S (1 + r )
t=1
RIt
Claims Valuation First, we separate the cash flows available to debt and equity holders Then we discount them at their respective required rates of return. o Cash flows available to debt holders are discounted at the cost of debt, o Cash flows available to equity holders are discounted at the cost of equity. The present values of the two cash flow streams are added to calculate the total value of the company/asset.
2013 ELAN GUIDES
CAPITAL STRUCTURE
CAPITAL STRUCTURE
The Capital Structure Decision rWACC =
()
D V
rD(1 - t) +
()
E V
rE
rD = Marginal cost of debt rE = Marginal cost of equity t = Marginal tax rate D = Market value of the companys outstanding debt E = Market value of shareholders equity V = D + E = Value of the company MM Proposition II without Taxes: Higher Financial Leverage Raises the Cost of Equity rWACC =
() ( )
D E
Slope
D E rD + rE = r0 V V
Companys cost of equity (rE) under MM Proposition II without taxs is calculated as:
Intercept Independent variable
rE = r0 + (r0 - rD)
Dependent variable
The total value of the company is calculated as: V= Interest EBIT - Interest + rD rE
The systematic risk () of the companys assets can be expressed as the weighted average of the systematic risk of the companys debt and equity. bA =
() ()
D E bD + bE V V
This formula can also be expressed as: bE = bA + (bA - bD)
()
D E
2013 ELAN GUIDES
CAPITAL STRUCTURE
Relaxing the Assumption of no Taxes

VL = VU + tD
The WACC is then calculated as: rWACC =
()
D V
rD(1 - t) +
()
E V D E
rE
And the cost of equity is calculated as: rE = r0 + (r0 - rD) (1 - t)
()
With Taxes
VL = VU + tD D E
Modigilani and Miller Propositions Without Taxes Proposition I Proposition II

VL = VU
rE = r0 + (r0 - rD)
rE = r0 + (r0 - rD) (1 - t)
()
D E
The Optimal Capital Structure: The Static Trade-Off Theory VL = VU + tD PV(Costs of financial distress)
2013 ELAN GUIDES
DIVIDENDS AND SHARE REPURCHASE
DIVIDENDS AND SHARE REPURCHASE

The expected decrease in share price when it goes ex-dividend can be calculated using the following equation: PW - PX =
1 - TD 1 - TCG
Pw = Share price with the right to receive the dividend PX = Share price without the right to receive the dividend D = Amount of dividend TD = Tax rate on dividends TCG = Tax rate on capital gains Double Taxation System ETR = CTR + [(1 CTR) MTRD] ETR = Effective tax rate CTR = Corporate tax rate MTRD = Investors marginal tax rate on dividends Split-Rate Tax System ETR = CTRD + [(1 CTRD) MTRD] CTRD = Corporate tax rate on earnings distributed as dividends. Stable Dividend Policy The expected increase in dividends is calculated as: Expected dividend increase = Increase in earnings Target payout ratio Adjustment factor Adjustment factor = 1/N N = Number of years over which the adjustment is expected to occur Analysis of Dividend Safety Dividend payout ratio = (dividends / net income) Dividend coverage ratio = (net income / dividends) FCFE coverage ratio = FCFE / [Dividends + Share repurchases]
2013 ELAN GUIDES
MERGERS AND ACQUISITION

Mergers and the Industry Life Cycle Industry Life Cycle Stage Pioneering development Industry Description Low but slowly increasing sales growth. Substantial development costs. Motives for Merger Younger, smaller companies may sell themselves to larger firms in mature or declining industries to enter into a new growth industry. Young companies may merge with firms that allow them to pool management and capital resources. To meet substantial capital requirements for expansion. To achieve economies of scale, savings, and operational efficiencies. Types of Merger Conglomerate Horizontal
Rapid accelerating growth Mature growth
High profit margins. Low competition. Decrease in the entry of new competitors. Growth potential remains. Increasing capacity constraints Increasing competition.
Conglomerate Horizontal Horizontal Vertical
Stabilization and market maturity
To achieve economies of scale in research, production, and marketing to match low costs and prices of competitors. Large companies may buy smaller companies to improve management and provide a broader financial base. Horizontal mergers to ensure survival. Vertical mergers to increase efficiency and profit margins. Conglomerate mergers to exploit synergy. Companies in the industry may acquire companies in young industries.
Horizontal
Deceleration of growth and decline
Overcapacity. Eroding profit margins.
Horizontal Vertical Conglomerate
Source: Adapted from J. Fred Weston, Kwang S. Chung, and Susan E. Hoag, Mergers, Restructuring, and Corporate Control (New York: Prentice Hall, 1990, p.102) and Bruno Solnik and Dennis McLeavy, International Investments, 5th edition (Boston: Addison Wesley, 2004, p. 264 265).
2013 ELAN GUIDES
Major Differences of Stock versus Asset Purchases Payment Approval Tax: Corporate Stock Purchase Target shareholders receive compensation in exchange for their shares. Shareholder approval required. No corporate-level taxes. Asset Purchase Payment is made to the selling company rather than directly to shareholders. Shareholder approval might not be required. Target company pays taxes on any capital gains. No direct tax consequence for target companys shareholders. Acquirer generally avoids the assumption of liabilities.
Tax: Shareholder Target companys shareholders are taxed on their capital gain. Acquirer assumes the targets Liabilities liabilities. Herfindahl-Hirschman Index (HHI)
S
i
Sales or output of firm i Total sales or output of market
100
HHI Concentration Levels and Possible Government Response Post-Merger HHI Less than 1,000 Between 1,000 and 1,800 More than 1,800 FCFF is estimated by: Net income + Net interest after tax = Unlevered income + Changes in deferred taxes = NOPLAT (net operating profit less adjusted taxes) + Net noncash charges Change in net working capital Capital expenditures (capex) Free cash flow to the firm (FCFF) Net interest after tax = (Interest expense Interest income) (1 tax rate) Working capital = Current assets (excl. cash and equivalents) Current liabilities (excl. short-term debt) Concentration Not concentrated Moderately concentrated Highly concentrated Change in HHI Any amount 100 or more 50 or more Government Action No action Possible challenge Challenge
2013 ELAN GUIDES
Comparable Company Analysis TP = (DP - SP) SP
TP = Takeover premium DP = Deal price per share SP = Targets stock price per share Bid Evaluation Target shareholders gain = Takeover premium = PT VT Acquirers gain = Synergies Premium = S (PT VT) S = Synergies created by the merger transaction The post-merger value of the combined company is composed of the pre-merger value of the acquirer, the pre-merger value of the target, and the synergies created by the merger. These sources of value are adjusted for the cash paid to target shareholders to determine the value of the combined post-merger company. VA* = VA + VT + S C VA* = Value of combined company C = Cash paid to target shareholders
2013 ELAN GUIDES
EQUITY VALUATION: APPLICATIONS AND PROCESSES
EQUITY VALUATION: APPLICATIONS AND PROCESSES

