Level 2 SS4-15 as of May 9
Describe key points of MM Proposition 1 with NO taxes
"Capital Structure Irrelevance" - Value of a levered firm = Value of an unlevered firm - Pie is the same size, no matter how you slice it - Holds in perfect markets - Assumes no transaction costs - Assumes no taxes - Assumes no cost of financial distress
Describe key points of MM Proposition 2 with NO taxes
"WACC Unchanged by Leverage" - the cost of equity increases linearly as the company increases its proportion of debt financing - the WACC is unaffected by the capital structure; it does not change - Assumes no taxes
CFA institute's definition of corporate governance
"the systems of principles, policies, procedures, and clearly defined responsibilities and accountabilities used by stakeholders to overcome conflicts of interest inherent in the corporate form.
What is the standard principal and maturity for eurodollar futures contracts
$1 million principal and 3-month maturity
An example of an overcollateralized ABS is one for which the liability structure is worth ______ and the collateral's value is worth ______.
$100 million, $105 million.
UPREIT
(umbrella partnership) where the REIT is the general partner and holds a controlling interest in a partnership that owns and operates the properties
What are the two things you should look for in any FCFE equation?
+ net borrowings - interest(1-t)
Describe the effect of changing from LIFO to FIFO in a period of inflation on the following financial ratios: - Current ratio - Inventory Turnover - Long Term Debt to Equity - Gross Profit - Net Profit
- Current ratio - increase (from increase in current assets) - Inventory Turnover - lower (lower COGS, higher inventory) - Long Term Debt to Equity - lower (higher equity) - Gross Profit - higher (lower COGS) - Net Profit - higher (offset by tax increase)
List examples of relative value measures that are often used to compare companies
- EV to EBITDA - EV to sales - P/E - P/B - P/S
Describe the difference between GDP and GDP per capita if you increase the quantity of labor
- GDP will increase - per capital GDP will not increase
List the reasons for transaction-related valuations.
- IPOs - acquisitions - bankruptcies - performance-based managerial compensation - VC financing
Compare Neoclassical and Endogenous Growth Theories in terms of diminishing returns to capital.
- Neoclassical growth assumes diminishing returns to capital - Endogenous growth says constant returns to capital are possible
What is most common for companies to maintain in terms of net assets/liabilities and net monetary assets/liabilities?
- Net asset exposures are most common, as most businesses have more assets than liabilities - Net monetary liability exposures are most common, as most firms maintain lower levels of monetary assets than monetary liabilities. - Most liabilities are considered monetary liabilities (current debt and long term debt, for example), whereas few assets are considered monetary assets.
What are the disadvantages to using P/B ratios?
- P/Bs do not reflect the value of intangible economic assets, such as human capital - P/Bs can be misleading when there are significant differences in the asset size of the firms under consideration - different accounting conventions across countries, which distort the true value of assets (e.g. R&D costs are expensed in the U.S. which can understate a company's investment in itself) - inflation and technological change can cause the book and market values of assets to differ significantly
Describe the characteristics of pure monetary model to exchange rate determination
- PPP holds at any point in time - output is held constant - fiscal and monetary expansion lead to an increase in prices and a depreciation of the currency - does not take into account expectations of future monetary expansion or contraction. Ex. if money supply is expected to increase, current exchange rates would not change.
What are the most risky REITs?
- REITs that invest in property sectors where significant mismatches between supply and demand are likely, such as healthcare, hotel, and office REITs - REITs that invest in sectors where the occupancy rates are most likely to fluctuate within a short period of time, such as hotels
How are stock grants accounted for in compensation expense?
- The fair value (or market value) of the stock is expensed as compensation expense in the income statement at the time of the grant. - If the grant awards stock several periods in the future, the expense is expensed gradually over the employee's service period.
How are stock options accounted for in compensation expense?
- The option premium is expensed as compensation expense over the life of the option to the income statement. - The life of the option is the service period (between the grant date and the vesting date). - Recognition of compensation expense will decrease net income and retained earnings. - Paid-in capital will increase so that total equity is not changed.
When the inventory is reported at cost on the balance sheet, it excludes the following:
- abnormal amounts - storage costs - admin overhead - selling costs
Discuss the motivations of companies to manipulate financial statements around mergers and acquisitions.
- acquiring company is incentivized to pursue aggressive accounting to inflate their stock price prior to acquisition - acquired company is incentivized to inflate their firm's stock price to achieve a better purchase price
List the four corporate strategy formulation styles
- adaptive - shaping - classical - visionary
Roots of unethical behavior:
- agents whose personal ethics are flawed are more likely to violate business ethics. - a simple failure to realize an issue may lead to an ethics violation. an executive should ask whether each decision has ethical implications. - a culture focused only on profit and growth. - a flawed business culture where top management sets unrealistic goals. - unethical leadership will set the tone and lead to violations.
Mechanisms to misstate profitability:
- aggressive revenue recognition, channel stuffing, bill and hold sales, outright fake sales - lessor (the company who leases an asset to a lessee) uses finance leases incorrectly (sales-type versus direct financing) - classification of non-operating revenue/income as operating, and operating expenses as non-operating, in order to mask declining sales - channeling gains through net income and losses through OCI
Why can inflated goodwill be used to increase future reported profits over the long term?
- although inflated goodwill will eventually have to be written down as part of impairment testing, the loss can be timed - impairment losses can be downplayed as a one-off, non-recurring event
Under IFRS 9, what are the possible classifications of securities?
- amortized cost (equivalent to held-to-maturity, debt securities only) - fair value through profit or loss (equivalent to held-for-trading, both debt and equity securities) - fair value through other comprehensive income (equivalent to available-for-sale, equity securities only)
Investing in a noncallable/nonputable convertible bond is equivalent to buying
- an option-free bond, and - a call option on an amount of the common stock equal to the conversion ratio
Describe the relationship behind volatility and OAS.
- as volatility increases, a call option becomes more valuable. - the initial assessment of bond price decreases as call option value increases - lower bond price will decrease the OAS needed to equate the model price to the market price
Monetary assets and liabilities
- assets/liabilities that are fixed in the amount of currency to be received or paid - include cash, receivables, payables, short-term debt, long-term debt - remeasured using the current exchange rate
List the key points of the CIG model
- assumes interest rates are mean reverting - volatility increases as interest rates increase
List the key points of the Vasicek model
- assumes interest rates are mean reverting - volatility is independent of interest rates - interest rates could be negative with this model (disadvantage)
Describe the characteristics of the Dornbusch model
- assumes prices are sticky in the short term - prices do not immediately reflect changes in monetary policy - in the short term, exchange rates overshoot long-run PPP implied values. Aka the depreciation of the currency is greater than implied by PPP - in the long term, exchange rates gradually increase toward their PPP implied values
Structural models of corporate credit risk (important)
- based on the structure of a company's BALANCE SHEET - rely on insights provided by option pricing theory.
What are the advantages to using P/B ratios?
- book value is a cumulative amount that is usually positive, even when the firm reports negative EPS - book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile - book value is an appropriate measure of net asset value for firms that primarily hold liquid assets (e.g. finance, investment and insurance firms)
Businesses that employ the shaping style may seek to influence their competitive environment by:
- building a network of committed customers, suppliers, and partners - defining new markets, technologies, and business practices - promoting interests through marketing, lobbying, and strategic partnerships
What are the methods of removing accounts receivables?
- by selling or transferring receivables to a related entity - by treating them as long-term receivables
What are the tools policymakers can use to reduce the problems of currency appreciation?
- capital controls - direct intervention
Under Neoclassical Growth Theory, in what circumstances does economic growth increase?
- capital deepening affects the level of output, but not the growth rate in the long run - the growth rate will revert back to equilibrium if there is no technological progress
What adjustments to the financial statements should analysts make before calculating NOPAT and invested capital for the EVA and residual income approaches?
- capitalize and amortize R&D costs (rather than expense them), and add them back to earnings to calculate NOPAT - add back charges on strategic investments that will generate returns in the future - capitalize (but do not amortize) goodwill, add amortization expense back to earnings to get NOPAT, and add accumulated amortization back to total (invested) capital - eliminate deferred taxes and consider only cash taxes as an expense - treat operating leases as capital leases and adjust nonrecurring items - add LIFO reserve to total (invested) capital and add back change in LIFO reserve to NOPAT
What are the advantages of using P/CF ratios?
- cash flow is harder for managers to manipulate than earnings - P/CF is more stable than P/E - no need to worry about differences in the quality of earnings reported
What are the two key inputs to a DCF approach to valuing a stock?
- cash flow or earnings measure - expected future growth rate
Holding period return can be broken into two components:
- cash flow yield (ex. dividends) - the return from price appreciation
Remeasurements result from:
- changes in actuarial assumptions (actuarial gains/losses), which affect the PBO - differences in the actual and expected return on plan assets
What are the three things you should exclude when calculating working capital investment?
- changes in cash/cash equivalents - notes payable - current portion of long-term debt
What are the explanations of changes in the effective tax rate on a parent company in terms of foreign operations?
- changes in the mix of profits from different countries with differing tax rates - changes in the tax rates
Examples of aggressive accounting practices are:
- channel stuffing, or accelerating revenue to the current period - deferring expenses to a later period to make current earnings better - using reserves to smooth income over time
Mechanisms to misstate assets/liabilities
- choosing inappropriate models and/or model inputs and thus affecting estimated values of financial statement elements (e.g. estimated useful lives for long-lived assets) - reclassification from current to non-current - over- or understating allowances and reserves - understating identifiable assets in acquisition method accounting for business combinations - overstating goodwill
What are the elements of a company's statement of corporate governance policies that investment analysts should assess.
- codes of ethics - directors' oversight, monitoring, and review responsibilities - management's responsibility to the board - reports of directors' oversight and review of management - board self assessments - management performance assessments - director training
Types of CDOs include:
- collateralized bond obligations, which are collateralized by corporate and emerging market debt - collateralized loan obligations, which are collateralized by leveraged bank loans
Warning signs of misstated profitability
- companies that repeatedly meet or repeatedly barely beat consensus estimates - restatements in the financial statements - revenue growth higher than peers' - receivables growth higher than revenue growth - high rate of customer returns - high proportion of revenue is received in the final quarter - unexplained boost to operating margin - operating cash flow lower than operating income - inconsistency in operating versus non-operating classification over time - aggressive accounting assumptions (e.g. high estimated useful lives) - executive compensation largely tied to financial results
When the actual GDP growth rate is higher than the potential GDP growth rate,
- concerns about inflation increase - central bank is more likely to contract monetary policy
What are common types of mergers during the pioneer/development stage of a company?
- conglomerate - horizontal
What are common types of mergers during the rapid growth stage of a company?
- conglomerate - horizontal
Examples of costs that are usually fixed:
- corporate headquarters expenses - management salaries - IT operations
Flow mechanism (in the context of currency account deficits leading to depreciation)
- current account deficits increase the supply of the currency in markets - eventually this causes the currency to depreciate - eventually this may restore the current account to balance
What are the differences in analyzing a replacement project versus a normal expansion project?
- current after tax savage value of the old asset reduces the initial cash outlay - depreciation is the CHANGE in depreciation if the project is accepted compared to the depreciation on the old project
Working capital ratios include
- current ratio - quick ratio - defensive interval ratio - days' sales outstanding (DSO) - days' inventory on hand (DOH) - days' payables - cash conversion cycle
Managers should attempt to intentionally create changes in Porter's five forces by reducing:
- customer power - supplier power - substitutes - threat of entry - rivalry
Key external stake holders
- customers - suppliers - creditors - unions - governments - local communities - general public
What are the advantages of DCF analysis?
- customizable and easy to change inputs - the estimate of company value is based on forecasts rather than on current data
What are the advantages of comparable companies analysis?
- data is easy to access - estimates of value are derived directly from the market, rather than from assumptions and estimates of future conditions
Noncash items (this is super important)
- depreciation - amortization - gain (loss) on asset sale - restructuring expense (income) - increases in deferred tax liabilities - amortization of bond discounts and premiums
List the factors that effect force 4.
- differentiation of inputs that are acceptable to the industry - presence of substitute inputs - supplier concentration - importance of volume to the supplier - the threat of forward integration - switching costs
What are the disadvantages of DCF analysis?
- difficult to apply when FCF is negative. For example, a target company experiencing rapid growth may have negative FCF due to large CapEx. - estimates are highly subjective - discount rate changers over time - the terminal value is highly sensitive to estimates used for the constant growth rate and discount rate
What are the primary disadvantages of dividend discount models?
- difficult to implement for firms that do not pay dividends - takes the perspective of an investor who owns a minority stake in the firm and cannot control the dividend policy
Examples of non-recurring items are:
- discontinued operations - accounting changes, such as changing the useful life of an asset from 10 to 15 years. This will result in a one-time adjustment that will increase net income. Remove this. - restructuring charges, which take the form of an accrued non-cash charge at the time of restructuring.
What are the advantages of using the dividend yield (D/P) approach?
- dividend yield directly contributes to total investment return - dividends are not as risky as the capital appreciation component of total return
The Gordon growth model assumes:
- dividends grow at a constant rate for an indefinite horizon - the growth rate is less than the required return
List the two main factors that affect force 5.
- do the firms follow sensible pricing policies, or do they engage in price competition that cannot be won? - do the firms engage in non-price competition that increases costs but fails to increase profits?
What are the characteristics of Relative PPP in the short versus long term?
- does not hold in the short term - could hold approximately in the long term
The four fundamental variables that influence stock price are:
- earnings - dividend payout rate - growth rate - required return
What are the shortcomings of using P/E ratios in valuation?
- earnings can be negative - volatile and transitory earnings can make P/Es inconsistent - management discretion can distort reported earnings
List the factors that effect force 1.
- economies of scale: the greater the economies of scale, the more difficult it will be for new entrants to achieve critical mass - product differences and brand identity - switching costs - capital requirements: needed to construct the facilities and other infrastructure required to enter the industry - access to distribution channels: existing distributors may be at or near capacity, and therefore not willing to take on new entrants' products - government policy: licensing or other approvals to enter the industry - cost and/or quality advantages enjoyed by incumbent firms
Typical adjustments to book value when calculating P/B include:
- eliminating intangible assets, such as goodwill and patents - adjusting for off balance sheet assets and liabilities - adjusting for accounting comparability, such as FIFO and LIFO
Benefits of stock appreciation awards (rights)
- employees have limited downside risk and unlimited upside potential - there is no dilution to existing shareholders
What are the objectives of capital controls or central bank intervention?
- ensure the domestic currency does not appreciate excessively - allow the pursuit of independent monetary policies - reduce excessive inflow of foreign capital
How can depreciation expense be manipulated to result in higher net income?
- excessively long depreciable life assumptions - excessively high salvage values - write down an asset, taking an immediate charge against income, then record less future depreciation expense based on the reduced carrying value
What effect does a higher potential GDP growth rate have on credit?
- expected credit risk declines - increases the credit quality of all debt
What are the factors in the commonly used supply side estimate of the equity risk premium?
- expected inflation - expected real growth in EPS - expected changes in the P/E ratio - expected yield on the index - expected risk-free rate
What are warning signs of incorrect capitalization of expenses?
- expenses missing from I/S - long-lived assets created in B/S - cost recognition deferred from I/S - PP&E/total assets increases - margin improvement - deterioration in asset turnover - increases in CapEx/gross PP&E - CapEx growth exceeds sales growth
List common mistakes in the capital budgeting process
- failing to incorporate economic responses into the analysis - misusing standardized project evaluation templates - having overly optimistic assumptions for pet projects of senior management - basing long-term investment decisions on short-term EPS or ROE considerations - using the IRR criterion for project decisions - poor cash flow estimation - misestimation of overhead costs - using a discount rate that does not accurately reflect the project's risk - politics involved with spending the entire capital budget - failure to generate alternative investment ideas - improper handling of sunk and opportunity costs
How are held-for-trading securities reported on the balance sheet and income statement?
- fair value on the balance sheet - changes in fair value, both realized and unrealized, are reported on the income statement - dividend or interest income reported on the income statement
How are "designated at fair value" securities reported on the balance sheet and income statement?
- fair value on the balance sheet - changes in fair value, both realized and unrealized, are reported on the income statement - dividend or interest income reported on the income statement - the same as held-for-trading securities
How are available-for-sale securities reported on the balance sheet and income statement?
- fair value on the balance sheet - only realized gains or losses reported on the income statement - dividend or interest income reported on the income statement - unrealized gains or losses are reported as a separate component of stockholder's equity in other comprehensive income - when the asset is sold, the unrealized gains and losses are removed from other comprehensive income, and are realized on the income statement
Describe how financial markets and intermediaries help economic growth
- financial markets determine which potential users of capital offer the best returns on a risk-adjusted basis - by pooling small amounts of savings from investors, intermediaries can finance projects on larger scales than would otherwise be possible - overall they help economic growth by efficiently allocating resources
List the reasons for compliance-related valuations.
- financial reporting - tax reporting
The residual income approach is most appropriate for:
- firms that do not have dividend histories - firms that have negative free cash flow for the foreseeable future - firms with transparent financial reporting and high quality earnings
Free cash flow models are most appropriate for the following situations:
- for firms that do not have a dividend payment history or have a dividend payment history that is not clearly and appropriately related to earnings - for firms with free cash flow that corresponds with their profitability - when the valuation perspective is that of a controlling shareholder
Uncovered interest rate parity occurs when
- forward currency contracts are not available - capital flows are restricted to prevent arbitrage
Liquidity preference theory
- forward rates reflect investors' expectations of future spot rates, plus a liquidity premium to compensate investors for exposure to interest rate risk - liquidity premium is positively related to maturity
Futures versus Forward contracts
- futures are exchange traded - futures don't have credit risk (backed by clearinghouse) - forwards are unregulated
List the nonrecurring components of earnings
- gains/losses from asset sales - asset writedowns - provisions for future losses - changes in accounting estimates
Describe the effects of fiscal expansion in high capital mobility environments
- govt spending increases - interest rates increase - investment increases - demand for the domestic currency increases - appreciation
What are procedures that can help control PAR problems?
- guide the behavior of agents by setting goals and principles of behavior - reduce the asymmetry of information - lead to the removal of agents who misbehave and violate ethical priciples
Businesses that follow the visionary style must:
- have adequate resources to commit - stay focused on a long term goal rather than constantly changing their strategy
How do IFRS and GAAP classify investments in financial assets?
- held-to-maturity - available-for-sale - fair value through profit or loss (including held-for-trading and securities designated at fair value)
What are the disadvantages of using P/Sales ratios?
- high growth in sales does not necessarily indicate high operating profits - does not capture differences in cost structures across companies
How should an analyst test for aggressive revenue recognition?
- higher receivables turnover over time is a red flag - increasing days' sales outstanding over time is a red flag
What are common types of mergers during the stabilization stage of a company?
- horizontal
What are common types of mergers during the mature growth stage of a company?
- horizontal - vertical
What are common types of mergers during the decline stage of a company?
- horizontal - vertical - conglomerate
Other factors (not linked to an accounting standard) that could indicate the functional currency:
- how autonomous is a subsidiary? - how large is a subsidiary's transactions with the parent? - if a subsidiary is paying a lot of dividends to the parent, the parent is likely the functional currency - if the subsidiary is drawing a lot of its financing from the parent, the parent is likely the functional currency
Employer contributions are a function of
- how much cash the employer has - how much it is legally required to contribute - whether or not the company has an overfunded or underfunded plan
For a company that does not hedge its input price exposure nor is vertically integrated, what questions should an analyst ask about the firm's exposure to input price changes?
- how rapidly and to what extent can an increase in costs be passed on to customers? - how rapidly and to what extent can the expected effect of price increases weigh on sales volume and revenue?
Two things analysts should keep in mind when considering antitrust regulations on companies
- how will regulators likely respond to an announced merger or acquisition? - how do antitrust law differentials across countries affect a multinational corporation?
Under IFRS 9, describe the process of reclassification of debt securities from fair value through profit or loss to amortized cost.
- if reclassifying in the opposite direction, debt securities are transferred at fair value on the transfer date, and that fair value will become the carrying amount - only allowed if the business model has changed
What are the problems that usually arise when using the asset-based approach to private company valuation?
- if the firm has many individual assets - if the firm has specialized assets - if the firm has many intangibles
What are the shortfalls of EV/EBITDA multiples over price multiples?
- if working capital is growing, EBITDA will overstate CFO - ifnores how different revenue recognition policies affect CFO - does not capture the amount of capital expenditures (EBITDA is before CapEx on the income statement), unlike FCFF. FCFF is more strongly linked with valuation theory.
Describe how earnings growth is related to GDP growth
- in the long-run, earnings growth cannot exceed GDP - equity growth drivers also drive GDP
Non-monetary assets and liabilities
- include inventory, fixed assets, intangible assets, etc - remeasured at historical (actual) rate
Warning signs of misstated assets/liabilities
- inconsistency in model inputs for valuation of assets versus valuation of liabilities - typical current assets (e.g. inventory, receivables) being classified as non-current - allowances and reserves differ from those of peers and fluctuate over time - high goodwill relative to total assets - use of special purpose entities (SPEs) - large fluctuations in deferred tax assets/liabilities - large off-balance-sheet liabilities
Qualified special purpose entities (QSPEs) are no longer allowed under GAAP. If asked to adjust for a QSPE that securitizes accounts receivable, what is the process?
- increase assets (accounts receivable) and liabilities by the same amount.
Warning signs of overstated CFO
- increase in payables combined with decreases in inventory and receivables - capitalized expenditures (which flow through investing activities) - sale and leaseback of assets - increases in bank overdraft
Describe the benefits of SROs with governmental recognition
- increase the overall level of regulatory resources - utilize their own industry professionals with the right expertise - allow government regulators to devote resources to other priorities
What types of costs should a cost-benefit analysis of a regulation include?
- indirect costs of regulations - hidden costs (ex. FDIC insurance for banks may incentivise banks to take excessive risks) The U.S. requires agencies to conduct a cost-benefit analysis for each new regulation.
How are held-to-maturity investments reported on the financial statements?
- initially at cost under IFRS or fair value under GAAP - interest and dividend income is recognized on the income statement - changes in fair value (unrealized gains/losses) are ignored, except for when the asset is impaired - balance sheet value is adjusted for amortization over time (add an amortization discount, subtract premium)
Describe the effects of monetary expansion in high capital mobility environments
- interest rates decrease - investment decreases - demand for the domestic currency decreases - depreciation
Describe the characteristics of treating an associate equity investment at fair value.
- irrevocable - unrealized gains and losses are recorded on the income statement - basically a held-for-trading investment
List the key points of the Ho-Lee model
- is a "calibration" model; it "solves for" a variable that equates bonds' market prices to an existing term structure - produces a normal distribution of rates - can be used to price zero-coupon bonds and find the spot curve
What are the limitations of the Altman model?
- it is a single-period static model and therefore does not capture the change in key variables over time - reduction in effectiveness over time as investors have taken advantage of the model
What are the disadvantages of using P/CF ratios?
- items affecting actual CFO are ignored when the EPS plus noncash charges estimate is used - theoretically, FCFE is preferable to CFO (however, it is more volatile than CFO)
What factors may cause directors to align more with management than with shareholders?
- lack of independence of board and management - board members have personal relationships with management - board members have consulting or other business agreements with the firm - interlinked boards (managers of firm A serving as directors of firm B, while managers of firm B serve as directors of firm A) - overcompensated directors (when directors favor managers so managers will in turn increase directors' compensation)
Benefits of leasing
- less costly financing - reduced risk of obsolescence - less restrictive provisions - off-balance-sheet financing - tax reporting advantages
The two primary determinants of gross interest expense are
- level of debt in the capital structure - market interest rates
What considerations come into play when choosing a valuation method for a private company that are usually not considered for public equities?
- lifecycle stage - firm size
List the stock-specific differences between private and public firms.
- liquidity of shares - restrictions on marketability of shares - concentration of control (ownership)
Synergies result from
- lowering costs - increasing revenues
What is the goal of the target company's due diligence process in a friendly merger?
- make sure the acquiring company has the financial capacity to pay for the transaction - protect the shareholders of the target company
What is the goal of the acquiring company's due diligence process in a friendly merger?
- make sure the target's assets truly exist - protect the shareholders of the acquiring company
Mechanisms to overstate operating cash flows
- management can use timing of cash flows to manipulate - misclassifying CFI as CFO - slowing payments to suppliers (e.g. stretching payables) - selling receivables - reducing inventories
Describe the difference between marginal product of capital and marginal productivity of capital
- marginal product of capital is the amount of additional output generated from one additional unit of capital - marginal productivity of capital is the increase of output per worker generated from one additional unit of capital per worker
In which industries are companies often valued using P/S ratios?
- mature or cyclical industries - start-up companies (when they have no record of earnings) - investment management companies
Describe expansionary monetary policy under a fixed rate regime
- money supply increases - interest rate decreases - pressure on the domestic currency to depreciate but the currency is fixed, so the government must: - purchase its currency in foreign markets to increase demand and maintain the peg - this reduces money supply and effectively reverses the expansion
What are the benefits of corporations over sole proprietorships and partnerships?
- much easier to raise large amounts of capital - no need for owners to be industry experts - ownership stakes are easily transferable, which allows a corporation to have an unlimited life - corporate shareholders have limited liability
Advantages of stock-based compensation
- no cash outlays
Arbitrage transactions involve:
- no initial cash outlays - positive riskless cash flow(s) sometime in the future
What are the advantages of comparable transaction analysis?
- no need to estimate a separate takeover premium - estimates of value are derived directly from recent prices for actual deals, rather than from assumptions and estimates of future conditions - use of prices established by recent transactions reduces the risk that the targets shareholders could file a lawsuit
The implications of non-agency RMBS in comparison to agency RMBS are:
- non-agency RMBS have more credit risk - therefore, they need credit enhancements
Examples of off-balance sheet financing include
- operating leases - debt guarantees - sales of receivables - take-or-pay agreements
Examples of classification issues
- operating versus nonoperating items - current versus noncurrent assets/liabilities
Inflection points occur due to changes in
- overall economic environment - business cycle stage - government regulations - technology
Floating-rate bond (floater)
- pays a coupon that adjusts every period based on an underlying reference rate - coupon rate is determined at the beginning of a period but is paid at the end of that period
Characteristics of FX carry trades
- performs well in periods of low volatility - high kurtosis of returns (more risk of loss) - you're betting that the funding currency will depreciate - only profitable if uncovered interest rate parity does not hold over the period of investment
Under Classical Growth Theory, in what circumstances does economic growth increase?
- population growth increases whenever there are increases in per capita income above the minimum income needed to maintain life - this increase is due to an increase in capital or technological progress - whenever this increase occurs, a population explosion occurs - in the long term, diminishing returns to labor will reduce productivity and drive GDP per capita back down, so there is no long-term growth in per capita income
List the methods of creating loan-level call protection.
- prepayment lockout - defeasance - prepayment penalty points - yield maintenance charges
Describe monetary expansion in the Dornbusch model
- real interest rates decrease - prices increase over time - depreciation occurs - capital flows out of the country
Characteristics of independent regulators
- recognized by government agencies - have power to make rules and enforce them - usually not funded by the government and hence are politically independent
Describe the benefits of SROs without governmental recognition
- relatively immune from political pressure - although still subject to pressure from their members
What are the advantages of using P/Sales ratios?
- sales revenue is always positive, which is not the case for earnings and even book value - revenue is not as easy to manipulate as earnings or book value - P/S ratios are not as volatile as P/E multiples
From the lessor's perspective, what are the options for recognizing a finance (capital) lease under GAAP?
- sales-type lease - direct financing lease If the present value of the lease payments > the carrying value of the asset, treat as a sales-type lease If the present value of the lease payments = the carrying value, treat as a direct financing lease
Common examples of unethical behavior amongst executives:
- self-dealing - when agents misappropriate corporate assets for personal use - information manipulation - ex. misleading financial information or hiding a health risk - anticompetitive behavior - pursuit of monopoly power (even if legal, it's unethical) - opportunistic exploitation of suppliers or distributors - substandard working conditions imposed on employees - environmental degradation - pollution, improper use of resources - corruption - ex. bribery
List the reasons for litigation-related valuations.
- shareholder law suits - damage claims - lost profits - divorces
When a company employs the survival style, it should focus on:
- shoring up capital - cutting expenses - restructuring After the business environment improves, the company can formulate a longer term strategy
List the factors that require adjustment when estimating the discount rate for private companies.
- size premiums (private firms usually smaller, riskier, higher discount rate) - availability and cost of debt (private firms usually have less access to debt financing, and equity financing is usually more expensive) - using the acquirer's versus target's discount rate (always use the target's rate) - projection risk (increases the discount rate) - lifecycle stage (can be difficult to estimate the discount rate for firms in an early stage of development)
Cobb-Douglass function
- states that GDP is a function of labor, capital, and their productivity - assumes constant returns to scale
Classifications of regulations
- statutes - administrative regulations - judicial law
What are the warnings signs of earnings manipulation in terms of accruals ratio changes over time?
- steadily increasing accruals ratios - wide fluctuations in accruals ratios
The two basic forms of acquisition are
- stock purchase - asset purchase
Key internal stake holders
- stockholders - employees - managers - members of the board of directors
List the two types of value additivity arbitrage.
- stripping - reconstitution
Acquirers are likely to earn positive returns on a deal characterized by these four factors:
- strong buyer - low premium - few bidders - favorable market reaction
List the common motivations behind M&A activity
- synergies - achieving more rapid growth - increased market power - gaining access to unique capabilities - diversification - bootstrapping EPS - personal benefits for managers - tax benefits - unlocking hidden value - achieving international business goals
Typical SPE uses are
- synthetic leases - sale and leaseback structured as an operating lease - synthetic loans - loans or mortgages sold to SPE which issues mortgage backed securities - sale of receivables - company sells accounts receivable to the SPE, which finances the purchase of the receivables by borrowing from a bank - R&D cost - SPE established to fund R&D avoids recognition of R&D expense or liabilities
What are the specific motivations of M&A activity around achieving international business goals?
- taking advantage of market inefficiencies - working around disadvantageous government policies - use technology in new markets - product differentiation - provide support to existing multinational clients
Under Endogenous Growth Theory, in what circumstances does economic growth increase?
- technological growth emerges as a result of investment in both physical and human capital - unlike the neoclassical model, there is no equilibrium growth rate, so increased investment can permanently increase the rate of growth - unlike the neoclassical model, an increase in savings will permanently increase the growth rate
What are the two methods an acquirer can use when appealing for an acquisition directly to shareholders?
- tender offer - proxy battle
What are the strengths of the residual income model?
- terminal value does not dominate the estimate of intrinsic value - accounting data usually accessible - applicable even without dividends or positive cash flow - applicable even when cash flows are volatile or unpredictable - focuses on economic profitability
Warning signs of a coming currency crisis are:
- terms of trade deteriorate - official foreign exchange reserves dramatically decline - real exchange rate is substantially higher than the mean-reverting level - inflation increases - equity markets experience a boom-bust cycle - money supply relative to bank reserves increases - nominal private credit grows
What are the disadvantages of comparable transaction analysis?
- the approach implicitly assumes that the M&A market valued past transactions accurately - there may not be enough comparable transactions - it is difficult to incorporate merger synergies or changing capital structures
What are the disadvantages of comparable company analysis?
- the approach implicitly assumes the market's valuation of the comparable companies is accurate - comparable companies provide an estimate of a fair stock price, but not a fair takeover price - it is difficult to incorporate merger synergies or changing capital structures - historical data may not be up to date
Describe how a lessor treats an operating lease.
