CFA Glossary Tuesday, May 31, 2011 Active portfolio management: justifications Why active portfolio management might add value in an efficient market environment? • Economic argument (logic) o If investors only invested in passively managed portfolios, then actively managed portfolios would cease to exist. As a consequence, inefficiencies will arise in securities markets and the resulting profit opportunities will lure active managers back thus enabling them to outperform passively managed portfolios. o (Incorrect description) If active managers were not able to consistently beat a passive investment strategy, investors would not be willing to pay high fees for active managers and funds under active management would cease to exist. Since there are many active managers, economic logic suggests they must be outperforming passive strategies. • Empirical evidence o Some managers have consistently produced excess returns relative to a passive strategy, suggesting skill rather than luck. Active portfolio management: justifications Why active portfolio management might add value in an efficient market environment? • Economic argument (logic) o If investors only invested in passively managed portfolios, then actively managed portfolios would cease to exist. As a consequence, inefficiencies will arise in securities markets and the resulting profit opportunities will lure active managers back thus enabling them to outperform passively managed portfolios. o (Incorrect description) If active managers were not able to consistently beat a passive investment strategy, investors would not be willing to pay high fees for active managers and funds under active management would cease to exist. Since there are many active managers, economic logic suggests they must be outperforming passive strategies. • Empirical evidence o Some managers have consistently produced excess returns relative to a passive strategy, suggesting skill rather than luck. Posted by Spanish Key at 2:17 PM No comments: Labels: A, CFA Level 2 (June 2011) Affirmative covenant A covenant calls upon a borrower (debt issuer) to do a certain thing (rather than restrictions on a certain ratio threshold/action). Posted by Spanish Key at 11:57 AM No comments: Labels: A, CFA Level 2 (June 2011) Tuesday, May 10, 2011 Accounting income Accounting income = Net income = Taxable income * (1-Tax rate) Taxable income = Operating income before tax - Interest expense Operating income before tax = Sales - Variable cash expenses - Fixed cash expenses - Depreciation = EBIT Posted by Spanish Key at 10:03 PM No comments: Labels: A, CFA Level 2 (June 2011) Wednesday, May 4, 2011 All-current method and Temporal method Local currency price: constant FC: depreciation (vs. DC) All-current method and Temporal method method Temporal in DC All-current Net income (before translation gains and losses) < D/E < Gross profit margin = (Revenue - COGS)/Revenue (A-H)/A < (A-A)/A COGS H > A Posted by Spanish Key at 2:07 PM No comments: Labels: A, CFA Level 2 (June 2011) Sunday, April 17, 2011 Acquisition: goodwill, amount reported in the B/S The pre-acquisition balance sheets 12/31/2007 in $ thousands Acquirer Target Target Book value/Fair value BV FV Assets Cash 710 100 100 Marketable securities 2,550 - - Inventory 2,000 400 400 Accounts receivable 3,000 500 500 PP & E 2,450 1,000 1,200 Total assets 10,710 2,000 2,200 Liabilities Accounts payable 3,310 400 400 Long-term debt 5,000 1,000 1,000 Equity 2,400 600 800 Total liabilities and equity 10,710 2,000 2,200 • On 12/31/2007, Acquirer purchased a 35% ownership interest in a strategic new firm called Target for $300,000 in cash. • The remaining useful life of the PP&E is 10 years with no salvage value. Both firms use the straight-line depreciation method. • For the year ended 2008, Target reported net income of $250,000 and paid dividends of $100,000. • During the first quarter of 2009, Target sold goods to Acquirer and recognized $15,000 of profit from the sale. At the end of the quarter, half of the goods purchased from Target remained in Acquirer's inventory. [Question] The amount of (partial) goodwill as a result of Acquirer's acquisition of Target is: 300,000 - 35% * 800,000 = 300,000 - 280,000 = $20,000 [Question] What amount