Perceived mispricing: Perceived mispricing = True mispricing + Error in the estimate of intrinsic value. VE P = (V P) + (VE V) VE = Estimate of intrinsic value P = Market price V = True (unobservable) intrinsic value
2013 ELAN GUIDES
RETURN CONCEPTS
RETURN CONCEPTS
Holding Period Return Holding period return = P H P0 + DH P0
PH = Price at the end of the holding period P0 = Price at the beginning of the period DH = Dividend Required Return The difference between an assets expected return and its required return is known as expected alpha, ex ante alpha or expected abnormal return. o Expected alpha = Expected return Required return The difference between the actual (realized) return on an asset and its required return is known as realized alpha or ex post alpha. o Realized alpha = Actual HPR Required return for the period
When the investors estimate of intrinsic value (V0) is different from the current market price (P0), the investors expected return has two components: 1. 2. The required return (rT) earned on the assets current market price; and The return from convergence of price to value [(V0 P0)/P0].
Internal Rate of Return Intrinsic Value = Next years expected dividend Required return Expected dividend growth rate D1 ke g
V0 =
If the asset is assumed to be efficiently-priced (i.e. the market price equals its intrinsic value), the IRR would equal the required return on equity. Therefore, the IRR can be estimated as: Required return (IRR) = Next years dividend Market price + Expected dividend growth rate
ke (IRR) =
D1 P0
+g
2013 ELAN GUIDES
RETURN CONCEPTS
Equity Risk Premium The required rate of return on a particular stock can be computed using either of the following two approaches. Both these approaches require the equity risk premium to be estimated first. 1. Required return on share i = Current expected risk-free return + i(Equity risk premium) 2. A beta greater (lower) than 1 indicates that the security has greater-than-average (lower-thanaverage) systematic risk.
Required return on share i = Current expected risk-free return + Equity risk premium Other risk premia/discounts appropriate for i This method of estimating the required return is known as the build-up method. It is discussed later in the reading and is primarily used for valuations of private businesses.
Gordon Growth Model (GGM) Estimates GCM equity risk premium estimate = D1 P0 + g rLTGD
Macroeconomic Model Estimates Equity risk premium = {[(1 + EINFL) (1 + EGREPS) (1 + EGPE) 1] + EINC} Expected RF Expected inflation = 1 + YTM of 20-year maturity T-bonds 1 + YTM of 20-year maturity TIPS 1
The Captial Asset Pricing Model (CAPM) Required return on i = Expected risk-free rate + Betai (Equity risk premium) The Fama-French Model ri = RF + bimktRMRF + bisizeSMB + bivalueHML mkt = Market beta size = Size beta value = Value beta The Pastor-Stambaugh model (PSM) ri = RF + bimktRMRF + bisizeSMB + bivalueHML + biliqLIQ liq = Liquidity beta
2013 ELAN GUIDES
RETURN CONCEPTS
BIRR model ri = T-bill rate + (Sensitivity to confidence risk Confidence risk) + (Sensitivity to time horizon risk Time horizon risk) + (Sensitivity to inflation risk Inflation risk) + (Sensitivity to business cycle risk Business cycle risk) + (Sensitivity to market timing risk Market timing risk) Build-up method ri = Risk-free rate + Equity risk premium + Size premium + Specific-company premium For companies with publicly-traded debt, the bond-yield plus risk premium approach can be used to calculate the cost of equity: BYPRP cost of equity = YTM on the companys long-term debt + Risk premium Adjusting Beta for Beta Drift Adjusted beta = (2/3) (Unadjusted beta) + (1/3) (1.0) Estimating the Asset Beta for the Comparable Publicly Traded Firm:
BASSET reflects only business risk of the comparable company. Therefore it is used as a proxy for business risk of the project being studied.
ASSET = EQUITY
1 + (1 - t)
1 D E
BEQUITY reflects business and financial risk of comparable company.
where: D/E = debt-to-equity ratio of the comparable company. t = marginal tax rate of the comparable company. To adjust the asset beta of the comparable for the capital structure (financial risk) of the project or company being evaluated, we use the following formula:
BPROJECT reflects business and financial risk of the project.
PROJECT = ASSET 1 + (1 - t)
D E
BASSET reflects business risk of project.
where: D/E = debt-to-equity ratio of the subject company. t = marginal tax rate of the subject company. Country Spread Model ERP estimate = ERP for a developed market + Country premium
2013 ELAN GUIDES
RETURN CONCEPTS
Weighted Average Cost of Capital (WACC) WACC = MVD MVD + MVCE rd (1 Tax rate ) + MVCE MVD + MVCE r
MVD = Market value of the companys debt rd = Required rate of return on debt MVCE = Market value of the companys common equity r = Required rate of return on equity
2013 ELAN GUIDES
DISCOUNTED DIVIDEND VALUATION

One-Period DDM V0 = D1 (1 + r)
1
P1 (1 + r)
1
D1 + P1 (1 + r)1
V0 = The value of the stock today (t = 0) P1 = Expected price of the stock after one year (t = 1) D1 = Expected dividend for Year 1, assuming it will be paid at the end of Year 1 (t = 1) r = Required return on the stock Multiple-Period DDM V0 = D1 Dn Pn 1 + ... + n+ (1 + r) (1 + r) (1 + r)n
V0 =
S (1 + r)
t=1
Dt
Pn (1 + r)n
Expression for calculating Value of a share of stock V0 =
S (1 + r)
t=1
Dt
Gordon Growth Model V0 = D0 (1 + g) D1 , or V0 = (r g) (r g)
Present value of Growth Opportunities V0 = P/E ratio P0 E1 D1/E1 r-g E1 + PVGO r
Justified leading P/E ratio =
(1 - b) r-g
Justified trailing P/E =
P0 E0
D1/E0 r-g
D0 (1 + g) / E0 r-g
(1 - b)(1 + g) r-g
2013 ELAN GUIDES
Value of Fixed-Rate Perpetual Preferred Stock V0 = D r
Two-Stage Dividend Discount Model V0 =
t=1
D0 (1 + gS)t D0 (1 + gS)n(1 + gL) + (1 + r)n(r gL) (1 + r)t
gS = Short term supernormal growth rate gL = Long-term sustainable growth rate r = required return n = Length of the supernormal growth period The H-Model V0 = D0 (1 + gL) D0H (gs gL) + r gL r gL
gS = Short term high growth rate gL = Long-term sustainable growth rate r = required return H = Half-life = 0.5 times the length of the high growth period The H-model equation can be rearranged to calculate the required rate of return as follows: r=
( )
D0 [(1 + gL) + H(gs gL)] + gL P0
The Gordon growth formula can be rearranged to calculate the required rate of return given the other variables. r= D1 +g P0
Sustainable growth rate (SGR) g = b ROE b = Earnings retention rate, calculated as 1 Dividend payout ratio
2013 ELAN GUIDES
ROE can be calculated as: ROE = Net income Total assets Sales Sales Shareholders equity Total assets
PRAT model g = Profit margin Retention rate Asset turnover Financial leverage g= Net income Sales Net income - Dividends Total assets Sales Total assets Net income Shareholders equity
2013 ELAN GUIDES
FREE CASH FLOW VALUATION

FCFF/FCFE
Firm Value =
S (1+WACC)
t=1
FCFFt
WACC =
MV(Equity) MV(Debt) r rd (1 - Tax Rate) + MV(Debt) + MV(Equity) MV(Debt) + MV(Equity)
Equity Value = Firm Value - Market value of debt
Equity Value =
S (1 + r)
t=1
FCFEt
Computing FCFF from Net Income FCFF = NI + NCC + Int(1 - Tax Rate) - FCInv - WCInv Investment in fixed capital (FCInv) FCInv = Capital expenditures - Proceeds from sale of long-term assets Investment in working capital (WCInv) WCInv = Change in working capital over the year Working capital = Current assets (exc. cash) - Current liabilities (exc. short-term debt) Table: Noncash Items and FCFF Noncash Item Depreciation Amortization and impairment of intangibles Restructuring charges (expense) Restructuring charges (income resulting from reversal) Losses Gains Amortization of long-term bond discounts Amortization of long-term bond premiums Deferred taxes Adjustment to NI to Arrive at FCFF Added back Added back Added back Subtracted Added back Subtracted Added back Subtracted Added back but requires special attention
2013 ELAN GUIDES
Computing FCFF from CFO Table: IFRS versus U.S. GAAP Treatment of Interest and Dividends IFRS U.S. GAAP CFO or CFI CFO Interest received CFO or CFF CFO Interest paid Dividend received Dividends paid CFO or CFI CFO or CFF CFO CFF
FCFF = CFO + Int(1 - Tax rate) - FCInv Computing FCFF from EBIT FCFF = EBIT(1 Tax rate) + Dep FCInv WCInv Computing FCFF from EBITDA FCFF = EBITDA(1 Tax rate) + Dep(Tax rate) FCInv WCInv
Computing FCFE from FCFF FCFE = FCFF Int(1 Tax rate) + Net borrowing Computing FCFE from Net Income FCFE = NI + NCC FCInv WCInv + Net Borrowing Computing FCFE from CFO
FCFE = CFO + FCInv Net borrowing