- the asset remains on the balance sheet - depreciation expense is recognized by the lessor - the lessor recognizes the lease payment as rental income
Dividends are appropriate as a measure of cash flow in the following cases:
- the company has a history of dividend payments - the dividend policy is clear and related to the earnings of the firm - the perspective is that of a minority shareholder
Under IFRS, the following factors likely signal the functional currency:
- the currency that influences sales prices - the currency of the country whose competitive forces and regulations mainly determine the sale price - the currency in which funds from financing activities are generated - the currency in which earnings from operating activities are retained, and not paid out to a parent in dividends (if a subsidiary is not paying much dividend to the parent, it is likely to be the functional currency)
List some common errors made using the DCF method.
- the discount rate does not adequately capture risk - income growth exceeds expense growth - the terminate cap rate and the going-in cap rate are not consistent - the terminal cap rate is applied to NOI that is atypical - the cyclicality of real estate markets is ignored
What factors affect how residual income will continue into the future?
- the dynamics of the industry in which the company operates - the firm's competitive prospects over the long term
What are the disadvantages of using the dividend yield (D/P) approach?
- the focus on dividend yield is incomplete because it ignores capital appreciation - the dividend displacement of earnings concept argues that dividends paid now displace future earnings, which implies a trade-off between current and future cash flows
The effectiveness of the flow mechanism, the idea that a decrease in the value of a currency may restore the current account deficit to a balance, depends on the following factors:
- the initial deficit (the larger the initial deficit, the more depreciation is needed to restore current account balance) - the influence of exchange rates on domestic import and export prices (consumers may not feel these effects) - price elasticity of demand of the traded goods (if the most important imports are relatively price inelastic, the quantity imported will not change)
Describe allowances for reclassification under IFRS 9.
- the initial selection of fair value through profit or loss or fair value through other comprehensive income is irrevocable. There is no reclassification out of these securities. - reclassification of debt securities from amortized cost to fair value through profit or loss is permitted only if the business model has changed
What are the two factors that effect prepayment risk?
- the level of interest rates at a particular point in time - the path rates took to get there
When is the maturity-matched rate most important for callable bonds? Putable bonds?
- the maturity matched rate dominates (i.e. has the highest key rate duration) callable bonds that have low coupon rates (unlikely to be called) - the maturity matched rate dominates putable bonds that have high coupon rates (unlikely to be called)
The high discount rate in VC investments is used because
- the probability of failure is high - there is a lack of diversification available in these VC investments
What are the shortcomings of the PEG ratio?
- the relationship between P/E and g is not linear, which is especially true if multistage growth models are used - PEG ratio still doesn't account for risk, one of the two fundamental factors that affect P/E
List the factors that effect force 2.
- the relative price performance of substitutes - how likely are the current buyers to switch - switching costs incurred by the buyer
Segmented markets theory
- the shape of the yield curve is determined by the preferences of borrowers and lenders - the yield at each maturity is determined independently of the yields at other maturities (essentially, each maturity is unrelated to others)
The gain in a merger is a function of what two factors?
- the synergies created by the merger - any cash paid to shareholders as part of the transaction
What are two common industry practices for management compensation that are considered poor corporate governance?
- the use of the salary at other companies as a reference point for compensation, rather than using its own performance - repricing of stock options, which allows management to recoup losses after a stock price decline
What are the challenges involved with valuation standards?
- there are many different valuation standards - compliance is at the appraiser's discretion - it is difficult to ensure compliance to the standards - technical guidance on the use of standards is limited - valuation will depend on the definition of value used
How are residual income models used other than for equity valuation purposes?
- to measure goodwill impairment - to evaluate managerial effectiveness - to evaluate executive compensation
How can an analyst detect an excessive asset base?
- too much cost capitalization - evaluate over time and using common-size balance sheets
What are the considerations to make when choosing comparables for the guidelines transactions method?
- transaction type: was the comparable transaction strategic vs. financial? - contingent consideration: did a company have any specific performance targets that its value was reliant on (such as receiving FDA approval of a drug)? more contingent considerations will raise company risk - type of transaction: cash vs. stock - availability of data: is the historical data for comparable transactions relevant and accurate? - date of data: is the historical data for comparable transactions up to date?
Under IFRS 9, describe the process of reclassification of debt securities under amortized cost to fair value through profit or loss.
- unrecognized gains/losses are recognized in the income statement - only allowed if the business model has changed
If earnings are negative, what are two common alternatives to using P/E?
- use E/P (earnings yield) - use normalized EPS
Forward rate model
- used to determine spot or forward rates - states that investors will be indifferent between buying, for example, a 5-year zero-coupon bond versus buying a 2-year zero-coupon bond and reinvesting the principal at maturity in the locked in 3-year forward rate
Forward pricing model
- used to value forward contracts - equates buying a zero-coupon bond to entering into a forward contract to buy a zero-coupon bond in the future that matures at the same time
What are the limitations of the Beneish model?
- uses accounting data and therefore does not take into account market and economic data - reduction in effectiveness over time as investors have taken advantage of the model
What are the limitations of the Gordon growth model?
- valuations are very sensitive to estimates of growth rates and required rates of return, both of which are difficult to estimate with precision - the model cannot b easily applied to non dividend paying stocks - unpredictable growth patterns of some firms would make using the model difficult and the resulting valuations unreliable
What are the two types of arbitrage opportunities for securities (in particular bonds)?
- value additivity (when the value of the whole differs from the sum of the parts) - dominance (when one asset trades at a lower price than another asset with identical characteristics)
When are residual income models appropriate to use?
- when a firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable - when expected free cash flows are negative for the foreseeable future - when the terminal value forecast is highly uncertain which makes dividend discount or FCF models less useful
Regulatory arbitrage
- when businesses shop for a country that allows a specific behavior rather than altering their own - when companies exploit the difference between economic substance and interpretation of a regulation
When should you solve for equity value, not firm value?
- when capital structure is constant
Under what circumstances should Adjusted CFO be used as a proxy for cash flow in valuation multiples?
- when comparing CFO repoorted under IFRS with CFO reported under U.S. GAAP - when comparing two IFRS companies when one classifies interest under CFO and the other under CFF
In what situations should an analyst use EV/EBITDA multiple over price multiples?
- when comparing firms with different degrees of financial leverage - when valuing capital-intensive businesses with high levels of depreciation and amortization - when EPS is negative (EBITDA is most often positive)
When should you solve for firm value, not equity value?
- when the capital structure changes - when the firm has a large outflow of cash - when FCFE is negative
When are residual income models not appropriate to use?
- when the clean surplus accounting relation is violated significantly - there is significant uncertainty concerning the estimates of book value and return on equity
Explain the thought process behind preventing reclassification into or out of fair value for profit or loss securities.
- you could reclassify an asset from available-for-sale to held-for-trading during a bull market, and recognize gains on the income statement - if you reclassified from held-for-trading to available-for-sale during a bear market, you would recognize losses under shareholders' equity, but income would stay the same - if you reclassified from held-for-trading to held-to-maturity during a bear market, you would not recognize any losses at all
When residual income drops immediately to zero, the persistence factor (Ɯ) will equal
0
What is the range of values within which the persistence factor can be?
0 to 1.0
What number did Taylor recommend for the coefficient of the Taylor rule?
0.5 (must be greater than 0)
When residual income persists at the current level forever, the persistence factor (Ɯ) will equal
1
List the several definitions of cash flow that can be used in price and enterprise value multiples.
1) CF (earnings-plus-noncash-charges) 2) adjusted CFO 3) FCFE 4) EBITDA
List the modern theories of the term structure of interest rates
1) Cox-Ingersoll-Ross Model (an equilibrium term structure model) 2) Vasicek Model (an equilibrium term structure model) 3) Ho-Lee Model (an arbitrage-free term structure model)
What are the three basic methods that analysts use to value target companies in an M&A transaction?
1) DCF analysis 2) comparable companies analysis 3) comparable transaction analysis
Outline the steps of a DCF
1) Determine which FCF model to use 2) Develop pro forma financial estimates 3) Calculate FCF estimates 4) Discount the FCF estimates back to the present 5) Calculate terminal value 6) Add the FCF estimates (enterprise value) to the terminal value
List the steps of spreadsheet modeling a company's value.
1) Establish the base level of cash flows or dividends 2) estimate changes in the firm's dividends for the foreseeable future 3) project future cash dividends using these estimates 4) estimate what normalized level of growth will occur at the end of the supernormal growth period 5) discount all projected dividends and the terminal value to the present
Examples of clean surplus relation violations are:
1) FX translation gains/losses 2) pension adjustments 3) gains/losses on cash flow hedges 4) changes in revaluation surplus (IFRS only) for long-lived assets 5) changes in the value of certain liabilities due to changes in the liability's credit risk (IFRS only) 6) changes in the market value of debt and equity securities classified as available-for-sale
List the five philosophies underlying business ethics
1) Friedman Doctrine 2) Utilitarianism 3) Kantian Ethics 4) Rights Theories 5) Justice Theories
What are the two ways to estimate terminal value?
1) Gordon growth model 2) market multiple approach
Stakeholder impact analysis
1) Identify the relevant stakeholders 2) Identify their critical interests and desires 3) Identify their demands 4) Prioritize the stakeholders 5) Design a business plan to meet critical demands
Levels of ownership
1) Less than 20% - Investments in financial assets (no significant influence) 2) 20-50% - Investment in associates (significant influence) 3) More than 50% - Business combinations (control)
List the propositions and their subsections made by Modigliani and Miller
1) Proposition 1 (value of a firm) with NO taxes 2) Proposition 2 (WACC) with NO taxes 3) Proposition 1 (value of a firm) WITH taxes 4) Proposition 2 (WACC) WITH taxes
The best ways to measure a company's ability to satisfy shareholders' demands are:
1) ROIC (dividends) 2) growth in profits
What are the two main types of delayed recognition of pension events and what accounting standards allow them?
1) Remeasurements (GAAP and IFRS) 2) Past service costs (GAAP only)
List the preconditions for economic growth
1) Savings and investment (public and private) 2) Financial markets and intermediaries 3) Political stability, rule of law, and property rights 4) Investment in human capital (education and healthcare) 5) Tax and regulatory systems 6) Free trade and unrestricted capital flows Note that this does not include increasing regulation or domestic investment in infrastructure, etc.
List the traditional theories of the term structure of interest rates
1) Unbiased expectations theory 2) Local expectations theory 3) Liquidity preference theory 4) Segmented markets theory 5) Preferred habitat theory
A bond that is both callable and convertible contains two embedded options:
1) a call option on the stock 2) a call option on the bond
What are the weaknesses of the residual income model?
1) accounting data can be manipulated by management 2) requires many adjustments (because of its links to financial statement analysis) 3) assumes that the clean surplus relation holds or that its failure to hold has already been taken into account
Mispricing perceived by analysts can be divided into two sources:
1) actual mispricing 2) valuation error
What are the criteria for earnings to be of high quality?
1) adequate - earnings must exceed the investor's required return; return on equity must cover the cost of equity 2) sustainable - adequate earnings must be sustainable in future periods
What are the two methods of adjusting valuation to reflect risk of failure for a VC investor?
1) adjust the discount rate 2) adjust the terminal value using scenario analysis
Terms of a private equity fund prospectus should:
1) align GP and LP interests 2) specify GP compensation
Four important effects on the balance sheet and income statement that result from the choice of accounting method:
1) all three methods report the same net income 2) equity method and proportionate consolidation report the same equity. Acquisition method equity will be higher by the amount of minority interest 3) assets and liabilities are highest under the acquisition method and lowest under the equity method. Proportionate consolidation is in between 4) revenues and expenses are highest under the acquisition method and lowest under the equity method. Proportionate consolidation is in between.
What is the effect of expansionary fiscal policy in 1) the MF model and 2) the portfolio balance model?
1) appreciation (short term) 2) depreciation (print money) (long term)
The bargaining power of the buyers of the industry's product can be viewed as coming from two main sources:
1) bargaining leverage 2) price sensitivity
What are the two largest areas of concern for PAR problems?
1) between managers and shareholders 2) between directors and shareholders
What are the tests used to identify amortized cost securities under IFRS 9?
1) business model test - unless its business model has changed, a company cannot recognize capital gains or losses prior to maturity of the security 2) cash flow characteristic test
How do you estimate NAVPS based on forecasted cash NOI?
1) calculate (NOI)/(cap rate) 2) add tangible assets 3) subtract liabilities
What are the two ways you can forecast free cash flow?
1) calculate historical free cash flow and simply apply a growth rate to it 2) forecast the underlying components of free cash flow separately
Growth in labor productivity comes from two sources:
1) capital deepening (increase in K/L) - diminishing returns to scale 2) technological progress (shifts curve up) - constant or increasing returns to scale, usually
What are the two variants of the total return method?
1) carry can be paid only after the entire committed capital is returned to LPs 2) carry can be paid when the value of the portfolio exceeds invested capital by some minimum amount
Factors to consider when evaluating the capital structure of a company
1) changes in capital structure over time - is there a trend? 2) capital structure of competitors with similar business risk 3) agency costs - higher quality of corporate governance lowers agency costs and reduces the need for high debt (leverage)
Macroeconomic multifactor models take five factors into account:
1) confidence risk 2) time horizon risk 3) inflation risk 4) business cycle risk 5) market timing risk
What are the three generic strategies a company can employ in order to compete and generate profits?
1) cost leadership - be the lowest cost producer 2) product differentiation - offer the widest range of products to be able to charge a premium 3) focus - focus on a particular segment of the industry in order to gain a compitative edge
List and define the two options for calculating the risk premium for emerging markets countries.
1) country spread model - add a premium equal to the difference between the yield on bonds in the EM market minus the yield on corresponding bonds in the developed market 2) country risk rating model - estimates an equation for the equity risk premium for developed countries, then regresses that against EM risk rating inputs to estimate the required return
The residual income valuation model breaks the intrinsic value of a stock into two elements:
1) current book value of equity 2) present value of expected future residual income
What factors effect the spread quoted by dealers?
1) dealer spreads vary directly with interbank spreads 2) transaction size - larger volumes need demand more liquidity, so spreads are wider 3) relationship between dealer and client
An effective corporate governance system will:
1) define the rights of shareholders and other important stakeholders 2) define and communicate to stakeholders the oversight responsibilities of managers and directors 3) provide for fair and equitable treatment in all dealings between managers, directors, and shareholders 4) have complete transparency and accuracy in disclosures regarding operations, performance, risk, and financial position
What are the three major assumptions all pension plans must make and disclose?
1) discount rate 2) rate of compensation increase 3) expected return on plan assets (GAAP only)
The present value of expected loss metric makes the following adjustments to the expected loss measure:
1) discounts expected losses to the present 2) also adjusts default probabilities to capture the riskiness of cash flows, which expected loss does not capture
Disadvantages of the residual dividend approach
1) dividend fluctuates with investment opportunities and earnings 2) uncertainty about future dividends signals higher risk, and causes higher required return and lower valuation
List the primary and alternative dividend policy theories
1) dividend irrelevance (homemade dividends) 2) bird-in-hand argument for dividend policy (dividend preference theory) (pro-dividends) 3) tax aversion (tax preference theory) (anti-dividends) Alternative theories: 1) Clientele effect 2) Agency issues
How is dividend safety measured?
1) dividend payout ratio (dividends/net income) - higher dividend payout ratio than its historical average suggests a higher probability of a dividend cut 2) FCFE coverage ratio (FCFE/dividends+share repurchases) - a value less than one is considered unsustainable
In stock valuations, what are the three predominant definitions of future cash flows?
1) dividends 2) FCF 3) residual income
Advantages of the residual dividend approach
1) easy for the company to use 2) maximizes allocation of earnings to investment
List the alternative forms of determining income on a project other than the standard method of accounting income (revenues - costs of the project).
1) economic profit - the income earned by all capital holders 2) residual income - the income to equityholders only 3) claims valuation - separates project cash flows into the portion to equityholders and the portion to debtholders
Describe the process of combining balance sheets using the acquisition method.
1) eliminate investment account of the parent 2) eliminate equity accounts of the subsidiary (stockholders' equity) 3) create minority interest (share of equity not owned by parent) 4) combine assets and liabilities of both firms, NOT including intercompany transactions. Even if the parent does not own 100% of the subsidiary, combine 100% of assets and liabilities.
Describe the process of combining income statements using the acquisition method.
1) eliminate subsidiary earnings from the parent (often dividends) 2) subtract minority share of earnings (share of earnings not owned) 3) combine revenues and expenses of both firms, net of intercompany transactions. Even if the subsidiary is not 100% owned, combine all revenues and expenses anyway.
Fair value of plan assets (asset side of the plan) depend on:
1) employer contributions 2) return on assets 3) benefits paid out to retirees
Steps in developing a sales-based pro forma model:
1) estimate revenue growth and future expected revenue 2) estimate COGS 3) estimate SG&A 4) estimate financing costs 5) estimate income tax expense and cash taxes 6) estimate cash taxes, taking into account changes in deferred tax items 7) model the balance sheet 8) estimate CapEx and net PP&E for the balance sheet 9) use the completed pro forma income statement and balance sheet to construct a pro forma cash flow statement
What are the main steps of the cost approach to valuing real estate?
1) estimate the market value of the land 2) estimate the replacement cost of the building 3) adjust for depreciation and obsolescence
What are the two major sources of error in valuation analysis?
1) estimating future growth in FCFF and FCFE 2) chosen base years for FCFF or FCFE growth forecasts. An incorrectly chosen base year, all subsequent analysis will be flawed.
Excessive capital inflows into emerging markets create the following problems
1) excessive real appreciation of the currency 2) financial asset or real estate bubbles 3) increases in external debt by business or government 4) excessive consumption in the domestic market fueled by credit
What three factors is the total compensation of a securities offering based on?
1) exchange ratio 2) number of shares outstanding of the target company 3) the value of the acquirer's stock on the day the deal is completed
What are the three key factors that impact the price-to-FFO and price-to-AFFO values of REITs and REOCs?
1) expectations for growth of FFO or AFFO 2) the level of risks inherent in the underlying real estate 3) risk related to the firm's leverage and access to capital
The two fundamental factors that affect justified P/E are:
1) expected growth rate 2) required return (which is related to risk)
Sources of information about risk
1) financial statements 2) audit report (size and change of audit firm) 3) notes to financial statements 4) management discussion and analysis (MD&A) 5) SEC form NT 6) financial press
What are the five accounting adjustments that the residual income method requires?
1) fix any violations of the clean surplus relationship 2) adjust for off-balance-sheet items 3) remove nonrecurring items from the income statement 4) adjust for aggressive accounting practices 5) adjust for international accounting differences
Describe the mechanisms through which a current account deficit leads to a depreciation of the domestic currency
1) flow mechanism 2) portfolio composition mechanism 3) debt sustainability mechanism
On what two factors should you always base judgements of company comparability when using the multiples valuation approach?
1) growth 2) risk
What are the three methods to valuing private firms?
1) guideline public company method (GPCM) 2) guideline transaction method (GTM) 3) prior transaction method (PTM)
Why is the average age of a firm's assets important?
1) helps identify older, less-efficient assets, which may make the firm less competitive 2) helps the analyst estimate when major CapEx will be required, and therefore, when significant financing will be required
Describe the effects of a current account deficit in the U.S.
1) high imports 2) increased MS 3) depreciation Longer term: 4) eventual increase in exports 5) eventual decrease in the deficit
In order to have high quality financial reports, you must have:
1) high reporting quality 2) high earnings quality
What factors effect interbank spreads?
1) high volume currency pairs will have lower spreads 2) time of day - the overlap during the trading day when both the New York and London currency markets are open is the most liquid and therefore has the narrowest spreads 3) market volatility
What are three questions an analyst should ask when considering the differences in accounting practices between countries in the context of the clean surplus relation?
1) how reliable are earnings forecasts? 2) are there systematic violations of the clean surplus relation? 3) do poor quality accounting rules result in financial statements that bear no resemblance to the economic reality of the business?
The four-step process for determining the beta of a thinly traded stock or a nonpublic company is:
1) identify a benchmark company that is publicly traded and similar 2) estimate the beta of that benchmark company 3) unlever the benchmark company 4) relever the benchmark company according to the capital structure of the original company
Steps to estimating the value of a merger target using comparable transaction analysis
1) identify a set of recent takeover transactions 2) calculate various relative value measures based on completed deal prices for the companies in the sample 3) calculate the mean, median, and range of the metrics for the sample, and use those to estimate the value of the firm
Outline the steps of a comparable company analysis
1) identify the set of comparable firms 2) calculate various relative value measures based on the current market prices of companies in the sample 3) calculate the mean, median, and range of the metrics for the sample, and use those to estimate the value of the firm (ex. use the mean P/E ratio to find the firm's market value) 4) estimate a takeover premium 5) calculate the estimated takeover price for the target (estimated value + takeover premium)
What are the issues with calculating NAV for a private equity fund?
1) if NAV is only adjusted when there are subsequent rounds of financing, NAV will be more stale when financings are infrequent 2) there is no definitive method for calculating NAV for a private equity fund because the market value of portfolio companies is usually not certain until exit 3) undrawn LP capital commitments are not included in the NAV calculation but are essentially liabilities for the LP 4) PE funds that include a variation of strategies and maturities may use different valuation methodologies
Under GAAP, how is impairment of goodwill recognized?
1) if the carrying value of the business unit > fair value, goodwill is impaired 2) impairment = business unit's reported goodwill - fair value of the goodwill
Possible methods for private company valuation:
1) income model (basically a DCF using income) 2) market model (using price multiples of comparables) 3) asset-based model (assets minus liabilities)
What two factors contribute to a firm's competitive strategy?
1) industry attractiveness 2) competitive advantage
What are the four factors that the CFA institute cites as important factors to shaping industry structure, but are not included in Porter's five forces because they are not long term factors (but still might affect the five forces)?
1) industry growth rate 2) innovation and technology 3) government policies 4) complementary products
What are the criteria for financial reports to have high reporting quality?
1) information within the financial reports must be relevant and useful; aka "decision useful" 2) must be accurate and GAAP compliant 3) the accounts must "enable assessment," meaning they must represent the true economic position of the company
Three explanations for conglomerate discounts, or the sum of the parts of a company being larger than the company as a whole, are:
1) internal inefficiently 2) endogenous (internal) factors 3) research measurement errors
Factors that affect dividend policy
1) investment opportunities - if the company takes advantage of investment opportunities, FCF will decline and the residual income available to pay as dividends will decrease 2) expected volatility of future earnings - firms are more cautious in changing dividend payout in the presence of high earnings volatility 3) financial flexibility - firms may not increase dividends, even in the presence of higher FCF, so as not to be forced to continue paying those dividends in the future 4) tax considerations - if dividend vs. capital gains tax rates are different, management might structure their dividend policy to maximize investors' after-tax income 5) flotation costs - these costs increase the cost of external equity, encouraging the firm to pay out less dividends and retain more earnings. 6) contractual and legal restrictions - dividends may be restricted by debt covenants or implicit restrictions caused by cash needs of the firm
Disadvantages of issuing stock-based compensation
1) issuing stock grants or options reduces earnings 2) stock grants may encourage management to be too risk averse 3) stock options may encourage management to take on too much risk (to try and boost the stock price if the option is out of the money) 4) a few employees incentive to perform better from owning stock is unlikely to have an effect on the stock price 5) voting rights of the existing shareholders are diluted as more shares are issued
What are the options for comparing mutually exclusive projects with unequal lives?
1) least common multiple of lives approach 2) equivalent annual annuity approach
Risks from ESG factors:
1) legislative and regulatory risk 2) legal risk 3) reputational risk 4) operating risk 5) financial risk
What are the three things you need to adjust for when calculating net borrowing? (Also known as the three stooges)
1) long term debt 2) changes in notes payable 3) current portion of long-term debt
Problems of currency appreciation
1) loss of competitiveness globally 2) asset bubbles 3) consumption fueled by credit
What are the roles of central banks' policy (target) interest rates?
1) maintain price stability (inflation target) 2) achieve the maximum sustainable level of employment
Embedded options in a bond allow the issuer to do what two things?
1) manage interest rate risk 2) issue the bonds at an attractive coupon rate
What are the two ways of discounting cash flows of a firm?
1) match a unique discount rate with each different type of cash flow. Cash flows to the entire firm should be discounted with the WACC. 2) only distinguish between two different types of cash flows: those that are used to service debt, and the rest as cash flows to equity. The cash flows to equity should be discounted at the required return to equity.
Potential problems that affect the quality of financial reports may arise from:
1) measurement and timing issues (when an item is recognized) and/or 2) classification issues
Types of agency costs of equity
1) monitoring costs - pay someone to improve corporate governance 2) bonding costs - costs assumed by management to assure shareholders that the managers are working in the shareholders' best interest 3) residual losses - the agency cost that you cannot eliminate.
What are some common reasons for restructuring?
1) no longer fits long-term strategy 2) lack of profitability 3) individual parts are worth more than the whole 4) infusion of cash is needed
Why are analysts skeptical of the equity method?
1) only one line is recorded on the balance sheet of the investor; you only see net assets of the associate company, you don't see liabilities. Therefore, leverage may be understated. 2) you only see the associate's net income on the income statement; you don't know if earnings are "high quality"
How is the real value of a currency related to 1) its real interest rate and 2) the risk premium paid to investors?
1) positively related to its real interest rate 2) negatively related to the risk premium investors demand for investing assets denominated in the currency
Describe the relationship between justified P/E and 1) expected cash flow growth, and 2) required return
1) positively related to the expected growth rate of cash flows 2) inversely related to the stock's required return
List the five common rationales for share repurchases versus dividends
1) potential tax advantages - when capital gains are taxed favorably as compared to dividends 2) share price support/signaling - management wants to signal better prospects for the firm 3) added flexibility - reduces the need for "sticky", or constant, dividends in the future 4) offsets dilution from employee stock options 5) increases financial leverage by reducing equity in the balance sheet
A company's business environment can be categorized using two key factors:
1) predictability 2) malleability
Three tools of regulatory intervention
1) price mechanisms (taxes, subsidies) 2) restricting/requiring certain activities (banning certain chemicals, requiring the filing of 10-Ks) 3) providing public goods (national defense) or financing private projects (small business loans)
Key differences of private equity versus public equity funds:
1) private equity funds gradually draw down capital 2) private equity funds have the J-curve
What are the three considerations when due diligencing private equity funds?
1) private equity funds have returns that tend to persist 2) the return discrepancy between outperformers and underperformers is very large 3) duration of a private equity investment is usually shorter than expected
What are the factors that affect earnings quality?
1) recognition of income (accelerating or premature recognition suggests lower quality) 2) classification of gains and nonoperating income (reclassification may suggest lower quality) 3) method of recognizing expenses and losses 4) calculating and estimating amortization, depreciation, and discount rates 5) classification of off-balance-sheet items
What are the steps of analyzing a replacement project?
1) reflect the sale of the old asset in the calculation of the initial outlay 2) calculate the incremental operating cash flows as the CHANGE in cash flows from the old asset to the new asset 3) compute the terminal year non-operating cash flow
Types of stock grants
1) restricted stock - stock awarded to an employee under the condition that it must be returned if certain conditions are not met (minimum employment length or performance goals) 2) performance shares - stock awarded to an employee if performance goals are met
Steps in the analysis of expense recognition practices
1) review cost capitalization disclosures 2) evaluate changes in noncurrent assets, margins, depreciation expense/rate, and CapEx 3) check for related party transactions
Steps in the analysis of cash flow quality
1) review for unusual items or items that have not shown up in prior years 2) check for revenue quality 3) check for provisions for restructuring - a cash inflow when created, and an outflow when ordinary operating expenses are channeled through the reserves
The three main factors to consider when an acquirer is negotiating with a target over the method of payment:
1) risk - which method, securities or cash offering, places more risk on the acquiring company versus the target company shareholders? 2) relative valuations - is the acquiring company's stock over or under valued? 3) capital structure - how will the capital structure change of the acquiring company?
What are the components of terminal cash flow?
1) sale of the asset 2) recapture of working capital 3) tax on the sale of the asset
The steps to estimate a future equity risk premium are:
1) select an equity index 2) select a time period 3) calculate the mean return on the index 4) select a proxy for the risk-free rate
Components of PBO
1) service cost 2) interest cost 3) actuarial gains and losses
How do you adjust NOI before estimating NAVPS?
1) subtract non-cash rent 2) adjust NOI to represent full-year rent for properties part-way through the year
Under GAAP, an SPE is considered a VIE and must be consolidated if any of the following conditions are met:
1) the SPE has at-risk equity, and the primary beneficiary has insufficient equity to finance the SPE's activities without additional financial support 2) shareholders of the SPE lack decisionmaking rights 3) shareholders of the SPE do not absorb expected losses 4) shareholders of the SPE do not receive expected residual returns
Credit analysis of ABS is different than credit analysis of corporate bonds because (two main reasons):
1) the cash flow characteristics of the ABS differs from the cash flow characteristics of corporate bonds 2) ABS can be viewed as credit derivatives due to distribution of the waterfall
What are the forecasting risks to which terminal value is exposed?
1) the forecast horizon 2) the relationship between r and g
What are the two methods of normalizing EPS?
1) the method of historical average EPS 2) the method of average return on equity
What are the three main limitations of predicted P/Es?
1) the predictive power of the P/E regression over a different time period (out of sample) is uncertain (this is obvious) 2) the relationships between P/E and the fundamental variables may change over time 3) multicollinearity (high correlation between one or more independent variables) is often a problem
What are the parties involved in an SPV and what are their functions?
1) the seller originates the loans and sells the portfolio of loans to the SPV 2) the issuer/trust is the SPV, which buys the loans from the seller and sells ABS to investors 3) the investor buys the ABS and receives the CFs 4) the servicer (often the issuer/trust/seller) collects service payments from the loans and pays principal and interest payments to the investors
When a firm's price multiple is less than the price multiple of a benchmark (another firm or set of firms), what are the three possible explanations?
1) the stock is undervalued 2) the stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower price multiple 3) the stock is properly valued, but it has a higher required rate of return (higher risk) than the benchmark, which leads to a lower price multiple If either 2 or 3 are the case, the benchmark is not comparable. It needs to have similar expected growth and risk characteristics.
When a company has future growth opportunities, it's value is comprised of two components:
1) the value of its assets in place, which is the present value of a perpetual cash flow 2) the present value of its future investment opportunities
Porter's five key forces that underlie an industry's long-run profitability are: (these are important to recite, must learn)
1) threat of new entrants into the industry 2) threat of substitutes 3) bargaining power of buyers 4) bargaining power of suppliers 5) rivalry among existing competitors
What are the five elements of industry structure as developed by professor Michael Porter?
1) threat of new entrants into the industry 2) threat of substitutes 3) bargaining power of buyers 4) bargaining power of suppliers 5) rivalry among existing competitors
List Porter's five forces:
1) threat of substitutes 2) intensity of industry rivalry 3) bargaining power of suppliers 4) bargaining power of customers 5) threat of new entrants
What is are the two primary purposes of valuation?
1) to assess the ability of the portfolio company to generate cash flow 2) to represent a benchmark for negotiations
What are the factors to consider in the guideline public company method?
1) transaction type (strategic or financial) 2) industry conditions (periodically, there is a flurry in industry acquisition activity, driving up acquisition prices) 3) type of consideration (cash or stock purchase? if the market prices are currently inflated, and a stock purchase was used, the control premium will be inflated) 4) reasonableness ("does this pass the sniff test?")
What are the three reasons for valuing private companies?
1) transaction-related valuations 2) compliance-related valuations 3) litigation-related valuations
List the technical analysis methods of forecasting FX trends.
