CFA pt. 2

LOS 41.b: Describe characteristics of the major asset classes that investors consider in forming portfolios.

As predicted by theory, asset classes with the greatest average returns have also had the highest risk. Some of the major asset classes that investors consider when building a diversified portfolio include small-capitalization stocks, large-capitalization stocks, long-term corporate bonds, long-term treasury bonds, and treasury bills. In addition to risk and return, when analyzing investment, investors also take into consideration an investment's liquidity, as well as non-normal characteristics such as skewness and kurtosis.

LOS 53.c: Describe typical structures of securitizations, including credit tranching and time tranching

Asset-backed securities (ABS) can be a single class of securities or multiple classes with differing claims to the cash flows from the underlying assets. Time tranching refers to classes that receive the principal payments from underlying securities sequentially as each prior tranche is repaid in full. With credit tranching, any credit losses are first absorbed by the tranche with the lowest priority, and after that by any other subordinated tranches, in order. Some structures have both time tranching and credit tranching.

LOS 53.h: Describe types and characteristics of non-mortgage asset-backed securities, including the cash flow risks of each type

Asset-backed securities may be backed by financial assets other than mortgages. Two examples are auto loan ABS and credit card ABS. Auto loan ABS are backed by automobile loans, which are typically fully amortizing but with shorter maturities than residential mortgages. Prepayments result when autos are sold or traded in, stolen or wrecked and paid off from insurance proceeds, refinanced, or paid off from the borrower's excess cash Credit card ABS are backed by credit card receivables, which are revolving debt (non-amortizing). Credit card ABS typically have a lockout period during which only interest is paid to investors and principal payments on the receivables are used to purchase additional receivables.

LOS 49.l: Describe asset-based valuation models and their use in estimating equity value.

Asset-based models value equity as the market of fair value of assets minus liabilities. These models are most appropriate when a firm's assets are largely tangible and have fair values that can be established easily.

LOS 44.b: Describe classification of assets and markets

Assets and markets can be classified as: -Financial assets (e.g. Securities, currencies, derivatives) versus real assets (e.g., real estate, equipment) -Debt securities versus equity securities. -Public securities that trade on exchanges or through dealers versus private securities. -Physical derivative contracts (e.g., on grains or metals) versus financial derivative contracts (e.g., on bonds or equity indexes.) -Spot versus future delivery markets. -Primary markets (issuance of new securities) versus secondary markets (longer-term debt instruments and equities) -Traditional investment markets (bonds, stocks) versus alternative investment markets (e.g., real estate, hedge funds, fine art)

LOS 57.i: Explain how the value of a European option is determined at expiration.

At expiration, the value of a call option is the greater of zero or the underlying asset price minus the exercise price. At expiration, the value of a put option is the greater of zero or the exercise price minus the underlying asset price.

LOS 57.m: Explain put-call-forward parity for European options.

Based on the fact that the present value of an asset's forward price is equal to its spot price, we can substitute the present value of the forward price into the put-call parity relationship at the initiation of a forward contract to establish put-call-forward parity as: c0 + X/(1+Rf)^T = F0(T)/(1+Rf)^T +P0

LOS 50.a: Describe basic features of a fixed-income security

Basic features of a fixed income security include the issuer, maturity date, par value, coupon rate, coupon frequency, and currency -Issuers include corporations, governments, quasi-government entities, and supranatural entities -Bonds with original maturities of one year or less are money market securities. Bonds with original maturities of more than one year are capital market securities. -Par value is the principal amount that will be repaid to bondholders at maturity. Bonds are trading at a premium if their market price is greater than par value or trading at a discount if their price is less than par value. -Coupon rate is the percentage of par value that is paid annually as interest. Coupon frequency may be annual, semiannual, quarterly, or monthly. Zero-coupon bonds pay no coupon interest and are pure discount securities. -Bonds may be issued in a single currency, dual currencies (one currency for interest and another for principal), or with a bondholder's choice of currency

LOS 57.f: Explain why forward and futures prices differ.

Because gains and losses on futures contracts are settled daily, prices of forwards and futures that have the same terms may be different if interest rates are correlated with futures prices. Futures are more valuable than forwards when interest rates and futures prices are positively correlated and less valuable when they are negatively correlated. If interest rates are constant or uncorrelated with futures prices, the prices of futures and forwards are the same.

LOS 46.g: Describe behavioral finance and its potential relevance to understanding market anomalies

Behavioral finance examines whether investors behave rationally, how investor behavior affects financial markets, and how cognitive biases may result in anomalies. Behavioral finance describes investor irrationality but does not necessarily refute market efficiency as long as investors cannot consistently earn abnormal risk-adjusted returns.

LOS 42.e: Calculate and interpret beta

Beta can be calculated using the following equation: βi = [Cov(Ri,Rm)]/σm^2 = Pi,mσi/σm Where [Cov(Ri,Rm)] and Pi,m are the covariance and correlation between the asset and the market, and σi and σm are the standard deviations of asset returns and market returns. The theoretical average beta of stocks in the market is 1. A beta of zero indicates that a security's return is uncorrelated with the returns of the market.

LOS 32. c: Distinguish between conservative and aggressive accounting.

Biased accounting choices that can be made with GAAP include conservative and aggressive accounting. Conservative accounting choices tend to decrease the company's reported earnings and financial position for the current period. Aggressive accounting choices tend to increase reported earnings or improve the financial position for the current period. Some managers employ conservative bias during periods when earnings are above target and aggressive bias during poor periods of below-target earnings to artificially smooth earnings.

LOS 51.c: Describe mechanisms available for issuing bonds in primary markets

Bonds may be issued in the primary market through a public offering or a private placement. A public offering using an investment bank may be underwritten, with the investment bank or syndicate purchasing the entire issue and selling the bonds to dealers; or on a best-efforts basis, in which the investment bank sells the bonds on commission. Public offerings may also take place through auctions, which is the method commonly used to issue government debt. A private placement is the sale of an entire issue to a qualified investor or group of investors, which are typically large institutions.

LOS 51.d: Describe secondary markets for bonds

Bonds that have been issued previously trade in secondary markets. While some bonds trade on exchanges, most are traded in dealer markets. Spreads between bid and ask prices are narrower for liquid issues and wider for less liquid issues. Trade settlement is typically T + 2 or T + 3 for corporate bonds and either cash settlement or T +1 for government bonds.

LOS 31.i: Compare the disclosures relating to finance and operating leases.

Both lessees and lessors are required to disclose useful information about finance leases and operating leases in the financial statements of in the footnotes, including: -General description of the leasing arrangement. -The nature, timing, and amount of payments to be paid or received in each of the next five years. Lease payments after five years can be aggregated. -Amount of lease revenue and expense reported in the income statement for each period presented. -Amounts receivable and unearned revenues from lease arrangements. -Restrictions imposed by lease agreements.

LOS 45.h: Describe types of equity indexes

Broad market equity indexes represent the majority of stocks in a market. Multi-market equity indexes contain the indexes of several countries. Multi-market equity indexes with fundamental weighting use market capitalization weighting for the securities within a country's market but then weight the countries within the global index by a fundamental factor Sector indexes measure the returns for a sector (e.g. health care) and are useful because some sectors do better than others in certain business cycle phases. These indexes are used to evaluate portfolio managers and as models for sector investment funds. Style indexes measure the returns to market capitalization and value or growth strategies. Stocks tend to migrate among classifications, which cause style indexes to have higher constituent turnover than broad market indexes.

LOS 22.a: Describe how business activities are classified for financial reporting purposes.

Business activities are classified as operating activities if they are part of a firm's ordinary business, investing activities if they involve buying or disposing of long-term assets, or financing activities if they are to issue or repay debt, issue or repurchase stock, or pay cash dividends.

LOS 35.b: Describe the basic principles of capital budgeting

Capital budgeting decisions should be based on incremental after-tax cash flows, the expected differences in after-tax cash flows if a project is undertaken. Sunk (already incurred) costs are not considered, but externalities and cash opportunity costs must be included in project cash flows.

LOS 35.a: Describe the capital budgeting process and distinguish among various categories of capital projects

Capital budgeting is the process of evaluating capital projects, projects with cash flows over more than a year The four steps of the capital budgeting process are: (1) Generate investment ideas; (2) Analyze project ideas; (3) Create firm-wide capital budget; and (4) monitor decisions and conduct a post-audit. Categories of capital projects include: (1) Replacement projects for maintaining business or for cost reduction; (2) Expansion projects; (3) New product or market development; (4) Mandatory projects to meet environmental or regulatory requirements; (5) other projects, such as research and development or pet projects of senior management.

LOS 53.d: Describe types and characteristics of residential mortgage loans that are typically securitized

Characteristics of residential mortgage loans include: -Maturity -Interest rate: fixed-rate, adjustable-rate, or convertible -Amortization: full, partial, or interest-only Prepayment penalties -Foreclosure provisions: recourse or non -recourse. The loan-to-value (LTV) ratio indicates the percentage of the value of the real estate collateral that is loaned. Lower LTVs indicate less credit risk.

LOS 53.i: Describe collateralized debt obligations, including their cash flows and risks

Collateralized debt obligations (CDOs) are structured securities backed by a pool of debt obligations that is managed by a collateral manager. CDOs include: -Collateralized bond obligations (CBOs) backed by corporate and emerging market debt. -collateralized loan obligations (CLOs) backed by leveraged bank loans. -Structured finance CDOs backed by residential or commercial MBS, ABS, or other CLOs -synthetic CDOs backed by credit default swaps on structured securities.

LOS 53.g: describe characteristics and risks of commercial mortgage-backed securities

Commercial mortgage-backed securities (CMBS) are backed by mortgages on income-producing real-estate properties. Because commercial mortgages are non-recourse loans, analysis of CMBS focuses on credit risk of the properties. CMBS are structured in tranches with credit losses absorbed by the lowest priority tranches in sequence. Call (prepayment) protection in CMBS includes loan-level call protection such as prepayment lockout periods, defeasance, prepayment penalty points, and yield maintenance charges, and CMBS-level call protection provided by the lower-priority tranches.

Commodities

Commodities The most common way to invest in commodities is with derivatives. Other methods include exchange-traded funds, equities that are directly linked to a commodity, managed futures funds, individual managed accounts, and specialized funds in specific commodity sectors. Beyond the potential for higher returns and lower volatility benefits to a portfolio, commodity as an asset class may offer inflation protection. Commodities can offset inflation, especially if commodity prices are used to determine inflation indices. Spot prices for commodities are a function of supply and demand. Global economics, production costs, and storage costs, along with value to user, all factor into prices.

LOS 47.a: Describe characteristics of types of equity securities.

Common shareholders have a residual claim on firm assets and govern the corporation through voting rights. Common shares have variable dividends which the firm is under no legal obligation to pay. Callable common shares allow the firm the right to repurchase the shares at a pre-specified price. Putable common shares give the shareholder the right to sell the shares bak to the firm at a pre-specified price. Preferred stock typically does not mature, does not have voting rights, and has dividends that are fixed in amount but are not a contractual obligation of the firm. Cumulative preferred shares require any dividends that were missed in the past (dividends in arrears) to be paid before common shareholders receive any dividends. Participating preferred shares receive extra dividends if firm profits exceed a pre-specified level and a value greater than the par value if the firm is liquidated. Convertible preferred stock can be converted into common stock at a pre-specified conversion ratio.

LOS 38.e: Calculate and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company's short-term investment policy guidelines.

Commonly used annualized yields for short-term pure discount securities are based on the days to maturity (days) of the securities and include: -Discount-basis yields = % discount from face value * (360/days) -Money market yields = HPY * (360/days) -Bond equivalent yields = HPY * (365/days) The overall objective of short-term cash management is to earn a reasonable return while taking on only very limited credit and liquidity risk. Returns on the firm's short-term securities investments should be stated as bond equivalent yields. The return on the portfolio should be expressed as a weighted average of these yields. An investment policy statement should include the objective of the cash management program, details of who is authorized to purchase securities, authorization for the purchase of specific types of securities, limitations on portfolio proportions of each type, and procedures in the event that guidelines are violated.

LOS 48.k: Describe the elements that should be covered in a thorough company analysis.

Company analysis should include an overview of the firm, industry characteristics, and analysis of product demand, product costs, the pricing environment, the firm's financial ratios, and projected financial statements and firm valuation. The analysis should describe the company's competitive strategy. Companies can employ a cost leadership (low-cost) strategy or a product or service differentiation strategy. A cost leadership firm seeks to have the lowest cost of production in the industry, offers the lowest price, and generate enough volume to make a superior return. A differentiation firm's products and services should be distinctive in terms of type, quality, or delivery.

LOS 47.c: distinguish between public and private equity services.

Compared to publicly traded firms, private equity firms have lower reporting costs, greater ability to focus on long-term prospects, and potentially greater return for investors once the firm goes public, However, private equity investments are illiquid, firm financial disclosure may be limited, and corporate governance may be weaker.

LOS 31.f: Explain motivations for leasing assets instead of purchasing them

Compared to purchasing an asset, leasing may provided the lessee with less costly financing, reduce the risk of obsolescence, and include less restrictive provisions than a typical loan. Synthetic leases provide tax advantages and keep the lease liability off the balance sheet.

LOS 28.l: Analyze and compare the financial statements of companies, including companies that use different inventory methods.

Comparison of company financial statements may require statements to be adjusted to reflect the same inventory costing methods for both firms, or for the subject firm and any industry or peer group of firms used for comparison.

LOS 55.f: Explain the four Cs (Capacity, Collateral, Covenants, and Character) of traditional credit analysis

Components of traditional credit analysis are known as the four Cs: -Capacity: the borrower's ability to make timely payments on its debt -Collateral: The value of assets pledged against a debt issue or available to creditors if the issuer defaults -Covenants: Provisions of a bond issue that protect creditors by requiring or prohibiting actions by an issuer's management -Character: Assessment of an issuer's management, strategy, quality of earnings, and past treatment of bondholders.

LOS 24.l: Describe, calculate, and interpret comprehensive income

Comprehensive income is the sum of net income and other comprehensive income. It measures all changes to equity other than those from transactions with shareholders.

LOS 32.e: Describe conditions that are conductive to issuing low-quality, or even fraudulent, financial reports.

Conditions that are often present when managers issue low-quality financial reports include motivations, opportunities, and rationalizations. Weak internal controls, inadequate oversight by the board of directors, and wide ranges of acceptable accounting treatments are among the factors that may provide opportunities for low quality reporting.

LOS 54.h: Calculate and interpret approximate convexity and distinguish between approximate and effective convexity

Convexity refers to the curvature of a bond's price-yield relationship Approximate convexity = V(-)+V(+)-2V / (∆YTM)^2 *V0 Effective convexity is appropriate for bonds with embedded options: Approximate effective convexity = V(-)+V(+)-2V / (∆curve)^2 *V0

LOS 55.i: Describe factors that influence the level and volatility of yield spreads

Corporate bond yields comprise the real risk-free rate, expected inflation rate, credit spread, maturity premium, and liquidity premium. An issue's yield spread to its benchmark includes its credit spread and liquidity premium. The level and volatility of yield spreads are affected by the credit and business cycles, the performance of financial markets as a whole, availability of capital from broker-dealers, and supply and demand for debt issues. Yield spreads tend to narrow when the credit cycle is improving, the economy is expanding, and financial markets and investor demand for new debt issues are strong. Yield spreads tend to widen when the credit cycle, the economy, and financial markets are weakening, and in periods when the supply of new debt issues is heavy or broker-dealer capital is insufficient for market making.

LOS 55.c: Describe seniority rankings of corporate debt and explain the potential violation of the priority of claims in a bankruptcy proceeding

Corporate debt is ranked by seniority or priority of claims. Secured debt is a direct claim on specific firm assets and has priority over unsecured debt. Secured or unsecured debt may be further ranked as senior or subordinated. Priority of claims may be summarized as follows: -First mortgage or first lien -Second or subsequent lien -Senior secured debt -senior unsecured debt -Senior subordinated debt -Subordinated debt -Junior subordinated debt.

LOS 34.a: Describe corporate governance.

Corporate governance refers to the internal controls and procedures of a company that delineate the rights and responsibilities of various groups and how conflicts of interest among the various groups are to be resolved.

LOS 50.c: Compare affirmative and negative covenants and identify examples of each

Covenants are provisions of a bond indenture that protect the bondholders' interests. Negative covenants are restrictions on a bond issuer's operating decisions, such as prohibiting the issuer from issuing additional debt or selling the assets pledged as collateral. Affirmative covenants re administrative actions the issuer must perform, such as making the interest and principal payments on time.

LOS 33.c: Describe the role of financial statement analysis in assessing the credit quality of a potential debt investment

Credit analysis uses a firm's financial statements to asses its credit quality. Indicators of a firm's creditworthiness include its scale and diversification, operational efficiency, margin stability, and use of financial leverage.

LOS 55.g: Calculate and interpret financial ratios used in credit analysis

Credit analysts use profitability, cash flow, and leveraged and coverage ratios to assess debt issuers' capacity. -Profitability refers to operating income and operating profit margin, with operating income typically defined as earnings before interest and taxes (EBIT) -Cash flow may be measured as earnings before interest, taxes, depreciation, and amortization (EBITDA); funds from operations (FFO); free cash flow before dividends; or free cash flow after dividends -Leverage ratios include debt-to-capital, debt-to-EBITDA, and FFO-to-debt. -Coverage ratios include EBIT-to-interest expense and EBITDA-to-interest expense

LOS 55.b: Describe default probability and loss severity as components of credit risk

Credit risk is composed of default risk, which is the probability of default, and loss severity, which is the portion of the value of a bond or loan a lender or investor will lose if the borrower defaults. The expected loss is the probability of default multiplied by the loss severity.

LOS 55.a: Describe credit risk and credit-related risks affecting corporate bonds

Credit risk refers to the possibility that a borrower fails to make the scheduled interest payments or return of principal. Spread risk is the possibility that a bond loses value because its credit spread widens relative to its benchmark. Spread risk includes credit migration or downgrade risk and market liquidity risk.

LOS 31.d: Describe the role of debt covenants in protecting creditors.

Debt covenants are restrictions on the borrower that protect the bondholders' interests, thereby reducing both the default risk and the borrowing costs. Covenants can include restrictions on dividend payments and share repurchases; mergers and acquisitions; sale, leaseback, and disposal of certain assets; and issuance of new debt in the future. Other covenants require the firm to maintain ratios or financial statement items at specific levels.

LOS 51.g: Describe types of debt issued by corporations.

Debt issued by corporations includes bank debt, commercial paper, corporate bonds, and medium-term notes Bank debt includes bilateral loans from a single bank and syndicated loans from multiple banks. Commercial paper is a money market instrument issued by corporations of high credit quality. Corporate bonds may have a term maturity structure (all bonds in an issue mature at the same time) or a serial maturity structure (bonds in an issue mature on a predetermined schedule) and may have sinking fund provision. Medium-term notes are corporate issues that can be structured to meet the requirements of investors.

LOS 45.c: Describe the choices and issues in index construction and management.

Decisions that index providers must make when constructing and managing indexes include: -The target market the index will measure -Which securities from the target market to include -The appropriate weighting method -How frequently to rebalance the index to its target weights -How frequently to re-examine the selection and weighting of securities

LOS 56.d: Describe purposes of, and controversies related to, derivative markets.

Derivative markets are criticized for their risky nature. However, many market participants use derivatives to manage and reduce existing risk exposures. Derivative securities play an important role in promoting efficient market prices and reducing transaction costs.

LOS 49.b: Describe major categories of equity valuation models

Discounted cash flow models estimate the present value of cash distributed to shareholders (dividend discount models) or the present value of cash available to shareholders after meeting capital expenditures and working capital expenses (free cash flow to equity models) Multiplier models compare the stock price to earnings, sales, book value, or cash flow. Alternatively, enterprise value is compared to sales or EBITDA Asset-based models define a stock's value as the firm's total asset value minus liabilities and preferred stock, on a per-share basis.

LOS 49.d: Describe dividend payment chronology

Dividend payment chronology: -Declaration date: The date the board of directors approves payment of the dividend. -Ex-dividend date: The first day a share of stock trades without the dividend, one or two business days before the holder-of-record date. On the ex-dividend date, the value of each share decreases by the amount of the divided. -Holder-of-record date: the date on which share owners who will receive the dividend are identified -Payment date: The date the dividend checks are sent to, or payment is transferred to, shareholders.

LOS 54.c: Explain why effective duration is the most appropriate measure of interest rate risk for bonds with embedded options

Effective duration is the appropriate measure of interest rate risk for bonds with embedded options because changes in interest rates may change their future cash flows. Pricing models are used to determine the prices that would result from a given size change in the benchmark yield curve.

LOS 34.i: Describe factors relevant to the analysis of corporate governance and stakeholder management.

Elements of corporate governance that analysts have found to be relevant include ownership and voting structures, board composition, management remuneration, the composition of shareholders, strength of shareholder rights, and managements of long-term risks.