Computing FCFE from EBIT FCFE = EBIT(1 Tax rate) Int(1 Tax rate) + Dep FCInv WCInv + Net borrowing Computing FCFE from EBITDA FCFE = EBITDA(1 Tax rate) Int(1 Tax rate) + Dep(Tax rate) FCInv WCInv + Net borrowing
2013 ELAN GUIDES
Uses of FCFF
Increases in cash balances Plus: Net payments to providers of debt capital + Interest expense (1 tax rate) + Repayment of principal - New borrowings Plus: Net payments to providers of equity capital + Cash dividends + Share repurchases - New equity issues = Uses of FCFF
Uses of FCFE Increases in cash balances Plus: Net payments to providers of equity capital + Cash dividends + Share repurchases - New equity issues = Uses of FCFE Constant Growth FCFF Valuation Model Value of the firm = FCFF0 (1 + g) FCFF1 = WACC - g WACC - g
WACC = Weighted average cost of capital g = Long-term constant growth rate in FCFF Constant Growth FCFE Valuation Model Value of equity = FCFE1 FCFE0 (1 + g) = r-g r-g
r = Required rate of return on equity g = Long-term constant growth rate in FCFE An International Application of the Single-Stage Model Value of equity = FCFE0 (1 + greal) rreal - greal
2013 ELAN GUIDES
General expression for the two-stage FCFF model: Firm value =
S (1 + WACC) + (WACC - g) (1 + WACC)

t=1 t
FCFFt
FCFFn+1
Firm value = PV of FCFF in Stage 1 + Terminal value Discount Factor General expression for the two-stage FCFE model: Equity value =
S (1 + r) +
t=1 t
FCFEt
FCFFn+1 r-g
1 (1 + r)n
Equity value = PV of FCFE in Stage 1 + Terminal value Discount Factor Determining Terminal Value Terminal value in year n = Justified Trailing P/E Forecasted Earnings in Year n Terminal value in year n = Justified Leading P/E Forecasted Earnings in Year n + 1 Non-operating Assets and Firm Value Value of the firm = Value of operating assets + Value of non-operating assets
2013 ELAN GUIDES
MARKET-BASED VALUATION: PRICE AND ENTERPRISE VALUE MULTIPLES

Price to Earnings Ratio Trailing P/E ratio = Current Stock Price Last years EPS Current Stock Price Expected EPS
Forward P/E ratio =
Price to Book Ratio P/B ratio = Market price per share Book value per share Market value of common shareholders equity Book value of common shareholders equity
P/B ratio =
Book value of equity = Common shareholders equity = Shareholders equity Total value of equity claims that are senior to common stock Book value of equity = Total assets Total liabilities Preferred stock Price to Sales Ratio P/S ratio = Market price per share Sales per share
Relationship between the P/E ratio and the P/S ratio P/E Net profit margin = (P / E) (E / S) = P/S Price to Cash Ratio P/CF ratio = Market price per share Free cash flow per share
Dividend Yield Justified trailing dividend yield Trailing dividend yield = Last years dividend / Current price per share Justified leading dividend yield Leading dividend yield = Next years dividend / Current price per share
2013 ELAN GUIDES
Justified P/E Multiple Based on Fundamentals V0 = D1 (r - g)
Justified leading P/E multiple Justified leading P/E = P0 E1 = D1/E1 r-g = (1 - b) r-g
(1 b) is the payout ratio. Justified trailing P/E multiple Justified trailing P/E = P0 E0 = D1/E0 r-g = D0 (1 + g) / E0 r-g = (1 - b)(1 + g) r-g
Justified P/B Multiple Based on Fundamentals P0 B0 =
ROE - g
r-g
ROE = Return on equity r = required return on equity g = Sustainable growth rate Justified P/S Multiple Based on Fundamentals P0 S0 = (E0/S0)(1 - b)(1 + g) r-g
E0/S0 = Net profit margin 1 b = Payout ratio Justified P/CF Multiple Based on Fundamentals V0 = FCFE0 (1 + g) (r - g)
Justified Dividend Yield D0 P0 = r-g 1+g
2013 ELAN GUIDES
P/E-to-growth (PEG) ratio PEG = P/E Growth (%)
Terminal price based on fundamentals TVn = Justified leading P/E Forecasted earningsn +1 TVn = Justified trailing P/E Forecasted earningsn Terminal price based on comparables TVn = Benchmark leading P/E Forecasted earningsn +1 TVn = Benchmark trailing P/E Forecasted earningsn EV/EBITDA Multiple Enterprise value = Market value of common equity + Market value of preferred stock + Market value of debt Value of cash and short-term investments EBITDA = Net income + Interest + Taxes + Depreciation and amortization Alternative Denominators in Enterprise Value Multiples plus less minus plus Free Cash Net less plus Flow to the Income Interest Tax Savings Depreciation Amortization Investment in Investment in Working Capital Fixed Capital Firm = Expense on Interest EBITDA= plus plus Net Income Interest Taxes Expense plus plus Net Income Interest Taxes Expense plus plus Net Income Interest Taxes Expense plus plus Depreciation Amortization plus Amortization
EBITA =
EBIT =
Justified forward P/E after accounting for Inflation P0 1 = E1 r + (1 - l) I l = The percentage of inflation in costs that the company can pass through to revenue. r = Real rate of return I = Rate of inflation
2013 ELAN GUIDES
Unexpected earnings (UE) UEt = EPSt E(EPSt) Standardized unexpected earnings (SUE) SUEt = EPSt - E(EPSt) s[EPSt - E(EPSt)]
EPSt = Actual EPS for time t E(EPSt) = Expected EPS for time t s[EPSt - E(EPSt)] = Standard deviation of [EPSt - E(EPSt)]
2013 ELAN GUIDES
RESIDUAL INCOME VALUATION

The Residual Income Residual income = Net income Equity charge Equity charge = Cost of equity capital Equity capital Residual income = After-tax operating profit - Capital charge Capital charge = Equity charge + Debt charge Debt charge = Cost of debt (1 Tax rate) Debt capital Economic Value Added EVA = NOPAT (C% TC) NOPAT = Net operating profit after tax = EBIT (1 Tax rate) C% = Cost of capital (WACC) TC = Total capital Market Value Added MVA = Market value of the company Accounting book value of total capital Market value of company = Market value of debt + Market value of equity. The Residual Income Model RIt = Et (r Bt-1) RIt = Residual income at time t Et = Earnings at time t r = Required rate of return on equity Bt-1 = Book value at time t-1 Intrinsic value of a stock: V0 = B 0 +
S (1 + r)
i=1
RIt
= B0 +
Et - rBt-1 (1 + r)t
i=1
V0 = Intrinsic value of the stock today B0 = Current book value per share of equity Bt = Expected book value per share of equity at any time t r = Required rate of return on equity Et = Expected EPS for period t RIt = Expected residual income per share
2013 ELAN GUIDES
Residual Income Model (Alternative Approach) RIt = EPSt - (R Bt-1) RIt = (ROE - r)Bt-1
V0 = B0 +
(ROEt - r)Bt-1 (1 + r)t
t=1
V0 = B0 +
ROE - r B0 r-g
Tobins q Tobins q = Market value of debt and equity Replacement cost of total assets
Multi-Stage Residual Income Valuation V0 = B0 +
S
t=1
(Et - rBt -1) (1 + r)

t
PT - BT (1 + r)T
When residual income fades over time as ROE declines towards the required return on equity, the intrinsic value of a stock is calculated using the following formula: V0 = B 0 +
S
t=1
T-1
(Et - rBt -1) (1 + r)

t
(1 + r - w)(1 + r)T-1
ET - rBT-1
w = Persistence factor. Implied Growth Rate g=r-
(ROE - r) B0 V0 - B0
2013 ELAN GUIDES
PRIVATE COMPANY VALUATION
PRIVATE COMPANY VALUATION