1) trend-following trade rules 2) carry trades + trend-following trade rules (hedge component) 3) dealer order books (unclear if they actually have a forecasting value) 4) options market indicators (don't forecast, just reflect)
The general steps in the equity valuation process are:
1) understand the business 2) forecast company performance 3) select the appropriate valuation model 4) convert the forecasts into a valuation 5) apply the valuation conclusions
Steps in the analysis of revenue recognition practices
1) understand the revenue recognition practives (shipping/credit terms, returns policy, multiple deliverables, practices of peers) 2) evaluate ageing of receivables (historical and peer group comparison) 3) evaluate earnings using cash vs. accrual accounting 4) compare financials with physical data provided by the company (capacity utilization levels, order books) 5) compare revenue trends to peers 6) check for related party transactions (a company might artificially boost Q4 revenues by recognizing a large sale to an affiliated entity)
The two approaches to managing crash risk in a carry trade are
1) volatility filter 2) valuation filter
Prepayment rates depend on what three factors?
1) weighted average coupon rate of the loan pool 2) current interest rates 3) prior payments of principal
If ROE = required return, the justified P/B ratio will be _____
1, as justified market value will equal book value
If the systematic risk of a stock equals that of the market, beta will equal
1.0
In a monopolistic market, firms will theoretically have a persistence factor equal to
1.0. In reality, regulated monopolies, such as utilities, have persistence factors close to 1.0.
Pip
1/10,000
The PSA prepayment benchmark CPR has a base of
100
If the post-merger HHI Index value is between 1,000-1,800, what is the change between pre- and post-merger HHI values that will trigger anti-trust regulators to challenge the deal?
100 or more
What is the general rule for the maximum dividend growth rate?
5%. Anything above is suspicious.
If the post-merger HHI Index value is greater than 1,800, what is the change between pre- and post-merger HHI values that will trigger anti-trust regulators to challenge the deal?
50 or more
A PSA of 50 means that prepayments are __% of the PSA benchmark CPR, and a PSA of 130 means that prepayments are __% of the PSA benchmark CPR.
50%, 130%
Does research prove acquirers benefit or suffer from mergers on average?
60% of acquirers underperform their peers
Best practices guidelines dictate corporations must have ___% of board members be independent.
75%
How should you adjust for a deferred tax asset to try and comply with the clean surplus relation?
A DTA arises due to a tax loss carryforward. If a firm is not expected to be profitable in the future, remove the DTA from assets reduce retained earnings equivalently. (confirm this)
Related party transactions
A business deal or arrangement between two parties who are joined by a special relationship prior to the deal. For example, a business transaction between a major shareholder and the corporation, such as a contract for the shareholder's company to perform renovations to the corporation's offices, would be deemed a related-party transaction.
Under proposition 2, what is the optimal capital structure for a firm?
A capital structure with 100% debt.
Stable dividend policy
A company bases its dividend payout (in dollar terms) on its long-term earnings forecast. - Dividends are smoothed so as not to fluctuate with earnings.
How can a company use capitalization to boost performance?
A company can under-report an operating expense by capitalizing it.
Constant payout ratio
A company defines a proportion of earnings that it will pay out regardless of volatility in earnings.
Longer term residual dividend
A company takes the residual dividend approach, attempts to forecast its capital budget over a longer time frame, and pays out residual earnings in steady dividend payments. - time frame is usually 5-10 years - any excess they will distribute through share repurchases
How does a finance leases versus an operating lease affect net income?
A finance lease will result in a higher expense in early years, leading to lower net income in early years. In later lease periods, net income will be higher.
Describe the thought process behind incorporating future growth opportunities into the valuation of a stock.
A firm that has additional opportunities to earn returns in excess of the required rate of return would benefit from retaining earnings and investing them rather than paying out dividends.
What is an example of why two firms in an industry can have significantly different amounts of assets?
A firm that outsources its production will have fewer assets and lower book value
What does it mean to have a high E/P? A low E/P?
A high E/P suggests a stock is undervalued, versus a low E/P suggests it is expensive.
Why is industry growth rate a factor, and not a force, of industry competition?
A high growth industry diminishes rivalry all else equal. However, it does not assure profitability in the long run if other factors are detrimental to profits.
Why are sales-type leases common amongst manufacturers or dealers?
A lease is defined as a sales-type lease if the present value of the lease payments exceeds the carrying value. Dealers and manufacturers, whose business model is to profit from leased assets, will normally incur a cost that is lower than the leased asset's fair value.
How do U.S. companies compare to european companies in terms of the amount of dividends they pay out?
A lower proportion of U.S. companies pay dividends as compared to their european counterparts
What is the difference between a sales type lease and a financing lease?
A sales-type lease is accounted for like a direct-financing lease, except that profit on a sale is recognized upon inception of the lease, in addition to the interest income recognized during the lease term. The gross profit recognized at the inception of the lease is the PV of all lease payments minus the cost of the leased asset.
How does a sequential pay CMO work?
A sequential pay CMO has different tranches into which cash flows from the underlying MBS flow separately according to their level of prepayment risk. - All tranches receive interest payments at a specified coupon rate. - However, all principal payments (both scheduled and prepayments) are paid to the first Tranche 1 (the short tranche) until its principal is paid off.
Contrast the interest rates for support versus PAC tranches.
A support tranche has a higher promised interest rate than a PAC tranche.
Double taxation system
A tax system (such as in the U.S.) in which earnings are taxed at the corporate level regardless of whether they are distributed as dividends. Then, dividends are taxed again at the shareholder level.
Pay-related plans
A type of defined benefit plan wherein pension benefits are based on future compensation, usually your final salary at retirement.
Non-pay-related plans
A type of defined benefit plan wherein pension benefits are unrelated to the employees salary level
Explain what is wrong with a business that follows a visionary approach by meeting monthly to discuss its ambitious goals, recognizing that it might have to change course if things don't work out.
A visionary approach requires conviction over the long term. Management must commit the necessary resources to the strategy, and have the courage to stay the course.
Growth relative to GDP approach
A way of forecasting revenue growth by combining the estimated GDP growth with the estimated increase in revenue growth
Describe the ranking structure of Moody's.
A-C, 1-3. 1 is the best. The more letters, the higher the quality.
Describe the ranking structure of Standard & Poor's.
A-D, + and -. The more letters, the higher the quality.
What is the highest credit rating provided by Standard & Poor's?
AAA
Contrast the difference between analysis of ABS and corporate bonds in terms of probability of default.
ABS do not default; rather, losses in an ABS's collateral pool are borne by different tranches of the ABS structure based on the distribution waterfall. Therefore, credit analysis of ABS entails evaluation of the collateral pool as well as the distribution waterfall.
What is the highest credit rating provided by Moody's?
Aaa
In general, what affect do accelerated depreciation methods have on after tax cash flows and NPV?
Accelerated depreciation leads to higher after tax cash flows and a higher project NPV.
Define accounting income versus economic income
Accounting income = revenues - costs of the project Economic income = after-tax cash flow of the project + change in the project's market value
What are the two key ways in which accounting income and economic income differ and why?
Accounting income and economic income values will differ for each period of the project. However, NPV will be the same. - Accounting depreciation is based on the original cost of the investment, not the market value - For accounting income, interest expense is subtracted from operating income to arrive at net income. For economic income, interest is ignored and instead included as a component of the discount rate.
How can you avoid regulatory arbitrage?
Achieve global cooperation and a cohesive framework
How do IFRS and GAAP classify business combinations (accounting treatment)?
Acquisition method
Describe the differences in goodwill used between the acquisition and equity methods.
Acquisition method - goodwill is calculated normally Equity method - goodwill is calculated using either partial or full goodwill. Noncontrolling interest differs on which method is used.
What effect does amortization of an actuarial gain have on periodic pension cost in the income statement?
Actuarial gain - reduction in periodic pension cost Actuarial loss - increase in periodic pension cost
In what directions do actuarial gains and losses change the PBO?
Actuarial gains - subtract from PBO Actuarial loss - add to PBO (increase the PBO)
Describe how actuarial gains/losses are reported in the financial statements under IFRS and GAAP.
Actuarial gains/losses result from actuarial assumptions being changed (interest rate, life expectancy, etc) and from differed gains and losses. GAAP - the amortized portion is reported in the income statement. The unamortized portion is reported in OCI. IFRS - not amortized; reported immediately in OCI (called "remeasurements")
The corporate formulation style that results from a less malleable and less predictable industry
Adaptive
How do you adjust CFO and operating income to make them comparable?
Add back cash paid for interest and taxes to CFO (eliminate them). No adjustment to operating income.
When valuing a controlling interest in a private company using a comparable company's value that is based on a noncontrolling interest, how do you adjust for that noncontrolling interest?
Add the control premium
Discuss the strength and weaknesses of multifactor models in estimating the required return on an equity investment.
Advantage: higher accuracy Disadvantage: more complex and expensive
Discuss the strength and weaknesses of built-up models in estimating the required return on an equity investment.
Advantage: simple and can apply to closely held companies Disadvantage: typically use historical values as estimates that may not be relevant to current market conditions
Discuss the strength and weaknesses of the CAPM in estimating the required return on an equity investment.
Advantage: simple, one factor Disadvantage: might not choose the right factor, especially if the stock trades in more than one market
Is the OAS added to the tree before or after adjusting for the embedded option?
After. The OAS is calculated after the option risk has been removed.
Contrast typical passthrough securities (RMBS) with collateralized mortgage obligations in terms of who they are issued by.
Agency RMBS are issued by Ginnie/Fannie/Freddie. They do not issue CMOs. Similar to non-agency RMBS, private investment firms create CMOs.
Describe the agency issues of dividend policy theory
Agency issues describe the contrasting priorities of shareholders and managers. In order of importance: 1) Dividends reduce agency costs to the firm. They reduce FCF for managers to invest in building their empires. 2) Dividends transfer wealth from bondholders to shareholders
Imputation tax system
All taxes are effectively paid at the shareholder tax rate. - Taxes are still paid at the corporate level. - After dividends are issued, the shareholder must settle the difference between his or her personal tax rate and the corporations'. - If the shareholder tax rate is less than the corporate tax rate, the shareholder would receive a tax credit equal to the difference between the two rates.
What are supply side estimates?
Also known as macroeconomic model estimates, these models are used to estimate the equity risk premium using the relationships between macroeconomic variables and financial variables.
What is the challenge that faces management buyouts?
Although management will have a strong interest in the subsequent success of the company, the resulting high leverage may limit management's flexibility
How should you treat debt and equity financing costs of projects when calculating NPV?
Always ignore debt financing costs, because they are reflected in the required rate of return. Always treat projects as if they were all equity financed.
When valuing a company using valuation multiples (like P/E, P/B, etc), how should you treat trailing versus leading numbers?
Always match trailing with trailing and leading with forecasts.
How should a purchaser account for any fair value market adjustment of a subsidiary's assets?
Amortize the adjustment over a given number of years, usually the remaining life of the company's equipment. - this should change the value of the asset in the balance sheet and the equity income on the income statement ?
Why does an equity offering tend to devalue a company's existing stock?
An equity offering could be a sign that management wants more shareholders to share the risk of owning the company. This suggests that a default might be possible in the near future.
What is a sign of earnings manipulation - an increase or a decrease in accruals?
An increase
Contrast an individual's credit score of 900 versus 450
An individual with a credit score of 900 has lower credit risk than an individual with a score of 450, but it is not equal to half the credit risk.
Why is technological innovation a standalone factor, and not a long term force, of industry competition?
An industry with improved technology does not improve profits if it attracts more competitors.
Describe the difference between antitrust regulations, dispute resolution regulations, and prudential supervision regulations.
Antitrust - regulating commerce Dispute resolution - regulating commerce Prudential supervision - regulating financial markets
When reclassifying a security, what is the general rule of thumb?
Any difference between the calssifications is considered an unrealized gain or loss. In other words, you "reclassify to fair value" to find the unrealized gain or loss, and recognize it according to each situation.
If the current growth rate is higher than the required rate of return, what valuation method should be used?
Any method as long as it is multi-stage. Single-stage methods will not work.
What is the best valuation method for firms in the transition stage?
Any multistage model.
Classical style
Applicable for a company in an industry that is highly predictable and that cannot be changed easily. A company should identify its unique abilities and resources, and formulate a plan to achieve the most favorable market position.
Shaping style
Applicable for a company in an industry that is less predictable but more malleable. Companies seek to influence the unpredictable business environment to further business interests.
Adaptive style and the six points that characterize it
Applicable for a company in an industry that is not predictable nor easily changed. A company must: - be willing to constantly refine long term goals - be able to quickly redistribute or acquire resources - maintain the goal of maximizing flexibility, not efficiency - have a short term or continuous planning process based on a hypothesis rather than a rigid plan - have strategies that are closely linked to operational processes, so the firm can pick up on signals of change quickly - minimize informational loss
When using a multiple approach to company valuation, when should you apply the control premium?
Apply it to the equity value only. First, use the raw multiple to estimate firm value without the control premium, and estimate the equity portion by subtracting debt. Then, apply the control premium to the equity portion.
How is impairment of goodwill of a business division reported?
As a separate line item on the income statement.
How is stockholders' equity, and therefore financial leverage, affected by treating an operating lease as a finance lease?
Assets and liabilities are initially increased by the same amount, so stockholders' equity is not changed. Financial leverage increases.
Describe how the PAR problem is innately compounded.
Asymmetric information makes it difficult for the principal to know enough to detect the agent's wrongdoing. The problem compounds at every level of delegation of duties that exists. For example, one level is between the C-level executives and the board of directors. The next level is between the vice presidents and the C-level executives. So on and so forth.
Describe how a sales-type lease is recorded on the income statement and balance sheet of the lessor.
At the inception of the lease, the lessor recognizes 1) a sale equal to the present value of the lease payments, and 2) COGS equal to the carrying value of the asset. - Inventory declines by COGS, the carrying value of the asset - A lease receivable, the present value of the lease payments, is created (an asset) - Profit is recognized on the income statement equal to (the present value of the lease payment - COGS) - As lease payments are received, the lease receivable is reduced, and cash is increased
Describe the process of recognizing a direct financing lease on the financial statements of the lessor.
At the inception of the lease, the lessor removes the asset from the balance sheet and creates a lease receivable. As the lease payments are received, - the principal portion of the lease payment reduces the lease receivable - the interest portion of the lease payment is recognized as interest income on the income statement
Discuss how a company can use goodwill in an acquisition to manipulate its earnings.
At the time of acquisition, an acquiring company must allocate the purchase price to fair value of identifiable net assets of the subsidiary and the balance to goodwill. Acquiring companies often underestimate the value of identifiable net assets - thereby overestimating goodwill on acquisition. Since goodwill is not amortized, the effect of overestimating goodwill (and underestimating the value of identifiable assets) is to increase future reported profits.
What is the lowest investment grade rating for Standard & Poors or Fitch?
BBB-
What is the lowest investment grade rating for Moody's?
Baa3
Is an increase in the cash conversion cycle good or bad?
Bad. Cash conversion cycle is the number of days it takes a company to convert inputs into cash.
How are employers required to report defined contribution plan payments on financial statements?
Balance sheet: often there is no balance sheet item at all if the employer contributes exactly what it is supposed to by the end of the year. If it pays too much or too little, an asset or a liability equal to the excess or shortfall of the payment relative to a contribution in a given period is reported. There is no future obligation to report as a liability. Income statement: simply equal to the employer's contribution
Balloon versus bullet payment
Balloon payment - some of the principal is paid off monthly, but a significant portion remains to be paid at the end of the loan period Bullet payment - no principal is paid of for the life of the loan; all comes at the end
Why are dividends, share repurchases, and share issues not included in calculations of cash flow?
Because these three things represent uses of cash flows; as such, these financing decisions do not affect the level of cash flow available.
Costs of asymmetric information
Because they run the business on a day to day basis, managers will know more about a company's performance than the principals. This information asymmetry is an efficiency cost to the firm, especially high for complex products or if the company produces poor quality financial statements.
Why are monetary assets and liabilities exposed to inflation?
Because we use the closing rate for monetary assets and liabilities.
What are the benefits and drawbacks of macroeconomic model estimates of the equity risk premium?
Benefit: use of proven models and current information Drawback: estimates are only appropriate for developed countries where public equities represent a relatively large share of the economy
Define and discuss force 2: the threat of substitute products.
Big question: do currently available or prospective alternative products put a ceiling on the price buyers are willing to pay? This force concerns not only existing substitutes but also those that could become available in the future.
Define and discuss force 4: the bargaining power of suppliers.
Big question: how strong is the negotiating position of the suppliers to the industry?
Define and discuss force 3: the bargaining power of buyers.
Big question: how strong is the negotiating power of the buyers of the firm's or industry's output? The bargaining power of the buyers can be viewed as coming from two main sources: bargaining leverage and price sensitivity.
Define and discuss force 1: the effect of new entrants into the industry.
Big question: what is the likelihood of new entrants emerging to alter the competitive landscape? The likelihood of new entrants largely depends on the size of the barriers to entry that are currently present. The higher the barriers, the weaker the threat, and the greater the pricing power of existing participants.
What is the big question behind force 5: the degree of rivalry among existing competitors?
Big question: will existing firms compete away the value-added through lower prices and higher costs to compete?
Describe the thought process behind dividends transferring wealth from bondholders to shareholders and why it is desirable.
Bond values decrease with dividends. - Bondholders receive money first in the event of a bankruptcy. Issuing dividends reduces cash available to bondholders, which will drive down the value of the bonds. However, shareholders will do whatever they can to "hose" bondholders because firm valuation does not change if bond values decline. - Shareholders try to drive down bond value by raising stock value, which will increase the valuation of the firm.
Contrast the metrics used to analyze the credit risk of an ABS versus a bond.
Bonds - use probability of default ABS - probability of loss (probability of default DOES NOT apply to ABS)
Do noncash charges affect just FCFF, just FCFE, or both?
Both
Does investment in fixed capital (CapEx) affect just FCFF, just FCFE, or both?
Both
Does investment in working capital affect just FCFF, just FCFE, or both?
Both
When applying the residual income model to value a company, should the analyst include separately identifiable intangible assets and/or goodwill?
Both
Discuss the differences in reporting FX gains or losses between IFRS and GAAP.
Both GAAP and IFRS require FX gains/losses to be reported on the income statement, but neither specify where. Therefore, one company could report it under operating income, and one could report it under non-operating income, leading to distortions between ratios when comparing the two companies.
How do IFRS and GAAP require the reporting of a bargain purchase?
Both IFRS and GAAP require the difference between fair value of net assets and purchase price be recognized as a gain in the income statement.
Contrast EBITDA and net income as proxies for FCFE.
Both are POOR proxies for FCFE.
Contrast existing versus potential substitutes as a threat for current products in an industry.
Both existing AND potential substitutes are threats. Not all substitutes must exist to have a pricing impact.
Contrast the structural model versus the reduced form model of credit analysis in terms of the market in which company assets are traded in.
Both models assume company assets are traded in a frictionless, arbitrage-free market. This market assumes a lognormal distribution.
How do the accounting standards require reporting of funded status?
Both require disclosure on balance sheet
What accounting method is used for joint ventures under GAAP and IFRS?
Both require the equity method. Under rare circumstances, the proportionate consolidation method may be used.
Other names for the "sum-of-the-parts" value are
Breakup value or private market value
Under covered interest rate parity, when the market forward rate > PPP forward rate, how should you buy/sell each currency?
Buy the denominator currency in the spot market, Enter into a forward contract to sell the denominator currency in the future
What makes CDOs different from ABS?
CDOs do not rely on interest payments from the collateral pool. Instead, CDOs have a collateral manager who buys and sells securities in the collateral pool in order to generate the cash to make the promised payments to investors.
Structured finance CDOs
CDOs whose collateral can include ABS, RMBS, CMBS, and other CDOs
Best practices guidelines dictate corporations must do what in terms of the CEO and chairman positions?
CEO and chairman must be separate positions
When you pay off debt, what type of cash flow is it?
CFF
Is CFO a before- or after-interest starting point?
CFO is an after interest starting point, meaning it has already been reduced for interest expense. To calculate FCFF, you have to add back the tax shield.
What are the effects of treating investing cash flows, such as the sale of long-term assets, as operating cash flows?
CFO is considered to be recurring; increasing it may lead to higher equity valuation.
Compare the effects of CFI and CFO using capitalization versus expensing.
CFO is higher when an asset is capitalized and lower when expensed. CFI is lower when an asset is capitalized and higher when expensed.
Are CMBS structured as recourse or non-recourse loans? What about RMBS?
CMBS - non-recourse loans only RMBS - recourse
Contrast which types of loans are and are not amortizing (payments include both interest and principal).
CMBS - partially amortizing (still some balloon payment left) Auto ABS - fully amortizing Credit Card ABS - nonamortizing Not sure about RMBS. I think all types are possible.
Contrast what entity the analysis of credit risk for RMBS versus CMBS focuses on.
CMBS - risk analysis focuses on the credit risk of the property RMBS - risk analysis focuses on the credit risk of the borrower
How do you create a CMO?
CMOs are securities secured by other securities. You create them by combining a whole tranche of agency passthrough securities.
How do CMOs attempt to alter risk?
CMOs reallocate risk to different tranches, no eliminate it.
In a period of deflation, how will COGS change over a period using FIFO versus LIFO?
COGS will be higher using FIFO than if you were to use LIFO.
Claims valuation approach
Calculated on the COMPANY level, not the project level. Divides operating cash flows based on the claims of debt and equityholders that provide capital to the company. Debt and equity cash flows are calculated separately and then added together to determine the value of the company.
Contrast the two levels of call protection on a CMBS.
Call protection on a CMBS protects the bondholder from prepayments. - Loan-level call protection is applied to the underlying individual mortgages - CMBS-level call protection is applied on the entire CMBS level by dividing loan pools into tranches with a specific sequence of repayment
If the tax rate on dividends is higher than the tax rate on capital gains, what would investors prefer to receive?
Capital gains
Return on assets of a pension plan are dependent on
Capital gains on securities sold or disposed of, dividends, interest, etc. Also, unrealized gains on securities will fluctuate with the market.
Which usually results in smoother reported earnings, expensing or capitalizing costs?
Capitalizing
Capitalizing vs. Expensing
Capitalizing - depreciating or amortizing the asset's cost over its useful life Expensing - immediate reduction of net income Generally, capitalize if there is a future economic benefit. Expense if the future benefit is unlikely or highly uncertain.
What type of ABS always have some sort of credit enhancement attached to them, and why?
Car loan ABS! This is because car values decline over time, so ABS sellers must attach some type of protection to make them attractive.
Contrast the definitions of cash flow for using in valuation multiples.
Cash flow (earnings plus noncash charges) - ignores some items that affect cash flow, such as noncash revenue and changes in net working capital Adjusted CFO - helpful to compare IFRS vs. GAAP companies FCFE - usually the preferred way to define cash flow, but is more volatile than regular CF EBITDA - better suited as an indicator of total company value rather than just equity value
When the acquirer is highly confident in he synergies and value that will be created by the merger, it is more likely to push for what type of offering in an acquisition?
Cash offering
How will earnings differ using cash versus accrual accounting?
Cash-based earnings are more persistent than accruals-based earnings
Why do companies prefer reducing bond value in an effort to increase equity value?
Changes in bond value does not effect company valuation. Share value changes do effect company valuation.
Why are changes in the market value of debt and equity securities classified as available-for-sale considered violations of the clean surplus relation?
Changes in market value of available-for-sale securities are considered unrealized gains/losses. The change is recognized by writing the security's value up or down, and by recognizing that unrealized gain/loss under other comprehensive income, a component of shareholders' equity on the balance sheet. Because the gain/loss is matched on the balance sheet, but not on the income statement, it is a violation.
Actuarial gains and losses
Changes in the PBO resulting from actuarial assumptions being changed and from differed gains and losses. Differed gains and losses result from differences in actual and expected returns on plan assets. Actuarial assumption changes include: - changes in discount rate - changes in life expectancy Actuarial assumption changes only affect the liability. Differed gains and losses affect the income statement as well (I think).
What are the characteristics of a company in its stabilization stage, and what are the corresponding merger motivations?
Characteristics: competition has reduced growth potential, higher capacity constraints Motivations: boost economies of scale, reduce costs, improve management
What are the characteristics of a company in its decline stage, and what are the corresponding merger motivations?
Characteristics: consumer tastes have shifted, overcapacity, shrinking profit margins Motivations: survival, improve operational efficiency, acquire new growth opportunities
What are the characteristics of a company in its rapid growth stage, and what are the corresponding merger motivations?
Characteristics: high profit margins, accelerating sales and earnings, competition still low Motivations: gain access to capital, expand capacity to grow
What are the characteristics of a company in its mature growth stage, and what are the corresponding merger motivations?
Characteristics: lots of new competition, still opportunities for above average growth Motivations: increase operational efficiencies, economies of scale/synergies
What are the characteristics of a company in its pioneer/development stage, and what are the corresponding merger motivations?
Characteristics: unsure of product acceptance, large capital requirements, low profit margins Motivations: gain access to capital from more mature businesses, share management talent
What is the key difference between the economic profit, residual income, and claims valuation approaches?
Claims valuation calculates the value of the company, not the project. The economic profit and residual income approaches calculate both project and company value.
The corporate formulation style that results from a less malleable and more predictable industry
Classical
Why is classification of items a tool for manipulating financial statements?
Classification of items as non-recurring is highly subjective.
Does classification of items affect net income?
Classification shifting (between recurring and non-recurring) does not affect the total net income. Rather, it is an attempt to mislead the analyst into believing that the "core" or "recurring" portion of earnings is higher than it actually is.
Static trade off theory
Combines the ideas of tax shields with the cost of financial distress. It is the point at which the cost of financial distress exceeds the value added by the tax shield. This point is the optimal capital structure
How does the use of debt and the maturity of the debt differ between common law versus civil law countries?
Common law countries have better legal systems. There is lower debt and longer debt maturity used in these countries.
SROs in common versus civil law countries
Common law countries usually recognize independent SROs. In civil law countries, independent SROs are less common. Examples of common law countries are U.K. and USA.
Describe the mistake that, according to research, companies tend to make in terms of assuming their industry is characteristic of a particular style.
Companies tend to assume their industry is relatively predictable and therefore use the classical or visionary approaches more often than when they are actually applicable.
What types of companies are less subject to the effects of variations in input prices?
Companies that are vertically integrated, meaning that they are, in effect, their own suppliers
Discuss the motivations and mechanisms of manipulating cash flow around a merger or an acquisition.
Companies with declining CFO may acquire other cash-generating entities to distract from CFO shortfalls; cash acquisitions are reflected in CFI. If acquisitions are paid for using stock, such a payment would bypass the cash flow statement altogether.
Reputational risk (in the context of ESG investing)
Companies with management that has been seen in the past to show insufficient regard for ESG issues will be valued at a lower market value
Describe the construction of an acquisition
Company A + Company B = (Company A + Company B) The new entity exists as a parent and a subsidiary
Describe the construction of a merger
Company A + Company B = Company A Net assets are transferred from company B to company A
Describe the construction of an consolidation
Company A + Company B = Company C
Overall, are the effects of 1) company specific factors and 2) stock specific factors positive or negative on private company valuations?
Company specific factors are usually negative, whereas stock specific factors can be mixed.
What is different about the usage of relative value metrics in a comparable companies analysis versus a comparable transaction analysis
Comparable companies analysis uses metrics based on current market prices. Comparable transaction analysis uses metrics based on prices of completed M&A deals.
How can you verify the estimation of a firm's growth rate?
Compare it to the growth rate of the economy. It is unrealistic to assume that a firm can grow at a faster pace than GDP + inflation over the long term (especially if the GGM is used which assumes indefinite growth).
How can you tell if an industry is subject to economies of scale?
Compare the operating margins of two or more firms. If the larger firm has a higher operating margin, then the industry is likely subject to economies of scale.
Why are complementary products a temporary factor, and not a long term force, of industry competition?
Complementary products have mixed effects. They can either increase or decrease rivalry and barriers to entry.
Conflict of interest concerns for sole proprietorships
Conflicts of interest do not exist between management and principals because they are the same person. However, they can exist between suppliers and creditors.
What is the evidence against diversification as a reason for M&A activity?
Conglomerates trade at a discount relative to the sum of the value of its individual businesses. Therefore, mergers are not likely to increase value purely for diversification reasons.
How can a company's tax situation benefit from a merger/acquisition?
Consider the case of two companies where one has large amounts of taxable income and the other has accumulated large tax loss carryforwards. By merging, the acquirer can can use the tax loss carryforwards to lower its tax liability.
What are examples of types of companies that often have a lot of information in their financial statements to help you predict different growth rates for different periods?
Construction firms and defense contractors have many long term contracts.
What is the best valuation method to use when valuing a company from the perspective of a controlling shareholder vs a noncontrolling shareholder?
Controlling - FCF Noncontrolling - DDM
Which should you trust more, NPV or IRR, when you have conventional cash flows?
Conventional cash flows are ones in which you have a single outflow followed only by positive inflows. In this case, NPV and IRR would give you the same result.
If a stock's price does not change over a given period of time, will an investor prefer to have bought the stock or a convertible bond?
Convertible bond, because it will at least return coupons
Agency costs of equity
Costs of conflict of interest between shareholders and managers. Managers are supposed to be the agents of shareholders, but often they act in their own interest. Conflicts of interest cost the firm efficiency.
Covered interest rate parity
Covered interest rate parity holds when any forward discount or premium exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency.
Covered versus uncovered interest rate parity
Covered interest rate parity is bound by arbitrage, whereas uncovered is not. Covered interest rate parity - currencies will not depreciate or appreciate. Uncovered interest rate parity - the currency with a high interest rate should depreciate relative to the currency with a lower interest rate. Therefore, with both covered and uncovered interest rate parity, investors should still earn the same return investing in either currency.
How do credit ratings adjust with the business cycle?
Credit ratings do NOT adjust with the business cycle, even though the probability of default changes with the business cycle. This is a weakness of credit ratings.
Credit spreads computed relative to a risk-free asset include premiums for which types of risk?
Credit risks and Liquidity risks
CTA
Cumulative translation adjustment is used in the current method to equate total assets with total liabilities + equity. CTA is a component of shareholders' equity.
Describe how current service cost is reported in the financial statements under IFRS and GAAP.
Current service cost is the increase in the PBO that is the result of employees working one more period. GAAP - immediately recognized in the income statement IFRS - immediately recognized in the income statement
Who manages the assets of defined benefit versus defined contribution plans?
DB - employer appoints an investment manager DC - employee directs investment policy
Who carries the risk of defined benefit versus defined contribution plans?
DB - employer carries risk DC - employee carries risk
Who owns the assets of defined benefit versus defined contribution plans?
DB - employer owns assets DC - employee owns assets, employer acts as agent
What is the primary difference between valuing a company using the DDM, FCFE, and residual income models?
DDM and FCFE models measure value by discounting a stream of expected cash flows BEFORE discounting the terminal value. The residual income model starts with a book value and then discounts the expected residual incomes.
Contrast the DLOC and DLOM.
DLOC - discount for lack of control (the discount to the value of a shareholder's stake in a company due to that shareholder's lack of control in the company) DLOM - discount for lack of marketability (the discount to the value of a shareholder's stake in a company due to the difficulty in selling his or her shares)
Contrast DPI and RVPI
DPI measures the LP's realized return, whereas RVPI measures the LP's unrealized return.
How should you adjust for a deferred tax liability to try and comply with the clean surplus relation?
DTLs that are increasing slowly over time and are not reversing - theoretically, they should not be liabilities but should be equity positions. Recategorize the DTL from a liability to equity. (confirm this)
If a company has a stock offering, the valuation of the equity __________
Decreases
What affect does inflation have on the value of fixed payments to bondholders?
Decreases the value of fixed payments to bondholders.
Describe how higher depreciation expense leads to higher cash flows.
Depreciation is a non tax expense. However, depreciation does affect tax expense. Higher depreciation leads to less net income, which will reduce the tax expense. Lower tax expense leads to a higher cash flow.
Is technological development more important for developing countries or developed countries for increasing growth?
Developed countries, because they already have a large capital stock and slower population growth rate.
Under the Neoclassical Growth Theory, what types of countries will be affected most by diminishing marginal productivity of capital?
