CFA level 1 complete flashcards quizlet

greater than positivesubstitution Causes of demand changes Income Increases as prices of substitute goods increase Decreases as the prices of complement goods increasesCauses of supply c

1,905 terms mccauley04

CFA Level 1 Complete

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Sealed bid auction Each bidder submits one bid, which is unknown to the

other bidders and the bidder with the highest bid winsthe item and pays the price;

The reservation price is the highest price that a bidder iswilling to pay;

The optimal bid for the bidder with the highestreservation price is just slightly above the bidder withthe second highest reservation price;

Bids are not necessarily equal to reservation priceSecond sealed bid

auction (Vickrey

auction)

The bidder with the highest bid wins the item but paysthe price bid by the second highest bidder;

No reason for a bidder not to bid his reserve price;

Similar to a an ascending price auction, the winningbidder tends to pay one increment of price more thanthe bidder who values the time the second most

Perfectly elastic is when the demand curve is horizontal; Perfectly inelastic is when the demand curve is perfectlyvertical

Unstable equilibrium When a supply curve intersects a demand curve more

than once, the unstable equilibrium is an equilibriumwhere supply can increase towards another equilibriumthat results in a lower price;

Caused by a nonlinear supply functionStatutory incidence Who is legally responsible for paying a tax

Incidence of tax Who ends up bearing the cost of a tax

Substitution effect Always acts to increase the consumption of a good that

has fallen in priceIncome effect Either increase or decrease a good that has fallen in

price;

Typical of normal good to have a positive income effect; Typical of inferior good to have negative substitutioneffect

greater than positive

substitution

Causes of demand

changes

Income Increases as prices of substitute goods increase Decreases as the prices of complement goods increasesCauses of supply

changes

Rises if technology increases;

Rises if input prices decreaseGiffen good An inferior good for which the income effect outweighs

the substitution effect so that the demand curve ispositively sloped (higher the price, higher the demand)Relationship cost

curves

AFC slopes downward Vertical distance between ATC and AVC equals AFC

MC initially declines, then rises

MC intersects AVC and ATC at their minimums ATC and AVC are u-shaped

The MC above the AVC is the firm's short-rum supplycurve

Firm should stay in business for long-run

Profit maximized Producing up to but not over MR=MC;

Producing quantity where TR-TC is at a maximumPerfect competition Many firms compete with identical products, low

barriers to entry, and the only way to compete is onprice;

Perfectly elastic demand curves for each firm;

A firm will continue to expand production until marginalrevenue equals marginal cost, which maximizes profit orwhere MR = MC;

Economic loss occurs when marginal revenue is less thanmarginal cost;

Firm can't make economic profit in long-run;

Long-run equilibrium output is where marginal revenueequals marginal cost equals average total cost ;

An increase/decrease in market demand willincrease/decrease both equilibrium price and quantity; Short-run supply curve is the marginal cost curve abovethe average variable cost

Monopolistic

competition

Many firms that compete with differentiated products; Demand curve is downward sloping and is highly elastic; Quality, Price and Marketing are key differentiators ; Low barriers to entry;

Firms must advertise and innovate;

In short run maximize economic profits by producingwhere marginal revenue equals marginal cost ;

In long run, price equals average total cost andeconomic profits are 0

Oligopoly Only a few firms compete and each must consider the

actions of others when setting price and strategy;

High barriers to entry;

Demand is less elastic than monopolistic competitionMonopoly Only one seller in the market and there are no good

substitutes;

High barriers to entry;

Maximize profit, not price;

Profit maximized when marginal revenue equals marginalcost when demand curve is above ATC

Natural monopoly When the average cost of production is falling over the

relevant range of demand and having two or moreproducers would lead to hire production costs and hurtthe consumer

Marginal cost pricing Forces the monopoly to reduce price to the point where

the firms marginal cost curve intersects the marketdemand curve

Oligopoly models -Kinked demand curve

-Cournot duopoly -Nash equilibrium -Dominant firm modelKinked demand curve Based on the assumption that an increase in a firm's

product price will not be followed by its competitors,but a price decrease will;

Firms assume that demand is more elastic above acertain price than below it;

Firms produce the quantity at the kink, assuming if theyincrease production, their revenues will be eroded bydecreased prices and if they decrease production theprice won't go up much;

Model doesn't account for cause of kinksCournot duopoly One firm will look at the other's price and production

and adjust accordingly until both firms meet at anequilibrium of the same price and quantity

Nash equilibrium When the choice of all firms are such that there is no

other choice that makes any firm better off;

Each decision maker will unilaterally choose what's bestfor himself

Dominant firm model When a firm with the vast majority prices smaller firms

out of the market over time by lowering prices to thepoint where it falls below the average total cost ofsmaller competitors

Concentration

measures

Nth firm indicator Herfindahl-Hirschman IndexNth firm indicator How much market share is held by the top N firms in the