should Acquirer report in its balance sheet as a result of its investment in Target at the end of 2008? Under the equity method, Original amount including goodwill + %ownership * (Net income - Dividends) - %ownership * Additional depreciation = 300,000 + 35% * (250,000 - 100,000) - 35% * ((1,200,000 - 1,000,000) - 0)/10 = 300,000 + 52,500 - 7,000 = 345,500 [Question] Which of the following best describes Acquirer's treatment of the intercompany sales transaction for the quarter ended 3/31/2009? Acquirer should reduce its equity income by: 15,000 * 50% * 35% = $2,625 Posted by Spanish Key at 8:47 AM No comments: Labels: A, CFA Level 2 (June 2011) Saturday, April 16, 2011 Acquisition method and Pooling of interest method IFRS Pooling of interest method Acquisition method Acquirer Acquirer Target Assets Book value Fair value Target Liabilities Book value Fair value Acquirer goodwill? No Yes (Question) Regarding the prior purchase that was accounted for under the pooling of interests method, had Acquirer reporeted this purchase under the acquisition method: A. the assets and liabilities of the purchased firm would not be included on Acquirer's balance sheet B. balance sheet assets and liabilities of the purchased firm would have been reported at fair value. C. reported goodwill could be less depending on the fair value of the identifiable assets and liabilities compared to their book values. Answer: B The assets and liabilities of the purchased firm are included on the balance sheet of the acquiring firm under either method. • Under the pooling method, there is no adjustment of balance sheet asset and liability values to their fair values (i.e. book value). o There is no goodwill reported under the pooling method; the purchase price is not reflected on the balance sheet of the acquiring firm. • Under the acquisition method, assets and liabilities acquired are reported at fair value at the time of the purchase. Posted by Spanish Key at 4:58 PM No comments: Labels: A, CFA Level 2 (June 2011) Monday, April 11, 2011 Acquisition method: consolidated current asset Acquirer →(45% ownership stake, $9 million in cash)→ Target Acquisition method: consolidated current asset acquisition Prior to Prior to After in $ millions Acquirer Target Acquirer (consolidated, acquisition method) Current asset 96 32 96-9+32 = 119 Total equity 80 16 Posted by Spanish Key at 9:51 AM No comments: Labels: A, CFA Level 2 (June 2011) Friday, March 11, 2011 Acquisition method, Equity method, and Proportionate consolidation: sample questions Acquisition Acquirer Target Accounting U.S.GAAP U.S.GAAP Purchase price - $185 million in cash (20% stake) Pre-Acquisition Balance Sheets (12/31/2010) in million $ Acquirer Target Current assets 13,900 716 PP&E 26,977 108 Total assets 40,877 824 Current liabilities 10,363 220 Other liabilities 11,121 8 Common stock 6,127 108 Retained earnings 13,266 488 Total liabilities and equity 40,877 824 Pro-Forma (i.e. projected) Income Statement (for the year ending 12/31/2011) in million $ Acquirer Target Revenue 66,176 2,176 Expenses 63,515 2,068 Net Income 2,661 108 Dividends 1,525 0 (Questions and Answers) 1. Assuming the acquisition goes through at the beginning of 2011, and that Acquirer will have a significant influence on Target, the total assets after acquisition would be: o 40,877 o The accounting for an ownership interest of between 20% and 50% in an associate is handled using the equity method. Acquirer also have a significant influence (NOT control) on Target. o Under the equity method, the initial investment is recorded at cost and reported on the balance sheet as a noncurrent asset. o Because the acquisition in this case is fully funded by cash, there will be no change to total assets for Acquirer. 