The Capitalized Cash Flow Method Vf = FCFF1 WACC - gf
Vf = Value of the firm FCFF1 = Free cash flow to the firm for next twelve months WACC = Weighted average cost of capital gf = Sustainable growth rate of free cash flow to the firm FCFE1 r-g
V=
V = Value of the equity FCFE1 = Free cash flow to the equity for next twelve months r = Required return on equity g = Sustainable growth rate of free cash flow to the equity Methods Used to Estimate the Required Rate of Return for a Private Company Capital Asset Pricing Model Required return on equity = Risk-free rate + (Beta Market risk premium) Expanded CAPM Required return on equity = Risk-free rate + (Beta Market risk premium) + Small stock premium + Company-specific risk premium Build-Up Approach Required return on equity = Risk-free rate + Equity risk premium + Small stock premium + Company-specific risk premium + Industry risk premium Discount for Lack of Control (DLOC) DLOC = 1 1 1 + Control Premium
2013 ELAN GUIDES
PRIVATE REAL ESTATE INVESTMENTS

Net Operating Income Rental income at full occupancy + Other income (such as parking) = Potential gross income (PGI) - Vacancy and collection loss = Effective gross income (EGI) - Operating expenses (OE) = Net operating income (NOI) The Direct Capitalization Method Cap rate = Discount rate Growth rate The cap rate can be defined as the current yield on an investment: Capitalization rate = NOI1 Value
Rearranging the above equation, we can estimate the value of a property by dividing its firstyear NOI by the cap rate. Value = NOI1 Cap rate
An estimate of the appropriate cap rate for a property can be obtained from the selling price of similar or comparable properties. Cap rate = NOI Sale price of comparable property
The cap rate derived by dividing rent by recent sales prices of comparables is known as the all risks yield (ARY). The value of a property is then calculated as: Market value = Rent1 ARY
Other Forms of the Income Approach Gross income multiplier = Selling price Gross income
Value of subject property = Gross income multiplier Gross income of subject property
2013 ELAN GUIDES
The Discounted Cash Flow Method (DCF) Value = NOI1 (r g)
The Terminal Capitalization Rate Terminal value = NOI for the first year of ownership for the next investor Terminal cap rate
Appraisal-Based Indices Return = NOI - Capital expenditures + (Ending market value - Beginning market value) Beginning market value
Loan to Value ratio LTV ratio = Loan amount Appraised value
Debt Service Coverage ratio DSCR = NOI Debt service
Equity dividend rate/Cash-on-cash return Equity dividend rate = First year cash flow Equity investment
2013 ELAN GUIDES
PUBLICLY TRADED REAL ESTATE SECURITIES
PUBLICLY TRADED REAL ESTATE SECURITIES

VALUATION: NET ASSET VALUE APPROACH Capitalization rate Capitalization rate = NOI of a comparable property Total value of comparable property
Net Asset Value per Share NAVPS = Net Asset Value Shares outstanding
VALUATION: RELATIVE VALUATION (PRICE MULTIPLE) APPROACH Funds from operations (FFO) Accounting net earnings Add: Depreciation charges on real estate Add: Deferred tax charges Add (Less): Losses (gains) from sales of property and debt restructuring Funds from operations Adjusted funds from operations (AFFO) Funds from operations Less: Non-cash rent Less: Maintenance-type capital expenditures and leasing costs Adjusted funds from operations AFFO is preferred over FFO as it takes into account the capital expenditures necessary to maintain the economic income of a property portfolio.
2013 ELAN GUIDES
PRIVATE EQUITY VALUATION

Quantitative Measures of Return PIC (paid in capital): Ratio of paid in capital to date to committed capital. DPI (distributed to paid-in) or cash-on-cash return: Value of cumulative distributions paid to LPs as a proportion of cumulative invested capital. o (DPI = Cumulative distributions / PIC) RVPI (residual value to paid-in): Value of LPs shareholdings held with the fund as a proportion of cumulative invested capital. o RVPI = NAV after distributions / PIC TVPI (total value to paid-in): Value of portfolio companies distributed (realized) and undistributed (unrealized) value as a proportion of cumulative invested capital. o TVPI = DPI + RVPI NAV before distributions = Prior years NAV after distributions + Capital called down Management Fees + Operating results NAV after distributions = NAV before distributions Carried interest Distributions Total Exit Value Exit value = Initial cost + Earnings growth + Multiple expansion + Debt reduction Post-money valuation (POST) POST = PRE + I Proportionate ownership of the VC investor = I / POST Post-money value Post-money value = Required wealth Required wealth = Investment (1 + IRR) Number of years to exit Ownership propotion Ownership proportion = Required wealth / Exit value Exit value (1 + Required rate of return )Number of years to exists
2013 ELAN GUIDES
Shares to be issued Shares to be issued = Price per share Price per share = Amount of venture capital investment Number of shares issued to venture capital investment Proportion of venture capitalist investment Shares held by company founders Proportion of investment of company founders
Adjusted discount rate Adjusted discount rate = 1+r 1 1q
r = Discount rate unadjusted for probability of failure. q = Probability of failure.
2013 ELAN GUIDES
FUNDAMENTALS OF CREDIT ANALYSIS
FUNDAMENTALS OF CREDIT ANALYSIS

Expected Loss Expected loss = Default probability Loss severity given default Yield on a corporate bond: Yield on a corporate bond = Real risk-free interest rate + Expected inflation rate + Maturity premium + Liquidity premium + Credit spread Yield Spread: Yield spread = Liquidity premium + Credit spread For small, instantaneous changes in the yield spread, the return impact (i.e. the percentage change in price, including accrued interest) can be estimated using the following formula: Return impact Modified duration DSpread For larger changes in the yield spread, we must also incorporate the (positive) impact of convexity into our estimate of the return impact: Return impact (MDur DSpread) + (1/2 Convexity DSpread2)
2013 ELAN GUIDES
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES
TERM STRUCTURE AND VOLATILITY OF INTEREST RATES

Measuring Historical Yield Volatility Xt = 100 ln where yt = yield on day t Annualizing the Standard Deviation Annualized standard deviation = Daily standard deviation No. of days in a year Calculating Variance of Daily Yield Changes Variance =
( )
yt yt-1
S
T
Xt2 t=1 T - 1 Wt Xt2 t=1 T - 1
... assigns an equal weight to all observations
Variance =
... attaches a greater weight to more recent information
where: Wt = the weight assigned to each daily yield change observation such that the sum of the weights equals 1.
2013 ELAN GUIDES
VALUING BONDS WITH EMBEDDED OPTIONS