= (Historical Return - Return Threshold)/(Volatility) Shortfall risk is the probability of being to the left of theminimum return

Lognormal Distribution The function e^x where x is normally distributed;

Positively skewed;

Bound to the left by 0

;Price relative is the ending price divided by the startingprice

entities over timeCentral Limit Theorem For simple random samples of size n from a population

with a mean u and a finite variance o, the samplingdistribution of the sample mean x approaches a normal

distribution with mean u and a variance equal to thepopulation variance divided by the number of sampleobservations

Standard Error Dividing the sample variance by the square root of the

number of observations since the populations standarddeviation is rarely known

to fall under;

When a distribution has a known population variance,found by:

(sample mean) (+\-) (z-statistic) * (standard error);

When distribution population variance is not known,found by:

(sample mean) (+\-) (t-statistic) * (standard error)T-Distribution A bell shaped distribution symmetrical about its median

used to make confidence intervals with small samples(<30) and unknown population variance;

Degrees of freedom = # of Observations - 1Process for Testing

Hypothesis

+State Hypothesis +Select Test Statistic +Specify Level of Significance +State Decision Rule Regarding Hypothesis +Calculate Sample Statistics

+Make a Decision about Hypothesis +Make a Decision Based on TestNull Hypothesis What you are testing

Alternative Hypothesis What is concluded if null is rejected

Type I Error Rejecting the null when it is true;

Significance level is probability of Type I errorType II Error Not rejecting a false null

Power of Test Probability of correctly rejecting the null;

Found by subtracting the probability of a Type II errorfrom 1

Z-Test Used to calculate a mean when population is known to

be normally distributedT-Test Used to compare two means when population is known

to be normally distributedChi-Squared Test Used to test hypothesis about one variance

Parametric Tests Rely on assumptions regarding the distribution of the

population and are specific to population parametersNonparametric Tests Do not make any assumptions about the population and

are used when parametric tests cannot beSpearman Rank

X = increase one box size

O = decrease one box sizeRelative Strength The asset's price charted against the index price

Reversal Pattern When a trend approaches a range of prices but fails to

continue beyond that rangeSentiment Indicators Discern the potential views of buyers and sellers

Put/Call Ratio Put volume divided by the call volume;

The higher the ratio, the more negative the sentiment; Sentiment indicator

Volatility Index (VIX) Measures the volatility of options on the S&P 500 index;

The higher the level, the more scared the market;

Sentiment indicatorMargin Debt An increase in the number indicates bullish sentiment;

Sentiment indicatorShort Interest Ratio The short interest divided by the average daily trading

volume;

Can indicate a bearish sentiment but also an upcomingspike from shorts closing positions;

Sentiment indicatorMutual Fund Cash

Position

Ratio of a mutual fund's cash to its total positions;

Increases in a down market, decreases in an up marketCycle Theory +Presidential Cycle = 4 years

+Decennial Cycle = 10 years +Kondratieff Wave = 54 yearsF-Test Statistic Examines two sample variances, with the larger in the

denominator and smaller in the numeratorTest's Significance The probability that a true null hypothesis will be

rejected by chanceCoefficient of Variation Standard deviation divided by the mean

Contents of Footnotes +The basis of presentation such as the accounting period

+Information about the accounting methods used +Additional information about extraordinary eventsContents of

Contents of Auditor's

Opinion

+Independent view of the firms financial statements +Generally accepted accounting policies were used andjudgements were reasonable

+Explanation when accounting policies change fromyear to year

Auditor's Opinions +Unqualified opinion

+A qualified opinion +An adverse opinion +A disclaimer opinionUnqualified auditor's

Adverse auditor's

opinion

The statements are not presented fairly or don't conform

to standardsDisclaimer auditor's

4 Financial statements are made from the adjusted trialbalances

+10-K +10-Q +DEF-14A +8-K +144 +Forms 3, 4, 5Form S-1 Filed before sale of a new security

Form 8-K Discloses material events

Form 144 Notice to the SEC of a sale of non-registered securitiesForms 3, 4, 5 Notices of insider ownership

Conceptual

Framework

+Assets +Liabilities +Equity +Income +ExpensesGoing Concern

financial statements

+Fair presentation +Going concern basis +Accrual basis

+Consistency +Materiality +Aggregation of only similar items +No offsetting of assets against liabilities or revenuesagainst expenses unless explicitly stated by a standard +Reporting frequency is annual

Differences between

IFRS and GAAP

+IASB lists income and expenses as elements related toperformance, GAAP includes revenues, gains, loses andcomprehensive income

+GAAP defines an asset as having future economicbenefit, IASB defines an asset as a resource for which a

future economic benefit is probable +GAAP doesn't allow for the upward valuation of mostassets