LOS 50.f: Describe contingency provisions affecting the timing and/or nature of cash flows of fixed-income securities and identify whether such provisions benefit the borrower or the lender

Embedded options benefit the party who has the right to exercise them. Call options benefit the issuer, while put options and conversion options benefit the bondholder Call options allow the issuer to redeem bonds a4t a specified call price. Put options allow the bondholder to sell bonds back to the issuer at a specified put price. Conversion options allow the bondholder to exchange bonds for a specified number of shares of the issuer's common stock.

LOS 49.k: Describe enterprise value multiples and their use in estimating value equity

Enterprise value (EV) measures total company value: EV = market value of common and preferred stock + market value of debt - cash and short-term investments EBITDA is frequently used as the denominator in EV multiples because EV represents total company value, and EBITDA represents earnings available to all investors.

LOS 47.e: Compare the risk and return characteristics of different types of equity securities

Equity investor returns consist of dividends, capital gains or losses from changes in share prices, and any foreign exchange gains or losses on shares traded in a foreign currency. Compounding of reinvested dividends has been an important part of an equity investor's long-term return. Preferred stock is less risky than common stock because preferred stock pays a known, fixed dividend to investors; preferred stockholders must receive dividends before common stock dividends can be paid; and preferred stockholders have a claim equal to the par value if the firm is liquidated. Putable shares are the least risky and callable shares are the most risky. Cumulative preferred shares are less risky than non-cumulative preferred shares, as any dividends missed must be paid before a common stock dividend can be paid.

LOS 47.f: Explain the role of equity securities in the financing of a company's assets.

Equity securities provide funds to the firm to buy productive assets, to buy other companies, or to offer to employees as compensation. Equity securities provide liquidity that may be important when the firm must raise additional funds.

LOS 44.g: Compare execution, validity, and clearing instructions.

Execution instructions specify how to trade. Market orders and limit orders are examples of execution instructions. Validity instructions specify when an order can be filled. Day orders, good-til-cancelled orders, and stop orders are examples of validity instructions. Clearing instructions specify how to settle a trade.

LOS 34.g: Describe market and non-market factors that can affect stakeholder relationships and corporate governance.

Factors that can affect stakeholder relationships and corporate governance include: -Communication and engagement with shareholders -Shareholder activism -threat of hostile takeover and existence of anti-takeover provisions. -Company's legal environment Growth of firms that advise funds on proxy voting and rate companies' corporate governance.

LOS 57.k: Identify the factors that determine the value of an option and explain how each factor affects the value of an option.

Factors that determine the value of an option: Increase in-Calloption values-put option values Price of underlying asset-increase-decrease exercise price-decrease-increase riskfree rate-increase-decrease volatility of underlying asset-increase-increase time to expiration-increase-increase(except some european puts) Costs of holding underlying asset-increase-decrease benefits of holding underlying asset-decrease-increase

LOS 44.d: Describe types of financial intermediaries and services they provide.

Financial intermediaries perform the following roles: -Brokers, exchanges, and alternative trading systems connect buyers and sellers of the same security at the same location and time. They provide a centralized location for trading. -Dealers match buyers and sellers of the same security at different points in time. -Arbitrageurs connect buyers and sellers of the same security at the same time but in different venues. They also connect buyers and sellers of non-identical securities of similar risk. -Securitizeurs and depository institutions package assets into a diversified pool and sell interests in it. Investors obtain greater liquidity and choose their desired risk level. -Insurance companies create a diversified pool of risks and manage the risk inherent in providing insurance. -Clearinghouses reduce counterparty risk and promote market integrity.

LOS 32.a: Distinguish between financial reporting quality and quality of reported results (including quality of earnings, cash flow, and balance sheet items).

Financial reporting quality refers to the characteristics of a firm's financial statements. High-quality financial reporting adheres to generally accepted accounting principles(GAAP) and is decision useful in terms of relevance and faithful presentation. Quality of reported results refers to the level and sustainability of a firm's earnings, cash flows, and balance sheet items. High-quality earnings are high enough to provide the firm's investors with an adequate return and are sustainable in future periods.

LOS 40.f: Identify financial and non-financial sources of risk and describe how they may interact.

Financial risks are those that arise from exposure to financial markets, including credit risk, liquidity risk, and market risk. Non-financial risks are the risks from the operation of the organization and from sources external to the organization. Individuals face mortality and longevity risk, in addition to financial risks. Interactions among risks are frequent and can be especially significant during periods of stress in financial markets.

LOS 48.b: Compare methods by which companies can be grouped, current industry classification systems, and classify a company, given a description of its activities and the classification system

Firms can be grouped into industries according to their products and services or business cycle sensitivity, or through statistical methods that group firms with high historical correlation in returns Industry classification systems from commercial providers include the Global Industry Classification Standard (Standard & Poor's and MSCI Barra), Russell Global Sectors, and the industry Classification Benchmark (Dow Jones and FTSE) Industry classification systems developed by government agencies include the International Standard Industrial Classification (ISIC), the North American Industry Classification System (NAICS), and systems designed for the European Union and Australia/New Zealand.

LOS 32.g: Describe presentation choices, including non-GAAP measures, that could be used to influence an analyst's opinion.

Firms may attempt to influence analysts' valuations by presenting non-GAAP measures, such as earnings that exclude certain non-recurring items, IFRS requires firms to define and explain the relevance of any non-GAAP measures and reconcile them to the most comparable IFRS measure. Similar requirements apply to US public firms.

LOS 45.i: Describe types of fixed-income indexes

Fixed income indexes can be classified by issuer, collateral, coupon, maturity, credit risk (e.g., investment grade vs. High-yield), and inflation protection. They can be delineated as broad market, sector, style, or other specialized indexes. Indexes exist for various sectors, regions, and levels of deployment. The fixed income security universe is much broader than the equity universe, and fixed income indexes have higher turnover. index providers must depend on dealers for fixed income security prices, and the securities are often illiquid. Fixed income security indexes vary widely in their numbers of constituent securities and can be difficult and expensive to replicate.

LOS 41.g: Describe and interpret the minimum-variance and efficient frontiers of risky assets and the global minimum-variance portfolio.

For each level of expected portfolio return, the portfolio that has the least risk is known as a minimum-variance portfolio. Taken together, these portfolios form a line called the minimum variance frontier. On a risk versus return graph, the one risky portfolio that is farthest to the left (has the least risk) is know as the global minimum-variance portfolio Those portfolios that have the greatest expected return for each level of risk make up the efficient frontier. The efficient frontier coincides with the top portion of the minimum variance frontier. Risk-averse investors would only choose a portfolio that lies on the efficient frontier.

LOS 56.c: Define forward contracts, futures contracts, option (call and puts), swaps, and credit derivatives and compare their basic characteristics.

Forward contracts obligate one party to buy, and another to sell, a specific asset at a specific price at a specific time in the future. Interest rate swaps contracts are equivalent to a series of forward contracts on interest rates. Futures contracts are much like forward contracts, but are exchange-traded, liquid, and require daily settlement of any gains or losses. A call option gives the holder the right, but not the obligation, to buy an asset at a specific price at some time in the future. A put option gives the holder the right, but not the obligation, to sell an asset at a specific price at some time in the future. A credit derivative is a contract that provides a payment if a specified credit event occurs.

LOS 52.h: Define forward rates and calculate spot rates from forward rates, forward rates from spot rates, and the price of a bond using forward rates.

Forward rates are current lending/borowing rates for short-term loans to be made in future periods. A spot rate for a maturity of N periods is the geometric mean of forward rates over the N periods. The same relation can be used to solve for a forward rate given spot rates for two different periods. To value a bond using forward rates, discount the cash flows at times 1 through N by the product of one plus each forward rate for periods 1 to N, and sum them. For a 3-year annual-pay bond: Price = coupon/(1+S1) + coupon/ (1+S1)(1+1y1y) + (coupon+principal)/ (1+S1)(1+1y1y)(1+2y1y)

LOS 54.i: Estimate the percentage price change of a bond for a specified change in yields, given the bond's approximate duration and convexitiy

Given values for approximate annual modified duration and approximate annual convexity, the percentage change in the full price of a bond can be estimated as: %∆full bond price = -annual modified duration(∆YTM) + .5annual convexity(∆YTM)^2

LOS 51.a: Describe classifications of global fixed-income markets

Global bond markets can be classified by -Type of issuer: Government (and government-related), corporate (financial and nonfinancial), securitized. -Credit quality: Investment grade, non-investment grade. -Original maturity: money market (one year or less), capital market (more than one year) -Coupon: fixed rate, floating rate -Currency and Geography: Domestic, foreign, global, eurobond markets; developed, emerging markets -Other classifications: Indexing, taxable status.

LOS 58.d: Describe hedge funds, private equity, real estate, commodities, infastructure, and other alternative investments, including, as applicable, strategies, sub-categories, potential benefits and risks, ffee structures, and due diligence.

Hedge Funds -Event-driven strategies include merger arbitrage, distressed/restructuring, activist shareholder and special situations. -relative value strategies seek profits from unusual pricing issues -macro hedge strategies are "top down' strategies based on global economic trends -Equity hedge strategies are "bottom up" strategies that take long and short positions in equities and equity derivatives. Strategies include market neutral, fundamental growth, fundamental value, quantitative directional, short bias, and sector specific. In periods of financial crisis, the correlation of returns between global equities and hedge funds tends to increase, which limits hedge funds' effectiveness as a diversifying asset class Due diligence factors for hedge funds are investment strategy, investment process, competitive advantages, track record, longevity of fund, and size (assets under management). Other qualitative factors include management style, key person risk, reputation, investor relations, growth plans, and management of systematic risk.

LOS 58.b: Describe categories of alternative investments

Hedge funds are investment companies that use a variety of strategies and may be highly leveraged, use long and short positions, and use derivatives. Private equity funds usually invest in the equity of private companies or companies wanting to become private, financing their assets with high levels of debt. This category also includes venture capital funds, which provide capital to companies early in their development. real estate as an asset class includes residential and commercial real estate, individual mortgages, and pools of mortgages or properties. it includes direct investment in single properties or loans as well as indirect investment in limited partnerships, which are private securities, and mortgage-backed securities and real estate investment trusts, which are publicly traded. Commodities refers to physical assets such as agricultural products, metals, oil and gas, and other raw materials used in production. Commodities market exposure can provide an inflation hedge and diversification benefits. Infrastructure refers to long-lived assets that provide public services and are often built or operated by governments. various types of collectibles, such as cars, wines, and art are considered alternative investments as well.

LOS 58.f: Describe issues in valuing and calculating returns on hedge funds, private equity, real estate, commodities, and infrastructure.

Hedge funds often invest in securities that are not actively traded and must estimate their values, and invest in securities that are illiquid relative to the size of a hedge fund's position. hedge funds may calculate a trading NAV that adjusts for the illiquidity of these securities. A private equity portfolio company may be valued using a market/comparables approach (multi-based approach), a discounted cash flow approach, or an asset-based approach. real estate property valuation approaches include the comparable sales approach, the income approach (multiples or discounted cash flows), and the cost approach. REITs can be valued using an income-based approach or an asset-based approach A commodity futures price is approximately equal to the spot price compounded at the risk-free rate, plus storage cost, minus the convenience yield.

LOS 48.g: Explain the effects of barriers to entry, industry concentration, industry capacity, and market share stability on pricing power and price competition.

High barriers to entry prevent new competitors from taking away market share, but they do not guarantee pricing power on high return on capital, especially if the products are undifferentiated or barriers to exit result in overcapacity. Barriers to entry may change over time. While market fragmentation usually results in strong competition and low return on capital, high industry concentration may not guarantee pricing power. If industry products are undifferentiated, consumers will switch to the cheapest producer. Overcapacity may result in price wars. Capacity is fixed in the short run and variable in the long run. Under capacity typically results in pricing power. Producers may over-invest in new capacity, especially in cyclical industries or if the capacity is physical and specialized. Non-physical capacity comes into production and can be reallocated more quickly than physical capacity. Highly variable market shares indicate a highly competitive industry. Stable market shares suggest less intense competition. High switching costs contribute to market share stability.

LOS 55.j: Explain special considerations when evaluating the credit of high yield, sovereign, and non-sovereign government debt issuers and issues

High yield bonds are more likely to default than investment grade bonds, which increases the importance of estimating loss severity. Analysis of high yield debt should focus on liquidity, protected financial performance, the issuer's corporate and debt structures, and debt covenants. Credit risk of sovereign debt includes the issuing country's ability and willingness to pay. Ability to pay is greater for debt issued in the country's own currency than for debt issued in foreign currency. Willingness refers to the possibility that a country refuses to repay its debts. Analysis of non-sovereign government debt is similar to analysis of sovereign debt, focusing on the strength of the local economy and its effect on tax revenues. Analysis of municipal revenue bonds is similar to analysis of corporate debt, focusing on the ability of a project to generate sufficient revenue to service the bonds.

LOS 54.e: Explain how a bond's maturity, coupon, and yield level affect its interest rate risk

Holding other factors constant: -Duration increases when maturity increases -Duration decreases when the coupon rate increases -Duration decreases when YTM increases.

LOS 41.a: Calculate and interpret major return measures and describe their appropriate uses.

Holding period return is used to measure an investment's return over a specific period. Arithmetic mean return is the simple average of a series of periodic returns. Geometric mean return is a compound annual rate Money-weighted rate of return is the IRR calculated using periodic cash flows into and out of an account and is the discount rate that makes the present value of cash inflows equal to the present value of cash outflows Gross return is total return after deducting commissions on trades and other costs necessary to generate the returns, but before deducting fees for the and administration of the investment account. Net return is the return after management and administration fees have been deducted. Pretax nominal return is the numerical percentage return of an investment, without considering the effects of taxes and inflation. After-tax nominal return is the numerical return after the tax liability is deducted, without adjusting for inflation. Real return is the increase in an investor's purchasing power, roughly equal to nominal return minus inflation. Leveraged return is the gain or loss on an investment as a percentage of an investor's cash investment

LOS 57.d: Describe monetary and nonmonetary benefits and costs associated with holding the underlying asset and explain how they affect the value and price of a forward contract.

If holding an asset has costs and benefits, the no-arbitrage forward price is: F0(T) = [S0+PV0(cost) - PV0(benefit)](1+Rf)^T The present values of the costs and benefits decrease as time passes. The value of the forward at time t is: Vt(T) = St+PVt(cost) - PVt(benefit) - F0(T)/ (1+Rf)^(T-t) At expiration the costs and benefits of holding the asset are zero and do not affect the value a long forward position, which is ST-F0(T)

LOS 57.j: Explain the exercise value, time value, and moneyness of an option.

If immediate exercise of an option would generate a positive payoff, the option is in the money. If an immediate exercise would result in a negative payoff, the option is out of the money. An option's exercise value is the greater of zero or the amount it is in the money. Time value is the amount by which an option's price is greater than its exercise value. Time value is zero at expiration.

LOS 30.g: Describe the valuation allowance for deferred tax assets - when it is required and what effect it has on financial statements

If it is more likely than not that some or all of a DTA will not be realized (because of insufficient future taxable income to recover the tax asset), then the DTA must be reduced by a valuation allowance. The valuation allowance is a contra account that reduces the DTA value on the balance sheet. Increasing the valuation allowance will increase income tax expense and reduce earnings. If circumstances change, the DTA can be revalued upward by decreasing the valuation allowance, which would increase earnings.

LOS 46.e: Explain the implications of each form of market efficiency for fundamental analysis, technical analysis, and the choice between active and passive portfolio management

If markets are weak-form efficient, technical analysis does not consistently result in abnormal profits. If markets are semi-strong form efficient, fundamental analysis does not consistently result in abnormal profits. However, fundamental analysis is necessary if market prices are to be semi-strong form efficient. If markets are strong-form efficient, active investment management does not consistently result in abnormal profits. Even if markets are strong-form efficient, portfolio managers can add value by establishing and implementing portfolio risk and return objectives and assisting with portfolio diversification, asset allocation, and tax minimization.

LOS 30.d: Calculate income tax expense, income taxes payable, deferred tax assets, and deferred tax liabilities, and calculate and interpret the adjustment to the financial statements related to a change in the income tax rate.

If taxable income is less than pretax income and the cause of the difference is expected to reverse in future years, a DTL is created. If taxable income is greater than pretax income and the difference is expected to reverse in future years, a DTA is created The balance of the DTA or DTL is equal to the difference between the tax base and the carrying value of the asset or liability, multiplied by the tax rate. Income tax expense and taxes payable are related through the change in the DTA and the change in the DTL: income tax expense = taxes payable + ∆DTL - ∆DTA

LOS 57.c: Explain how the value and price of a forward contract are determined at expiration, during the life of the contract, and at initiation.

If there are no costs or benefits from holding the underlying asset, the forward price of an asset to be delivered at time T is: F0(T) = S0 (1+Rf)^T The value of a forward contract is zero at initiation. During its life, at time t, the value of the forward contract is: Vt(T) = St - F0(T)/(1+Rf)^T-t. At expiration, the payoff to a long forward is ST-F0(T), the difference between the spot price of the asset at expiration and the price of the forward contract.

LOS 39.c: Describe defined contribution and defined benefit pension plans.

In a defined contribution plan, the employer contributes a certain sum each period to the employees's retirement account. The employer makes no promise regarding the future value of the plan assets; thus, the employee assumes all of the investment risk. In a defined benefit plan, the employer promises to make periodic payments to the employee after retirement because the employee's future benefit is defined, the employer assumes the investment risk.

LOS 57.g: Explain how swap contracts are similar but different from a series of forward contracts.

In a simple interest-rate swap, one party pays a floating rate and the other pays a fixed rate on a notional principal amount. The first payment is known at initiation and the rest of the payments are unknown. the unknown payments are equivalent to the payments on off-market FRAs. To replicate a swap with a value of zero at initiation, the sum of the present values of these FRAs must equal zero.

LOS 46.a: Describe market efficiency and related concepts, including their importance to investment practitioners

In an informationally efficient capital market, security prices reflect all available information, fully, and rationally. the more efficient a market is, the quicker its reaction will be to new information. Only unexpected information should elicit a response from traders. If the market is fully efficient, active investment strategies cannot earn positive risk-adjusted returns consistently, and investors should therefore use a passive strategy

LOS 45.f: Describe rebalancing and reconstitution of an index

Index providers periodically rebalance the weights of the constituent securities. this is most important for equal-weighted indexes. Reconstitution refers to changing the securities that are included in an index. This is necessary when securities mature or when they no longer have the required characteristics to be included.

LOS 45.g: Describe uses of security market indexes

Indexes are used for the following purposes: -Reflection of market sentiment -Benchmark of manager performance -Measure of market return -Measure of beta and excess return -Model portfolio for index funds

LOS 45.j: Describe indexes representing alternative investments

Indexes have been developed to represent markets for alternative assets such as commodities, real estate, and hedge funds. Issues in creating commodity indexes include the weighting method (different indexes can have vastly different commodity weights and resulting risk and return) and the fact that commodity indexes are based on the performance of commodity futures contracts, not the actual commodities, which can result in different performance for a commodity index versus the actual commodity. Real estate indexes include appraisal indexes, repeat property sales indexes, and indexes of real estate investment trusts. Because hedge funds report their performance to index providers voluntarily, the performance of different hedge fund indexes can vary substantially and index returns have an upward bias.

LOS 48.a: Explain uses of industry analysis and the relation of industry analysis to company analysis

Industry analysis is necessary for understanding a company's business environment before engaging in analysis of the company. The industry environment can provide information about the firm's potential growth, competition, risks, appropriate debt levels, and credit risk. Industry valuation can be used in an active management strategy to determine which industries to overweight or underweight in a portfolio. Industry representation is often a component in a performance attribution analysis of a portfolio's return.

LOS 22.g: Describe the flow of information in an accounting system.

Information enters an accounting system as journal entries, which are sorted by account into a general ledger. Trial balances are formed at the end of an accounting period. Accounts are then adjusted and presented in financial statements.

Infrastructure

Infrastructure Infrastructure investments may be classified as greenfield (assets to be built) or brownfield (existing asset) Liquidity is low for direct investments in infrastructure because the assets are long-lived and tend to be large-scale. however, some liquid investment vehicles exist that are backed by infrastructure assets.

LOS 51.b: Describe the use of interbank offered rates as reference rates in floating-rate debt.

Interbank lending rates, such as London interbank Offered Rate (Libor), are frequently used as reference rates for floating-rate debt. An appropriate reference rate is one that matches a floating-rate note's currency and frequency of rate resets, such as 6-month U.S. dollar Libor for a semiannual floating-rate note issued in U.S. dollars.

LOS 31.b: Describe the effective interest method and calculate interest expense, amortization of bond discounts/premiums, and interest payments.

Interest expense includes amortization of any discount or premium at issuance. Using the effective interest rate method, interest expense is equal to the book value of the bond liability at the beginning of the period multiplied by the bond's yield at issuance. For a premium bond, interest expense is less than the coupon payment (yield< coupon rate). The difference between interest expense and the coupon payment is subtracted from the bond liability on the balance sheet. For a discount bond, interest expense is greater than the coupon payment (yield>Coupon rate). The difference between interest expense and the coupon payment is added to the bond liability on the balance sheet.