Developing countries will be affected less by diminishing marginal productivity of capital, so they will have higher growth rates than developed countries. However, there will eventually be a convergence of per capita income.
Direct versus indirect costs of financial distress
Direct costs - bankruptcy expenses, i.e. paying lawyers, accountants, etc Indirect costs - as leverage increases, the firm may lose customer trust, and management might have to spend a lot of time easing investors' concerns rather than running the company, etc.
Interest income/expense of plan assets =
Discount rate x beginning period PBO If the plan is reporting a liability, an expense is recorded
Describe how diversification through M&A activity benefits shareholders versus managers.
Diversification makes no sense for shareholders because they can simply diversify their stock portfolios. Diversification may be rational for managers, but often it is not.
What are the signals available from dividends?
Dividend increase - positive Decrease/omission - negative Initiation of dividend - positive (usually)
How does informational asymmetry between managers and shareholders relate to dividend payments?
Dividend payments have "signaling" effects because they take advantage of the information gap between management and principals. Dividends represent the actual cash available to the firm, so they are a signal to management of the health of the firm.
Residual dividend approach
Dividends are based on earnings less funds the firm retains to finance the equity portion of its capital budget.
Why is a dividend decrease a negative sign?
Dividends are expected to be "sticky," as they expect to stick to the policy for a long time. Companies will not cut dividends unless they expect that the lower levels of dividends reflect long-run poor prospects of the company in the future.
How do Modigliani and Miller feel about dividends?
Dividends are irrelevant in MM theory, because they have no effect on the price of a firm's stock or its cost of capital. MM assumes perfect markets, with no taxes, bankruptcy costs, or transaction costs.
Explain how dividends, share repurchases, share issues, and changes in leverage affect future FCFF and FCFE.
Dividends, share repurchases, and share issues have no effect of FCFF and FCFE. Changes in leverage have a minor effect on FCFE, and no effect on FCFF.
________ the ask
Down
For most countries, what has been the general trend in average hours worked?
Downward
Is the volatility curve upward or downward sloping?
Downward sloping as maturity of the bond increases
Under accrual accounting, what two components of income should you analyze to test for earnings manipulation?
Due to the subjectivity in revenue and expense recognition when using accrual accounting, you should break down income into its two major components: - cash - accruals
Unlevered net income also equals
EBI, or, EBIT(1-t)
If capital expenses equal depreciation expenses, what iteration of cash flow should you use in valuation multiples - EBITDA or FCFF?
EBITDA (Book 3 p210)
What is different about EBITDA versus FCFE?
EBITDA is a pretax and pre-interest measure, therefore representing cash flow to both equity and debt
When calculating leading P/E, which value is leading and which value is current?
EPS is leading, Price is current.
Give an example of how the stages of a private company's lifecycle can influence the methods one uses for valuation.
Early in its life, a firm's future cash flows may be subject to so much uncertainty that an asset-based approach would be more appropriate. As the firm moves into a high growth phase, it might be more appropriate to use an income approach, such as the FCF model. As the firm moves into the maturity stage, it might be more appropriate to use the market approach to valuation.
Are earnings more or less easily manipulated than cash flow?
Earnings are more easily manipulated
Earnings can be dis-aggregated into what two components using what two methods?
Earnings can be dis-aggregated into cash flow and accruals using either: - the balance sheet approach - the cash flow statement approach
Spit rate corporate tax system
Earnings distributed as dividends are taxed at a lower rate than earnings that are retained. Dividends are still taxed twice - the difference is that earnings distributed as dividends are taxed at a lower rate than the corporate tax rate, which is imposed on retained earnings.
What is the effect of using sales-type leases versus direct finance leases?
Earnings on the income statement is the same under both methods. But the sales-type method allows you to recognize more earnings earlier; in other words, it accelerates revenue recognition.
Where do companies report the effect of foreign currencies?
Effects of currencies on profits are often discussed in the MD&A section, but not required.
When calculating normalized EPS using the method of average return on equity, do you multiply average ROE by end-of-period BVPS or average BVPS?
End-of-period BVPS
Compare Neoclassical and Endogenous Growth Theories.
Endogenous growth model implies that an increase in savings or in R&D will permanently increase the growth rate. Neoclassical growth model assumes that capital investment will expand as a result of technological improvements (i.e. growth comes from increases in innovation, not from investment in R&D within the model).
Describe the process of combining equity and COGS accounts using the acquisition method.
Equity - combine the parent's equity account + minority interest. Ignore the equity accounts of the subsidiary. COGS - combine the parent's COGS account + the parent's % share of the subsidiary's COGS
How do IFRS and GAAP classify investments in associates (accounting treatment)?
Equity method
What is a more expensive source of financing - debt or equity?
Equity, especially for private companies, because of their (usually) higher risk
The credit risk analysis of an ABS entails what two components?
Evaluation of the credit risk of the collateral pool in conjunction with the distribution waterfall.
What is a common way for management to increase their status and pay?
Expanding the business (empire building) through acquisitions which may not benefit the existing shareholders. Company size has been strongly linked to executive compensation.
Why do companies use expected return rather than actual returns on plan assets in the pension expense account in the income statement?
Expected return allows companies to use a long term projected number, which smooths out gains and losses. If they were to use actual returns, the pension gains or losses would fluctuate widely with the stock market, and therefore cause significant fluctuations in the company's earnings.
What affect does having more management/shareholder overlap in a private company have on the influence of external shareholders?
External shareholders usually have less influence in private companies
Contrast the FCFE model and the dividend discount model as methods of valuing a company.
FCFE Model - takes the perspective of a controlling firm, and assumes recognition of value is immediate Dividend Discount Model - takes the perspective of a minority shareholder, and assumes value may not be realized until the dividend policy accurately reflects the firm's long-run profitability
If notes payable increases by $100 and there is a 40% tax rate, what is the effect on FCFF and FCFE?
FCFE increases by $100
In the excess earnings method, what can be used in place of normalized earnings?
FCFF
When a private firm's capital structure is uncertain going forward, what method of cash flow estimation is best?
FCFF
LIFO Reserve =
FIFO inventory - LIFO Inventory
When prices are rising, FIFO provides an artificially ____ value of COGS because
FIFO provides an artificially low value of COGS because it does not take into account most recent prices.
Contrast: fair market value, market value, investment value, and intrinsic value
Fair market value - what we think the company should sell for Market value - what the company is actually selling for Investment value -what the company would sell for to a specific buyer Intrinsic value - the true value of the company
Contrast the definitions of investment value versus fair market value in the context of buyers and sellers.
Fair market value is the value at which any willing buyer and any willing seller would exchange a company. Investment value is the value at which a SPECIFIC buyer would buy a company. It takes the individual needs and considerations of the buyer into account.
How are fake sales reversed and what is their affect on cash flow?
Fake sales are reversed through inventory increases. These decrease CFO.
Finance versus operating lease
Finance lease - purchase of an asset with debt (assets and liabilities increase) Operating lease - rental arrangement (no asset or liability is reported by the lessee, and periodic payments are recognized as rental expense on the income statement)
What types of firms are most often valued using the asset-based approach to company valuation? Why?
Finance, investment, and real estate firms are the best candidates for the asset-based approach. This is because their assets are easily identifiable and are often close to market value.
What has a lower premium - a strategic or financial transaction?
Financial transaction
List the financing options in order of most to least favored by managers.
Financings options are favored based on their information content. 1) internally generated funds (most favored, most available) 2) debt 3) newly issued equity (least favored, least available)
Equivalent annual annuity approach
Find the yearly payment of cash flows using the WACC and the NPV.
Flip-in versus flip-over pill
Flip-in: a type of poison pill that gives the target company's shareholders the right to buy the target's shares at a discount Flip-over: a type of poison pill where the target's shareholders have the right to buy the acquirer's shares at a discount
A firm can reduce rivalry by
Focusing on differentiating products and finding new market niches and geographic segments, rather than letting the market get saturated
How should one approach an operating lease when evaluating the quality of earnings?
For analytical purposes, an operating lease should be treated as a finance lease, increasing assets and liabilities by the present value of future lease payments.
When assets and liabilities are modified for hyperinflation, how do you account for their gains in the financial statements?
For non-monetary assets and liabilities that are "indexed" up for inflation, gains are matched in stockholders' equity. Changes in value of monetary assets and liabilities will automatically be recognized in the income statement from PPP.
In general, how do private companies differ from public companies in terms of concentration of control?
For private companies, control is usually concentrated in the hands of a fe shareholders, sometimes at the expense of minority shareholders.
Market growth and market share approach
Forecasted revenue growth is forecasted market size multiplied by the forecasted market share
Do futures or forwards have credit risk?
Forwards do, futures don't.
Which type of free cash flow (FCFF or FCFE) is associated with post-leverage cash flows?
Free cash flow to equity (FCFE)
Which type of free cash flow (FCFF or FCFE) is associated with pre-levered (before any financing decisions) cash flows?
Free cash flow to the firm (FCFF)
What is the importance of financial reports quality?
From most to least important: 1) GAAP compliant and decision-useful, high-quality earnings 2) GAAP compliant and decision-useful, but low-quality earnings 3) GAAP compliant but not decision-useful (biased) 4) noncompliant accounting 5) fraudulent accounting
Describe the difference in noncontrolling interest according to full versus partial goodwill.
Full goodwill method: noncontrolling interest = % not owned x fair value of the subsidiary Partial goodwill method: noncontrolling interest = % not owned x fair value of the subsidiary's net identifiable assets
What goodwill method results in higher assets and equity?
Full goodwill results in higher total assets and total equity. Thus, ROE and ROA will be lower using full goodwill.
Describe the differences in reporting pension expense between IFRS and GAAP.
GAAP - all components of net pension expense that are reported in the income statement are aggregated and presented as a single line item. IFRS - components may be presented separately, but not required. Both GAAP and IFRS require disclosure of total pension expense in the notes to financial statements.
Under what circumstances can you treat associate equity investments at fair value?
GAAP - all entities can report an associate investment as fair value through profit or loss IFRS - only venture capital, mutual funds, and unit trusts
How are past service costs reported under GAAP versus IFRS?
GAAP - changes in PBO due to plan amendments are amortized to the income statement over the service life of the employees. IFRS - expensed immediately on the income statement
In a hyperinflationary environment, what interest rate translation method should you use under GAAP versus IFRS?
GAAP - if hyperinflation exists, the temporal method is required. IFRS - all nonmonetary assets and liabilities are restated for inflation and then translated at the current exchange rate
Describe how changes in expected return are reported in the financial statements under IFRS and GAAP.
GAAP - immediately in the income statement IFRS - immediately in the income statement
Do GAAP and IFRS define a expected rate of return to be used in calculated expected return on plan assets?
GAAP does not specify. IFRS requires companies to use the expected yield on long-term high quality corporate debt. Overall, GAAP allows much more manipulation of the discount rate and expected rate of return.
How do GAAP and IFRS differ in requirements for full versus partial goodwill?
GAAP requires full goodwill IFRS permits full or partial goodwill
Contrast Ginnie Mae, Fannie Mae, and Freddie Mac.
GNMA is a government agency, whereas FNMA (Fannie Mae) and FHLMC (Freddie Mac) are government sponsored enterprises. The latter two are not backed by the full faith and credit of the U.S. government, but they are still considered to have very high credit quality.
If a company sells a good to a foreign buyer for a specified amount in the foreign currency to be exchanged on a future date, will the company recognize a gain or a loss if the foreign currency strengthens?
Gain
Why is government policies a temporary factor, and not a long term force, of industry competition?
Government policies, good or bad, can change over time.
What affect does greater financial leverage have on agency costs? What is the reasoning?
Greater financial leverage reduces agency costs. - with greater financial leverage, interest costs are higher - higher interest costs use up free cash flow - less free cash flow available gives management less opportunity to squander it
How can you tell on the exam if they have given you gross or net PP&E on the balance sheet? (important)
Gross PP&E will ALWAYS be followed by accumulated depreciation on the next line, and then will be followed by net PP&E. If you see just "PP&E," then it is net.
What are the two components of profit recognized by the lessor in a sales-type lease?
Gross profit - the difference between the cost of the asset and the present value of the lease payments Interest revenue - equal to the interest rate x lease receivable at the beginning of the period
What are the factors that affect future growth in FCFF and FCFE?
Growth forecasts depend on a firm's future profitability, which in turn depends on: - sales growth - changes in profit margin - position in the life cycle - competitive strategy - overall industry profitability
Hard versus soft capital rationing
Hard - when funds allocated to managers under the capital budget cannot be increased down the road. Soft - managers are allowed to increase their allocated capital budget if they can justify their reasoning to senior management.
What is the idea behind paying a control premium?
Having a controlling interest in a company adds value.
Describe key points of MM Proposition 1 WITH taxes
Having debt creates a tax shield, which increases the value of the firm. The more debt you have, the higher the tax shield is, and the higher the value of the firm is. - in most countries, dividends are paid using after-tax income, whereas interest is paid using pre-tax income. - Therefore, companies are encouraged to use debt financing because debt provides a tax shield.
What is the difference in accounting for unrealized gains and losses for held-for-trading (fair value) versus available-for-sale securities?
Held-for-trading - unrealized gains and losses recognized on the income statement Available-for-sale - unrealized gains and losses recognized under other comprehensive income (stockholders' equity)
Are barriers to entry for a broad based generalist retailer, like wal mart, high or low?
High
In general, what is a company's profit margin in the initial growth, transition, and maturity stages?
High, above average but falling, and stable at long run level, respectively
Earnings that are closer in value to CFO are _______ quality.
Higher
What is the relationship between COGS and income taxes?
Higher COGS lead to lower net income and a lower tax expense.
How does a country that has a greater reliance on the banking system affect the use of debt and the maturity of the debt?
Higher debt, because higher reliance on banks leads to better monitoring of the debt. Banks are good at monitoring. There is no affect on maturity.
How often do firms test for impairment under IFRS and GAAP?
IFRS - assess annually whether events or circumstances indicate that impairment might have occurred GAAP - test for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use
Contrast how IFRS and GAAP allow interest expensed to be classified on the cash flow statement.
IFRS - interest expense can be classified as CFO or CFF GAAP - interest expense must be classified as CFO
Describe the difference in reporting available-for-sale securities under GAAP and IFRS in terms of FX considerations.
IFRS - realized AND unrealized gains and losses from FX are recognized in the income statement GAAP - like normal, UNrealized gains and losses from FX are recognized in stockholders equity, and realized gains and losses from FX are recognized on the income statement
What are the business combinations under GAAP and IFRS?
IFRS does not differentiate between business structures. GAAP: 1) Merger 2) Acquisition 3) Consolidation 4) Variable Interest Entity
From the lessor's perspective, what are the options for recognizing a lease under IFRS?
IFRS does not distinguish between a sales-type lease and a direct financing lease. However, for manufacturers or dealers of equipment, the lessor is able to treat the lease as a sales-type lease.
What accounting standard is more strict in terms of reclassification of security types?
IFRS is much stricter - you cannot reclassify into or out of fair value for profit or loss (held-for-trading) securities. Under GAAP, you can essentially manipulate earnings.
Describe the difference in the definition of impairment between IFRS and GAAP under the equity method.
IFRS needs evidence of the impairment: 1) loss event 2) impact on future cash flows 3) a reliable form of measuring the associate's value If the associate is impaired, write it down to fair value and recognize a loss on the income statement.
What results in higher valuation of private equity portfolio companies - IPOs, secondary market sales, and management buyouts?
IPOs - generally the highest valuation Secondary market sales - highest after IPOs
Is IRR the time- or money-weighted return calculation?
IRR is the money-weighted (cash-weighted) return
Under what circumstances should the lessor treat a lease as a finance lease under GAAP?
If ALL of these criteria are met: 1) if any one of the finance lease criteria for lessees is met 2) the collectability of lease payments is reasonably certain 3) the lessor has substantially completed performance
Under what circumstances should the lessee treat a lease as a finance lease under GAAP?
If ANY of these criteria are met: 1)Title to the leased asset is transferred to the lessee at the end of the lease 2) a bargain purchase option exists 3) the lease period is at least 75% of the asset's economic life 4) the PV of the lease payments > or = 90% of the leased asset's fair value
Describe in which situations a plans funded status will be underfunded or overfunded.
If FV > PBO, overfunded If FV < PBO, underfunded
Discuss the effects on the balance sheet and the income statement from a past service cost under GAAP and IFRS.
If a firm adopts or amends its pension plan, the PBO is immediately increased on the balance sheet. However, the income statement would not necessarily reflect an immediate change. Under GAAP, the past service costs are reported as a part of other comprehensive income and amortized over the remaining service life of the affected employees. Under IFRS, the past service costs are recognized in periodic pension cost in the income statement immediately - they are expensed immediately and not amortized.
What's a sign that a firm should distribute dividends to shareholders in terms of the required rate of return?
If a firm has no additional opportunities to earn returns in excess of the required rate of return, it should distribute all of its additional earnings to shareholders in the form of dividends.
How should an analyst account for real estate when calculating normalized earnings of a private firm?
If a private firm is leasing a piece of property, the lease expense should be recognized at the market rate. adjust earnings accordingly. If a private firm owns a piece of property that is NOT core to its business, the depreciation expense and capital investment in the property should be eliminated from expenses.
How can you tell if cash flows are of high quality?
If both: - CFO is positive and sustainable - CFO > CapEx + debt service + dividends
Under what circumstances would a borrower of a mortgage strategically default?
If home values fall so the outstanding loan principal is greater than the home value
In what directions do past service costs change the PBO?
If past service costs increase, aka the plan is more generous, the PBO (liability) will increase.
Under what circumstances may pension costs be capitalized?
If pension costs are included in the cost of production of goods, such as labor costs for work-in-progress or finished goods, they may be capitalized as part of the valuation of inventory. When the inventory is sold, the pension costs are expensed as a component of COGS.
Bear hug
If the target company's management does not support an acquisition deal, the acquiring company submits a proposal directly to the target's board in a process called a "bear hug". If the bear hug is unsuccessful, the acquiring company appeals directly to the target's shareholders.
How is fair value of an option determined?
If there is a similar option available, the observable market price for that option is used. Otherwise, an option-pricing model is used. IFRS and GAAP are indifferent between option-pricing models.
How can you use PP&E on the balance sheet to determine net fixed capital investment (CapEx)?
If you are given gross PP&E on the balance sheet during the exam, and there are no disposals on assets during the period (this is important - there cannot be any disposals), then the change in the gross PP&E from one period to the next is the CapEx for the period.
How do you tell if you need to adjust NOI when calculating NAVPS?
If you begin with an estimate of cash NOI, do not adjust for non-cash rents.
Tainted held-to-maturity securities
If you choose to remove held-to-maturity securities early and realize gains or losses, you have to reclassify all of the held-to-maturity securities you own at that time.
How should you treat interest when evaluating the cost of a project?
Ignore it - it's part of the WACC already
How are current service costs and interest costs recorded?
Immediately in the income statement. Interest cost is always a pension expense.
Where are actuarial gains and losses recorded?
In OCI
Strategic transaction
In a strategic transaction, valuation of the firm is based in part on the perceived synergies between the acquirer and the target.
In a world with no taxes, how does capital play into the WACC?
In a world with no taxes, capital structure does NOT matter. The WACC will remain constant.
When will reinvestment risk increase for investors in MBS - when interest rates are higher or lower?
In both situations reinvestment risk will increase!
How does the strategy of eliminating rivals compare in the long term versus the short term?
In both the long term and the short term, eliminating rivals is NOT an effective strategy.
How has the proportion of companies that pay cash dividends changed over time across the globe?
In developed markets, the proportion of companies paying cash dividends has trended downwards over the long term
The purchase price using the equity method is comprised of three components:
In one line in the balance sheet, the purchase price includes: 1) purchaser's share of the book value of net assets 2) purchaser's share of any fair market adjustment 3) goodwill
What assumption does the single-stage residual income valuation model make?
In reality, residual income is likely to approach zero over time as competitive forces drive industry profit margins to normal levels. However, the single-stage residual income valuation model assumes that dividends and earnings will grow at a constant rate indefinitely.
Where is the LIFO reserve found?
In the footnotes.
Describe how the conflict between stakeholders is balanced in the long term.
In the long term, the twin strategies of maximizing ROIC and growth maximizes the funds available for division amongst the stakeholders.
If a firm reports interest as a financing cash flow under IFRS, how do you adjust for that when comparing CFO and operating income?
In this case, you do not add the interest expense back to CFO, because it has already been accounted for in CFF.
How does income differ over the term of the lease between direct financing and operating leases?
Income is higher in the early years of a direct financing lease, because interest income is higher. Similar to an amortizing loan, the interest is higher in early years.
When estimating CapEx for maintenance, how should you treat historical depreciation?
Increase it by the inflation rate, because replacement costs (maintenance) can be expected to increase with inflation
If the acquirer borrows money to raise cash for a cash offering, what will happen to the acquirer's balance sheet?
Increased liabilities, meaning increased leverage and risk
If a company has a debt offering, the valuation of the equity __________
Increases
A firm can reduce customer power by
Increasing service or bypassing the middle man and selling directly to end users
Contrast SROs and non-SROs
Independent regulators can be either self-regulating organizations (SROs) or non-SROs. - SROs regulate and represent their members - not all SROs are independent regulators. These do not have government recognition. - not all independent regulators are SROs.
In a world with no taxes, according to the MM model, will a business owner prefer more or less debt?
Indifferent between capital structures. The WACC and the value of the firm will be constant.
Rivalry tends to increase over time as
Industry growth slows and producers converge to new industry standards.
What is the effect on a project if inflation exceeds expected inflation?
Inflation causes a project's cash flows to be worth less, so profits will look bigger than they actually are, and the value of the project will be less than expected.
How are long-term held-to-maturity securities reported on the balance sheet?
Initially at purchase, they are reported at: - cost including transaction costs (GAAP) - fair value including transaction costs (IFRS) Afterwards, they are reported at amortized cost (both GAAP and IFRS).
Describe how interest cost is reported in the financial statements under IFRS and GAAP.
Interest cost is the increase in the PBO due to the passage of time. GAAP - immediately in the income statement IFRS - immediately in the income statement
Under what circumstances can interest be capitalized?
Interest is capitalized when incurred during construction (held-for-use assets). The objective is to accurately measure the asset's cost and better match cost with revenues. Interest expense on debt in excess of construction costs is immediately expensed.
Discuss the difference between reporting interest payments on the cash flow statement versus on the income statement.
Interest payments are an operating cash flow, but are not considered an operating expenditure: finance lease interest payments are not used in calculating operating income - rather, they are subtracted when calculating net income.
How are the components of profits of a direct financing lease recorded on the cash flow statement?
Interest revenue - CFO inflow Principal reduction - CFI inflow
How are the components of profits of a sales-type lease recorded on the cash flow statement?
Interest revenue - CFO inflow Principal reduction - CFI inflow (same as a direct financing lease)
Discuss when intrinsic value versus investment value is used.
Intrinsic value is used mostly for stock purchase decisions. Investment value is often used in evaluations of M&A opportunities.
What is the relationship between COGS and ending inventory?
Inverse relationship. If an inventory cost flow method increases the value of ending inventory, COGS will decrease.
What is the main implication of the unbiased expectations theory?
Investors are RISK NEUTRAL: an investor should, for example, earn the same return by investing in a five-year bond or by investing in a three-year bond and then a two-year bond after the three-year bond matures.
What is the disadvantage of the issuer-pays model of credit ratings?
Issuer-pays model is when credit rating agencies are paid by the issuers (the borrowers) for the rating. Therefore, there is an inherent conflict of interest.
What is the advantage of using the residual income approach to valuing a stock?
It can be used on firms with negative free cash flow and on dividend and non-dividend paying firms
What affect does an interest-only loan have on the principal?
It does not reduce the outstanding balance
How does an individual's credit score differ for different types of loans?
It doesn't. Credit scoring does not take into account differing probabilities of default for different loans taken out by the same borrower. For example, a borrower is more likely to default on a credit card loan than on a mortgage due to differing consequences, but the same credit score is considered for both loans.
Describe why the H-model is only an approximation.
It is an approximation because if we were to calculate the exact answer, we would have to forecast each of the period's dividends, applying a different growth rate to each.
What is a benefit of using the EV/S ratio?
It is appropriate for comparing companies with significantly different capital structures
What is the disadvantage of using free cash flow models to value stocks?
It is difficult to use on firms with negative FCF
What is the bias in an entrepreneurs projection of its company's value?
It is normally optimistic and based on an assumption that the company will not fail.
Does innovation and technology have an affect on an industry's profitability in the short and long term?
It may affect an industry temporarily, but it does not have a long-term affect unless it changes one of Porter's five forces (which means it causes a structural change in the industry, I guess).
What is the disadvantage of using the rideable income approach to valuing a stock?
It requires an in-depth analysis of a company's accruals. Also, a company's accruals may have incorporated a lot of subjectivity from management; if the accounting is not transparent or of high quality, the accuracy of the estimate is unlikely.
What is a tax shield?
It shields you from paying out taxes. Tax shields are created by claiming allowable deductions from taxes on interest payments, depreciation, etc.
When a company operates in multiple industries or regions, what corporate strategy should it use?
It should use several, applicable to each division of the business as appropriate
Why is the sustainable growth rate important?
It tells the analyst how quickly a firm can grow with internally generated funds.
What is the strength of using the comparables approach to price multiples valuation versus the fundamentals approach?
It uses market data exclusively, whereas the fundamentals approach requires estimates.
How does treating an operating lease as a finance lease affect the interest coverage ratio?
It will decline
Justice theories
John Rawls argued that justice is met if all participants would agree the rules are fair if the results would be acceptable when decided under a "veil of ignorance." - focuses on a just distribution of economic output.
Do net borrowing adjustments affect just FCFF, just FCFE, or both?
Just FCFE
Are spot rates and forward rates in binomial trees able to be calculated using the multiplier (e^2Ө)
Just forward rates
What is the bottom line rule for international accounting differences in the context of the clean surplus relation?
Just remember that it is difficult to apply the residual income approach in an international context especially when there are less strict accounting regulations in a country. (?)
Assuming inflation, how does LIFO versus FIFO effect COGS?
LIFO - higher FIFO - lower
Assuming inflation, how does LIFO versus FIFO effect debt-to-equity?
LIFO - higher FIFO - lower
Assuming inflation, how does LIFO versus FIFO effect inventory turnover?
LIFO - higher FIFO - lower
Assuming inflation, how does LIFO versus FIFO effect cash flows?
LIFO - higher (less taxes) FIFO - lower (more taxes)
Assuming inflation, how does LIFO versus FIFO effect inventory balances?
LIFO - lower FIFO - higher
Assuming inflation, how does LIFO versus FIFO effect net and gross margins?
LIFO - lower FIFO - higher
Assuming inflation, how does LIFO versus FIFO effect net income?
LIFO - lower FIFO - higher
Assuming inflation, how does LIFO versus FIFO effect taxes?
LIFO - lower FIFO - higher
Assuming inflation, how does LIFO versus FIFO effect the current ratio?
LIFO - lower FIFO - higher
Assuming inflation, how does LIFO versus FIFO effect working capital?
LIFO - lower FIFO - higher
In an ideal world, how would an analyst use inventory accounting methods in the income statement versus the balance sheet?
LIFO in the income statement FIFO in the balance sheet
When prices are rising, LIFO provides an artificially ____ value of ending inventory.
LIFO provides an artificially low value of ending inventory
What will happen to the LIFO reserve if a firm is liquidating its inventory?
LIFO reserve will decline
What is a disadvantage that applies to REITs but not to REOCs?
Lack of flexibility: REETs are prevented from making certain kinds of investments and from retaining most of their income. REOCs, on the other hand, are free to retain income and devote those funds to property development when managers see attractive opportunities.
What is unique about land when valuing a firm's assets?
Land is not a depreciable asset. It should be excluded when calculating the ending gross & net investment.
What does the significance of relative strength indicators depend on?
Largely on the investor's time horizon
Is M&A activity as a way to achieve growth considered to be more or less risky in comparison to organic growth?
Less risky
Is the passthrough rate of an MBS greater than or less than the mortgage rate of the underlying mortgages in a pool?
Less than, due to fees
Contrast how the principal portion of a direct financing lease is reported between the lessee and the lessor.
Lessee - CFF outflow Lessor - CFI inflow
How does treating an operating lease as a finance lease affect leverage?
Leverage increases as assets rise but equity stays constant. The company could issue equity to keep leverage unchanged, but that would dilute ownership.
Projected benefit obligation (PBO)
Liability of the pension plan based on: - present value of all future pension payments from moment of retirement to expected death - based on how many years you have worked so far - bases on final, not current, expected salary at retirement - assumes employee works until retirement - estimate of the liability on a going concern basis because it assumes the pension and the business will continue to exist
The visionary style require a long term or a short term outlook?
Long term
How can you determine if there were any disposals / sale of assets during the period?
Look on the income statement right above net income - if there was a sale, you will have a gain/loss from an asset sale, as an unusual or infrequent item
If a company purchases a foreign good for a specified amount in the foreign currency to be exchanged on a future date, will the company recognize a gain or a loss if the foreign currency strengthens?
Loss
In general, what is a company's level of dividend payout in the initial growth, transition, and maturity stages?
Low or zero, increasing, stable at long-run level, respectively
What effects will an increase in production volume have on a company with economies of scale, in terms of costs and operating margins?
Lower costs, higher operating margins
How does having a greater institutional investor presence affect the use of debt and the maturity of the debt?
Lower debt because institutional investors, who tend to have a lot of capital to put to work and therefore larger stakes in companies, have more of an incentive to monitor the debt on their own. If management isn't doing a good job, institutional investors will get active. Therefore less debt is needed. (The reasoning behind this is contradictory to the reasoning behind a country's reliance on the banking system, but just take it as a given.) Longer maturity on the debt.
How does having favorable personal tax rates on dividends versus interest affect the use of debt?
Lower debt because people are more willing to issue equity.
How do debt ratings affect the cost of capital?
Lower debt rating heightens the cost of debt and the cost of capital.
How does having a strong legal system affect the use of debt and the maturity of the debt?
Lower debt, longer maturity
How does having less informational asymmetry affect the use of debt and the maturity of the debt?
Lower debt, longer maturity
How does having higher GDP growth affect the use of debt and the maturity of the debt?
Lower debt, longer maturity.
How does having higher inflation affect the use of debt and the maturity of the debt?
Lower debt, shorter maturity
What is preferable - higher or lower PEG ratios between companies?
Lower, given that the selected companies have similar risk characteristics.
What is a faster way to achieve growth - M&A activity or organic growth?
M&A activity
Mundell-Flemming model versus the portfolio balance model
MF model - covers the short term effects of monetary or fiscal policy on exchange rates Portfolio balance model - covers the long term effects of monetary or fiscal policy on exchange rates
The value created by a firm's ability to generate economic profit is measured by
MVA (market value added)
A firm can reduce substitutes by
Making the product more widely available, or by enhancing the product features. For example, cell phone makers compete with land lines by adding texting, video, music, etc.
Define malleability in assessing an industry.
Malleability is the extent to which a company and its competitors can influence an industry.
When adding non-operating and operating assets to find the total value of a firm, do you use book or market value?
Market value
Will mean reversion of a company's earnings occur faster using cash or accrual accounting?
Mean reversion of earnings will occur faster with accrual accounting. If accruals are discretionary, mean reversion will happen even faster.
Describe the risk in the relationship between managers and members of the board.
Members of the board of directors are supposed to monitor and evaluate the performance of the senior managers of the company. If they become too close to managers, they can favor the interests of the managers they should be supervising, rather than putting the interests of the shareholders first.
Under the Mundell-Fleming model, describe the effects of monetary and fiscal expansion.