Characteristics of a

coherent financial

framework

+Transparency +Comprehensiveness +Consistency

Barriers to Creating a

Coherent Financial

Framework

+Valuation +Standard setting +Measuring value at a point in time versus it's movementover a period of time

Why Firms Support

One Set of Reporting

Standards

Would reduce the cost and the time spent on reporting

Long Lived Assets:

IFRS v GAAP

Disclosures are more extensive under GAAP

Unrealized

Gains/Losses on Held

For Trading Securities

Included in net income

Unrealized

Gains/Losses on

Securities Available For

Sales

Included in comprehensive income

Bond Indenture The contract that specifies all the rights and obligations

of the issuer and the owners of a fixed income securityZero-Coupon Bonds Do not pay periodic interest;

Sold at a discount and pay par value at maturityStep-Up Notes Coupon rates increase over time at a specified rateDeferred-Coupon

Bonds

Initial coupon payment is delayed;

Interest accrues and is paid as a lump sum;

Coupons paid regularly after the first

Floating-Rate Bonds Coupon payments are based on another rate or index;

Reference rate is the underlying rate;

Payment is a specified spread applied to the referencerate;

Indenture lists schedule of rate changesCum Coupon When the buyer is entitled to the next couponn

Ex-Coupon When the buyer does not get the next coupon

Non-Amortizing

(Bullet) Bonds

Pays interest until maturity, then principal is repaid

Amortizing Bonds Pay periodic interest and principal payments over the life

series of payments over the life of the issuance;

In a cash payment, the issuer can deposit the requiredcash amount annually to a trustee, who will randomlycall a portion of the issuance back;

In a delivery of securities, the issuer purchases bondswith a total par value equal to the amount that is to beretired in that year in the market and deliver them to thetrustee who will retire them;

Prices

Redemption prices from a sinking fund or governmentmandated sale

Repo Agreement An arrangement by which an institution sells a security

with a commitment to buy it back at a later date for ahigher price

Term Repo Repo lasting longer than a day

Risks of Bonds +Interest rate risk

+Yield curve risk +Call risk

+Reinvestment risk +Credit risk

+Liquidity risk +Exchange rate risk +Inflation risk +Volatility risk +Event risk +Sovereign riskInterest Rate Risk The effect of changes in bond rates on bond valuesYield Curve Risk Possibility of a change in the shape of the yield curveCall Risk As interest rates fall, an issuer is more likely to call its

bonds and refinance at a lower rateReinvestment Risk Not being able to reinvest money at the same rate of

return if interest rates fall and issuers call bonds orprepay loans

Credit Risk Chance the creditworthiness of an issuer will decreaseLiquidity Risk Chance a bond will be sold at less than market price due

to a lack of liquidityExchange Rate Risk Uncertainty about the value of foreign currency cash

flows to an investor in terms of his domestic currencyInflation Risk Uncertainty of future inflation rates and decreased real

return ratesVolatility Risk Chance of increased interest rate volatility causing

prepaymentsEvent Risk Effects from factors outside of financial markets

Sovereign Risk Credit risk of a sovereign bond outside of the investor's

home marketPar Bond When the bond's coupon rate equals the market yield;

Bonds are typically issued near par valueDiscount Bond Bond priced below its par value;

Yield required in the market rises, causing prices to fallPremium Bond Bonds priced above the bond's par value;

Yield required in the market decreased, causing prices

to riseDuration Bond's interest rate sensitivity;

The ratio of the percent change in price to the percentchange in yield;

= (- Percent Change in Bond Price)/Yield Change inPercent;

Longer maturities have longer durations;

Lower coupon rates have higher duration;

Callable bonds have lower duration;

Putable bonds have less duration risk

Reasons Floating Rate

Might Reset at Par

*Placing a cap on a floating rate can increase the interestrate risk

*There is time until the next reset

*If the spread in indenture no longer reflects the creditand liquidity risk of the bond

Parallel Shift Shift in the curve is when the entire curve shifts by the

same amountNon-Parallel Shift When not all maturities change by the same amountDisadvantages of

Callable Bonds

+Uncertainty about cash flow stream +Principal tends to be returned at times when thepossibilities for reinvestment are less attractive +Capital appreciation potential is less than an option-free bond

+Corporate Restructuring +Regulatory Issues

Ways to Issue

Sovereign Debt

*Single price, regular auction cycle

*Multiple price, regular auction cycle

*Ad hoc auction services

*Tap system

Single Price, Regular

previously issued bondsTypes of Treasury

Securities

+Treasury Bills +Treasury Notes and Bonds +TIPS

Treasury Bills Maturities of less than a year and do not make explicit

Notes have maturities of 2, 3, 5, and 10 years;

Until 1984, were callable every 5 years;

Bonds have maturities of 20 or 30 yearsBond Pricing Prices quoted in percent and 32nds of a percent;