Treasury Market Benchmark Spread Measure Nominal Zero-volatility Option-adjusted Benchmark Treasury yield curve Treasury spot rate curve Treasury spot rate curve Reflects Compensation For Credit risk, liquidity risk and option risk Credit risk, liquidity risk and option risk Credit risk and liquidity risk
Specific Bond Sector with a Given Credit Rating Benchmark Spread Measure Nominal Zero-volatility Option-adjusted Benchmark Sector yield curve Sector spot rate curve Sector spot rate curve Reflects Compensation For Credit risk, liquidity risk and option risk Credit risk, liquidity risk and option risk Credit risk and liquidity risk
Issuer-Specific Benchmark Spread Measure Nominal Zero-volatility Option-adjusted Benchmark Issuer yield curve Issuer spot rate curve Issuer spot rate curve Reflects Compensation For Liquidity risk and option risk Liquidity risk and option risk Liquidity risk
Summary of Relationships between Benchmark, OAS and Relative Value Benchmark Treasury market Negative OAS Overpriced (rich) security Zero OAS Overpriced (rich) security Positive OAS Comparison must be made between security OAS and OAS of comparable securities (required OAS): If security OAS > required OAS, security is cheap If security OAS < required OAS, security is rich If security OAS = required OAS, security is fairly priced Comparison must be made between security OAS and OAS of comparable securities (required OAS): If security OAS > required OAS, security is cheap If security OAS < required OAS, security is rich If security OAS = required OAS, security is fairly priced
Overpriced (rich) security Bond sector with a (assumes credit rating higher given credit rating (assumes credit rating than security being analyzed) higher than security being analyzed)
Overpriced (rich) security (assumes credit rating higher than security being analyzed)
2013 ELAN GUIDES
Summary of Relationships between Benchmark, OAS and Relative Value (Contd.) Positive OAS Benchmark Zero OAS Negative OAS Bond sector with a given credit rating (assumes credit rating lower than security being analyzed) Comparison must be made between security OAS and OAS of comparable securities (required OAS): If security OAS > required OAS, security is cheap If security OAS < required OAS, security is rich If security OAS = required OAS, security is fairly priced Underpriced (cheap) Underpriced (cheap) security security (assumes credit rating lower than (assumes credit rating security being analyzed) lower than security being analyzed)
Issuers own securities Overpriced (rich) security
Fairly valued
Under priced (cheap) security
Determining Bond Value at a Node Applying Backward Induction

Bond's value in higher-rate state 1-year forward
Bond's value in lower-rate state 1-year forward
The present values of the these two cash flows discounted at the 1-year rate (r3,HHL) at Node NHHL are: 1.
2.
( (
VHHHL + C 1 + r3,HHL VHHLL + C 1 + r3,HHL
) )
Present value in the higher one-year rate scenario
Present value in the lower one-year rate scenario
1-year rate at the node at which we are calculating the bond's value, VHHL
NHHL r3,HHL
VHHL
VHHHL + C r4,HHHL NHHHL
NHHLL r4,HHLL VHHLL+ C
Cash flow in higher rate state
Cash flow in lower rate state
2013 ELAN GUIDES
Finally, the expected value of the bond, VHHL at Node NHHLis calculated as: 1 2
VHHHL + C 1 + r3,HHL
)(
+
VHHLL + C 1 + r3,HHL
Determining Call Option Value Value of call option = Value of option-free bond Value of callable bond. Determining Put Option Value Value of put option = Value of putable bond - Value of option-free bond Effective Duration and Effective Convexity Duration = V- - V+ 2V0 (Dy) V- + V+ - 2V0 2V0 (Dy)2
Convexity =
Traditional Analysis of a Convertible Security Conversion value = Market price of common stock Conversion ratio Market price of convertible security Conversion ratio
Market conversion price =
Market conversion premium per share = Market conversion price - Current market price Market conversion premium per share Market price of common stock
Market conversion premium ratio =
Premium payback period =
Market conversion premium per share Favorable income differential per share Coupon interest - (Conversion ratio Common stock dividend per share) Conversion ratio
Favorable income differential per share =
Premium over straight value =
Market price of convertible bond Straight value
-1
2013 ELAN GUIDES
An Option-Based Valuation Approach Covertible security value = Straight value + Value of the call option on the stock Covertible callable bond value = Straight value + Value of the call option on the stock - Value of the call option on the bond Covertible callable and putable bond value = Straight value + Value of the call option on the stock - Value of the call option on the bond + Value of the put option on the bond
2013 ELAN GUIDES
MORTGAGE-BACKED SECTOR OF THE BOND MARKET
MORTGAGE-BACKED SECTOR OF THE BOND MARKET

Single Monthly Mortality Rate (SMM) SMMt = Prepayment in month t Beginning mortgage balance for month t - Scheduled principal payment in month t
Prepayment in month t = SMM (Beginning mortgage balance for month t - Scheduled principal payment in month t) Conditional Prepayment Rate (CPR) CPR = 1 - (1 - SMM)12 Given the CPR, the SMM can be computed as: SMM = 1 - (1 - CPR)1/12 Average Life Average life =
S
t=1
t Projected principal recieved at time t 12 Total principal
t = Number of months Distribution of Prepayment Risk in a Sequential-Pay CMO Contraction Risk Extension Risk Tranche HIGH A (sequential pay) LOW B (sequential pay) C (sequential pay) Z (accrual pay) LOW HIGH
Prepayment Risk in Different PAC Tranches Prepayment Risk Tranche LOW PAC I - Senior PAC I - Junior PAC II Support HIGH
2013 ELAN GUIDES
ASSET-BACKED SECTOR OF THE BOND MARKET
ASSET-BACKED SECTOR OF THE BOND MARKET

Parties to the Securitization Party Description Seller Issuer/Trust Originates the loans and sells loans to the SPV The SPV that buys the loans from the seller and issues the assetbacked securities Services the loans Party in Illustration ABC Company SPV
Servicer
Servicer
Manufactured Housing-Backed Securities SMM = ABS 1 [ABS (M 1)] SMM 1 + [SMM (M 1)]
ABS =
VALUING MORTGAGE-BACKED AND ASSET-BACKED SECURITIES

Cash Flow Yield ABS and MBS typically have monthly cash flows, so the cash flow yield on these securities is compared to the yield on Treasury coupon securities based on their bond equivalent yields. The bond equivalent yield for MBS/ABS is calculated as: Bond equivalent yield = 2 [(1 + monthly cash flow yield)6 1] Option Cost Option cost = Zero-volatility spread Option-adjusted spread Duration Duration = V- - V+ 2V0 (D y)
2013 ELAN GUIDES
DERIVATES
DERIVATIVES
FORWARD MARKETS AND CONTRACTS