2. The fair value of Target's other assets PP&E is $250 million. The amount allocated to goodwill would be: o 37.4 o (Partial) goodwill = Purchase price (cash) - Pro-rata book value of Target - Amount of excess purchase price allocated to PP&E = 185 - (108+488)*20% - (250-108)*20% = 37.4 o Full goodwill = 185/20% - (108+488) - (250-108) = 187.0 = 37.4/20% 3. For this question only, assume that as a result of the acquisition, Acquirer must depreciate an additional $50 million over a 10-year period to zero salvage value. Target's contribution to Acquirer's EBT for 2011 is projected to: o 16.6 o Equity income: 108*20% - (50-0)/10 = 16.6 4. For this question only, assume that the acquisition occurs on December 31, 2010, and that there is no additional depreciation expense as a result of the acquisition. Compared to its beginning of year investment balance, the balance for Acquirer's investment in Target on December 31,2011, will be lower, higher, or unchanged? o Higher o No calculations are required to solve this problem. o Acquirer's investment balance = Investment balance at the beginning of year + equity income - dividend paid (under no additional depreciation assumption) o Increase/Decrease to Acquirer's investment balance = Target's equity income - Target's dividend paid (under no additional depreciation assumption) o The equity income is positive Target had positive net income, and there is no additional depreciation expense to subtract. Additionally, Target is not expected to make any dividend payments for 2011. o Based on this, Acquirer's investment balance will increase. 5. "Since Target is profitable and pays no dividends, the equity method will result in higher net income than proportionate consolidation. Additionally, the equity method will result in lower return on assets (ROA) than the acquisition method with partial goodwill." Is this stament correct for both net income and ROA? o Under the condition above, the equity method, proportionate consolidation, and the acquisition method all report the same net income. o ROA is higher under the equity method than under proportionate consolidation because the equity method does report lower assets than proportionate consolidation. 6. If an analyst were to follow IFRS instead of U.S. GAAP, the accounting method predescribed for this type of investment would most likely be (A) the equity method, (B) the acquisition method, or (C) proportionate consolidation? o Equity method o When the investment constitutes 20% to 50% of the associate, and the investor has significant influence on the associate, IFRS prescribes the equity method for accounting for the invesment. Posted by Spanish Key at 8:20 AM No comments: Labels: A, CFA Level 2 (June 2011) Monday, February 28, 2011 Autoregressive Conditional Heteroskedasticity (ARCH) (Question) Squared Residuals Regression Coefficient Standard Error p-value Intercept 3.00 0.577 0.01 Lagged residual squared 0.28 0.185 0.31 From the data provided above, for a 5% level of significance, one should conclude that his or her AR(1) model exhibits: A. no autocorrelation. B. no autoregressive conditional heteroskedasticity (ARCH). C. no multicollinearity. Answer: B Autoregressive conditional heteroskedasticity refers to an autoregressive equation which the variance of the errors terms is heteroskedastic. (i.e., error variance is not constant.) The presence of ARCH is tested with the following regression: e t 2 = β 1 + β 2 * e t-1 2 + v t which serves as a proxy for: var(e t ) = β 1 + β 2 * var(e t-1 ) + v t The exhibit above indicates that the slope estimate in the ARCH equation is not significant (the t-statistic for the slope estimate of the ARCH equation is not significant.) Therefore, the squared error does not depend on its lagged value (i.e., if the slope value is zero, then the error variance equals the constant β 1 , which indicates no conditional heteroskedasticity in the AR model). ARCH is not present. Posted by Spanish Key at 8:26 AM No comments: Labels: A, CFA Level 2 (June 2011) Monday, February 21, 2011 After-tax cash flow for a replacement project A project would replace a portion of a company's equipment with new machinery expected to last three years. Current machinery item $ amount Book value 120,000 Market value 195,000 New machinery item $ amount Cost 332,000 ΔCurrent assets 190,000 ΔCurrent liabilities 80,000 Δ means the change in the dollar amount. Tax rate = 40% Time horizon of the project = 3 years New machinery Existing Equipment The project Increment Annual sales 523,000 708,000 708,000-523,000 = 185,000 Cash operating expenses 352,000 440,000 440,000-352,000 = 88,000 Annual depreciation 40,000 110,667 110,667-40,000 = 70,667 Accounting salvage value 0 0 0 Expected salvage