102-5 is equal to $102.16 per bondTIPS Inflation protected 5 and 10 year notes and 20 year

for changes to the CPI;

COUPON IS PAID ON ADJUSTED PAR VALUE;

Bond holder gets the greater of $1,000 or the finaladjusted par value at maturity;

The par value increase is taxed as income in that year

On The Run Issues Most recently auctioned treasury issues;

More actively traded than other issuances;

Provide best informationTreasury Strips Treasury securities that are sold in bulk to large dealers,

who then strip out the coupons from principal,repackage the cash flows, and sell them separately aszero-coupon bonds;

Coupon strips are strips created from coupon paymentsstripped from the original security;

Principal strips refer to principal payments with thecoupons stripped off;

Taxed on their implicit interest rateAgency Bonds Securities issued by various agencies and organizations

of the Federal government;

Most aren't guaranteed by US Government explicitly, but

it is implicit;

Federally related institutions are owned by the USGovernment and are exempt from SEC rules and areguaranteed by US Gov't;

Government sponsored enterprises are privately ownedbut publicly chartered organizations and were created

by Congress but not guaranteed by US Gov'tFederally Related

Self-amortizing and can be paid early;

Issued by Ginnie Mae, Fannie Mae and Freddie Mac; Cash flows are of periodic interest, scheduled principalrepayments, and unscheduled principal payments; Mortgage pass through securities pass payments made

on a pool of mortgages through proportionally to eachsecurity holder;

Collateralized mortgage obligations are derivatives ofmortgage passthroughs;

Stripped mortgage-backed securities are eitherprincipal or interest portions of a mortgage backedsecurity

Tax Backed (General

Obligation Bonds

Backed by unlimited taxing power of the issuer;

General obligationDouble-Barrel Bonds Backed by both taxes but also special charges that are

collected outside of the general fund;

General obligationAppropriations Backed

Obligations

When the state isn't the issuer but can act as a back up ifthe issuer defaults;

General obligationDebt Supported by

funded by the proceeds of the issuance;

Only required to pay interest and back principal if theproject generates a sufficient amount of revenueInsured Bonds Carry a third-party guarantee that cannot be cancelled

and is good for the life of the bond;

Usually raises rating to AAA;

More common for a revenue bond than generalobligation

Prefunded Bonds Bonds for which Treasury securities have been

purchased and placed in escrow to make all of theremaining required bond payments;

Income and principal from Treasuries must be enough tocover remaining payments until maturity or next calldate;

Have little credit riskFirm Specific Credit

Factors

*Past payment history

*Quality of management and their ability to adapt tochanging conditions

*Industry outlook and firm strategy

*Overall debt level of firm

*Operating cash flow and ability to service debt

*Sources of liquidity

*Competitive position, regulatory environment and unionhistory

*Financial management and controls

*Susceptibility to event and political riskIssue Specific Credit

Factors

*Priority of claim being rated

*Value/quality of collateral pledged to issuance

Unsecured Debt Credit

Inverse Floater Structured note increase when reference rates decrease

and vice versa

Deleveraged Floater Structured note that has coupon rates that equal a

fraction of the reference rate plus a constant marginDual Index Floater Structured note that has two reference rates

Range Notes Floaters that equal the reference rate if it is within a

specific range or zero if it is outside the rangeIndex Amortizing

Certificates of Deposit Issued by banks and sold to their customers;

A promise by the bank to repay a certain amount plusinterest;

Issued in specific denominations and for specifiedperiods of time that can be of any length;

Penalty if funds are withdrawn earlier than the maturitydate

Banker's Acceptance Guarantees by a bank that a loan will be repaid;

Part of a commercial transaction;

Gives assurance to counterparty that financing is securefor the trade;

Counterparty can sell the acceptance in a secondarymarket or hold until it is paid;

Credit risks are the borrower does not repay or theacceptance bank does not pay

Collateralized Debt

Obligation

Debt instrument where the collateral for the promise topay is an underlying pool of other debt obligations; Tranches are created for seniority of cash flows

Arbitrage CDO Created by a sponsor seeks to profit from the spread

between the rate earned on the underlying assets andthe rate promised to CDO holders

Balance Sheet CDO Created by a bank to reduce its loan exposure on its

balance sheetUnderwritten Issues When a banker purchases the entire issue and resells it;

Arrangement is called a firm commitment;

Deal is called a bought deal;

Typically a syndicate of other banks is put together tohelp sell issue;

Goal is to presell as much of the debt as possible

Best Efforts Sale When the banker agrees to sell as much of the issue as

not required to be registered with the SEC;

Issue can be better tailored for the investors' needs; Buyers will require a slightly higher interest rate sinceissue can not be resold to the public

Interest Rate Tools of

the Fed

+Discount rates +Open market operations +Bank reserve requirements +Persuading banks to change credit policiesShapes of Yield Curve +Normal (upward sloping)

