Residual income model: advantage

Which of the following is the most appropriate description for residual income model?

A. The analyst need not adjust the book value of common equity for off-balance sheet items.
B. The analyst need not adjust the book value of common equity for non-recurring items.
C. The interest expense in the residual income model correctly captures the cost of debt capital.


B

While it is important to adjust income for non-recurring items, these adjustment do not need to be made to the book value because they are already reflected in the value of the assets.

CFO: indirect method in the presentation of CFO

Adjustment to Net income related to the pension plan, ignoring income taxes.

CFO = NI + Pension expense - Employer's contributions

Compensation expense related to the stock option

Compensation expense related to the stock option (per year)
= Options granted * Option price on the grant date * (1/Service period in year) * Time from the grant date to fiscal year end

Growth accounting

The following, according to growth accounting, are helpful in increasing the growth rate of an economy:

• Stimulate saving
• Stimulate research and development
• Target high-technology industries
• Encourage international trade
• Improve the quality of education

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Primary goal: to raise its per capita GDP, which depends on increasing the country's growth rate of capital per hour of labor. (under New Growth Theory)

Two correct recommendations:

1. provide tax incentives to stimulate savings, and
2. invest in education to raise the population's productivity

(1) Higher savings increase investment in capital.
(2) Increasing investment in education makes labor and machines more productive.
(3) In addition, the New Growth Theory states that knowledge is NOT subject to the laws of diminishing returns.

Economic Growth: three sources

1. Physical capital growth
2. Human capital growth
• (e.g.) Investment in human capital to boost literacy and technical skills.
3. Technological advances
• (e.g.) Discovery of new technologies to increase productivity.

Increasing consumption through population growth, including immigration, does NOT necessarily lead to economic growth.

Active portfolio management: justifications

Why active portfolio management might add value in an efficient market environment?

• Economic argument (logic)
• If investors only invested in passively managed portfolios, then actively managed portfolios would cease to exist. As a consequence, inefficiencies will arise in securities markets and the resulting profit opportunities will lure active managers back thus enabling them to outperform passively managed portfolios.
• (Incorrect description) If active managers were not able to consistently beat a passive investment strategy, investors would not be willing to pay high fees for active managers and funds under active management would cease to exist. Since there are many active managers, economic logic suggests they must be outperforming passive strategies.
• Empirical evidence
• Some managers have consistently produced excess returns relative to a passive strategy, suggesting skill rather than luck.

Portfolio management process: planning step

Parts of the planning step of the portfolio management process:

1. Identify the investment objectives and constraints.
2. Create an investment policy statement.
3. Form a set of capital market expectations.
4. Determine a strategic asset allocation.

Following parts are NOT in the planning step.

• Evaluation of the performance of the portfolio.
• Selection of assets or managers for the portfolio.

Local currency debt (relative to foreign currency debt)

Criteria established by rating agencies to assess sovereign debt:

Local currency debt (relative to foreign currency debt)

		Local currency debt	Foreign currency debt
Political stability		Yes
Fiscal policy flexibility		Yes
Ability to raise taxes		Yes
Willingness to pay debt (history of defaults)		Yes
Level of external debt			Yes
Level of exchange rate			Yes

High yield issuers

Investments in securities issued by high yield companies.

• Bank loans are an attractive part of the capital structure since they have priority over other bondholders in the firm's assets.
• Bank loans can enhance recovery values because they are senior in the capital structure and generally secured by a lien on the firm's assets, providing priority over other debt holders.
• These companies often have a holding company structure from which it can issue bonds but is reliant on the ability of operating subsidiaries to move cash to the holding company to pay bondholders which may be restricted by covenants, even if they are senior bonds.
• Bonds can be issued out of a holding company but assets and cash flows are typically resident at operating companies which may be restricted by covenants from up streaming funds to the holding company even for the payment of senior bonds.

Affirmative covenant

A covenant calls upon a borrower (debt issuer) to do a certain thing (rather than restrictions on a certain ratio threshold/action).