LOS 36.b: Describe how taxes affect the cost of capital from different capital sources

Interest expense on a firm's debt is tax deductible, so the pre-tax cost of debt must be reduced by the firm's marginal tax rate to get an after-tax cost of debt capital: after-tax cost of debt=kd(1-firm's marginal tax rate) The pre-tax and after-tax capital costs are equal for both preferred stock and common equity because dividend paid by the firm are not tax deductible.

LOS 28.b: Describe different inventory valuation methods (cost formulas).

Inventory cost flow methods: -FIFO: the cost of the first item purchased is the cost of the first item sold, Ending inventory is based on the cost of the most recent purchases, thereby approximating current cost. -LIFO: the cost of the last item purchased is the cost of the first item sold. Ending inventory is based on the cost of the earliest items purchased. LIFO is prohibited under IFRS. -Weighted average cost: COGS and inventory values are between their FIFO and LIFO values. -Specific identification: Each unit sold is matched with the unit's actual cost.

LOS 43.e: Describe the investment constraints of liquidity, time horizon, tax concerns, legal and regulator factors, and unique circumstances thad their implications for the choice of portfolio assets.

Investment constraints include: -Liquidity--The need to draw cash from the portfolio for anticipated or unexpected future spending needs. High liquidity needs often translate to a high portfolio allocation to bonds or cash. -Time Horizon-- Often the period over which assets are accumulated and before withdrawals begin. Risky or illiquid investments may be inappropriate for an investor with a short time horizon. -Tax considerations-- Concerns the tax treatments of the investor's various accounts, the relative tax treatment of capital gains and income, and the investor;s marginal tax bracket. -Legal and regulatory-- Constraints such as government restrictions on portfolio contents or laws against insider trading. -Unique circumstances-- Restrictions due to investor preferences (religious, ethical etc.) or other factors not already considered.

LOS 47.d: Describe methods for investing in non-domestic equity securities.

Investors who buy foreign stock directly on a foreign stock exchange receive a return denominated in a foreign currency, must abide by the foreign stock exchange's regulations and procedures, and may be faced with less liquidity and less transparency than is available in the investor's domestic markets. Investors can often avoid these disadvantages by purchasing depository receipts for the foreign stock that trade on their domestic exchange. Global depository receipts re issued outside the United States and outside the issuer's home country. American depository receipts are denominated in U.S. dollars and are traded on U.S. exchanges. Global registered shares are common shares of a firm that trade in different currencies on stock exchanges throughout the world. Baskets of listed depository receipts are exchange-traded funds that invest in depository receipts.

LOS 55.d: Distinguish between corporate issuer credit ratings and issue credit ratings and describe the rating agency practice of "notching"

Issuer credit ratings, or corporate family ratings, reflect a debt issuer's overall creditworthiness and typically apply to a firm's senior unsecured debt. Issue credit ratings, or corporate credit ratings, reflect the credit risk of a specific debt issue. Notching refers to the practice of adjusting an issue credit rating upward or downward from the issuer credit rating to reflect the seniority and other provisions of debt issue.

LOS 54.d: Define key rate duration and describe the use of key rate durations in measuring the sensitivity of bonds to changes in the shape of the benchmark yield curve.

Key rate duration is a measure of the price sensitivity of a bond or a bond portfolio to a change in the spot rate for a specific maturity. We can use the key rate durations of a bond or portfolio to estimate its price sensitivity to changes in the shape of the yield curve.

Know these terms: -Gross profits -operating profits -net income -total capital -total capital

Know these terms: -Gross profits = net sales - COGS -operating profits = Earnings Before taxes = EBIT -net income = Earnings after taxes but before dividends -total capital = long-term debt + short-term debt + common and preferred equity -total capital = total assets

LOS 46.c: Explain factors that affect a market's efficiency

Large numbers of market participants and greater information availability tend to make markets more efficient. Impediments to arbitrage and short selling of high costs of trading and gathering information tend to make markets less efficient.

LOS 50.d: Describe how legal, regulatory, and tax considerations affect the issuance and trading of fixed-income securities

Legal and regulatory matters that affect fixed income securities include the places where they are issued and trade, the issuing entities, sources of repayment, and collateral and credit enhancements. -Domestic bonds trade in the issuer's home country and currency. Foreign bonds are from foreign issuers but denominated in the currency of the country where they trade. Eurobonds are issued outside the jurisdiction of any single country and denominated in a currency other than that of the countries in which they trade. -Issuing entities may be government or agency; a corporation, holding company, or subsidiary; or a special purpose entity. -The source of repayment for sovereign bonds is the country's taxing authority. For non-sovereign government bonds, the sources may be taxing authority or revenues from a project. Corporate bonds are repaid with funds from the firm's operations. Securitized bonds are repaid with cash flows from a pool of financial assets. -Bonds are secured if they are backed by specific collateral or unsecured if they represent an overall claim against the issuer's cash flows and assets -Credit enhancement may be internal (overcollateralization, excess spread, tranches with different priority of claims) or external (surety bonds, bank guarantees, letters of credit) Interest income is typically taxed at the same rate as ordinary income, while gains or losses from selling a bond are taxed at the capital gains tax rate. However, the increase in value toward par of original issue discount bonds is considered interest income. In the United States, interest income from municipal bonds is usually tax-exempt at the national level and the issuer's state.

LOS 55.e: Explain risks in relying on ratings from credit rating agencies.

Lenders and bond investors should not rely exclusively on credit ratings from rating agencies for the following reasons: -Credit ratings can change during the life of a debt issue. -Rating agencies cannot always judge credit risk accurately -Firms are subject to risk of unforeseen events that credit ratings do not reflect. -Market prices of bonds often adjust more rapidly than credit ratings.

LOS 37.a: Define and explain leverage, business risk, sales risk, operating risk, and financial risk and classify a risk.

Leverage increases the risk and potential return of a firm's earnings and cash flows. Operating leverage increases with fixed operating costs. Financial leverage increases with fixed financing costs. Sales risk is uncertainty about the firm's sales. Business risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. Business risk is magnified by operating leverage. Financial risk refers to the additional variability of EPS compared to EBIT. Financial risk increases with greater use of fixed cost financing (debt) in a company's capital structure.

LOS 55.h: Evaluate the credit quality of a corporate bond issuer and a bond of that issuer, given key financial ratios of the issuer and the industry.

Lower leverage, higher interest coverage, and greater free cash flow imply lower credit risk and higher credit rating for a firm. When calculating leverage ratios, analysts should include in a firm's total debt its obligations such as underfunded pensions and off-balance-sheet financing. For a specific debt issue, secured collateral implies lower credit risk compared to unsecured debt, and higher seniority implies lower credit risk compared to lower seniority.

LOS 54.b: Define, calculate, and interpret Macaulay, modified, and effective durations

Macaulay duration is the weighted average number of coupon periods until a bond's scheduled cash flows. Modified duration is a linear estimate of the percentage change in a bond's price that would result from a 1% change in its YTM. Approximate modified duration = V(-)-V(+)/2V0∆YTM Effective duration is a linear estimate of the percentage change in a bond's price that would result from a 1% change in the benchmark yield curve Effective duration = V(-)-V(+)/2V0∆curve

LOS 48. j: Describe macroeconomic, technological, demographic, governmental, and social influences on industry growth, profitability, and risk.

Macroeconomic influences on industries include long-term trends in factors such as GDP growth, Interest rates, and inflation, as well as structural factors such as the education level of the workforce. Demographic influences include the size and age distribution of the population. Government factors include tax rates, regulations, empowerment of self-regulatory organization, and government purchases of goods and services. Social influences relate to how people interact and conduct their lives. Technology can dramatically change an industry through the introduction of new or improved products.

LOS 43.b: Describe the major components of an IPS

Many IPS include the following sections: -Introduction - Describes the client -Statement of Purpose - The intentions of the IPS -Statement of Duties and Responsibilities - Of the client, the asset custodian, and the investment managers. -Procedure - relating to keeping the IPS updated and responding to unforeseen events. -Investment Objectives - The client's investment needs, specified in terms of required return and risk tolerance. -Investment Constraints - Factors that may hinder the ability to meet investment objectives; typically categorized as time horizon, taxes liquidity, legal and regulatory, and unique needs. -Investment Guidelines - For example, Whether leverage, derivatives, or specific kinds of assets are allowed. -Evaluation and Review - Related to feedback on investment Results. -Appendices - May specify the portfolio's strategic asset allocation (policy portfolio) or the portfolio's rebalancing policy

LOS 52.e: Describe matrix pricing

Matrix pricing is a method used to estimate the yield-to-maturity for bonds that are not traded or infrequently traded. The yield is estimated based on the yields of traded bonds with the same credit quality. If these traded bonds have different maturities than the bond being valued, linear interpolation is used to estimate the subject bond's yield.

LOS 30.h: Explain recognition and measurement of current and deferred tax items.

Measurement of deferred tax items depends on the tax rate expected to be in force when the underlying temporary difference reverses. The applicable tax may depend on how the temporary difference would be settled (e.g, if a capital gains tax rate will apply). If a change that leads to a deferred tax item is taken directly to equity, such as an upward revaluation, the deferred tax item should also be taken directly to equity.

LOS 38.b: Compare a company's liquidity measures with those of peer companies.

Measures of a company's short-term liquidity include: -Current ratio = current assets/current liabilities -Quick ratio = (cash + Marketable securities + receivables)/ current liabilities. Measures of how well a company is managing its working capital include: -receivables turnover = credit sales/average receivables. -Number of days of receivables = 365/receivables turnover -inventory turnover = COGS/average inventory -Number of days of inventory = 365/inventory turnover -Payables turnover = purchases/average trade payables -Number of days of payables = 365/Payables turnover.

LOS 32.f: Describe mechanisms that discipline financial reporting Quality and the potential limitations of those mechanisms.

Mechanisms that help to discipline financial reporting quality include regulation, auditing, and private contracts. Regulators typically require public companies to provide periodic financial statements and notes, including management commentary, and obtain independent audits. A clean audit opinion offers reasonable assurance that financial statements are free from material errors but does not guarantee the absence of error or fraud. The fact that firms select and pay their auditors may limit the effectiveness of auditing to discipline financial reporting quality.

LOS 34. k: Describe how environmental, social, and governance factors may be used in investment analysis.

Methods of integrating ESG concerns into portfolio construction are negative screening, positive screening, best-in-class investing, impact investing, and thematic investing

LOS 54.g: Calculate and interpret the money duration of a bond and price value of a basis point (PVBP)

Money duration is stated in currency units and is sometimes expressed per 100 of bond value Money duration = annual modified duration * Full price of bond position Money duration per 100 units of par value = annual modified duration * full bond price per 100 of par value. The price value of a basis point is the change in the value of a bond, expressed in currency units, for a change in YTM of one basis point, or 0.01% PVBP = [(V(-)-V(+))/2]*par value * 0.01

LOS 32.d: Describe motivations that might cause management to issue financial reports that are not high quality.

Motivations for firm managers to issue low-quality financial reports may include pressure to meet or exceed earnings targets, career considerations, increasing their compensation, improving perceptions of the firm among customers and suppliers, or meeting the terms of debt covenants.

LOS 39.e: Describe mutual funds and compare them with other pooled investment products.

Mutual funds combine funds from many investors into a single portfolio that is invested in a specific class of securities or to match a specific index. Many varieties exist, including money market funds, bond funds, stock funds, and balanced (hybrid) funds. Open-ended shares can be bought or sold at the net asset value. Closed-ended funds have a fixed number of shares that trade at a price determined by the market. Exchange-traded funds are similar to mutual funds, but investors can buy and sell ETF shares in the same way as shares of stock. Management fees are generally low, though trading ETFs results in brokerage costs. Separately managed accounts are portfolios managed for individual investors who have substantial assets. In return for an annual fee based on assets, the investor receives personalized investment advice Hedge funds are available only to accredited investors and are exempt from most reporting requirements. Many different hedge fund strategies exist. A typical annual fee structure is 20% of excess performance plus 2% of assets under management. Buyout funds involve taking a company private by buying all available shares, usually funded by issuing debt. The company is then restructured to increase cash flow. Investors typically exit the investment within 3 to 5 years. Venture capital funds are similar to buyout funds, except that the companies purchased are in the start-up phase. Venture capital funds, like buyout funds, also provide advise and expertise to the start-ups.

LOS 35.d: Calculate and interpret net present value (NPV), internal rate of return (IRR), payback period, discounted payback period, and profitability index (PI) of a single capital project.

NPV is the sum of the present values of a project's expected cash flows and represents the increase in firm value from undertaking a project. Positive NPV projects should be undertaken, but negative NPV projects are expected to decrease the value of the firm The IRR is the discount rate that equates the present values of the project's expected cash inflows and outflows and, thus, is the discount rate for which the NPV of a project is zero. a project for which the IRR is greater (less) than the discount rate will have an NPV that is positive (negative) and should be accepted (not accepted). The payback (discounted payback) period is the number of years required to recover the original cost of the project (original cost of the project in present value terms). The profitability index is the ratio of the present value of a project's future cash flows to its initial cash outlay and is greater than one when a project's NPV is positive

Know these terms (how they relate in income statement) -Gross profits -operating profits -net income -total capital -total capital

Net sales - Cost of goods sold ------------------------------------ Gross profits - Operating Expenses ------------------------------------ Operating Profit (EBIT) - Interest ------------------------------------ Earnings before taxes (EBT) - Taxes ----------------------------------- Earnings after taxes +/- Below the line items adjusted for tax ----------------------------------- Net income - Preferred dividends ---------------------------------- Income available to common

LOS 44.i: Define primary and secondary markets and explain how secondary markets support primary markets.

New issues of securities re sold in primary capital markets. Secondary financial markets are where securities trade after their initial issuance. In an underwritten offering, the investment bank guarantees that the issue will be sold at a price that is negotiated between the issuer and the bank. In a best efforts offering, the bank acts only as a broker. In a private placement, a firm sells securities directly to qualified investors, without the disclosures of a public offering. A liquid secondary market makes it easier for firms to raise external capital in the primary market, which results in a lower cost of capital for firms.

LOS 51.f: Describe securities issued by non-sovereign governments, quasi-government entities, and supranational agencies

Non-sovereign government bonds are issued by governments below the national level such as provinces or cities, and may be backed by taxing authority or revenues from a specific project. Agency or quasi-government bonds are issued by government sponsored entities and may be explicitly or implicitly backed by the government. Supranational bonds are issued by multilateral agencies that operate across national borders.

LOS 26.b: Describe how non-cash investing and financing activities are reported.

Noncash investing and financing activities, such as taking on debt to the seller of a purchased asset, are not reported in the cash flow statement but must be disclosed in the footnotes or a supplemental schedule.

LOS 42.b: Explain the capital allocation line (CAL) and the capital market line (CML)

On a graph of return versus risk, the various combination of a risky asset and the risk-free asset form the capital allocation line (CAL). In the specific case where the risky asset is the market portfolio, the combinations of the risky asset and the risk-free asset form the capital market line (CML).

LOS 26.e: Describe how the cash flow statement is linked to the income statement and the balance sheet.

Operating activities typically relate to the firm's current assets and current liabilities. Investing activities typically relate to noncurrent assets. Financing activities typically relate to noncurrent liabilities and equity. Timing of revenue or expense recognition that differs from the receipt or payment of cash is reflected in changes in balance sheet accounts.

LOS 54.k: Describe the relationships among a bond;s holding period return, its duration, and the investment horizon

Over a short investment horizon, a change in YTM affects market price more than it affects reinvestment income. Over a long investment horizon, a change in YTM affects reinvestment income more than it affects market price. Macaulay duration may be interpreted as the investment horizon for which a bond's market price risk and reinvestment risk just offset each other. Duration gap = Macaulay duration-investment horizon

LOS 53.b: Describe securitization, including the parties involved in the process and the roles they play.

Parties to a securitization are a seller of financial assets, a special purpose entity (SPE) and a servicer. -The seller is the firm that is raising funds through securitization -An SPE is an entity independent of the seller. The SPE buys financial assets from the seller and issues asset-backed securities (ABS) supported by these financial assets. -The servicer carries out collections and other responsibilities related to the financial assets. The servicer may be the same entity as the seller but does not have to be. The SPE may issue a single class of ABS or multiple classes with different priorities of claims to cash flows from the pool of financial assets.

LOS 48.h: Describe industry life cycle models, classify an industry as to life cycle stage, and describe limitations to the life-cycle concept in forecasting industry performance.

Phases of the industry life-cycle model are the embryonic, growth, shakeout, maturity, and decline stages. -Embryonic stage: Slow growth; high prices; large investment required; high risk of failure -Growth stage: Rapid growth; little competition; falling prices; increasing profitability. -Shakeout stage: Slowing growth; intense competition; industry overcapacity; declining profitability; cost cutting; increased failures. -Mature stage: Slow growth; consolidation; high barriers to entry; stable pricing; superior firms gain market share. -Decline stage: Negative growth; declining prices; consolidation A limitation of life-cycle analysis is that life-cycle stages may not be as long or as short as anticipated or might be skipped altogether due to technological change, government regulation, societal change, or demographics. Firms in the same life-cycle stage will experience dissimilar growth and profits due to their competitive positions.

LOS 33.d: Describe the use of financial statement analysis in screening for potential equity investments.

Potentially attractive equity investments can be identified by screening a universe of stocks, using minimum or maximum values of one or more ratios. Which (and how many) ratios to use, what minimum or maximum values to use, and how much importance to give each ratio all present challenges to the analyst.

LOS 49.f: Calculate the intrinsic value of non-callable, non-convertible preferred stock

Preferred stock typically pays a fixed dividend and does not mature. It is valued as: Preferred stock value = Dp/kp

LOS 53.f: Define prepayment risk and describe the prepayment risk of mortgage-backed securities

Prepayment risk refers to the uncertainty about the timing of the principal cash flows from an ABS. Contraction risk is the risk that loan principal will be repaid more rapidly than expected, typically when interest rates have decreased. Extension risk is the risk that loan principal will be repaid more slowly than expected, typically when interest rates have increased.

LOS 45.e: Calculate and analyze the value and return of an index given its weighting method

Price-weighted index = Sum of stock prices/number of stocks in index adjusted for splits. Market capitalization-weighted index = (Current total market value of index stocks/ base year total market value of index stocks) * Base year index value Equal-weighted index = (1+average percentage change in index stocks) *initial index value

LOS 38.a: Describe primary and secondary sources of liquidity and factors that influence a company's liquidity position.

Primary sources of liquidity are the sources of cash a company uses in its normal operations. If its primary sources are inadequate, a company can use secondary sources of liquidity such as asset sales, debt renegotiation, and bankruptcy reorganization. A company's liquidity position depends on the effectiveness of its cash flow management and is influenced by drags on its cash inflows (e.g., uncollected receivables, obsolete inventory) and pulls on its cash outflows (e.g., early payments to vendors, reductions in credit limits)

Private Equity

Private Equity Leveraged buyouts (LBOs) and venture capital are the two dominant strategies. Other strategies include developmental capital and distressed securities. Types of LBOs include management buyouts, in which the existing management team is involved in the purchase, and management buy-ins, in which an external management team replaces the existing management. Stages of venture capital investing include the formative stage (composed of the angel investing, see, and early stages); the later stage (expansion); and the mezzanine stage (prepare for IPO) Methods for exiting investments in portfolio companies include trade sale (sell to a competitor or another strategic buyer); IPO (sell some or all shares to investors); recapitalization (issue portfolio company debt); secondary sale (sell to another private equity firm or other investors): or write-off liquidation. Private equity has some historical record of potential diversification benefits. An investor must identify top performing private equity managers to benefit from private equity. Due diligence factors for private equity include the manager's experience, valuation methods used, fee structure, and drawdown procedures for committed capital

LOS 27.g: Describe how ratio analysis and other techniques can be used to model and forecast earnings.

Ratio analysis in conjunction with other techniques can be used to construct pro forma financial statements based on a forecast of sales growth and assumptions about the relation of changes in key income statement and balance sheet items to growth of sales.

LOS 27.e: Calculate and interpret ratios used in equity analysis and credit analysis.

Ratios used in equity analysis include a price-to-earnings, price-to-cash flow, price-to-sales, and price-to-book value ratios, and basic and diluted earnings per share. Other ratios are relevant to specific industries such as retail and financial services. Credit analysis emphasizes interest coverage ratios, return on capital, debt-to-assets ratios, and cash flow to total debt.

Real Estate

Real Estate Reasons to invest in real estate include potential long-term total returns, income from rent payments, diversification benefits, and hedging against inflation. Forms of real estate investing: Public (indirect) Debt: -mortgage-backed securities -Collateralized mortgage obligations Public (indirect) Equity: -Real estate corporation shares -Real estate investment trust shares Private (direct) Debt: -Mortgages -Construction Loans Private (direct) Equity: -Sole ownership -joint ventures -Limited partnerships -Commingled funds Real estate investment categories include residential properties, commercial real estate, REITs, mortgage-backed-securities, and timberland and farmland Historically, real estate returns are highly correlated with global equity returns but less correlated with global bond returns. The construction method of real estate indexes may contribute to the low correlation with bond returns. Due diligence factors for real estate include global and national economic factors, local market conditions, interest rates, and property-specific risks including regulations and abilities of managers. Distressed properties investing and real estate development have additional risk factors to consider.