value 90,000 113,000 113,000-90,000 = 23,000 (Question) Assuming that working capital will be recaptured at the end of the project, what is the final period after-tax cash flow for the project? Recaptured working capital at the end of the project = ΔCurrent assets - ΔCurrent liabilities = 190,000 - 80,000 = 110,000 Because the project is a replacement project, the incremental cash flows must be calculated. Total cash flow in the final period = Project cash flows + Return of net working capital + After-tax sale of fixed capital used in the project = (185,000-88,000-70,667)*(1-40%) + 70,667 + 110,000 + (23,000 - 0)*(1-40%) = 210,266.8 Posted by Spanish Key at 7:35 AM No comments: Labels: A, CFA Level 2 (June 2011) Sunday, January 30, 2011 Auto Loan ABS and Credit Card Receivable ABS Auto Loan ABS and Credit Card Receivable ABS Auto Loan ABS Credit Card Receivable ABS ABS backed by Amortizing assets (auto loan) Nonamorzing assets (credit card receivable) Collateral structure Generally does NOT change once the security is issued. (*1) Change during the lockout period. ("revolving structure") (*2) Call provision (*3) Usually included. Prepayment rate of the ABS when interest rates ↑ or ↓ NOT significantly affected (*4)NOT significantly affected (*5) (*1) The collateral simply gets smaller as the loans are paid off by the borrower. (*2) During the lockout period, principal payments on the collateral are used to purchase additional assets. (*3) A call provision causes cash flows to be directed at principal reduction, rather than purchasing new collateral assets. (e.g.) cleanup call : it is triggered by a decline in the value of the collateral. (*4) Because autoloans are short-term loans and the underlying asset (the automobile) has a tendency to rapidly depreciate in the early years, there is little incentive for borrowers to prepay the loan even if interest rates decline. Borrowers who take out an auto loan generally do not refinance their vehicles as interest rates decline. (*5) During the lockout period, any principal payments (and prepayments) are used to purchase additional collateral for the ABS. Thus, any change in prepayment rates induced by interest rate changes would be offset by additional purchases of collateral. A contraction, or extension, would be unlikely to occur. Posted by Spanish Key at 2:50 PM No comments: Labels: A, CFA Level 2 (June 2011) Tuesday, January 18, 2011 Acquisition: Form of integration & Type of merger Acquisition: Form of integration Form of integration Subsidiary • Maintain the successful target company's brand and operational structure. • Most subsidiary mergers occur when the target has a well-known brand that the acquirer wants to maintain. Statutory • The target company would cease to exisit as a separte entity. Acquisition: Type of merger Type of merger Horizontal • An acquirer and a target company are in the same industry. Vertical • An acquirer would be moving up or down the supply chain. Posted by Spanish Key at 10:02 AM No comments: Labels: A, CFA Level 2 (June 2011) Acquisition, Equity, and Proportionate consolidation method Accounting treatment method equity proportionate consolidation acquisition IFRS OK: Allowed OK: Preferred OK U.S. GAAP OK Generally NOT allowed (*) OK Net income +share(%) = +share(%) < +100(%) Total liabilities - < +share(%) < +100(%) Total assets - < +share(%) < +100(%) ROA > ? (*) Proportionate consolidation is not allowed except in very limited situations. Posted by Spanish Key at 7:46 AM No comments: Labels: A, CFA Level 2 (June 2011) Acquisition method and Equity method (U.S. GAAP) (Case) A U.S. company's 45% ownership stake in another U.S. company: Accounting treatment (U.S. GAAP) method equity acquisition Net income +share(%) < +100(%) Total asset - < +share(%) ROA >, <, or = Posted by Spanish Key at 7:29 AM No comments: Labels: A, CFA Level 2 (June 2011) Monday, January 17, 2011 APT and CAPM [...]