+Inverted (downward sloping) +Flat

+HumpedInterest Rate Theories +Pure Expectations Theory

+Liquidity Preference Theory +Market Segmentation Theory

Liquidity premium can distort information coming fromthe yield curve

Treasury Spot Rates

The rates for different time periods that correctly value aTreasury bond;

Discount rates for a zero-coupon bondYield Spreads +Absolute yield spread

+Relative yield spread +Yield ratio

Absolute Yield Spread The difference between yields on two bonds;

= Higher Bond Yield - Lower Bond Yield;

Most commonly used;

Shortcoming is it may always remain constant even asyield rise or fall

Relative Yield Spread The absolute yield spread as a percentage of the

benchmark bond's yield;

= Absolute Yield Spread/Yield on Benchmark BondYield Ratio The ratio of the yield on the subject bond to the yield on

the benchmark bond;

= Subject Bond Yield/Benchmark Bond Yield;

= 1 + Relative Yield Spread

Credit Spread The difference in yields between two issues that are

similar in all respects except credit rating;

Decline in an expanding economy;

Increase during economic contractionsAfter-Tax Yield = Taxable Yield * (1 - Marginal Tax Rate)

LIBOR The rate paid on negotiable CDs by banks and bank

branches located in London;

Most important reference rate for floating-rate debtFunded Investor Investor who borrows to finance an investment positionCapital Budgeting

process

identifying and evaluating capital projects projectswhere the cash flow to the firm will be received over aperiod longer than a year

Capital Budgeting

Steps

1) idea generation 2) analyzing project proposals 3) create the firm-wide capital budget 4) monitoring decisions and conducing a post-audtiCap Budgeting

Externalities effects the acceptance of a project may have on other

firm cash flows

Cannibalization when a new project takes sales from an existing productConventional Cash

Flow Patter

sign on the cash flows changes only once, with one ormore cash outflows followed by one or more cashinflows

Internal rate of return discount rate that makes the PV of the expected

incremental after-tax cash inflows just equal to the initialcost of the project

PV (inflows) = PV (outflows)

IRR decision rule determine required rate of return for given project

IRR > required rate return, accept IRR < required rate return, rejectPayback period number of years takes to recover initial cost of

investmentPayback period = full years until recover + (unrecovered cost at beginning

of last year / cash flow during last year)Discounted payback

period

uses present values of the projects estimated cash flows.Number of years takes a project to recover its initialinvestment in a PV term and must be greater than thepayback period without discounting

Profitability Index (PI) PV of a projects future cash flows divided by the initial

cash outlay

also 1+ (NPV / CFo)

PI Decision Rule PI > 1, accept project

PI < 1, reject projectCrossover rate NPV's are equal

Key advantage of NPV direct measure of the expected increase in the value of

the firm main weakness doesn't take consideration ofproject size

Key advantage of IRR measures profitability as a %, showing the return on each

dollar invested Provides info on margin of safety thatNPV does not

Disadvantages - 1) possibility of producing rankings of mutuall exclusiveprojects different from NPV analysis

2) possibility are multiple IRRs or no IRR for projectWeighted Average

Cost of Capital

marginal cost of capital (MCC) - discount rate cost of financing firms assets View as opportunity cost

Kd rate at which the firm can issue new debt

Kd (1-t) After-tax cost of debt t is firms marginal tax rate The

after tax component cost of debt, Kd (1-t) is used to calcWACC

Kce Cost of common equity Required rate of return on

common stock and is generally difficult to estimateWACC = (Wd)[Kd(1-t)] + (Wps)(Kps) + (Wce)(Kce)

Wd = % of debt in cap structure Wps = % preferred stock in cap structure Wce = % C/S in cap structure

Kcs = RFR +B [E(Rm) - RFR]

Dividend Discount

Model Kce =

Po = D1 / Kce - g Kce = (D1 / Po) + g (D1 / Po) +g

Bond yield + risk

premium Kce =

Bond yield + Risk Premium

Pure-play equity beta of a publicly traded firm that is engaged in a

business similar to, and with risk similar to, project underconsideration

Beta Asset = Bequity x [ 1 / 1 + ((1-t) D/E) ]

D/E: comparable company's debt-to-equity ratio

t : marginal tax rateBeta Project = Basset [ 1 + ((1-t) D/E) ]

Beta -estimated using historical returns data

-estimate is affected by which index is chosen torepresent market return

-revert toward 1 over time, and estimate may need to beadjusted for this tendency

-estimates for small-cap firms may need to be adjustedupward to reflect risk inherent in small firms

Country Risk Premium added to market risk premium when using CAPM

Sovereign yield spread general risk of developing country Difference in yields

between the developing countrys government bondsand T bonds of similar maturity

Revised Capm with

country risk premium

Kce = Rf + B [E (Rmkt) - Rf + CRP]