LOS 49.c: Describe regular cash dividends, extra dividends, stock dividends, stock splits, reverse stock splits, and share repurchases

Regular cash dividends are paid at set intervals. A special dividend is a one-time cash payment to shareholders. Stock dividends are additional shares of stock. Stock splits divided each existing share into multiple shares. In either case, the value of each share will decrease because the total value of outstanding shares is unchanged. The portion of the company owned by each shareholder is also unchanged. In a reverse stock split, the number of shares owned by each shareholder is decreased, so total shares outstanding are decreased and the value of a single share is increased. A share repurchase is a purchase by the company of its outstanding shares. Share repurchases are an alternative to cash dividends as a way to distribute cash to shareholders.

LOS 23.e: Describe general requirements for financial statements under International Financial Reporting Standards (IFRS)

Required financial statements are the balance sheet, comprehensive income statement, cash flow statement, statement of changes in owners' equity, and explanatory notes. The general features for financial statements according to IAS No. 1 are: -Fair presentation -Going concern -Accrual accounting -Consistency -Materiality -aggregation -no Offsetting -reporting frequency -Comparative information. Other presentation requirements include a classified balance sheet and specific minimum information that must be reported in the notes and on the face of the financial statement.

LOS 28.i: Describe the financial statement presentation of and disclosures relating to inventories.

Required inventory disclosures: -the cost flow method (LIFO, FIFO, etc.) used -Total carrying value of inventory and carrying value by classification (raw materials, work-in-process, and finished goods) if appropriate. -Carrying value of inventories reported at fair value less selling costs. -The cost of inventory recognized as an expense (COGS) during the period. -Amount of inventory write-downs during the period. -Reversals of inventory write-downs during the period (IFRS only because US GAAP) does not allow reversals) -Carrying value of inventories pledged as collateral.

LOS 40.e: Describe risk budgeting and its role in risk governance.

Risk budgeting is the process of allocating the total risk the firm will take (risk tolerance) to assets or investments by considering the risk characteristics of each and how they can be combined to best meet the organization's goals. The budget can be a single risk measure or the sum of various risk factors.

LOS 40.c: Define risk governance and describe elements of effective risk governance.

Risk governance refers to senior management's determination of the risk tolerance of the organization, the elements of its optimal risk exposure strategy, and the framework for oversight of the risk management function.

LOS 40.a: Define risk management

Risk management is the process of identifying and measuring the risks an organization (or portfolio manager or individual) faces, determining an acceptable level of overall risk (establishing risk tolerance), deciding which risks should be taken and which risks should be reduced or avoided, and putting the structure in place to maintain the bundle of risks that is expected to best achieve the goals of the organization.

LOS 58.g: Describe risk management of alternative investments.

Risk management of alternative investments require understanding of the unique circumstances for each category. -Standard deviation of returns may be misleading as a measure of risk -use of derivatives introduces operational, financial, counterparty, and liquidity risk. -Performance for some alternative investment categories depends primarily on management expertise. -Hedge funds and private equity funds are less transparent than traditional investments. -Many alternative investments are illiquid Indices of historical returns and standard deviations may not be good indicators of future returns and volatility. -Correlations vary across periods and are affected by events. Key items for due diligence include organization, portfolio management, operations, and controls, risk management, legal review, and fund terms.

LOS 43.c: Describe risk and return objectives and how they may be developed for a client

Risk objectives are specifications for portfolio risk that are developed to embody a client's risk tolerance. Risk objectives can be either absolute (e.g. , no losses greater than 10% in any year) or relative (e.g.,, annual return will be within 2% of FTSE return). Return objectives are typically based on an investor's desire to meet a future financial goal, such as a particular level of income in retirement. Return objectives can be absolute (e.g., 9% annual return) or relative (e.g. Outperform the S&P by 2% per year). The achievability of an investor's return expectations may be hindered by the investor's risk objectives.

LOS 56.e: Explain arbitrage and the role it plays in determining prices and promoting market efficiency

Riskless arbitrage refers to earning more than the risk-free rate of return with no risk, or receiving an immediate gain with no possible future liability. Arbitrage can be expected to force the prices of two securities or portfolios of securities to be equal if they have the same future cash flows regardless of future events.

LOS 45.k: Compare types of security market indexes

Security market indexes available from commercial providers represent a variety of asset classes and reflect target markets that can be classified by: -Geographic location, such as country, regional, or global indexes -sector or industry, such as indexes of energy producers -level of economic development, such as emerging market indexes -Fundamental factors, such as indexes of value stocks or growth stocks.

LOS 51.i: Describe short-term funding alternatives available to banks

Short-term funding alternatives available to banks include: -Customer deposits, including checking accounts, savings accounts, and money market mutual funds -Negotiable CDs, which may be sold in the wholesale market -Central bank funds market. Banks may buy or sell excess reserves deposited within their central bank. -Interbank funds. Banks make unsecured loans to one another for periods up to a year.

LOS 22.h: Describe the use of the results of the accounting process in security analysis.

Since financial reporting requires choice of method, judgement, and estimates, an analyst must understand the accounting process used to produce the financial statements in order to understand the business and the results for the period. Analysts should be alert to the use of accruals, changes in valuations, and other notable changes that may indicate management judgment is incorrect or, worse, that the financial statements have been deliberately manipulated.

LOS 47.b: Describe differences in voting rights and other ownership characteristics among different equity classes.

Some companies' equity shares are divided into different classes, such as Class A and Class B shares. Different classes of common equity may have different voting rights and priority in liquidation.

LOS 54.a: Calculate and interpret the sources of return from investing in a fixed-rate bond

Sources of return from a bond investment include: -Coupon and principal payments -Reinvestment of coupon payments -Capital gain or loss if bond is sold before maturity. Changes in yield to maturity produce market price risk (uncertainty about a bond's price) and reinvestment risk (uncertainty about income from reinvesting coupon payments). An increase (a decrease) in YTM decreases (increases) a bond's price but increases (decreases) its reinvestment income.

LOS 51.e: Describe securities issued by sovereign governments

Sovereign bonds are issued by national governments and backed by their taxing power. Sovereign bonds may be denominated in the local currency or a foreign currency.

LOS 52.c: Define spot rates and calculate the price of a bond using spot rates.

Spot rates are market discount rates for single payments to be made in the future. The no-arbitrage price of a bond is calculated using (no-arbitrage) spot rates as follows: no-arbitrage price = coupon/(1+S1) + coupon/(1+S2)^2 +...+ (coupon+principle)/ (1+SN)^N

LOS 34.d: Describe stakeholder management.

Stakeholder management refers to the management of the company relations with stakeholders and is based on having a good understanding of stakeholder interests and maintaining effective communication with stakeholders.

LOS 48.f: Describe the principles of strategic analysis of an industry.

Strategic analysis of an industry involves analyzing the competitive forces that determine the possibility of economic profits. Porter's five forces that determine industry competition are: 1. Rivalry among existing competitors 2. Threat of entry 3. Threat of substitutes 4. Power of buyers 5. Power of suppliers.

LOS 43.g: Describe the principles of portfolio construction and the role of asset allocation in relation to the IPS.

Strategic asset allocation is a set of percentage allocations to various asset classes that is designed to meet the investor's objectives. The strategic asset allocation is developed by combining the objectives and constraints in the IPS with the performance expectations of the various asset classes. These strategic allocation provides the basic structure of a portfolio. Tactical asset allocation refers to an allocation that deviates from the baseline (strategic) allocation in order to profit form a forecast of shorter-term opportunities in specific asset classes

LOS 51.h: Describe structured financial instruments.

Structured financial instruments include asset-backed securities and collateralized debt securities as well as the following types: -Yield enhancement instruments include credit linked notes, which are redeemed at an amount less than par value if a specified credit event occurs on a reference asset, or at par if it does not occur. The buyer receives a higher yields for bearing the credit risk of the reference asset. -Capital protected instruments offer a guaranteed payment, which may be equal to the purchase price of the instrument, along with participation in any increase in the value of an equity, an index, or other asset. -Participation instruments are debt securities with payments that depend on the returns on an asset or index, or depends on a reference interest rate. One example is a floating rate bond, which makes coupon payments that change with a short-term reference rate, such as LIBOR. Other participation instruments make coupon payments based on the returns on an index of equity securities or on some other asset. -An inverse floater is a leveraged instrument that has a coupon rate that varies inversely with a specified reference interest rate, for example, 6% - (L*180-day LIBOR). L is the leverage of the inverse floater. An inverse floater with L>1, so that coupon rate changes by more than the reference rate, is termed a leveraged inverse floater. An inverse floater with L<1 is a deleveraged floater.

LOS 42.c: Explain systematic and nonsystematic risk, including why an investor should not expect to receive additional return for bearing nonsystematic risk

Systematic (market) risk is due to factors, such as GDP growth and interest rate changes, that affect the values of all risky securities. Systematic risk cannot be reduced by diversification. Unsystematic (firm-specific) risk can be reduced by portfolio diversification. Because one of the assumptions underlying the CAPM is that portfolio diversification to eliminate unsystematic risk is costless, investors cannot increase expected equilibrium portfolio returns by taking on unsystematic risk.

LOS 42.h: Describe and demonstrate applications of the CAPM and the SML

The CAPM and the SML indicate what a security's equilibrium required rate of return should be based on the security's exposure to market risk. An analyst can compare his expected rate of return on a security to the required rate of return indicated by the SML to determine whether the security is overvalued, undervalued, or properly valued.

LOS 42.g: Calculate and interpret the expected return of an asset using the CAPM

The CAPM relates expected return to the market factor (beta) using the following formula: E(Ri)-Rf = β[E(Rm)-Rf]

LOS 35.f: Describe expected relations among an investment's NPV, company value, and share price

The NPV method is a measure of the expected change in company value from undertaking a project. A firm's stock price may be affected to the extent that engaging in a project with that NPV was previously unanticipated by investors.

LOS 49.i: Explain the rationale for using price multiples to value equity, how the price to earnings multiple relates to fundamentals, and the use of multiples based on comparables.

The P/E ratio based on fundamentals is calculated as: P0/E1 = (D1/E1) / (k-g) if the subject firm has a higher dividend payout ratio, higher growth rate, and lower required return than its peers, it may be justified in having a higher P/E ratio. Price multiples are widely used by analysts, are easily calculated and readily available, and can be used in time series and cross-sectional comparisons.

LOS 42.i: Calculate and interpret the Sharpe ratio, Treynor ratio, M^2, and Jensen's alpha

The Sharpe ratio measures excess return per unit of total risk and is useful for comparing portfolios on a risk-adjusted basis. The M-squared measure provides the same portfolio rankings as the Sharpe ratio but is stated in percentage terms. Sharpe ratio = (Rp-Rf / σp) M-squared = (Rp-Rf) * σm/σp -(Rm-Rf) The treynor measure measures a portfolio's excess return per unit of systematic risk. Jensen's alpha is the difference between a portfolio's return and the return of a portfolio on the SML that has the same beta: Treynor measure = Rp-Rf /βp Jensen's alpha = αp = Rp - [Rf+βp(Rm-Rf)]

LOS 47.h: Compare a company's cost of equity, its (accounting) return on equity, and investors' required rates of return

The accounting return on equity (ROE) is calculated as the firm's net income divided by the book value of common equity. ROE measures whether management is generating a return on common equity but is affected by the firm's accounting methods. The firm's cost of equity is the minimum rate of return that investors in the firm's equity require. Investors' required rates of return are reflected in the market prices of the firm's shares.

LOS 30.j: Identify the key provisions of and differences between income tax accounting under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP)

The accounting treatment of income taxes under US GAAP and their treatment under IFRS are similar in most respects. One major difference relates to the revaluation of fixed assets and intangible assets. US GAAP prohibits upward revaluations, but they are permitted under IFRS and any resulting effects on deferred tax are recognized in equity.

LOS 42.a: Describe the implications of combining a risk-free asset with a portfolio of risk assets.

The availability of a risk-free asset allows investors to build portfolios with superior risk-return properties. By combining a risk-free asset with a portfolio of risky assets, the overall risk and return can be adjusted to appeal to investors with various degrees of risk aversion.

LOS 36.f: Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach.

The before-tax cost of fixed-rate debt capital, kd, is the rate at which the firm can issue new debt -The yield-to-maturity approach assumes the before-tax cost of debt capital is the YTM on the firm's existing publicly traded debt. -if a market YTM is not available, the analyst can use the debt rating approach, estimating the before-tax cost of debt capital based on market yields for debt with the same rating and average maturity as the firm's existing debt.

LOS 47.g: Distinguish between the market value and book value of equity securities.

The book value of equity is the difference between the financial statement value of the firm's assets and liabilities. Positive retained earnings increase book value of an equity. Book values reflect the firm's past operating and financing choices. The market value of equity is the share price multiplied by the number of shares outstanding. Market value reflects investors' expectations about the timing, amount, and risk of the firm's future cash flows.

LOS 37.d: Calculate the breakeven quantity of sales and determine the company's net income at various sales levels.

The breakeven quantity of sales is the amount of sales necessary to produce a net income of zero (total revenue just covers total costs) and can be calculated as: fixed operating cost + fixed financing costs / price - variable cost per unit. Net income at various sales levels can be calculated as total revenue (i.e. price * quantity sold) minus total costs (i.e., total fixed cost plus total variable costs.)

LOS 42.f: Explain the capital asset pricing model (CAPM), including its assumptions,and the security market line (SML)

The capital asset pricing model (CAPM) requires several assumptions: -Investors are risk averse, utility maximizing, and rational -Markets are free of frictions like costs and taxes. -All investors plan using the same time period. -All investors have the same expectations of security returns. -Investments are infinitely divisible -Prices are unaffected by an investor's trades. The security market line (SML) is a graphical representation of the CAPM that plots expected return versus beta for any security.

LOS 29.g: Describe how the choice of amortization method and assumptions concerning useful life and residual value affect amortization expense, financial statements, and ratios.

The choice of amortization method will affect expenses, assets, equity, and financial ratios in exactly the same way that the choice of depreciation method will. Just as with the depreciation of tangible assets, increasing either the estimate of an asset's useful life or the estimate of its residual value will reduce annual amortization expense, which will increase net income, assets, ROE, and ROA for a typical firm.

LOS 49.h: Identify characteristics of companies for which the constant growth or a multistage dividend discount model is appropriate.

The constant growth model is most appropriate for firms that pay dividends that grow at a constant rate, such as stable and mature firms or noncyclical firms such as utilities and food producers in mature markets. A 2-stage DDM would be most appropriate for a firm with high current growth that will drop to a stable rate in the future, an older firm that is experiencing a temporary high growth phase, or an older firm with a market share that is decreasing but expected to stabilize. A 3-stage model would be appropriate for a young firm still in a high growth phase.

LOS 36.l: Explain and demonstrate the correct treatment of flotation costs.

The correct method to account for flotation costs of raising new equity capital is to increase a project's initial cash outflow by the flotation cost attributable to the project when calculating the project's NPV.

LOS 36.g: Calculate and interpret the cost of noncallable, nonconvertible preferred stock.

The cost (and yield) of noncallable, nonconvertible preferred stock is simply the annual dividend divided by the market price of preferred shares.

LOS 36.h: Calculate and interpret the cost of equity capital using the capital asset pricing model approach, the dividend discount model approach, and the bond-yield-plus risk-premium approach.

The cost of equity capital, kce, is the required rate of return on the firm's common stock. These are three approaches to estimating kce: -CAPM approach: kce=Rf+β[E(Rmkt)-Rf]. -Dividend discount model approach: kce=(D1/P0)+g -Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm's long-term debt.

LOS 37.b: Calculate and interpret the degree of operating leverage, the degree of financial leverage, and the degree of total leverage.

The degree of operating leverage (DOL) is calculated as: Q(P-V) / Q(P-V)-F and is interpreted as %∆EBIT/%∆Sales The degree of financial leverage (DFL) is calculated as EBIT/EBIT-I and is interpreted as %∆EPS/%∆EBIT. The degree of total leverage (DTL) is the combination of operating and financial leverage and is calculated as DOL * DFL and interpreted as %∆EPS/%∆sales

LOS 49.e: Explain the rationale for using present value models to value equity and describe the dividend discount and fee-cash-flow-to-equity models.

The dividend discount model is based on the rationale that a corporation has an indefinite life, and a stock's value is the present value of its future cash dividends. The most general form of the model is: V0 = ∑ Dt / (1+ke)^t Where: V0 = Current stock value Dt = dividend at time t ke = required rate of return on common equity Free cash flow to equity (FCFE) can be used instead of dividends. FCFE is the cash remaining after a firm meets all of its debt obligations and provides for necessary capital expenditures. FCFE reflects the firm's capacity for dividends and is useful for firms that currently do not pay a dividend. By using FCFE, an analyst does not need to project the amount and timing of future dividends.

LOS 34.f: Describe functions and responsibilities of a company's board of directors and its committees.

The duties of a board of directors include: -Selecting senior management, setting their compensation, and evaluating their performance. -Setting the strategic direction for the company. -Approving capital structure changes, significant acquisitions, and large investment expenditures. -Reviewing company performance and implementing any necessary corrective steps. -Planning for continuity of management and the succession of the CEO. -Establishing, monitoring, and overseeing the firm's internal controls and risk management. -Ensuring the quality of the firm's financial reporting and internal.

LOS 52.f: Calculate and interpret yield measures for fixed-rate bonds, floating-rate notes, and money market instruments.

The effective yield of a bond depends on its periodicity, or annual frequency of coupon payments. For an annual-pay bond the effective yield is equal to the yield-to-maturity. For bonds with greater periodicity, the effective yield is greater than the yield-to-maturity. A YTM quoted on a semiannual bond basis is two times the semiannual discount rate. Bond yields that follow street convention use the stated coupon payment dates. A true yield accounts for coupon payments that are delayed by weekends or holidays and may be slightly lower than a street convention yield. Current yield is the ratio of a bond's annual coupon payments to its price. Simple yield adjusts current yield by using straight-line amortization of any discount or premium. For a callable bond, a yield-to-call may be calculated using each of its call dates and prices. the lowest of these yields and TYM is a callable bond's yield-to-worst. Floating rate notes have a quoted margin relative to a reference rate, typically Libor. The quoted margin is positive for issuers with more credit risk than the banks that quote Libor and may be negative for issuers that have less credit risk than loans to these banks. The required margin on a floating rate note may be greater than the quoted margin if credit quality has decreased, or less than the quoted margin if credit quality has increased. For money market instruments, yields may be quoted on a discount basis or an add-on basis, and may use 360-day or 365-day years. A bond-equivalent yield is an add-on yield based on a 365 day year.

LOS 48.i: Compare characteristics of representative industries from various economic sectors.

The elements of an industry strategic analysis are the major firms, barriers to entry, industry concentration, influence of industry capacity on pricing, industry stability, life cycle, competition, demographic influences, government influence, social influence, technological influence, and whether the industry is growth, defensive, or cyclical.

LOS 31. e: Describe the financial statement presentation of and disclosures relating to debt.

The firm separately discloses details about its long term debt in the footnotes. These disclosures are useful for determining the timing and amount of future cash outflows. The disclosures usually include a discussion of the nature of the liabilities, maturity dates, stated and effective interest rates, call provisions and conversion privileges, restrictions imposed by creditors, assets pledged as security, and the amount of debt maturing in each of the next five years.

LOS 52.d: Describe and calculate the flat price, accrued interest, and the full price of a bond

The full price of a bond includes interest accrued between coupon dates. The flat price of a bond is the full price minus accrued interest. Accrued interest for a bond transaction is calculated as the coupon payment times the portion of the coupon period from the previous payment date to the settlement date. Methods for determining the period of accrued interest includes actual days (typically used for government bonds) or 30-day months and 360-day years (typically used for corporate bonds).

LOS 49.g: Calculate and interpret the intrinsic value of an equity security based on the Gordon (constant) growth dividend discount model or a two stage dividend discount model, as appropriate

The gordon growth model assumes the growth rate in dividends is constant: V0 = D1 / ke-gc The sustainable growth rate is the rate at which earnings and dividends can continue to grow indefinitely: g = b * ROE where: b = earnings retention rate = 1-dividend payout rate ROE = Return on equity A firm with high growth over some number of periods followed by a constant growth rate of dividends forever can be valued using a multistage model: Value = D1/(1+ke) + D2/(1+ke)^2 +...+ Dn/(1+ke)^n + Pn/(1+ke)^n where: Pn = D(n+1) / ke-gc gc = constant growth rate of dividends n = number of periods of supernormal growth.

LOS 41.f: Describe the effect on a portfolio's risk of investing in assets that are less than perfectly correlated.

The greatest portfolio risk will result when the asset returns are perfectly positively correlated. As the correlation decreases from +1 to -1, portfolio risk decreases. The lower correlation of asset returns, the greater risk reduction (diversification) benefit of combining assets in a portfolio.

LOS 24.a: Describe the components of the income statement and alternative presentation formats of that statement.

The income statement shows an entity's revenues, expenses, gains and losses during a reporting period. A multi-step income statement provides a subtotal for gross profit and a single step income statement does not. Expenses on the income statement can be grouped by the nature of the expense items or by their function, such as with expenses grouped into costs of goods sold.