... Spanish Key at 7:53 AM No comments: Labels: A, CFA Level 2 (June 2011) Tuesday, January 11, 2011 Amortizing asset and Non-amortizing asset Amortizing asset and Non-amortizing asset composition of the loans in the asset example pool Amortizing asset • auto loan Non-amortizing asset • credit card receivable Posted by Spanish Key at 8:57 PM No comments: Labels: A, CFA Level 2 (June 2011) does NOT change does... of the assets Posted by Spanish Key at 12:21 PM No comments: Labels: CFA Level 2 (June 2011), R CFO: indirect method in the presentation of CFO Adjustment to Net income related to the pension plan, ignoring income taxes CFO = NI + Pension expense - Employer's contributions Posted by Spanish Key at 12:10 PM No comments: Labels: C, CFA Level 2 (June 2011) Compensation expense related to the stock option... Spanish Key at 12:10 PM No comments: Labels: C, CFA Level 2 (June 2011) Compensation expense related to the stock option Compensation expense related to the stock option (per year) = Options granted * Option price on the grant date * (1/Service period in year) * Time from the grant date to fiscal year end Posted by Spanish Key at 12:08 PM No comments: Labels: C, CFA Level 2 (June 2011) Monday, May 30, 2011... No comments: Labels: C, CFA Level 2 (June 2011) Cash Flow Yield (CFY) • • dependent on prepayment assumptions o if prepayment rates differ from the assumption, the CFY will not be realized The reinvestment assumption of the CFY is a weakness The CFY calculation assumes that interim cash flows are reinvested at the CFY Posted by Spanish Key at 10:38 PM No comments: Labels: C, CFA Level 2 (June 2011)... comments: Labels: C, CFA Level 2 (June 2011) Wednesday, April 27, 2011 Capture hypothesis • The regulatory decisions favor an industry, because: o the regulatory bodies tend to have members who used to work in the industry o the industry has greater economic resources and incentives than consumers The industry "captures" the regulators Posted by Spanish Key at 11:38 PM No comments: Labels: C, CFA Level 2 (June... by Spanish Key at 4:43 PM No comments: Labels: C, CFA Level 2 (June 2011) Tuesday, April 5, 2011 consolidating SPEs on the balance sheet consolidating SPEs on the balance sheet (previously)equity method SPEs consolidated on the balance sheet Assets ↑ Net income → (no change) Equity → (no change) Posted by Spanish Key at 11:31 AM No comments: Labels: C, CFA Level 2 (June 2011) Monday, April 4, 2011 Callable... labor and machines more productive (3) In addition, the New Growth Theory states that knowledge is NOT subject to the laws of diminishing returns Posted by Spanish Key at 3:13 PM No comments: Labels: CFA Level 2 (June 2011), G Economic Growth: three sources 1 Physical capital growth 2 Human capital growth o (e.g.) Investment in human capital to boost literacy and technical skills 3 Technological advances... to the number of predictors, the value of R-Square and adjusted R-Square will be much closer because the ratio of (N-1)/(N-k-1) will approach 1 Posted by Spanish Key at 10:24 AM No comments: Labels: A, CFA Level 2 (June 2011) Sunday, May 30, 2010 Accrual Tranche (CMO) (e.g.) Investor's desired investment maturity and cash flow characteristics for CMO • • investment maturity: long-term investment (average... Monday, May 30, 2011 Capitalization of interest Capitalization of interest Capitalization of interest (to fixed assets) Net income ↑ CFI ↓ CFO ↑ Posted by Spanish Key at 5:04 PM No comments: Labels: C, CFA Level 2 (June 2011) Saturday, April 30, 2011 Convenience Yield • • The convenience yield decreases the futures price (like dividend yield) The price of an index futures contract is reduced by cash... accrual tranche does not pay interest but accrues it to principal, meeting the investor's need to not receive any cash flow for a number of years Posted by Spanish Key at 7:18 AM No comments: Labels: A, CFA Level 2 (June 2010) Friday, May 28, 2010 Accounting Income (AKA Net Income) Accounting Income = (Operating Income Before Tax - Interest Paid) * (1 - Tax Rate) = (Operating Income Before Tax - Capital . CFA Glossary Tuesday, May 31, 2011 Active portfolio management: justifications Why active portfolio. passive strategy, suggesting skill rather than luck. Posted by Spanish Key at 2:17 PM No comments: Labels: A, CFA Level 2 (June 2011) Affirmative covenant A covenant calls upon a borrower (debt issuer) to. a certain ratio threshold/action). Posted by Spanish Key at 11:57 AM No comments: Labels: A, CFA Level 2 (June 2011) Tuesday, May 10, 2011 Accounting income Accounting income = Net income