Monetary + Fiscal expansion will lead to currency appreciation in a low capital mobility environment. In a high capital mobility environment, effects are uncertain.
Projects with more sensitive NPVs are more or less risky?
More
The shorter the high-growth period, the ________ accurate the H-model is.
More
The smaller the spread between the short term and long term interest rates in the H-model, the ________ accurate it is.
More
How has the amount of companies making stock repurchases changed over time?
More companies in the U.S., U.K., and Europe have been making stock repurchases over time.
What type of debt security can not be valued using the binomial interest rate tree framework? Why?
Mortgage backed securities cannot use this method because the value of the cash flows in each period will be dependent on interest rate changes. Therefore you must use the Monte Carlo forward-rate simulation model.
In general, how do private companies differ from public companies in terms of management/shareholder overlap?
Most private firms have significant management/shareholder overlap.
How do you calculate the discount to a comparable firm when using both the DLOC and the DLOM? Is it an additive or multiplicative adjustment?
Multiplicative. Discount = (1-DLOC) x (1-DLOM) - 1
Malleability is also referred to as
Mutability
What is generally the most appropriate measure of the fundamental value of REITs and REOCs?
NAVPS
In general, what is a company's level of FCFE in the initial growth, transition, and maturity stages?
Negative, growing and possibly positive, and stable at long run level, respectively
Compare Neoclassical and Endogenous Growth Theories in the context of developing countries and trade.
Neoclassical - developing countries attract FDI and as a result benefit from economic growth - eventually they will converge with developed countries - they must have free trade for greater growth Endogenous - free trade fosters innovation - the best advanced companies will survive and benefit the country, not just themselves
Discuss the differences between the endogenous and neoclassical growth models in the context of open markets and free trade.
Neoclassical - the benefit of open markets is temporary Endogenous - open markets lead to higher growth permanently for all markets (not just developed markets, for example)
How will a parent company's net assets versus net liability exposures be affected under the current rate method when the local currency depreciates?
Net assets - the parent company will lose Net liabilities - the parent company will gain
How does treating an operating lease as a finance lease affect net income?
Net income will be lower in early years, as the depreciation and interest expense on a finance lease are greater than the lease payment on an equivalent operating lease.
How will a parent company's net monetary assets versus net monetary liability exposures be affected under the temporal rate method when the local currency appreciates?
Net monetary assets - the parent company will gain Net monetary liabilities - the parent company will lose When a parent company has a net monetary liability, it owes more cash than it has on hand. When a foreign currency appreciates, it will take more of the parent company's currency to repay what it owes to the subsidiary's foreign currency.
Does the percentage of debt and equity used by an investor to finance real estate affect the property's value?
No
How do more liquid markets affect the use of debt and the maturity on the debt?
No affect on the amount of debt used, but debt will be of longer maturities.
How do impairment losses affect cash flow?
No effect
Economic income versus profit
No explanation given; just know that the two equations are different. Also, economic income in the capital budgeting context is not the same as economic income used in equity valuation.
Describe the idea behind a direct financing lease.
No gross profit is recognized by the lessor at the inception of the lease. The lessor is simply providing a financing function to the lessee.
Are impairment reversals allowed under GAAP and IFRS using the equity method? Why or why not?
No reversals are allowed because the measurement of fair value of an associate tends to be very subjective.
How is the DLOM estimated?
No straightforward way; very subjective. Common methods include: - the difference between restricted vs. publicly traded share prices - the difference between pre-IPO vs. post-IPO prices - the relation between the put price and the actual stock price
Do you have to test for impairment of goodwill separately under the equity method? Why or why not?
No, because goodwill is included in the carrying value of the business on the balance sheet, so it has already been tested. Remember, goodwill of an associate investment is included in the single line item - it is not a separate item. Therefore, it cannot be tested separately.
Does the size of the liquidity premium in the liquidity preference theory remain constant over time?
No, it does not need to.
Can goodwill impairment be reversed?
No.
Is the conversion option in a convertible bond sensitive to interest rates?
No.
Is free cash flow to equity equal to dividends paid?
No. FCFE rarely equals dividends paid.
Do cash flows into the pool of mortgages from borrowers coincide with cash flows out of the pool to security holders?
No; there is a delay
How do monetary and nonmonetary items differ in the context of PPP?
Nonmonetary items are not exposed to PPP gains/losses during inflation. Monetary assets will result in PPP losses, while monetary liabilities will result in PPP gains.
Contrast the definitions of normalized earnings in the public equity context and the private equity context.
Normalized earnings in a public equity context is the average earnings over the business cycle (the mid-point in the cycle). Normalized earnings in a private equity context is the firm's earnings if the firm were acquired. Here, the calculation of normalized earnings requires adjustment for firm-specific characteristics.
What is the discount rate used to discount free cash flows back to the present?
Normally, the WACC. Don't forget to adjust the WACC in the cash of a potential merger.
What are the post-merger value brackets for the HHI Index that indicate an industry is not concentrated, moderately concentrated, and highly concentrated
Not concentrated: below 1,000 Moderately concentrated: 1,000-1,800 Highly concentrated: above 1,800
Does the number of paths in a pathwise valuation model result in a more accurate valuation?
Not necessarily. Statistically, yes it will improve accuracy. However, whether the value is closer to the true fundamental value of the bond depends on the accuracy of the interest rate inputs.
If a held-t0-maturity security's market value changes, is the gain or loss recognized?
Not unless it is considered impaired.
Which states have the most protection in terms of restrictive takeover laws?
Ohio and Pennsylvania
When is the exchange ratio in a securities offering determined?
On the day the deal closes
How are one-sided durations different than effective duration?
One-sided durations are better at capturing interest rate sensitivity
Under IFRS, where are revaluations recognized on the financial statements?
Only firms that use IFRS are allowed to revalue long-lived assets. In general, losses are recognized on the income statement, and gains are recognized under other comprehensive income. However, any gains must first make up for any losses on the income statement, and similarly and losses must first account for any gains under other comprehensive income.
Under what circumstances should you remove the subsidiary's equity from the parent's balance sheet for analysis purposes?
Only if it is specified in the problem, or if the problem asks you to interpret the affect of a subsidiary on financial ratios. Otherwise, always assume a subsidiary has a similar capital structure as the parent.
What is the difference between finance and operating leases in terms of cash flow?
Over the life of the lease, total expense for a lease will be the same whether it is a finance or an operating lease. A finance lease reduces CFO by the interest expense and CFF by the depreciation expense (principal). An operating lease only reduces CFO. Therefore, CFO will be higher for a finance lease (and CFF will be lower).
If a stock is trading at a market price higher than the price implied by a dividend discount model calculation, the stock is considered to be
Overvalued
The valuation multiples least affected by differences in international accounting standards are:
P/(adjusted CFO) and P/FCFE
What valuation multiple is the residual income model most closely linked to?
P/B
The valuation multiples most affected by differences in international accounting standards are:
P/B, P/E, P/EBITDA, and EV/EBITDA because they are more influenced by management's choice of accounting methods and estimates
Which common price multiple(s) have been shown to help explain differences in long-run average stock returns?
P/E, P/B, P/CF and P/S
Characteristics of the risk of PAC tranches
PAC tranches have reduced contraction risk AND reduced extension risk compared to the underlying MBS
What are the impacts on the PBO and the pension cost in the income statement from an increase in the discount rate (GAAP only)?
PBO - higher discount rate will result in a lower present value, and therefore lower PBO Pension cost - lower. The two components of pension cost are service cost and interest cost. Service cost will decline because of a small present value. The interest cost will decline because despite a higher discount rate, the beginning PBO will be lower.
What are the impacts on the PBO and the pension cost in the income statement from higher wage rate increases?
PBO - higher wages lead to higher payout from the firm, leading to higher PBO Pension cost - higher service costs, leading to higher pension cost
What are the impacts on the PBO and the pension cost in the income statement from higher expected return on assets (GAAP only)?
PBO - unaffected. Expected return on plan assets does not appear in the PBO. Pension cost - lower; higher expected return on assets will reduce pension expense in the income statement.
Current service costs
PV of benefits earned by the employees during the current period. I.e. the increase in PBO attributed to employees working one extra year. For every extra year you work, you're entitled to more benefits.
What factor is particularly important to pay attention to when comparing a company's dividend yield to the dividend yield of a peer or group of peers?
Particular emphasis should be placed on determining whether any difference in dividend yield is due to expected growth differences.
What is the primary advantage of a partnership?
Partners can pool knowledge and capital, and share business risks.
Describe how past service cost is reported in the financial statements under IFRS and GAAP.
Past service cost is a retroactive benefit awarded to employees. GAAP - recognized under OCI, amortized to income statement over the service life of the employee IFRS - immediately recognized in the income statement; amortization is not allowed
Benefits paid
Payments made from the PBO to retirees. The PBO will decrease as benefits are paid.
Kantian ethics
People are different from other factors of production. They are more than just an economic input and deserve dignity and respect.
What effects will an increase in production volume have on a company with economies of scale, in terms of correlation between sales volume and margins?
Positive correlation between sales volume and margins. Economies of scale leads to higher sales volume and higher margins.
Describe the relationship between P/B and ROE, all else equal.
Positive relationship
Describe the relationship between P/S and earnings growth rate, all else equal.
Positive relationship
Describe the relationship between P/S and profit margin, all else equal.
Positive relationship
Is it better to have a positive or negative CFO/operating income ratio?
Positive.
What are the possible negative and positive signals of initiating a dividend?
Positive: having great prospects for company earnings Negative: having no good investment opportunities
Is an increase in PP&E over time a warning sign?
Possibly. Examine PP&E over time using a common size balance sheet. If it is increasing over time, there should be an explanation of why there is a systematic capitalization of expenses.
What types of merger defense mechanisms are harder to defend in court - pre-offer or post-merger mechanisms?
Post-merger mechanisms are harder to defend.
What are the two categories of defensive measures used to resist a hostile takeover?
Pre-offer defenses and post-offer defenses.
Define predictability in assessing an industry.
Predictability is measured by how accurately and how far into the future a company can forecast factors (such as industry demand, corporate governance, and market expectations)
Who does the prepayment penalty benefit and when would it be realized?
Prepayment penalty benefits the lender. It is most likely realized if interest rates decrease.
What is another term used by IFRS for PBO?
Present value of the defined benefit obligation (PVDBO)
Are private companies more or less heterogeneous than public companies?
Private companies are more heterogeneous because public companies often share common regulatory requirements, which force them to conduct business and accounting practices in a certain way.
In general, how do private companies differ from public companies in terms of size?
Private companies are usually smaller and riskier.
In general, how do private companies differ from public companies in terms of restrictions on selling shares?
Private companies often have agreements that prevent shareholders from selling.
In general, how do private companies differ from public companies in terms of company lifecycle?
Private companies tend to be less mature
In general, how do private companies differ from public companies in terms of taxes?
Private firms are usually more concerned with taxes. This is because taxes directly impact equity owners, of which there is a small and concentrated amount for private firms.
Credit analysis for corporate bonds incorporates what credit measures?
Probability of default, expected loss, and present value of expected loss
Credit analysis for ABS incorporates what credit measures?
Probability of loss, expected loss, and present value of expected loss. Probability of default is not calculated because ABS do not default.
In general, how do private companies differ from public companies in terms of time horizon?
Public company shareholders often focus on short term earnings gains and performance. Private company shareholders are often managers and therefore have longer term views for the firm.
What factors effect a buyer's price sensitivity?
Qualitative: brand identity, product differences, quality Quantitative: price relative to total purchases and profitability
Are REITs and REOCs restricted in the use of leverage?
REITs - yes. REOCs - no.
Forced equity issuance
REITs frequently participate in bond markets to refinance maturing debt in order to maintain financial leverage. When credit is difficult to obtain (e.g. during the 2008 crisis), a REIT may be forced to issue equity at a disadvantageous price
Agency RMBS
RMBS issued by a government agency (Ginnie Mae) or a government sponsored agency (Fannie Mae, Freddie Mac)
Contrast typical passthrough securities (RMBS) with collateralized mortgage obligations in terms of the components of payments they offer investors.
RMBS payments include interest, principal, and prepayment compensation all at the same time. In contrast, CMOs segregate the prepayment risk into different tranches. (clarify this stuff - p257 book4)
Non-agency RMBS
RMBS that are issued by private entities and do not have government backing because they do not meet certain standards defined by min % down payment, max LTV ratio, max size, min documentation, and insurance.
You can think of a firm as having a competitive advantage when its _____ is greater than its _____.
ROE > required return
In general, what is a company's level of ROE vs. required return in the initial growth, transition, and maturity stages?
ROE>r, ROE approaching r, ROE=r, respecitvely
Why is return on invested capital often a preferred measure over ROE?
ROIC measures the return to both equity and debt. Therefore, it is often preferable to ROE because it allows comparisons across firms with different capital structures.
A firm can reduce the threat of entry by
Raising fixed costs through increased R&D or mechanization, or lobbying regulators for more protection. For example, banks have raised entry barriers by investing in large bank networks that make it difficult for smaller banks to compete
Why does real estate have both bond- and stock-like characteristics?
Real estate investments receive periodic rental payments, similar to the coupon payments of a bond. However, there is uncertainty about the persistence of the cash flows depending on the renewal of the lease and future rental rates.
Describe the thought process behind interest costs in the context of the PBO as a whole.
Remember the PBO is the present value of the future DB benefits you will receive. The closer you get to retirement, the fewer years will be used to discount the DB benefits to the present. Therefore, the PBO will increase in value over time, even if service costs and actuarial gains and losses are held constant. Interest cost is the difference in this value each year.
How does treating an operating lease as a finance lease affect the income statement?
Replace the rental expense with two components: 1) the principal component, which is before operating income, and 2) the interest expense, which is after operating income
What is the best valuation method for firms that do not pay dividends, have negative FCF, or have transparent financial reporting and high earnings quality?
Residual income
What is the main difference between residual income and DCF models in determining intrinsic value?
Residual income models recognize total value (in the form of book value at time 0) BEFORE discounting residual incomes. A portion of the intrinsic value calculated using the residual income model comes from the book value at the beginning, which is known and does not need to be forecasted. DCFs, however, recognize total value in the form of an estimate of terminal value AFTER discounting all the cash flows. In this case, a significantly larger portion of the intrinsic value comes from the terminal value, which is an estimate. Therefore, residual income models have less forecast error.
What is the difference between residual income and economic value added?
Residual income takes into account both interest and a charge for equity capital. EVA does not take into account interest, but does take into account a charge for debt and equity capital using the WACC. Conceptually, they are both measuring economic income.
Past service costs
Retroactive benefits awarded to employees when a firm adopts or amends its pension plan. If the plan becomes more generous, the past service costs increase the PBO on the balance sheet immediately. Ex. Changing the payout from 60% to 65% of final salary would increase the PBO.
Legislative and regulatory risk (in the context of ESG investing)
Risk that a firm will suffer from new laws or regulations the government might impose (ex. emissions standards). Cleaner companies (ESG) will likely suffer less than their competitors.
Is eliminating rivals considered a sound or risky strategy?
Risky strategy, because increased profitability will likely attract more rivals.
What is the difference in total income from sales-type, direct financing, and operating leases?
Sales-type leases will generate more income. Direct financing and operating leases will generate equal income.
What type of analysis should be performed on each of the variables involved in calculating exit value?
Scenario analysis
What types of analysis should you perform when estimating cash flows of a private firm - sensitivity, scenario, or simulation analysis?
Scenario analysis. This is helpful because there is often a wide range of outcomes of a firm when cash flows are very uncertain. For each scenario, use a customized discount rate. A value for the firm is based on each scenario.
If the acquirer's shares are considered overvalued by the market, the acquirer should use what type of offering in an acquisition?
Securities offering
What are the two basic methods of payment?
Securities offerings and cash offerings
Which two traditional theories of term structure of interest rates share the theory that market participants have strong preferences for particular maturities and are unlikely to purchase other maturities?
Segmented Markets Theory and Preferred Habitat Theory
Are senior tranches or subordinated tranches more subject to contraction risk?
Senior tranches
Contrast sensitivity analysis, scenario analysis, and simulation analysis.
Sensitivity analysis - varying one independent variable to see how much the dependent variable changes, all other variables held constant Scenario analysis - varying multiple independent variables at once to see how the dependent variable changes (best case, worst case, most likely case) Simulation analysis - repeated random draws of each input variable to generate a simulated probability distribution of NPV
If the acquirer issues new stock for a securities offering, what will be the main concern to shareholders of the acquirer?
Shareholders will have their ownership diluted
What type of volatility is associated with the long end of the volatility curve versus the short end of the volatility curve?
Short end - monetary policy risks Long end - uncertainty regarding the economy and inflation
In general, what is a company's level of capital investment in the initial growth, transition, and maturity stages?
Significant requirements, decreasing, and stable at long run level, respecitvely
Proportionate consolidation method
Similar to a business acquisition, except the investor only reports the proportionate share of the assets, liabilities, revenues, and expenses. Since only the proportionate share is reported, no minority interest is necessary.
Target payout adjustment model
Similar to the stable dividend policy approach, this model uses a long term forecast of earnings. It issues dividends based on a long term target percentage of those earnings, and slowly moves toward the target over time. It avoids cutting or eliminating dividends except for in extreme circumstances.
Fair value of plan assets
Simply the market value of plan assets, reported on the balance sheet
Why does a corporation limit the liability of shareholders?
Since there is a legal distinction between a corporation and its shareholders, the most a shareholder can lose is the amount invested. Nothing more.
In general, how do private companies differ from public companies in terms of quality of management?
Smaller private firms may not be able to attract as many qualified applicants as public firms.
Impairment of capital rule
Some countries require legally that companies cannot pay dividends in excess of retained earnings. Impairment of this rule is a factor that affects a company's dividend policy.
What types of rates are considered superior - spot rates or YTM?
Spot rates
As forward exchange rate quotes mature, do spreads narrow or widen?
Spreads widen with maturity.
What is the difference between stock and asset purchases in terms of taxes?
Stock purchases - the shareholders have to pay capital gains, but the corporation does not pay any taxes, because the purchase goes directly to shareholders. Asset purchases - the shareholders do not pay any taxes, but the corporation pays capital gains.
Which type of acquisition allows the target company's tax loss carryforwards to be used to reduce the acquiring company's tax liabilities?
Stock purchases only, but not asset purchases
Which type of acquisition requires the acquiring company to assume liabilities of the target company?
Stock purchases, not asset purchases
Which type of acquisition usually entails purchasing the entire company rather than just a portion?
Stock purchases. Asset purchases are more targeted.
What are the two transaction types of acquisitions from the perspective of the buyer?
Strategic and financial (nonstrategic).
Contrast the strengths/weaknesses of the structural model versus the reduced form model of credit analysis in terms of asset values.
Structural model - asset values are often not directly observable, which makes it difficult to model even a simple balance sheet (weakness) Reduced form model - does not require modeling a balance sheet in the first place (strength)
Contrast the strengths/weaknesses of the structural model versus the reduced form model of credit analysis in terms of assumptions of company balance sheets.
Structural model - assumes a simple balance sheet structure, which is unrealistic (weakness) Reduced form model - assumes a company has one zero-coupon bond, which saves the analyst from having to specify a balance sheet (strength)
Contrast the structural model versus the reduced form model of credit analysis in terms of fluctuations of credit risk over the business cycle.
Structural model - does not consider the business cycle conditions (weakness) Reduced form model - credit risk can fluctuate with the business cycle (strength)
Contrast the structural model versus the reduced form model of credit analysis in terms of input estimation.
Structural model - inputs estimated using current market prices (strength) Reduced form model - inputs estimated using historical data (strength), but historical market conditions are often not a good representation of the future (weakness)
Contrast the structural model versus the reduced form model of credit analysis in terms of how the risk free rate changes.
Structural model - the risk free rate remains constant over time Reduced form model - the risk free rate is stochastic, meaning the model assumes it changes randomly over time
Are senior tranches or subordinated tranches more subject to extension risk?
Subordinated tranches
How do you remove the impact of a subsidiary from a parent's market value?
Subtract the subsidiary's market value, adjusted for % of ownership, from the parent's market value.
What types of risk do support tranches of CMOs assume, and how much risk do they assume in comparison to other tranches?
Support tranches have both more contraction risk AND more extension risk than the underlying MBS and PAC tranches.
Periodic pension costs versus total periodic pension costs
TPPC uses actual return on plan assets PPC reported on the income statement uses expected return on plan assets
Contrast YTM, forward rates, and spot rates.
TYM - used to discount all bond CFs Forward rates - future rates Spot rates - rates at a specific moment in time
How should you adjust operating leases to try and comply with the clean surplus relation?
Take the present value of future lease payments and add an asset and a liability to the balance sheet equal to that value. Amortize the liability over time and straight-line depreciate the asset.
What does empirical data show on the effects of mergers on acquirers versus targets directly after announcements?
Target stock prices increase by 30% Acquirer stock prices decrease by 1-3%
What exchange rate is used for revenues and SG&A under the temporal method versus the current rate method?
Temporal - average rate Current - average rate
What exchange rate is used for monetary assets and liabilities under the temporal method versus the current rate method?
Temporal - current rate method Current - current rate
What exchange rate is used for COGS under the temporal method versus the current rate method?
Temporal - historical rates Current - average rate
What exchange rate is used for depreciation and amortization under the temporal method versus the current rate method?
Temporal - historical rates Current - average rate
What exchange rate is used for nonmonetary assets and liabilities under the temporal method versus the current rate method?
Temporal - historical rates Current - current rate
What exchange rate is used for common stock under the temporal method versus the current rate method?
Temporal - historical rates Current - historical rates
Where is exchange rate gain or loss reported under the temporal method versus the current rate method?
Temporal - income statement Current - equity
What exchange rate is used for equity (as a whole) under the temporal method versus the current rate method?
Temporal - mixed Current - current rate There are some exceptions here, so look into this.
What exchange rate is used for net income under the temporal method versus the current rate method?
Temporal - mixed rate Current - average rate
What are the alternate names for the temporal method of translation and the current rate method of translation?
Temporal method - remeasurement Current rate method - translation
Large gaps between the mean and median values of a peer group's price multiples suggests what?
That there is a significant presence of outliers in the data
Contrast the guideline public company method and the guideline transactions method in terms of control premiums.
The GTM already has control premiums built in - this model assumes comparable companies were valued from the perspective of a controlling interest that bought the whole firm The GPCM does not include control premiums - this model assumes comparable companies were valued from the perspective of a noncontrolling interest
PEG ratio
The P/E per unit of expected earnings growth. In effect, it standardizes the P/E ratio for stocks with different expected growth rates.
Justified P/E
The P/E ratio using the value calculated from the Gordon growth model in place of price. In other words, it's the fundamental value to earnings ratio.
Tender offer
The acquirer offers to buy the shares directly from the target shareholders and each individual shareholder either accepts or declines the offer.
Proxy battle
The acquirer seeks to control the target by attempting to have shareholders approve a new board of directors. Proxy votes are sent to the shareholders, and if the new board is approved, the new board steps in and the merger offer likely becomes friendly.
If both parties are more confident that synergies will be realized in a merger deal, who will prefer a stock versus a cash offer - the target or the acquirer?
The acquirer will prefer a cash offer, and the target will prefer a stock offer, as confidence rises.
How does the acquisition method differ from the equity method in terms of net income, revenues and expenses?
The acquisition method results in higher revenues and expenses, but net income is the same.
When adjusting for beta drift, describe how the adjusted beta value will change versus the original beta.
The adjusted beta will be closer to 1.0 than the original beta.
Residual income
The amount of earnings during the period that exceeds the investors' required return
If a firm's capital structure is not optimal, what is the procedure for accounting for that in a valuation?
The analyst should drop interest expense from the calculation of operating income. This assumes that the capital structure will be changed if the firm is acquired. Later, interest expense is added back when calculating free cash flow to the firm.
When estimating normalized earnings for a strategic transaction, how should you incorporate synergies? What about for a financial transaction?
The analyst should incorporate any synergies as in increase in revenues or as a reduction in costs. Financial transactions ignore synergies.
Describe the balance between using too much and too little debt in a private equity firm.
The balance is between wanting to increase firm value through an increase in debt, versus keeping debt manageable in order to maintain credibility and access to capital markets.
Describe the balance sheet asset or liability under IFRS and GAAP of a DB plan.
The balance sheet will report the net of the PBO (the liability of the plan) and the fair value of the plan assets that are used to fund it. It will report "funded status" on the balance sheet: - if the plan is overfunded, it is an asset - if underfunded, it is a liability - theoretically, if the PBO and the plan assets were equal, you wouldn't see anything on the balance sheet at all
Given a quote A/B, describe under what circumstances will the base currency depreciate/appreciate
The base currency will appreciate if Ra - Rb If the interest rate in country A is less than in country B, the base currency will depreciate
In the Pastor-Stambaugh model, what is the baseline liquidity factor beta, and what what should it be for less liquid versus more liquid assets?
The baseline liquidity beta is 0. Less liquid stocks should have a positive beta, and more liquid stocks should have a negative beta. A negative beta will reduce the equity risk premium.
What is the primary difference between the binomial bond option model and the binomial stock option model?
The binomial bond option model always assumes 50/50 chances of arriving at one interest rate or another in the binomial tree. Whereas the binomial stock option model could be any probability of arriving at one value or the other.
The bootstrap effect occurs when a firm with a _______ P/E ratio acquires a firm with a ______ P/E ratio.
The bootstrap effect occurs when a firm with a high P/E ratio (high growth prospects) acquires a firm with a low P/E ratio (low growth prospects)
If you buy a bond at a discount, how will the carrying value change over time?
The carrying value will increase by the amortization discount (interest expense - coupon)
Free cash flow to equity
The cash available to stockholders after funding capital requirements and expenses associated with debt financing
Free cash flow to the firm
The cash flow generated by the firm's operations that is in excess of the capital investment required to sustain the firm's current productive capacity
What is the clean surplus relation?
The clean surplus relation assumes that ending book value is simply equal to the beginning book value, plus earnings, minus dividends. If, however, there are any accounting charges that are taken directly to the equity accounts, such as currency translation gains/losses, the clean surplus relation will not hold.
Clientele effect
The clientele effect refers to the varying dividend preferences of different groups of investors. If a stock has historically not paid a dividend, and they suddenly announce one, many of the investors who have owned the stock will sell it because they do not want a dividend paying stock. This will cause the stock to sell off temporarily until a new clientele picks up the stock.
The two-stage DDM assumes what?
The company grows at a high rate for a relatively short period of time, then reverts to a long run perpetual growth rate
If after-tax cost of borrowing is greater than the company's earnings yield, will the company's EPS increase or decrease as a result of a share repurchase funded with debt?
The company's EPS will decrease if the cost of borrowing is greater than earnings yield.
Where can analysts find information about a company's legal risk?
The company's regulatory filings, such as form 10-K, which require companies to disclose possible legal risk exposures
Give an example of bonding costs
The cost of insurance premiums to guarantee management performance
What FX translation method will result in higher gross profit margin in a depreciating environment?
The current rate method. Under the temporal method, the subsidiary's COGS will be remeasured at the historical rate. Using FIFO, COGS will be relatively larger under the temporal method than COGS under the current rate method, which uses the average rate. Smaller COGS under the current rate method will lead to relatively higher operating profit, meaning relatively higher gross profit margin.
Present value of expected loss (important)
The difference in value of a credit-risky bond and an otherwise identical risk-free bond
Expected return on plan assets
The employer contributes assets to a separate entity (trust) to be used to satisfy the pension obligation in the future. The return on the plan assets has no effect on the PBO, but the expected return on the plan assets is a component of reported pension expense.
When an investee is profitable, and its dividend payout ratio is less than 100%, what method usually results in lower debt - the equity method or the acquisition method?
The equity method.
When an investee is profitable, and its dividend payout ratio is less than 100%, what method usually results in higher earnings - the equity method or the accounting method?
The equity method. Therefore, the analyst should consider whether the equity method is appropriate for the investor.
What are the components of other comprehensive income?
The exact same as the violations of the clean surplus relation. 1) FX translation gains/losses 2) pension adjustments 3) gains/losses on cash flow hedges 4) changes in revaluation surplus (IFRS only) for long-lived assets 5) changes in the value of certain liabilities due to changes in the liability's credit risk (IFRS only) 6) changes in the market value of debt and equity securities classified as available-for-sale
Explain the reasoning behind using the discount rate of intangible assets in the excess earnings method of valuing a private company.
The excess earnings method values a company using the DDM model, except with dividends replaced with excess earnings. Excess earnings are the difference between earnings and capital investment on tangible assets. Therefore, excess earnings are essentially the earnings generated by intangible assets, and you need to use the corresponding discount rate to value them.
Given the ratio of CapEx of a business segment to Assets of a business segment, a value greater than one suggests what?
The firm is growing that segment by allocating a greater percentage of its CapEx to a segment than that segment's proportion of total assets.
If the firm's actual growth rate is forecasted to be greater than its sustainable growth rate, what does this mean?
The firm will have to issue equity unless it increases its retention ratio, profit margin, total asset turnover, or leverage
Under uncovered interest rate parity, what will happen to the foreign currency if the foreign interest rate is higher by 2%?
The foreign currency is expected to depreciate by 2%. Therefore, the investor should be indifferent between investing in foreign versus domestic.
Homemade dividends
The idea that if an investor prefers to have shares rather than cash, they can use the dividends to buy shares. Or, the other way around in the event of a stock dividend. Homemade dividends assumes the existence of dividends has no impact on the valuation of the firm. MM assumes perfect markets.
Interest cost
The increase in the PBO resulting from the passage of time. PBO at beginning of year x discount rate
Describe the relationship between ROE and r in terms of P/B, all else equal.
The larger the spread between ROE and r, the higher the P/B ratio.
How does a firm recognize a loss from impairment under IFRS and GAAP?
The loss is recognized on the income statement under both IFRS and GAAP.
How are finance lease payments recognized on the balance sheet and income statement?
The lower of (the present value of future minimum lease payments) and (fair value) is recognized as an asset and as a liability on the lessee's balance sheet. Over the term of the lease, depreciate expense and interest expense are recognized in the income statement.
Which method of calculating normalized EPS accounts best for changes in firm size?
The method of average ROE, because it relies on book value per share. This method is always preferred.
Optimal capital structure
The mixture of debt and equity that minimizes WACC and maximizes the value of the firm
How will an inflationary environment affect a net monetary asset exposure?
The net asset appears to grow and the company will recognize a loss in the income statement.
How will an inflationary environment affect a net monetary liability exposure?
The net liability appears to shrink and the company will recognize a gain in the income statement.
Exchange ratio in a securities offering
The number of shares of the acquiring company's stock the shareholders of the target company receive in exchange for one of their shares
Required return for a company
The opportunity cost to the supplier of capital
Why does a firm seek to minimize the WACC?
The optimal capital structure minimizes the WACC because a lower WACC causes the discounted values of the company's future cash flows to be greater, giving the company a higher valuation.
Definitive merger agreement
The outline of the terms of a friendly merger, executed by moth management teams.
What does the OIS rate stand for, what is it, and what makes it special?
The overnight indexed swap rate roughly reflects the federal funds rate. It includes minimal credit risk.
If the subsidiary has a net asset exposure and the local currency is appreciating, what will happen to the parent's financial statements? Why?
The parent will recognize a gain in the income statement. The net assets, that is, the subsidiary's equity, is exposed to the changing exchange rate.
Subsidiaries whose operations are well integrated with the parent company will generally use what currency as the functional currency?
The parent's currency, or the reporting currency.
Operating risk (in the context of ESG investing)
The possibility that a firm will be formed to modify an operation, or shut it down altogether, due to impact of ESG factors.
Legal risk (in the context of ESG investing)
The potential for lawsuits resulting from management's failure to adequately address one of the ESG factors.