Value of a Forward Contract Time At initiation During life of the contract At expiration Long Position Value Zero, as the contract is priced to prevent arbitrage St F(0,T) (1 + r)
T-t
Short Position Value Zero, as the contract is priced to prevent arbitrage F(0,T) (1 + r)T-t - St
ST - F(0,T)
F(0,T) - ST
Price of an Equity Forward with Discrete Dividends
PV(D,0,T) =
S (1 + r)
i=1 n
Di
ti T
... Approach I
F(0,T) = [S0 PV(D,0,T)] (1 + r)
FV(D,0,T) =
S D (1 + r)
i=1 i T
T-ti
... Approach II
F(0,T) = S0 (1 + r) FV(D,0,T) Price of an Equity Forward with Continuous Dividends F(0,T) = (S0e-d T)er T F(0,T) = S0 e(r -d )T rc = Continuously compounded risk-free rate dc = Continuously compounded dividend yield Value of an Equity Forward Vt(0,T) = [St PV(D,t,T)] [F(0,T) / (1 + r)T t] PV(D,t,T) = PV of dividends expected to be received over the remainder of the contract term (between t and T). Assuming continuous compounding, the value of a forward contract on a stock index or portfolio can be calculated as: Vt(0,T) = Stedc(T t) F(0,T)erc(T t) Vt(0,T) = St e
dc(T t)
c c c c
F(0,T) erc(T t)
2013 ELAN GUIDES
DERIVATES
Calculating the No-Arbitrage Forward Price for a Forward Contract on a Coupon Bond F(0,T) = [B0C(T+Y) PV(CI,0,T)] (1 + r)T Or F(0,T) = [B0C(T+Y)] (1 + r)T FV(CI,0,T) BC = Price of coupon bond T = Time of forward contract expiration Y = Remaining maturity of bond upon forward contract expiration T+Y = Time to maturity of the bond at forward contract initiation. PV(CI,0,T) = Present value of coupon interest expected to be received between time 0 (contract initiation) and time T (contract expiration). FV(CI,0,T) = Future value of coupon interest expected to be received between time 0 (contract initiation) and time T (contract expiration). Valuing a Forward Contract on a Coupon Bond The value of the long position in a forward contract on a fixed income security prior to expiration can be calculated as: Vt(0,T) = BtC(T+Y) PV(CI,t,T) F(0,T) / (1 + r)T t PV(CI,t,T) = Present value of coupon payments that are expected to be received between time t and time T. BtC(T+Y) = Current value of coupon bond with time T+Y remaining until maturity Pricing a Forward Rate Agreement 1 + L0(h + m) FRA(0,h,m) = 1 + L0( h )
( ) ( ) ( )
h+m 360 -1 h 360
360 m
FRA(0,h,m) = The annualized rate on an FRA initiated at Day 0, expiring on Day h, and based on m-day LIBOR. h = Number of days until FRA expiration m = Number of days in underlying hypothetical loan h+m = Number of days from FRA initiation until end of term of underlying hypothetical loan. L0 = (Unannualized) LIBOR rate today
2013 ELAN GUIDES
DERIVATES
FRA Payoff FRA payoff = NP [(Market LIBOR FRA rate) No. of days in the loan term / 360] 1 + [Market LIBOR (No. of days in the loan term / 360)]
Valuing FRA prior to expiration NP [(Current forward rate FRA rate) No. of days in the loan term / 360] 1 + {Current LIBOR [(No. of days in loan term + No. of days till contract expiration) / 360]} Or: Vg (0,h,m) = 1 1 + Lg (h - g) 1 + FRA(0,h,m) 1 + Lg (h + m - g)
( )
h-g 360
( )
m 360 360
h+m-g
g = Number of days since FRA initiation. Pricing a Currency Forward Contracts F(0,T) = S0 (1 + RDC)T (1 + RFC)T
F and S are quoted in terms of DC per unit of FC RDC = Domestic risk-free rate RFC = Foreign risk-free rate T = Length of the contract in years. Remember to use a 365-day basis to calculate T if the term is given in days. Valuing a Currency Forward Contract The value of the long position in a currency forward contract at any time prior to maturity can be calculated as follows: Vt (0,T) = St (1 + RFC)
(T-t)
F (0,T) (1 + RDC)(T-t)
Assuming continuous compounding, the price and value of a currency forward contract can be calculated by applying the formulas below: F(0,T) = (S0e r
cFC T
) er
cDC T
or F(0,T) = S0 e(r
cDC (T t)
cDC rcFC) T
Vt(0,T) = [St / er
cFC (T t)
] [F(0,T) / er
rc here represents a continuously compounded riskfree rate in these formulas.
2013 ELAN GUIDES
FUTURES MARKETS AND CONTRACTS

If we ignore the effects of the mark-to-market adjustment on futures contracts, we can make the simplifying assumption that the futures price and forward price are the same. f0(T) = F(0,T) = S0 (1 + r)T f0(T) = Futures price today of a futures contract that expires at time T. F(0,T) = Forward price of a forward contract that expires at time T. S0 = Spot price of underlying asset today r = Annual risk-free rate The Effect of Storage or Carrying Costs on the Futures Price f0(T) = S0 (1 + r)T + FV(SC,0,T) The Effect of Monetary Benefits on the Futures Price f0(T) = S0 (1 + r)T - FV(CF,0,T) The Effect of Non-Monetary Benefits on the Futures Price FV(CB,0,T) = Costs of storage Nonmonetary benefits (Convenience yield) If costs exceed benefits, FV(CB,0,T) is a positive number and is known as cost of carry. In this case, the general futures pricing formula is given as: f0(T) = S0 (1 + r)T + FV(CB,0,T) Pricing Treasury Bond Futures f0(T) = B0C(T+Y) [(1 + r0(T)]T FV(CI,0,T) BC = Price of coupon bond T = Time of futures contract expiration Y = Remaining maturity of bond upon futures contract expiration T+Y = Time to maturity of the bond at futures contract initiation. r0(T) = Interest rate at time 0 for period until time T. FV(CI,0,T) = Future value of coupon interest expected to be received between time 0 (contract initiation) and time T (contract expiration). The adjusted futures price of a t-bond futures contract is calculated as: f0(T) = B0C (T + Y) [1 + r0 (T)]T - FV (CI,0,T) CF(T)
CF(T) = Conversion factor on CTD bond
2013 ELAN GUIDES
Pricing Stock Index Futures f0(T) = S0 (1 + r)T FV(D,0,T) f0(T) = S0 e(r

c
dc)T
Pricing Currency Futures f0(T) = S0 (1 + rDC)T (1 + rFC)T
F and S are quoted in terms of DC/FC rDC = Domestic currency interest rate rFC = Foreign currency interest rate T = Length of the contract in years. Remember to use a 365-day year if maturity is given in days. If interest rates are assumed to be continuously compounded, then the no-arbitrage futures price is calculated as: f0(T) = S0 e(r
cDC rcFC)T
rc represents the continuously compounded risk-free rate.
2013 ELAN GUIDES
OPTION MARKETS AND CONTRACTS

Put-Call Parity C0 + X = P0 + S0 (1 + RF)T
Synthetic Securities Strategy fiduciary call Consisting of long call + long bond Value C0 + X (1 + RF)T Equals = Strategy Protective put Consisting of long put + long underlying asset Value P0 + S0
long call
long call
C0
long put + long Synthetic call underlying asset + short bond long call + short Synthetic put underlying asset + long bond Synthetic underlying asset Synthetic bond long call + long bond + short put
P0 + S 0 -
X (1 + RF)T
long put
long put
P0
C0 - S0 +
X (1 + RF)T
long underlying asset long bond
long underlying asset long bond
S0 X (1 + RF)T
C0 +
X - P0 (1 + RF)T
long put + long underlying asset + short call
P0 + S0 - C0
2013 ELAN GUIDES
One-Period Binomial Model Computing the two possible values of the stock: S+ = Su S- = Sd Binomia Call Option Pricing Call payoff = Max(0, S+ X) Binomial Put Option Pricing Put payoff = Max (0, X ST) Compute the risk-neutral probabilities: p= (1 + r - d) (u - d)
Calculating the value of the call option: c= p c+ + (1 p) c1+r
Calculating the value of the put option: p= p p+ + (1 p) p1+r
Hedge Ratio n= c+ - cS+ - S-
Intrinsic value of caplet at expiration: Caplet value = Max {0, [(One-year rate Cap rate) Notional principal]} 1 + One-year rate
Intrinsic value of floorlet at expiration: Floorlet value = max {0, [(Floor rate One-year rate) Notional principal]} 1 + One-year rate
2013 ELAN GUIDES
The Black-Scholes-Merton Formula c = S0N(d1) - Xe-r TN(d2) p = Xe-r T[1 - N(d2)] - S0[1 - N(d1)] Where: d1 = ln(S0 X) + [rc + (s2 2)]T
c c
s T
d2 = d1 - s T
s= the annualized standard deviation of the continuously compounded return on the stock rc = the continuously compounded risk-free rate of return N(d1) = Cumulative normal probability of d1.
Delta Delta = Change in option price Change in underlying price
Change in option price = Delta Change in underlying price An approximate measure for option delta can be obtained from the BSM model: N(d1) from the BSM model approximately equals call option delta. N(d1) 1 approximately equals put option delta. Therefore: D c N(d1) D S D p N(d1) 1] D S Put-Call Parity for Forward Contracts Value at Expiration Transaction Call and Bond Buy call Buy bond Total Put and Forward Buy put Buy forward contract Total Current Value c0 [X F(0,T)]/(1 + r)T c0 + [X F(0,T)]/(1 + r)T p ST X 0 X F(0,T) X F(0,T) ST > X ST X X F(0,T) ST F(0,T)
0 p0
X ST ST F(0,T) X F(0,T)
0 ST F(0,T) ST F(0,T)
2013 ELAN GUIDES
Put-call-forward parity c0 + X F(0,T) = p0 (1 + r)T
Forward Contract and Synthetic Forward Contract Value at Expiration Transaction Forward Contract Long forward contract Synthetic Forward Contract Buy call Sell put Buy (or sell) bond Total Current Value 0 c0 p0 ST X ST F(0,T) 0 ( X ST) X F(0,T) ST F(0,T) ST > X ST F(0,T) ST X 0 X F(0,T) ST F(0,T)
[X F(0,T)]/(1 + r) c0 p0 + [X F(0,T)]/(1 + r)T
The Black Model The Black model is used to price European options on futures. c = e-r T [f0(T)N(d1) - XN(d2)] p = e-r T (X[1 - N(d2)] - f0(T)[1 - N(d1)]) Where: d1 = ln(f0(T) X) + (s2 2)]T
c c
s T
d2 = d1 - s T f0(T) = the futures price Notice that the Black model is similar to the BSM model except that e-r T f(T) is substituted for S0. In fact, the price of a European option on a forward or futures would be the same as the price of a European option on the underlying asset if the options and the forward/futures contract expire at the same point in time.
c
2013 ELAN GUIDES
SWAP MARKETS AND CONTRACTS
SWAP MARKETS AND CONTRACTS