LOS 44.f: Calculate and interpret the leverage ratio, the rate of return on a margin transaction, and the security price at which the investor would receive a margin call.

The leverage ratio is the value of the asset divided by the value of the equity position. Higher leverage ratios indicate greater risk. The return on a margin transaction is the increase in the value of the position after deducting selling commissions and interest charges, divided by the amount of funds initially invested, including purchase commissions. The maintenance margin is the minimum percentage of equity that a margin investor is required to maintain in his account. If the investor's equity falls below the maintenance margin, the investor will receive a margin call. The stock price that will result in a margin call is: Margin call price = P0(1-initial margin / 1-maintenance margin) Where: P0 = initial purchase price.

LOS 44.c: Describe the major types of securities, currencies, contracts, commodities, and real assets that trade in organized markets, including their distinguishing characteristics and major subtypes.

The major types of assets are securities, currencies, contracts, commodities, and real assets. Securities include fixed income (e.g., bonds, notes, commercial paper), equity (common stock, preferred stock, warrants), and pooled investment vehicles (mutual funds, exchange-traded funds, hedge funds, asset-backed securities) Contracts include futures, forwards, options, swaps, and insurance contracts. Commodities include agricultural products, industrial and precious metals, and energy products and are traded in spot, forward, and futures markets. Most national currencies are traded in spot markets and some are also traded in forward and futures markets.

LOS 34.e: Describe mechanisms to manage stakeholder relationships and mitigate associated risks.

The management of stakeholder relationships is based on a company's legal, contractual, organizational, and governmental infrastructures.

LOS 36.e: Explain the marginal cost of capital's role in determining the net present value of a project.

The marginal cost of capital (the WACC for additional units of capital) should be used as the discount rate when calculating project NPVs for capital budgeting decisions. Adjustments to the cost of capital are necessary when a project differs in risk from the average risk of a firm's existing projects. The discount rate should be adjusted upward for higher-risk projects and downward for lower risk projects.

LOS 36.k: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points.

The marginal cost of capital schedule shows the WACC for successively greater amounts of new capital investment for a period, such as the coming year. The MCC schedule is typically upward-sloping because raising greater amounts of capital increases the cost of equity and debt financing. Break points (increases) in the marginal cost of capital schedule occur at amounts of total capital raised equal to the amount of each source of capital at which the component cost of capital increases, divided by the target weight for that source of capital.

LOS 44.l Describe objectives of market regulation.

The objectives of market regulation are to: -Protect unsophisticated investors -Establish minimum standards of competency -Help investors to evaluate performance -prevent insiders from exploiting other investors -Promote common financial reporting requirements so that information gathering is less expensive. -Require minimum levels of capital so that market participants will be able to honor their commitments and be more careful about their risks.

LOS 37.e: Calculate and interpret the operating breakeven quantity of sales.

The operating breakeven quantity of sales is the amount of sales necessary to produce and operating income of zero (total revenue just covers total operating costs) and can be calculated as: fixed operating costs / price-variable cost per unit.

LOS 38.c: Evaluate working capital effectiveness of a company based on its operating and cash conversion cycles and compare the company's effectiveness with that of peer companies.

The operating cycle and the cash conversion cycle are summary measures of the effectiveness of a company's working capital management. -Operating cycle = days of inventory + days of receivables. -Cash conversion cycle = days of inventory + days of receivables - days of payables. Operating and cash conversion cycles that are high relative to a company's peers suggest the company has too much cash tied up in working capital

LOS 52.a: Calculate a bond's price given a market discount rate

The price of a bond is the present value of its future cash flows, discounted at the bond's yield-to-maturity, For an annual-coupon bond with N years to maturity: Price = coupon/(1+ YTM) + coupon/(1+ YTM)^2 +...+(coupon+principal)/ (1+YTM)^N For a semiannual-coupon bond with N years to maturity: Price = coupon/(1+ YTM/2) + coupon/(1+ YTM/2)^2 +...+(coupon+principal)/ (1+YTM/2)^2N

LOS 57.b: Distinguish between value and price of forward and futures contracts.

The price of a forward or futures contract is the forward price that is specified in the contract. The value of a forward or futures contract is zero at initiation. Its value may increase or decrease during its life, with gains or losses in the value of a long position just opposite to gains or losses in the value of a short position.

LOS 57.h: Distinguish between the value and price of swaps.

The price of a swap is the fixed rate of interest specified in the swap contract. The value depends on how expected future floating rates change over time. An increase in expected short-term future rates will produce a positive value for the fixed-rate payer, and a decrease in expected future rates will produce a negative value for the fixed-rate payer.

LOS 49.j: Calculate and interpret the following multiples: Price to earnings, Price to an estimate of operating cash flow, price to sales, and price to book value

The price-earnings (P/E) ratio is a firm's stock price divided by earnings per share. The price-sales (P/S) ratio is a firm's stock price divided by sales per share. The price-book value (P/B) ratio is a firm's stock price divided by book value per share. The price-cash flow (P/CF) ratio is a firm's stock price divided by cash flow per share. Cash flow may be defined as operating cash flow or free cash flow.

LOS 57.o: Explain under which circumstances the values of European and American options differ.

The prices of European and American options will be equal unless the right to exercise prior to expiration has positive-value. For a call option on an asset that has no cash flows during the life of the option, there is no advantage to early exercise so identical American and European call options will have the same value. If the asset pays cash flows during the life of a call option, early exercise can be valuable and an american call option will be priced higher than an otherwise identical European call option. For put options, early exercise can be valuable when the options are deep in the money and an American put option will be priced higher than an otherwise identical European put option.

LOS 53.a: Explain benefits of securitization for economies of financial markets

The primary benefits of the securitization of financial assets are: -Reduce the funding costs for firms selling the financial assets to the securitizing entity. -Increase the liquidity of the underlying financial assets.

LOS 58.c: Describe potential benefits of alternative investments in the context of portfolio management

The primary motivation for adding alternative investments to a portfolio is to reduce portfolio risk based on the less-than-perfect correlation between alternative asset returns and traditional asset returns. For many alternative investments, the expertise of the manager can be an important determinant of returns.

LOS 34.b: Describe a company's stakeholder groups and compare interests of stakeholder groups.

The primary stakeholders of a corporation include shareholders, the board of directors, senior management, employees, creditors, and suppliers.

LOS 34.c: Describe principal-agent and other relationships in corporate governance and the conflicts that may arise in these relationships

The principal-agent relationship refers to owners employing agents to act in their interests. Conflicts can arise because the agent's incentives may not align with those of the owner, or more generally, because the interests of one group within a corporation are no the same as those of other groups.

LOS 40.d: Explain how risk tolerance affects risk management.

The risk tolerance for an organization is the overall amount of risk it will take in pursuing its goals and is determined by top management.

LOS 41.d: Explain risk aversion and its implications for portfolio selection

The risk-averse investor is one that dislikes risk. given two investments that have equal expected returns, a risk-averse investor will choose the one with less risk. However, a risk-averse investor will hold risky assets if he feels that the extra return he expects to earn is adequate compensation for the additional risk. Assets in the financial markets are priced according to the preferences of risk-averse investors. A risk-seeking (risk-loving) investor actually prefers more risk to less and, given investments with equal expected returns, will choose the more risky investment. A risk-neutral investor has no preference regarding risk and would be indifferent between two investments with the same expected return but different standard deviation of returns.

LOS 34.h: Identify potential risks of poor corporate governance and stakeholder management and identify benefits from effective corporate governance and stakeholder management.

The risks of poor governance include weak control systems, poor decision making, legal risk, reputational risk, and default risk. Good corporate governance can improve operational efficiency and performance, reduce default risk, reduce the cost of debt, improve financial performance, and increase firm value.

LOS 41.e Calculate and interpret portfolio standard deviation

The standard deviation of returns for a portfolio of two risky assets is calculated as follows: σportfolio = √w1^2σ^2+w2^2σ^2 +2w1w2p1,2σ1σ2

LOS 54.j: Describe how the term structure of yield volatility affects the interest rate risk of a bond.

The term structure of yield volatility refers to the relationship between maturity and yield volatility. Short-term yields may be more volatile than long-term yields. As a result, a short-term bond may have more price volatility than a longer-term bond with a higher duration.

LOS 44.a: Explain the main functions of the financial system

The three main functions of the financial system are to: 1. Allow entities to save, borrow, issue equity capital, manage risks, exchange assets, and utilize information 2. Determine the return that equates aggregate savings and borrowing 3. Allocate capital efficiently

LOS 39.d: Describe the steps in the portfolio management process.

The three steps in portfolio management process are: 1. Planning: Determine client needs and circumstances, including the client's return objectives, risk tolerance, constraints, and preferences. Create, and then periodically review and update, an investment policy statement (IPS) that spells out these needs and circumstances. 2.Execution: Construct the client portfolio by determining suitable allocations to various asset classes based on the IPS and on expectations about macroeconomic variables such as inflation, interest rates, and GDP growth (top-down analysis), Identify attractively priced securities within an asset class for client portfolios based on valuation estimates from security analysts (bottom-up analysis) 3. Feedback: Monitor and rebalance the portfolio to adjust asset class allocations and securities holdings in response to market performance. Measure and report performance relative to the performance benchmark specified in the IPS

LOS 58.e: Describe, calculate, and interpret management and incentive fees and net-of-fees returns to hedge funds.

The total fee for a hedge fund consists of a management fee and an incentive fee. Other fee structure specifications include hurdle rates and high water marks. Funds of funds incur additional level of management fees. Fee calculations for both management fees and incentive fees can differ by the schedule and method of fee determination

LOS 34.j: Describe environmental and social considerations in investment analysis.

The use of environmental, social, and governance (ESG) factors in making investment decisions is referred to as ESG investing. Many issues can be considered in this context, including harm or potential harm to the environment, risk of loss due to environmental accidents, the changing demographics of the workforce, and reputational risks from corrupt practices or human rights abuses.

LOS 46.d: Contrast weak-form, semi-strong-form, and strong-form market efficiency

The weak form of the efficient market hypothesis (EMH) states that security prices fully reflect all past price and volume information. The semi-strong form of the EMH states that security prices fully reflect all publicly available information. The strong form of the EMH states that security prices fully reflect all public and private information

LOS 38.g; Evaluate the choices of short-term funding available to a company and recommend a financing method.

There are many choices for short-term borrowing. The firm should keep costs down while also allowing for future flexibility and alternative sources. The choice of short-term funding sources depends on a firm's size and creditworthiness. Sources available, in order of decreasing firm creditworthiness and increasing cost, include: -Commercial paper -Bank lines of credit -Collateralized borrowing -nonbank financing -Factoring.

LOS 44.j: Describe how securities, contracts, and currencies are traded in quote-driven, order-driven, and brokered markets.

There are three main categories of securities markets: 1. Quote-driven markets: Investors trade with dealers that maintain inventories of securities, currencies, or contracts. 2. Order-driven markets: Order-matching and trade-pricing rules are used to match the orders of buyers and sellers. 3. Brokered markets: Brokers locate a counterparty to take the other side of a buy or sell order. In call markets, the securities are only traded at specific times. In continuous markets, trades occur at any time the market is open.

LOS 54.f: Calculate the duration of a portfolio and explain the limitations of portfolio duration

There are two methods for calculating portfolio duration: -Calculate the weighted average number of periods until cash flows will be received using the portfolio's IRR (its cash flow yield). This method is better theoretically but cannot be used for bonds with options -Calculate the weighted average of durations of bonds in the portfolio (the method most often used). Portfolio duration is the percentage change in portfolio value for a 1% change in yields, only for parallel shifts of the yield curve.

LOS 57.n: Explain how the value of an option is determined using a one-period binomial model.

To determine the value of an option using a one-period binomial model, we calculate its payoff following an up-move and following a down-move, estimate risk-neutral probabilities of an up-move and a down-move, calculate the probability-weighted average of its up-move and down move payoffs, and discount this value by one period.

LOS 38.d: Describe how different types of cash flows affect a company's net daily cash position.

To manage its net daily cash position, a firm needs to forecast its cash inflows and outflows and identify periods when its cash balance may be lower than needed or higher than desired. Cash inflows include operating receipts, cash from subsidiaries, cash received from securities investments, tax refunds, and borrowing. Cash outflows include purchases, payroll, cash transfers to subsidiaries, interest and principal paid on debt, investments in securities, taxes paid, and dividends paid.

LOS 33.a: Evaluate a company's past financial performance and explain how a company's strategy is reflected in past financial performance.

Trends in a company's financial ratios and differences between its financial ratios and those of its competitors or industry average ratios can reveal important aspects of business strategy.

LOS 39.b: describe types of investors and distinctive characteristics and needs of each.

Types of investment management clients and their characteristics: InvestorType-RiskTolerance-InvestmentHorizon-LiquidityNeeds-IncomeNeeds Individual-Depends on individual-Depends-Depends-Depends Banks-Low-Short-High-PayInterst Endowments-High-Long-Low-SpendingLevel Insurance-Low-Long(life)Short(P&C)-High-Low Mutualfunds-DependsonFund-depends-High-Depends DefinedBenefitPension-High-Long-Low-DependsonAge

LOS 31.g: Distinguish between a finance lease and an operating lease from the perspectives of the lessor and lessee.

Under IFRS, if substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease by both the lessee and the lessor. Otherwise, the lease is an operating lease. Under US GAAP, the lessee must treat a lease as a capital (finance) lease if any one of the following criteria is met: -Title to the leased asset is transferred to the lessee at the end of the lease period. -A bargain purchase option exists. -The lease period is 75% or more of the asset's economic life. -The present value of the lease payments in 90% or more of the fair value of the leased asset. Under US GAAP, the lessor capitalizes the lease if any one of the finance lease criteria for lessees is met, collectability of lease payments is reasonably certain, and the lessor has substantially completed performance.

LOS 37.c: Analyze the effect of financial leverage on a company's net income and return on equity.

Using more debt and less equity in a firm's capital structure reduces net income through added interest expense but also reduces net equity. The net effect can be to either increase or decrease ROE.

LOS 57.a: Explain how the concepts of arbitrage, replication, and risk neutrality are used in pricing derivatives.

Valuation of derivatives is based on a no-arbitrage condition with risk-neutral pricing. Because the risk of a derivative is entirely based on the risk of the underlying asset, we can construct a fully hedged portfolio and discount its future cash flows at the risk-free rate. We can describe three replications among a derivative, its underlying asset, and a risk-free asset: risky asset + derivative = risk-free asset risky asset - risk free asset = -derivative position derivative position - risk-free asset = -risky asset

LOS 36.a: Calculate and interpret the weighted average cost of capital (WACC) of a company

WACC = (wd)(kd)(1-t) + (wps)(kps) + (wce)(kce) The weighted average cost of capital, or WACC, is calculated using weights based on market values of each component of a firm's capital structure and is the correct discount rate to use to discount the cash flows of projects with risk equal to the average risk of a firm's projects.

LOS 36.c: Describe the use of target capital structure in estimating WACC and how target capital structure weights may be determined.

WACC should be calculated based on a firm's target capital structure weights. If information on a firm's target capital structure is not available, an analyst can use the firm's current capital structure, based on market values, or the average capital structure in the firm's industry as estimates of the target capital structure.

LOS 41.c: Calculate and interpret the mean, variance, and covariance (or correlation) of asset returns based on historical data.

We can calculate the population variance σ^2 when we know the return Rt for period t, the total number T of periods, and the mean µ of the population's distribution: Population variance = σ^1 = ∑(Rt-µ)^2 /T In finance, we typically analyze only a sample of returns, so the sample variance applies instead: Sample variance = S^2 = ∑(Rt-Rbar)^2 /T-1 Covariance measures the extent to which two variables move together over time. Positive covariance means the variables (e.g., rates of return on two stocks) tend to move together. Negative covariance means that the two variables tend to move in opposite directions. Covariance of zero means there is no linear relationship between the two variables. Correlation is a standardized measure of co-movement that is bonded by -1 and +1: p1,2 = Cov1,2/σ1σ2

LOS 31.a: Determine the initial recognition, initial measurement and subsequent measurement of bonds.

When a bond is issued, assets and liabilities both initial increase by the bond proceeds. At any point in time, the book value of the bond liability is equal to the present value of the remaining future cash flows (coupon payments and maturity value) discounted at the market rate of interest at issuance. The proceeds are reported in the cash flow statement as an inflow from financing activities. A premium bond (coupon rate>market yield at issuance) is reported on the balance sheet at a value greater than its face value. As the premium is amortized (reduced), the book value of the bond liability will decrease until it reaches its face value at maturity. A discount bond (market yield at issuance > coupon rate) is reported on the balance sheet at less than its face value. As the discount is amortized, the book value of the bond liability will increase until it reaches its face value at maturity.

LOS 36.i: Calculate and interpret the beta and cost of capital for a project.

When a project's risk differs from that of the firms average project, we can use the beta of a company or group of companys that are exclusively in the same business as the project to calculate the project's required rate of return. This pure-play method involves the following steps: 1. Estimate the beta for a comparable company or companies. 2. Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company: βasset = βequity{1/1+[(1-t)(D/E)]} 3. Relever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project: βproject=βasset{1+[(1-t)(D/E)]} 4. Use the CAPM to estimate the required return on equity to use when evaluating the project. 5. Calculate the WACC for the firm using the projects' required return on equit.

LOS 29.a: Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred.

When an asset is expected to provide benefits for only the current period, its cost is expensed on the income statement for the period. If an asset is expected to provide benefits over multiple periods, it is capitalized rather than expensed.

LOS 31.c: Explain the derecognition of debt.

When bonds are redeemed before maturity, a gain or loss is recognized equal to the difference between the redemption price and the carrying (book) value of the bond liability at the reacquisition date.

LOS 33.e: Explain appropriate analyst adjustments to a company,s financial statements to facilitate comparison with another company.

When companies use different accounting methods or estimates relating to areas such as inventory accounting, depreciation, capitalization, and off-balance-sheet financing, analysts must adjust the financial statements for comparability. LIFO ending inventory can be adjusted to a FIFO basis by adding the LIFO reserve. LIFO cost of goods sold can be adjusted to FIFO basis by subtracting the change in the LIFO reserve. When calculating solvency ratios, analysts should estimate the present value of operating lease obligations and add it to the firm's liabilities.

LOS 43.d: Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor's financial risk tolerance

Willingness to take financial risk is related to an investors psychological factors, such as personality type and level of financial knowledge. Ability or capacity to take risk depends on financial factors, such as wealth relative to liabilities, income stability, and time horizon. A client's overall risk tolerance depends on both his ability to take risk and his willingness to take risk. A willingness greater than ability, or vice versa, is typically resolved by choosing the more conservative of the two and counseling the client.

LOS 35.c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing

acceptable independent projects can all be undertaken, while a firm must choose between or among mutually exclusive projects. Project sequencing concerns the opportunities for future capital projects that may be created by undertaking a current project. If a firm cannot undertake all profitable projects because of limited availability to raise capital, the firm should choose that group of fundable positive NPV projects with the highest total NPV.

LOS 40.g: Describe methods for measuring and modifying risk exposures and factors to consider in choosing among the methods.

risk of assets is measured by standard deviation, beta, or duration. Derivatives risk measures include delta, gamma, vega, and rho. Tail risk is measured with value at risk (VaR) or conditional VaR. Some risks must be measured subjectively. An organization may decide to bear a risk (self-insurance), avoid or take steps to prevent a risk, efficiently manage a risk through diversification, transfer a risk with insurance or a surety bond, or shift a risk (change the distribution of uncertain outcomes) with derivatives. Organizations may use multiple methods of risk modification after considering the cost and benefits from the various methods. The end result is a risk profile that matches the organization's risk tolerance and includes the risks that top management has determined match the organization's goals.

LOS 58.a: Compare alternative investments with traditional investments

"traditional investments" refers to long-only positions in stocks, bonds, and cash. "alternative investments" refers to some types of assets such as real estate, commodities, and various collectables, as well as some specific structures of investment vehicles. hedge funds and private equity funds (including venture capital funds) are often structured as limited partnerships; real estate investment trusts (REITs) are similar to mutual funds; and ETFs can contain alternative investments as well. Compared to traditional investments, alternative investments typically have lower liquidity; less regulation and disclosure; higher management fees and more specialized management; Potential diversification benefits; more use of leverage, use of derivatives; potentially higher returns; limited and possibly biased historical returns on data; problematic historical risk measures; and unique legal and tax considerations.

LOS 50.b: Describe content of a bond indenture

A bond indenture or trust deed is a contract between a bond issuer and the bondholders, which defines the bond's features of the issuer's obligations. An indenture specifies the entity issuing the bond, the source of funds for repayment, assets pledged as collateral, credit enhancements, and any covenants with which the issuer must comply

LOS 50.e: Describe how cash flows of fixed-income securities are structured.

A bond with a bullet structure pays coupon interest periodically and repays the entire principal value at maturity A bond with an amortizing structure repays part of its principal at each payment date. A fully amortizing structure makes equal payments throughout the bond's life. A partially amortizing structure has a balloon payment at maturity, which repays the remaining principal as a lump sum. A sinking fund provision requires the issuer to retire a portion of a bond issue at specified times during the bonds life. Floating-rate notes have coupon rates that adjust based on a reference rate such as Libor. Other coupon structures include step-up coupon notes, credit-linked coupon bonds, payment-in-kind bonds, deferred coupon bonds, and index-linked bonds

LOS 52.b: Identify the relationships among a bond's price, coupon rate, maturity, and market discount rate (yield-to-maturity).