Country Risk Premium

=

Sovereign Yield Spread x (annualized std of equity index

of developing country / annualized std of sovereignbond mkt in terms of developed mkt currency)Marginal Cost of cost of the last new dollar of capital a firm raises As firm

Capital raises more and more capital, the costs of difference

sources of financing will increase Raising additionalcapital increases WACC

Shows WACC for differenc amounts of financingBreak Points occur at any time the cost of one of the components of

the company's WACC changesBreak Point = amount of capital at which components cost of capital

changes / weight of component in capital structureFlotation Costs fees charged by investment bankers when a company

raises external equity capital

incorrect treatment increase the WACC by a fixedpercentage and will be a factor for the duration of theproject because future project cash flows are

discounted at this higher WACC to determine NPVFlotation costs are a cash outflow that occurs at the initiation of a

project and affect the project NPV by increasing theinitial cash flow Correct way to account for flotationcosts is to adjust the initial project cost

Leverage amount of fixed costs a firm has

ex) operating expenses, building, equipment leases -Greater leverage leads to greater variability of the firmsafter-tax operating earnings and net income

Business risk risk associated with firms operating income and is result

of uncertainty about a firms revenues and expendituresnecessary to produce those revenues

Sales Risk uncertainty about firms sales

Operating Risk additional uncertainty about operating EARNINGS

caused by fixed operating costs

Financial Risk additional risk that a firm's common stockholders must

bear when a firm uses fixed cost (debt) financing LTleases also introduce risk

DOL = percentage change in EBIT / percentage change in sales

Q (P-V) / Q (P-V) - F

-

S - TVC / S - TVC - F

S - salesDFL = ratio of the percentage change in net income (or EPS) to

the percentage change in EBIT

% change in EPS / % Sales

or EBIT / EBIT - interest

DTL = combines the degree of operating leverage and financial

leverage DTL measures the sensitivity of EPS to change

in sales

= DOL x DFL

= (%ΔEBIT/%Δsales) x (%ΔEPS / %ΔEBIT) = (%ΔEPS /

%Δsales)Look back at formulas

for DOL and DFL

Convince yourself if no fixed costs, DOL = 1 and if nointerest cost DFL = 1 Values of 1 mean no leverage

Leverage & ROE ROE is higher using leverage than without Also increases

the rate of change for ROE ROE varies directly with thechange in EBIT

Breakeven quantity of

Sales

quantity of sales for which revenues equal total costs, sonet income is zero

Contribution margin difference between price and variable cost per unit, is

available to help cover fixed costs

Qbe (break even

Special Dividends favorable circumstances allow the firm to make a

one-time cash payment to shareholders, in addition to anyregular dividends the firm pays

Liquidating dividends when a company goes out of business and distributes

the proceeds to shareholders Treated as a return ofcapital and amounts over the investors tax basis aretaxed as capital gains

Stock Splits divide each existing share into multiple shares, thus

creating more shares No change in wealthAfter splits or

dividends - trend

- stock prices tend to rise after

- price increases appear because splits are taken as apositive signal from mgmnt about future earnings -If no good earning report, stock prices revert tooriginal levels

-tend to reduce liquidity due to higher percentagebrokerage fees on lower-priced stocks

Create more shares but do not increase shareholdervalue

Reverse Stock Splits opposite of stock splits Fewer shares outstanding but

higher priced stock

Declaration Date date the board of directors approves payment of the

dividendEx-dividend date first day a share of stock trades without a dividend

Occurs two business days before the holder-of-recorddate If buy a share on or after the ex-dividend date, youwill not receive the dividend

Holder-of-record date date on which the shareholders of record are

designated to receive the dividend

Payment Date Date the dividend checks are mailed out - sent

electronicallyShare repurchase transaction in which a company buys back shares of its

own common stock

Buy in open market companies may repurchase stock in open market at the

prevailing market price.

Buy a fixed number of

shares at a fixed price

Company may repurchase stock by making a tendoroffer to repurchase a specific number of shares at aprice that is usually at a premium to the current marketprice

Repurchase by direct

negotiation

companies may negotiate directly with large shareholder

to buy back a block of shares, usually at a premium tothe market price Will reduce number of shares out, andincrease EPS

Share repurchase if

after-tax cost of

borrowing is less than

earnings yield (vice

versa)

share repo will increase company's EPS (vice versa)

EPS after buyback = (total earnings - after-tax cost of funds) / shares

outstanding after buybackBVPS BVPS will decrease if the purchase price is greater than

the original BVPS and increase if the repo price is lessthan the original BVPS

Drag on liquidity delay reduce cash inflows, or increase borrowing costs

-uncollected receivables and bad debts, obsoleteinventory

Pulls in liquidity accelerate cash outflows

-paying vendors soonerCost of trade credit = (1 + (% discount / 1 - % discount)) ^ (365/days past