The Swap Fixed Rate Swap fixed rate =
1 - B0(N) B0(1) + B0(2) + B0(3) + ... + B0(N)
100
Valuing a Swap Value of pay-fixed side of plain-vanilla interest rate swap: Present value of floating-rate payments - Present value of fixed-rate payments Value of pay-floating side of plain-vanilla interest rate swap: Present value of fixed-rate payments - Present value of floating-rate payments Valuing Equity Swaps Pay a fixed rate and receive the return on equity swap [(1 + Return on equity) Notional principal] - PV of the remaining fixed-rate payments Pay a floating rate and receive the return on equity swap [(1 + Return on equity) Notional principal] - PV (Next coupon payment + Par value) The value of a pay the return on one equity instrument and receive the return on another equity instrument swap is calculated as the difference between the values of the two (hypothetical) equity portfolios: [(1 + Return on Index 2) NP] [(1 + Return on Index 1) NP] Payer swaption (Market fixed-rate Exercise rate) No. of days in the payment period 360 Notional principal
Receiver swaption (Exercise rate Market fixed-rate) No. of days in the payment period 360 Notional principal
2013 ELAN GUIDES
INTEREST RATE DERIVATIVE INSTRUMENTS
INTEREST RATE DERIVATIVE INSTRUMENTS

Table: Caps, Floors, Interest Rate Options, Bond Options and Interest Rates Benefits when Security Interest rates rise (fall) Long cap (floor) Interest rates rise (fall) Long call (put) option on interest rates Interest rates fall (rise) Long call (put) option on a fixed income instrument Payoff to the buyer of an interest rate cap Payoff = Max [0,(Market interest-rate Cap rate) Payoff to the buyer of an interest rate floor Payoff = Max [0,(Floor rate Market interest-rate) No. of days 360 Notional principal] No. of days Notional principal] 360
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
PORTFOLIO CONCEPTS
Expected return on Two-Asset Portfolio E(RP) = w1E(R1) + w2E(R2) E(R1) = expected return on Asset 1 E(R2) = expected return on Asset 2 w1 = weight of Asset 1 in the portfolio w2 = weight of Asset 2 in the portfolio Variance of 2-asset portfolio:
2 2 2 2 s2 = w1 s 1 + w2 s2 + 2w1w2r1, 2s1s2 P
s1= the standard deviation of return on Asset 1 s2= the standard deviation of return on Asset 2 r1, 2= the correlation between the two assets returns Variance of 2-asset portfolio:
2 2 2 2 2 sP = w1 s 1 + w2 s2 + 2w1w2Cov1,2
Cov1,2 = r1, 2s1s2 Expected Return and Standard Deviation for a Three-Asset Portfolio Expected return on 3-asset portfolio: E(RP) = w1E(R1) + w2E(R2) + w3E(R3) Variance of 3-asset portfolio:
2 2 2 2 2 2 2 sP =w 1 s1 + w2 s 2 + w 3 s 3 + 2w1w2r1, 2s1s2 + 2w1w3r1, 3s1s3 + 2w2w3r2, 3s2s3
Variance of 3-asset portfolio:

2 2 2 2 2 2 2 sP =w 1 s1 + w2 s 2 + w 3 s 3 + 2w1w2Cov1, 2 + 2w1w3Cov1, 3 + 2w2w3Cov2, 3
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Expected Return and Variance of the Portfolio For a portfolio of n assets, the expected return on the portfolio is calculated as: E(RP) =
S w E(R )
j=1 j j n i j i j
The variance of the portfolio is calculated as: s2 = P
S S w w Cov(R ,R )
i=1 j=1
Variance of an Equally-weighted Portfolio

2 sP =
1 2 n-1 s + Cov n n
s2 = s2 P
1-r n
+r
)
[E(Ri) - RFR] si
Expected Return for a Portfolio Containing a Risky Asset and the Risk-Free Asset E(RP) = RFR + sP
Standard Deviation of a Portfolio Containing a Risky Asset and the Risk-Free Asset sP = wisi
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
CML Expected return on portfolios that lie on CML: E(RP) = w1Rf + (1 - w1)E(Rm) Variance of portfolios that lie on CML:
2 2 2 s2 = w1 sf + (1 - w1)2sm + 2w1(1 - w1)Cov(Rf , Rm)
Equation of CML: E(RP) = Rf + E(Rm) - Rf sP sm
Calculation and Interpretation of Beta bi = Cov(Ri,Rm)

2 sm
ri,msi,sm
2 sm
ri,msi sm
The Capital Asset Pricing Model E(Ri) = Rf + bi[E(Rm) Rf ] The Decision to Add an Investment to an Existing Portfolio E(Rnew) - RF E(Rp) - RF > Corr(Rnew,Rp) sp snew
Market Model Estimates Ri = ai + bi RM + ei Ri = Return on asset i RM = Return on the market portfolio ai = Average return on asset i unrelated to the market return bi = Sensitivity of the return on asset i to the return on the market portfolio ei = An error term bi is the slope in the market model. It represents the increase in the return on asset i if the market return increases by one percentage point. ai is the intercept term. It represents the predicted return on asset i if the return on the market equals 0.
Expected return on asset i E(Ri) = ai + biE(RM)
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Variance of the return on asset i

2 2 Var(Ri) = b2 i sM+ se i
Covariance of the returns on asset i and asset j Cov(Ri,Rj) = bibjs2