A bond's price and YTM are inversely related. An increase in YTM decreases the price and a decrease in YTM increases the price. A bond will be priced at a discount to par value if its coupon rate is less than its YTM, and at a premium to par value if its coupon rate is greater than its YTM. Prices are more sensitive to changes in YTM for bonds with lower coupon rates and longer maturities, and less sensitive to changes in YTM for bonds with higher coupon rates and shorter maturities. A bond's price moves towards par value as time passes and maturity approaches.

LOS 54.l: Explain how changes in credit spread and liquidity affect yield-to-maturity of a bond and how duration and convexity can be used to estimate the price effect of the changes.

A bond's yield spread to the benchmark curve includes a premium for credit risk and a premium for illiquidity. Given values for duration and convexity, the effect on the value of a bond from a given change in its yield spread (∆spread) can be estimated as: -duration(∆spread) + .5convexity(∆spread)^2

LOS 27.f: Explain the requirements for segment reporting and calculate and interpret segment ratios.

A business or geographic segment is a portion of a firm that has risk and return characteristics distinguishable from the rest of the firm and accounts for more than 10% of the firm's sales or assets. Firms are required to report some items for significant business and geographic segments. Profitability, leverage, and turnover ratios by segment can give an analyst a better understanding of the performance of the overall business.

LOS 33.b: Forecast a company's future net income and cash flow.

A company's future net income and cash flows can be projected by forecasting sales growth and using estimates of profit margins and the increases in working capital and fixed assets necessary to support the forecast sales growth.

LOS 36.j: Describe uses of country risk premiums in estimating the cost of equity.

A country risk premium should be added to the market risk premium in the Capital Asset Pricing Model to reflect the added risk associated with investing in a developing market.

LOS 48.c: Explain the factors that affect the sensitivity of a company to the business cycle and the uses and limitations of industry and company descriptors such as "growth", "defensive", and "cyclical"

A cyclical firm has earnings that are highly dependent on the business cycle. A non-cyclical firm has earnings that are less dependent on the business cycle. Industries can also be classified as cyclical or non-cyclical. Non-cyclical industries or firms can be classified as defensive (demand for the product tends not to fluctuate with the business cycle) or growth (demand is so strong that it is largely unaffected by the business cycle). Limitations of descriptors such as growth, defensive, and cyclical include the facts that cyclical industries often include growth firms; even non-cyclical industries can be affected by severe recessions; defensive industries are not always safe investments; business cycle timing differs across countries and regions; and the classification for firms is somewhat arbitrary.

LOS 30.g: Explain how deferred tax liabilities and assets are created and the factors that determine how a company's deferred tax liabilities and assets should be treated for the purpose of financial analysis.

A deferred tax liability is created when income tax expense (income statement) is higher than taxes payable (tax return). Deferred tax liabilities occur when revenues (or gains) are recognized in the income statement before they are taxable on the tax return, or expenses (or losses) are tax deductible before they are recognized on the income statement. A deferred tax asset is created when taxes payable (tax return) are higher than income tax expense (income statement). Deferred tax assets are recorded when revenues (or gains) are taxable before they are recognized in the income statement, when expenses (or losses) are recognized in the income statement before they are tax deductible, or when tax loss carryforwards are available to reduce future taxable income. Deferred tax liabilities that are not expected to reverse, typically because of expected continued growth in capital expenditures, should be treated for analytical purposes as equity. If deferred tax liabilities are expected to reverse, they should be treated for analytical purposes as liabilities.

LOS 56.a: Define a derivative and distinguish between exchange-traded and over-the-counter derivatives

A derivative's value is derived from the value of another asset or an interest rate Exchange-traded derivatives, notably futures and some options, are traded in centralized locations (exchanges) and are standardized, regulated, and are free of default Forwards and swaps are custom contracts (over-the-counter derivatives) created by dealers for financial institutions. There is limited trading of these contracts in secondary markets and default (counterparty) risk must be considered

LOS 39.a: Describe the portfolio approach to investing

A diversified portfolio produces reduced risk for a given level of expected return, compared to investing in an individual security. Modern portfolio theory concludes that investors that do not take a portfolio perspective bear risk that is not rewarded with greater expected return.

LOS 57.l: Explain put-call parity for European options

A fiduciary call ( a call option and a risk-free zero-coupon bond that pays the strike price X at expiration) and a protective put (a share of stock and a put at X) have the same payoffs at expiration, so arbitrage will force these positions to have equal prices: c+X/(1-RF)^T = S+p. This establishes put-call parity for European options. Based on the put-call parity relation, a synthetic security (stock, bond, call, or put) can be created by combining long and short positions in the other three securities. -c = s+p-X/(1+Rf)^T -p=c-S+X/(1+Rf)^T -S=c-p+X/(1+Rf)^T -X/(1+Rf)^T=S+p-c

LOS 31.h: Determine the initial recognition, initial measurement, and subsequent measurement of finance leases.

A finance lease is, in substance, a purchase of an asset that is financed with debt. At any point in time, the lease liability is equal to the present value of the remaining lease payments. From the lessee's perspective, finance lease expense consists of depreciation of the asset and interest on the loan. The finance lease payment consists of an operating outflow of cash (interest expense) and a financing outflow of cash (principle reduction). An operating lease is simply a rental arrangement; no asset or liability is reported by the lessee. The rental payment is reported as an expense and as an operating outflow of cash. From the lessor's perspective, a finance lease is either a sales-type lease or a direct financing lease. In either case, a lease receivable is created in the inception of the lease, equal to the present value of the lease payments. The lease payments are treated as part interest income (CFO) and part principle reduction (CFI). With a sales-type lease, the lessor recognizes gross profit at the inception of the lease and interest income over the life of the lease. With a direct financing lease, the lessor recognizes interest income only.

LOS 31.j: Compare the presentation and disclosure of defined contribution and defined benefit pension plans.

A firm reports a net pension liability on its balance sheet if the fair value of a defined benefit plan's asset is less than the estimated pension obligation, or a net pension asset if the fair value of the plan's assets is greater than the estimated pension obligation. The change in net pension asset or liability is reflected in a firm's comprehensive income each year. Under IFRS, service costs (including past service costs) and interest income or expense on the beginning plan balance are included in pension expense in the income statement. Remeasurements are recorded in other comprehensive income. These include actuarial gains or losses and the difference between the actual return and the expected return on plan assets. Under US GAAP, service costs, interest income or expense, and the expected return on plan assets are included in pension expense. Past service costs and actuarial gains or losses are recorded in other comprehensive income and amortized over time to the income statement. Pension expense for a defined contribution pension plan is equal to employer' contributions.

LOS 38.f: Evaluate a company's management of accounts receivable, inventory, and accounts payable over time and compared to peer companies.

A firm's inventory, receivables, and payables management can be evaluated by comparing days of inventory, days of receivables, and days of payables for the firm over time and by comparing them to industry averages or averages for a group of peer companies. A receivables aging schedule and a schedule of weighted average days of receivables can each provide additional detail for evaluating receivables management.

LOS 36.d: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget.

A firm's marginal cost of capital (WACC at each level of capital investment) increases as it needs to raise larger amounts of capital. This is shown by an upward-sloping marginal cost of capital curve. An investment opportunity schedule shows the IRRs of (in decreasing order), and the initial investment amounts for, a firm's potential projects. The intersection of a firm's investment opportunity schedule with its marginal cost of capital curve indicates the optimal amount of capital expenditure, the amount of investment required to undertake all positive NPV projects.

LOS 56.b: Contrast forward commitments with contingent claims

A forward commitment is an obligation to buy or sell an asset or make a payment in the future. Forward contracts, futures contracts, and swaps are all forward commitments. A contingent claim is an asset that has a future payoff only if some future event takes place (e.g., asset price is greater than a specified price.) Options and credit derivatives are contingent claims.

LOS 57.e: Define a forward rate agreement and describe its uses

A forward rate agreement (FRA) is a derivative contract that has a future interest rate, rather than an asset, as its underlying. FRAs are used by firms to hedge the risk of borrowing and lending they intend to do in the future. A firm that intends to borrow in the future can lock in an interest rate with a long position in an FRA. A firm that intends to lend in the future can lock in an interest rate with a short position in an FRA.

LOS 44.e: Compare positions an investor can take in an asset.

A long position in an asset represents current or future ownership. A long position benefits when the asset increases in value. A short position represents an agreement to sell or deliver an asset or results from borrowing an asset and selling it (i.e., a short sale). A short position benefits when the asset decreases in value. When an investor buys a security by borrowing from a broker, the investor is said to buy on margin and has leveraged position. The risk of investing borrowed funds is referred to as financial leverage. More leverage results in greater risk.

LOS 46.f: Describe market anomalies

A market anomaly is something that deviates from the efficient market hypothesis. Most evidence suggests anomalies are not violations of market efficiency but are due to the methodologies used in anomaly research, such as data mining or failing to adjust adequately for risk. Anomalies that have been identified in time-series data include calendar anomalies such as the January effect (small firm stock returns are higher at the beginning of January), overreaction anomalies (stock returns subsequently reverse), and momentum anomalies (high short-term returns are followed by continued high returns). Anomalies that have been identified in cross-sectional data include a size effect (small-cap stocks outperform large-cap stocks) and a value effect (value stocks outperform growth stocks). Other identified anomalies involve closed-end investment funds selling at a discount to NAV, slow adjustments to earnings uprises, investor overreaction to and long-term underperformance of IPOs, and a relationship between stock returns and prior economic fundamentals.

LOS 44.h: Compare market orders with limit orders.

A market order is an order to execute the trade immediately at the best possible price. A market order is appropriate when the trader wants to execute a transaction quickly. The disadvantage of a market order is that it may execute at an unfavorable price. A limit order is an order to trade at the best possible price, subject to the price satisfying the limit condition. A limit order avoids price execution and uncertainty. The disadvantage of a limit order is that it may not be filled. A buy (sell) order with a limit of $18 will only be executed if the security can be bought (sold) at a price of $18 or less (more).

LOS 48.d: Explain how a company's industry classification can be used to identify a potential "peer group" for equity evaluation

A peer group should consist of companies with similar business activities, demand drivers, cost structure drivers, and availability of capital. To form a peer group, the analyst will often start by identifying companies in the same industry, but the analyst should use other information to verify that the firms in an industry are comparable.

LOS 45.b: Calculate and interpret the value, price return, and total return of an index

A price index uses only the prices of the constituent securities in the return calculation. The rate of return is called the price return A total return index uses both the price of and the income from the index securities in the return calculation

LOS 45.d: Compare the different weighting methods used in index construction

A price-weighted index is the arithmetic mean of the prices of the index securities. The divisor, which is initially equal to the number of securities in the index, must be adjusted for stock splits and changes in the composition of the index over time. An equal-weighted index assigns the same wight to each of its constituent securities A market capitalization-weighted index gives each constituent security a weight equal to its proportion of the total market value of all securities in the index. Market capitalization can be adjusted for a security's market float or free float to reflect the fact that not all outstanding shares are available for purchase A fundamental-weighted index uses weights that are independent of security prices, such as company earnings, revenue, assets, or cash flow

LOS 51.j: Describe repurchase agreements (repos) and the risks associated with them

A repurchase agreement is a form of short-term collateralized borrowing in which one party sells a security to another party and agrees to buy it back at a predetermined future date and price. The repo rate is the implicit interest rate of a repurchase agreement. The repo margin, or haircut, is the difference between the amount borrowed and the value of the security. Repurchase agreements are an important source of short-term financing for bond dealers. If a bond dealer is lending funds instead of borrowing, the agreement is known as a reverse repo.

LOS 42.d: Explain return generating models (including the market model) and their uses.

A return generating model is an equation that estimates the expected return of an investment, based on a security's exposure to one or more macroeconomic, fundamental, or statistical factors. The simplest return generation model is the market model, which assumes the return on an asset is related to the return on the market portfolio in the following manner: Ri = αi + βiRm + ei Where Ri = Return on asset i Rm = market return βi= Slope coefficient αi = intercept ei = abnormal return on asset i

LOS 45.a: Describe a security market index

A security market index represents the performance of an asset class, security market, or segment of a market. The performance of the market or segment over a period of time is represented by the percentage change in (i.e. the return on) the value of the index

LOS 32. b: Describe a spectrum for assessing financial reporting quality.

A spectrum for assessing financial reporting quality considers both the quality of a firm's financial statements and the quality of its earnings. One such spectrum, from highest quality to lowest, is the following: -Reporting is compliant with GAAP and decision useful; earnings are sustainable and adequate -reporting is compliant and decision useful, but earnings quality is low. -Reporting is compliant, but earnings quality is low and reporting choices and estimates are biased. -Reporting is compliant, but earnings are actively managed. -Reporting is not compliant, but the numbers presented are based on the company's actual economic activities.. -Reporting is not compliant and includes numbers that are fictitious or fraudulent.

LOS 48.e: Describe the elements that need to be covered in a thorough industry analysis.

A thorough industry analysis should: -Evaluate the relationships between macroeconomic variables and industry trends. -Estimate industry variables using different approaches and scenarios. -Check estimates against those from other analysts. -Compare the valuation for different industries. -Compare the valuation for industries across time to determine risk and rotation strategies. -Analyze industry prospects based on strategic groups -Classify industries by their life-cycle stage -Position the industry on the experience curve -Consider demographic, macroeconomic, governmental, social, and technological influences. -Examine the forces that determine industry competition

LOS 25.g: Convert balance sheets to common-size balance sheets and interpret common-size balance sheets.

A vertical common-size balance sheet expresses each item of the balance sheet as a percentage of total assets. The common-size format standardizes the balance sheet by eliminating the effects of size. This allows for comparison over time (time-series analysis) and across firms (Cross-sectional analysis)

LOS 44.k: Describe characteristics of a well-functioning financial system.

A well-functioning financial system has the following characteristics: -Complete markets: Savers receive a return, borrowers can obtain capital, hedgers can manage risks, and traders can acquire needed assets. -Operational efficiency: trading costs are low -Informational efficiency: Prices reflect fundamental information quickly -Allocation efficiency: Capital is directed to its highest valued use.

LOS 43.a: Describe the reasons for a written investment policy statement (IPS)

A written investment policy statement, the first step in the portfolio management process, is a plan for achieving investment success. An IPS forces investment discipline and ensures that goals are realistic by reacquiring investors to articulate their circumstances, objectives, and constraints.

LOS 52.g: Define and compare the spot curve, yield curve on coupon bonds, par curve, and forward curve.

A yield curve shows the term structure of interest rates by displaying yields across different maturities The spot curve is a yield curve for single payments in the future, such as zero-coupon bonds or stripped treasury bonds. The par curve shows the coupon rates for bonds of various maturities that would result in bond prices equal to their par values. A forward curve is a yield curve composed of forward rates, such as 10year rates available at each year over a future period.

LOS 52.i: Compare, calculate, and interpret yield spread measures

A yield spread is the difference between a bond's yield and a benchmark yield or yield curve. If the benchmark is a government bond yield, the spread is known as a government spread or G-spread. If the benchmark is a swap rate, the spread is known as an interpolated spread or I-spread. A zero-volatility spread or Z-spread is the percent spread that must be added to each spot rate on the benchmark yield curve to make the present value of a bond equal to its price. An option-adjusted spread or OAS is used for bonds with embedded options, for a callable bond, the OAS is equal to the Z-spread minus the call option value in basis points.

LOS 32.h: Describe accounting methods (choices and estimates) that could be used to manage earnings, cash flow, and balance sheet items.

Accounting choices and estimates that can be used to manage earnings include: -Revenue recognition choices such as shipping terms (FOB shipping point versus FOB destination), accelerating shipments (channel stuffing), and bill-and-hold transactions. -Estimates of reserves for uncollectible accounts or warranty expenses. -Valuation allowances on deferred tax assets. -Depreciation methods, estimates of useful lives and salvage values, and recognition of impairments. -Inventory cost flow methods. -Capitalization of expenses. -Related-party transactions.

LOS 32.i: Describe accounting warning signs and methods for detecting manipulation of information in financial reports.

Accounting warning signs that indicate a need for closer analysis may include: -Revenue growth out of line with comparable firms, changes in revenue recognition methods, or lack of transparency about revenue recognition. -Decrease over time in turnover ratios (receivables, inventory, total asset). -Bill-and-hold, barter, or related-party transactions. -net income not supported by operating cash flows. -Capitalization decisions, depreciation methods, useful lives, salvage values of line with comparable firms -Fourth-quarter earnings pattens not caused by seasonality -frequent appearance of nonrecurring items -Emphasis on non-GAAP measures, minimal information and disclosure in financial reports.

LOS 27.b: Classify, calculate, and interpret activity, liquidity, solvency, profitability, and valuation ratios.

Activity ratios indicate how well a firm uses its assets. They include receivables turnover, days of sales outstanding, inventory turnover, days of inventory on hand, payables turnover, payables payment period, and turnover ratios for total assets, fixed assets and working capital. Liquidity ratios indicate a firm's ability to meet its short-term obligations. they include the current, quick, and cash ratios, the defensive interval, and the cash conversion cycle. Solvency ratios indicate a firm's ability to meet its long-term obligations. They include the debt-to-equity ratio, debt-to-capital ratio, debt-to-assets ratio, financial leverage, interest coverage, and fixed charge coverage ratios. Profitability ratios indicate how well a firm generates operating income and net income. They include net, gross, and operating profit margins, pretax margin, return on assets, operating return on assets, return on total capital, return on total equity, and return on common equity. Valuation ratios are used to compare the relative values of stocks. They include earnings per share and price-to-earnings, price-to-sales, price-to-book value, and price-to-cash flow ratios.

LOS 49.m: Explain advantages and disadvantages of each category of valuation model.

Advantages of discounted cash flow models: -Easy to calculate -Widely accepted in the analyst community -FCFE model is useful for firms that currently do not pay a dividend -Gordon growth model is useful for stable, mature, non-cyclical firms. -Multistage models can be used for firms with non consistent growth Disadvantages of discounted cash flow models: -Inputs must be forecast -Estimates are very sensitive to inputs -For the Gordon growth model specifically: >Very Sensitive to the k - g denominator >Required return on equity must be greater than the growth rate >required return on equity and growth rate must remain constant >Firm must pay dividends. Advantages of price multiples: -Often useful for predicting stock returns. -Widely used by analysts -Easily calculated and readily available -Can be used in time series and cross-sectional comparisons -EV/EBITDA multiples are useful when comparing firm values independent of capital structure or when earnings are negative and the P/E ratio cannot be used. Disadvantages of price multiples: -P/E ratio based on fundamentals will be very sensitive to the inputs -may not be comparable across firms, especially internationally -Multiples for cyclical firms may be greatly affected by economic conditions. P/E ratio may be especially inappropriate. (The P/S multiple may be more appropriate for cyclical firms) -A stock may appear overvalued by the comparable method but undervalued by the fundamental method or vice versa. -Negative denominator results in a meaningless ratio; the P/E ratio is especially susceptible to this problem -A potential problem with EV/EBITDA multiples is that the market value of a firm's debt is often not available. Advantages of asset-based models: -Can provide floor values -Most reliable when the firm has mostly tangible short-term assets, assets with a ready market value, or when the firm is being liquidated -May be increasingly useful for valuing public firms if they report fair values. Disadvantages of asset based models: -Market values of assets can be difficult to obtain and are usually different than book values -Inaccurate when a firm has a large amount of intangible assets or future cash flows not reflected in asset value -Asset values can be difficult to value during periods of hyperinflation.

LOS 53.e: Describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type.

Agency residential mortgage-backed securities (RMBS) are guaranteed and issued by GNMA, Fannie Mae, or Freddie Mac. Mortgages that back agency RMBS must be confirming loans that meet certain minimum credit quality standards. Non-agency RMBS are issued by private companies and may be backed by non-conforming mortgages. Key characteristics of RMBS include: -Pass-through rate, the coupon rate on the RMBS -Weighted average maturity (WAM) and weighted average coupon (WAC) of the underlying pool of mortgages. -Conditional prepayment rate (CPR), which may be compared to the public securities administration (PSA) benchmark for expected prepayment rates. Non-agency RMBS typically include credit enhancement. External credit enhancement is a third-party guarantee. Internal credit enhancement includes reserve funds (cash or excess spread), overcollateralization, and senior/subordinated structures. Collateralized mortgage obligations (CMOs) are collateralized by pools of residential MBS. CMOs are structured with tranches that have different exposures to prepayment risks. In a sequential-pay CMO, all scheduled principal payments and prepayments are paid to each tranche in sequence until that tranche is paid off. the first tranche to be paid principal has the most contraction risk and the last tranche to be paid principal has the most extension risk. A planned amortization class (PAC) CMO has PAC tranches that receive predictable cash flows as long as the prepayment rate remains within a predetermined range, and support tranches that have more contraction risk and more extension risk than the PAC tranches.