Free Operating Cash Flow

Free Operating Cash Flow = CFO - NWCInv - FCInv

NWCInv: change in net working capital (net investment in working capital)
FCInv: capital expenditures

The higher the Free Operating Cash Flow, the stronger credit based on cash flow analysis.

Traditional credit analysis

• Current ratio = Current assets/Current liabilities
• Long-term debt to Capitalization = Long-term debt / (Total debt + Total Equity)
• EBIT Interest coverage = EBIT / Interest expense

FCFE: debt paydown

"Although the FCFE declines in the year when debt is paid down, it will increase in subsequent years."

Correct.

FCFE↓ = NI + NCC + Net borrowing↓ - NWCInv - FCInv

In the later years, however, it will increase because of the reduced interest expense(e.g. higher net income); thus, a higher shareholder value.

ROE (Return On Equity)

The lower payout ratio will increase the return on equity.

Incorrect.

g = ROE * (1 - d↓)
Lower payout ratio does not necessary increase the ROE.

Signaling theory

The reduction in dividends is taken as a negative signal by investors therefore dividend reduction almost always results in a reduction in share price.

Capitalization of interest

Capitalization of interest

			Capitalization of interest (to fixed assets)
Net income			↑
CFI			↓
CFO			↑

Generalized least squares model

"First, if ARCH exists, the standard errors for the regression parameters will not be correct. In case ARCH exists, we will need to use generalized least squares..."

OAS

• (Average) OAS is calculated using a:
• binominal model or
• Monte Carlo model (simulation)
• The OAS measures the average spread over a Treasury spot rate curve, and NOT over the Treasury yield.
• It is an average spread since the OAS is found by averaging over the interest rate paths for the possible Treasury spot rate curves.
• The OAS represents compensation for credit risk, liquidity risk, and modeling risk.
• Modeling risk
• The Monte Carlo model uses several critical assumptions and parameters. If those assumptions prove incorrect or if the parameters are misestimated, the prepayment model will not calculate the true level of risk, resulting in modeling risk.
• If the security is issued by a government agency, the credit risk component is not relevant in the OAS.
• If a security is issued by a government agency such as Ginnie Mae, there is no required compensation for credit risk and this will be reflected in the OAS level.

Treynor-Black model

1. The model construct the optimal risky portfolio as a combination of the passive and active portfolios.
2. Each stock's weight in the active portfolio is determined on the basis of its alpha, beta, and σ(e).

External crossing

To achieve best execution in its international investing, the fund emphasizes two aspects related to execution costs:

1. maintaining anonymity
2. minimizing commissions and fees.

[Question]
Which of the following trading techniques is most consistent with the claim above regarding best execution in the firm's international investing?

A. Agency trade
B. Principal trade
C. External crossing

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[Answer]
C

External crossing keeps execution costs very low and anonymity is assured.

Withholding taxes

income gains (dividend) = 1.2 million EUR
capital gains = 2.0 million EUR

withholding tax = 15%

Follow the standard approach with respect to withholdings.


Total amount of withholding taxes the fund will reclaim is:
0.15 * 1.2 = 0.18 million EUR

The standard approach is that withholding is applied to the dividend income only.

Residual income models

• One disadvantage(drawback) to the single-stage residual income model is that it assumes the excess ROE above the cost of equity will persist indefinitely.
• In residual income models the terminal value may NOT be a large component of total value because ROE may fade over time toward the cost of equity.

Effective tax rate on dividends

1 - Effective tax rate on dividends = (1 - corporate tax rate on dividends)*(1 - personal tax rate)

Effective tax rate on dividends = 1 - (1 - corporate tax rate on dividends)*(1 - personal tax rate)

Pension Expense

Pension Expense
= Service cost + Interest cost - Expected return on plan assets + Amortization of unrecognized service cost + Amortization of unrecognized loss


See also Economic Pension Expense.