M
Correlation of returns between assets i and j Corr(Ri,Rj) =

2 bibjsM 2 2 1/2 2 2 1/2 (b2 (b2 i sM + s ei) e j) j sM + s
Market Model Estimates: Adjusted Beta Adjusted beta = 0.333 + 0.667 (Historical beta) Macroeconomic Factor Models Ri = ai + bi1FINT + bi2FGDP + ei Ri = the return to stock i ai = the expected return to stock i FINT = the surprise in interest rates FGDP = the surprise in GDP growth bi1 = the sensitivity of the return on stock i to surprises in interest rates. bi2 = the sensitivity of the return on stock i to surprises in GDP growth. ei = an error term with a zero mean that represents the portion of the return to stock i that is not explained by the factor model. Fundamental Factor Models Ri = ai + bi1FDY + bi2FPE + ei Ri = the return to stock i ai = intercept FDY = return associated with the dividend yield factor FPE = return associated with the P-E factor bi1 = the sensitivity of the return on stock i to the dividend yield factor. bi2 = the sensitivity of the return on stock i to the P-E factor. ei = an error term Standardized sensitivities are computed as follows: bij = Assets is attribute value - Average attribute value s(Attribute values)
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Arbitrage Pricing Theory and the Factor Model E(RP) = RF + l1bp,1 + ... + lKbp,K E(Rp) = Expected return on the portfolio p RF = Risk-free rate l j = Risk premium for factor j bp,j = Sensitivity of the portfolio to factor j K = Number of factors Active Risk TE = s(Rp - RB) Active risk squared = s2(Rp - RB) Active risk squared = Active factor risk + Active specific risk Active specific risk =
Sw s
i=1
a 2 i ei
Where: wia= The ith assets active weight in the portfolio (i.e., the difference between the assets weight in the portfolio and its weight in the benchmark). se2 = The residual risk of the ith asset (i.e., the variance of the ith assets returns that is not explained i by the factors). Active factor risk = Active risk squared Active specific risk. Active Return Active return = Rp RB Active return = Return from fctor tilts + Return from asset selection Active return =
S[(Portfolio sensitivity) - (Benchmark sensitivity) ] (Factor return) + Asset selection

j=1 j j j
2013 ELAN GUIDES
PORTFOLIO CONCEPTS
Factors Marginal Contribution to Active Risk Squared (FMCAR) ba j FMCARj =
S b Cov(F ,F )
i=1 a i j i
Active risk squared Active factor risk Active risk squared
FMCARj = where:
ba j = The portfolios active exposure to factor j ba j
S b Cov(F ,F ) = The active factor risk for factor j

i=1 a i j i
The Information Ratio IR = Rp - RB s(Rp - RB)
2013 ELAN GUIDES
THE THEORY OF ACTIVE PORTFOLIO MANAGEMENT

Weight of security k in the active portfolio (Portfolio A) wk = ak / s2(ek)
n
S ai / s2(ei) i=1
The expression for the optimal weight, w*, of the active portfolio (Portfolio A) in the optimal risky portfolio (Portfolio P) is given as: w* = aA aA(1-bA) + RM s2(eA) s2M
Assuming (for simplicity) that the beta of Portfolio A equals 1, the optimal weight, w0, of Portfolio A in Portfolio P is calculated as: aA w0 = RM s2(eA) s2M If the beta of Portfolio A does not equal 1, we can use the following equation to determine the optimal weight, w*, of Portfolio A in Portfolio P. w* = w0 1 + (1-bA)w0 = aA /s2(eA) RM /s2M
Evaluation of Performance Sharpe Ratio The Sharpe ratio of the optimal risky portfolio (Portfolio P) can be separated into contributions from the market and active portfolio as follows:
2 2 SP = SM
s2(eA)
s2A
[ ][ ]
RM sM
2
sA
s(eA)
Information Ratio
[ ] [ ]
sA s(eA)
2
=S
i=1
si s(ei)
2013 ELAN GUIDES
Imperfect Forecasts of Alpha Values Actual (realized) alpha: a = R - bRM To measure the forecasting accuracy of the analyst, we can regress alpha forecasts (af) on realized alpha (a).
2 2 = sa sa + se2 f
We can evaluate the quality of the analysts forecasts by calculating the coefficient of determination of the regression described above. R =
2 2 sa 2 sa f
2 sa 2 2 sa + se
2013 ELAN GUIDES
THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT
THE PORTFOLIO MANAGEMENT PROCESS AND THE INVESTMENT POLICY STATEMENT

Risk Tolerance Willingness to Take Risk Below Average Above Average Ability to Take Risk Above Average Below Average Resolution needed Below-average risk tolerance Above-average risk tolerance Resolution needed
Return Requirements and Risk Tolerances of Various Investors Type of Investor Individual Return Requirement Depends on stage of life, circumstances, and obligations The return that will adequately fund liabilities on an inflationadjusted basis Risk Tolerance Varies
Pension Plans (Defined Benefit)
Depends on plan and sponsor characteristics, plan features, funding status, and workforce characteristics Varies with the risk tolerance of individual participants Determined by amount of assets relative to needs, but generally above- average or average Below average due to factors such as regulatory constraints Below average due to factors such as regulatory constraints
Pension Plans (Defined Contribution) Foundations and Endowments
Depends on stage of life of individual participants The return that will cover annual spending, investment expenses, and expected inflation
Life Insurance Companies Non-Life- Insurance Companies
Determined by rates used to determine policyholder reserves Determined by the need to price policies competitively and by financial needs Determined by cost of funds
Banks
Varies
2013 ELAN GUIDES

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We started Elan Guides with a mission to provide CFA candidates with the most effective and efficient study

WHY USE ELAN GUIDES?

2013 ELAN GUIDES

CORRELATION AND REGRESSION

Sample correlation coefficient = r =

2013 ELAN GUIDES

=b +b X , i = 1,...., n Regression line equation = Y i 0 1 i Regression Residuals

Unexplained variation Total variation

The regression sum of squares (RSS) RSS = ^ -Y) S (Y

The sum of squared errors or residuals (SSE) SSE =

2013 ELAN GUIDES

Error (unexplained) Total

k = the number of slope coefficients in the regression.

2013 ELAN GUIDES

MULTIPLE REGRESSION AND ISSUES IN REGRESSION

MULTIPLE REGRESSION AND ISSUES IN REGRESSION ANALYSIS

2013 ELAN GUIDES

MULTIPLE REGRESSION AND ISSUES IN REGRESSION

Remove one or more independent variables; often no solution based in theory

2013 ELAN GUIDES

TIME SERIES ANALYSIS

2013 ELAN GUIDES

TIME SERIES ANALYSIS

2013 ELAN GUIDES

TIME SERIES ANALYSIS

2013 ELAN GUIDES

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Forward exchange rates (F) - Any Investment Horizom

FFC/DC = SFC/DC FPC/BC = SPC/BC

Currencies Trading at a Forward Premium/Discount

FFC/DC - SFC/DC = SFC/DC FPC/BC - SPC/BC = SPC/BC

2013 ELAN GUIDES

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Covered Interest Rate Parity

1 + (iPC Actual 360) 1 + (iBC Actual 360)

SePC/BC SPC/BC SPC/BC

2013 ELAN GUIDES

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

Forward Rate as an Unbiased Predictor

Foreign-Domestic Expected Inflation Differential peFC - peDC International Fisher Effect

Uncovered Interest Rate Parity

Forward Discount FFC/DC - SFC/DC SFC/DC

Foreign-Domestic Interest rate Differential iFC - iDC

2013 ELAN GUIDES

CURRENCY EXCHANGE RATES: DETERMINATION AND FORECASTING

2013 ELAN GUIDES

ECONOMIC GROWTH AND THE INVESTMENT DECISION

ECONOMIC GROWTH AND THE INVESTMENT DECISION

2013 ELAN GUIDES

ECONOMIC GROWTH AND THE INVESTMENT DECISION

Neoclassical Model (Solows Model) Y 1 = K s

Production Function in the Endogenous Growth Model ye = f(ke) = cke

2013 ELAN GUIDES

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENTS AND RATIOS

Higher under LIFO

Lower under LIFO

Higher under LIFO

Activity ratios Inventory turnover Total asset turnover

Higher under LIFO Higher under LIFO

2013 ELAN GUIDES

INVENTORIES: IMPLICATIONS FOR FINANCIAL STATEMENT AND RATIOS