LOS 35.e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods

An NPV profile plots a project's NPV as a function of the discount rate, and it intersects the horizontal axis (NPV=0) at its IRR. If two NPV profiles intersect at some discount rate that is the crossover rate, and different projects are preferred at discount rates higher and lower than the crossover rate. For projects with conventional cash flow patterns, the NPV and IRR methods produce the same accept/reject decision, but projects with unconventional cash flow patterns can produce multiple IRRS or no IRR. Mutually exclusive projects can be ranked based on their NPVs, but rankings based on other methods will not necessarily maximize the value of the firm.

LOS 43.f: Explain the specification of asset classes in relation to asset allocation

An asset class is a group of securities with similar risk and performance characteristics. Examples of major asset classes include equity, fixed income, cash, and real estate Portfolio managers also use more narrowly defined asset classes, such as large cap US equities or speculative international bonds, and alternative asset classes, such as commodities or investments in hedge funds.

LOS 49.a: Evaluate whether a security, given its current market price and a value estimate, is overvalued, fairly valued, or undervalued by the market.

An asset is fairly valued if the market price is equal to its estimated intrinsic value, undervalued if the market price is less than its estimated value, and overvalued if the market price is greater than the estimated value. For a security valuation to be profitable, the security must be mispriced now and price must converge to intrinsic value over the investment horizon. Securities that are followed by many investors are more likely to be fairly valued than securities that are neglected by analysts.

LOS 46.b: Distinguish between market value and intrinsic value

An asset's market value is the price at which it can currently be bought or sold An asset's intrinsic value is the price that investors with full knowledge of the asset's characteristics would place on the asset

LOS 41.h: Explain the selection of an optimal portfolio, given an investor's utility (or risk aversion) and the capital allocation line. (graph relevant)

An indifference curve plots combinations of risk and expected return that an investor finds equally acceptable. Indifference curves generally slope upward because risk-averse investors will only take on more risk if they are compensated with greater expected returns. A more risk-averse investor will have steeper indifference curves. Flatter indifference curves (less risk aversion) result in an optimal portfolio with higher risk and higher expected return. An investor who is less risk averse will optimally choose a portfolio with more invested in the risky asset portfolio and less invested in the risk-free asset.

LOS 26.g: Convert cash flows from the indirect to direct method.

An indirect cash flow statement can be converted to a direct cash flow statement by adjusting each income statement account for changes in associated balance sheet accounts and by eliminating noncash and non-operating items.

LOS 40.b: Describe features of a risk management framework

An overall risk management framework should address the following activities: -Identifying and measuring existing risks. -determining the organization's overall risk tolerance -Establishing the process and policies for risk governance -managing and mitigating risks to achieve the optimal bundle of risks -monitoring risk exposures over time -communicating across the organization -performing strategic risk analysis.

LOS 29.m: Analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets.

Analysts can use disclosures of the historical cost, accumulated depreciation (amortization), and annual depreciation (amortization) expense to estimate average age of assets, total useful life of assets and remaining useful life of assets. These estimates are more accurate for firms that use straight-line depreciation Average age = accumulated depreciation/ annual depreciation expense Total useful life = historical cost/ annual depreciation expense. Remaining useful life = ending net PP&E/ annual depreciation expense.

LOS 31.k: Calculate and interpret leverage and coverage ratios.

Analysts use solvency ratios to measure a firm's ability to satisfy its long-term obligations. In evaluating solvency, analysts look at leverage ratios and coverage ratios. Leverage ratios, such as debt-to-assets, debt-to-capital, debt-to-equity, and the financial leverage ratio, focus on the balance sheet. Debt-to-assets ratio = total debt/ total assets debt-to-capital ratio=total debt/(total debt+total equtiy) debt-to-equity ratio=total debt/total equity financial leverage ratio=average total assets/average total equity Coverage ratios, such as interest coverage and fixed charge coverage,focus on the income statement. Interest coverage = EBIT/interest payments Fixed charge coverage = (EBIT+lease payment).(interest payments+lease payments)

LOS 23.i: Analyze company disclosures of significant accounting policies.

Under IFRS and U.S. GAAP, companies must disclose their accounting policies and estimates in the footnotes and MD&A. Public companies are also required to disclose the likely impact of recently issued accounting standards on their financial statement.

LOS 23.g: Identify characteristics of a coherent financial reporting framework and the barriers to creating such a framework.

A coherent financial reporting framework should exhibit transparency, comprehensiveness, and consistency. Barriers to creating a coherent framework include issues off valuation, standard setting, and measurement.

LOS 24.i: Distinguish between dilutive and anti dilutive securities and describe the implications of each for the earnings per share calculation.

A dilutive security is one that, if converted to its common stock equivalent, would decrease the EPS. An anti dilutive security is one that would not reduce EPS if converted to its common stock equivalent.

LOS 24.j: Convert income statements to common-size income statements.

A vertical common-size income statement expresses each item as a percentage of revenue. The common-size format standardizes the income statement by eliminating the effects of size. Common-size income statements are useful for trend analysis and for comparisons with peer firms.

LOS 28.h: Describe implications of valuing inventory at net realizable value for financial statements and ratios

A write-down of inventory value from cost to net realizable value will: -Decrease inventory, assets, and equity -Increase asset turnover, the debt to equity ratio and the debt to asset ratio. -Result in a loss on the income statement, which will decrease net income and the net profit margin, as well as ROA and ROE for a typical firm.

LOS 27.c: Describe relationships among ratios and evaluate a company using ratio analysis

An analyst should use an appropriate combination of different ratios to evaluate a company over time and relative to comparable companies. The interpretation of an increase on ROE, for example, may be quite different for a firm that has significntly increased its financial leverage compared to one that has maintained or decreased its financial leverage.

LOS 24.k: Evaluate a company's financial performance using common-size income statements and financial ratios based on the income statement.

Common-size income statements are useful in examining a firm's business strategies. Two popular profitability ratios are gross profit margin (Gross profit / revenue) and net profit margin (net income/revenue). A firm can often achieve higher profit margins by differentiating its products form the competition.

LOS 25.b: Describe uses and limitations of the balance sheet in financial analysis.

The balance sheet can be used to assess a firm's liquidity, solvency, and ability to pay dividends to shareholders. Balance sheet assets, liabilities, and equity should not be interpreted as market value or intrinsic value. For most firms, the balance sheet consists of a mixture of values including historical cost, amortized cost, and fair value. Some assets and liabilities are difficult to quantify and are not reported on the balance sheet.

LOS 21.f: Describe the steps in the financial statement analysis framework.

The framework for financial analysis has six steps: 1. State the objective of the analysis 2. Gather data 3. process the data 4. Analyze and interpret the data. 5. Report the conclusions or recommendations 6. Update the analysis.

LOS 22.e: Describe the need for accruals and valuation adjustments in preparing financial statements.

A firm must recognize revenues when they are earned and expenses when they are incurred. Accruals are required when the timing of cash payments made and received does not match the timing of the revenue or expense recognition on the financial statements.

LOS 28.e: Explain LIFO reserve and LIFO liquidation and their effects on financial statements and ratios.

A firm that reports under LIFO must disclose a LIFO reserve, which is the difference between LIFO inventory reported and inventory had the firm used the FIFO method. LIFO reserve will be positive during periods of rising inventory costs and negative during periods of falling inventory costs. A LIFO liquidation occurs when a firm using LIFO sells more inventory during a period than it produces. During periods of rising prices, this drawdown on inventory reduces cost of goods sold because the lower cost of previously produced inventory is used, resulting in an unsustainable increase in gross profit margin.

LOS 24.c: Calculate revenue given information that might influence the choice of revenue recognition method.

A firm using a revenue recognition method that is aggressive will inflate current period earnings at a minimum and perhaps inflate overall earnings. Because of the estimates involved, the percentage-of-completion method is more aggressive than the completed contract method. Also, the installment method is more aggressive than the cost recovery method.(Both display higher earnings in period).

LOS 30.f: Distinguish between temporary and permanent differences in pre-tax accounting income and taxable income.

A temporary difference is a difference between the tax base and the carrying value of an asset or liability that will result in taxable amounts or deductible amounts in the future. A permanent difference is a difference between taxable income and pretax income that will not revers in the future. Permanent differences do not create DTAs or DTLs.

LOS 27.d: Demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components.

Basic DuPont equation: ROE = (net income/sales)(sales/assets)(assets/equity) Extended DuPont equation: ROE = (net income/EBT)(EBT/EBIT)(EBIT/revenue)(revenue/total assets)(total assets/total equity)

LOS 24.h: Describe how earnings per share is calculated and calculate and interpret a company's earnings per share (both basic and diluted earnings per share) for both simple and complex capital structures.

Basic EPS = (net income - preferred dividends)/ (weighted average number of common shares outstanding) When a company has potentially dilutive securities, it must report diluted EPS. For a convertible preferred stock, Convertible debt, warrants, or stock options that are dilutive, the calculation of the diluted EPS is: diluted EPS= [(net income - preferred dividends)+(convertible preferred dividends)+(convertible debt interest)(1-tt)] / [(weighted average shares)+(Shares from conversion of conv. pfd shares)+(shares from conversion of conv. debt)+(shares issuable from stock options)]

LOS 25.e: Describe different types of assets and liabilities and the measurement bases of each.

Cash equivalents are short term, highly liquid financial assets that are readily converted to cash. Their balance sheet values are generally close to identical using either amortized cost or fair value. Accounts receivable are reported at net realizable value by estimating bad debt expense. Inventories are reported at the lower of cost or net realizable value (IFRS) or the lower of cost or market (US GAAP). Cost can be measured using standard costing or the retail method. different cost flow assumptions can affect inventory values. Property, plant, and equiptment (PP&E) can be reported using the cost model or revaluation model under IFRS. Under US GAAP, only the cost model is allowed. PP&E is impaired if its carrying value exceeds the recoverable amount. Recoveries of impairment losses are allowed under IFRS but not US GAAP. Intangible assets created internally are expensed as incurred. Purchased intangibles are reported similar to PP&E. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Both research and development costs are expensed under US GAAP. Goodwill is the excess of purchase price over fair value of the identifiable net assets (assets minus liabilities) acquired in a business acquisition. Goodwill is not amortized but must be tested for impairment at least annually. Held-to-maturity securities are reported at amortized cost. Trading securities, available-for-sale securities, and derivatives are reported at fair value. For trading securities and derivatives, unrealized gains and losses are recognized in the income statement. Unrealized gains and losses for available-for-sale securities are reported in equity (other comprehensive income). Accounts payable are amounts owed to suppliers for goods or services purchased on credit. Accrued liabilities are expenses that have been recognized in the income statement but are not yet contractually due. Unearned revenue is cash collected in advance of providing goods and services. Financial liabilities not issued at face value, like bonds payable, are reported at amortized cost. Held-for-trading liabilities and derivative liabilities are reported at fair value.

LOS 26.a: Compare cash flows from operating, investing, and financing activities and classify cash flow items as relating to one of those three categories given a description of these items.

Cash flow from operating activities (CFO) consists of all the inflows and outflows of cash resulting from transactions that affect a firm's net income Cash flow from investing activities (CFI) consists of the inflows and outflows of cash resulting from the acquisition or disposal of long-term assets and certain investments. Cash flow from financing activities (CFF) consists of all the inflows and outflows of cash resulting from transactions affecting a firm's capital structure, such as issuing or repaying debt and issuing or repurchasing stock.

LOS 30.i: Analyzed disclosures relating to deferred tax items and the effective tax rate reconciliation and explain how information included in these disclosures affects a company's financial statements and financial ratios.

Firms are required to reconcile their effective income tax rate with the applicable statutory rate in the country where the business is domiciled. Analyzing trends in individual reconciliation items can aid in understanding past earnings trends and in predicting future effective tax rates. Where adequate data is provided, they can also be helpful in predicting future earnings and cash flows or for adjusting financial ratios.

LOS 29.o: Explain and evaluate how leasing rather than purchasing assets affects financial statements and ratios.

For a lessee, the accounting treatment of a finance (capital) lease is like that of purchasing the asset with debt. the leased asset is recorded on the lessee's balance sheet and depreciated over its life. The present value of the lease payment is a liability that is amortized over the term of the lease. the interest portion of the lease payment and the cash depreciation of the asset are recorded as expenses on the income statement. On the cash flow statement, the interest portion of the lease payment is an operating cash outflow and the principal portion is a financing cash outflow. With an operating lease, the full lease payment is reported as rental expense on the lessee's income statement and as an operating cash outflow. No asset or liability reported on the balance sheet.

LOS 26.i: Calculate and interpret free cash flow to the firm, free cash flow to equity, and performance and coverage cash flow ratios.

Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders. -FCFF = net income + noncash charges + [interest expense * (1-tax rate)] - fixed capital investment - working capital investment. -FCFF = CFO + [interest expense*(1-taxrate)] - fixed capital investment. Free cash flow to equity (FCFE) is the cash flow available for distribution to the common shareholders after all obligations have been paid. FCFE = CFO - fixed capital investment + net borrowing. Cash flow performance ratios, such as cash return on equity or on assets, and cash coverage ratios, such as debt coverage or cash interest coverage, provide information about the firm's operating performance and financial strength.

LOS 29.k: Explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios

Impairment charges decrease net income, assets, and equity, which results in lower ROA and ROE and higher debt-to-equity and debt-to-assets ratios for a typical firm Upward revaluation increases assets and equity, and thereby decreases debt-to-assets and debt-to-equity ratios. A downward revaluation has opposite effects. The effect on net income and related ratios depends on whether the revaluation is to a value above or below cost. Derecognition of assets can result in either a gain or loss on the income statement. A loss will reduce net income and assets, while a gain will increase net income and assets.

LOS 21.c: Describe the importance of financial statement notes and supplementary information - including disclosures of accounting policies, methods, and estimates - and management's commentary.

Important information about accounting methods, estimates, and assumptions is disclosed in the footnotes to the financial statements and supplementary schedules. These disclosures also contain information about segment results, commitments and contingencies, legal proceedings, acquisitions or divestitures, issuance of stock options and details of employee benefit plans. Management's commentary (management's discussion and analysis) contains an overview of the company and important information about business trends, future capital needs, liquidity, significant events, and significant choices of accounting methods requiring management judgement.

LOS 29.e: Describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements and ratios.

In the early years of an asset's life, accelerated depreciation results in higher depreciation expense, lower net income, and lower ROA and ROE compared to straight-line depreciation. Cash flow is the same assuming tax depreciation is unaffected by the choice of method for financial reporting Firms can reduce depreciation expense and increase net income by using longer useful lives and higher salvage values.

LOS 28.k: Calculate and compare ratios of companies, including companies that use different inventory methods

Inventory turnover, days of inventory on hand, and gross profit margin can be used to evaluate the quality of a firm's inventory management. -Inventory turnover that is too low (high days of inventory on hand) may be an indication of slow-moving or obsolete inventory. -High inventory turnover together with low sales growth relative to the industry may indicate inadequate inventory levels and lost sales because customer orders could not be fulfilled. -High inventory turnover together with high sales growth relative to the industry average suggests that high inventory turnover reflects greater efficiency rather than inadequate inventory

LOS 22.d: Describe the process of recording business transactions using an accounting system based on the accounting equation.

Keeping the accounting equation (A - L = E) in balance requires double entry accounting, in which a transaction is recorded in at least two accounts. An increase in an asset account, for example, must be balanced by a decrease in another asset account or by an increase in a liability or owners' equity account.

LOS 23.b: Describe roles and desirable attributes of financial reporting standard-setting bodies and regulatory authorities in establishing and enforcing reporting standards, and describe the role of the International Organization of Securities Commissions.

Standard-setting bodies are private sector organizations that establish financial reporting standards. The two primary standard-setting bodies are the International Accounting Standards Board (IASB) and, in the United States, the Financial Accounting Standards Board (FASB). Regulatory authorities are government agencies that enforce compliance with financial reporting standards. Regulatory authorities include the Securities and Exchange Commission (SEC) in the US, and the Financial Conduct Authority in the UK. Many national regulatory authorities belong to the International Organization of Securities Commissions (IOSCO)

LOS 22.c: Explain the accounting equation in its basic and expanded forms.

The basic accounting equation: Assets = liabilities + Owner's equity The expanded accounting equation: assets = liabilities + contributed capital + ending retained earnings. The expanded accounting equation can also be stated as: assets = liabilities + contributed capital + beginning retained earnings + revenue - expenses - dividends.

LOS 28.f: Convert a company's reported financial statements from LIFO to FIFO for purposes of comparison

To convert a firm's financial statements from LIFO to what they would have been under FIFO: 1. Add the LIFO reserve to the LIFO inventory. 2. Subtract the change in the LIFO reserve for the period from COGS. 3. Decrease cash by LIFO reserve * Tax rate 4. Increase retained earnings (Equity) by LIFO reserve * (1-tax rate).

LOS 22.b: Explain the relationship of financial statement elements and accounts, and classify accounts into the financial statement elements.

Transactions are recorded in accounts that form the financial statement elements: -Assets - A firm's economic resources -Liabilities - Creditor's claims on the firm's resources. -Owner's Equity - Paid-in capital (common and preferred stock), retained earnings, and cumulative other comprehensive income. -Revenues - Sales, investment income, and gains. -Expenses - cost of goods sold, selling and administrative expenses, depreciation, interest, taxes, and losses.

LOS 24.m: Describe other comprehensive income and identify major types of items included in it.

Transactions with shareholders, such as dividends paid and shares issued or repurchased, are not reported on the income statement. Other comprehensive income includes transactions that affect equity but do not affect net income, including: -Gains and losses from foreign currency translation -Pension obligation adjustments. -Unrealized gains and losses from cash flow hedging derivatives. -Unrealized gains and losses on available-for-sale securities.

LOS 26.c: Contrast cash flow statements prepared under International Financial Reporting Standards (IFRS) and US generally accepted accounting principles (US GAAP)

Under US GAAP, dividends paid are financing cash flows, interest paid, interest received, and dividends received are operating cash flows. All taxes paid are operating cash flows. Under IFRS, dividends paid and interest paid can be reported as either operating or financing cash flows. Interest received and dividends received can be reported as either operating or investing cash flows. Taxes paid are operating cash flows unless they arise from an investing or financing transaction.

LOS 25.c: Describe alternative formats of balance sheet presentation.

A classified balance sheet separately reports current and non current assets and current and non current liabilities. Alternatively, liquidity-based presentations, often used in the banking industry, present assets and liabilities in order of liquidity.

LOS 30.a: Describe the differences between accounting profit and taxable income and define key terms, including deferred tax assets, deferred tax liabilities, valuation allowance, taxes payable, and income tax expense.

Deferred tax terminology: -Taxable income: Income subject to tax based on the tax return -Accounting profit: Pretax income from the income statement based on financial accounting standards -Deferred tax assets: Balance sheet asset value that results when taxes payable (tax return) are greater than income tax expense (income statement) and the difference is expected to reverse in future periods. -Deferred tax liabilities: Balance sheet liability value that results when income tax expense (income statement) is greater than taxes payable (tax return) and the difference is expected to reverse in future periods. -Valuation allowance: Reduction of deferred tax assets (contra account) based on the likelihood that the future tax benefit will not be realized. -Taxes payable: The tax liability from the tax return. Note that this term also refers to a liability that appears on the balance sheet for taxes due but not yet paid. -Income tax expense: Expense recognized in the income statement that includes taxes payable and changes in deferred tax assets and liabilities.

LOS 29.d: Describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense.

Depreciation methods: -Straight-line: Equal amount of expense each period. -accelerated (Declining balance): Higher depreciation expense in the early years and lower depreciation expense in the later years of an asset's life. -Units-of-production: Expense based on percentage usage rather than time. Straight-line method: Depreciation expense = (Original cost - salvage value) / depreciable life. Double-declining balance (DDB), an accelerated depreciation method: DDB depreciation in year x = (2/depreciable life in years) * Book value @ beginning of year x Units of production method: [(Original cost-salvage value)/Life in output units] * Output units used in the period IFRS requires component depreciation, in which significant parts of an asset are identified and depreciated separately.

LOS 21.e: Identify and describe information sources that analysts use in financial statement analysis besides annual financial statements and supplementary information.

Along with the annual financial statements, important information sources for an analyst include a company's quarterly and semiannual reports, proxy statements, press releases, and earnings guidance, as well as information on the industry and peer companies from external sources.

LOS 29.f: Describe the different amortization methods for intangible assets with finite lives and calculate amortization expense.

Amortization methods for intangible assets with finite lives are the same as those for depreciation: Straight line, accelerated, or units of production. Calculation of amortization expense for such assets is the same as with depreciation expense.

LOS 23.h: Describe implications for financial analysis of differing financial reporting systems and the importance of monitoring developments in financial reporting standards.

An analyst should be aware of evolving financial reporting standards and new products and innovations that generate new types of transactions.

LOS 26.h: Analyze and interpret both reported and common-size cash flow statements.

An analyst should determine whether a company is generating positive operating cash flow over time that is greater than its capital spending needs and whether the company's accounting policies are causing reported earnings to diverge from operating cash flow. A common-size cash flow statement shows each item as a percentage of revenue or shows each cash inflow as a percentage of total inflows and each outflow as a percentage of total outflows.