Minimum-variance efficient frontier: instability

The instability of the minimum-variance efficient frontier is attributed to:

• Absence of a short sales constraint
• Historical betas

Total Shareholders' Equity (in a consolidated balance sheet on the date of acquisition)

Total Consolidated Shareholders' Equity
= Shareholders' Equity (Parent) + Noncontrolling interest
= Shareholders' Equity (Parent) + (1 - %Interest of Parent) * Shareholders' Equity (Child)

The noncontrolling interest is now reported in the shareholders' equity section under both U.S. GAAP and IFRS.

Accounting income

Accounting income = Net income = Taxable income * (1-Tax rate)

Taxable income = Operating income before tax - Interest expense


Operating income before tax = Sales - Variable cash expenses - Fixed cash expenses - Depreciation = EBIT

Stock options and Stock grants

Stock options are affected by higher volatility and would have increased the compensation expense and lowered net income.

Stock grants are based on the fair market value of the stock on the date of the grant and are NOT affected by the stock's volatility.

equity market neutral

[Question]
benchmark: 30-day Treasury bill rate + a spread of 250 bps

The intended benchmark for hedge fund investments would be most appropriate for:

A. distressed securities funds.
B. equity market neutral funds.
C. fixed income arbitrage funds.

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[Answer]
B

Because

• while "application of some universal benchmark, no matter how well constructed, is unlikely to capture the essence of all hedge funds' performances"
• "the hedge fund strategy that comes closer to pure risk-free arbitrage is equity market neutral."

It is reasonable to benchmark risk-free arbitrage against the risk free rate plus a spread to represent return required to compensate for management fees.

roll yield

commodities

roll yield
positive(*)	Futures price > "full carry" price	backwardation	This may occur when prices are low and volatile and commodities producers are concerned that they will fall further, to a level that is unprofitable. Producers will accept less that the "full carry" price in oder to hedge price risk.

(*) If you long a commodity futures and sell at a higher price at roll over date, you will get a positive roll yield.

CFA Institute Research Objectivity Standards: Standard 6, Relationship with Subject Companies

• Sharing any section of a research report that might communicate the analyst's proposed recommendation, rating, or price target, is prohibited by the Standards.
• Factual information is allowed to be shared.

Stock forward: current value of the short position

Financial market information

U.S. three-month (90 day) annualized risk-free rate			6.00%

• Six months ago, you entered into a forward contract to sell the underlying stock at a price of $80.
• The forward contract has three months to expiration now and the stock is currently trading at $75.
• A 360-day year.

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[Question]
What is the current value of the short position in the stock forward contract?

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[Answer]
The value of a long position in a forward contract at any time is:
V_t = S_t - F_(0,T)/(1+r)^(T-t)
(Assumed that there is no dividend.)

V_t = $75 - $80/(1+6.00%)^(90/360) = -$3.84

The value to the short position has the opposite sign and is $3.84.

estimation of the WACC for an emerging country firm

[Question]

1. When estimating the percent of debt and equity in the capital structure, the market value of the firm's debt and equity should be used, not the book value.
2. The beta will be needed to obtain the cost of equity capital in the CAPM. The beta should be estimated for the company by regressing the company's returns against a well diversified global index, not the local market index.

Are both statements correct?

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[Answer]

1. Incorrect. The debt and equity weights from a global industry index should be used, not the weights for the firm. Firms in emerging markets often use debt conservatively and this results in lower leverage ratios than for firms in the same industry in other countries.
2. Incorrect. An industry beta for the firm's industry should be estimated, not an individual firm beta. It is correct however that a well diversified global index, not the local market index, should be used.

Emerging market country risk: adjusting emerging market country risk by the cash flows

[Question]

1. One argument is that companies respond differently to the risk in their country. For example, exporters would benefit from a weaker local currency but importers would be hurt by a depreciating currency. Adjusting the discount rate by the same amount for all companies within a country would misstate the influence of country risk on each company.
2. Additionally, country risk is one-sided and asymmetric in that the country risk to foreign investors is much greater than that to local investors. So if a single discount rate were used to discount cash flows, then the valuations would be inaccurate for either the foreign investors or the local investors.