Sustainable growth rate
The rate at which earnings and dividends can continue to grow indefinitely, assuming that the firm's debt to equity ratio is unchanged
If ex-ante PPP holds, what will happen to the real exchange rate?
The real exchange rate will be constant at its equilibrium level.
What is the factor in a DCF model that has the largest potential forecast error?
The relationship between r and g which can throw off the terminal value estimate
Contrast the use of beginning-of-year and end-of-year values for the residual income model.
The residual income model uses end-of-period earnings, but uses equity charges based on beginning-of-period book value.
Cost of financial distress
The risk of bankruptcy that increases with higher % debt in the capital structure (higher leverage). Both indirect and direct costs contribute to financial distress.
Contrast who assumes the risk in a cash versus a securities offering.
The shareholders of both the target company and the acquirer assume the risk in a securities offering. In a cash offering, only the acquiring corporation assumes the risk.
When prepayments increase (higher PSA), how does the support tranche shelter the PAC tranche?
The support tranche absorbs the excess prepayments over the PAC tranche to smooth its cash flows
When prepayments decrease (lower PSA), how does the support tranche shelter the PAC tranche?
The support tranche gives up some of its principal to the PAC tranche to smooth its cash flows
How is target versus actual capital structure used on the exam?
The target/optimal capital structure in reality is impossible to pinpoint. However, if you're given both the target and actual cap structure on the exam, ALWAYS use the target cap structure.
Describe key points of MM Proposition 2 WITH taxes
The tax shield provided by debt causes the WACC to decline as leverage increases. - the value of the firm is maximized at the point where the WACC is minimized, which is 100% debt - in a graph of cost of capital on the y axis and % debt on the x axis, the WACC line is decreasing as % debt reaches 100%.
What is the rationale behind examining earnings surprises?
The thought that positive surprises may lead to persistent positive abnormal returns.
When a sale of an asset occurs in one period, but the payment is received in another, describe how FX gains/losses are accounted for in the income statement.
The time between the sale and when the payment is actually received is split. One gain/loss is recognized on the income statement for the time between sale and the end of the period. A separate gain/loss is recognized on the income statement for the time between the beginning of the next period and the moment the payment is received.
When the price of a company's stock declines, will the price of the company's convertible bonds increase or decrease? At a faster or slower rate?
The value of the convertible bond will decrease as the stock price declines, but at a slower rate.
Should the intrinsic value derived using the DDM, FCFE, and residual income models be equal?
Theoretically, yes. However, in reality, it is almost impossible to forecast all of the common inputs with the same degree of accuracy.
What is the risk of a white squire defense?
There is a high risk of litigation depending on the details of the transaction, especially if the third party acquires shares directly from the company and the target's shareholders do not receive any compensation.
Uncovered interest rate parity assumes what about investors?
They are risk neutral
What is the advantage of using free cash models to value stocks?
They can be applied to many firms regardless of dividend policies or capital structures.
How can real options help or hurt the NPV estimate of a project?
They can only help - they cannot hurt.
Discuss the motivations of acquiring companies to acquire a company to hide pre-acquisition accounting irregularities.
They may acquire targets with dissimilar operations or with less publicly available information to reduce the comparability and consistency of their own financial statements.
Pecking order theory
This theory assumes that managers are lazy. They will choose the financing option that is easiest for them - the financing option that is most readily available. Therefore, you can sense the health of a company through the way management chooses to finance a company.
In general, what is a company's appropriate share valuation model in the initial growth, transition, and maturity stages?
Three stage DDM, two stage DDM, Gordon growth model, respectively
How does cash flow differ over the term of the lease between direct financing and operating leases?
Total cash flow is the same. Operating lease - CFO is higher Direct financing lease - the lease payment is split between CFO (interest) and CFI (principal), so CFO is lower, and CFI is higher.
Contrast total periodic pension cost between GAAP and IFRS
Total periodic pension cost is the same under IFRS and GAAP, but they differ on how much goes to the income statement and how much goes to other comprehensive income.
What is more common to use - trailing or forward cash flows in valuation multiples?
Trailing
How should you consider a subsidiary's capital structure versus a parent's capital structure?
Treat them the same, unless otherwise noted.
Intrinsic value
True value. Intrinsic value is theoretically calculated by someone who has complete understanding of the characteristics of the asset or issuing firm.
With a USD/EUR exchange rate, which one is the base currency and which is the price currency?
USD - price currency EUR - base currency
Corridor approach
Under GAAP only, once the beginning balance of actuarial gains and losses exceeds 10% of the greater of beginning PBO or plan assets, amortization is required. The excess amount over the 10% "corridor" is amortized as a component of periodic pension cost in the income statement over the remaining service life of the employees.
Is adjusting nonmonetary assets and liabilities allowed?
Under GAAP, it is not; that's why you must use the temporal method. Under IFRS, it is allowed. Neither GAAP nor IFRS allows monetary assets and liabilities to be adjusted for inflation.
Under what conditions are revaluations permitted?
Under GAAP, most long-lived assets are reported on the balance sheet at depreciated cost. Revaluing assets upward to fair value is generally prohibited, except for with long-lived held-for-sale assets. Under IFRS, long-lived assets can be reported at either depreciated cost or at fair value. For the assets reported at fair value, the firm is allowed to recognize revaluations.
Describe the net interest expense (income) component of periodic pension costs in the context of GAAP vs. IFRS.
Under GAAP, net interest expense is broken down into two separate components: interest cost and expected return on plan assets. However, IFRS combines these two figures. IFRS is able to do this because it requires that the expected rate of return on plan assets equal the discount rate.
What is significant about the change in security classification of fair value through other comprehensive income in IFRS 9 standards?
Under IFRS 9, only equity securities can recognize unrealized gains or losses in OCI. Previously, a company could recognize gains or losses on debt securities in OCI.
Are actuarial gains and losses amortized?
Under IFRS, actuarial gains and losses are not amortized. Under GAAP, they are amortized using the corridor approach.
Under what conditions are loss recoveries permitted?
Under IFRS, loss recoveries are permitted. Under GAAP, loss recoveries are permitted for held-for-sale assets only.
Describe how expected return on plan assets differs between IFRS and GAAP.
Under IFRS, the expected rate of return on plan assets equals the discount rate. Therefore, the expected return on plan assets is equal to net income expense (or income).
Describe the flexibility companies have in amortizing actuarial gains and losses over time under IFRS and GAAP.
Under both IFRS and GAAP, companies can choose to amortize actuarial gains and losses more quickly than implied by the corridor method. However, the application must be consistent for both gains and losses.
What is the equivalent of CTA under the temporal method?
Under the temporal method, no CTA is reported in shareholders' equity. Instead, the remeasurement gain or loss is recognized in the income statement.
What is the difference between the current and temporal methods in terms of exposure to exchange rates?
Under the temporal method, the nonmonetary assets and liabilities are remeasured at historical rates. Thus, only the monetary assets and liabilities are exposed to changing exchange rates.
A lower EV/EBITDA ratio relative to peer firms suggests that the firm is ________
Undervalued
Contrast total invested capital and enterprise value
Unlike EV, TIC includes cash and short-term investments
________ the bid
Up
When valuing a noncontrolling interest in a private company using a comparable company's value that is based on a controlling interest, how do you adjust for that controlling interest?
Use the DLOC reduce the calculated value
What depreciation method should you use for capital budgeting?
Use the same method that is used for tax reporting. This is because capital budgeting analysis is based on after tax cash flows, not on accounting income.
How do you find the effective tax rate for a corporation that has taxable income in several countries?
Use the weighted average of the effective rates in each country, with the weights being equal to the proportion of taxable income from each country
How should you calculate ROE on the exam - using beginning shareholders equity or average shareholders equity?
Use whichever is provided on the exam, although technically it should be beginning shareholders equity.
Temporal method of translation
Used when the local currency is different than the functional and the presentation currencies. Aka remeasurement
Current rate method of translation
Used when the local currency is the same as the functional currency, but different from the presentation currency. Aka translation
How is carry measured?
Using NAV
A firm can reduce supplier power by
Using standardized parts that can be sourced from many vendors, or by outsourcing labor to cheaper markets
Is diversification a sound reason for M&A activity?
Usually not. Shareholders can diversify on their own on the portfolio level.
Which method results in more volatile net income, the current or temporal rate method, and why?
Usually the temporal rate method, because remeasurement gain or loss is recognized in net income rather than shareholders' equity.
When is a poison pill triggered?
Usually when a shareholder's equity stake exceeds some threshold level, ex. 10%.
Describe the relationship between currents account and capital accounts
Usually, a current account deficit (lots of imports) goes along with capital account surplus (lots of FDI)
Venture capital firms usually emphasize what characteristic in their portfolio companies versus private equity firms?
VC firms emphasize revenue growth, whereas private equity firms emphasize EBIT or EBITDA growth (and stability of the growth).
How are venture capital portfolio companies different from companies acquired through buyout?
VC portfolio companies are immature and risky; they require a lot of funding and often have limited access to financing (especially debt).
In general, what is a company's level of earnings growth in the initial growth, transition, and maturity stages?
Very high, above average but falling, and stable at long run level, respectively
Describe the level of power that buyers have with large retailers.
Virtually no power. The percent of sales of wal mart to even its largest customer is tiny.
The corporate formulation style that results from a more malleable and more predictable industry
Visionary
What discount rate should be used when calculating firm value?
WACC (then you subtract g)
Give an example of when a two-stage DDM model would apply
When a company has a patent that will expire.
When is the sum-of-the-parts valuation model used most often?
When a company has multiple divisions with different business models
Shifting interest mechanism - define it and discuss the thought process behind it.
When an MBS defaults, losses are often spread over tranches. The subordinated tranche assumes losses up to its value. If losses exceed the subordinated tranche's value, the senior tranche assumes losses. If there is a very large loss, the senior tranche may lose more than the subordinated tranche - it can lose an unlimited amount. The shifting interest mechanism controls for this by redirecting payments to the subordinated tranches for a period of time until the credit enhancement of the senior tranche is restored.
What is the connection between comprehensive income and net income?
When clean surplus accounting holds, comprehensive income = net income
How specifically does a conflict of interest arise between directors and shareholders?
When directors align more with management rather than with the interests of shareholders.
When should a company use the survival style approach to corporate strategy planning?
When it faces severe restrictions on its access to capital or other important resources
In what situations are market regulations needed?
When markets cannot provide efficient solutions for all problems. - informational frictions - externalities
What is the relationship between net income and CFO that usually suggests earnings manipulation?
When net income is positive and CFO is negative.
Externalities
When people share public goods, such as a park or national defense, it's free but they do not necessarily consume it in equal proportions. Externalities arise from these situations, and regulations are necessary to ensure that enough of the public good is produced to avoid externalities.
When the clean surplus relation is violated, what happens on the balance sheet versus the income statement?
When the clean surplus relation is violated, it basically means that there was a change in an item on the balance sheet that was not matched on the income statement.
At what point is the announcement made of a friendly merger?
When the definitive merger agreement is signed.
In what situation would a firm not increase its prices when other firms increase their prices in a response to higher costs?
When the firm wants to gain market share over the other firms
Contrast what happens when a corporate bond issuer defaults versus when one of the constituents in the collateral pool of an ABS defaults.
When the issuer defaults on a corporate bond, the cash flows cease and there is a terminal cash flow based on the recovery rate. When one of the constituents of an ABS defaults, the ABS itself does not default; rather, the ABS distributes whatever CF was received during the period to the holders of different ABS tranche securities per the pre-specified distribution waterfall.
predicted P/E
When you estimate P/E using a linear regression of historical P/Es against fundamental variables such as expected growth and risk.
What is the difference between valuing an FX contract before versus after contract initiation?
Whenever you're asked to value a contract after initiation, think of it as unwinding the position, and treat it as an opposing contract. Ex. given an AUD/CAD exchange rate, if you are long CAD, go down the quote. However, if you are asked to find mark-to-market value of the quote after initiation, you would sell CAD, so go up the quote.
Describe how an H-model works
While a two stage DDM assumes the growth rate changes immediately, the H-model assumes the growth rate declines linearly over the high growth stage until it reaches the long run average growth rate.
What types of banks frequently use the swap curve to value their assets and liabilities?
Wholesale banks
Will a larger size (volume) FX transaction lead to a wider or narrower bid-ask spread?
Wider, because the larger trade demands more liquidity.
In a hyperinflationary environment, what are the effects of using the current versus temporal rate methods? Why?
With high inflation in the parent's currency, the local currency should be depreciating (PPP). This affects all assets and liabilities, including those that are non-monetary. Because the temporal method only measures effects of currency changes on monetary assets and liabilities (it only uses historic rates on measurements of assets and liabilities), the temporal method is the least distorted. Under the current rate method, asset and liability values will be smaller because of rapid depreciation.
How do you report the multiple of debt used in a private equity versus public equity firms?
With public equity managers, debt is quoted as a multiple of equity. With private equity managers, debt is quoted as a multiple of EBITDA.
Real options
Without options, we assume one set of inputs at the beginning of the project. Options allow you to adjust these inputs in the future.
Contrast working capital versus fixed capital investment
Working capital - short term. Applicable over one cycle. Fixed capital - longer term. Multiple cycles.
Do the cash flow characteristics of an ABS differ from the cash flow characteristics of a corporate bond?
Yah, duh.
Can the GGM be used to value market indices?
Yes
If a firm issued new equity, would the sustainable growth rate be affected?
Yes
Are natural resources necessary for economic growth?
Yes, but ownership of natural resources is not necessary. As long as nations can acquire natural resources through trade, they can experience substantial growth.
Can you use both the structural and the reduced form models of corporate credit risk to analyze ABS?
Yes, but the valuation must account for the distribution waterfall.
If the dealer quote falls outside of the calculated cross rates, is arbitrage possible?
Yes, it may be possible.
Can the balance sheet method and the cash flow statement method of calculating the accruals ratio produce different results?
Yes, results can differ, although the results conceptually would be the same
Will the value of a private firm differ if the acquirer is buying the whole company versus buying just a portion?
Yes, the value can vary, because it can be controlling or noncontrolling interest. Work this into cash flow estimates? (don't really understand this)
Can you have a gain under the current rate method but a loss under the temporal rate method?
Yes, when a company has a net monetary liability exposure but a net asset exposure.
Can you have a positive salvage value but depreciate it fully to 0?
Yes.
Should you include opportunity costs in capital budgeting analysis?
Yes.
Will the backward induction method and the pathwise valuation method result in the same value of a bond?
Yes.
When calculating NOPAT, should you add back R&D?
Yes. Do not add back to net income, though.
Should you include externalities, like cannibalism, in capital budgeting analysis?
Yes. Subtract the lost sales of the existing product from the expected sales of the new product.
Will a given firm's high degree of operating/financial leverage have an effect on other market participants' prices that they charge?
Yes; other market participants will price cut in order to defend their market share and attempt to cover fixed costs
What type of loan-level call protection is designed to make lenders indifferent to prepayment?
Yield maintenance charges
What is the unique change to the equation for calculating FCFF from EBITDA?
You add back the noncash charges (depreciation) times the tax, rather than just noncash changes. This is because we capture the tax benefit from deducting the depreciation.
Describe how to use historical estimates to estimate the equity risk premium.
You can estimate the equity risk premium as the difference between the historical mean return of a equity index over the historical mean return of a risk-free rate over a given time period.
When valuing a bond with a call option using the binomial tree model, what discounted cash flow values do you use?
You chose the minimum of the discounted value and the par value for each node. So, if you discounted one term back to 99.8 and one to 100.3, and par is 100, use 99.8 and 100.
What are the two options for determining fixed capital investment?
You will need to calculate it using either gross PP&E or net PP&E, whichever is given.
If a firm has no additional opportunities to earn returns past the required rate of return, what is the firm's growth rate?
Zero
What is unique about a zero coupon bond in terms of risk?
Zero coupon bonds have no reinvestment risk
Maturity matching
a bond investing strategy wherein the investor purchases bonds that have a maturity equal to the investor's investment horizon. This is considered the most straightforward strategy.
Riding the yield curve
a bond investing strategy wherein the investor will purchase bonds with maturities longer than his investment horizon. As time passes and maturity shortens, the bond's cash flows will be discounted at successively lower yields, and therefore have successively higher prices. This assumes an upward sloping yield curve.
Sole proprietorship
a business owned and operated by a single individual. - since there is no distinction between the business and its owner, the liability on the owner is potentially unlimited
What is the thought process behind the cost approach to valuing real estate?
a buyer is unlikely to pay more for a property than it would cost to purchase land and build a comparable building.
Owning equity is the economic equivalent of owning
a call option on the firm's assets with a strike price equal to the face value of the firm's debt.
What does a change in the forward price suggest about spot rates?
a change in the forward price indicates that the future spot rates did not conform to the forward curve (if they had, the spot and forward rates would have been equal and the curves been identical)
True-up
a clawback that is settled annually
Divestitures
a company selling, liquidating, or spinning off a division or subsidiary
Term sheet
a contract between a private equity firm and its portfolio company that specifies the terms of the investment
Forward premium
a currency is at a forward premium if the forward price is greater than the spot price. Ex. 1.20 USD/EUR spot, 1.25 USD/EUR forward. The Euro is trading at a forward premium
Capped floater
a floater that contains an issuer option that prevents the coupon rate from rising above a maximum rate (cap)
Mezzanine financing
a hybrid between debt and equity and can be structured to suit each particular transaction
An investment in the equity or residual tranche of a CDO can be viewed as
a leveraged investment where borrowed funds (raised from selling the senior and mezzanine tranches) are used to purchase the debt securities in the CDO's collateral pool.
Fully amortizing loan
a loan for which each payment includes both an interest payment and a repayment of some of the loan principal so there is no principal remaining after the last regular mortgage payment.
Partially amortizing loan
a loan for which payments each have a component of principal repayment, but there is a lump sum of principal that remains to be paid at the end of the loan period
Internal rate of return for publicly traded securities
a market determined rate that equates the value of the discounted cash flows to the current price of the security
HHI Index
a measure of market concentration that is used to determine the potential for antitrust violations.
Shifting interest mechanism
a method for addressing a decrease in the level of credit protection provided by junior tranches as prepayments or defaults occur in a senior/subordinated structure. See notes.
Convertible mortgage
a mortgage for which the initial interest rate terms, fixed or adjustable, can be changed at the option of the borrower, to adjustable or fixed, for the remaining loan period.
Fama French model of estimating required return on equity
a multi factor model that is associated with the returns of small cap stocks
What qualifies as a business segment?
a portion of a larger company that accounts for more than 10% of revenues or assets and is distinguishable from the company's other lines of business in terms of risk and return characteristics.
Deal-by-deal distribution waterfall
a private equity fund provision wherein carry can be distributed after each individual deal
Organic growth
a product of internal investment, not from M&A activity
Bargain purchase option
a provision of a lease that permits the lessee to purchase the leased asset for a price that is significantly lower than the fair market value of the asset at some future date
Stability in credit ratings comes from
a reduction in correlation with default probability, which therefore reduces the accuracy of the credit rating. This is a weakness of credit ratings.
Transaction-based indices can be constructed using what two types of indices?
a repeat-sales index and a hedonic index
Defined contribution plan
a retirement plan in which the firm contributes a percentage of the employee's salary towards their retirement account for each year that he or she works. The employer is NOT promising any retirement benefits.
According to the structural model, owning risky debt with a face value of K is equivalent to owning (important):
a risk free bond with the same face value of K and writing a European put option on the assets of the company with a strike price of K
Senior/subordinated structure
a security that contains at least two tranches
What type of planning style does a shaping style business require?
a short term or continuous planning cycle with a high degree of flexibility
Discuss the approaches to estimating PP&E
a simple method: assume it will be equal to its historical average proportion of sales so that PP&E will grow at the same rate as revenue a more complex method: separate by "CapEx for maintenance" and "CapEx for growth"
Collateralized debt obligation (CDO)
a structured security issued by an SPV for which the collateral is a pool of debt obligations
A deferred tax asset arises from
a tax loss carryforward
Planned amortization class (PAC) tranche
a tranche that is structured to make predictable payments regardless of actual prepayments to the underlying MBS.
Prepayment penalty points
a type of loan-level call protection on a CMBS wherein a penalty fee expressed in percentage points is charged to borrowers who prepay mortgage principal. Each point is 1% of the principal amount prepaid.
Yield maintenance charges
a type of loan-level call protection on a CMBS wherein the bondholder is charged the amount of interest lost by the lender should the loan be repaid.
Prepayment lockout
a type of loan-level call protection on a CMBS which prohibits the borrower from prepaying the mortgage loan for a specific period of time (usually 2-5 years)
Defeasance
a type of loan-level call protection on a CMBS. If the borrower of an underlying mortgage in a CMBS insists upon repaying principal, the prepayments are invested in government bonds rather than returning the money to investors.
White knight defense
a white knight is a third party that comes to the rescue of the target company after a hostile takeover offer. The target will usually seek out a third party with a good strategic fit with the target that can justify a higher price than the hostile acquirer.
Non-discretionary accruals
accruals that occur as part of normal business
Discretionary accruals
accruals that result from non-normal transactions or accounting choices, and are sometimes used to manipulate earnings.
Appraisal-based indices tend to lag transaction-based indices because
actual transactions occur before appraisals are performed (appraisals are based on transaction data).
Under the current portion of long term debt adjustment for net borrowing, how does an increase in short term debt affect FCF?
add it to FCFE. No affect on FCFF.
Under the long term debt adjustment for net borrowing, how does an increase in long term debt affect FCF?
add it to FCFE. No affect on FCFF.
Under the notes payable adjustment for net borrowing, how does an increase in notes payable affect FCF?
add it to FCFE. No affect on FCFF.
How should you adjust for LIFO inventory accounting to try and comply with the clean surplus relation?
add the LIFO reserve to the LIFO inventory balance. This will change it to a FIFO inventory balance, which is more representative of current costs.
How should you adjust for off-balance-sheet items to try and comply with the clean surplus relation?
add them back to the balance sheet
How should an analyst account for discretionary vs. personal expenses when calculating normalized earnings?
add them both back to earnings if they are not part of the firm's normal business activities
Dilution costs of a private equity fund
additional rounds of financing and stock options issued to both management and the private equity firm will result in dilution
Pastor-Stambaugh Model
adds a liquidity factor to the Fama-French model
Bond-yield plus risk premium method
adds a risk premium to the yield to maturity of the company's long term debt. Use if the company has publicly traded debt.
Crown jewel defense
after a hostile takeover offer, a target may decide to sell a subsidiary or major asset to a neutral third party. If the hostile acquirer views this asset as essential, then it may abandon the takeover attempt.
Leveraged recapitalization
after a hostile takeover offer, the target assumes a large amount of debt that is used to finance share repurchases. The effect is to create a significant change in capital structure that makes the target less attractive while delivering value to shareholders.
Pac-man defense
after a hostile takeover offer, the target can defend itself by making a counteroffer to acquire the acquirer. In practice, it is rarely used because it means a smaller company would have to acquire a larger company.
Share repurchase
after a hostile takeover offer, the target can submit a tender offer for its own shares. This forces the acquirer to raise its bid in order to stay competitive with the target's offer and also increases the use of leverage in the target's capital structure.
Litigation
after a hostile takeover offer, the target files a lawsuit against the acquirer that will require expensive and time-consuming legal efforts to fight.
Greenmail
after a hostile takeover offer, the target pays off the potential acquirer to terminate the hostile takeover attempt. It allows the target to repurchase its shares from the acquirer at a premium to the market price.
Under the equity method, where in the income statement is income from associates reported?
after operating income, because the investor does not have control of the associate - only influence.
Mortgage passthrough securities
agency and non-agency RMBS. They are securities that represent a claim on the cash flows of a pool of other mortgages.
Channel stuffing
aggressively selling products to distributors on generous terms
The cost at which inventory is reported on the balance sheet is defined as
all costs of bringing inventory to its current location and condition.
The law of one price
all goods should have the same price in all locations (after adjusting for the exchange rate).
Rights theories
all individuals have fundamental rights and privileges. - the greatest good to result from Utilitarianism must not come in violation of these fundamental rights of others. - managers must have a moral compass. Even if sweatshop labor is legal, it may violate fundamental rights and be unethical.
Sequential pay CMO
all principal payments (both scheduled and prepayments) are paid to the highest tranche (the short tranche) until its principal is paid off. Then, principal payments flow to the next tranche down.
The liability of the GP is
all the firm's debts and, thus, has unlimited liability
Timing options
allow a company to delay making an investment
Expansion options
allow a company to make additional investments in a project if doing so creates value
Abandonment options
allow management to abandon a project in the PV of the incremental CFs from exiting a project exceeds the PV of the incremental CFs from continuing a project
Extendible bond
allows the investor to extend the maturity of the bondd
Realized gains and losses are recognized on the income statement for what types of securities?
always recognized on the income statement for all types of securities.
How is the unrealized gain or loss treated for a reclassification from available-for-sale to held-to-maturity?
amortize out of other comprehensive income over the remaining life of the security
Asset-based models
an absolute valuation approach that estimates a firm's value as the sum of the market value for the assets it owns
What is the rationale for subtracting cash and investments from enterprise value?
an acquirer's net price paid for an acquisition target would be lowered by the amount of the target's liquid assets
An example of the classical style approach to corporate strategy is
an analysis based on Porter's five forces
Conditional prepayment rate (CPR)
an annualized version of the single monthly mortality rate
Ratchet
an economic term of a private equity fund that specifies the allocation of equity between stockholders and management of the portfolio company and allows management to increase their allocation, depending on company performance
Joint venture
an entity whereby control is shared by two or more investors
A convertible bond is equivalent to
an equity call option held by the bondholder
normalized (or normal) EPS
an estimate of EPS in the middle of the business cycle
An increase in raw materials and/or work-in-progress inventory may be an indication of
an expected increase in demand
What is an equivalent version of a two-year 3% bond extendible for an additional year using a put option?
an identical three-year bond that is putable in two years.
Private equity portfolio companies should see what characteristics at the end of the investment?
an increase in price multiples, an increased ability to pay down debt, and a growth in earnings.
FX carry trade
an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency.
Best practices guidelines dictate corporations must evaluate the board of directors with what frequency?
annual
Best practices guidelines dictate corporations must hold board elections with what frequency?
annual
Best practices guidelines dictate boards of directors must meet without management present with what frequency?
annually
Term structure of interest rates
another phrase for the shape of the yield curve
What are two common grounds on which a target can attach the acquirer in a litigation defense?
anti-trust violations or securities law violations
Tag-along, drag-along clause
anytime an acquirer acquires control of the investment company, they must extend the acquisition offer to all shareholders, including firm management
What type of indices, appraisal-based or transaction-based, appear to have lower correlations with other asset classes?
appraisal-based
What type of index is the NCREIF?
appraisal-based index, value weighted
If the real exchange rate increases, what happens to the base currency?
appreciation
Principal agent relationship (PAR)
arises when one group (principal) delegates decision-making or control to another group (agent)
When there are extreme outliers in a calculation of the mean P/E of a portfolio, what type of mean calculation will be the most affected?
arithmetic mean
How do you perform step 3: estimation of SG&A?
as either fixed, growing with revenue, or some other estimation technique
As of when is the post-money value calculated?
as of the time of each new investment in the company
Down the quote, use the
ask
Out of all the methods of private company valuation, what normally results in the lowest value?
asset-based approach
For what types of investments is the equity method used?
associates and joint ventures
Financial transaction
assumes no synergies, often when one firm buys another in a dissimilar industry.
Real interest rate parity
assumes real interest rates converge across different markets. This is because with free capital flows, funds will move to the country with a higher real interest rate until they are equalized.
Should you discount capped or floored floaters at the discount rate or coupon rate?
at the true discount rate!
Define commercial MBS and list examples of types of properties that back CMBS.
backed by income-producing real estate: - apartments (multi-family) - warehouses - shopping centers - office buildings - health care facilities - senior housing - hotel/resort properties
How do you perform step 7: modeling the balance sheet?
base your balance sheet model on items that flow from the income statement, namely working capital accounts (accounts receivable, accounts payable, and inventory)
How do you perform step 2: estimation of COGS?
based on a percentage of sales, or on a more detailed method based on business strategy or competitive environment
Bootstrapping
basically the idea that if you have the first two interest rates you can find the third, if you know the first three you can find the fourth, etc.
Best practices guidelines dictate board members must
be knowledgeable and experienced and serve only two or three boards
Why are earnings predictable for REITs?
because REITs' rental income is fixed by contracts
Why are REITs able to avoid most taxation?
because a major part of REIT distributions are treated as a return of capital and are thus not taxable.
Sunset clause
because costs of regulations are often difficult to measure and assess before implementation, a sunset clause requires regulators to re-evaluate the regulation before it is renewed.
Why is it only appropriate to use macroeconomic models to estimate the equity risk premium in developed countries?
because in developing countries, there is sometimes not a relationship between macroeconomic variables and asset prices
Why is AFFO considered a better measure of FFO?
because it considers the CapEx that are required to sustain the property's economic income
Why do investors require higher rates of return on management-intensive properties?
because of higher operational risk
Unquoted investments risk of a private equity fund
because private equity investments do not have a publicly quoted price, they may be riskier than publicly traded securities
Why does financial leverage magnify the effect of changing NOI on cash flow?
because the interest expense owed to lenders is a fixed cost
Why is the total expense for a lease the same for a finance and an operating lease?
because the sum of depreciation expense and interest expense is equal to the total of the lease payments.
In private equity firms, why are managers able to focus more on long-term performance?
because, unlike public companies, private companies do not face the scrutiny of analysts, shareholders, and the broader market
NOI is calculated _______ (before/after) subtracting financing costs and income taxes.
before
Low switching costs and readily available substitutes benefit _________ by giving them ________.
benefit buyers by giving them bargaining leverage.
Up the quote, use the
bid (offer)
Far out of the money convertible bonds trade like
bonds, and can be considered a fixed income equivalent
Does residual income explicit deduct capital costs of equity, debt, or both?
both
Who assumes the risk and potential reward in a stock offer, the acquirer or the target?
both the acquirer and the target assume some risk and potential reward.
If an acquirer makes a stock offer in a deal, but the synergies realized are greater than expected, what would happen to the takeover premium for the acquirer and the target?
both the acquirer and the target would benefit from the upside.
Pure ratio
both the numerator and denominator come from the same financial statement - either the income statement or the balance sheet. Using the current rate method, pure ratios will be the same after translation.
If cash operating expenses increase by $100 and there is a 40% tax rate, what is the effect on FCFF and FCFE?
both will decrease by $60
If depreciation increases by $100 and there is a 40% tax rate, what is the effect on FCFF and FCFE?
both will increase by $40 (due to the tax shield)
The sales comparison approach is susceptible to
bubbles
Utilitarianism
businesses must - weigh the consequences to society of each of their actions - seek to produce the highest good for the largest number of people.
For the base currency, you ______ at the ask price and _______ at the bid price.
buy at the ask price, sell at the bid price
A trader expecting lower future spot rates would _________ (buy/sell) a forward contract
buy, because if future spot rates are lower, forward prices will rise, and the trader would profit from the appreciation
How is the prepayment risk of the PAC tranches reduced?
by increasing the prepayment risk of the CMO's support tranches
Present value (discounted) model
calculates today's value of all future cash flows
Prepayment risk can be considered similar to
call risk in a callable bond
If interest rates decrease, does a bond issuer want a callable or putable bond?
callable bond
What is the benefit of "designating at fair value" securities that could otherwise be classified as available-for-sale or held-to-maturity?
can reduce volatility and inconsistencies that result from measuring assets and liabilities using different valuation bases
Total return distribution waterfall
carry is calculated on the entire portfolio
Using the equity method, an asset is impaired if
carrying value > fair value
Cash reserve funds as an internal credit enhancement
cash deposits that come from issuance proceeds of non-agency RMBS
Post-leverage cash flow
cash flow AFTER net borrowance. Net borrowance is the new bonds issued minus the new bonds purchased by a firm.