Revolving line of credit more reliable source of short-term financing than a

committed line Typically for longer terms thancommitted, sometimes as long as years

Bankers acceptances used by firms that export goods Guarantee from bank

of firm that has ordered goods stating that a paymentwill be made upon receipt of goods

Factoring Actual sale of receivables at a discount from their face

values Size of discount will depend on how long it isuntil the receivables are due, creditworthiness of firmscredit customers, and firms collection history onreceivables

Nonbank finance

companies

smaller firms or firms with poor credit use for short-termfunding

Commercial paper large creditworthy companies can issue short-term debt

securities called commercial paper Firm sells paperdirectly to investors (direct placement) or sells throughdealers (dealer-placed paper), interest costs slightly lessthan rate can get from bank

Pro-forma balance

sheets / IS

forward-looking financial statements that areconstructed based on specific assumptions about futurebusiness conditions and firm performance (don't

confuse with proforma financial statements)Constructing Sales

Driven Pro Forma

Financial

1 - estimate relation tween changes in sales and changes

in sales-driven income statement and bal sheet items

2 - Estimate future tax rate, i rate on debt, leasepayments

3 - Forecast sales for period of interest

4 - Estimate fixed operating costs and fixed financialcosts

5 - Integrate these estimates into pro forma financialstatements for period of interest

Surplus difference between projected growth in assets and

projected growth in liabilities and stockholders equityCorporate governance set of internal controls, processes, and procedures by

which firms are managed

Net Profit Margin = NI / Sales

= EBT x (1 - t) / SalesThe Compensation

if after-tax cost of debt < earnings yield = EPS increases

if after-tax cost of debt > earnings yield = EPS decreases

(or Forward Contract)

An agreement between two parties Buyer agrees to buy

an asset from a seller at a future date and priceestablished at the start It is a completely customized,OTC, product and includes forwards, futures and swaps.Contingent Claim Options - Give a buyer the right but not obligation to

buy/sell a security at a predetermined price and date.Includes OTC and exchange traded options

Purpose and Criticism

of Derivative Markets

Purposes:

Price discovery - often the contract closest to expirationserves as a proxy for the price of the underlying asset

Hedging - Companies want to lock-in a certain price for

a good they either rely on or produce in order to betterforecast their prices/costs

Criticisms:

Too complex, fail to do their job, legalized gamblingWhat role does

Arbitrage play in

determining prices and

Arbitrage keeps prices in line across markets, products

If arbitrage opportunities are available, they will be taken

promoting market

efficiency?

advantage of until the prices converge - "The Law ofOne Price"

What is a swap? A forward contract that is equivalent to a series of

forwards Usually, one cash flow is fixed, the other isvariable and tied to another rate (exchange rate, stockprice, commodity price) They are private transactions.Explain default risk for

both long and short

positions in a forward

contract

The contract is not settled unless both parties deliver ontheir side of the contract Default risk is counter-partyrisk in this case

Discuss how forward

What is LIBOR? The rate of eurodollars, LIBOR (London Interbank Offer

Rate) is the rate at which London banks lend USDs toother London banks

- the rate at which London banks lend USDs to otherLondon banks

Eurobor: Euro time-deposits The cost of borrowing

Euros from another bank Quotes issued by the ECB(European Central Bank).

How do you calculate

the cost of a $10,000,

30 day, 5.25%

Eurodollar deposit?

$10,000 x (1 + 0525(30/360)) = $10,043,750 in 30 days The convention is to use 360 days The quoted interestover 360 days is pro-rated and then added to the facevalue called "add-on interest."

calculate and interpret

the payoff of an FRA,

and explain each of

the component terms

What does 1 X 3 and 12

X 18 mean for an FRA?

10,000,000(((.06-.055)(180/360))/(1.06(180/360))) =

$24,272 Long makes money in this case

Notional principal ((Underlying rate at Exp - ForwardContract Rate)(Days in underlying

rate/360))/(1+Underlying rate at exp.(Days in underlyingrate/360))

FRA notation:

1 X 3 : Contract expires in 1 Month, underlying rate is 60day LIBOR (3 b/c it is total time, including contract timeincluded)

12 X 18 : Contract expires in 12 months, underlying rate

An agreement to buy/sell a certain amount of a currency

at a certain time for a certain rate Cash or deliverysettlement

What does it mean to

be long vs short in a

forward contract?

Long = Buyer Short = Seller

What are the methods

of settlement for a

forward contract?