LOS 28.j: Explain issues that analysts should consider when examining a company's inventory disclosures and other sources of information.

An analyst should examine inventory disclosures to determine whether: -The finished goods category is growing while raw materials and goods in process are declining, which may indicate decreasing demand and potential future inventory write-downs. -Raw materials and goods in process are increasing, which may indicate increasing future demand and higher earnings. -Increases in finished goods are greater than increases in sales, which may indicate decreasing demand or inventory obsolescence and potential future inventory write downs.

LOS 30.c: Calculate the tax base of a company's assets and liabilities.

An asset's tax base is its value for tax purposes. The tax base for a depreciable fixed asset is its cost minus any depreciation or amortization previously taken on the tax return. When an asset is sold, the taxable gain or loss on the sale is equal to the sale price minus the asset's tax base A liability's tax base is its value for tax purposes. When there is a difference between the book value of a liability on a firm's financial statements and its tax base that will result in future taxable gains or losses when the liability is settled, the firm will recognize a deferred tax asset or liability to reflect this future tax or tax benefit.

LOS 25.a: Describe the elements of the balance sheet: assets, liabilities, and equity.

Assets are resources controlled as result of past transactions that are expected to provide future economic benefits. Liabilities are obligations as a result of past events that are expected to require an outflow of economic resources. equity is the owners' residual interest in the assets after deducting the liabilities. A financial statement item should be recognized if a future economic benefit to or from the firm is probable and the item's value or cost can be measured reliably.

LOS 25.h: Calculate and interpret liquidity and solvency ratios

Balance sheet ratios, along with common-size analysis, can be used to evaluate a firm's liquidity and solvency. Liquidity ratios measure the firm's ability to satisfy its short-term obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and the cash ratio. Solvency ratios measure the firm's ability to satisfy long-term obligations. Solvency ratios include the long-term debt-to-equity ratio, the total debt-to-equity ratio, the debt ratio, and the financial leverage ratio.

LOS 24.d: Describe key aspects of the converged accounting standards for revenue recognition issued by the International Accounting Standards Board and Financial Accounting Standards Board in May 2014.

Converged accounting standards issued in May 2014 take a principles-based approach to revenue recognition. These standards identify a five-step process for recognizing revenue: 1. Identify the contract(s) with a consumer. 2 Identify the performance obligations in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue when (or as) the entity satisfies a performance obligation.

LOS 28.a: Distinguish between costs included in inventories and costs recognized as expenses in the period in which they are incurred.

Costs included in inventory on the balance sheet include purchase cost, conversion costs, and other costs necessary to bring the inventory to its present location and condition. All of theses costs for inventory acquired or produced in the current period are added to beginning inventory value and then allocated either to cost of goods sold for the period or ending inventory. Period costs, such as abnormal waste, most storage costs, administrative costs, and selling costs are expensed as incurred.

LOS 25.d: Distinguish between current and non-current assets and current and non-current liabilities.

Current (noncurrent) assets are those expected to be used up or converted to cash in less than (more than) one year or the firm's operating cycle, whichever is greater. Current (noncurrent) liabilites are those the firm expects to satisfy in less than (more than) one year or the firm's operating cycle, whichever is greater.

LOS 23.c: Describe the status of global convergence of accounting standards and ongoing barriers to developing one universally accepted set of financial reporting standards.

Efforts to achieve convergence of local accounting standards with IFRS are underway in most major countries that have not adopted IFRS. Barriers to developing one universally accepted set of financial reporting standards include differences in opinion among standard-setting bodies and regulatory authorities from different countries and political pressure within countries from groups affected by changes in reporting standards.

LOS 24.g: Distinguish between the operating and non-operating components of the income statement.

Operating income is generated from the firm's normal business operations. For a non-financial firm, income that results from investing or financing transactions is classified as non-operating income, while it is operating income for a financial firm since its business operations include investing in and financing securities.

LOS 25.f: Describe the components of shareholders' equity.

Owners' equity includes: -Contributed capital - the amount paid in by common shareholders. - Preferred stock - Capital stock that has certain rights and privileges not possessed by the common shareholders. Classified as debt if mandatorily redeemable. -Treasury Stock - Issued common stock that has been repurchased by the firm. -Retained earnings - Cumulative undistributed earnings of the firm since inception. -noncontrolling (minority) interest - The portion of a subsidiary that is not owned by the parent. -Accumulated other comprehensive income - Includes all changes to equity from sources other than net income and transactions with shareholders. The statement of changes in stockholders' equity summarizes the transactions during a period that increases or decrease equity, including transactions with shareholders.

LOS 27.a: Describe tools and techniques used in financial analysis, including their uses and limitations.

Ratios can be used to project earnings and future cash flow, evaluate a firm's flexibility, assess management's performance, evaluate changes in the firm and industry over time, and compare the firm with industry competitors. Vertical common-size data are stated as percentages of sales for income statements or as a percentage of total assets for balance sheets. Horizontal common-size data present each item as a percentage of its value in a base year. Ratio analysis has limitations. Ratios are not useful when viewed in isolation and require adjustments when different companies use different accounting treatments. Comparable ratios may be hard to find for companies that operate in multiple industries. Ratios must be analyzed relative to one another, and determining the range of acceptable values for a ratio can be difficult.

LOS 24.f: Describe the financial reporting treatment and analysis of non-recurring items (including discontinued operations, unusual or infrequent items) and changes in accounting policies.

Results of discontinued operations are reported below income from continuing operations, net of tax, from the date the decision to dispose of the operations is made. These results are segregated because they likely re non-recurring and do not affect future net income. Unusual or infrequent items are reported before tax and above income from continuing operations. An analyst should determine how "unusual" or "infrequent" these items really are for the company when estimating future earnings or firm value. Changes in accounting standards, changes in accounting methods applied, and corrections of accounting errors require retrospective restatement of all prior-period financial statements included in the current statement. A change in an accounting estimate, however, is applied prospectively (to subsequent periods) with no restatement of prior-period results.

LOS 24.b: Describe general principles of revenue recognition and accrual accounting, specific revenue recognition applications (including accounting for long-term contracts, installment sales, barter transactions, gross and net reporting of revenue), and implications of revenue recognition principles for financial analysis.

Revenue is recognized when earned and expenses are recognized when incurred. Methods for accounting for long-term contracts include: -Percentage-of-completion- Recognizes revenue in proportion to costs incurred. -Completed-contract- Recognizes revenue only when the contract is complete. Revenue recognition methods for installment sales are: -Normal revenue recognition at time of sale if collectibility is reasonably assured. -Installment sales method if collectibility cannot be reasonably estimated. -Cost recovery method if collectibility is highly uncertain. Revenue from barter transactions can only be recognized if its fair value can be estimated from historical data on similar non-barter transactions. Gross revenue reporting shows sales and costs of goods sold, while net revenue reporting shows only the difference between sales and cost of good sold and should be used when the firm is acting essentially as a selling agent and does not stock inventory, take credit risk, or have control over the supplier and price.

LOS 23.f: Compare key concepts of financial reporting standards under IFRS and US generally accepted accounting principles (US GAAP) reporting systems.

The IASB and FASB frameworks are similar but are moving towards convergence. Some of the remaining differences are: -The IASB lists income and expenses as performance elements, while the FASB lists revenues, expenses, gains, losses, and comprehensive income. -There are minor differences in the definition of assets. Also, the FASB uses the word probable when defining assets and liabilities. -The FASB does not allow the upward revaluation of most assets. Firms that list their shares in the US but do not use U.S. GAAP or IFRS are required to reconcile their financial statements with U.S. GAAP. For IFRS firms listing their shares in the US, reconciliation is no longer required.

LOS 23.d: Describe the international Accounting Standards Board's conceptual framework, including the objective and qualitative characteristics of financial statements, requiring reporting elements, and constraints and assumptions in preparing financial statements.

The IFRS "Conceptual Framework for Financial Reporting" defines the fundamental and enhancing qualitative characteristics of financial statements, specifies the required reporting elements, and notes the constraints and assumptions involved in preparing financial statements. -The fundamental characteristics of financial statements are relevance and faithful representation. The enhancing characteristics include comparability, verifiability, timeliness, and understandability. -Elements of financial statements are assets, liabilities, and owners equity (for measuring financial position) and income and expenses (for measuring performance). -Constraints on financial statement preparation include cost versus benefit and the difficulty of capturing non-quantifiable information in financial statements. -The two primary assumptions that underlie the preparation of financial statements are the accrual basis and the going concern assumption.

LOS 22.f: Describe the relationships among the income statement, balance sheet, statement of cash flows, and statement of owners' equity.

The balance sheet shows a company's financial position at a point in time. Changes in balance sheet accounts during an accounting period are reflected in the income statement, the cash flow statement, and the statement of owner's equity.

LOS 29.b: Compare the financial reporting of the following types of intangible assets: Purchased, internally developed, acquired in a business combination.

The cost of a purchased finite-lived intangible asset is amortized over its useful life. Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually. The cost of internally developed intangible assets is expensed. Under IFRS, research costs are expensed but development costs may be capitalized. Under US GAAP, both research and development costs are expensed as incurred, except in the case of software created for sale to others. The acquisition method is used to account for assets acquired in a business combination. The purchase price is allocated to the fair value of identifiable assets of the acquired firm less its liabilities. Any excess of the purchase price above the fair value of the acquired firm's net assets is recorded as goodwill, un unidentifiable intangible asset that cannot be separated from the business itself.

LOS 26.f: Describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.

The direct method of calculating CFO is to sum cash inflows and cash outflows for operating activities. -Cash collections from customers: Sales adjusted for changes in receivables and unearned revenue. -Cash paid for inputs: COGS adjusted for changes in inventory and accounts payable. -Cash operating expenses: SG&A adjusted for changes in related accrued liabilities or prepaid expenses. -Cash interest paid: Interest expense adjusted for the change in interest payable. -Cash taxes paid: Income tax expense adjusted for changes in taxes payable and changes in deferred tax assets and liabilities. The indirect method of calculating CFO begins with net income and adjusts it for gains or losses related to investing or financing cash flows, noncash charges to income and changes in balance sheet operating items. CFI is calculated by determining the changes in asset accounts that result from investing activities. The cash flow from selling an asset is its book value plus any gain on the sale (or minus any loss on the sale) CFF is the sum of net cash flows from creditors (new borrowings minus principal repaid) and net cash flows from shareholders (new equity issued minus shares repurchased minus cash dividends paid).

LOS 24.e: Describe general principles of expense recognition, specific expense recognition applications, and implications of expense recognition choices for financial analysis.

The matching principle requires that firms match revenues recognized in a period with the expenses required to generate them. One application of the matching principle is seen in accounting for inventory, with costs of goods sold as the cost of units sold from inventory that are included in the current-period revenue. Other costs, such as depreciation or fixed assets or administrative overhead, are period costs and are taken without regard to revenues generated during the period. Depreciation methods: -Straight-line: Equal amount of depreciation expense in each year of the asset's useful life. -Declining balance: Apply a constant rate of depreciation to the declining book value until the book value equals the residual value. Inventory Valuation methods: -FIFO: inventory reflects cost of most recent purchases, COGS reflects cost of oldest purchases. -LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest purchases. -Average cost: Unit cost equals cost of goods available for sale divided by the total number of units available and is used for both COGS and inventory. -Specific identification: Each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold. Intangible assets with limited lives should be amortized using a method that reflects the flow over time of their economic benefits. Intangible assets with indefinite lives (e.g., goodwill) are not amortized. Users of financial data should analyze the reasons for any changes in estimates of expenses and compare these estimates with those of peer comapnies.

LOS 21.d: Describe the objective of audits of financial statements, the types of audit reports, and the importance of effective internal controls.

The objective of audits of financial statements is to provide an opinion on the statements' fairness and reliability. The auditor's opinion gives evidence of an independent review of the financial statements that verifies that appropriate accounting principles were used, that standard auditing procedures were used to establish reasonable assurance that the statements contain no material errors, and that management's report on the company's internal controls has been reviewed. An auditor can issue an unqualified (clean) opinion if the statements are free from material omissions and errors, a qualified opinion that notes any exceptions to accounting principles, an adverse opinion if the statements are not presented fairly in the auditor's opinion, or a disclaimer of opinion if the auditor is unable to express an opinion. A company's management is responsible for maintaining an effective internal control system to ensure the accuracy of its financial statements.

LOS 23.a: Describe the objective of financial statements and the importance of financial reporting standards in security analysis and valuation.

The objective of financial statements is to provide economic decision makers with useful information about a firm's financial performance and changes in financial position. Reporting standards are designed to ensure that different firms' statements are comparable to one another and to narrow the range of reasonable estimates on which financial statements are based. This aids users of financial statements who rely on them for information about the company's activities, profitability, and creditworthiness.

LOS 21.a: Describe the roles of financial reporting and analysis

The role of financial reporting is to provide a variety of users with useful information about the company's performance and financial position. The role of financial statement analysis is to use the data from financial statements to support economic decisions.

LOS 21.b: Describe the roles of the statement of financial position, statement of comprehensive income, statement of change in equity, and statement of cash flows in evaluating a company's performance and financial position.

The statement of financial position (balance sheet) shows assets, liabilities, and owners' equity at a point in time. The statement of comprehensive income shows the results of a firm's business activities over the period. Revenues, the cost of generating those revenues, and the resulting profit or loss are presented on the income statement. The statement of changes in equity reports the amount and sources of changes in the equity owners' investment in the firm. The statement of cash flows shows the sources and uses of cash over a period.

LOS 29.l: Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets.

There are many differences in the disclosure requirements for tangible and intangible assets under IFRS and US GAAP. However, firms are generally required to disclose: -Carrying values for each class of asset. -Accumulated depreciation and amortization. -Title restrictions and assets pledged as collateral -For impaired assets, the loss amount and the circumstances that caused the loss. -For revalued assets (IFRS only), the revaluation date, how fair value was determined, and the carrying value using the historical cost model.

LOS 29.n: Compare the financial reporting of investment property with that of property, plant, and equipment

Under IFRS (but not US GAAP), investment property is defined as property owned for the purpose of earning rent, capital appreciation, or both. Firms can account for investment property using the cost model or the fair value model. Unlike the revaluation model for property, plant, and equipment, increases in the fair value of investment property above its historical cost are recognized as gains on the income statement if the firm uses the fair value model.

LOS 29.i: explain the impairment of property, plant, and equipment and intangible assets.

Under IFRS, an asset is impaired when its carrying value exceeds the recoverable amount. The recoverable amount is the greater of fair value less selling costs and the value in use (present value of expected cash flows). If impaired, the asset is written down to the recoverable amount. Loss recoveries are permitted, but not above historical cost. Under US GAAP, an asset is impaired if its carrying value is greater than the asset's undiscounted future cash flows. If impaired, the asset is written down to fair value. Subsequent recoveries are not allowed for assets held for use. Asset impairments result in losses in the income statement. Impairments have no impact on cash flow as they have no tax or other cash flow effects until disposal of the asset.

LOS 29.h: Describe the revaluation model

Under IFRS, firms have the option to revalue assets based on fair value under the revaluation model. US GAAP does not permit revaluation. The impact of revaluation on the income statement depends on whether the initial revaluation resulted in gain or loss. If the initial revaluation resulted in a loss (decrease in carrying value), the initial loss would be recognized in the income statement and any subsequent gain would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholders' equity as a revaluation surplus. If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would bypass the income statement and be reported as a revaluation surplus. Later revaluation losses would first reduce the revaluation surplus.

LOS 28.g: Describe the measurement of inventory at the lower of cost and net realizable value

Under IFRS, inventories are valued at the lower cost or net realizable value. Inventory write-ups are allowed, but only to the extent that a previous write-down to net realizable value was recorded. Under US GAAP, inventories are valued at the lower of cost or net realizable value for companies using cost methods under LIFO or the retail method. For companies using LIFO or the retail method, inventories are valued at the lower of cost or market. Market is usually equal to replacement cost but cannot exceed net realizable value or be less than net realizable value minus a normal profit margin. No subsequent write-up is allowed for any company reporting under US GAAP

LOS 28.c: Calculate and compare cost of sales, gross profit, and ending inventory using different inventory valuation methods and using perpetual and periodic inventory systems.

Under LIFO, costs of sales reflects the most recent purchase or production costs, and balance sheet inventory values reflect older outdated costs. Under FIFO, cost of sales reflects the oldest purchase or production costs for inventory, and balance sheet inventory values reflect the most recent costs. Under the weighted average cost method, cost of sales and balance sheet inventory values are between those of LIFO and FIFO When purchase or production costs are rising, LIFO cost of sales is higher than FIFO cost of sales, and LIFO gross profit is lower than FIFO gross profit as a result. LIFO inventory is lower than FIFO inventory. When purchase or production costs are falling, LIFO cost of sales is lower than FIFO cost of sales, and LIFO gross profit is higher than FIFO gross profit as a result. LIFO inventory is higher than FIFO inventory. In either case, LIFO cost of sales and FIFO inventory values better represent economic reality (replacement costs). In a periodic system, inventory values, and COGS are determined at the end of the accounting period. In a perpetual system, inventory values and COGS are updated continuously. In the case of FIFO and specific identification, ending inventory values and COGS are the same whether a periodic or perpetual system is used. LIFO and weighted average cost, however, can produce different inventory values and COGS depending on whether a periodic or perpetual system is used.

LOS 26.d: Distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method.

Under the direct method of presenting CFO, each line item of the accrual-based income statement is adjusted to get cash receipts or cash payments. the main advantage of the direct method is that it presents clearly the firm's operating cash receipts and payments. Under the indirect method of presenting CFO, net income is adjusted for transactions that affect net income but do not affect operating cash flow, such as depreciation and gains or losses on asset sales, and for changes in balance sheet items. The main advantage of the indirect method is that it focuses on the differences between net income and operating cash flow. This provides a useful link to the income statement when forecasting future operating cash flow

LOS 30.e: Evaluate the effect of the tax rate changes on a company's financial statements and ratios.

When a firm's income tax rate increases (decreases), deferred tax assets and deferred tax liabilities are both increased (decreased) to reflect the new rate. Changes in these values will also affect income tax expense. An increase in the tax rate will increase both a firm's DTL and its income tax expense. A decrease in the tax rate will decrease both a firm's DTL and its income tax expense. An increase in the tax rate will increase a firm's DTA and decrease its income tax expense. A decrease in the tax rate will decrease a firm's DTA and increase its income tax expense.

LOS 29.j: Explain the derecognition of property, plant, and equipment and intangible assets.

When a long-lived asset is sold, the difference between the sale proceeds and the carrying (book) value of the asset is reported as a gain or loss in the income statement. When a long-lived asset is abandoned, the carrying value is removed from the balance sheet and a loss is recognized in that amount. If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or fair value of the new asset if more clearly evident).

LOS 28.d: Calculate and explain how inflation and deflation of inventory costs affect the financial statements and ratios of companies that use different inventory valuation methods.

When prices are increasing and inventory quantities are stable or increasing: LIFO results in: -Higher COGS -Lower gross profit -Lower inventory balances -higher inventory turnover FIFO results in: -Lower COGS -Higher gross Profit -Higher inventory balances -Lower inventory turnover When prices are decreasing and inventory quantities are stable or increasing: LIFO results in: -Lower COGS -Higher gross profit -Higher inventory balances -Lower inventory turnover FIFO results in: -Higher COGS -Lower gross profit -Lower inventory balances -Higher inventory turnover The weighted average cost method results in values between those of LIFO and FIFO if prices are increasing or decreasing.

LOS 29.p: Explain and evaluate how finance leases and operating leases affect financial statements and ratios from the perspective of both the lessor and the lessee.

With an operating lease, the asset remains on the balance sheet of the lessor and is depreciated. The lease payments are rental income. For a finance lease, the lessor removes the asset from the balance sheet and replaces it with a lease receivable. The interest portion of the lease payment is interest income to the lessor and the remainder of the payment isa principal repayment that decreases the lease receivable on the lessor's balance sheet. Compared to an operating lease, a finance lease adds the asset and the related lease liability to the lessee's balance sheet so that equity is initially unchanged. The leased asset is depreciated over the lease term. Depreciation and interest expense comprise the lease expenses recorded on the income statement and will exceed the lease payment in the early years of the lease and be less than the lease payment in the later years of the lease. This results in less profit for the lessee in the early years of a lease and greater profit in the later years.

LOS 29.c: Explain and evaluate how capitalizing versus expensing costs in the period in which they are incurred affects financial statements and ratios

With capitalization, the asset value is put on the balance sheet and the cost is expensed through the income statement over the asset's useful life through either depreciation or amortization. Compared to expensing the asset cost, capitalization results in: -Lower expense and higher net income in period of acquisition, higher expense (depreciation or amortization) and lower net income in each of the remaining years of the asset's life. -Higher assets and equity. -Lower CFI and higher CFO because of the cost of a capitalized asset is classified as an investing cash outflow. -Higher ROE and ROA in the initial period, and lower ROE and ROA in subsequent periods because net income is lower and both assets and equity are higher. -Lower debt-to-assets and debt-to-equity ratios because assets and equity are higher.