What is the important assumption of the binomial valuation process?
cash flows at any node do not depend on the path rates took to get to that node.
Cash tax rate
cash taxes paid as a percentage of pretax income
What are ordinal rankings of credit quality and what is their disadvantage?
categorize borrowers from highest to lowest risk but do not communicate the degree to which the credit risk differs amount ranks
Ordinal credit rating
categorize borrowers from highest to lowest risk, but do not communicate the degree to which the credit risk differs among ranks. (i.e. the credit risk of an individual with a credit score of 900 is not equal to half the credit risk of an individual with a credit score of 450)
What are the effects of reclassifying expenses as non-operating?
causes analysts to treat recurring expenses as one-time costs.
Relative PPP
changes in exchange rates should exactly offset the price effects of any inflation difference between two countries. Ex. if country A has a 6% inflation rate and country B has a 4% inflation rate, country A's currency should depreciate by 2%
Shaping risk
changes in portfolio value due to changes in the shape of the benchmark yield curve
What types of balance sheet changes should you ignore when calculating cash flows?
changes in shareholders' equity, or changes in any other accounts between the firm and equityholders
You cannot use the residual income model when the ________ is violated significantly.
clean surplus relation
Are most private equity LP fund structures open or closed end?
closed end
International Fischer equation
combines the Fischer equation and real interest rate parity. The difference between two countries' nominal interest rates should be equal to the difference between their expected inflation rates.
Describe the idea on which the insurance perspective is based.
commodity producers use commodity futures to mitigate the price risk of commodities that they produce. These producers (hedgers) must offer an insurance premium (risk premium) in order to entice speculators into taking the opposite side of the trade.
momentum indicators
compare a stock's price or a company's earnings to their values in earlier periods
Golden parachutes
compensation agreements between the target and its senior management that give the managers lucrative cash payouts if they leave the target company after a merger. In practice, golden parachutes are not large enough to prevent a large merger, but they do ease managers' fears of losing their jobs.
Partnerships
composed of two or more owners/managers, but otherwise similar to a sole proprietorship in that there is no legal distinction between the business and its owners. Liability is unlimited, but is shared among the partners.
Survey estimates
consensus of the opinions for a sample of people
The Cobb-Douglass function exhibits what type of returns to scale?
constant
Differences between spot prices and futures prices are driven by
convenience yield and storage costs
Conditional convergence
convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions. - the growth rate will be higher for developing countries until they catch up.
In a business combination, how is the equity method and acquisition method similar in terms of balance sheet transformation?
convert the book value to fair value ?
If the ex-ante version of relative PPP holds, what will happen to countries with high versus low relative inflation?
countries with high relative inflation would see their currencies depreciate relative to countries with low relative inflation
When analyzing the credit risk of ABS, you should view them as:
credit derivatives, rather than as ordinary bonds
Inflation gap =
current inflation - target inflation
The price of nonrenewable commodities is most affected by
current investor demand
Output gap =
current output - target output
Implied volatility
current volatility implied by prices of options on equities or currencies
Held-for-trading
debt and equity securities acquired for the purposes of profiting in the near term, usually less than three months
Available-for-sale
debt and equity securities that are neither held-to-maturity or held-for-trading.
Held-to-maturity secutiries
debt securities acquired with the intent and ability to be held until maturity. They cannot be sold prior except in unusual circumstances.
How do you define the current portion of long term debt?
debt that is maturing within one year.
Finished goods inventory that is growing faster than sales may be an indication of
declining demand and/or obsolete inventory
A PSA higher than the benchmark will ________ (increase/decrease) the average life of an MBS.
decrease
An increase in working capital investment results in a __________ of free cash flow
decrease
Decreases in accrued taxes and expenses result in a(n) ________ of free cash flow
decrease
Increases in accounts receivable result in a(n) ___________ of free cash flow
decrease
Product differences _________ rivalry between companies
decrease
The more the seller seeks high volume, the harder they will work to maintain this volume and therefore their bargaining power will _________
decrease
When interest rates decrease, a callable bond's effective duration will _________
decrease
A greater pool of buyers would have what affect on the DLOM?
decrease the DLOM
An impending IPO or firm sale will have what affect on the DLOM?
decrease the DLOM
Earlier and higher payments (i.e. shorter duration) would have what affect on the DLOM?
decrease the DLOM
The payment of dividends would have what affect on the DLOM?
decrease the DLOM
An increase in the interest burden suggests that the impact of interest charges on operating earnings has _________
decreased
An increase in the tax burden suggests that the effective tax rate has __________
decreased
As market interest rates move below the coupon rate, the likelihood of a putable bond being put ________
decreases
As market interest rates move below the coupon rate, the time to exercise rate on a putable bond ________ in dominance over the time to maturity rate.
decreases
As volatility increases, OAS _______ (increases/decreases).
decreases
Dividend yield will increase if the forecasted growth rate of dividends ________
decreases
EV/EBITDA will increase if the firm's overall risk level and WACC _________
decreases
P/CF will increase if required return _________
decreases
An increase in finished goods inventory while raw materials inventory is decreasing may be an indication of
decreasing demand
Capital outflow means
depreciation
The value of PP&E on the balance sheet is determined by
depreciation and CapEx
Relative value models
determine the value of an asset in relation to the values of other assets. Examples include P/E and P/B ratio comparisons with other firms.
Do the securitized mortgages in a pool of mortgages have the same or different maturities and mortgage rates?
different maturities and different mortgage rates, typically
Capital deepening exhibits what type of returns to scale?
diminishing
Labor productivity (output per worker) exhibits what type of returns to scale?
diminishing, unless both K and L increase at the same rate
What is the primary advantage of dividend discount models?
dividends are less volatile than other measures (such as earnings or FCF), and therefore the estimates are less volatile and reflect the long-term earning potential of the company
Do caps and floors cap coupon rates or dollar values?
dollar values only!
One-sided durations
durations that apply only when interest rates rise (or, only when rates fall)
Under what conditions does an FX carry trade perform well?
during periods of low volatility. It is only profitable if uncovered interest rate parity does not hold over the investment horizon
What is the largest threat to increasing the availability of substitutes for the retail industry?
eCommerce
Farmland and timberland are unique categories of real estate investments because
each can produce a saleable commodity as well as have the potential for capital appreciation
High quality earnings
earnings are high quality only if they are backed by cash. Ex. the associate might reinvest some of its earnings rather than distribute as dividends. The investor records its proportion of the associate's earnings as profit, but the cash isn't actually there; it remains with the associate company.
For buyouts, what are the drivers of returns?
earnings growth, the increase in multiple upon exit, and the reduction in debt
What is the primary determinant of investment value?
earnings power, as measured by earnings per share
What are common momentum indicators?
earnings surprise, standardized unexpected earnings, relative strength
The most important terms of a private equity fund can be characterized into two components:
economic terms and corporate governance terms
The effects of increasing a product's price on a company's revenues and sales volume depend on the product's
elasticity of demand
Examples of nonstorable commodities
energy and livestock
Restricted voting rights
equity ownership above some threshold level, such as 15%, triggers a loss of voting rights unless approved by the board
Commodity investments have historically had returns similar to
equity returns, but with lower volatility
Dividend discount models
estimate the value of a share based on the present value of all expected dividends discounted at the opportunity cost of capital (the cost of putting your capital elsewhere)
Absolute valuation models
estimates an asset's intrinsic value without regard to the value of other firms. Examples include present value models, asset-based models or dividend discount models.
Altman Model
estimates the probability of default of a company. A higher z-score signals less likelihood of bankruptcy
Beneish Model
estimates the probability of earnings manipulation. Any M-score above -1.78 (less negative) suggests a higher-than-acceptable probability of earnings manipulation. Values greater than 1 for each variable are a warning sign. The goal is to get the variables as small as possible.
How often do TIPS pay interest?
every six months
Should normalized earnings for private companies include or exclude nonrecurring and unusual items?
exclude; so add back to expenses, and subtract gains
Normalized earnings
expected mid-cycle earnings. In other words, the expected earnings when the current (temporary) effects of events or cyclicality are no longer affecting earnings
As the average life of a tranche increases, extension risk ________ (increases/decreases) and contraction risk ________.
extension risk increases and contraction risk decreases
Balloon risk is a source of what type of risk for CMBS investors?
extension risk. Balloon risk is the risk that a commercial mortgage borrower will not be able to repay the principal that is due at the maturity date. If the borrower in fact is not able to, the term of the loan is extended, which increases extension risk.
What is the main difference between depreciation for appraisal purposes and for financial reporting or tax reporting purposes?
financial and tax depreciation involve the allocation of the original cost over time, whereas for appraisal purposes, depreciation represents an actual decline in value
Designated at fair value
financial assets and liabilities that a firm chooses to report at fair value rather than as available-for-sale or held-to-maturity.
Judicial law
findings of the court
What types of firms most often use the asset-based valuation model?
firms that own or control natural resources, such as oil fields, coal deposits, etc
In what situation(s) is the asset-based approach to private company valuation is best used?
for firms that are NOT assumed to be a going concern (not assumed to be around much longer)
What is the disadvantage of a deal-by-deal distribution waterfall?
from the LP's perspective, one deal could earn $10 million and another could lose $10 million, but the GP would still receive carry on the first deal, even though the LPs have not earned an overall positive return
How can you derive a market-based estimate of expected inflation?
from the differences in the yields for T-bonds and TIPS with comparable maturities
Long-term interest rates equal the mean of
future expected short term rates
Describe the path of futures prices over time, and what type of return can be generated by taking advantage of this.
futures prices converge towards spot prices over time. Rolling maturing futures contracts into new futures contracts results in roll return.
Flexibility options
give managers choices regarding the operational aspects of a project. The two main forms are price setting and production flexibility options.
Poison put
gives bondholders the option to demand immediate repayment of their bonds if there is a hostile takeover. This additional cash burden may fend off a would-be acquirer.
Poison pill
gives current shareholders the right to purchase additional shares of stock at attractive prices (discount to current market value), which causes dilution and effectively increases the cost to the potential acquirer. In case of a friendly merger offer, most poison pills give the board of directors the right to redeem the pill prior to a triggering event.
Stock appreciation award (right)
gives the employee the right to receive compensation based on the increase in the price of the firm's stock over a predetermined amount. The firm may pay the appreciation in cash, equity, or a combination of both.
Spot prices of industrial metals like copper are strongly correlated with
global economic development
In a situation of normal backwardation, the speculative investor should
go long commodities futures
Regulators can be either
government agencies or independent regulators
Describe the meaning of free mobility of capital in the global economy in terms of monetary policy and exchange rate management.
governments cannot both manage exchange rates as well as pursue independent monetary policy
SG&A's fixed cost component is generally _______ than its variable cost component.
greater
The greater the participant's commitment to business, the ______ the likelihood of competitive behavior
greater
The more competitors there are, the _________ the potential for rivalry.
greater
The shorter the shelf life of a product, the ________ the potential for price competition
greater
Higher debt-to-service coverage ratio suggests
greater protection of the mortgage lender
Stakeholders
groups with an interest or claim in a company. They can be internal or external to the company, and make differing contributions to the company.
Organic growth in sales
growth excluding the effects of acquisition divestitures and currency effects
What are the three types of commodity futures market participants?
hedgers, speculators, and arbitrageurs
A low LIBOR-OIS spread is a sign of ________ (high/low) market liquidity
high
According to the liquidity preference theory, a bond with a longer maturity will have a ________ (higher/lower) liquidity premium than a short term bond.
higher
Commodities that are more difficult to store will have a ________ (higher/lower) convenience yield.
higher
Companies that are in industries that historically have high residual income persistence will tend to have _______ (higher/lower) persistence factors.
higher
Companies that pay out a relatively low amount of dividends will tend to have ________ (higher/lower) persistence factors.
higher
If principal repayments are more rapid than expected, the support tranche receives _______ (higher/lower) principal repayments.
higher
Property with more incurable items will have a ________ (higher/lower) effective age.
higher
The greater the switching costs, the __________ the supplier power.
higher
Uncertainty about future NOI may result in a ________ (higher/lower) cap rate
higher
A putable bond will have _______ upside potential than a callable bond.
higher (this is always true)
How will an upward revaluation effect depreciation expense and therefore net income?
higher depreciation expense, which will lead to lower net income in periods after revaluation.
Higher potential GDP growth implies
higher real interest rates and higher real asset returns
How does proportionate consolidation affect revenues and expenses?
higher revenues and expenses compared to the equity method, but net income is the same.
A small number of suppliers means _________ supplier concentration, and suggests their relative power _________.
higher supplier concentration, and suggests their relative power increases
How will an upward revaluation effect total assets and shareholders equity?
higher total assets and higher shareholders' equity
Higher priority tranches in a CMBS will have a _______ (higher/lower) credit rating than lower priority tranches.
higher, because loan defaults will first affect the lower tranches
The lower the LTV, the _______ (higher/lower) the borrower's equity in the property, and therefore the _______ (more/less) risky the loan is.
higher, less
According to the structural model, owning a company's equity is equivalent to (important):
holding a European call option on the company's assets
What is a red flag for analysts in terms of the difference between effective and statutory tax rates?
if a company consistently reports an effective tax rate that is less than the statutory rate, or consistently less than that of comparable peer companies
Describe the savings and investment precondition for economic growth
if a country has insufficient savings, it must attract foreign investment in order to grow. - positively correlated with economic development
Clawback
if a fund subsequently underperforms, the GP is required to pay back a portion of the early profits to the LPs; the clawback is usually settled at termination of the fund
Best practices guidelines dictate related-party transactions should only be approved if
if approved by the board of directors, NOT by management.
Under what circumstances should a lease be treated as a finance lease under IFRS?
if substantially all rights and risks of ownership are transferred
When should a property's NOI be stabilized?
if the NOI is not representative of the NOI of similar properties because of a temporary issue
Under IFRS, how is impairment of goodwill recognized?
if the carrying value of the business unit > recoverable amount, recognize difference as impairment
Give an example of how implied volatility estimates from foreign exchange options can give insight into markets expectations of future changes in the value of a currency
if the implied volatility in a call option is higher than the implied volatility in the corresponding put option, the market expects that the currency is more likely to appreciate than depreciate
Under what circumstances will ARY (all risks yield) differ from the discount rate?
if the investor expects growth in rents and value
Broken PAC
if the prepayment rate is outside of the bounds of the initial PAC collar and the payments to a PAC tranche are either sooner or later than promised, the tranche is referred to as a broken PAC tranche.
Why would absolute PPP not hold?
if the weights (consumption patters) of the various goods in the two economies are not the same. Ex. if people eat more potatoes in Russia than in Japan
Describe uncovered interest rate parity in the context of an unbiased predictor
if uncovered interest rate parity (and covered interest rate parity?) holds, the forward rate is an unbiased predictor of expected future spot rates
What is an example of an impairment provision used to shift future expenses into the current period?
impairment losses on long-lived assets recognized in the current period. This will reduce future depreciation expense.
Valuation filter
in a carry trade, if the value of the currency falls below a standard deviation band, the trade will overweight the currency in the trader's portfolio
Volatility filter
in a carry trade, whenever implied volatility increases above a certain threshold, the trade positions are closed (i.e. reversed)
Describe the effects of monetary and fiscal expansion in low capital mobility situations (emerging markets)
in low capital mobility situations, expansionary monetary and fiscal policy have the same effects: - imports increase - interest rates decrease - demand for domestic currency decreases - depreciation
Where is translation gain or loss reported when using the current rate method?
in shareholders' equity as part of the cumulative translation adjustment (CTA)
Where is remeasurement gain or loss recognized when using the temporal method?
in the income statement
Where can you find short term debt in the financial statements?
in the short term working capital component of the balance sheet
Estate put
includes a provision that allows the heirs of an investor to put the bond back to the issuer upon the death of the investor
Effective tax rate
income tax expense as a percentage of pretax income
Increases in accounts payable result in a(n) ________ of free cash flow
increase
The existence of exit barriers will ________ the potential for competition.
increase
When spot rates turn out to be lower than implied by the forward curve, the forward price will ______ (increase/decrease)
increase
If marginal product of capital > marginal cost of capital, you should
increase capital until MPC=MCC
Defeased loans have what effect on the credit quality of a CMBS loan pool?
increase credit quality
Capital deepening
increase in the capital to labor ratio (think more machines per worker)
Contractual restrictions on selling stock will have what affect on the DLOM?
increase the DLOM
Greater risk and value uncertainty will have what affect on the DLOM?
increase the DLOM
As a country's deficit increases, the yield on its sovereign debt
increases
As market interest rates move below the coupon rate, the likelihood of a callable bond being called ________
increases
As market interest rates move below the coupon rate, the time to exercise rate on a callable bond ________ in dominance over the time to maturity rate.
increases
As volatility increases, volatility of a call option ________ (increases/decreases).
increases
As volatility increases, volatility of a put option ________ (increases/decreases).
increases
Dividend yield will increase if the required rate of return ________
increases
EV/EBITDA will increase if the growth rate in FCFF ________
increases
P/CF will increase if the growth rate _________
increases
The level of protection for the senior tranches _______ (increases/decreases) with the percentage of subordinated bonds in the structure.
increases
The value of credit default swaps increase in value as the credit quality of their reference securities _______ (increases/decreases).
increases
EV/EBITDA will increase if the growth rate in EBITDA ________
increases (counterintuitive, but it's true)
What are the effects of reclassifying inventory as other (long-term) assets?
increases inventory turnover ratio. Current ratio will decrease.
As capital flows into a country, demand for that country's currency
increases, resulting in appreciation
Net leases are common in what industry?
industrial leases
Physical capital
infrastructure, computers, telecommunications (ICT), and non-ICT (machinery, transportation, non-residential construction)
Outside bodies
institutions that are not regulators, but their product is referenced by regulators. Ex. FASB and IASB
How is interest treated across different types of securities?
interest paid and received is recognized on the income statement for all types of securities.
If NRV is lower than cost,
inventory is written down to NRV, and a loss is recognized on the income statement. Reversals are allowed under IFRS, up to the value of the original writedown.
What is the relationship between inventory levels and convenience yield?
inverse
Private equity closed end fund
investors can only redeem the investment at specific time periods
Tax preference theory
investors prefer small or no dividend payments because of taxes. - paying capital gains tax in one lump some at the sale of the stock, rather than on smaller dividends over the life of the holding, PV of the taxes is lower. - smaller/no dividends result in higher stock price and lower cost of equity
Dividend preference theory
investors prefer the certainty of a cash dividend, rather than the uncertainty of a stock price increase (bird-in-the-hand is better than two in the bush). Higher dividends lead to lower risk. Lower risk leads to lower cost of equity and therefore higher stock prices.
What is the purpose of a hurdle rate?
it incentivizes the GP
How is the reversion cap rate derived when using the term and reversion approach to property valuation?
it is derived from comparable, fully let properties
Describe how a sales-type lease works from the lessor's perspective.
it is treated as if the lessor sold the asset at fair market value, and loaned the lessee the purchase price.
How is the general public viewed as a stakeholder?
it provides national infrastructure to the firm in exchange for an increased quality of life due to the existence of the firm.
What affect does the harmonic mean method have on smaller weighted P/Es?
it puts more weight on smaller portfolio holdings, so relatively higher weight on less significant P/Es.
If a portfolio company cannot be sold due to weak capital markets, what alternative should the private equity firm consider?
it should consider buying another portfolio company at a depressed price, merge the two companies, and waiting until capital market conditions improve to sell both portfolio companies as one
A firm has net monetary assets if
its monetary assets exceed its monetary liabilities
Human capital
knowledge and skills of individuals
In a competitive industry, will the pricing decisions of firms have a larger or smaller effect on the market shares of all other firms in the industry?
larger
Common examples of partnerships are
law firms, real estate firms, advertising agencies
Statutes
laws made by legislative bodies
How is interest expense calculated for a finance lease?
lease liability at the beginning of the period multiplied by the interest rate implicit in the lease.
Corporations
legal entities that have rights similar to those of an individual person.
Special purpose entity
legal structure created to isolate certain assets and liabilities of the sponsor.
If interest rates increase, the average life of a MBS will ________ (shorten/lengthen)
lengthen
Compared to COGS, SG&A operating expenses are ______ sensitive to changes in sales volume.
less
Putable bonds with high coupon rates are ________ (more/less) likely to be put.
less
Weighted average life of a MBS is always _______ (greater/less) than weighted average maturity because of prepayments.
less
Absolute convergence
less developed countries will achieve equal living standards over time.
Higher loan-to-value ratio suggests
less protection of the mortgage lender
The first tranche to be paid in a CMO has ________ (more/less) extension risk than the other tranches.
less. If borrowers repay mortgages slower than expected, the life of the underlying pool of loans will increase, and extension risk will increase. However, the first tranche will be better off (have less extension risk) because it is paid sooner.
When using a DCF approach to value a REIT, what do you divide each cash flow by?
like a normal DDM, the denominator terms should use r (not the cap rate)
The liability of LPs is
limited to the amount they have invested
Club convergence
living standards in some less developed countries may converge to living standards of developed countries if they are in the same "club," comprised on countries with similar institutional structures. Countries outside of the club will not see convergence.
Recourse loans
loans for which the lender has a claim against the borrower for the amount by which the sale of a repossessed collateral property falls short of the principal outstanding on the loan
Non-recourse loans
loans for which the lender has no claim against assets of the borrower except for the collateral property itself
List the different types of ABS:
loans, leases, company receivables, royalties, credit card debt
Commodity producers have a naturally _______ (long/short) position in the commodity that they produce.
long
Credit analysis of ABS uses probability of _______ as a credit measure.
loss, not default
High imports are associated with
low investment
In an upward-sloping yield curve, shorter maturity bonds have _______ (higher/lower) yields than longer maturity bonds.
lower
The greater the potential input options in an industry, the ________ the power of the suppliers.
lower
The larger the support tranche(s) relative to the PAC tranches, the _______ (higher/lower) the probability that the cash flows to the PAC tranches will differ from their scheduled payments.
lower
The more actual or prospective substitutes that exist, the _________ the supplier power.
lower
The presence of industry growth implies that the need to engage in competition is ________
lower
How will an upward revaluation effect ROA and ROE?
lower ROA and ROE in periods after revaluation. However, if the increase in the asset value is the result of higher operating capacity, higher capacity should result in higher revenues and, thus, higher earnings and potentially higher ROA and ROE in the future.
How will an upward revaluation effect the debt ratio and the debt-to-equity ratio?
lower debt ratio (total debt / total assets) and lower debt-to-equity ratio
Companies that have high accounting accruals will tend to have _______ (higher/lower) persistence factors.
lower, because accounting anomalies tend to put downward pressure on residual incomes
Companies that have significant levels of nonrecurring items will tend to have _______ (higher/lower) persistence factors.
lower, because accounting anomalies tend to put downward pressure on residual incomes
Companies that have high ROEs will tend to have _______ (higher/lower) persistence factors.
lower, because these companies attract more competition, which will put downward pressure on residual incomes over time.
How should an analyst account for management compensation when calculating normalized earnings of a private firm?
management compensation should be recognized at the market level. if executive compensation is higher than the market level, add back the difference to earnings.
Ratchet determines the allocation of equity between _________ and _________, not between _______ and ________.
management of the portfolio company and the stockholders, not between the GP and the LPs of the private equity fund.
Total invested capital is also referred to as
market value of invested capital
If you see a mixture of nominal and real interest rates and cash flows on an exam problem, when in doubt, always
match like with like interest rates and cash flows. Ex. always use nominal CFs with nominal interest rates, and real CFs with real interest rates.
Is M&A activity more common in young or mature industries?
mature industries where organic growth opportunities are limited
Effective duration
measures PRICE sensitivity to small PARALLEL shifts in the yield curve
Arbitrage-free valuation methods
methods to value securities such that no market participant can earn an arbitrage profit in a trade
What are the effects of reclassifying non-core revenues as revenues from core continuing operations?
misleads analysts about the sustainability of future revenues.
Prudential supervision
monitoring and regulating financial institutions to reduce system-wide risks and to protect investors. Ex. the failure of one financial institution can have far-reaching impacts due to high mobility of capital across the developed world.
A high degree of operating or financial leverage makes it _________ likely participants will engage in price competition to defend their market share and to cover fixed costs
more
As the coupon rate increases, a callable bond is _______ (more/less) likely to be called.
more
As the coupon rate on a callable bond increases, the time-to-exercise rate will become _______ (more/less) important than the time-to-maturity rate.
more
Putable bonds with high coupon rates are ________ (more/less) sensitive to their maturity-matched rates.
more
The amount of informational complexity can make it difficult for competitors to communicate discretely, which can lead to ___________ damaging competition
more
The first tranche to be paid in a CMO has ________ (more/less) contraction risk than the other tranches.
more
Are selling/distribution costs more or less related to sales volumes than COGS and SG&A?
more directly related
What can dilute a VC investor's ownership?
more financing, conversion of convertible debt into equity and the issuance of stock options to management
If a private firm has an unusually high level of unsystematic risk, should an acquirer use the CAPM?
most likely not (no alternative given; book 3 p278)
Economic rate of return
must equal the project's cost of capital
Are spreads wider or narrower in the interbank market?
narrower
Friedman Doctrine
narrowly addresses the social responsibility of business (not business ethics). - concludes that the only social responsibility of businesses is to increase profits "within the rules of the game," meaning through "open and fair competition without deception or fraud" - Milton Friedman did not want to get into business ethics, but many argue that this is walking the line.
What is the largest driver of economic value for REITs?
national GDP growth
Is income tax considered an operating expense?
no
Is interest expense considered an operating expense?
no
If cash dividends increases by $100 and there is a 40% tax rate, what is the effect on FCFF and FCFE?
no effect
What type of valuation is most commonly used in venture capital deals?
no specific model; venture capital deals are often subject to negotiation and are informal due to the uncertainty of future cash flows.
Can you use the CAPM to derive a commodity's expected return?
no, because commodities are not capital assets
Should normalized earnings for private companies include or exclude tax-motivated expenses?
no; add them back.
When there is a flurry in industry acquisition activity, should you add a control premium to the acquisition price?
no; normally a premium is already added for a controlling stake in a company. Adding a further premium is unnecessary.
Are undrawn LP capital commitments included in the NAV calculation?
no; they're essentially liabilities for the LP
Provisions (in the context of earnings manipulation)
non-cash expenses charged in the current period in order to relieve future losses/expenses. Future expenses from provisions bypass the income statement.
Are borrowers more likely to default on recourse or non-recourse loans?
non-recourse loans, because there is less incentive for the borrower not to default
Earnings with a high proportion of __________ are considered to be non-sustainable.
non-recurring items
Contemporaneous
not lagged
LIFO liquidation
occurs when a LIFO firm's inventory quantities are declining. Results in higher profit margins and higher income taxes, although higher profit is not sustainable.
How do private equity firms receive their distributions from portfolio companies?
often in the form of preferred dividends and sometimes as a multiple of their original investment, and always before other owners of the portfolio company
An example of a nonrenewable commodity is
oil/minerals
Plain vanilla interest rate swap
one party makes payments based on a fixed rate while the counterparty makes payments based on a floating rate
What is the bottom line rule for defining non-recurring items?
only include items that are normal and recurring.
Best practices guidelines dictate the nominating committee of the board includes
only independent directors
Best practices guidelines dictate finance committee of the board includes
only independent directors with finance expertise
Unrealized gains and losses are recognized on the income statement for what types of securities?
only with held-for-trading securities (fair value securities)
Required return on an asset is also called the ____________
opportunity cost for investing in the asset
One of the main goals of the classical style is to
optimize efficiency
Best practices guidelines dictate corporations must only use counsel from within or outside the firm?
outside
Accounting income will _________ (over/understate) returns from the perspective of equity investors because it ignores the cost of equity.
overstate
If working capital is growing, EBITDA will ________ (over/understate) CFO.
overstate
If the market price (current price at which the stock is trading) is higher than the model price (price implied by your own valuation), the stock is currently
overvalued
When current P/E exceeds fair value P/E of a company or an industry, that company or industry is
overvalued
If expected future spot rates exceed forward rates, are bonds over or undervalued?
overvalued, because investors believe that spot rates will be higher than what the market is pricing in at purchase. If interest rates turn out to be higher, bond prices will move lower.
Are owners or tenants usually responsible for the upkeep of multifamily homes?
owners
Bootstrapping
packaging the combined earnings from two companies after a merger so that the merger generates an increase in the EPS of the acquirer, even when no real economic gains have been achieved
Transaction fees of a private equity firm
paid by third parties to the GP in their advisory capacity. These fees are usually split evenly with the LPs and, when received, are deducted from management fees.
Paythrough securities (CMOs) are made of
passthrough securities
When payments are fixed for the life of the loan, payments in the beginning of the loan term are primarily ________ (interest/principal), versus payments towards the end of the loan are primarily ________ (interest/principal).
payments are primarily interest in the beginning, and primarily principal towards the end.
What is an alternative to paying dividends that a company can do to retain its financial flexibility?
payout excess cash through a stock repurchase
Underlying earnings
persistent, continuing, core earnings that exclude nonrecurring components
What type of depreciation should be accounted for when using the cost approach to real estate valuation?
physical deterioration, functional obsolescence, locational obsolescence, and economic obsolescence
Demand for multi-family properties depends most on
population growth, especially in the age demographic that typically rents apartments
Do nonstorable commodities exhibit positive or negative roll returns?
positive
Inflation will lead to ________ (positive/negative) spot return
positive
The spread between ROE and r is _______ related to the persistence factor.
positively
Is CFO a pre- or post-leverage value?
post
Is net income a pre- or post-leverage value?
post
Pre-levered cash flow comes before what expenses?
pre-interest, and pre-borrowings
The value of the company at the first round of financing is based on
pre-money valuation at the following round (round 2)
For venture capital, what are the drivers of returns?
pre-money valuation, the investment, and potential subsequent equity dilution
A private equity firm's payoff includes what two components?
preferred shares and residual exit value
You can consider call protection of MBS as equivalent to
prepayment protection (restrictions on the early return of principal) (not sure why it's called "call" protection)
An important characteristic of pass-through securities (MBS) is
prepayment risk, because the underlying securitized mortgages in a pool have no prepayment penalty. This is for agency MBS only, I think.
Is debt more heavily used in private equity or public equity firms?
private
Market risk of a private equity fund
private equity is subject to long-term changes in macroeconomic factors; short-term changes are usually insignificant
Although rare, which types of companies are sometimes allowed (under both IFRS and GAAP) to value inventories above cost? How are they reported?
producers and dealers of commodity-like products are sometimes allowed to do this. Ex. oil producers. Inventories would be reported on the balance sheet at NRV at the live quoted price if active markets exist. If they do not, NRV is reported at the most recent price.
Economic profit
profit in excess of the dollar cost of capital invested in a project
Fundamental options
projects that are options themselves because the payoffs depend on the price of an underlying asset
The sales comparison approach assumes
purchasers are acting rationally, and that prices paid are representative of the current market
What affect does using the residual dividend approach have on cost of capital and valuation of a company?
raises the cost of capital and lowers valuation due to uncertainty.
Flexible (floating) exchange rate system
rates are determined by supply and demand in the foreign exchange markets
Corporate credit ratings
ratings of the bond itself
Corporate family ratings
ratings of the issuer
Expected real growth in EPS should be approximately equal to the __________
real GDP growth rate
How is the unrealized gain or loss treated for a reclassification from held-for-trading to available-for-sale?
recognized on the income statement
How is the unrealized gain or loss treated for a reclassification from held-for-trading to held-to-maturity?
recognized on the income statement
How is the unrealized gain or loss treated for a reclassification from held-to-maturity to held-for-trading?
recognized on the income statement
How is the unrealized gain or loss treated for a reclassification from held-to-maturity to available-for-sale?
recognized under other comprehensive income
What are the effects on ratios of removing accounts receivables?
reduces days' sales outstanding and enhances the receivables turnover ratio. May be done to mask aggressive revenue recognition practices.