Delivery = Seller delivers the good to the buyer Cash Settlement.= Buyer and Seller exchange the netcash value at the settlement date

Cash is much more commonWhat is a non-

margin in the securities

markets and margin in

the futures markets,

and explain the role of

Initial margin - a minimum amount deposited todemonstrate a commitment to pay the full value

Maintenance margin - an amount lower than the initialmargin If the balance of the margin account dropsbelow the maintenance margin, the account holder isrequired to deposit enough money to return the account

to the initial margin level or close the position and settlethe loss

Settlement price - the avg of the final few trades of theday

Variation margin: additional margin posted to meet initialmargin after losing more than the maintenance margin.describe price limits Limits: Absolute price change over the previous day

and the process of

marking to market, and

calculate and interpret

the margin balance,

given the previous

day's balance and the

change in the futures

price

allowed for a specific futures contract If price hits a limit,the futures contract has made a limit move Limit up, limitdown If a transaction cannot take place because of alimit, it is called locked limit

Marking to market: The clearinghouse can mark tomarket, intraday and collect losses, distribute gainsthrough daily settlement to keep loses from getting out

Via off-setting If a buyer has purchased a certain future,

it offers for sale the same security

to pay additional money and vice versa Thus, atsettlement, the futures price is multiplied by aconversion factor which attempts to balance out thevalue Since different bonds cost different amounts tobuy in the open market and get multiplied by differentconversion factors, the seller is still able to deliver the

"cheapest to deliver" bond which fulfills their obligation.Thus, it is assume that the cheapest to deliver bondunderlies the future

Stock Index futures: Quoted in the same magnitude asthe index (1187 for the S&P which is trading at 1185 etc.)but then is multiplied by a standard amount ($250 forS&P) to determine the actual price S&P futures expireMarch, June, Sept, and Dec on the Thursday before thethird Friday of the month Cash settled

Currency Futures: A much smaller market than currencyforwards Euro face value * conversion rate = price

Difference between

forwards and futures?

1) Futures are not private transactions 2) Futures are traded on a futures exchange 3) Futures are standardized

4) Futures have a secondary market 5) Futures are guaranteed against credit losses resultingfrom a counter-party's ability to pay

6) Futures contracts are regulated at the federal levelWhat types of options

exist?

Stock options, index options, bond options (primarilyOTC), interest rate options, currency options, options onfutures, commodity options, weather options, real

options

Define interest rate

caps, floors and

collars

Interest rate cap: a series of interest rate calls, expiring

on the floating loan reset dates

Interest rate floor: a series of interest rate puts, expiring

on the floating loan reset dates

Interest rate collar: Long cap, short floor or Short cap,long floor The short offsets the cost of the long azero cost collar

Define intrinsic value

and time value, explain

explain how option

prices are affected by

the exercise price and

the time to expiration

Higher the exercise price, lower the price of a call,higher the price of a put and vice versa

The greater the time till expiration, the higher the price

of the bought option

Describe the An agreement between two parties to exchange a series

characteristics of swap

contracts and explain

how swaps are

terminated (reading

72)

of future cash flows -initially, no cash is exchanged -payment is made at the settlement date through nettingunless the swap is initiated in two different currencies -The final payment is made on the termination date -The original time to maturity of the swap is called thetenor of a swap

-Swaps are subject to default risk and can be tricky tountangle If A misses a payment to B but A's swap (afterbeing discounted to present) is worth more than B's, thevalue of the swap will be used to settle the existingliability

*swaps are completely OTC

Swap Termination:

1) Can terminate the swap ahead of time, discount thecash flows and pay the net difference This can onlyhappen if both parties agree to do so in advance or ifboth parties agree to at the time

2) Terminate by setting up an off-setting swap Exposesyou to dual default risk Most likely, the off-setting swapwon't be perfect but at least the floating rate risk is nolonger present

3) Exercise an off-setting swaption an option to enzter into a sway at terms that are established in advance

Chapter 7 versus

Chapter 11 bankruptcy

protection

Ch 7 = protection for liquidation

Ch 11 = protection for reorganization

Describe the sources

of return and risk for a

+Information about the accounting methods used +Additional information about extraordinary eventsContents of

Management

+The basis of presentation such as the accounting period+Information about the accounting methods used

+Explanation when accounting policies change fromyear to year

Auditor's Opinions +Unqualified opinion

+A qualified opinion +An adverse opinion +A disclaimer opinionUnqualified auditor's

Accrual Accounts +State the objective and context

+Gather data +Process data +Analyze and interpret data +Report conclusions and recommendations +Update analysis

3 An initial trade balance is prepared at the end of theperiod to show the balance of each account andadjustments are then made

4 Financial statements are made from the adjusted trialbalances

+10-K +10-Q +DEF-14A +8-K +144 +Forms 3, 4, 5Form S-1 Filed before sale of a new security

Form 8-K Discloses material events

Form 144 Notice to the SEC of a sale of non-registered securitiesForms 3, 4, 5 Notices of insider ownership

Conceptual

Framework

+Assets +Liabilities +Equity