Are both statements 1 and 2 correct?

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[Answer]
No, only Statement 1 is correct.

It is correct that emerging market valuations should be adjusted for country risk by adjusting the cash flows and not the discount rate.

1. The argument that companies within an emerging market will be affected differently by country risk is correct.

2. It may be true that country risk for foreign investors is greater than that for local investors. However, it is incorrect in the justification because it incorrectly describes the one-sided nature of country risk in this context. Country risk is asymmetric because many emerging market companies have risk profiles that are one-sided (down only). It is best to adjust for this in the cash flows rather than to adjust the discount rate.

Financial transaction and Strategic transaction

Strategic transaction and Financial transaction

transaction
strategic transaction			A firm is acquired based in part on the synergies it brings to the acquirer.
financial transaction			There are no synergies.

FRA (Forward Rate Agreement)

• A project has eight months until project completion.
• Funding for the project will run out in approximately six months. Need to cover the funding gap.
• Funding = $1,275,000

To mitigate the interest rate uncertainty, you have decided to enter into a FRA based on LIBOR.

LIBOR rates on July 1 (current)

Day			All-current
90			4.28%
180			4.52%
240			5.11%
360			5.92%

LIBOR rates on October 1

Day			All-current
90			5.12%
150			5.96%
210			6.03%
300			6.41%

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[Question 1]

What is the price of the FRA on the date of the contract inception?

(1+R₂₄₀*240/360) = (1+R₁₈₀*180/360)(1+FRA_6x8*60/360)
FRA_6x8 = ((1+R₂₄₀*240/360)/(1+R₁₈₀*180/360) - 1)*(360/60)
= ((1+5.11%*240/360)/(1+4.52%*180/360) - 1 )*(360/60)
= 0.067279

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[Question 2]

What is the value of the forward rate agreement three months after the inception of the contract (from fixed-payer's perspective)? For this question only, assume that the interest rate at inception was 6.0%.

(1+R₁₅₀*150/360) = (1+R₉₀*90/360)(1+FRA_3x5*60/360)

(1)

FRA_3x5 = ((1+R₁₅₀*150/360)/(1+R₉₀*90/360) - 1)*(360/60)

= ((1+5.96%*150/360)/(1+5.12%*90/360) - 1)*(360/60)

= 0.071288 = 7.13%

or

(2)

FRA_3x5 = ((1+R₁₅₀*150/360)/(1+R₉₀*90/360) - 1)*(360/60)

= ((1+5.96%*150/360)/(1+5.12%*90/360) - 1)*(360/60)

= (1.0248/1.0128 - 1)*(360/60)

= 0.0118*(360/60)

= 0.0708 = 7.08%

(1)

(7.13%-6.0%)*(60/360)*$1,275,000/(1+5.96%*150/360)
= 2343.064

(2)

(7.08%-6.0%)*(60/360)*$1,275,000/(1+5.96%*150/360)

= 2239.389

Weighted Average Cost of Capital (WACC)

WACC = (D+PVOL)/(E+D+PVOL) * r_d * (1-t) + E/(E+D+PVOL) * r_e

D: market value of the firm's debt
PVOL: Present value of operating lease
r_d: (pretax) cost of debt = debt yield = interest rate on operating lease (in this case)
t: corporate tax rate

E: market value of the firm's equity

r_e: cost of equity

All-current method and Temporal method

Local currency price: constant
FC: depreciation (vs. DC)

 All-current method and Temporal method

method	Temporal	in DC	All-current
Net income (before translation gains and losses)		<
D/E		<
Gross profit margin = (Revenue - COGS)/Revenue	(A-H)/A	<	(A-A)/A
COGS	H	>	A