Net regulatory burden
regulatory burden - the private benefits of regulation
Regulatory competition
regulatory differences between jurisdictions that lead to regulators competing to provide the most business-friendly environment
Momentum indicators
relate either the market price or a fundamental variable like EPS to a time series of historical or expected values.
Because of the difficulty in measuring depreciation and obsolescence, the cost approach is most useful when the subject property is __________
relatively new
Repeat-sales index
relies on repeat sales of the same property. A change in market conditions can be measured once a property is sold twice; using this information, a regression is developed to allocate the change in value to each quarter.
How is the unrealized gain or loss treated for a reclassification from available-for-sale to held-for-trading?
remove from other comprehensive income and recognize in the income statement
Term structure of credit spreads
represents the relationship of credit spreads to debt maturity
Sinking fund bonds (sinkers)
require the issuer to set aside funds periodically to retire the bond. This reduces the credit risk of the bond.
What discount rate should be used when calculating equity value?
required return on equity (then you subtract g)
Supermajority voting provision for mergers
requires more than just a simple majority to approve a merger (such as 75% or 80%)
Hedonic index
requires only one sale. A regression is deveoped to control for differences in property characteristics such as size, location, age, etc
Excess servicing spread funds as an internal credit enhancement
reserve funds in the form of an excess spread above the required payments to holders of non-agency RMBS and above the required loan servicing and other administrative expenses.
If ROE > required return, residual income will be _______ (positive or negative) and justified P/B ratio will be _______ (greater or less than 1)
residual income will be positive, and justified P/B ratio will be greater than 1
Fair price amendment
restricts a merger offer unless a fair price is offered to current shareholders, as calculated by a specific formula or independent appraisal
Earnings management under GAAP
restructuring provisions and impairment losses that provide opportunities to time the recognition of losses
Terminal value in property valuation is also known as
reversion or resale value
Administrative regulations
rules issued by government agencies or other bodies authorized by the government
Phantom stock
same as stock appreciation awards except the compensation is based on a hypothetical stock instead of the firm's actual shares. - helpful in privately held firms and firms with highly illiquid shares
Return on capital employed
same thing as ROIC, but using pre-tax operating income, rather that after-tax
Spot prices of agricultural products are strongly correlated with
seasonal factors
Conforming loans
securitized mortgages that meet the standards of inclusion in agency RMBS
Antitrust regulation
seek to promote domestic competition by monitoring and restricting activities that reduce or distort competition Ex. blocking a merger that would lead to excessive market concentration.
For the price currency, you ______ at the ask price and _______ at the bid price.
sell at the ask price, buy at the bid price
The financing of a LBO typically involves what types of assets?
senior debt, junk bonds, equity, and mezzanine finance
Conflict of interest concerns for corporations
separation of ownership and management
Long term equity
shareholders' equity
Commodity consumers (manufacturers) have a naturally ______ (long/short) position in the commodity that they use.
short
In a situation of normal contango, the speculative investor should
short the commodity future; she would then earn an insurance premium
If interest rates decrease, the average life of a MBS will ________ (shorten/lengthen)
shorten
In the U.S., the depreciable life of real estate is usually ______ (shorter/longer) than the actual life.
shorter
Preferred habitat theory
similar to the liquidity preference theory, the preferred habitat theory proposes that forward rates represent expected future spot rates plus a premium. - but it does not support the view that this premium is directly related to maturity.
Local expectations theory
similar to the unbiased expectations theory, but with one major difference: the local expectations theory states that over longer periods of time, risk premiums should exist.
Conflict of interest concerns for partnerships
similar to those of sole proprietors: suppliers and creditors. Conflicts of interest amongst partners are normally addressed by creating contracts that clearly define their roles and responsibilities.
Operating lease
simply a rental agreement; the lessee reports neither an asset nor a liability on the balance sheet, even though the lessee may have a contractual obligation under the lease agreement.
"Just say no" defense
simply say no to the offer. If the acquirer goes directly to shareholders, the target can make a case to the shareholders of why the acquirer's offer is not in their best interests.
Carrying value =
simply the balance sheet value
Why is the cost approach sometimes considered the upper limit of value?
since an investor would never pay more than the cost to build a comparable building on a piece of property
When the persistence factor is close to zero, the firm's valuation will be _______ (smaller, greater).
smaller
What are research measurement errors in the context of conglomerate discounts?
some hypothesize that conglomerate discounts do not exist, but rather are a result of incorrect measurement
When residual income declines over time to zero, the persistence factor (Ɯ) will equal
some value between zero and one
The majority of commodity futures' return variation can be traced back to
spot price volatility
Zero-coupon rates are another term for
spot rates
Far in the money convertible bonds trade like
stock
When the value of a company is inflated, what type of acquisition is the purchaser more likely to make - a cash or stock acquisition?
stock
If a non cash charge increases net income, how do you adjust for it when calculating FCFE and FCFF?
subtract it from net income
In general, when calculating a post-leverage figure, do you want to subtract or add back the tax shield?
subtract the tax shield, or make sure the calculation is post-taxes. (I think)
If rents are expected to increase at a constant rate each year, the IRR can be approximated by
summing the cap rate and growth rate
What types of rates are more comparable across different countries - interest rates or swap rates?
swap rates, because the swap market is not controlled by governments.
In a comparable company analysis, should your comparable companies be similar to the target company pre- or post-merger?
target company post merger.
Total factor productivity is synonymous with
technological process
A rising TED spread indicates
that market participants believe banks are increasingly likely to default on loans and, therefore, t-bills are becoming more valuable in comparison
What does the IRR calculation assume?
the IRR calculation assumes intermediate cash flows are reinvested at the IRR
Hurdle rate
the IRR that a private equity fund must meet before the GP can receive carried interest. It usually varies from 7-10%
What is the LIBOR-OIS spread used for?
the LIBOR-OIS spread is a useful measure of credit risk and an indication of the overall wellbeing of the banking system (because LIBOR includes credit risk whereas OIS does not)
What type of simulation is used to value mortgage-backed securities, and why?
the Monte Carlo method is used because mortgage cash flows ARE path dependent, meaning they change depending on previous cash flows. There is prepayment risk in mortgages. So you can't simply place a 50/50 chance on a spot rate moving up or down by a certain amount.
Market value added
the NPV based on economic profit. Use the same NPV calculator function, using the economic profit values as cash flows, and the WACC as the discount rate.
DOWNREIT
the REIT has an ownership interest in more than one partnership and can own properties both at the partnership level and at the REIT level
The success of regulatory tools depends on
the ability to enforce sanctions on violators effectively. Ex. sanctions placed on a company that end up effecting the customers rather than the management would be considered ineffective.
Who assumes the risk and potential reward in a cash offer, the acquirer or the target?
the acquirer all the risk and potential reward, because their upside and downside is unlimited. The target receives a fixed amount of cash, and retains no equity in the company, leaving no risk.
Statutory merger
the acquiring company acquires all of the target's assets and liabilities
The fashion retailing industry is an example of one in which companies most often use the __________ style because
the adaptive style, because consumer tastes change rapidly and businesses must be tuned in to capture that information
Rebalancing return
the additional return on a portfolio of commodity futures (does not apply to individual contracts)
Capital rationing
the allocation of a fixed amount of capital among a set of projects that will maximize NPV. Pick and choose projects that fall within the allocation of capital and create the highest total NPV.
What is the LIBOR-OIS spread and why is it useful?
the amount by which LIBOR exceeds the overnight indexed swap rate. LIBOR includes credit risk whereas the OIS rate does not
Full goodwill
the amount by which the fair value of the subsidiary exceeds the fair value of the subsidiary's identifiable assets
TED Spread
the amount by which the interest rate on loans between banks (3m LIBOR) exceeds the interest rate on short-term U.S. government debt (3m t-bills)
Partial goodwill
the amount by which the purchase price exceeds the fair value of the parent company's share of the subsidiary's identifiable assets
Conglomerate discount
the amount by which the sum-of-the-parts value exceeds the market value
Swap spread
the amount by which the swap rate exceeds the yield of a government bond with the same maturity
Takeover premium
the amount by which the takeover price must exceed the market price of the target in order to persuade the target shareholders to approve the merger deal
I-spread
the amount by which the yield on a risky bond exceeds the swap rate for the same maturity
Paid-in capital
the amount of funds actually received from private equity investors
What factor most effects elasticity of demand?
the availability of substitutes
Straight-line rent
the average contractual rent over a lease period, not the cash rent paid during the lease
When we talk about currencies in general, assume that the statements are about which currency - currency A or B (A/B)?
the base currency, B. Ex. when USD/EUR changes from 1.30 to 1.20, we say that the euro, the base currency, depreciated.
Staggered board
the board of directors is split into three equal-sized groups. Each group is elected for a three year term in a staggered system (in the first year the first group is elected, etc). In any given year, a potential acquirer can win at most one-third of the board seats. It would take a potential acquirer at least two years to gain majority control of the board.
Where can you find the schedule for the shifting interest percentage required to calculate the senior prepayment percentage?
the bond prospectus
What information can be found in the swap spread of a default free bond?
the bond's liquidity (or lack thereof)
Terminal (residual) cap rate
the cap rate used the terminal value
Equity dividend rate is also known as
the cash-on-cash return (measures the cash return on the amount of cash invested)
LIFO Effect
the change in LIFO reserve
The oil industry is an example of one in which companies most often use the __________ style because
the classical style, because factors affecting demand a well known (such as GDP growth)
Term and reversion approach to property valuation
the contract (term) rent and the reversion are appraised separately using different cap rates.
Regulatory burden
the cost of compliance for the regulated entity
How is the cost of fixing curable items accounted for using the cost approach to real estate valuation?
the cost of fixing curable items is subtracted from replacement cost
Molodovsky effect
the countercyclical tendency to have high P/Es due to lower EPS at the bottom of the cycle (when prices down), and low P/Es due to high EPS at the top of the cycle (when prices are up)
Passthrough rates
the coupon rate on the MBS, also called its net interest or net coupon
Presentation currency
the currency in which the multi-national firm prepares its final consolidated financial statements. Usually this is the country in which the parent company operates.
Local currency
the currency of the country in which the foreign subsidiary is located
Functional currency
the currency of the primary economic environment in which the firm operates. This is the currency in which the firm generates the majority of its sales and spends the majority of its cash. There is subjectivity here.
Market value, as used under GAAP
the current replacement cost, subject to: - an upper limit: NRV - lower limit: NRV - normal profit margin
Economic depreciation
the decline in an investment project's market value due to use over the course of its life
Valuation error
the difference between the analyst's estimate of intrinsic value and the actual intrinsic value
Actual mispricing
the difference between the market price and the intrinsic value
The gain in a merger
the difference between the value of the combined firms and the sum of the separate firms. Any merger that makes economic sense will have a positive gain.
The general definition/calculation of credit spreads
the difference between the yield of a zero-coupon credit-risky bond and an equivalent zero-coupon risk-free bond
The biggest difference between residential and commercial MBS loans is
the different obligations of the underlying borrowers. RMBS loans are repaid by homeowners, whereas CMBS loans are repaid by real estate investors who, in turn, rely on tenants and customers to provide the cash flow to repay the mortgage loans.
Will the discount rate applied to the contract rent be higher or lower than the reversion rate when using the term and reversion approach to property valuation?
the discount rate applied to the contract (term) rent will likely be lower than the reversion rate because the contract rent is less risky (existing tenants are not likely to default on a below-market lease)
Should the discount rate be higher or lower than the mortgage rate when valuing a property? Why?
the discount rate should be higher than the mortgage rate because of more risk and should reflect the riskiness of the investment relative to other alternatives
How do dividend discount models define cash flows?
the dividends to be received by shareholders
Key rate duration
the duration (interest rate sensitivity to changes in yield) of a bond of a certain maturity
Market timing risk in the context of macroeconomic multifactor models
the equity market return that is not explained by the other four factors of the macroeconomic multifactor model
What ownership accounting method is required by IFRS and GAAP for joint ventures?
the equity method. In rare cases, the proportionate consolidation method is allowed.
Another term for balance sheet leverage ratio is
the equity multiplier
Liquidation value
the estimate of what assets of a firm would bring if sold separately, net of liabilities
Cross rate
the exchange rate between two currencies implied by their exchange rates with a common third currency
The spot price of renewable commodities is highly influenced by
the expected cost of that commodity's future production
How are employers required to report defined benefit plan payments on financial statements?
the firm must forecast a number of variables such as future compensation levels, employee turnover, average retirement age, mortality rates, and appropriate discount rate
Defined benefit plan
the firm promises to make periodic payments to employees after retirement
Vesting date
the first date the employee can actually exercise an option
If a spot curve is upward-sloping, the forward rate curve is assumed to be _______ (above/below) the spot curve.
the forward curve will be above the spot curve if upward sloping
The further out the forward curve predicts, the ________ (larger/smaller) the gap will be between the it and the spot curve.
the gap will be larger for a far forward rate in the near term, but all spot and forward rate curves will converge over time. (see the chart, it's hard to explain)
What is the main driver of spot price return and volatility?
the global balance between supply and demand
The minimum value of a convertible bond is equal to (important)
the greater of its conversion value or its straight value
How should an analyst choose her forecast horizon?
the horizon should be long enough that the effects of teh current phase of the economic cycle are not driving above-trand or below-trend earnings. The forecast horizon should be long enough to include the middle of a business cycle.
What is the idea behind synergies as a motivation for M&A activity?
the idea that a merger will make the combined company worth more than the two companies would be worth if operating separately
Regulatory capture theory
the idea that, regardless of the original purpose behind a regulatory body's establishment, it will at some point be influenced or controlled by the industry that it is regulating. Due to their experience in the industry, regulators' ability to make impartial decisions will eventually be impaired.
Roll return
the income generated as you close out maturing futures contracts and replace them with newer future contracts
Option adjusted spread
the interest rate spread added to all rates in a binomial tree so that the model price is equal to market price
Collateral return
the interest received on the assets you post as collateral in the futures market (e.g. you earn interest on T-Bills you post as collateral)
Upstream sale
the investee sells to the investor. - the investee recognizes all of the profit in its income statement - the investor only recognizes its portion of the investee's equity income as profit
Investors use debt financing to increase returns. There will be positive leverage and returns will be magnified as long as
the investment return is greater than the interest paid to lenders
In a putable bond, who is the long position - the issuer or investor?
the investor is the long in a putable bond
Downstream sale
the investor sells to the investee. - the investor recognizes all of the profit in its income statement from the sale - the investor only recognizes its proportionate share of the investee's equity income as profit
In a callable bond, who is the long position - the issuer or investor?
the issuer is the long in a callable bond
Absolute PPP
the law of one price for a basket of goods. Aka, the law of one price is correct on average for a basket of goods in each country.
How are investment vehicle fund setup costs treated for a private equity fund?
the legal and other costs of setting up the fund are usually amortized over the life of the fund
Over the long run, growth rates tend to revert to a long run rate approximately equal to:
the long term growth rate in real GDP plus the long term inflation rate. Historically, that number has been between 2% and 5%.
Funding currency
the lower yielding currency in an FX carry trade. You're betting that the funding currency will depreciate.
Agency risk of a private equity fund
the managers of private equity portfolio companies may not act in the best interests of the private equity firm and investors
Define total invested capital
the market value of the company's equity and debt
Enterprise value
the market value of the firm's debt and equity minus the value of cash and investments
The most important spot rate for option-free bonds not trading at par is
the maturity-matched rate (the rate at maturity)
Dividend safety
the metric used to evaluate the probability of dividends continuing at the current rate for a company
Required return
the minimum return an investor requires given the asset's risk
Convenience yield
the monetary benefit from holding a physical commodity versus being long the equivalent futures contract. A manufacturer that holds a storable commodity input has a valuable option to consume that input at any time.
What do investors receive in exchange for investing in mortgage passthrough securities?
the monthly cash flows generated by the underlying pool of mortgages, less any servicing and guarantee/insurance fees
The lower the predictability and malleability of the competitive environment,
the more complex the environment and more challenging the corporate strategy formulation process is
Conversion ratio of a convertible bond
the number of shares per bond you receive upon conversion
In a justified price multiple, is the numerator or the denominator the hypothesized fundamental value derived from a valuation model?
the numerator, the "price" value
Beta drift
the observed tendency of an estimated beta coefficient to revert to a value of 1.0 over time
American option
the option can be exercised at any time after the lockout period
European option
the option can only be exerised on a single day immediately after the lockout period
Bermudan option
the option whereby the option can be exercised at fixed dates after the lockout period
Convertible bond
the owner has the right to convert the bond into a fixed number of common shares of the issuer during a specified timeframe (conversion period) and at a fixed amount of money (conversion price)
Gross lease
the owner is responsible for the operating expenses
Net asset value per share
the per-share amount by which BV of assets exceed BV of liabilities
Single monthly mortality rate
the percentage by which prepayments reduce the month-end principal balance, compared to what it would have been with only scheduled principal payments (no prepayments)
Spot return
the percentage change in a commodity's spot price
Recovery rate
the percentage of money received upon default of the issuer
Loan-to-value ratio
the percentage of the value of the collateral real estate that is loaned to the borrower (loan amount over appraised value)
Statutory tax rate
the percentage tax changed in the country where the firm is domiciled
Lockout period on Credit Card ABS
the period during which no principal is paid to the ABS holders, which may last from 18 months to 10 years after the ABS is created.
Amortized cost
the present value of the remaining cash flows (coupon payments and face amount) discounted at the market rate of interest at issuance
How does the reduced form model of credit analysis consider the probability of default/recovery rate?
the probability of default and the recovery rate depend on the state of the economy and are not constant.
Persistence factor
the projected rate at which residual income is expected to fade over the life cycle of the firm
Senior prepayment percentage
the proportion of prepayments that are applied to the senior tranche
Unbiased expectations theory is also known as
the pure expectations theory
Initial PAC collar
the range, given in terms of PSA, within which the support tranches are sufficient to provide or absorb actual prepayment fluctuations
If markets are efficient, the IRR of a publicly traded security will equal
the required return
Why is the use of debt believed to make private equity portfolio companies more efficient?
the requirement to make interest payments forces the portfolio companies to use free cash flow more efficiently
Effectiveness of capital controls or central bank intervention depends on
the reserves in a country's central bank versus the volume traded of its currency. - a country whose currency is highly traded (developed countries) will have difficulty intervening - emerging markets can have more of an impact domestically - large and persistent capital flows are harder for central banks to mitigate than small and less persistent capital flows
Continuing residual income
the residual income that is expected beyond the estimated horizon
Projection risk
the risk associated with private firms wherein management is less able to forecast future earnings or market conditions accurately. This is due to private firms having a lower availability of information.
Financial risk (in the context of ESG investing)
the risk that ESG risk factors will result in a monetary cost to the firm or shareholders.
Contraction risk
the risk that prepayments will be more rapid, and therefore shrink the lifespan of the underlying pool of mortgages in a MBS, as a result of a decrease in interest rates
Extension risk
the risk that prepayments will be slower than expected due to increases in interest rates
Ex-ante PPP
the same as Relative PPP, except using expected inflation
Key rate duration
the sensitivity of the value of a security (or a bond portfolio) to changes in a single spot rate, holding all other spot rates constant
The software industry is an example of one in which companies most often use the __________ style because
the shaping style, because it experiences rapid changes and company actions often dictate the direction of the industry
Under the build-up method, how does the size premium change with company size?
the smaller the company, the larger the premium, leading to a higher required rate of return
Time-to-exercise rate
the spot rate in the year in which a given callable or putable bond can be exercised
Time-to-maturity rate
the spot rate used to discount the final value of the bond
For a bond investor, the return on a bond over a one-year horizon is always equal to the one-year risk-free rate if
the spot rates evolve as predicted by today's forward curve
Z-spread
the spread that, when added to each spot rate on the default-free spot curve, makes the present value of a bond's cash flows equal to the bond's market price
You can find a reconciliation of which two tax rates in the footnotes to financial statements?
the statutory and effective tax rates
The disadvantage of investing in commodities through a representative stock is
the stock often has low correlation with the price of the underlying commodity, therefore you lose the diversification benfit
For a CDO to be plausible, how must the tranches be structured?
the structure of the CDO must offer an attractive expected return on the subordinated tranche (which will have characteristics more similar to equity investments rather than bonds) AFTER accounting for the yields that must be offered on the senior and mezzanine bond classes.
The fixed rate in an interest rate swap is also known as
the swap rate
If an acquirer makes a cash offer in a deal, but the synergies realized are greater than expected, what would happen to the takeover premium for the acquirer and the target?
the takeover premium would remain unchanged for the target while the acquirer would reap all the reward.
Subsidiary merger
the target company becomes a subsidiary of the purchaser
White squire defense
the target seeks a friendly third party that buys a minority stake in the target without buying the entire company. The goal is for the friendly third party to acquire enough of the target to prevent the hostile acquirer from gaining enough shares to complete the merger.
Statutory tax rate
the tax rate provided by the tax code of the home country
Deferred tax liabilities arise from
the temporary timing difference between straight line depreciation (usually used for financial reporting) and accelerated depreciation (usually used for tax reporting)
Net lease
the tenant is responsible for paying the operating expenses
Winners curse
the tendency for the winner to overpay in a competitive bidding situation, such as one sparked by a white knight coming into a hostile takeover situation
Managerial hubris
the tendency of managers to overestimate the synergies and expected benefits of a merger
Unbiased expectations theory
the theory that investors' expectations determine the shape of the interest rate curve. - forward rates are solely a function of expected future spot rates - every maturity strategy has the same expected return over a given investment horizon - investors are risk neutral: they do not demand a risk premium for maturity strategies that differ from their investment horizon
enterprise value
the total value of the firm, including equity AND debt, minority interest and preferred shares. Does not include cash or cash equivalents.
What theories of term structure of interest rates hypothesize that over short time periods, every bond (even longer-maturity risky bonds) should earn the risk free rate?
the unbiased AND local expectations theory (yes, I'm sure)
Inflation risk in the context of macroeconomic multifactor models
the unexpected change in the inflation rate
Business cycle risk in the context of macroeconomic multifactor models
the unexpected change in the level of real business activity
Time horizon risk in the context of macroeconomic multifactor models
the unexpected change in the spread between the return of long-term government bonds and treasury bills
Confidence risk in the context of macroeconomic multifactor models
the unexpected change in the spread between the return of risky corporate bonds and government bonds
Valuation risk of a private equity fund
the valuation of a private equity investments reflects subjective, no independent, judgement
Straight value of a convertible bond
the value if it were not convertible
Investment value
the value of a stock to a particular buyer, which may take into account the buyer's specific needs and expectations and perceived synergies
Sum-of-the-parts value
the values of a company's individual assets or divisions, totaled
The riskiest corporate strategic planning style is
the visionary style
What are the implications of being able to reverse writedowns under IFRS?
theoretically, a company could "manage" their earnings from year to year. They could writedown their inventories, and then reverse it the next year, pushing some of their earnings to the next year.
The sales comparison approach is most useful when
there are a number of properties similar to the subject that have sold recently (single family homes)
How does the bond-yield plus risk premium method treat the effects of inflation, leverage, and the firm's sensitivity to the business cycle?
these factors are assumed to be included in the bond's YTM, so they are disregarded
Bonds with embedded options are dominated by the time-to-exercise rate when
they are more likely to be put or called
If no growth is expected in NOI, what is the relationship between the cap rate and the discount rate?
they are the same
How are unions viewed as stakeholders?
they are viewed as external stakeholders representing internal employees
Do swap rates reflect the credit risk of governments or private institutions?
they reflect the credit risk of commercial banks, not governments
Synthetic CDOs
those where the collateral is a portfolio of credit default swaps on structured securities
Best practices guidelines dictate corporations must compensate senior managers according to what structure?
tied to performance
What is the purpose of the stakeholder impact analysis?
to force the company to identify which stakeholder groups are the most critical to the company.
The primary goal of corporate governance is
to minimize conflicts of interest between management and owners through the application of practical measures and policies
What is the typical motivation of an SPE?
to reduce risk and thereby lower the cost of financing
What is the purpose of a board of directors?
to serve as an intermediary between shareholders and management to help ensure that management is acting in the shareholders' best interest.
Conglomerate merger
two companies operate in completely separate industries
When do most currency trades deliver?
two days after the trade
Law of One Price (in terms of price multiples, not PPP)
two similar assets should sell at comparable price multiples, such as P/E. This is a relative valuation method, so we can only asset that a stock is over- or undervalued relative to a benchmark.
Relative strength indicators
types of momentum indicators that compare a stock's price or return during a given time period with its own historical performance or with a group of peer stocks.
If ex-ante relative PPP and the international Fisher relation hold,
uncovered interest rate parity will also hold
If a bond's OAS is higher than the OAS of an equivalent bond, it is considered to be ________ (over/undervalued).
undervalued
Spot return is highly correlated with
unexpected inflation
The cost approach to valuing real estate is used most often for what types of properties?
unusual properties or properties where comparable transactions are limited
Ex ante estimates
use current information and expectations to make forward-looking estimates
How do you perform step 8: estimation of CapEx and net PP&E on the balance sheet?
use depreciation and capital expenditures for maintenance and for growth from the income statement to estimate the accounts on the balance sheet
How does the structural model consider a company's default probability and loss given default?
uses option pricing theory to understand a company's default probability (ex. the value of risky debt = value of risk free debt + value of European put option on company assets)
How do you perform step 5: estimation of income tax expense and cash taxes?
using historical effective rates and trends, segment information for different tax jurisdictions, and anticipated growth in high- and low-tax segments
How do you perform step 4: estimation of financing costs?
using interest rates, debt levels, the the effects of any large anticipated increases or decreases in capital expenditures or anticipated changes in financial structure
How do you perform step 1: estimation of revenue growth and future expected revenue?
using market growth plus market share, trend growth rate, or growth relative to GDP growth
Choosing high dividend yielding stocks suggests an analyst has what type of investment strategy (value or growth)?
value
Is value recognized earlier or later in the residual income model versus the DCF model?
value is recognized earlier under the residual income model
Pathwise valuation
values a bond by taking the average of each possible path of an interest rate tree - uses forward rates rather than spot rates
Backward induction
values a bond using an interest rate tree - uses forward rates rather than spot rates (I think)
Method of forecasted fundamentals
values a stock based on the ratio of its value from a DCF model to some fundamental variable (e.g. EPS)
Valuation multiples on a portfolio or index level are best calculated using what type of mean?
weighted harmonic mean
justified price multiple
what the multiple SHOULD be if the stock is fairly valued
An example of a renewable commodity is
wheat
Off-balance-sheet financing
when a liability is not recognized on the balance sheet, therefore improving leverage ratios
Spin-offs
when a new independent company is formed by distributing shares proportionately to the parent company's shareholders. No public shares are offered.
Split-offs
when a new independent company is formed by offering new shares in exchange for a portion of the parent company's shareholders' current shares
Equity carve-outs
when a new, independent company is formed by giving an equity interest in a subsidiary to outside shareholders. Shares are issued in an IPO.
Clean-surplus accounting
when an analyst includes the gains and losses that are reported in shareholders' equity in net income
Dirty-surplus accounting
when an analyst leaves alone gains and losses that are reported in shareholders' equity
Agency relationship
when an individual, who is referred to as the agent, acts on behalf of another individual, the principal.
Strategic default
when borrowers of a mortgage voluntarily return the property to the lender
When does the real interest rate increase?
when either 1) the nominal rate increases, or 2) expected inflation decreases
When is the build-up method of estimating the equity risk premium most often used?
when estimating the required return of companies for which betas are not readily obtainable
Informational frictions
when information is not equally available or distributed (informational asymmetry)
Portfolio composition mechanism (in the context of currency account deficits leading to depreciation)
when investor countries decide to rebalance their investment portfolios, it can have a significant negative impact on the value of the investee country currencies
Build-up method
when it is not possible to find comparable public firms for beta estimation, the build-up method can be used. Beginning with the expected return on the market, premiums are added for small size, industry factors, and company specific factors.
When is there potential for conflict of interest in a REIT?
when it is structured as an UPREIT or a DOWNREIT
Under GAAP, when is an asset impaired?
when its carrying value > its UNDISCOUNTED future cash flows. If impaired, the asset is written down to fair value. If fair value is not available, it is written down to the DISCOUNTED value of the future cash flows.
Under IFRS, when is an asset impaired?
when its carrying value > recoverable amount. The recoverable amount is the greater of (fair value - selling costs) and value-in-use. Value-in-use is the present value of expected future cash flows. If impaired, the asset is written down to the recoverable amount.
Under what circumstances will LIFO reserve increase?
when prices are rising
Overcollateralization
when the ABS is issued with a face value less than the value of the underlying collateral
Backward integration
when the acquirer moves down the supply chain away from the consumer. Ex. when an ice cream manufacturer buys a dairy farm
Forward integration
when the acquirer moves up the supply chain toward the consumer. Ex. when an ice cream manufacturer decides to acquire a storefront
Vertical merger
when the acquiring company seeks to move up or down the product supply chain
Bargain purchase
when the acquisition purchase price is less than the fair value of net assets acquired.
When does the PAR problem arise?
when the agent, who has an asymmetric information advantage over the principal, uses the information advantage for their own interests to the detriment of the interests of the principal
Hyperinflation as defined under GAAP
when the cumulative annual inflation rate compounded over three years exceeds 100%
Bill and hold sales
when the economic title may not truly pass to customers after sale
When can a private equity portfolio company's valuation multiples be forecasted more accurately?
when the exit is anticipated within a year or two; beyond this time horizon, the exit valuation multiple becomes much more uncertain
Unbiased predictor
when the forward rate is equal to the expected future spot rate, the forward rate is an unbiased predictor of the future spot rate
Normal contango
when the futures price is higher than the expected spot price in the future
Normal backwardation
when the futures price is lower than the expected spot price in the future, meaning a long position in commodity futures should have a positive expected return
Debt sustainability mechanism (in the context of currency account deficits leading to depreciation)
when the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrowers currency
Elastic demand
when the percentage reduction in unit sales is greater than the percentage increase in price
Consolidation of SPEs under IFRS are required when:
when the sponsor has control. This is indicated by the following: 1) SPE benefits the sponsor 2) the sponsor has decision-making power 3) the sponsor is able to absorb rewards and risks 4) the sponsor has residual interest
The threat of forward integration by the supplier
when the supplier is interested in sharing the the value-added directly as an industry participant, not just a supplier, if they can't get the pricing power they want for their inputs.
Horizontal merger
when the two businesses operate in the same or similar industries and may often be competitors
Interest-only mortgage
when there is no principal repayment for either an initial period OR the life of the loan
When is the gordon growth model not reliable?
when used to estimate the equity risk premium in rapidly growing economies or in environments where estimates change rapidly.
When can you NOT use the z-spread?
when valuing bonds with embedded options, because without any interest rate volatility options are meaningless
A higher accruals ratio suggests better or worse earnings quality?
worse
Are nonoperating assets included in the asset-based valuation approach?
yes
Is fractional ownership calculated using the NPV method the same as using the IRR method?
yes, as long as the same compound rate is used the calculate the present value of the exit value and the future value of the VC investment
Is R&D considered a fixed or variable cost?
yes, but a short term fixed cost. (confirm this)
Does RVPI take carry into account?
yes; RVPI is net of carry
What information do you need in order to calculate IRR with leverage?
you need to consider the cash flows over the entire holding period, including the change in value of the original investment.
LIFO reserve must be disclosed if
you use LIFO. If you use FIFO or WAC, you do not need to disclose it.
In a purely competitive market, firms will theoretically have a persistence factor equal to
zero
Longer forecast periods result in the continuing residual income converging towards
zero
